Whatever it Takes

For going on two years,  the Eurozone policy response has seemed to be stuck in traffic. Mario Draghi’s mid-summer pledge to do ‘whatever it takes’ to save the euro raised expectations that a decisive moment was at hand. Last week, it looks like he delivered.

If Eurozone policymakers are no longer ‘stuck in traffic’, then one must wonder whether the junction at which they now find themselves is a crossroads or a roundabout. Is the Eurozone on the verge of turning a corner, or is this one more spin on the merry-go-round?

The so-called Outright Monetary Transactions (OMT) programme, introduced over Bundesbank objections, has been sold as the ‘big bazooka’ needed to save the euro. Finally, the ECB balance sheet has been pledged as backstop to supposedly solvent sovereigns unable to finance themselves at sustainable rates on the open market.

Critically, potential bond purchases are to be ‘unlimited’. In theory, the ECB can print  money at will to buy bonds on the secondary market.

The ECB has waived its ‘seniority’. In the event of a Greek-style debt writedown, the ECB will not exercise its right to be repaid first. It will get in line with every other creditor.

This is important, because private sector investors will not now be pushed further and further back in the repayment queue as the ECB buys more and more bonds. Otherwise, ECB intervention could have undermined its very purpose, eventually driving private sector investors out of the market.

The ECB’s latest bout of bond buying is to come with strict ‘conditionality’. Spain, Italy or any other Eurozone member who wants the ECB to act to bring down their borrowing costs will have to formally apply for aid, and will have to meet fiscal and other reform criteria, much as Ireland, Greece and Portugal do at present. This is no free lunch.

So, has the ECB just cranked up the printing presses? No. Unlike the US Federal Reserve and the Bank of England, both of whom have engaged in quantitative easing – or printing money – to buy bonds and therefore bring down interest rates in the private sector, the ECB’s OMT programme is to be ‘sterilized’.

To appease German concerns about the risk of inflation, all bond purchases are to be ‘sterilized’ by restricting the banking sector’s ability to lend similar amounts to the private sector, for insance by incentivizing banks to deposit money at the ECB rather than lending it to businesses.

Sterilization may remove the risk of inflation – a risk that was marginal to begin with, at least in the short term – but at what cost? Already, banks in peripheral Europe, not least in Ireland, have been buying the sovereign bonds of their host countries in ever greater amounts. In effect, they have been lending to their governments rather than to households and businesses.

At a time when credit is scarce, and becoming more so as banks across Europe try to ‘de-leverage’, the OMT programme looks likely to divert further resources away from a credit-starved private sector. Furthermore, ‘sterilization’ undermines the ‘unlimited’ nature of the OMT. In practice, there is only so many bond purchases that can be sterilized without completely choking off private sector lending.

Certainly, the OMT will dispel doubts for the immediate future that monetary union is on the verge of collapse. Much as the ECB’s infusion of ‘LTRO’ liquidity into the banking sector last winter eased market tensions for a time, so the OMT should provide relief for stressed soveriegns, and time to get their house in order.

Anyone who has driven a car will at one point have found themselves driving several times around a roundabout looking for the right exit. Yes, it looks like the Eurozone is no longer stuck in traffic but, far from having turned a corner, the ECB has just given the green light for politicians to keep looking for the right exit.

The OMT buys time for European leaders to put in place a more comprehensive solution that will be sustainable over the longer term. Efforts to establish a European banking union, let alone the sort of Treaty reforms that would be necessary for the mutualization of debt,  will take time to bear fruit.

It remains to be seen whether Greece and others are really prepared to do ‘whatever it takes’ to stay in the euro, whether semi-permanent austerity is socially or politically sustainable in the face of economic depression.

We may yet be several years from a successful resolution, but staying on the roundabout is preferable when taking the wrong exit could be fatal.

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