This post responds to recent interventions by Paul de Grauwe, which I think put up interesting counter-hypotheses to the position of the German constitutional court, essentially supporting the ECB, but don’t undermine their case.
To recap on my previous posts on this. I do think OMTs were, on balance, the right thing to try. If there was a chance that they would be believed, and the promise could be sustained for long enough without some judicial intervention undermining it, it was worth it. However, I also think they were an almighty bluff, implying uncapped losses that would have meant either breaking the promise to bring about price stability, or bankrupting itself and its stakeholders, or even both. There are definitely risks associated with getting a reputation for bluffing. But desperate times demand taking them.
But, this post isn’t about whether OMTs were right or wrong, it’s about the debate over whether they justly fall within the ECB’s remit or not, and the arguments made by the ECB and the Court claiming that they do or don’t.
Paul contests that the policies were ‘economic’, in the sense of being directed at resolving solvency problems in troubled sovereigns in the EZ, on the grounds that, contrary to the assumption of the court, it’s possible that yields on those troubled sovereign bonds can diverge from yields based on rational assessments of the sovereign’s long-term solvency. He suggest that the German court’s ruling is false because it relies on the defunct and false assumption of perfect markets (in the sense of agents in those markets having perfect, correct information about the fundamentals of the sovereigns).
Well, I agree it’s possible that this is why sovereign yields blew up in those troubled countries. I don’t agree that real-time indicators of sovereign fundamentals mentioned in his post are such a good guide. After all, the point is to project out into the future what might happen to the tax base, and to yields. So, for example, debt to GDP ratios are not that helpful. My debt to GDP doesn’t look that bad. But if tomorrow I lose my mind, I won’t have much chance of paying off my mortgage. Still, it’s distinctly possible that market prices are based on false information about ‘fundamentals’.
However, it’s also possible that markets had a point. That markets were guessing that there might be trouble in those sovereigns’ banking systems; that EZ-wide monetary policy was incompatible with those sovereigns’ state of the business cycle; that they could not withstand the fiscal pressure of the politically-essential automatic-stabilisers. Personally, I think there’s quite a lot in this conjecture. But it only has to be a conjecture. And we don’t have to conjecture that these views were exactly right. We can just conjecture that they were approximately right. In reality, there is a probability distribution over future outcomes for troubled sovereign finances. We don’t know what it is, but we can conjecture that markets’ distributions over this had roughly the right shape. You don’t need to assume ‘perfection’ on the part of market participants’ expectations.
Since either hypothesis is plausible, a reasonable assessment is that it’s at least possible that those sovereigns did have a genuine long-term solvency problem, and that they had an ‘economic’ problem whose day of reckoning was at least postponed by the promise of OMTs. Provided it’s at least possible, one can’t judge those policies as purely equilibrium selection policies. To do that involves taking an extreme view of the possible causes, not substantiated by the meagre evidence of contemporaneous fiscal and economic indicators. After all, Paul and the ECB are putting on the table multiple rational expectations equilibria as part of their story. Fair and educative to do so, but these stories require many leaps of faith to believe too, so they cannot be the only possible explanation.
The ECB itself made a lot of the distinction between what it called ‘liquidity’ problems of such sovereigns, caused by multiple equilibria, and genuine ‘solvency’ problems. It saw itself – and Paul sees them – as able to separate out the two nicely, and to use its balance sheet in the service of providing liquidity, confident in the knowledge that solvency of the troubled sovereign is not in question, and, therefore, that the ECB balance sheet is safe. It made a lot of this distinction because it was hoping to pre-empt legal challenges that would prevent it from using its balance sheet to address solvency problems. Liquidity is ok. Solvency is out-of-bounds. However, I don’t think it’s possible to make such a distinction in practice with any confidence. For the same reasons that you can’t have complete confidence in the reason for a sovereign not being able to sell its bonds.
And anyway, is the distinction meaningful? Imagine the hypothetical situation that the ECB is the only one who thinks a member sovereign long-term solvent, buys its bonds when no-one else will. It buys them because it calculates correctly that if everyone else believed that those sovereigns were solvent, and/or that everyone else believed that everyone else believed that they were solvent, the sovereign would, in fact, be able to sell its bonds. However, why does this nonexistent hypothetical world where beliefs line up with the ECBs conjecture make the policy not fiscal? What if beliefs never change about the long-term viability of the sovereign in the absence of ECB action, and yields are only low because everyone believes (surprisingly as I’ve argued), that the ECB will foot the bill? Does the ECB’s view of the matter make it not fiscal just because it has a different view? What would it even mean to be ‘right’ in this case? Simply to maintain that there was a counterfactual world in which everyone shared its view and prices reflected that? So what if there was such a counterfactual world? How would one ever hold such an institution to account if the monetariness of a policy was decided simply by maintaining that there was such a world in which everyone shared its view? It would surely be in the interests of the ECB to say exactly what it did say, and express unjustified confidence in one amongst many explanations for why yields were high in the periphery. It’s hardly going to say ‘you know what, we don’t really know why those yields are high; it might be that those governments are basket cases and just can’t get along in the EZ, but it’s worth a go with our balance sheet to see if we can’t buy a bit of time for another bail-out.’
Paul’s other point is that the fiscal risks taken by OMTs aren’t a problem. It doesn’t matter anyway if the ECB’s capital is wiped out, the ECB doesn’t need capital. Here, I get lost. I think it boils down to saying that the ECB can simply print money to recapitalise itself. Sure, like any central bank, it can. However, it can’t guarantee that the ECBs inflation target can be achieved at the same time. We can’t say for sure that it wouldn’t be delivered. There might be scenarios where the requisite money printing actually helped. But there are lots of scenarios where it would not. If you like, we could put back on the table multiple rational expectations equilibria and argue that just the knowledge that the ECB was prepared to set aside risks to its capital would lead to a speculative attack on the value (in terms of goods) of the euro, bringing about extremely rapid inflation. Only a possibility, mind. Even leaving aside such attacks. How much inflation would generate the seigniorage to recoup a few tens of billions of euros, or even a couple of hundred, lost through worthless OMTs? Quite a lot, especially if it was expected. Think of the calculation that someone forecasting future inflation might make if they conjectured that the market called the ECBs bluff and put its’ promise to make uncapped purchases, of potentially worthless bonds to the test.
Paul asserts correctly that central banks don’t need inviolate reserves of capital to function. But surely they are vital safeguards to prevent them from functioning in a way that defrauds the citizens who use its liabilities as a unit of account and medium of exchange. If an ECB loss of this kind were just ‘bookkeeping’ then why not get the ECB to buy all outstanding Greek, Portuguese and Irish debt and bookkeep the problem away for good? Why bother with simply promising to do it in the event that yields rise above what it thinks is warranted? Just buy the whole damned lot! The Greek economy has suffered catastrophe on account of its fight to generate primary surpluses and stay in the EZ. What is the point if a bit of bookkeeping and interest flow adjustments would make things better?
The point is that once the ECB balance sheet was seen to be fair game for making good fiscal trouble, EZ price stability, and perhaps even the usefulness of the euro money at all, would be presumed over.