In what it calls a program of “Outright Monetary Transactions”, the European Central Bank has committed to buying an unlimited amount of government bonds where there are, in the words of the ECB, “severe distortions in government bond markets”.
A little over a month ago, European Central Bank president Mario Draghi said that he would do “whatever it takes” to hold the eurozone together. The announcement of OMTs overnight is clearly a demonstration that Draghi is serious about contributing to what is a long-term fix, even if having the central bank intervene in the bond market is seen by some as a radical and a somewhat risky approach.
As has been said many times before, the depth of the sovereign debt crisis requires radical action.
The theory behind OMT has two main purposes – to make sure that the governments in the eurozone (particularly the likes of Spain and Italy) can finance themselves during the long transition to improving their fiscal settings; and it aims to directly lower bond yields which will help support economic activity.
In announcing OMT, Draghi said that the ECB bond purchases would be “an effective backstop to remove tail risks from the euro area”. The radical and unprecedented policy will see the ECB buy bonds of between one and three years duration. In a concession to Germany, the bond purchases will be “sterilised” from the market which means the overall impact on the money supply will be neutral.
It is also vital to acknowledge that OMT comes with strings attached.
It is not a blank cheque, even if the bond buying program is open ended. Countries must continue on the path of fiscal repair because the structure of the OMT program means governments have to make a request to access the bailout fund and the ECB could reject that request if it judges the path to fiscal reform is inadequate. Mr Draghi said that “the ECB reserves the right to terminate bond purchases if governments don’t fulfil their part of the bargain”, in others words, holding to the path of fiscal reform and austerity.
An optimist could hope that the ECB action will be prove to be an important factor that in a couple of years will see progress on the sovereign debt problems and even return to decent economic growth.
Despite what any reasonable person would judge to be the strict conditionality of the OMT, there were some who were highly critical of the scheme, with the main criticisms from German officials and politicians. In a sign of professional petulance, the Bundesbank went so far as to issue a statement after Mr Draghi’s press conference which said the proposal was “tantamount to financing governments by printing banknotes”.
During his press conference, Mr Draghi acknowledged that there was one dissenter at the ECB's governing council meeting, although he refused to say who it was. But given recent public comments on the matter and the Bundesbank statement, it was undoubtedly the Bundesbank’s president Jens Weidmann.
German Finance Minister Wolfgang Schaeuble has also kept up his attack on the ECB suggesting the “monetary policy can’t solve fiscal problems” and “false incentives” must be avoided in the euro crisis. Rounding out his venting, Schaeuble suggested that the European Union would become “irrelevant” if it couldn’t unite.
While the Germans were clearly not happy with the proposal, financial markets were. Even though the details of the ECB plan were pretty much fully leaked yesterday, that did not stop a powerful reaction in financial markets. Share prices jumped sharply with the major European markets rising 2 to 3 per cent. In Spain and Italy, shares were up close to 5 per cent for the day.
The optimism spread to the US where stocks prices rose by around 2 per cent to reach multi-year highs. The euro rose to around US$1.2650 and the optimism even spread to the Australian dollar which is back near US$1.0300, despite a run of softer local economic news. Bond yields in the Spain and Italy continued their stellar rally as investors got in ahead of the ECB intervention.
The OMT is a long run plan to hold the eurozone together and to repair the damage from unsustainable fiscal settings. Its success will be best judged in the years ahead, not in the next few months. But if it can facilitate a move to balanced budgets and at the same time put a floor under the recession and some time next year see the eurozone return to growth, it is a policy worth pursuing.