Further thoughts on the fiscal implications of OMT

Florian and I are having a good discussion on the fiscal implications of the ECB’s OMT program. I don’t have much time right now, but I want to make two points in response to his latest post. 

First, Flo’s latest post taught me something I didn’t know: The ECB’s use of the term “sterilization” is somewhat different from the textbook use. A sterilized intervention is usually defined as an action by the central bank that leaves the monetary base unaffected. What the ECB did in its SMP program (and, as best we can guess, that’s what it will do in the OMT program) was buying government bonds with newly created base-money and simultaneously taking short-term deposits from commercial banks in the same amount. So, figuratively speaking, the ECB prints a new euro, uses it to buy government bonds from the banks, and offers the banks the opportunity to deposit the newly created euro with the ECB at interest. Clearly, this intervention increases the monetary base, although the money in circulation stays unaffected.

Fair enough. So what does this mean for our discussion on the fiscal implications of the OMT program? Nothing.

What matters for our discussion is the effect of the OMTs on the ECB’s net profit: roughly speaking interest earnings on assets minus interest payments on deposits. Under conventional sterilization the ECB would reduce its holdings of interest bearing assets and hence reduce its interest earnings. Under the ECB’s sterilization technique, new liabilities are incurred which increases the ECB’s interest payments. As long as the ECB’s lending interest rate is not substantially different from the deposit interest rate (both are essentially zero at the moment), the effect of net profit is the same in both cases.

So the particular way how OMT bond purchases are going to be neutralized seems to me quite irrelevant to our discussion.

The relevant question is this: Will the bonds the ECB is likely to purchase under the OMT program be bought for more or less than they are really worth. If the price the ECB pays is too high there will losses to the ECB and therefore, eventually, to all Eurozone governments except those whose bonds were being bought. If the price is too low there will be gains to the EZ governments. It is, of course, possible that the ECB knows exactly the true default probability of periphery governments and therefore the true value of their bonds.

However, I think the most important thing to notice is this: the purpose of the OMT is to signal to the market the ability and willingness to lend without limit to EZ governments. If the public believes that promise, the ECB will never have to make any actual bond purchases at all. The only circumstance in which the ECB would have to buy periphery bonds is when investors are so convinced that those bonds are going to default that no promise of Mr Draghi can calm them. In such a situation I find it highly likely that the ECB will incur losses on its bond purchases.

The ECB’s Sterilization Policy And Its Fiscal Effects

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?

Continue reading