The German Constitutional Court’s recent ruling to rein in the ECB operations known as “Outright Monetary Transactions” (OMT) as unconstitutional, has elated many German politicians and Euro-sceptic economists. But this is a pyrrhic victory for Germany, and a sad week for the European periphery.
Princeton University economist Ashoka Mody for example has labelled the OMT as economically “ill-conceived” in his recent Project Syndicate article. The argument goes that ECB claims that risk premiums reflect unfounded fear were based on “Cherry-picked evidence” and that the OMT program by definition conceded that “assessments of creditworthiness reflected a real default risk”. Thus, one should let the market price this risk adequately to create an optimal solution. In other words, the ECB has given periphery Europe a free lunch, and distorted the sovereign bond pricing system in the Eurozone.
An implicit notion in this argument however is that causality between finance and fundamentals is a one-way street. Financial feed-back loops, either do not affect the real economy, or they are completely rational and optimise results. This is clearly fallacious. The risk of Sovereign default is almost purely a function of the interest rates that must be paid on their debt. In addition, risky markets do not operate anything like their safer financial and real counterparts in reducing volatility and allocating capital.
In financial markets optimal results requires a balance of speculators and fundamentals traders (value investors). The speculators, supply liquidity to the market and trade in line with trends. The value investors however, absorb this liquidity and tend to trade against trends. The result is a stable asset pricing system, where small shocks do not get blown out of proportion and liquidity is sufficient.
So who are the value traders in Sovereign debt markets? When it’s high grade, there are sovereign wealth funds, superannuation funds, etc. that all use these low-risk assets to hedge against adverse economic shocks. The problem is though, that periphery European debt markets nowadays are no longer high-grade. Indeed, risk premiums have consumed a major part of debt repayments from peripheral Eurozone countries and many of the historical value investors have moved away. Thus the speculative component of these markets is probably too high.
And so the periphery of Europe is faced with a double dilemma. Two positive feedback loops that can cause the downfall of the Eurozone. If individual country risk premiums reach a point where they begin to threaten national solvency, then speculative component of the asset holders will do the rest. They will begin shorting the debt and creating higher interest rates whilst pulling back liquidity lines. Any sizeable shift in fundamentals therefore (such as an elimination of OMT) will cause carnage.
For example, Spain’s public debt still only hovers at around 90% of annualised GDP, and risk premiums are far higher than in the US where debt as a percentage of GDP is around 130%. Risk premiums cause default risk, and more risk premiums. This is an equilibrium reached under artificial circumstances, and it should not be tolerated. It is clearly a market flaw. If Sovereigns are able to repay their debt reasonably, that should be strived for. OMT facilitates this by a reduction in national stress, and reduces actual risk in a very real sense. It breaks the speculative loop and changes the fundamental solvency of the beneficiaries.
Attempts at destroying OMT are thus almost wholly political, and are not astute economic policies. Attempts at diluting it are even worse. To date, OMT has managed to avoid speculative attacks on the ECB’s commitment to do “whatever it takes”, and premia have been meaningfully reduced. If the German High Court, and the European Court of Justice however, choose to dilute the OMT program then a very different scenario could emerge, and the ECB could lose the credibility it’s fought so hard for these past few years.