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What is OMT and how does it save the euro?

An explanation of the European Central Bank's latest plan to solve the eurozone crisis with 'outright monetary transactions', or OMT.

What is OMT and how does it save the euro?

The eurozone debt crisis is littered with an array of confusing acronyms. The latest is OMT, which stands for 'outright monetary transactions' by the European Central Bank.

I explain what OMT means and how it is meant to help struggling countries like Italy and Spain and, in the process, save the euro.

This is the latest video in The Lolly Investor Programme series, aimed to help beginners get the basics of investing.

Hello, welcome to The Lolly Investor Programme.

Having had a go at explaining the Bank of England’s quantitative easing programme last time, this week I’m going to tackle another of the big economic stories of our time.

What is being done to solve the eurozone debt crisis that is casting a dark shadow over both the UK and the global economy?

Earlier this month the European Central Bank (ECB) unveiled its most ambitious attempt yet to help the struggling economies of Italy and Spain and save the euro from breaking up.

For a short moment it looked like the ECB had given people like me a gift in talking about what it was doing. It was reported that the central bank’s initiative was going to be called MOT.

Which is why I’m standing in the Citywire car park!

Unfortunately, by the time ECB president Mario Draghi stood up in Frankfurt to present his measures it had become OMT, standing for ‘outright monetary transactions’.

Someone had got the letters the wrong way round.

Nevertheless, the idea of an MOT is a good one. The question then is, did Draghi and the ECB pass the test? Have they done enough to save the euro?

The big idea behind OMT is that the ECB will buy lots of government bonds of the most indebted Eurozone countries. This will push up the price of these bonds and lower their yields which will have the effect of reducing the amount of interest the countries pay on their debts.

There are five parts to OMT.

Unlimited:

First it is unlimited. The ECB says it will buy as many bonds as it takes for markets to get the message that countries like Greece, Spain and Italy are not leaving the euro, that the single currency is irreversible. Like the Bank of England the ECB can create new money to fund these bond purchases so it is a powerful player.

Conditionality:

Secondly, there is one big string attached. To get this help countries must apply for aid from the European bailout funds. That means they have to agree to cut spending and raise taxes, probably under the eye of the International Monetary Fund.

Short term:

Thirdly, the OMT will only buy short-term bonds between one and three-year duration. In other words this massive intervention in the bond markets is meant to be temporary.

No 'seniority' for ECB:

Fourthly, the ECB will not put itself ahead of private bond investors. If the countries it helps default on their debts the ECB will lose money alongside other bond holders. This is important as it makes investors more comfortable about lending money to the weaker euro countries.

Sterilised:

Last but not least the OMT purchases will be sterilised. This is a classic bit of banking jargon, but what it means is that the ECB will put OMT through the car wash, removing as many euros from the system as it injects via its bond buying.

It’s giving with one hand and removing with the other.

This is significant as it means the ECB is not embarking on quantitative easing like the Bank of England or the US Federal Reserve.

It is not increasing the amount of money in circulation in the euro area, which the German Bundesbank president Jens Weidmann believes would be highly inflationary. It is simply taking big steps to ensure that government bond markets work properly so that when the ECB cuts interest rates countries like Spain and Italy get the benefit.

Will it work?

This bold – or desperate – move by the ECB is its latest attempt to grapple with the Eurozone debt crisis. There is no guarantee that it will work, although markets soared after the announcement.

A big fly in the ointment is that Spain and Italy are desperate to avoid the humiliation of asking for a bailout like Greece, Portugal and Ireland. They may have no choice, however.

Also once OMT starts, can it be stopped? If a country fails to cut its debts, would the ECB stop buying its bonds? Critics doubt the ECB would have the political will to pull the plug.

Even if OMT does work it does nothing to help southern European economies grow their way out of a tough recession, which is the root of all their problems.

1 comment so far. Why not have your say?

Tim G

Sep 16, 2012 at 15:48

How refreshing! A technical abbreviation (OMT) explained in simple terms. I applaud your efforts Mr Lumsden, keep up the good work.

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