Last month, the German Constitutional Court in Karlsruhe has opened hearings on a complaint that concerns actions taken by the ECB to deal with the debt crisis. The Court is expected to make its decision known in the Fall, probably after the elections. This case is fascinating because it encapsulates all the controversies that have marred the European Monetary Union. The fact that the Bundesbank has offered testimony that appears to back the complaint, while the ECB considers that it is unjustified, further reveals the depth of disagreements.
The plaintiffs, a group of Euroskeptic politicians and academics, consider that the Outright Monetary Transactions (OMT) program violate the German constitution. This program, which was announced in June 2012 and formally adopted in September, is a promise by the ECB to limit spreads on sovereign bonds. The ECB considered that the extra-large differences in bond rates that emerged as the crisis exploded reflected the risk of exit of some member countries from the Euro Area. The ECB justified its commitment by stating that he did not accept the idea of a break-up of the monetary union and that, consequently, the interest rate spreads reflected erroneous market expectations. These spreads imposed huge funding costs for both the private and public sectors in a number of member countries. For the ECB they were unjustified and dangerous.
Since the OMT program was announced, interest rates on bonds issued by crisis country governments have considerably declined, to the point where some observers and most officials have (mistakenly) declared the crisis over. This spectacular result has been achieved without the ECB actually buying bonds, at least in significant amounts. Such is the power of a central bank that a mere statement can be a game-changer.
The plaintiffs’ first claim is that the OMT program is illegal because it lies outside the ECB’s mandate. They define the mandate as price stability, and only price stability. This view, which is widely shared in Germany, is a truncated interpretation of Art. 127 of the Treaties on the Functioning of the European Union, which states: “The primary objective of the European System of Central Banks shall be to maintain price stability. Without prejudice to the objective of price stability, the ESCB shall support the general economic policies in the Union with a view to contributing to the achievement of the objectives of the Union.” Preventing a collapse of the Euro Area can be seen as part of the “objectives of the Union”. In addition, the kind of crisis that would follow a breakup of the Euro Area could well lead to deflation, clearly not a case of price stability. Finally, since the start of the crisis, inflation has been declining below the 2% objective.
The second claim is that the ECB is not allowed to finance governments, more precisely to buy public debt on the primary market, that is, directly from governments upon issuance. The OMT program specifically rules out such actions. The intention is to buy public bonds on the secondary markets, precisely because this is where the interest rate spreads are generated. Of course, the promise of central bank purchases on the secondary market has the effect of making the primary market “easy” for governments: there is no reason not to subscribe to debt issues if you are sure that you re-sell the bonds on the secondary market. This loophole has been known for a long time, ever since the Treaty was adopted, but in the present case it does not even apply. The ECB has never intended to bring the spreads to zero, in fact it has long complained that they were too small. It only wants to limit their size, without any commitment as to how small it wants them. This means that anyone who buys a bond worth, say, €100, can only expect to sell it to the ECB at no less than, say, €90 if that is the limit that the ECB intends to enforce. But as long as the spreads are not zero, the selling price must be less €100. This means that buying on the primary market to sell to the ECB entails a capital loss of unforeseeable size. The OMT program in no way offers the kind of guarantee needed to open a loophole.
The third argument is that the program represents an open-ended commitment by the ECB. Indeed, the required amount of bond purchases is effectively unlimited. Consequently, the potential losses – if bond prices nevertheless decline – are also unlimited. This runs counter an earlier ruling by the Karlsruhe Court that banned unlimited commitments by Germany. In this case the commitment would come via the Bundesbank, which is a shareholder of the ECB. This argument is correct, but it clashes with the very raison d’être of a central bank.
The characteristic of a central bank is that it can produce money in unlimited quantities. This characteristic can be misused and lead to inflation, possibly hyper-inflation as has been the case so often. On the other hand, it is what gives a central bank the unique and precious power to deal with financial market turmoil. It has worked since September 2011 when the SNB (SNBN 5650 -0.88%) announced the famous 1.20 limit on the Swiss franc precisely because it promised to sell unlimited amounts of money. It underpins bank deposit guarantees and thus prevents destructive bank runs. And it has brought some relief to the Euro Area through the OMT program.
This power is very subtle. Why has the current sovereign debt crisis been circumscribed to Euro Area countries? The public debt is much higher in Japan than anywhere in Europe. It is of a similar order of magnitude – and growing rapidly – in the US and the UK as in many Euro Area crisis countries. The answer is: because markets know that the central banks of Japan, the US and the UK will never stay idle if there is a sovereign debt crisis in their countries. Knowing that these central banks would buy “whatever it takes”, as President Draghi said when announcing the OMT program, the markets do not even consider possible the occurrence of a crisis… and the crisis does not occur. In fact, the central banks of Japan, the US and the UK have bought massive amounts of their government public debts. This is what Quantitative Easing (QE) is all about.
A key weakness of the Euro Area is that markets have had doubts about the ECB’s willingness to back member countries’ sovereign debts. Indeed, the ECB has long been far too timid, buying public debts when the markets were panicking but immediately stating that these purchases were limited in size and duration. The explicitly limited nature of these interventions is the reason why the crisis has spread and threatened the very existence of the euro. This is also why the mere announcement of the OMT program has been so miraculously effective.
German Public Opinion
But why has the ECB dithered for three long years? Partly, I believe, because its previous management never quite grasped the nature of the crisis. Partly also, I suspect, because the ECB was worried about the reaction of German public opinion. On that dimension, it was right: it now faces a legal challenge in front of the German Constitutional Court. Is self-censorship the way to behave when the house is burning? This is the true question in front of the Court.
What will the Court decide? The case is a bit bizarre in the following sense. Art. 125(1) of the same Treaty reads as follows: ”The Union shall not be liable for or assume the commitments of central governments, regional, local or other public authorities, other bodies governed by public law, or public undertakings of any Member State, without prejudice to mutual financial guarantees for the joint execution of a specific project. A Member State shall not be liable for or assume the commitments of central governments, regional, local or other public authorities, other bodies governed by public law, or public undertakings of another Member State, without prejudice to mutual financial guarantees for the joint execution of a specific project.” Most people read this as declaring illegal the bailouts of Greece, Ireland and Portugal, and it also concerns the European Stability Mechanism (ESM) designed to organize more bailouts. The case of the ESM was brought last year to the Karlsruhe Court, which did not censor it.
If the bailouts are not illegal, then what is? Certainly not the OMT program. It would be extraordinary that a legal body takes a view on issues that go so deeply into the subtleties of central banking and the behavior of financial markets, which even many economists find hard to comprehend. Next, if there is one taboo in Germany, it is the principle of central bank independence. What would be left of this principle if a court were to issue an opinion on the merits or demerits of unlimited commitments. Finally, a ruling that the OMT program is illegal could well lead to the breakup of the Euro Area. This is not a responsibility that the Karlsruhe Court is likely to take, unless it is not aware of the risks, or unless some of its members so dislike the euro that they are ready to kill it.