Yesterday, the European Central Bank finally unveiled its long heralded bazooka, interestingly called Outright Monetary Transactions. According to Mario Draghi, this is “to be perceived as a fully effective backstop that removes tail risk from the euro area”. In other words, the ECB sent its strongest signal yet that it is willing to deploy unlimited firepower in defence of the Eurozone.
This new development of the European saga is only the most recent episode in an escalation of commitment which started in May 2010, when the ECB first announced its sovereign rescue programme. A few successively larger rounds of bond-buying and a couple of LTROs later, a pattern is starting to emerge, and it looks a lot like heroin addiction. Sure, increasing the dose works, at first, but how sustainable is that?
A central bank’s strongest asset is its credibility. It is primarily the credibility of a central bank that enables it to deliver; in essence, if the markets believe it will deliver on its inflationary targets, for instance, then they will act according to that belief and not create an inflationary wave in the first place. Whenever there is a drop in that belief, the central bank must purchase some more credibility by acting in the market. Traditionally, the credibility a central bank buys is far more valuable than what it pays for it.
But ECB’s credibility account is getting depleted faster and faster; as ECB is approaching the far end of the supply-demand curve, the cost of an incremental unit of credibility gets more and more expensive to fund. Faced with a rapidly steepening cost curve, ECB is rather counter intuitively saying “we will pay whatever the cost”, hoping the price will consequently come down.
ECB’s argument is predicated on the assumption of rationality in the markets. “The markets demand higher yields because of the perception of elevated risks; if we tackle that perception, yields should come down”. But that was the exact same argument in May 2010, and in every subsequent intervention.
“Ah, but this time it’s different”, say the pundits. “This is the bazooka. This time it’s unlimited”.
What exactly is unlimited? The notion of infinity certainly does not deserve to be thrown around so easily. How much bond buying can take place before the contingent austerity measures become politically unbearable? How long before the ECB will have to dilute its concept of “austerity measures” to the point of losing its meaning entirely? How much will it cost to restore credibility? Why are we so obsessed with bazookas, when the real driver is the concern about erratic national economies?
For all the negative press he’s been getting, Weidmann is right in that the focus of the debate needs to shift from technical monetary measures to the more fundamental questions of the Eurozone and the sustainability of its constituent economies. “But now is not the time for these philosophical debates”, say his critics, “let’s put out the fire first, and then think about the long run”.
Sure, that sounds reasonable. But that argument is being tossed around for more than two years now. When will there ever be a good time to discuss the fundamentals of the Eurozone? How many years must pass until we start discussing the more painful questions of European integration? Perhaps therein lies the true usefulness of the Outright Monetary Transactions; perhaps they can buy just enough time for everyone to calm down and start discussing the real issues. But if that is true, then we shouldn't waste another moment. We should use whatever breathing room the markets will allow to honestly and openly talk about the deepest Eurozone fear: "are we really meant for each other?".
In the end ECB is in the thankless position of a shepherd, alone with his flock in the night, trying to keep the surrounding wolves at bay by throwing them pieces of meat, hoping that the dawn is near. However, the meat is running out, the wolves are getting bolder and bolder, while the sheep are indignantly debating the fairness of the shepherd’s decisions about the communal life.
At some point, this shepherd will have to fire his bazooka, and how unlimited it actually is remains to be seen.