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.