OMT. Part I

These blog posts eventually lead to the Outright Monetary Transactions (OMTs), which was recently announced by the ECB.

First, I think it’s important to get a refresher on the problems in Europe.  I am going to use Spain as an example. 

1. Countries like Spain ran up large debts earlier in the decade, which was a boom to asset prices and growth. 
2. Thus, as capital began to leave Spain asset prices began to fall.  And so started a negative feedback loop – lower asset prices, capital flees, resulting in lower asset prices, more capital flight, etc.
3. This puts Spanish banks in a bad spot as their assets decrease in value and their funding sources dry up.  This results in a pullback in lending.
4. So back to point 1, growth was also dependent on credit, which is now being taken away.  As a result, growth stalls.  Again this creates another negative feedback loop – lower growth, less lending, resulting in lower growth, thus less lending, etc.
5. The combination of 2 and 4 lead to private defaults and exacerbates the fall in asset prices and growth.  Further, it puts the banks at risk.
6. This also leads to a collapse in tax revenues, a massive increase in stabilizers (i.e. the social safety net), a possible bailout of the financial system, and thus a ballooning of the public deficit to GDP.  This in turn causes interest rates to rise.
7. Rising interest rates create a self-fulfilling prophecy.  Higher interest payments = higher deficit = higher interest rates.  This continues until a breaking point when interest rates are too high and governments default.  
8. Simultaneous to #1, foreign capital is being pulled out of banks (i.e. “a run on the bank”) as the probability of public default rises.  This is because after the default deposits will be in the new local currency, which will be devalued relative to the Euro.
9. Number 8 exacerbates the problem of interest rates rising, as the reserves used to pay off public debt being to dwindle.

If you read the above and thought “this sounds a lot like the US” you would be correct… up until number 6.  So why aren’t we seeing the same sort of interest rate problem as Spain?  The most basic reason is that a key ingredient in the above is missing – monetary policy (the Fed and ECB).