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Let me outline what I believe are the three major lessons of the crisis. First, the crisis has reconfirmed both the scope and the limits of what central banks can do to support the economy. Central banks play a pivotal role in stabilising funding conditions at times of acute market turmoil. But they cannot compensate for weaknesses in banks’ capital positions. And they cannot substitute for reforms to boost the growth potential of economies.
Second, in the euro area, the crisis has demonstrated the capacity and unwavering commitment of the European Central Bank (ECB) to support the economy in its pursuit of price stability. We have adopted monetary policy measures that are unprecedented in scale and scope. In doing so, we have benefitted from the array of different perspectives on the Governing Council. These different perspectives collectively shape the single monetary policy for all euro area countries and form a durable basis for our united institutional decisions.
Third, the crisis has shown the need to adjust our monetary policy toolkit to a new reality. A very important new tool have been the two three-year LTROs (long-term refinancing operations) that helped avoid a massive euro area wide credit crunch in early 2012. But the most salient feature of this new reality is financial fragmentation across euro area countries.
At almost one year from its announcement, the benefits of OMT are visible to everybody:
Spreads in sovereign debt markets have fallen substantially. Since the OMT announcement, spreads on long-term bonds for Spain, Italy and Ireland have fallen by around 250 to 300 basis points and for Portugal by almost 600 basis points. Spreads in corporate debt markets have fallen by about 150 to 200 basis points for important market segments, and made it easier for firms to raise funds in the market. This has been the case for highly rated large corporations as well as for other corporations. Banks have been able to re-access the market, for both funding and for raising capital, and the strong divergence in funding costs across constituencies has receded somewhat. Deposits have flown back: banks in stressed countries have seen the deposits by the euro area money-holding sector increasing by about €200 billion since August 2012.
Another sign of normalisation, and a very important one for German savers, pension funds and insurance companies, has been the increase in German government bond yields, previously suppressed by panic-driven safe-haven flows, which have edged up by around 25 basis points.
And the best summary indicator for fragmentation and related payment flows in the euro area, the level of Target balances, has shown a decline by €285 billion, or 25 per cent, since the peak last year. Target balances now roughly stand at levels prevailing before the launch of the two three-year LTROs in late-2011. The establishment of OMT has therefore been beneficial to everybody: sovereigns, corporations, banks as well as individuals, and it has benefitted both periphery and core countries.
One concern that has been raised with regard to OMTs is that they may discourage reform at the national level. Quite the opposite is true. OMTs can be applied only if governments accept policy conditionality that leads to reforms. At the same time, it was the requirement of effective conditionality embedded in OMTs discourages governments and parliaments from requesting a programme unless strictly necessary. They can either reform without OMTs and retain economic sovereignty or they can reform with OMTs but give up some of their economic sovereignty. Either way, they have to persevere in their reform efforts.
Another concern made against OMT was that conditionality weakens the independence of monetary policy. The reality is that OMT’s are not tied to political decisions since the Governing Council retains its full discretion, even after a country has engaged in a programme. In addition, that same conditionality ensures that the governments remain solvent, which in turn protects the freedom of action of monetary policy.
A third argument made against OMTs suggests that they would reintroduce excessive compression of euro area bond yield spreads, as observed prior to the crisis. This too is inaccurate. OMTs are designed to keep government bond yields just below ‘panic’ levels, as previously defined, not to bring them down to levels that would somehow help government solvency. As we have seen, the mere existence of OMTs keeps government bond yields from rising excessively: the market expects that if yields rose too much, governments would apply for the programme and ECB purchases would bring yields back down. OMTs have therefore had a self-fulfilling downward effect on yields, just as before, in absence of OMT, there was a self-fulfilling upward effect with a potentially catastrophic risk for the euro area. But this downward effect does not mean that spreads are forced to converge. In fact, ECB intervention under OMTs would not address those parts of sovereign bond yield spreads that are fundamentally justified. The implication of a high backstop rate is that governments continue to have the incentives to raise their primary balance towards stabilising levels and to engage in structural reform. These are the only two options for them to lower their funding costs well below the backstop level implied by the OMTs.
For governments and parliaments, the ultimate driver of their actions remains employment. It is important to recall that always and especially in the present situation, the need for governments and parliaments to reform does not stem so much from the bond market but from the dramatic conditions in the labour market. Unfortunately, millions of unemployed are a much greater driver to reform that the interest rate to be paid on sovereign debt. And unfortunately, OMTs have almost no effect on the sources of employment creation. Indeed, while OMTs have eliminated one dimension of financial fragmentation (the risk of euro breakup), they only have a muted and indirect effect on the other source of fragmentation – the adverse feedback loop between sovereigns and banks.
A final criticism of OMTs is portraying them as a means of transferring risks from peripheral to core euro area countries via the ECB balance sheet. Quite the opposite has happened: the elimination of catastrophic outcomes strongly benefits core countries. To see this, recall that the tail risks that OMTs seek to address distort financial prices and quantities in both the core and the periphery. Tail risks generate a glut of liquidity in core banking systems, as monetary assets are relocated by panicking investors from fragile countries to safe-havens. With OMTs, pressure to reform remains on peripheral countries, while re-establishing confidence in the euro area reduces the flows of money from the periphery to the core countries like Germany.