The ECB president, Mario Draghi, has announced a new programme of ‘Outright Monetary Transactions (OMTs)’ to ease the difficulties of countries such as Greece, Spain, Portugal and Italy. The idea is to push down interest rates for these countries’ bonds. If successful, this will make it more affordable for them to service their debts.
OMTs involve the ECB buying these countries’ bonds on the secondary market (i.e. existing bonds). This will be limited to bonds with no more than three years to maturity. Although restricting purchases to the secondary market would not involve the ECB lending directly to these countries, the bond purchases should push down interest rates on the secondary market and this, in turn, should allow the countries to issue new bonds at lower rates on the primary market.
The OMT programme replaces the previous Securities Markets Programme (SMP), which began in May 2010. This too involved purchasing bonds on the secondary market. By the time of the last actions under SMP in January 2012, €212 billion of purchases had been made. Unlike the SMP, however, OMTs are in principle unlimited, with the ECB president, Mario Draghi, saying that the ECB would do ‘whatever it takes’ to hold the single currency together. This means that it will buy as many bonds on the market as are necessary to bring interest rates down to sustainable levels.
Critics, however, argue that this will still not be enough to stimulate the eurozone economy and help bring countries out of recession. They give two reasons.
The first is that OMTs differ from the quantitative easing programmes used in the UK and USA. OMTs would not increase the eurozone money supply as the ECB would sell other assets to offset the bond purchases. This process is known as ‘sterilisation’, which is defined as actions taken by a central bank to offset the effects of foreign exchange flows or its own bond transactions so as to leave money supply unchanged.
The second reason is that OMTs will be conducted only if countries stick to previously agreed strong austerity measures. This is something that it looking increasingly unlikely as protests against the cuts mount in countries such as Greece and Spain.
Articles
Super Mario to the rescue Financial Standard, Benjamin Ong (7/9/12)
Outright monetary transactions: Lowdown on bond-buying scheme Irish Times, Dan O’Brien (7/9/12)
Draghi comments at ECB news conference Reuters (6/9/12)
ECB’s Mario Draghi unveils bond-buying euro debt plan BBC News (6/9/12)
ECB Market Intervention: Outright Monetary Transactions (“OMT”) – A Preliminary Assessment Place du Luxembourg (9/9/12)
Evaluating the OMT: OrlMost Too late? Social Europe Journal, Andrew Watt (7/9/12)
Mario Draghi speech: what the analysts said The Telegraph (6/9/12)
ECB challenges German concern over bond-buying Irish Times, Derek Scally (26/9/12)
Draghi: efforts helping to support stable future MarketWatch, Tom Fairless (25/9/12)
Mario and Mariano versus the man with the beard BBC News, Paul Mason (6/9/12)
Good week for the euro – but also a warning BBC News, Stephanie Flanders (12/9/12)
The price of saving the eurozone BBC News, Robert Peston (26/9/12)
Special Report – Inside Mario Draghi’s euro rescue plan Reuters, Paul Carrel, Noah Barkin and Annika Breidthardt (25/9/12)
ECB to face biggest test on euro gambit Financial Times, Michael Steen and Peter Spiegel (25/9/12)
Press release
ECB: Monetary policy decisions ECB Press Release, (6/9/12)
Questions
- What are the key features of the OMT programme? How does it differ from the former Securities Markets Programme (SMP)?
- In what ways does the OMT programme differ from the quantitative easing programmes in the USA and UK?
- How will the ECB’s buying bonds in the secondary market influence the primary bond market? What will influence the size of the effect?
- How does sterilisation work in (a) the bond market; (b) the foreign exchange market?
- Why is it claimed that the OMT programme is a necessary but not sufficient condition for solving the crisis in the eurozone? What additional measures would you recommend and why?
- What are the risks associated with the OMT programme?
The US Federal Reserve bank has launched a third round of quantitative easing, dubbed QE3. The hope is that the resulting growth in money supply will stimulate spending and thereby increase growth and employment.
Ben Bernanke, the Fed Chairman, had already said that the stagnation of the labour market is of grave concern because of “the enormous suffering and waste of human talent it entails, but also because persistently high levels of unemployment will wreak structural damage on our economy that could last for many years”. Not, surprisingly, the markets were expecting strong action – and that is what they got.
Under QE3, the Fed will buy mortgage-backed securities of $40bn per month. And this will go on for as long as it takes for the employment market to show significant improvement. It is this open-ended commitment which makes QE3 different from QE1 and QE2. Under these earlier rounds of quantitative easing, the Fed purchased a fixed amount of assets – $2.3tn of bonds.
QE3 also comes on top of a policy in operation since September 2011 of buying long-term government bonds in the market and selling shorter-dated ones. This ‘funding’ operation is known as ‘Operation Twist’.
The markets responded favourably to the announcement of QE3, especially to the fact that its size and duration would depend on the state of the real economy. Nevertheless, there are real questions about its likely effectiveness. The most important is whether the increase in narrow money will translate into an increase in borrowing and spending and hence an increase in broad money; or whether the rise in narrow money will be offset by a fall in the velocity of circulation as banks seek to increase their liquidity ratios and to recapitalise.
The following articles look at the details of QE3 and whether it is likely to achieve its desired result. Will the Fed be forced to raise asset purchases above $40bn per month or to introduce other measures?
Articles
Federal Reserve to buy more debt to boost US economy BBC News (14/9/12)
Bernanke takes plunge with QE3 Financial Times, Robin Harding (14/9/12)
US monetary policy at an important turning point Financial Times, Gavyn Davies (2/9/12)
Cliffhanger The Economist (22/9/12)
Your flexible Fed BBC News, Stephanie Flanders (13/9/12)
Back Ben Bernanke’s QE3 with a clothes peg on your nose The Telegraph, Ambrose Evans-Pritchard (23/9/12)
QE3 Stimulus from Federal Reserve Drives Mortgage Rates Down to Record Lows TellMeNews, Sharon Wagner (24/9/12)
Helicopter Ben Bernanke: The Problem With QE1, QE2, QE3 and QE Infinity TellMeNews, Martin Hutchinson (18/9/12)
QE: More bang than buck Business Spectator, Stephen Grenville (18/9/12)
QE3: What it Really Means PBS NewsHour, Paul Solman (20/9/12)
US Data
US Money Stock Measures Federal Reserve Statistical Release
Data Releases Board of Governors of the Federal Reserve System
Civilian Unemployment Rate (UNRATE) FRED Economic Data
Questions
- What distinguishes the Fed’s QE3 from its QE1 and 2?
- What will determine the likely success of QE3 in stimulating the real economy?
- Why has there been a huge surge in liquidity preference in the USA? What would have been the impact of this without QE1 and QE2?
- Explain what is meant by ‘portfolio balance effects’ and how significant are these in determining the success of quantitative easing?
- Does QE3 suggest that the Fed is pursuing a type of Taylor Rule?
- Why might QE3 be a “pro-cyclical” blunder?
- To what extent would monetarists approve of the Fed’s policies on QE?
- How is QE3 likely to affect the dollar exchange rate and what implications will this have for countries trading with the USA?
With the UK and eurozone economies in recession and with business and consumer confidence low, the Bank of England and the ECB have sprung into action.
The ECB has cut its main refinancing rate from 1% to an all-time low of 0.75%. Meanwhile, the Bank of England has embarked on a further round of quantitative easing (QE). The MPC voted to inject a further £50 billion through its asset purchase scheme, bring the total to £375 billion since QE began in March 2009.
And it is not just in Europe that monetary policy is being eased. In Australia and China interest rates have been cut. In the USA, there have been further asset purchases by the Fed and it is expected that the Japanese central bank will cut rates very soon, along with those in Korea, Indonesia and Sri Lanka.
But with consumers seeming reluctant to spend and businesses being reluctant to invest, will the new money in the UK and elsewhere actually be lent and spent? Or will it simply sit in banks, boosting their liquidity base, but doing little if anything to boost aggregate demand?
And likewise in the eurozone, will a 25 basis point reduction in interest rates (i.e. a 0.25 percentage point reduction) do anything to boost borrowing and spending?
It is like pushing on a string – a term used by Keynesians to refer to the futile nature of monetary policy when people are reluctant to spend. Indeed the evidence over the past few years since QE started is that despite narrow money having risen massively, M4 lending has declined (see chart).
For a PowerPoint of the chart, click here.
The following articles look at the conundrum
Articles
Draghi-King Push May Mean Bigger Step Into Zero-Rate Era BloombergBusinessweek, Simon Kennedy (4/7/12)
QE and rate cut as central banks play stimulus card Independent, Ben Chu (6/7/12)
QE is welcome, but not enough Independent, Leader (6/7/12)
Interest rates cut to spur growth China Daily, Wang Xiaotian, Ding Qingfen and Gao Changxin (6/7/12)
Rate cuts shake global confidence Sydney Morning Herald, Eric Johnston, Clancy Yeates and Peter Cai (7/7/12)
Global Policy Easing Presses Asia to Cut Rates BloombergBusinessweek, Sharon Chen and Justina Lee (6/7/12)
Economic slowdown raises alarm in China, Europe Globe and Mail, Kevin Carmichael (5/7/12)
Bank of England sets sail with QE3 BBC News, Stephanie Flanders (5/7/12)
The twilight of the central banker The Economist (26/6/12)
The case for truly bold monetary policy Financial Times, Martin Wolf (28/6/12)
Questions
- Is the world economy in a liquidity trap?
- What advice would you give politicians around the world seeking to boost consumer and business confidence?
- Are we witnessing “The twilight of the central banker”? (See The Economist article above.)
- Explain the following extracts from the Martin Wolf article: “In a monetary system, based on fiat (or man-made) money, the state guarantees the money supply in the interests of the public. In normal times, however, actual supply is a byproduct of lending activities of banks. It is, in brief, the product of privately operated printing presses… In the last resort, the power to create money rests properly with the state. When private sector supply is diminishing, as now, the state not only can, but should, step in, with real urgency.”
- Should monetary policy in the UK be combined with fiscal policy in providing a stimulus at a time when the government can borrow ultra cheaply from the Bank of England? Does this apply to other governments around the world?
- Why did Asian share prices fall despite the stimulus?
Eurozone leaders met at a summit in Brussels on 28 and 29 June. Expectations ahead of the summit were low that any significant progress would be made on supporting eurozone banks and governments, on achieving more effective bank regulation or stimulating economic growth.
For once, EU leaders surprised markets by reaching a more comprehensive agreement than anticipated. The agreement has five key elements:
1. The use of funds from the soon-to-be launched eurozone bailout fund, the European Stability Mechanism (ESM), to lend to banks directly. Previously, funds had been made available to national governments to lend to their banks. This, however, increased the debts of the national governments, such as Spain, which made it harder for them to meet deficit and debt targets.
2. The setting up of a new banking supervisory body to impose common standards, such as capital adequacy requirements, on banks across the eurozone.
3. The use of the eurozone bailout fund to buy government bonds on the secondary market, provided governments are sticking to agreed deficit reduction measures. This would help to reduce interest rates on government bonds in countries such as Spain, Italy and Greece, currently having to pay interest rates 5 or 6 percentage points above those on German bonds.
4. A €120bn growth package to target EU money at small businesses, youth unemployment and infrastructure improvements. Most of the money would be from existing funds, such as EU Structural Funds, which are currently unused. There would be some additional funds, however, including €10bn to boost the lending capacity of the European Investment Bank.
5. A 10-year ‘roadmap’ towards greater fiscal union, including the creation of a eurozone treasury, which could limit overall spending by national governments.
Generally the agreement has been greeted positively, with stock markets in the eurozone and across the world rising significantly. But will the measures be enough to reassure investors over the coming weeks? Will they cure the problems of the eurozone or are they just one more, albeit larger, sticking plaster?
The following webcasts, podcasts and articles look at the agreement and the resulting prospects for the eurozone.
Webcasts and podcasts
Eurozone bends the rules to save single currency euronews (29/6/12)
Markets Like Euro Crisis Deal, Merkel Defensive Associated Press (29/6/12)
Eurozone crisis: ‘Breakthrough’ at summit BBC News, Gavin Hewitt (29/6/12)
EU summit outcome exceeds – low – expectations euronews (29/6/12)
Italy and Spain are main beneficiaries after EU summit euronews (30/6/12)
EU bank aid deal ‘better than expected, worse than needed’ euronews (29/6/12)
New eurozone deal ‘not enough’ BBC Today Programme, James Shugg (29/6/12)
Eurozone: ‘Massive concession’ from Angela Merkel BBC Today Programme, Gavin Hewitt and Robert Peston (29/6/12)
Articles
Eurozone bank bailout deal throws lifeline to Spain and Italy Guardian, Ian Traynor and Phillip Inman (29/6/12)
Spain lifeline after EU allows direct access to eurozone bailout funds Guardian (29/6/12)
Less disunion The Economist, Charlemagne’s notebook (29/6/12)
Eurozone agrees on bank recapitalisation BBC News (29/6/12)
Merkel defends compromise deal on eurozone banks BBC News (29/6/12)
A first, tentative step to salvation for the eurozone Independent, Leading article (29/6/12)
Analysis – Sharing a vision may be Europe’s biggest challenge Reuters, Alan Wheatley (3/7/12)
Eurozone bank agreement welcomed FT Adviser, Rebecca Clancy & Bradley Gerrard (2/7/12)
The real victor in Brussels was Merkel Financial Times, Wolfgang Münchau (1/7/12)
Finns, Dutch cast first doubt on EU summit deal EurActiv (3/7/12)
A Euro deal from Brussels BBC News, Stephanie Flanders (29/6/12)
Document
Conclusions of the European Council (28/29 June 2012) European Council (29/6/12)
Questions
- What are the advantages of the ESF lending to banks directly? Are there any problems associated with the proposal?
- To what extent will the measures solve the problems of the eurozone? What else might need to be done?
- Are there any potential moral hazards contained in the proposals and how are they likely to be tackled?
- Explain the concept of ‘seniority’ in the following statement: “the debt owed by Spain to the EFSF, if and when it is transferred to the ESM, will not gain seniority”. Why might this be good for private financiers?
- If governments’ bonds are to be purchased by the ESM, what conditions are likely to be attached?
With the deepening euro crisis, the slide back into recession in many developed countries and the slowing down of fast-growing developing countries, such as China and India, confidence is waning.
But just as pessimism increases, so too does uncertainty. The global economy is getting more and more difficult to forecast. So should economists give up trying to forecast? Should we rely on guesswork and hunch, or looking into crystal balls?
Bank of England representatives have been appearing before the Treasury Select Committee. And they have reiterated the consensus that things are getting more difficult to forecast. As Mervyn King said in his evidence:
There is just enormous uncertainty out there. I have no idea what is going to happen in the euro area.
And this uncertainty is making people cautious, which, in turn, damages recovery. As Dr King went on to say:
There is no doubt that with the additional uncertainty this year there’s evidence of people behaving in a very defensive way, being unwilling to invest and of course the most extreme example of that would be if we were to get to a liquidity trap where essentially the main assets people wanted to hold were claims on the central bank.
Part of the reason for the uncertainty about global growth prospects is uncertainty about what European leaders will decide about the future of the eurozone. Another is uncertainty about how people will respond to the uncertainty of others. But predicting how others will predict is very difficult as they will themselves be predicting what others will predict. This dilemma was observed by Keynes when observing how investors on the stock market behaved, all trying to predict what others will do, and is known as the Keynesian Beauty Contest dilemma (see also).
So are governments and central banks powerless to counteract the uncertainty and pessimism? Can they restore confidence and growth? Members of the Bank of England’s Monetary Policy Committee believe that further action can be taken to stimulate aggregate demand. Further quantitative easing and cuts in interest rates could help as, according to Dr King, we are not yet in a liquidity trap.
UK Economic Outlook Uncertain Amid Euro Zone Crisis – BOE NASDAQ, Ilona Billington (26/6/12)
BOE King: UK Not In Liquidity Trap; No Limit On QE Market News International (26/6/12)
BOE King: Unity On Loose Policy; Not Half Way Through Crisis Market News International (26/6/12)
Full Text Of BOE MPC Dale At Treasury Select Committee Market News International (26/6/12)
Recovery still five years away, Mervyn King warns The Telegraph, Philip Aldrick (26/6/12)
Governor pessimistic on recovery ShareCast, Michael Millar (26/6/12)
Bank’s King says ‘pessimistic’ about worsening economy BBC News (26/6/12)
UK economic outlook getting worse, warns Bank of England Guardian, Phillip Inman (26/6/12)
Questions
- Why is it worth economists forecasting, even if those forecasts rarely turn out to be totally accurate?
- Why is it particularly difficult in current circumstances to forecast the state of the macroeconomy 12 months hence – let alone in two or three years?
- In what ways is the global macroeconomic situation deteriorating? What can national governments do about it?
- What limits the effectiveness of government action to deal with the current situation?
- What is meant by the liquidity trap? Are we close to being in such a situation today?
- Explain what is meant by the Keynesian Beauty Contest? How is this relevant today in explaining economic uncertainty and the difficulty of forecasting the economy?
The ECB president, Mario Draghi, has announced a new programme of ‘Outright Monetary Transactions (OMTs)’ to ease the difficulties of countries such as Greece, Spain, Portugal and Italy. The idea is to push down interest rates for these countries’ bonds. If successful, this will make it more affordable for them to service their debts.
