Outright Monetary Transactions: The ECB's Palliative Medicine To Treat The Crisis

 |  Includes: FXE
by: Alberto Abaterusso

The European Central Bank "stands ready to activate the OMT if needed" Joerg Asmussen, the ECB Executive Board member, said last week. Outright Monetary Transactions, or OMT, is a plan from the European Central Bank under which the bank buys sovereign bonds of the region's troubled nations in the secondary markets, but on the condition that the countries meet certain requirements regarding their economic policies. The plan to deal with the region's debt crisis was announced by the ECB on Sept. 6, 2012. The OMT would make the ECB's monetary policy more effective. It represents a turning point for countries in debt crisis, but not enough to prevent these countries to make the reforms that they need.

The program is not an alternative to reforms that national governments must make. "OMT only comes along with" the reforms, Mario Draghi said during the Economic Council of the CDU. Germany (whose constitutional court will decide in the coming weeks on the constitutionality of the OMT) was initially opposed to OMT, arguing that it could discourage indebted countries from adopting reforms. Germany's concern about the OMT plan is groundless because the activation of OMT is not an option without those structural reforms. Also, according to the post-Keynesian economists' view, the program is not sufficiently effective to enable Southern European countries to get out of a recession, "if they have succumbed to a fiscal austerity package ensures that their growth prospects deteriorated even further." The only possible way for southern Europe to get out of recession is for budget deficits to expand.

OMT also produced "visible benefits" for eurozone investors, said Draghi, who also added that "there were positive effects for the Germans. A very important sign is the rise in interest rates on the German Bonds previously cleared by the race to non-monetary investments." OMT is an open market operation through which the ECB implements an expansionary monetary policy, by following the decision to lower interest rates. When the ECB buys short-term government bonds, the market price of the securities increases and consequently their yield decreases.

When investors see that the yield on short-term government bonds decreases, they sell them and buy long-term government bonds. The increase in demand for long-term securities makes their market price increase and thus their yield decrease. Therefore, OMT reduces the yield spread between long-term government bonds of Southern European countries whose economies are in difficulty and those of countries whose economies are considered strong (e.g., the spread between Italian BTPs and German bunds).

For Christine Lagarde, managing director of the International Monetary Fund, "OMT was not only a turning point for countries in crisis," but it even helped to "prevent a catastrophe and the monetary policy to be effective again." Lagarde pointed out that without OMT "today there would be more stagnation, more unemployment and social tension."

Probably the non-implementation of OMT would have made the public debt of the countries of Southern Europe even more onerous and deteriorated even more the capability of their governments to honor commitments. And in such a case we wonder what would have been blamed for more stagnation, unemployment, and social tensions: the non-activation of OMT, which is considered to be an effective monetary policy, or the application of austerity programs where "timing and intensity [...] have been dictated too much by market sentiments of fear and panic instead of being the outcome of rational decision-making processes," as the authors of this research said about the policies used by governments to reduce budget deficits.

According to the study just mentioned, it seems as if the prevented catastrophe would be due to the austerity programs poorly modulated: " sharp austerity measures that were imposed by market and policymakers' panic not only produced deep recessions in the countries that were exposed to the medicine, but also […] led to even higher debt-to-GDP ratios and undermined the capacity of these countries to continue to service the debt. Thus the liquidity crisis that started all this risks degenerating into a solvency crisis."

The concept of effectiveness of OMT was also reaffirmed by Joerg Asmussen who explained that "the goal of OMT of buying government bonds is not to prevent the insolvency of countries," but rather to help the "effectiveness of ECB's monetary policy." The effectiveness of OMT as an ECB's monetary policy is to maintain price stability within the eurozone. "Shield anti-spread OMT program has helped both peripheral and core countries of the eurozone" and "the OMT is in line with the mandate of the ECB," Draghi said.

According to Professor of Economics Paul De Grauwe and Economist Ji Yuemei, the "strong decline in the spreads of the Eurozone countries can be mainly attributed to the OMT policy of the ECB. Thus OMT turned out to be quite effective." The President of the European Parliament, Martin Schulz, has justified the actions taken by the ECB. He said that the President of the ECB "acted in a logical way and strongly defended the common currency."

The ECB will have worked in a logical manner through the activation of the OMT plan to reduce the spread, but the same thing cannot be said for those who let themselves be driven too much by the sentiments of financial markets in modulating intensity and times of austerity programs. It looks as if entire populations are prisoners of the euro, whose fate depends on the prominent sentiment of financial markets. OMT seems to be a cold accompanying therapy until the countries that are in serious difficulties fail. Just as Bill Mitchell said about the compliance requirements of the program: "They are saying that they will keep a member state alive so that it can die slowly."

Disclosure: I have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.