Saturday, November 22, 2014

Pulling the OMT Trigger

CHICAGO – Europe has been experiencing a period of calm after the storm since European Central Bank President Mario Draghi’s “whatever it takes” speech in July and the ECB’s decision in September to proceed with its “outright monetary transactions” (OMT) program to purchase distressed eurozone members’ government bonds. The interest-rate spreads for Italian and Spanish government bonds have dropped dramatically, corporate-bond issues have resumed, and a sense of normalcy is slowly pervading the continent.

But it would be foolish to conclude that the euro’s problems have been solved. The economic fundamentals are far from stable, while the reduced financial tension is the fortunate outcome of an expectation game. As long as investors believe that Italy and Spain will eventually be rescued by the OMT, these countries’ borrowing costs will be low, and the rescue will not be needed. If, however, the slightest doubt about the OMT’s effectiveness arises, the expectation game will shift into reverse, and both countries’ bonds will quickly come under attack.

One such source of doubt may be the OMT’s safety catch. To become operational, all European governments must approve it. The rules vary among EU countries, but, in Germany, “government approval” implies parliamentary approval. In an emergency situation, it is difficult to imagine that Germany will not prefer approval to the disaster of an Italian or Spanish default. Still, any delay could be enough to trigger a bank run in either country. By the time the German Bundestag decided, it could be too late.

To eliminate this uncertainty, Italy and Spain should ask for the OMT intervention before it is desperately needed – a request that the Bundestag would most likely approve, viewing it as an insurance scheme rather than a pure transfer. Doing so would also eliminate the uncertainty surrounding the program itself and its implementation mechanisms. Identifying and addressing problems when intervention is not urgently needed is much easier than working them out under the threat of a pending sovereign default.

Finally, an early request for OMT intervention would not only reduce the Italian and Spanish governments’ borrowing costs (and thus their fiscal deficits), but would also lower the cost of capital for local firms, which currently find it difficult to borrow and invest. Thus, it would provide a much-needed boost to these countries’ struggling economies.

So, if triggering OMT intervention would be so beneficial, why are the Spanish and Italian governments so reluctant to do so? The main reason is political. In the 1930’s, all European governments feared that breaking from the gold standard would be perceived as a sign of weakness. As a result, they waited too long. The same is true of the OMT program: elected politicians fear that triggering it would be perceived as a sign of weakness, implying a cost that they have a strong incentive to delay paying.

But why is Italian Prime Minister Mario Monti, who is not an elected politician (and has promised not to run for election), so hesitant? Given that he does not have to fear electoral defeat, he could help Spanish Prime Minister Mariano Rajoy by filing first, which would weaken the political stigma for Rajoy’s government were it to file subsequently. Triggering OMT now would also be a safe play for Italy in the face of an imminent general election with a highly uncertain outcome.

What is not uncertain is that an anti-euro party, run by a professional comedian, Beppe Grillo, will gain at least 20% of the Italian vote. The political instability that could ensue would not provide a good opportunity to ask Germany for help. In fact, if one were to imagine reasons why Germany might not approve a request by Italy to trigger the OMT, political turmoil would top the list. By contrast, triggering the OMT in advance would promote political stability in the face of uncertainty, because it would tie the hands of any future Italian government.

Why, then, is Monti not acting? One possible reason is personal pride. Monti wants to be remembered as the prime minister who saved Italy from disaster. He does not want to go down in history as the prime minister who had to surrender Italy’s sovereignty to save the country from default. An alternative explanation is that Monti does indeed have political ambitions. While Monti’s mandate was set to last until the election, he might be trying to extend it with the support of the new parliament.

Delay for either of these reasons would be a very selfish act. Monti should not risk European stability for his personal benefit. He should trigger OMT before it is too late.

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    1. Commentednicola perali

      On the contrary I agree with Mr Zingales arguments and as such I believe he did not neglect the conditionality problem. If Mr Monts or whoever for him in the next future waits too much and recession - very likely so -deepens, eventual conditions will be far harsher than the conditions the prime minsiter would obtain at today's situation. He would probably get guidelines to stay on his course. Meanwhile, interest cost would lower at a faster pace.

    2. CommentedRonald Lattuf

      Mr. Zingales, I would argue you're being over-optimistic about the benefits of an early OMT intervention. There is an element that you do not mention in your article that may be the main reason why it has not been requested by countries such as Spain or Portugal. If they file for it, there will be a strict conditionality attached to it, and continued support by the ECB will be strictly dependent on the beneficiary's ability to stick to the conditions. Shall one of these countries not follow these conditions, support would be withdrawn and that would be the end of the game for OMT interventions.

    3. CommentedMarco Cattaneo

      "In the 1930’s, all European governments feared that breaking from the gold standard would be perceived as a sign of weakness." Zingales fails to see that breaking from the gold standard was the 1930's equivalent of breaking from the euro today.
      "Pulling the OMT trigger" would imply accepting "conditionality" ie further austerity - an avenue proven to be counterproductive (to put it mildly).
      Zingales dismisses "Grillo's movement as an anti-euro party, run by a professional comedian". It actually is the only major Italian political force where the faults of the european monetary system are clearly recognized and solutions (including but not limited to an euro exit) are proposed and discussed.

    4. Portrait of Michael Heller

      CommentedMichael Heller

      Luigi, my blog post at Project Syndicate today is a little critical of this article. Usually I’m a great supporter. However I don’t see how it’s possible to discuss uncertainty about OMT without at least mentioning the uncertainty about conditions which must essentially attach to OMT. Possibly you see structural reform and conditionality as subtext of your support for preemptive OMT. I and many Europeans would put them in bold!