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Michael Hennigan noted fairly enough that my previous post was a bit on the arcane side.   I’m afraid he will see this one as no better.  

I think it is worthwhile to take a step back and think about how ECB bond buying could have positive effect, and to think about the effectiveness of past and possible future bond-buying programmes in that light.   A useful starting point is to recognise that the willingness to pay for a bond with a given face value and coupon rate depends on the “risk free rate” and the perception of default risk.   If everyone agreed on the default risk, then the demand curve for bonds would be perfectly flat.   If a bond buying programme did not actually change the perception of default risk, then bond buying would have no effect on secondary market price and thus on yields.   (A useful way of thinking about official bond buying is that it shifts the market supply curve leftwards; if the market demand curve is horizontal, then there will be no change in price (and thus yields)).  

However, if there are varying perceptions of default risk, then – even if the bond buying programme itself does not change anyone’s perception of default risk – the programme will raise bond prices (and reduce yields), as the market moves up along a downward sloping demand curve.   (The differing perceptions of default risk is what makes the demand curve downward sloping, given the resulting variation in willingness to pay.)   My sense is that this is what broadly happened in the first phase of bond buying.  The weak commitment to the programme did little to change actual perceptions of default risk.   Thus, while purchases were somewhat effective in reducing yields, the positive impact was very limited, as ultimate default risks were left largely unchanged.  The programme ended up in failure.

It seems Mario Draghi is well aware of this, and he wants any future to operate quite differently.   The key is to provide a credible commitment to keep yields down and ensure that expectations of a “bad expectational equilibrium” do not take hold.  But there is understandable concern over moral hazard.   Although some European policy makers seem to have a difficult time giving up on market discipline (even after Deauville), I don’t see how we can pull out of the crisis unless the perception of default risk is kept low.  This leaves “conditionality” as the only feasible disciplining device.   But I don’t see how the ECB would be in a position to make a credible commitment to do what it takes unless this alternative disciplining device is in place, which explains the requirement that benefiting countries enter a programme.  

The goal should be to take risk of sovereign debt restructuring off the table as far as possible in any future programme.   (The example of Greece shows that the possibility of restructuring cannot be completely removed; and it did the credibility of the Trichet-led ECB no good to make ludicrous statements that restructuring was impossible.)  Mr. Draghi’s (vague) commitment to revisit ECB seniority can be viewed as backing up this approach, so that even in the low probability event that there is a restructuring, the losses would be shared with official creditors.  

(As an aside, I think that a major factor behind the fall in Irish yields is the that, even if there is need for a second programme, the risk of a debt restructuring being part of that programme has fallen significantly.)  

Overall, Mr. Draghi seems to moving in the right direction.   Let’s hope he can deliver.

Karl Whelan has a good post on the exaggerated fears of ECB insolvency, rightly pointing out that standard ideas of bank or non-bank-corporate insolvency do not transfer well to a central bank with the power to create liabilities at will.

But I think Karl’s post underplays the importance of potential redistribution effects of monetary policy within a monetary union.   (Although the ECB’s stress on price stability gets most attention, my sense is that the avoidance of redistributions between members plays at least as important a role in their thinking.)   One way of seeing this is to recognise that the amount of seigniorage-related revenues available for ultimate distribution to member governments is fixed by the inflation target (given real growth and other determinants of the change in money demand.)   Losses on asset purchases will lower these revenues. 

This also relates to discussions of design flaws in the euro, and especially the absence of effective bailout mechanisms.   The revealed fragility of creditworthiness within the monetary union shows the seriousness of this flaw.  But the “no-bailout-rule” was there to reduce the risk of redistributions, and without it many countries would not have signed up.   The revealed design flaw will have to be fixed if the euro is to survive.   Yet I think there is a better chance of effective negotiated change if legitimate concerns over redistributions are recognised.

I have a survey paper on the fiscal dimensions of the euro crisis in the Summer 2012 issue of JEP.

Link here

The FT editorial provides a “fair and balanced” assessment of this initiative – here.

Mario Draghi’s introductory statement is here.  Parts of the following extract were re-read by Draghi in response to some predictable questions early in the press conference.

The Governing Council extensively discussed the policy options to address the severe malfunctioning in the price formation process in the bond markets of euro area countries. Exceptionally high risk premia are observed in government bond prices in several countries and financial fragmentation hinders the effective working of monetary policy. Risk premia that are related to fears of the reversibility of the euro are unacceptable, and they need to be addressed in a fundamental manner. The euro is irreversible.

In order to create the fundamental conditions for such risk premia to disappear, policy-makers in the euro area need to push ahead with fiscal consolidation, structural reform and European institution-building with great determination. As implementation takes time and financial markets often only adjust once success becomes clearly visible, governments must stand ready to activate the EFSF/ESM in the bond market when exceptional financial market circumstances and risks to financial stability exist – with strict and effective conditionality in line with the established guidelines.

The adherence of governments to their commitments and the fulfilment by the EFSF/ESM of their role are necessary conditions. The Governing Council, within its mandate to maintain price stability over the medium term and in observance of its independence in determining monetary policy, may undertake outright open market operations of a size adequate to reach its objective. In this context, the concerns of private investors about seniority will be addressed. Furthermore, the Governing Council may consider undertaking further non-standard monetary policy measures according to what is required to repair monetary policy transmission. Over the coming weeks, we will design the appropriate modalities for such policy measures.