Last Summer, the ECB stemmed the panic in peripheral sovereign debt markets with a promise. The promise was to undertake ‘Outright Market Transactions’; purchases of short-term debt issued by troubled sovereigns, from secondary markets, in quantities not limited at the outset, provided the country in question submit itself to the discipline of seeking conditional assistance from the European Stability Fund. It seems amazing to me that this has worked so well and that no-one has tried to call the ECB’s bluff.
Why do I think OMTs are a bluff? If markets did not believe the promise, and continued to require such high premia from peripheral sovereigns that the sustainability of their finances, and their continued membership of the euro was in doubt, the ECB would be pouring good money after bad. It would stand to lose a great deal on the bonds it bought, whose value would be very uncertain, clouded by a possible redenomination and/or default. The protection of buying short-term bond would not be much protection, as their value could evaporate in minutes. It is at least possible that there would not be the political support from the core, creditor countries, already on the hook to the tune of around 700 billion euros if there were a quick euro area break-up, to back unlimited ECB operations as this dynamic played out. Even if it could be argued that such operations were in the core’s long-term interests, it is surely possible, if not highly likely, that voters in Germany (for example) would themselves panic as purchases began, or that the German leadership would worry that they would.
If the view that this was how things would turn out were to take hold in markets at any point this would cause the premia that the OMTs had eliminated to re-emerge and force the ECB’s hand. The ECB’s promise is bluff because they could not carry it out, nor would they wish to, in all possible circumstances. The ECB’s discussion of multiple equilibria in speeches like this one by Coeure on the ECB board is highly pertinent. But its account of the phenomenon is misleading. Since the ECB would clearly could not, nor would not want to carry out unlimited OMTs in all circumstances, it clearly is a valid candidate forecast that they would not, and that the events associated with them not doing it (sovereign default, euro exit) might take place. Since it is a valid forecast that this would happen, it’s also valid to forecast that others will forecast that this will happen, and so on. In order to stop a self-fulfilling prophecy, you have to make it irrational to forecast doom in the first place.
The OMT bluff is also not particularly well executed bluff, and there are several curious aspects to it.
One is the talk about redenomination risk. The ECB wishes that we believe it can distinguish between redenomination risk and other premia priced into troubled sovereign bonds. It’s important for the motivation for the policy that it argues it can, because addressing other premia (like those connected with troubled sovereign solvency) is the preserve of fiscal policy, which is the preserve of other bodies. If the opposite view of OMTs were to prevail, that might risk the German constitutional court standing in the way of OMTs, or risk people believing that it might, which would trigger all the events described above. Even if were possible, conceptually, to separate out this particular premia, it would be a stretch to believe that the ECB could measure it. But in this case, it is surely not possible to distinguish ‘redenomination risk’ from risks connected with the solvency of a government and an exit from the euro. The two are bound up with each other, because it is precisely that prospect of running out of money which would mean that governments would be forced to pay their bills by printing their own.
Another curious aspect of the bluff is the talk of the conditionality of the OMTs. This is needed to make OMTs as un-fiscal as possible. If it can be argued that the fiscal problems are being addressed by an explicitly fiscal body or fund (the IMF, the EFSF or ESM), then there is no further fiscal problem to deal with, and the OMTs can be argued to be a measure aimed at monetary policy purposes. But this is just talk. One can almost argue the opposite. That without the fast-moving, potentially unlimited capacity of the monetary authority to create money to plug the financing gap of troubled sovereigns, the slower-moving, clearly limited capacity of the ESF and its sponsors would not work. And it is also stretching it to argue that this fiscal conditionality is watertight. The ‘reforms’ spoken about as being required as part of an ESF loan are not specified. As we have seen with Greece and Portugal, it is a subjective matter as to whether they have been carried out. Once the loan in exchange for reform is agreed to, it is often, after the event, not in the interests of the lender to carry out the threat not to hand over the money when reforms don’t happen.
Yet another curious thing about the bluff is the behaviour of the political custodians of the ECB and the currency union. One might guess from the fact that Draghi announced OMTs that Merkel and co supported them. But that it is not an adequate rebuttal of the charge that OMTs are a bluff. It simply says that the ECB got Merkel’s agreement to have a go at bluffing. (After all, if you have run out of options, why not try it?) What evidence have we got that the Germans would be willing to follow through? Has there been any decisive change in the opinion polls indicating public support for extending much larger credit to troubled sovereigns in the euro area? I’m not aware of any such shift. More plausibly, the German political elite extend credit reluctantly because they know that this is the view of their voters; that explains their tardiness before OMTs, and it must surely colour how they view OMTs themselves.
One can almost see these concerns and delicacies in the central texts outlining the bluff, the text that describes the limits or lack of them on OMTs. ‘No ex ante quantitative limits are set on the size of Outright Monetary Transactions‘ is the phrased used. The phrase is clearly aimed at making it clear that they don’t want to disclose a cap yet, because that would allow people to look at the cap and figure out whether they think it is large enough to do the job. But then, the text does not have, yet could have, had a prhase that said ‘whatever quantities are deemed necessary to convince market participants that pricing in a risk of exit is not rational’. So in the absence of such a text, should we interpret what has been written as ‘not yet limited, but if things start going badly, it soon will be, don’t worry, and we will pull out’? It’s as if the ECB knows it can’t actually write ‘unlimited’, because they know that it would not be believed, nor judged consistent with their mandate. There are no fiscal funds earmarked to recapitalise ECB losses associated with ‘ex post limited’ OMTs, and allowing these losses to be absorbed by money creation is not consistent with the mandate for price stability, nor would be judged so by the German constitutional court. The phrase ‘no exante quantitative limits’ seems designed to impress a busy markets trader, but reassure a concerned German constitutional lawyer. It might well reassure the lawyers, but I don’t understand why it should have impressed markets.
If you are persuaded that OMTs are just bluff, and a bluff not very well executed at that, it’s then a puzzle why the policy was so successful, and no-one has tried, seriously, to call the ECB (and the Germans) on it.