Will the new European TPI be an ATM? by Willem H. Buiter

One of the reasons why the European Central Bank’s earlier asset purchase program was never used is that financially fragile governments were reluctant to submit to its strict eligibility conditions. But following the deployment of a new program with much more flexible conditions, the balance has changed.

NEW YORK – It’s finally arrived. The European Central Bank has launched a Transmission protection instrument (TPI) to avoid the fragmentation of monetary policy within the euro area. Announced just after the ECB Governing Council meeting on July 21, the TPI overshadowed the news that the ECB would raise its key rate by 50 basis points, which is more than expected but lower than the macroeconomic situation and to the request for the price stability mandate.

According to the ECB Press release, the TPI “will be an addition to the Governing Council’s toolbox and can be activated to counter unwarranted and disorderly market dynamics that seriously threaten the transmission of monetary policy in the euro area”. If certain pre-established criteria are met, “the Eurosystem may make purchases on the secondary market of securities issued in jurisdictions experiencing a deterioration in funding conditions not justified by the fundamentals specific to each country, in order to counter the risks weighing on transmission mechanism.

I can see the economics of creating a facility to act as a market maker of last resort, or rather a buyer of last resort when market liquidity is materially impaired in the sovereign debt (and in systemically important corporate securities markets). Financial markets can be capricious and unreliable. They are complex, nonlinear systems that can oscillate chaotically between irrational exuberance and unwarranted discouragement. Self-validated episodes of fear and panic can cause market liquidity to dry up. In a world of multiple equilibria, even technically efficient financial markets can generate unwanted price bubbles, leading to self-fulfilling debt crises and defaults.

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Mary I. Bruner