Blog Post

The ECB’s Magic Wand

This column was written as the editorial of the September/October 2012 issue of Intereconomics We know there is no magic. But after a clever trick by the magician and a wave of the magic wand, the audience still applauds for quite some time. The new magic wand of the European Central Bank (ECB), Outright Monetary […]

By: Date: October 1, 2012 Topic: European Macroeconomics & Governance

This column was written as the editorial of the September/October 2012 issue of Intereconomics

We know there is no magic. But after a clever trick by the magician and a wave of the magic wand, the audience still applauds for quite some time. The new magic wand of the European Central Bank (ECB), Outright Monetary Transactions (OMT), has so far resulted in the 2-year Spanish government bond yield falling from a 15-year record high of 6.9% in late July 2012 to below 3% in early September 2012. Longer maturity yields have also fallen somewhat.

Was the OMT move a wise decision? Are the criticisms that are being voiced justified? What is the OMT action good for and what are its limitations?

Let us try to imagine where the euro area would be heading without the OMT programme. Up to late July 2012, Spanish and Italian government bond yields were on an escalating path. The speculation that some struggling countries would exit the euro had increased, which led to increased capital outflows from southern eurozone members, fragmentation of credit markets across national borders, and lower consumer and investment demand, thereby negatively impacting output, employment, bank balance sheets and public finances.

Undoubtedly, several southern eurozone members face severe structural weaknesses, banking woes and perilous fiscal situations. But market reactions also depend on psychological factors, because pessimism is self-fulfilling. This vicious circle had to be broken or else the situation would have gotten out of control, with extremely detrimental effects for all euro area members (as well as for outsiders). The announcement by ECB President Mario Draghi on 26 July 2012 that a new instrument was in the making did exactly this: using only the power of words (i.e. without any actual intervention), the escalating trend in government bonds yields was reversed.

The ECB already put a similar programme in place in May 2010, the Securities Markets Programme (SMP), which had exactly the same purpose as the OMT: “to address the malfunctioning of securities markets and restore an appropriate monetary policy transmission mechanism”. But the SMP has been a major failure, as it had only temporary effects on bond yields, for several reasons. First, the modalities of the SMP were unclear: the ECB started and ended bond purchases without known guidelines. Second, the ECB communicated that the SMP was a limited programme, and a weekly cap was introduced in December 2011. Third, by claiming senior creditor status, ECB purchases increased the eventual losses of other bondholders in the case of a default. Fourth, concerning Greece, the SMP aimed at tempering the government bond market of a country with an unsustainable fiscal situation. Finally, the SMP was subject to moral hazard, exemplified by the Italian government’s backtracking on promised reforms in the summer of 2011, after the ECB began purchasing Italian bonds.

The OMT programme, which will also be conducted on secondary sovereign bond markets, differs from the SMP in major respects. The first is conditionality, i.e. compliance with a full or precautionary macroeconomic adjustment programme by either the European Financial Stability Facility (EFSF) or the European Stability Mechanism (ESM). ECB intervention will not be automatic, but the Governing Council will decide on a case-by-case basis when and to what extent it will intervene. Second, OMT will be unlimited in principle. Third, the ECB will be treated pari passu with other creditors, i.e. the ECB will not have any preferential treatment in the case of a credit event. Furthermore, the transparency of OMT purchases will be greater (the breakdown by country and the average duration of holdings will be published). Moreover, there is clarity on the maturity of eligible bonds, i.e. between one and three years, which is the relevant horizon for monetary transmission. These characteristics likely constitute the outer limit of what is feasible within the ECB’s mandate.

Several criticisms have been voiced, e.g. that the OMT would finance unsound states and lead to a redistribution of wealth from the healthy to the troubled states, that it is a reflection of the politicisation of central banking, that the distinction between monetary and fiscal policies has now disappeared, that it increases the power of the ECB to decide on the fate of governments, that countries receiving support from the ECB will ease back on painful structural reforms, that the OMT action is tantamount to central bank financing of governments, and that it will create inflation.

However, most of these criticisms have neglected to take notice of the major condition, i.e. the EFSF/ESM programme. Entering a programme and assessing compliance, therefore, will remain the province of the member states, and thus e.g. the German Bundestag will also have to approve all new programmes. The ECB can only decide afterward. This ensures that unsound states will not be able to benefit from the OMT, that the OMT will not be used for wealth redistribution, that monetary and fiscal policies wouldn’t be merged, that countries cannot easily backtrack from agreed reforms, and that the ECB will not have to decide on the fate of governments. The politicisation argument does not deserve a word.

The criticism of the “central bank financing of government” also rests on weak grounds. The ECB would purchase bonds only on secondary markets, not new bonds issued to finance budget deficits. The goal of the OMT is not to reduce borrowing costs to an artificially low level, but to prohibit interest rate increases which are not justified by economic fundamentals. For example, I would not expect ECB intervention at Spain’s current 3% borrowing rate for bonds with 2-year maturities.

The inflation criticism is also unjustified. OMT would be used only in a crisis situation, which is characterised by recession, weak consumer and investment demand, and insufficient bank lending to the economy. Such circumstances are not conducive to inflation. Also, the ECB will fully sterilise its OMT purchases, i.e. take back the money created by the OMT through other means.

Nonetheless, the OMT magic wand is not a panacea either.

First, the OMT action cannot solve the euro crisis and cannot fully eliminate the risk of a euro area exit. The OMT can contain a self-fulfilling bubble in bond yields and help monetary transmission when things are not too bad, ie it can buy precious time. But the exit risk will remain until robust economic growth and job creation start in southern economies, which in turn depend on a number of other factors, and unfortunately the outlook is not bright in this regard.

Second, the OMT programme cannot address the competitiveness problems of southern European countries. In fact, so far it has worsened the situation by leading to an appreciation of the euro. Yet a weaker euro would help southern economies to improve their trade balances with non-euro countries and would also boost German exports. This in turn would help to address intra-euro imbalances, since increased exports would likely translate into greater wage increases in Germany, due to the country’s tight labour market, but not in Spain, due to its high unemployment. Thus, Spain’s competitiveness vis-à-vis Germany would also improve. Without a weaker euro, Spain would need to enter a deflationary period, which on the one hand is difficult to achieve and on the other would make debt sustainability even more difficult. The ECB therefore should consider further interest rate cuts and quantitative easing as well, which would be justified by the weak economic outlook and would also weaken the euro.

Third, even if governments seeking assistance wish to comply, they may not be able to due to either inefficiencies in public administration or a deeper than expected recession, which has so far been the rule rather than the exception concerning the macroeconomic forecasts of southern economies. If the OMT programme is started for a country, its abrogation in the event of non-compliance would likely lead to a disorderly default. Yet in such a case, the ESM programme should also be abrogated, which would have similarly disastrous consequences even without OMT; thus, the OMT programme does not add much downside to the adverse outcome.

Notwithstanding these caveats, it was a wise decision to launch the OMT programme, given the alternative of an escalation of the euro crisis. It has worked like a magic wand, as government bond yields have fallen without any actual intervention. Let us hope that the time during which the audience is applauding will be used wisely and that politicians will not impair the magic power of the OMT by mismanaging other aspects of the euro crisis.


Republishing and referencing

Bruegel considers itself a public good and takes no institutional standpoint. Anyone is free to republish and/or quote this post without prior consent. Please provide a full reference, clearly stating Bruegel and the relevant author as the source, and include a prominent hyperlink to the original post.

Read article
 

Blog Post

Will European Union recovery spending be enough to fill digital investment gaps?

The recovery facility will boost digital transformation, but questions remain whether it will be sufficient to achieve Europe’s digital ambitions.

By: Zsolt Darvas, J. Scott Marcus and Alkiviadis Tzaras Topic: European Macroeconomics & Governance, Innovation & Competition Policy Date: July 20, 2021
Read about event More on this topic
 

Upcoming Event

Sep
1
12:30

The EU recovery fund - state of play and outlook

Bruegel Annual Meetings, Day 1- In this session we will discuss the EU recovery fund, its state of play and outlook.

Speakers: Nadia Calviño, Karolina Ekholm and Guntram B. Wolff Topic: European Macroeconomics & Governance Location: Bruegel, Rue de la Charité 33, 1210 Brussels
Read about event More on this topic
 

Upcoming Event

Sep
2
10:00

Conversation on the recovery programmes

Bruegel Annual Meetings, Day 2- In this session, we discuss the recovery programmes.

Speakers: Maria Demertzis, Henry Foy and Tadeusz Kościński Topic: European Macroeconomics & Governance Location: Palais des Academies, Rue Ducale 1
Read about event
 

Upcoming Event

Sep
2
13:00

European banks: under global competitive pressure?

Bruegel Annual Meetings, Day 2 - European banks have lost stature and remain generally low-profitability, low-valuation in comparison to their global peers. Is that a problem? If so, what can EU policymakers do to address it?

Speakers: José Antonio Álvarez Álvarez, Mairead McGuinness and Nicolas Véron Topic: European Macroeconomics & Governance, Finance & Financial Regulation Location: Palais des Academies, Rue Ducale 1
Read about event More on this topic
 

Upcoming Event

Sep
2
15:45

Blending physical and virtual: shaping the new workplace

Bruegel Annual Meetings, Day 2 - This panel will cover the changes the COVID-19 pandemic made to our workplaces, and what to expect in the near future.

Speakers: Nicholas Bloom, Michael Froman, Mario Mariniello, Sara Matthieu and Luca Visentini Topic: European Macroeconomics & Governance Location: Academy Palace
Read about event More on this topic
 

Upcoming Event

Sep
3
09:00

The role of the EU's trade strategy for an inclusive and sustainable recovery

Bruegel Annual Meetings, Day 3 - We are delighted to welcome Valdis Dombrovskis, Executive Vice President of the European Commission for An Economy that Works for People to talk about Europe's trade strategy.

Speakers: Valdis Dombrovskis, Alicia García-Herrero and Guntram B. Wolff Topic: European Macroeconomics & Governance Location: Palais des Academies, Rue Ducale 1
Read about event More on this topic
 

Upcoming Event

Sep
3
10:15

Conference on the Future of Europe: envisioning EU citizens engagement

Bruegel Annual Meetings, Day 3 - Panellists will discuss different options and what they may entail while revisiting the debates on the future of Europe at national and EU-level that have been conducted thus far.

Speakers: Caroline de Gruyter, Kalypso Nicolaïdis, Niclas Poitiers and György Szapáry Topic: European Macroeconomics & Governance Location: Palais des Academies, Rue Ducale 1
Read article Download PDF
 

Policy Contribution

A new direction for the European Union’s half-hearted semiconductor strategy

The EU needs a more targeted strategy to increase its presence in this strategic and thriving sector, building on its existing strengths, while accommodating its relatively low domestic needs.

By: Niclas Poitiers and Pauline Weil Topic: European Macroeconomics & Governance, Innovation & Competition Policy Date: July 15, 2021
Read article More by this author
 

Blog Post

Fit for 55 marks Europe’s climate moment of truth

With Fit for 55, Europe is the global first mover in turning a long-term net-zero goal into real-world policies, marking the entry of climate policy into the daily life of all citizens and businesses.

By: Simone Tagliapietra Topic: Energy & Climate, European Macroeconomics & Governance Date: July 14, 2021
Read article More on this topic
 

Blog Post

Fair vaccine access is a goal Europe cannot afford to miss – July update

European countries must do more to tackle the vaccine uptake gap. Vaccination data should be published at the maximum granularity level so researchers and local decision-makers can monitor progress.

By: Lionel Guetta-Jeanrenaud and Mario Mariniello Topic: European Macroeconomics & Governance Date: July 14, 2021
Read article More by this author
 

Blog Post

SPACs in the gap

Special-purpose acquisition vehicles could fill a gap in European equity markets and lure risk-averse investors off the sidelines.

By: Rebecca Christie Topic: European Macroeconomics & Governance, Finance & Financial Regulation Date: July 13, 2021
Read article More on this topic
 

Blog Post

A breakdown of EU countries’ post-pandemic green spending plans

An analysis of European Union countries’ recovery plans shows widely differing green spending priorities.

By: Klaas Lenaerts and Simone Tagliapietra Topic: European Macroeconomics & Governance Date: July 8, 2021
Load more posts