It’s the size of the pie, stupid

When ECB president Mario Draghi decided to stabilize the short rates of troubled Eurozone countries, did he do the right thing? In a powerful report, Chicago Board of Trade on-air editor Rick Santelli said No! The Outright Monetary Transactions (OMTs) that Draghi announced on September 6, 2012, are not about growth. Santelli made his point by slicing a small pie and a large pie into four pieces. You want a part of the small pie or one of the large pie? Bottom line is: the stabilization of the short rates proved to be effective (see the figure below), but it is not about growth. Or is it?

Yield Spanish Gov Bonds 2 YR source: Bloomberg ticker GSPG2YR; highlighted: the day after Draghi’s announcement of the OMTs

September 6, 2012: Outright Monetary Transactions

The OMTs will be directed on the shorter part of the yield curve. Sovereign bonds with a maturity of between one and three years will be bought on the secondary market. No ex ante quantitative limits are set. The bonds bought by the ECB will not have a rank that is senior to those bought by private investors. With the start of the OMTs the Securities Markets Program (SMP) is terminated.

Santelli’s opinion is part of a wider austerity versus growth debate. The advocates of austerity stress balanced government budgets, whereas the growth people are less concerned about fiscal deficit and government debt and underline the necessity of fiscal measures since monetary measures only may have no impact at all on the real economy.

Is Santelli right? I think the OMTs and the 1 trillion euro Long Term Refinancing Operations (LTROs) can be linked to growth in two ways.

Monetary policy and Basel III

In the first place, the ECB’s expansionary policies eased the pressure on banks to sell assets at depressed prices. The influex of cheap money succeeded in preventing a credit crunch that was expected to take place when banks start their Basel III programs. In order to increase their capital ratios they need to expand their common equity base, reduce their balance sheet or both. However, a reduction of the exposures is not a very welcome development given the bleak economic prospects in the wake of the subprime and sovereign debt crises. The ECB’s expansionary monetary policies could thus have prevented a disorderly deleveraging with severe consequences for economic growth.

However, since the banks have reinvested a significant part of the LTRO funds to buy sovereign bonds, the dangerous dependency between banks and governments has not been reduced. The EU Capital Requirement Directive has introduced a generalized zero risk weight for the sovereign debt of all member states (‘the biggest accounting scam in history’, according to the chairman of the International Accounting Standards Board). Also, sovereign debt is the most important part of the liquid assets required in the Basel III Liquidity Coverage Ratio (LCR). The LCR could be seen as an incentive for banks to hold sovereign debt.

Conditionality linked to EFSF/ESM aid and labor market reforms

In the second place, Draghi announced a strict conditionality to be applied. The OMTs will be implemented in conjunction with aid from the EFSF/ESM funds. This aid is conditioned on a macroeconomic adjustment program. It is expected that Spain will apply for EFSF/ESM aid and will step up labor reforms and measures to stimulate employment especially for the young unemployed Spaniards (50% youth unemployment). Labor market reforms such as lowering the dismissal costs of permanent workers are already under way.

Now that the ECB has provided welcome accommodation of growth strategies, it now up to the EU political leaders to implement bold labor reforms. That is the only way forward to enlarge the pie.

In discussion with Rick Santelli at the Chicago Board of Trade


Over Folpmers
Financial Risk Management consultant, manager van een FRM consulting department, bijzonder hoogleraar FRM

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