Wednesday, 12 February 2014

ECB's OMT, QE and why they won't matter

The biggest news on Friday was that the German Constitutional Court had passed on the examination of whether the Outright Monetary Transaction (OMT) scheme proposed by Mario Draghi in August 2012 was legal under the ECB mandate, to the European Court of Justice. This story was considered as a win by most on the pro-ECB camp, under the assumption that the ECJ would actually approve the scheme. The problem is that whether it does or not, it makes no difference. 

As Frances Coppola noted at the time of the Draghi announcement (and has recently repeated to all those who haven't been listening), the whole idea of the OMT is not to protect the Member-States but to protect the Euro. Even more, the OMT is best used as a threat rather than actual implementation. Market reaction to the threat was as predicted: pressure on the euro started to decline and soon the currency was much stronger than before. Yet, as many know, in this case, the threat is stronger than anything else.

You see, even if the ECJ approves OMT, it will do nothing to ensure that the crisis ends. The main function of the scheme is to purchase bonds in countries which are paying high interest rates (and are in bail-out agreement). As of lately, no country is paying especially high rates; even Greek bonds have shown significant signs of decrease. Thus, even if the scheme passes, no country will benefit.

Another idea, (one which I have to disgracefully admit that I thought was rather interesting before thinking it through) was a European Quantitative Easing. The problem here is how the markets that the ECB will purchase bonds from will be defined. It's easy in the US and the UK as there is just one market with sovereign bonds; what happens when you have 17 of them, each faced with its own issues? Clearly, QE is not the answer.

In order to find the correct answer, we have to make sure we are facing the right question, and the one in our case is how to stimulate demand. Forget of all the "competitiveness" and "supply liberalizations" which some think will cure everything. As stated before, supply does create its own demand but not all the time; and this time it's different. The problem is that the usual stimulants, i.e. government intervention (either in increasing demand or decreasing taxation), are constrained in the bailed-out countries, and many others by their debt-to-GDP ratios and fact that they are in a currency union. The other usual way, of increased bank lending, is again constrained by either the banks' inability to lend or the peoples' unwillingness to borrow.

Thus what is left one might add, if supply won't help and banks and governments are constrained? The magic word here is confidence and expectations. As recent research has shown, expectations matter more than we usually thought; the recovery from the 1929 Great Depression was most likely driven by a shift in expectations as Eggertson (2008) suggests. So what shifts expectations is the big question?

Simply put, it's the willingness of the governing authorities (whether those be politicians or policymakers) to stick to their agenda of reforms and promote the idea that inflation will increase in the future, or forward guidance in the central bank parlance (something that BoE's Mark Carney is famous about). The problem is that just saying so doesn't really change anything, you have to stick by what you claim and make efforts to keep them in line with peoples' expectations.

How to do that is rather simple: either the ECB should issue fresh money and channel them to the countries (most likely via the EIB) at a scale larger than ever before or boost bank lending in countries where banks are willing to lend (but are constrained) and people are willing to borrow, most likely by decreasing the ELA rate. I see no other solution to the current problems: either the banks are supported and they are allowed to lend, and more investment is brought forth directly from the EU or the shift in expectations will take much longer to manifest, just like it did in the 1930's. Trust me here, we do not want a repetition of history.

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