First of all, it’s obvious that I have horribly failed at something I always try to do when writing a new post: coming up with a title that hopefully makes people actually want to read it. Yet I still feel this is important, and I’m thankful to Max for insisting on continuing the discussion. In the comments section of my last post, originally meant more as a general monetary policy post, a vivid discussion has emerged on what the ECBs Outright Monetary Transactions Policy (OMT) entails and particularly in what way it would potentially lead to fiscal transfers between Eurozone members, potentially making it illegal under EU treaties. While writing my latest comment, I noticed it was getting way too long, so let me offer a response as a new post.
The way I see it, the main disagreement between Max and me involves the direction any possible fiscal transfers would go if the ECB would, some day, actually buy bonds under the OMT program. We don’t seem to disagree on the fact that any purchases of government bonds by the ECB would potentially prove legally problematic, but rather on what these purchases would entail economically with regards to possible fiscal transfers within the Union. Max argues that, through sterilization, i.e. the ECBs attempts to remove an equal amount of money from the market as it is injecting by buying government bonds of troubles periphery countries, it is substituting low-risk assets on its balance sheet for high-risk assets, making its entire balance sheet more risky and thus representing a real cost to the core, which gets their share of any interest payments accrued from these assets (and thus potentially stands to loose these due to their increased riskiness). However, it would seem that this is based on an inaccurate description of how the ECB conducts (and would conduct) said sterilization. That no OMT purchases have ever actually taken place does not really make the issue harder – for all intents and purposes, OMT is just a replacement for the Securities Markets Program (SMP) instituted by the ECB in 2010 and under which it has already bought around €200 billion worth of bonds of periphery countries (mostly Italy), most of which it still holds on its books. Although there might be some technical differences, conceptually it would seem to me that the main feature of the “change” is that OMT made this program open-ended (thus also reducing the actual need to buy the bonds in the first place). So we know pretty well how OMT as well as sterilization measures would work – so how would they?
Basically, what the ECB does to sterilize its bond purchases is offer banks in the Eurozone system the possibility of stashing an equal amount of money at its facilities for one-week periods at a time while paying a slightly higher interest rate than its deposit facility pays. The banks then bid for this privilege, and due to the competitive nature of the process, the actual interest rates these one-week deposits pay is essentially the same as the interest rate it pays on overnight deposits, i.e 0. Looked at from the perspective of its balance sheet, the ECB expands its assets by adding government bonds to its books, on the other side makes up for this by printing new money to pay for these bonds, yet through a technical maneuver prevents the effective amount of money in circulation from actually rising (assuming full sterilization, which was not completely the case under SMP). As far as I can see, however, technically M0 still expands. It’s just the amount of money that moves beyond banks that doesn’t.
In other words, the ECBs sterilization does not, as Max suggests, entail substituting low-risk assets for high-risk assets, as would be the case if the ECB sold e.g. an equal value of German bonds and instead bought Spanish bonds. The cost of sterilizing its bonds purchases is essentially 0 – both to the ECB as well as for the core. Any interest payments that accrue from these bonds purchases, however, are very real. In other words, at best Germany gets interest payments (indirectly, through the ECB) from Spain it would not have gotten otherwise, and at worst (if Spain were to default) it gets the same amount of interest payments from government bonds as it would have gotten had the ECB never implemented OMT (or SMP) – none.