As had been expected, despite the dissention of the Bundesbank, the ECB has announced a programme of, in principle, unlimited purchases of euro area government bonds on secondary markets. Adding yet another acronym to the alphabet soup engendered by the crisis, the program is termed OMT – Outright Monetary Transactions – and will replace the previous SMP (Securities Markets Programme). ECB President Draghi justified the measure by the need to ensure the effectiveness of monetary policy and safeguard price stability. The features of the OMT are as follows:
The ECB will buy short-run sovereign bonds (one to three years) without an ex ante quantitative limit. It retains full discretion: bonds will be purchased to the extent ‘warranted from a monetary policy perspective’. The countries benefiting from such purchases will have to be under a European rescue programme (specifically: a full macroeconomic adjustment programme of the EFSF/ESM or a so-called precautionary programme), and the ECB will terminate the bond purchases ‘when there is non-compliance’ with the associated national commitments. The bonds purchased will no longer be senior to those held by the private sector. The transactions will be fully sterilised (i.e. there will be offsetting sales of other assets and thus no net increase in the money supply). Finally, full details of the transactions will be published.
It is best to start with a little history. We are some two-and-a-half years into the sovereign debt crisis. Euro area governments repeatedly failed to prevent a crisis initially affecting countries with some 6% of euro area GDP from deepening and spreading. Indeed by imposing austerity (unfortunately encouraged by the ECB) and insisting on a haircut for private bondholders (rightly resisted by the ECB) they made a bad situation worse. Having poured oil on the fire by raising interest rates, the ECB made two attempts to reduce interest-rate spreads. But by emphasising the limited and temporary nature of sovereign bond purchases (not least to assuage German opposition) it condemned the programmes to failure.
Seen against this background, the OMT is the logical (provisional) conclusion of a process. Given the failure of the political system, it has been obvious to this and many other observers for some time now that only an unlimited commitment by the ECB with its, in principle, unlimited capacity for bond purchases was going to be enough to stop the rot. In those terms, it is welcome, but long overdue. Today’s move does have the capacity, in principle (I will come back to that caveat) to turn the situation around. It is a necessary condition. The problem is that already the European economy as a whole – and not just the so-called crisis countries – is on its way into a painful second recession. Unless concrete and substantial actions by the ECB follow these words very soon, and, crucially, other actions are taken to support demand and encourage investment, it may be too late. The OMT is very far from being a sufficient condition.
At least two elements of the OMT deserve more detailed discussion. One is the issue of ECB discretion and the consequent uncertainty about the size of the OMT. Explicitly no ex ante targets have been set for the level of interest rates targeted by the central bank. What level of premiums over German bunds constitutes a distorted monetary policy transmission mechanism requiring intervention? We are not told. There is a strong argument for making such figures explicit: rational market actors would almost certainly almost completely price that in to their decisions. At the limit, the mere announcement of such a target (for instance a maximum spread of 1 percentage point over equivalent German bonds) would dispense with the need for actual interventions; the example of the Swiss central bank, with its 1.20 target rate for the CHF, appears to confirm this. There is a powerful counter argument, though, namely that there is no easy answer to the question of what is the ‘right’ premium for each EMU member. Neither economically nor politically. In short, while I think an explicit ex ante target would have been preferable, I can understand why it has not been announced.
Of course this leaves as an open question the extent of the ECB’s ambition. The so-called ‘markets’ (i.e. currency speculators) will be watching carefully. Forthcoming publications of the transaction volumes will be carefully studied. There is a substantial risk that, as with the two former bond-buying programmes, the announcement will soon be followed by disappointment and rates will spike again, destabilising expectations and forcing the ECB into making very large purchases or (worse) backing down. This clearly indicates the need, early on, for a ‘shock and awe approach’ as a substitute for an explicit target.
The second issue, also related to the ECB’s very large element of discretion, is conditionality. As everyone familiar with the debate knows, this is the crux. Without external support for sovereigns the euro is finished. But support cannot give a carte blanche to national governments. Unlimited in size, yes. Unconditional in application, no. The ECB clearly cannot impose political conditionality on sovereign governments on its own. Under the OMT that will come via the EFSF/ESM programmes. Deviate from policy commitments and the OMT will be stopped. As a matter of procedural principle, this is fine. Of course when is a deviation large enough to justify cutting the lines is ultimately a political one. But the much more serious problem is that the adjustment programmes are deeply misguided in terms of content. Even fiscal hawks have been forced to accept the view that coordinated austerity has failed. Output continues to fall precipitously in the crisis countries and is now dragging down the whole European economy. And many of the demanded reforms are socially unjust and often counterproductive. Merely reducing sovereign bond interest rates, while helpful and indeed necessary, will not in itself be enough to change the perception of investors and consumers and bring about recovery.
But we need the ECB support now and new, more sensible programmes would take time to negotiate. What can feasibly be done in the reasonably short run? (Note: this is different from the question, ‘what is the ideal solution?’) One proposal would be to suspend the programme compliance requirement for an initial period. For example, the OMT would be launched and would run on an unconditional basis for six months. National governments may choose to stick to their national programmes in whole or part, but during that period there will be no penalty (withholding of EFSF/ESM lending, termination of OMT) for not doing so. At the end of the half-year a review could decide on whether the conditionality could be re-imposed (for some or all countries) or be extended. This would give the countries a breathing space in a ‘good equilibrium’ (i.e. low interest rates and positive expectations) during which positive signs of a turnaround would shift perceptions and, hopefully, permit the cautious reapplication of consolidation measures.
A second option, which could be combined with the first, would be to offset the demand-reducing effect of austerity programmes by an urgent and substantial package of investment from the European level (European Investment Bank, structural funds, etc.). To pick a number, an investment of 1% of pre-crisis GDP should be injected into each of the programme countries in the coming 12 months. This would need to be in addition to the broadly sensible but inadequately targeted measures announced at the June European Council – see the annex of here – which are in any case mostly a redistribution of existing measures.
What is really needed, third, would be to extract a commitment from countries with current account surpluses – i.e. precisely those countries not subject to existing conditionality – to reflate their economies and act as a demand-locomotive for the whole euro area. In principle the Macroeconomic Imbalance Procedure constitutes a tool to achieve this, but in its current form it is asymmetrically set up to squeeze the deficit rather than, as would be necessary, the surplus countries, and in any case is a medium-term affair. We need a short-term commitment, but I do not see a lever to achieve this, unless for some reason the scales suddenly fall from the eyes of the politicians running a well-known large European country. In fact the core economies are also sliding into recession and such stimulus is in their own interests. This does not mean that it will happen, though.
It would also help (a little) if the fetish about ‘sterilisation’ were abandoned. The whole European economy is short of demand. The overall money supply is expanding too slowly, not too fast. Sterilisation is an economically senseless political sop to monetarists, and innumerate ones at that. (The aforementioned politicians of the aforementioned country spring to mind.)
The OMT is broadly what Europe needs now, but only because of the serial failings of the past. I understand those that are chary of direct monetary financing of government budgets, but things have only come to such a pass precisely because of the opposition of such people to the much more modest measures that would have resolved the crisis at earlier stages. The OMT is now a necessary condition to save the euro. Of course the justifications given by ECB President Draghi when announcing the OMT – safeguarding monetary policy transmission mechanisms and the price stability mandate – are purely for the gallery. On the one hand price stability in Europe is not in any danger, on the other the concept of the stable prices of a monetary union that has ceased to exist is ludicrous. We should be under no illusions. The OMT is there to keep the euro area alive. Full-stop.
Considerable uncertainty remains about whether it is sufficient to achieve the aims of significantly and reducing reducing bond spreads. It should therefore be kicked off with a shock and awe approach. Otherwise disillusion will quickly set in. The approach to conditionality is ok in principle: what we need to do is change the conditions. Commentators will no doubt argue that the OMT will not help in the long run if there is no reform. There is some truth in that, but the more important point is that the OMT will not work in the long run if governments persist in driving their economies into the ground with excessive austerity.
It is absolutely vital to realise that after the ECB announcement a set of sufficient conditions now needs to be met. This column has made some suggestions as to how that might be achieved in the short run: a moratorium on programme conditionality, an EU-led stimulus package, reflation by surplus countries and dropping sterilization. But more ideas and, above all, more political pressure will be needed in the coming weeks. We are a long way from being out of the woods yet.