Monday, September 10, 2012

ECB Swings into Action - Markets Jump Accordingly

The  ECB Bond-Buying Plan
Last week, ECB chief Mario Draghi launched and ECB bond-buying plan, sparking a dramatic rally in the world's financial markets. "Economic growth in the Euro Area is expected to remain weak, with the ongoing tensions in financial markets and heightened uncertainty weighing on confidence and sentiment" said Draghi. Faced with pressure to prevent the collapse of Europe's monetary union, Draghi finally launches a monetary plan which amounts to more than merely a bandage has finally been set in place. Due to proximity of interest rates to the Zero-Lower-Bound, further reduction of interest rates would essentially be of limited effectiveness. More unorthodox monetary measures are therefore needed. Unfortunately, since this move is late in emerging, potential costs are much higher than they otherwise could have been. The bond-buying plan makes use of Outright Monetary Transactions (OMTs) and focuses on sovereign bonds maturing within three years. According to Draghi, OMTs will only be used in conjunction with the EFSF or the ESM.

Role of the Central Bank
Despite fears of inflation - and above the opposition of Bundesbank chief Jens Weidmann (who also represents the German voice in the ECB's governing council), the plan went ahead due to support from all other members of the ECB's governing council. During recessions, a focus on price stability is not only of limited relevance but also wholly insufficient as a policy response, given anemic growth prospects. Moreover, the nature of the ECB's delay to respond to turmoil in the markets had contributed greatly to the generalized lack of investor confidence and poor growth so far. A fact which will undoubtedly increase the cost of this maneuver to both the ECB and the European taxpayer. 

While there are voices that feel that the ECB should not be in the business of helping stabilize sovereign bond spreads and foster growth, one must consider exactly where the sovereign interest of the EU and that of most of the Eurozone members lies. "OMTs will enable us to address severe distortions in government bond markets, which originate from, in particular, unfounded fears on the part of investors of the reversibility of the Euro" said Draghi. It must also be remembered that this takes place against the backdrop of Germany's role in the Eurozone. While it is the single country which has benefited the most from the Euro given the currency's boost for German exports due low low currency prices which Germany could never enact on its own , it has also been the first -and most frequent- country country to violate the convergence criteria. 

The Potential Downside

With all of the bond-buying plan's upsides, and its long overdue nature, the plan does cast a dark shadow for the economic sovereignty of the Eurozone member nations, as outlined in the UK press. In a structure similar to that of the IMF, access to potentially unlimited funding is likely to be made conditional on potentially severe austerity measures which will actually be monitored by the IMF. In other words, as if it weren't bad enough that three years of austerity measures have already failed to reduce debt-to-GDP ratios in the PIIGS, the same failed model will likely be forced onto any member-nation which runs into economic trouble in the future. It paints a picture mimicking the worst days of the IMF.

Market Response
Markets responded immediately, sending the S&P 500 and the Nasdaq to multi-year highs not seen since 2008 and 2000 respectively, while the Euro climbed 0.3% against the US dollar in a matter of hours. Yields on Italian and Spanish bonds also dropped dramatically. One can only wonder what markets might look like by now had the ECB only decided act sooner. 
About the Author: 
Max Berre is a financial-regulatory economist at the EDHEC-Risk Institute (Ecole Des Hautes Etudes Commerciales du Nord) who has worked as a sovereign debt expert at the Inter-American Development Bank in Washington and has taught financial economics at Maastricht University in the Netherlands.