In what it calls a program of “Outright Monetary Transactions”, the European Central Bank has committed to buying an unlimited amount of government bonds where there are, in the words of the ECB, “severe distortions in government bond markets”.
A little over a month ago, European Central Bank president Mario Draghi said that he would do “whatever it takes” to hold the eurozone together. The announcement of OMTs overnight is clearly a demonstration that Draghi is serious about contributing to what is a long-term fix, even if having the central bank intervene in the bond market is seen by some as a radical and a somewhat risky approach.
As has been said many times before, the depth of the sovereign debt crisis requires radical action.
The theory behind OMT has two main purposes – to make sure that the governments in the eurozone (particularly the likes of Spain and Italy) can finance themselves during the long transition to improving their fiscal settings; and it aims to directly lower bond yields which will help support economic activity.
In announcing OMT, Draghi said that the ECB bond purchases would be “an effective backstop to remove tail risks from the euro area”. The radical and unprecedented policy will see the ECB buy bonds of between one and three years duration. In a concession to Germany, the bond purchases will be “sterilised” from the market which means the overall impact on the money supply will be neutral.
It is also vital to acknowledge that OMT comes with strings attached.
It is not a blank cheque, even if the bond buying program is open-ended. Countries must continue on the path of fiscal repair because the structure of the OMT program means governments have to make a request to access the bailout fund and the ECB could reject that request if it judges the path to fiscal reform is inadequate. Draghi said that “the ECB reserves the right to terminate bond purchases if governments don’t fulfil their part of the bargain”, in others words, holding to the path of fiscal reform and austerity.