Massive government interventions always lead to unintended consequences. ECB President Mario Draghi announced the Outright Monetary Transactions (OMT) plan in early September. OMT is merely a euphemism for printing euros to bail out distressed sovereigns and banks.
Investors have demanded higher interest rates for PIIGS debt due to deteriorating economic conditions and the increased chance of a eurozone breakup. By announcing its plans to buy debt maturing in one to three years on the open market, the ECB hopes to bid up prices so that the PIIGS can continue issuing debt at a lower interest rate, that is a cheaper price.
In the short-term, this plan will continue to work and keep interest rates lower than they should be. In the long-term, the plan is doomed because it sows the seeds of its own destruction through those pesky unintended consequences.
It is counter-intuitive that interest rates on a country’s debt should decline on news that this country is seeking a bailout. The reason for this dynamic is that speculators are attempting to frontrun the ECB. There is now a floor under the price of these bonds which makes them more attractive. This lowers the price of this debt in short-term.
The first unintended consequence of OMT is that it will actually encourage banks to sell their debt back to the ECB in the long-term. OMT is actually a backdoor bailout for European banks that loaded up on PIIGS debt. Once OMT commences these banks will be able to sell their holdings at a profit, so they will. They could continue to hold onto to it, but then they are holding on to the risk of a default, too.
Using the Greek bailout pattern as a template for the upcoming Spanish one, Spain is in a depression and will experience at least a partial default in the near future. When it becomes apparent that a default is in the cards, these banks will dump all of their Spanish debt.
The prospect of a default is self-fulfilling, and the banks mass sales in anticipation of default will lead to default while the ECB spends taxpayer money to buy the debt on the open market.
The European taxpayer is actually double-screwed. He will be paying the costs of a Spanish bailout and for the close to worthless bonds held by the ECB; remember that the ECB is supposedly no longer a preferred creditor and will take a hit along with all the private investors. (We’ll see) This is the endgame for Spain when it enters OMT.
The other unintended consequence of this program is that it will force other countries to enter the program. The financial markets are a zero-sum game. A euro invested in Spain is a euro less to invest in the debt of other countries.
When the ECB begins buying Spanish bonds to hold down yields, money will flow from other risky eurozone countries to take advantage of the price floor. Italy will be the first to feel the effects of this process.
Even though it is in better economic and fiscal shape than Spain, its bonds will now be riskier because there is no OMT price floor. Italy’s interest rates on its short-term debt will begin to rise as it loses investors. When the interest rate hits a certain threshold, it too will be forced to enter the program.
Eventually, each distressed country will be forced to enter OMT, and the ECB will need to print more and more euros to accommodate them. With each printed euro, a currency crash followed by a massive financial panic becomes more and more likely.
Meanwhile, while OMT does bail out the banks and the sovereigns, it does virtually nothing for the mass unemployed. An economic depression will continue to persist during the print-fest. The only way out of the debt trap and the depression is to abandon the euro and the politicians who seek to maintain it.
Down with OMT
Down with OMT
Whose down with OMT
All the Piiggies!