OMT! Enter The Draghi

As leaked earlier by Bloomberg, Mario Draghi in a press conference today, presented his big plan to save the world.

This will involve OMTs (Outright Monetary Transactions) – in which a Euro Area nation central government requesting aid from the EFSF/ESM will also be provided help by the ECB. Under this plan, when a nation’s government asks for financial aid (and a big if), the ECB/Eurosystem may buy government bonds in the open markets to bring the yields down.

The Eurosystem will buy bonds with maturities between one and three years and will accept credit risk on these bonds and will not ask for a seniority status in case of default. Of course, this will come with strict conditions – the government asking for aid would need to commit to a tighter fiscal policy and promise supply side reforms. There will be no upper limit to the  amount of bonds purchased by the Eurosystem.

The full details are here: Introductory statement to the press conference6 September 2012 – Technical features of Outright Monetary Transactions.

During the press conference (actually a bit before as well – after Bloomberg leaked a part of the plan), government bond yields had huge moves (e.g, Spanish ten year yields decreased 39bp). Now, if the yields do not reverse and deteriorate again soon, governments requiring help may just delay asking for aid. However, sooner or later bond yields may rise again – especially if foreigners holding the bonds start to get nervous.

My own view is that this plan significantly reduces the risk of an exit by a Euro Area member. Unlike previous plans (SMP, EFSF, ESM) this has no limit on the amount of funds needed. There is no need to wait for parliaments and courts to approve any transaction or aid.

Of course this is not a happy set of affairs. Forcing governments into retrenchment will lead to economic conditions deteriorating further. One however needs to realize that an independent fiscal policy for the troubled nations – while it (an expansion) increases national income and output – will have the adverse effect of deteriorating the balance of payments – resulting in the public debt and the nation’s net indebtedness to foreigners (and the latter is already high for troubled nations) rising without limit relative to output. The plan will look good in retrospect if it is supposed to be a bridge toward a political union with a central government.

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