As I write on 13 September, it’s been a good week for europhiles. On 6 September, Mario Draghi unveiled the ECB’s plan for Outright Monetary Transactions (OMT). The German Constitutional Court ratified the European Stability Mechanism (ESM) on 12 September. And the Dutch electorate favoured two pro-euro parties.
Look at the markets, and you’d be forgiven for thinking that the euro-zone crisis has
reached a turning point. But the optimism is way overcooked: the most fundamental problems still await solutions; and OMT, while buying time yet again, also adds complexity.
The first thing to note is that any bond purchases made by the ECB will be sterilised - to keep the operations within the scope of the ECB’s mandate. That is why Draghi was careful to say that there were no “ex-ante quantitative limits” on purchases, rather than claim that he could make “unlimited” purchases, as many commentators have. The purchases will be limited by the market’s demand for euro-denominated short-dated paper. The ECB will presumably purchase bonds in the biggest volumes if yields creep back to unsustainable levels; in this new world in which we have apparently reached the limits of what the ECB can legitimately do, we must assume this would be another extreme crisis point. Who will be seeking out euro-denominated paper, except to gamble on a lottery-like re-denomination premium?
And then there is the added moral hazard. The bond markets rallied fiercely for five weeks before OMT was even confirmed - and even now the ECB cannot buy Spain’s or Italy’s bonds. It can only buy the bonds of issuers that have applied for money from the ESM; but governments would only apply to the ESM (and shoulder its austerity conditions) if their short-term yields were too high to allow refinancing. Sure enough, now that Spain’s front-end yields have collapsed before the Draghi put, Spain’s government is equivocating complacently over its need to go to the ESM.
The euro-zone’s real problem is a lack of competitiveness in the periphery; the solution is reform; but disaster-prevention efforts relieve the pressure for reform. The markets seem to understand this, at some level. That is surely why Spanish and Italian bond yields hit their peaks, not before New Democracy staved off disaster by winning the Greek election in June, but a month later. It is also why investors should not assume that those markets will prove unwilling to fight the ECB on the subject of the fundamental value of the periphery’s bonds.