On Thursday, ECB chief Mario Draghi announced a bond-buying program that had been largely leaked the day prior, namely that of a new bond buying program, the Outright Monetary Transactions, or OMT. Bond yields in Italy and Spain had already come down on the rumor, and stock markets around the world rallied on the news.
The enthusiasm appears overdone when you look at the sketchy details. Draghi is implementing an improved version of the Securities Market Program, which only temporarily suppressed periphery country bond yields. As hedge fund manager Scott commented via e-mail: I don’t think this is anything but the SMP with more conditionality and pari passu treatment. Markets seem to like it, though.” “Conditionality” is Eurocrat-speak for “debtor countries must agree to wear the particular austerity hair shirt we have designed for them before they get any dough.” Per the ECB’s press release, the new program will be more bloody minded about compliance than the old SMP (which is being terminated). The ECB requires that countries must not only agree to “strict and effective conditionality,” but the central bank also
will consider Outright Monetary Transactions..as long as programme conditionality is fully respected, and terminate them once their objectives are achieved or when there is non-compliance with the macroeconomic adjustment or precautionary programme
While bright lines are useful in theory, in practice, suddenly withdrawing support from a non-complying country is the sort of thing that would provoke the very type of market upset that the central bank seems keen to avoid. So it is not at all clear whether this threat is credible.
Now of course, there were other differences, at least in the mind of Mr. Market. The belief is that the ECB, which is the only actor positioned to buy the eurozone enough time to create a fiscal union and unified bank regulation, has gotten control of the game board. Draghi made clear that only one central bank was opposed to the OMT, which will engage in “unlimited” and sterilized purchases of one to three year government bonds to meet target, but unstated, interest rates. Of course, the Germans central bank was in opposition, and the German media took up the cry:
“Financial markets cheer the death of the Bundesbank.”
But what does this mean in practice? Well, first, neither Italy nor Spain have yet formally asked for help (the first step in the dreaded “conditionality” process. Italy does not want to ask before Spain, and Spain has and presumably is continuing to try to get some waivers from the sort of conditions that have been imposed on other borrowers before it requests assistance (the press is now reporting that Spain will submit its petition on September 14).
The second part that is striking is that even though Draghi has used the bold word “unlimited,” he finessed the question of what the rate targets would be. And how aggressive the rate buying needs to be is very much a function of the rate target. In theory, since the ECB would be moving risk onto its balance sheet, it should set the short end rates at the same level as the creditor nations, since more rate relief would help in reducing their debt overhangs. But a move like that could be politically divisive. So not knowing the rate target (or more accurately, finding it out only when the program goes live) is a big gap in assessing whether the program is likely to live up to its promise.
Third, the ECB has had problems sterilizing its debt purchased under the SMP, and it is likely to face this problem on a bigger scale with the presumably much larger OMT. From Colin Lokey:
In any event, the ECB hasn’t always been successful in soaking-up the excess liquidity injected into the system via bond purchases. Notably in June 2010 and in November of 2011, bids for the term deposits came-up short by around 23 billion euros and 9 billion euros respectively. Over all, the ECB has failed to sterilize its purchases on at least six separate occasions. The problem is that banks are the most unwilling to part with their cash when anxiety peaks which of course is likely to coincide with spikes in periphery short-term yields. In other words, the bond buying is likely to coincide with cash hoarding, raising considerable doubts about the ECB’s ability to ‘soak-up’ the liquidity it pumps out. In turn, this raises the possibility that the ECB will fail to soak-up enough of the excess cash to keep inflation expectations in check and to keep its credibility from being questioned
Now in fact, the ECB ought not to care all that much if it can’t sterilize all its purchases, but it is much more hawkish than the Fed, so a certain level of (supposedly) inflationary sterilization fail would give it heartburn. (Inflation fears are overdone is that the European economy has tons of slack and high unemployment).
There is also the pesky question of reality. Per Clusterstock’s write-up of the ECB press conference, the one point where the interaction got testy was when the German reporters pressed Draghi on the legality of the program. Reader Jeremy B highlighted Article 123 of the Consolidated Version of the Treaty of the Functioning of the European Union (boldface his):
Overdraft facilities or any other type of credit facility with the European Central Bank or with the central banks of the Member States (hereinafter referred to as ‘national central banks’) in favour of Union institutions, bodies, offices or agencies, central governments, regional, local or other public authorities, other bodies governed by public law, or public undertakings of Member States shall be prohibited, as shall the purchase directly from them by the European Central Bank or national central banks of debt instruments.
Drahgi has taken the position that these short term bond purchases are monetary operations and hence permissible, and claims they were contemplated in the ECB’s charter. But it is awfully hard to see a purchase of sovereign bonds in the context of a bailout as a monetary activity, as opposed to using monetary tools for other ends.
Finally, one might regard this move as a breakthrough if there were reason to think the eurocrats would make good use of the time that this sort of program will buy. But the eurozone leadership seems no closet to resolving its basic impasse than it was in May 2010, the first acute eurocrisis episode. Germany is still unwilling to give up running surpluses, yet Germany and its fellow creditor nations are unwilling to fund the deficit countries who are Germany’s and their customers. And as we are seeing in Greece, the austerity hairshirt only makes matters worse. The resulting deflationary spiral alone makes debt to GDP ratios worse. And as conditions worsen, the institutional and social fabric starts to decay, which makes recovery even more unlikely. As Costas Lapavitsas writes in the Guardian:
Last week I was in Athens and took the metro to Syntagma Square. Like many northern Greeks, I have mixed feelings towards the capital. Northerners do not like to admit it, but we secretly enjoy the smell of jasmine – the true scent of Athens. But this time the air smelt of cordite.
Syntagma was abnormally quiet: shops shut, people halfheartedly shopping, riot police everywhere. The atmosphere crackled with the expectation of something sinister about to happen. And lo, in Monastiraki Square, afew hundred yards away, agroup of young men attacked a shop owner; just another violent episode in a city resembling a tinderbox…
Today, ECB president Mario Draghi tried to stop the rot by promising to buy unlimited amounts of short-term public debt from states that accepted austerity programmes. His aim was to compress interest rates and reverse the fragmentation of banking, but it will be a short-term palliative at most. Banks need restructuring, and peripheral competitiveness needs to be restored through an investment programme to raise the productivity of labour. Instead, the EU has opted for the blunderbuss of cuts to labour costs. For the periphery this means high unemployment and low growth; for the eurozone it means a break-up is more likely.
The eurozone mess is the classic illustration of a saying attributed to Herbert Stein, “Economists are very good at saying that something cannot go on forever, but not so good at saying when it will stop.” But while it once looked like market pressures would force a change in policy, it now looks like the shift will come as a result of punitive austerity, either open revolt or widespread disobedience. And they can be as abrupt as market events.
So while Draghi may have achieved what many commentators see as a firm defense, what he has constructed is the economic equivalent of a Maginot line. While it could be an effective bulwark against financial market attacks, it remains vulnerable to political and legal outflanking.