The European Central Bank’s (ECB's) introduction of Outright Monetary Transactions (OMTs)—the purchase of government bonds in the secondary market—has been a game changer in the sovereign-debt crisis that has plagued the euro zone over the last three years.
Following ECB president Mario Draghi’s announcement in early September, spreads on Spanish and Italian debt relative to those of Germany have continued to seesaw nervously but have dropped sharply and are on average about one hundred basis points lower than before. This occurred despite the reluctance expressed by Spanish and Italian leaders Mariano Rajoy and Mario Monti to ask for help from the ECB and their preemptive refusal of new (and as yet unknown) conditions that would accompany such a program. Unfortunately, both the markets and politicians are underestimating the risks associated with the ECB’s new course.
Everyone, even those highly critical of Draghi’s adroitly engineered initiative, knows that there was little choice to avoid the successive implosion of Spain, Italy and the euro. It would have been far preferable for politicians to agree on issuance of Eurobonds, for example. Or politicians could have agreed to build a much bigger war chest for the European Stability Mechanism (ESM) to do its work in conjunction with a reinforced International Monetary Fund. Either of these arrangements would have the legitimacy that only decisions by democratically elected politicians can bring. Instead, by putting the ECB before the fact that the euro could collapse, the burden of decision has been shifted onto the ECB’s technocrats, thus blurring the lines of responsibility between them and the politicians, undermining their independence and raising a big question about whether they are exceeding their mandate.
In fact, doubts persist on the legality of the ECB’s new program. The German Constitutional Court’s ruling that endorsed the ESM, whose conditions must be applied in member states for OMTs to begin, does not extend to the OMT. The court gave its go-ahead to the ESM only on condition that the Bundestag must approve any increase in Germany’s liability beyond the current level of 200 billion euros. It announced at the same time that it will separately examine the legality of OMTs, in which the ECB can potentially engage without limit—and indeed has explicitly stated that it will do so if needed—at a later date.
But even if one believes that future legal challenges are unlikely to thwart the ECB’s determinations, which were made with the implicit or explicit consent of Europe’s political leadership, the deeper implications of Draghi’s move give plenty of cause for worry. This new phase of the crisis implies three sets of risk.
First, for the troubled countries, a durable and artificial containment of the spreads they pay implies a sharp reduction in the pressures to put their house in order, and, because such external pressures are typically a necessary part of the political economy of reforms, may make the most important and thorniest changes impossible to agree—or if agreed, to execute. Indeed, one can read Rajoy’s and Monti’s preemptive rejection of conditionality as a very loud signal that the ECB’s commitment to OMT has already improved their bargaining position vis-à-vis Germany and the other core countries. Yet, high sovereign spreads are only the symptom of the euro disease.
The real causes of the crisis lie in the European periphery’s faltering competitiveness, the collapse of its housing and domestic-demand-based growth model, its labor and product-market rigidities as well as its overextended governments and banks. Until these problems are addressed, it is highly doubtful that confidence can reappear, households and firms can regain access to credit at reasonable interest rates and economic growth can return. Without growth, it will be impossible to service large debts, and it is only a matter of time before markets and populations realize the limits of OMTs. Then, capital flight will resume, and the political challenges to the euro regime in the troubled countries will once again surface.
Second, in Germany and other AAA-rated countries, the obvious risk implied by large ECB and sustained bond purchases is political, while the longer-term risk to their stability remains. Unless their taxpayers see visible progress and big reductions in the deficits of the periphery, it will be impossible to justify large and sustained bond purchases without igniting fears that a transfer union has been set up behind the cloak of monetary policy. That inevitably will undermine the standing of incumbents who are perceived to be pro-euro.
Third, the European Central Bank is taking on big risks. Some experts such as Willem Buiter, a former member of the Bank of England’s Monetary Policy Committee, claim that it has the capacity to purchase trillions of euros of government debt with printed money without triggering inflation or otherwise impairing the currency. In one narrow sense, the experts may well be correct, as the ECB should be able to sterilize its bond purchases within some limits.
Yet, a major question is left hanging: What is the end game? Will the ECB eventually be able to dispose of its large bond holdings without destabilizing bond markets or causing another liquidity crunch? Only if the adjustment in the periphery succeeds.
But the experts are also missing the main point, which is that the ECB can only retain its credit standing and its role as a lender of last resort if there is unshakeable political support for the euro. In this regard, the ECB is subject to risks that do not apply to the Federal Reserve or the Bank of England, for example.
On the one hand, a decision by Greece or Spain to default and leave the euro would create a big hole in the ECB’s balance sheet. The ECB’s exposure to Greece is well in excess of 100 billion euros (through its long-term refinancing operations and other liquidity efforts, government bond holdings and the Target 2 balances of the euro system of Central Banks).
On the other hand, growing internal opposition to OTMs by an ECB creditor such as Finland or Holland could escalate into a full-fledged challenge to their participation in the euro project. Even if an actual exit from the euro is unlikely, the uncertainty about the euro’s future would erode the confidence of investors and of depositors across the euro zone and ultimately undermine the ECB’s capacity to carry risk.
The key factors that will determine the euro’s long-term survival have not changed in the wake of OMTs: completion of the European banking and fiscal union, ultimately requiring much closer political ties; deeper structural and fiscal reforms in the periphery; and a more accommodating stance on demand and wages in Germany and the other AAA countries. In theory, the ECB could make the OMTs conditional on progress on all these three fronts. In practice, the idea that its bureaucrats will impose such far-reaching conditions on politicians is both far-fetched and intrinsically undemocratic.
OMTs are being introduced because politicians have not enacted the reforms needed to ensure the euro’s survival despite enormous pressures from financial markets. It remains to be seen whether the ECB technocrats and politicians will be any more effective at setting conditions on each other.