Tuesday, September 18, 2012

Expectations and asset prices: Keynes meets Hayek

by Giovanni Cespa and Xavier Vives


September 18, 2012

Is the ECB right to buy up sovereign bonds in southern Europe? This column argues that the answer depends on who is right: Keynes or Hayek.

The financial crisis has vividly put into question the alignment of asset prices and fundamental values. For an example of this, look no further than at the current decision made by the ECB president, Mario Draghi, to launch a courageous programme (dubbed Outright Monetary Transactions) to prop up the prices of short-term bonds issued by EU member states that ask for the help of the European stability funds (EFSF and ESM). The thrust of the argument is fairly simple: in the current market conditions, peripheral EU states find it hard to fund themselves in the market, and are forced to pay dearly to convince investors to buy their bonds. This impairs the monetary policy transmission mechanism, which relies on the interest rate set by the ECB. Thus, allowing the ECB to act as a ‘buyer of last resort’ in the secondary market ensures that bond prices don’t spike, hopefully taming interest rates and contributing to restoring the workings of EU monetary policy.

Two important and related ideas underlie this argument. The first is that bond prices in some EU states do not accurately reflect underlying fundamental values. The second one is that that such fundamentals are better impounded in some form of consensus view about those countries’ ability to service their debt. In other words, there appears to be a disconnect between the asset price that market actors contribute to generate with their trades, and the view that several market participants have about the ‘true’ underlying value that such prices should reflect. Such a situation is far from a novel one.


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