ECB President Mario Draghi mounted a robust defense of the independence of the central bank against critics who say that the new Outright Monetary Transactions (OMT) bond buying program compromises it. Vocal critics include former German council members Jürgen Stark and Axel Weber, who have pointed out that the conditionality of the OMT constrains monetary policy when the ECB should be ensuring proper transmission across the euro area regardless of any aid program.
Draghi’s defense seems to stem from his experience at the Bank of Italy and academic studies that point to the problem of ‘fiscal dominance.’ So, Draghi says that OMT enhances ECB independence because it addresses fiscal dominance, reduces moral hazard by governments and acts as a credit enhancement on government bonds.
A way to think about fiscal dominance is to consider how high levels of government debt can influence long-term bond yields. A highly-indebted country may find that its yields or borrowing costs are high as a result. But, as monetary policy aims to change borrowing costs that are determined by long-term rates, fiscal dominance can compromise the operation of interest rates in the real economy. A central bank cutting short-term rates may not do much to lower borrowing costs. Thus, Draghi seemed to say that OMT can help reduce yields and increase the effectiveness of independent monetary policy.
It is also related to the point that Draghi made about moral hazard. OMT conditionality increases fiscal discipline, so it reduces the incentives of governments to act irresponsibly if the central bank buys their bonds and lowers their yields, which could enable them to borrow and spend more. As central banks tend to operate on what’s called a Stackelberg leadership model, monetary policy “reacts” to fiscal policy so governments are the “first movers.” Central banks observe the fiscal picture and then set their policies. Thus, via conditionality, the ECB appears to be more proactive and thus monetary policy operates rather more independently and less entirely reactively.
The jury may be out on whether the ECB can justify introducing conditionality into monetary policy. But, what is clear is that the high levels of government debt will likely dominate the policymaking landscape for some years to come.
Watch Draghi’s news conference and our ECB special show here: