The details of the European Central Bank bond purchase plan have been leaked to Bloomberg, and they confirm perhaps the worst fears of how this program would be managed. As I’ve been saying all along, Mario Draghi was faced with a dilemma. He needed to act to save troubled sovereigns in Europe like Spain and Italy from default, but he didn’t want to give up his hole card, the promise of aid linked to euphemistically titled “labor market reforms” that amount to subjugation of the state and its citizens. In addition, he had to manage a very disparate set of central banks who wanted to rely on treaty requirements to deny aid outright, and who constantly despaired of hyperinflation from central bank purchases.
So here’s what Draghi came up with:
European Central Bank President Mario Draghi’s bond-buying proposal involves unlimited purchases of government debt that will be sterilized to assuage concerns about printing money, two central bank officials briefed on the plan said.
Under the blueprint, which may be called “Monetary Outright Transactions,” the ECB would refrain from setting a public cap on yields, according to the people, and a third official, who spoke on condition of anonymity. The plan will only focus on government bonds rather than a broader range of assets and will target short-dated maturities of up to about three years, two of the people said [...]
To sterilize the bond purchases, the ECB will remove from the system elsewhere the same amount of money it spends, ensuring the program has a neutral impact on the money supply.
Draghi will stress conditionality of the program tomorrow, with the ECB likely to stop buying the bonds of any government that fails to meet the conditions it agrees to when it signs up for aid from Europe’s rescue fund — a precondition for ECB action — two of the people said. Another proposal is for the ECB to sell the bonds it has bought if a country doesn’t comply with the conditions, two of the officials said.
So we have a system of central bank purchases that will be immediately offset by other central bank sales. There’s no commitment to capping debt yields, and the bond purchases will all be government short-term debt rather than a basket of securities. Moreover, the “conditionality” means that countries like Spain and Italy have to come begging to the ECB for help by signing up to the European bailout fund, which will carry all sorts of strings.
First of all, the “sterilization” of the purchases means that they will not be effective on the continent as a whole. They may mean some flows to the more troubled countries in terms of the money supply, which could balance current monetary policy. But the idea that you commit to “unlimited” purchases on one side, and sterilization on the other (with “unlimited” sales?), makes no sense.
However, the real effort here is to trap the countries that need the help into giving up some of their sovereignty:
What the ECB is doing, in essence, is setting itself up as the shadow government of Italy, Spain, Portugal, and perhaps Ireland. If the governments of those countries do what Draghi wants, Draghi will provide them with generous subsidy. If the governments of those countries don’t do what Draghi wants, he’ll use a monetary laser to destroy their budgets. Fear will keep the peripheral states in line.
As I’ve said many times before, this is an incredibly destructive course for a central banker to steer. The job of a central bank is to provide a stable and appropriate course of aggregate demand. The job of a legislature is to figure the rest out. If Italian politicians want to stick with policies that leave the economy rigid and cause a lot of that demand to turn into inflation rather than real output, that’s their problem. If Portugese politicians disagree with ECB staff economists about what kind of policies are likely to lead to long-term prosperity for Portugal’s citizens, they’re entitled to give it a try. And while it happens to be the case that the ECB is pushing a set of more or less “business-friendly” policies, the course it’s steering is incredibly hostile to the basic interests of any kind of reasonable businessman. In order to make its political threats credible, the ECB has to essentially promise that it won’t be delivering stable monetary conditions. Instead the plan is to let things whipsaw as a means to discipline and punish elected officials.
The only hope to break this cycle is if the intention to purchase the bonds is enough to lower the yields all by itself. But that would be an unintended consequence. Draghi, and by extension the whole of the European policy apparatus, wants this kind of power. And because nobody spells out what “labor market reforms” means, let me help you by looking at Greece, where they’re trying to roll back the weekend.
This is about the worst possible policy announcement the ECB could make. The only hope is that the bond market finds it credible enough to never test it. And if they were sound economic analysts, they wouldn’t, because the results for Spain and Italy and the rest of the troubled countries would be disastrous, including for their chances of ever paying back their debts.