What’s at stake: The ECB has announced “Outright Monetary Transactions” (OMT) on 6th September. Comprising of potentially unlimited purchases of government bonds, it is the largest ECB intervention so far. In the blogosphere, OMT is mainly evaluated as intended to prevent market panic from pushing otherwise solvent governments into bad equilibria, insolvency due to mounting interest payments. Criticism focuses on either conditionality requiring more austerity, stopping growth or on conditionality being not fully credible as OMT support cannot easily be withdrawn from non-compliant countries.
In a press release, the ECB has published the details of the programme:
- Objective: “safeguarding an appropriate monetary policy transmission and the singleness of the monetary policy”.
- Conditionality: An EFSF or ESM programme with the possibility of EFSF/ESM primary bond market purchases must be in place in the respective country.
- Decision: The decision on starting and ending OMT for a country is taken by the ECB governing council.
- Unlimited purchases: no ex ante quantitative limits exist on bond purchases.
- Focus on short-term debt: OMT will concentrate on buying one to three year bonds.
- No direct government financing: Bonds are purchased on secondary bond markets only.
- No seniority: The Eurosystem has “pari passu” creditor status (unlike in the SMP programme).
- Full sterilisation of the liquidity effect.
Preventing bad equilibria, but failing on the growth front?
Paul de Grauwe believes the ECB was right in committing unlimited resources. OMT should stop panic leading to upward pressure on interest rates and bad equilibria in government finances. However, further austerity measures implied by the conditionality on ESM programmes are the problematic side of OMT.
Greg Ip also has a two-handed view on OMT. On the positive side, the barrier for OMT action is not set too high. This means it should be effective to calm panic on the bond markets. On the negative side, we still lack financial conditions conducive to growth in Southern Europe. Due to capital flight, a credit crunch exists in the region. It is unlikely that the ECB will do much about this, nor can it do much anyway. In effect, its monetary policy potency will not really be restored and the Euro economy is still in danger.
Do countries need to receive actual OMT support?
Jacob Kierkegaard argues that OMT requires three conditions to work: first, markets will want to be convinced of the political commitment, which means countries (Spain first) need to enter EFSF/ESM programmes and become eligible for OMT aid. Second, it must enjoy political support by key countries’ governments, especially Germany, which is the reason for including conditionality in OMT. Third, the conditions must be acceptable for receiving countries, ideally if they are not yet on the brink of collapse. This also requires willingness by national governments to overcome the stigma of entering a programme. An immediate application by Spain, which is not yet on the brink, would be a reassuring signal.
Wolfgang Münchau writes that there is a strong risk that, given the political disincentives to do so, no country will ever apply for OMT. This would reduce OMT to an attempted confidence trick and will only again slow down political decision-making as long as interest rates are low. To repair the broken monetary transmissions mechanism and to halt the self-reinforcing crisis, a full programme of quantitative easing would be necessary, consisting of massive purchases of fixed-income securities.
The focus on actual purchasing misses the aim of OMT, argues Francesco Saraceno. The objective of OMT is to defuse speculation about the solvency of governments by the ECB acting as a lender of last resort. A success criterion for this is indeed that the ECB never actually needs to purchase bonds. Although a monetary stimulus would have been desirable, the ECB has elected to go for a programme that only keeps government finance afloat while hoping that structural reforms will spur growth.
Redenomination risk and centrifugal forces in the Eurozone
Tyler Durden discusses a chart by Bloomberg’s David Powell showing that Taylor rule interest rates for Eurozone countries still wildly diverge. With the Eurozone interest rate below the Taylor rule rate for Germany and above that for Spain, shifting capital to the creditor nations is perfectly rational to hedge against a redenomination risk. OMT does nothing to assuage fears of a break-up of the monetary union due to economic fragmentation, thus increasing incentives to move one’s deposits to surplus countries.
An interesting idea on how to combat capital flight and preserve the Euro comes from Louis-Vincent Gave of GaveKal Research, reported on Free Exchange: As capital flight from Southern Europe is primarily due to fears of a Eurozone break-up and subsequent devaluation of the southern currencies, he suggests the ECB should sell insurance against redenomination, as no private market for this exists. With the possibility of a hedge against devaluations, capital would return both to the private and public sector in Southern Europe.
Is conditionality credible?
Simon Johnson and James Kwak think that OMT marks a victory of the ‘Latin view’ of soft money. Conditionality on austerity programmes will eventually fall, as further austerity is politically impossible to enforce in Southern Europe. This will lead to a situation similar to Argentina or Russia in the 1990s, where bailouts to regions led to runaway inflation and messy defaults. Along similar lines, Holger Steltzner and Joachim Starbatty also argue that the conditionality of OMT is not credible: if conditions are not met, stopping bond purchases would cause further harm to the monetary policy transmission mechanism. Once started, bond purchasing can no longer be stopped.
Martin Wolf writes that OMT fails to make the irreversibility of the Euro fully credible. The threat of a break-up is strongest when a country fails to meet policy conditions. If the ECB then stops buying, the bond market implodes and an exit is likely. If the ECB ditches conditionality and keeps buying, it is unclear how German politicians, sceptical of the programme in the first place, would respond. Including conditionality has left an avenue open for break-up fear.
Conditionality is credible, argues Jacob Kierkegaard: There is the example of the ECB cutting SMP aid to Italy when Berlusconi’s reform progress was unsatisfactory. Even then, there was no default of Italy. The “nuclear option” of immediate default is not a credible strategy of governments as they will not benefit from destroying their domestic banking system and savings base. Furthermore, the inclusion of the ESM allows the ECB to bring in the power of the other Eurozone governments to ensure compliance.
In Free Exchange, it is argued that fears over excessive credit risks to the Eurosystem and conditionality credibility may be allayed if OMT was transformed into a more forward-looking programme, conditional on implementation rather than promises of implementing reform programmes. With the market knowing that the ECB would eventually buy all bonds if a country follows its reform programme, interest rates on bonds should drop such that, combined with the reform effects, the country in question is again solvent.
Risks to the ECB’s balance sheet?
Ulrich Hege and Harald Hau write that the ECB could be digging its own grave. It redistributes default risk from a country to the whole zone, but does nothing to restore a country to solvency. It also leaves this institution vulnerable to political backlashes. Instead of submitting the public to sovereign exposure, the Eurozone should accept an early partial default of the insolvent countries and bail in private investors. Since foreign exposure to sovereign debt has been greatly reduced, contagion risks are lower now.
In Free Exchange, Columbia University’s Ricardo Reis is cited pointing out that OMT’s proper use is in the case of countries in a “bad equilibrium” where, without negative market expectations filtering into debt refinancing costs, the country would be solvent. In the case of a real insolvency, losses are shifted to the ECB’s balance sheet. This may be disastrous as a central bank needs to be able to back asset losses with its (future) seigniorage revenues, with a reasonable estimate of the ECB’s loss absorption capacity at €200 billion. A recapitalisation mechanism – a minimal fiscal union – is required to back the ECB.
Democracy in danger?
As it is unclear whether the Southern European economies, with the possible exception of Italy, are solvent, the prospects for a real end of the crisis remain bleak, argues Marshall Auerback. As long as the ECB provides unlimited funding for governments, the Eurozone could go on for a long time in an underemployment equilibrium of austerity policies and low growth. But whether the still young democracies of Southern Europe survive such a situation for long is another question.
Matt Yglesias believes that OMT is a power grab by the ECB. Submitting countries to reform programmes is not part of the ECB’s mandate and in doing so, it transgresses the authority of democratically elected governments. “What the ECB is doing, in essence, is setting itself up as the shadow government of Italy, Spain, Portugal, and perhaps Ireland.” The same view is voiced by Clemens Fuest.
Tyler Cowen thinks a power grab can only go so far: if there is a true rejection of conditions by a population, it will just pull the plug on the programme. On the question of whether the grab by the ECB is a loss for Germany, he advises caution: The more responsibility the ECB has for the money it hands out, the more its perspective will approach that of Germany.
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