2013-61. A useful opinion on ECB moves

The article is useful, because it shows how the ECB operated to solve the Euro zone crisis

The Euro area faced the same problems as the US during the financial crisis: the credit market did not function well, there was insufficient liquidity in the system and many banks had troubles meeting their obligations. The Long Term Refinancing Operation (LTRO) introduced by the European Central Bank (ECB) in 2011 aimed at solving the problem. Essentially it allowed banks to borrow near unlimited funds from the ECB at a low interest rate (1%) for a period of three years. Banks could use the funds however they wanted. So they borrowed large amounts and bought higher-yields assets, including government bonds. This helped another problem: high interest rates on debt of Italy and Spain, two weak countries of the Euro area. As banks bought Italian and Spanish bonds, their prices increased, and their interest rates fell. This led to an improvement of the fiscal position of the two countries as they could now borrow at lower rates.

How big was the program? Very big. For example in March 2012 the ECB lent over 500 billion Euro, or over $700 billion.

In August 2012 the ECB introduced another program, specifically aimed at reducing interest rates on long-term bonds of problem countries. Outright Monetary Transactions (OMT) is a program under which the ECB buys directly government bonds maturing in 1-3 years. The purchases are made in the secondary market. The purchases raise the prices of government debt and reduce interest rates on 1-3 year bonds. Through the term structure, they also reduce interest on long - term bonds. They also increase confidence of private investors, raising private purchases of government bonds and further increasing their price and lowering the interest rate.

The lesson from this: apart from setting the short-term nominal interest rate, central banks have many tools at their disposal to affect markets in time of  crisis.

But, as the article points out, the intervention creates moral hazard. By reducing fiscal difficulties of problem countries, it reduces commitment to fiscal reform.