The ECB’s OMT is seen the ultimate bazooka that backstops the debt crisis: it is so big and comes from such a powerful factor. However, this bazooka also has adverse effects: it curbs the enthusiasm for reform and also pushes the value of the euro higher.
After Draghi showed us that he is not shy of joining the currency wars, he can take one step further.
Mario Draghi, president of the European Central Bank, said on July 26th 2012: “We will do everything to preserve the euro, and believe me, it will be enough”. This is seen as the turning point in the debt crisis. The ECB later followed up on these words by presenting a program called Outright Monetary Transactions (OMT). With this program, the ECB would buy bonds of countries that have asked and received a bailout.
Spain, that saw bond yields soar that summer, discussed a potential bailout but never had to take it: the mere existence of the ECB’s program restored confidence in Spain, the euro-zone and the euro. Money began flowing back into the monetary union, Spanish borrowing costs began falling and Spain did not need to ask for a bailout.
So, the OMT so far serves as a big “bazooka”. The term bazooka was used by then Treasury Secretary Henry Paulson, during the height of the financial crisis:
“If you’ve got a bazooka, and people know you’ve got it, you may not have to take it out. … By increasing confidence, it will greatly reduce the likelihood it will ever be used”
The ECB is probably the strongest factor that can combat the debt crisis. It presented a weapon that was definitely big: the ECB can buy endless amounts of bonds, and it wasn’t used so far.
Bazooka Backfire
However, this bazooka can also backfire: without higher borrowing costs, Spain and other European governments have less motivation for reform. Without reform, the OMT could only buy limited time until the next crisis. Spain still has a high unemployment rate (26% and rising), no growth prospects and a growing national debt. Thanks to the OMT, Spain has been away from the limelight.
However, this can change very quickly: as we have seen recently, a corruption scandal in Spain had adverse effects on Spanish yields and reminded us all about Spain’s issues.
Ex-ECB governing council member Athanasios Orphanides suggested that the ECB should consider suspending the OMT. Even a small hint about retiring the program could send bond yields screaming higher and add pressure for some reform.
In addition, such a move could also weigh on the value of the euro, something the ECB made clear that it wants as well. If Draghi truly wants a lower value of the euro to help the euro-zone get out of its recession, a hint about suspending the OMT could be a step in the right direction.
Further reading: Euro to dollar forecast.