Winner of the New Statesman SPERI Prize in Political Economy 2016

Thursday 17 December 2015

Is OMT a bluff?

Tony Yates yesterday commented on my two recent pieces on Germany. The second issue he raises, on countercyclical fiscal policy, is I think quite easy to deal with. He may be right that there was general unhappiness with how fiscal freedoms had been abused in the past. But if so, that suggested something very similar to the SGP (i.e. rules designed to reduce debt policed by Brussels), but with an additional countercyclical element. That in particular would have applied pressure on the Irish and Spanish governments before the recession, pressure that the actual SGP notably failed to do.

His discussion of OMT (the ECB acting as a sovereign lender of last resort) suggests OMT is a bluff. The argument is that if, under the protection of OMT, the market still refused to buy a government’s debt, the ECB would be forced to buy it, and because there was the possibility of a loss for the ECB they would not do so. I think this is unlikely in practice and is certainly wrong if it is true.

OMT is not extended to any Eurozone country that gets into difficulties. The ECB has to have the right to say no, leading to almost certain immediate default. The test is whether the government is willing and able to stay solvent. The ECB also has to have the right to withdraw support if conditions change sufficiently to put its earlier judgement in question. That is a good argument for why OMT support should come with some form of conditionality, so as to give the country fair warning that support might be withdrawn.

If the ECB gets that judgement right, then there are no implications for inflation. Just as with QE, the central bank will have created money to buy assets which it will at some point sell off again. In fact the central bank makes profits, because the interest it receives from the government on that debt will exceed the interest it pays on reserves. If the ECB gets it wrong there will be costs, but they are not unlimited: they are simply the amount of debt it bought until it decided to withdraw support. The benefits that OMT provides surely outweigh the expected value of those costs, although I agree with Tony that some in countries that are never likely to require OMT may take a more narrow view. Even then there are no necessary implications for inflation, as Eurozone governments should make good the ECB’s losses.

The most worrying thing in Tony’s post is his suggestion that limits should be applied to the amount central banks outside the Eurozone should provide as a sovereign lender of last resort. Such limits can only do harm. They are based on a myth that independent central banks can stop a highly profligate government from raising inflation. It is a myth because the first thing such a government would do is abolish those limits. More generally, a government that is so profligate that future default was inevitable would have no hesitation in abolishing central bank independence. You cannot stop a government of central bank nightmares. Such limits are therefore either meaningless, or could do harm.  


  1. My problem with this post is I am not sure that you NK types, understand the difference between a currency issuer and a currency user. Every member state in the Eurosystem "uses" a foreign currency, including Germany; the Euro. They have no direct control over interest rates or the exchange value of that currency.

    The UK government Treasury spends its own fiat Pound Sterling "unit of account" into existence and taxes the same out of existence. The outstanding amounts at any moment are being saved by the non-government sector, households, firms etc. Nobody, and definitely not the BoE, has the power to bounce a UK Treasury cheque in Pounds Sterling.

    Likewise, in the Eurosystem, nobody has the power to bounce an ECB cheque written in Euro. The ECB can never go broke in the Euro currency, it has a bottomless pit full of the stuff, it is the Euro currency issuer.

    Eurosystem member states' Treasuries, don't spend Euro into existence, they can't, they are not the Euro issuer. They spend Bonds, debt instruments, into a parasitic secondary non-government "market" casino. The ECB makes sure there are enough liquid Euro in the system to cover these bond purchases, if not the ECB will buy them, without limit, should it have to. It is not allowed, by Treaty, to let any of the nineteen national central banks to be insolvent.

    OMT is a bluff. The ECB as the currency issuer, only has to threaten to buy a Bond in unlimited quantities, should an interest rate go above a certain level. The casino bond market will shift to a yield that will be a few basis points below the ECB threat level. The ECB may buy very few of those bonds, the threat is enough to do the job. Any sovereign currency issuing government Treasury and its tethered central bank, can do the same.

    The Eurozone fundamental design fault is there is no sovereign currency issuing Treasury, preferably under some sort of democratic control. It is currently the same as if the UK government Treasury, handed over the fiscal policy of the UK, to the monetary policy institution; the BoE. Crazy!

    1. whether or not a cheque clears or bounces is up to the issuer's bank not the recipients bank. So it would be up to the Bank of England to run an overdraft, if required by the Treasury. In practice the Treasury does not run an overdraft with the BoE over consecutive days so in practice the Government taxes and spends money created by the private sector, as it taxes deposits and spends deposits, which are created by commercial banks and their customers.

  2. "They are based on a myth that independent central banks can stop a highly profligate government from raising inflation."

    But only if, in the current configuration, the central bank is unable to suppress private borrowing sufficiently *or refuses to do so*.

  3. "Fundamentally, economists have long been aware that the effectiveness of monetary policy has its limits once interest rates reach very low levels. As Keynes noted as he watched the Great Depression unfold, fiscal policy tends to be a more powerful tool than monetary policy in such extreme circumstances. It may sound ironic, but the circumstances under which it may be appropriate to consider unconventional monetary policies are also those under which fiscal policy tends to be most effective."

    Canada: looking good for the future

  4. I don't quite know what to do about this statement: "That in particular would have applied pressure on the Irish and Spanish governments before the recession, pressure that the actual SGP notably failed to do." I haven't gone looking for the data today, so maybe my memory is playing tricks on me, but I could have sworn that Spain was running a budget surplus before the recession. Ireland's fault, IIRC, was that they agreed to take over the private banks' debt before they knew how large it was, and it turned out to be ruinous for them. I don't see what the SGP has to do with Spain's current problems, except that it prevented them from using fiscal policy to ease the injuries to their people. The Irish situation was so chaotic and, seemingly, corrupt, that I don't have any idea what effect either the SGP or OMT would have had on them. Can anyone direct me to someplace where I can find out what Spain did that was contrary to the spirit, intent, and letter of the SGP?


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