From SMP to OMT: ECB commits to destroy monetary transmission

This is not a humorous title, and this is not a funny post. A couple of days ago, the ECB announced after its Governing Council meeting that it would initiate a new program of sovereign debt purchases. The program is named Outright Monetary Transactions, which adds OMT to the endless list of acronyms that has emerged after the onset of the financial crisis. The program replaces the Securities Markets Programme (SMP), or, rather, extends it in a number of directions.

As mentioned in my post on the last ECB policy meeting, its need for emphasizing that what it does is not illegal strikes me as odd if not suspicious. At least I think it gives an impression that there is some bad consciousness involved. Or perhaps it is just a preemptive strike to silence those who think government bond purchases by the ECB are a violation of the Treaty of the European Union (or maybe it is done to cater the one country who cast a dissenting vote regarding the OMT). In any case, just as under the SMP, bond purchases will be conducted on secondary markets, and not directly from governments. The label “outright” otherwise does, according to some dictionaries, mean “direct”, “openly”, “without reservation or qualification” inter alia. But according to the Treaty, the market on which you acquire government debt sems of essence when it comes to aiding governments in fiscal trouble. I never understood this, but it is a distinction that enables the ECB to sidestep all issues about an independent central bank not being allowed to help out governments with their finances. It is like a situation where buying drugs from a drug producer is illegal, but going out on the streets to buy drugs is legal.

However, these legislative details appear entirely unimportant to the ECB, as its rationale for introducing the program is action towards restoring the monetary transmission mechanism in the Euro area—just as the SMP was. The argument is that the divergence in government bond yields are hampering monetary transmission in the Euro area, and thereby hampering the ECB’s efforts at attaining price stability—their primary mandate. I have still not understood this argument entirely (if at all), but Mario Draghi gave some explanation at the press conference to which I return shortly.

First, however, I should mention the main differences between the OMT and SMP. The main difference is that purchases under the OMT come with conditionality. Countries whose bonds the ECB buy, must meet relevant requirements set up by the European Financial Stability Facility/European Stability Mechanism (the IMF will also become a player of the game to the extent that it can monitor whether countries satisfy to conditions). Moreover, there are no limits to how much can be bought, but the purchases stop whenever the ECB’s objectives of “securing appropriate monetary transmission and the singleness of the monetary policy” are achieved. Alternatively, they stop if the country in question does not satisfy the conditions. Due to this conditionality, it is obviously not possible to hide which countries the ECB buys bonds from (even on secondary markets). Hence, both the amount of holdings and the nationality will now be disclosed (and ECB tries to score a “Transparency Point” on that fact). As with the SMP, purchases are going to be fully sterilized. So this is not quantitative easing, but the German member of the Governing council, Jens Weidman, who in all likelihood cast the dissenting vote, has nevertheless been stating that bond purchases were “too close to state financing via the money press for me”. Finally, the ECB gives up on its seniority status on bonds.

All in all, it appears as a further step away from the intentions of the Treaty on the European Union which in letter states that

“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 (Article 123)”

It clearly represents an upgrade in the efforts of affecting government financing conditions. I mean, if it is not a scheme that represents a credit facility on favor of a union central government, which is prohibited, then I don’t know.  (The fact that the ECB is not in conflict with the second part of the Article doesn’t nullify this.) The conditionality aspect may comfort some, but to me it just makes it looks even more as a fiscal policy action. But still, the ECB maintains it is for monetary policy purposes only. At the press conference, there was one question in particular, which created important food for thought, and also allowed Draghi to explain this monetary policy aspect in more detail.

The question, posed by a reporter Draghi clearly respects, is the second part of a two-part question starting at 26:21 in the press-conference clip below:

The first part is a clarifying question on the announced maturities of the bonds eligible for purchase (up to 3 years to maturity). The second part is on the conditionality part and goes:

 “Now you mentioned that the OMT would be suspended, if countries didn’t fulfill the necessary conditions set out in the MoU. Now, given that these purchases are explicitly for monetary policy purposes, does this mean that you will suspend the ECB’s independence if the countries don’t fulfill the conditions? I don’t quite understand this contradiction. Maybe you could elaborate that for me?”

Draghi answers:

“On conditionality  . . . The assessment of the Governing Council is that we are in a situation now where you have large parts of the Euro area in what we call a bad equilibrium. Namely, an equilibrium where you have self-fulfilling expectations, you may have self-fulfilling expectations, that generate, they feed upon themselves, and generate adverse, very adverse, scenarios. So there is a case for intervening through, in a sense break these expectations, which by the way don’t only concerns the specific countries, but the whole Euro area as such. But then, and this would justify the intervention of the central bank, but then we should not forget why countries have found themselves in a bad equilibrium to start with. And this is because of policy mistakes. That’s why we need both legs to fix, in a sense, this situation: to move from a bad equilibrium into a good equilibrium. If the central bank were to intervene without any action on the government side, without any conditionality, it would not be effective. It would not be effective, and it would loose its independence. At the same time we see that we are in a bad equilibrium, and therefore policy actions, though convincing doesn’t seem to produce, or [inaudible] to produce, in a relatively medium term, the results for which it is geared. So that’s why we need both legs, for this action, and I think, hope, this answers your question”

The question hints to a contradiction that Draghi never gets to. Perhaps the question is not formulated entirely clear on this issue, so Draghi spends time explaining conditionality and why it is necessary. During this, he clearly states that the high yields on some government bonds are not fundamentally based. They are a result of a “bad equilibrium” brought about by self-fulfilling expectations, e.g., due to “unwarranted” expectations about the disruption of the Euro area. As it affects the whole Euro area, it is of concern for the ECB (by the Treaty, the ECB must not care particularly about single countries, so it is important for the ECB to emphasize that the debt crises in some countries hamper all countries).

The rest that follows is strange. Draghi concedes that the bad equilibrium is triggered by bad fiscal policy in some countries. Does this mean that the excess yields are partly a country-specific fiscally-based risk premium and an “unwarranted” Euro-break-down premium? Or is it only an unwarranted Euro-break-down premium triggered by bad fiscal policy? This is not spelled out and will leave market unsure as to when the ECB will “pull” out of a given country’s bonds. In either case, why is conditionality then needed to eliminate the self-fulfilling expectations? This can only be because it is believed that an improvement in fiscal performance is a necessary condition for the elimination of self-fulfilling expectations. This is consistent with Draghi stating that without conditionality, ECB purchases will have no effect, and ECB’s independence would be lost. So he is effectively admitting that the SMP was an ineffective construct, and even one that gave away ECB independence. However, improvement in fiscal performance is not considered sufficient to eliminate the bad equilibrium, so that is why the OMT must be implemented to bring about a good equilibrium. And presumably if it works, then the ECB does not loose its independence.

I think one can construct a consistent story behind the multiple equilibrium theory and the corresponding fiscal-monetary program needed to bring down yields, but how that in any way relates to the ECB’s independence is vague. It seems that Draghi is simply saying that if purchases are effective, then the ECB has maintained its independence!

The reporter’s question may have had a different connotation—one that really fleshes out a contradiction in the OTM scheme. At least for me, this particular Q/A triggered the following question: If a country does not live up to the conditions, will the ECB accordingly abandon it, and thus accept the resulting disruption of the monetary transmission; i.e., accept that the whole Euro area will be left in a bad equilibrium? By letter of the OMT scheme, to which the ECB have committed, it should. But in reality it ultimately depends on the credibility of this “threat strategy”;  i.e., of whether the ECB is really willing to abandon a country. As is well known, a commitment is only as good as the credibility of its support. I.e., the actions taken when some breaks the rules (in game theory, this is what is meant with credibility of “off-equilibrium” strategies, or, perfect Nash equilibrium strategies).

Here I see the contradiction: On the one hand, the OMT is emphasized to be initiated for the sake of monetary policy transmission purposes only, but it will be stopped vis-a-vis countries that violates the associated conditions. But by the ECB’s own logic such a violation will ruin the very same transmission mechanism, as it will trigger a bad (or, worse) equilibrium. Hence, if the ECB should obtain credibility about its commitment to this program, it must be willing in some circumstances to ruin the monetary transmission mechanism, send the entire Euro area into a bad equilibrium, and thereby be willing to make it hard for them (by their own logic) to fulfill its objective of price stability. So to be in accordance with the Treaty and its own objectives, the ECB has committed to a scheme where the “threat strategy” that will give credence the its commitment will make it impossible to live up to the Treaty! Talk about setting up traps for yourself!

So not only have the ECB embarked on a program that is the most blatant fiscal rescue plan ever seen by an independent central bank, it has also done it in a way that is bound to create insurmountable challenges for itself down the road. I honestly think that the ECB should have stuck with monetary policy, and left the fiscal problems where they belong: in the hands of governments. This was indeed the idea behind the Treaty in the first place as I understand it from Article 123.

Oh, and at the press conference, there was actually one, yes one, question about monetary policy, more specifically the interest-rate decision. It was on whether the ECB had thought of a change, and we were told it had not. Nobody seemed to care one bit.

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