Saturday, November 29, 2014

The ECB’s Bridge Too Far

PRINCETON – The German Constitutional Court’s recent decision to refer the complaint against the European Central Bank’s so-called “outright monetary transactions” to the European Court of Justice (ECJ) leaves the scheme’s fate uncertain. What is clear is that the economics behind OMT is flawed – and so is the politics.

The OMT program arose in August 2012, when months of relentlessly rising risk premiums on Spanish and Italian sovereign bonds were threatening the eurozone’s survival and endangering the world economy. To restore confidence and buy time for governments to reduce borrowing, ECB President Mario Draghi pledged to do “whatever it takes” to preserve the eurozone – and that meant potentially unlimited purchases of distressed eurozone members’ government bonds.

Draghi’s declaration worked, prompting a sharp decline in risk premiums across the eurozone’s troubled economies. But Bundesbank President Jens Weidmann, a member of the ECB’s Governing Council, immediately challenged OMT, asserting that the program exceeded the ECB’s mandate and violated Article 123 of the Lisbon Treaty, which bars monetary financing of distressed sovereigns. Before OMT was ever activated, Weidmann took his case to the German Constitutional Court.

OMT supporters were aghast at Weidmann’s attempt to overturn the arrangement. After all, the mere announcement of the program had provided relief to struggling governments and may well have saved the monetary union, at least temporarily. Draghi audaciously described OMT as “probably the most successful monetary-policy measure undertaken in recent time.”

But the German Constitutional Court remains dubious. While it has withheld a final judgment in deference to the ECJ, it has upheld the Bundesbank’s view that OMT, in its current form, violates the Lisbon Treaty. OMT may still survive; but, if it does, it will likely be diluted, allowing the problems that inspired it to reemerge.

However problematic this might be for OMT’s supporters, it should not have come as a surprise. The program was ill-conceived and sold by sleight of hand. The court was right to question the factual basis of the ECB’s claim that the risk premiums reflected an unfounded market fear – a claim that was based on cherry-picked evidence. Indeed, the program’s public defense rests shakily on a presumption of baseless speculative pressures.

The program’s design, however, conceded that the market’s assessments of creditworthiness reflected a real default risk. As a lender of last resort to sovereigns, a central bank must stand ready to purchase sovereign debt unconditionally, in order to neutralize the effects of temporary market disruptions. But OMT is intended to operate more like the International Monetary Fund’s lending – that is, to rescue a particular government conditional on its pursuit of fiscal belt-tightening. If the ECB were truly convinced that risk premiums were unreasonably high, and that distressed countries’ debt was sustainable, conditionality would have been unnecessary.

Moreover, by tackling default risk, the OMT program created a new problem: private creditors, assured that the ECB would prevent governments from defaulting, were encouraged to lend with greater abandon. Reading the decline in risk premiums as a sign of renewed market confidence in distressed sovereigns’ creditworthiness was another self-serving misinterpretation.

A similar situation has unfolded before. In the pre-euro era, propping up the Italian lira invited unrelenting speculative pressure. With the lira eliminated, holding down yields on sovereign debt can be a fool’s errand.

Just as untenably high exchange rates must ultimately depreciate, default is necessary in cases of unsustainable sovereign debt. This is all the more important in view of the ECB’s disinclination to reverse near-deflationary conditions, which raise the effective debt-repayment burden further.

Sovereign-debt attorneys Lee Buchheit and Mitu Gulati warn that markets could “mercilessly test the ECB’s willingness to persist in buying unlimited quantities of peripheral sovereign bonds.” This test will be all the more severe if, as the ECB has conceded to the German Constitutional Court, the bond purchases would actually be limited.

The eurozone must allow for selective default on sovereign debt, with the ECB acting as a lender of last resort for solvent governments. Of course, solvency can be difficult to assess during a crisis. But pretending that sovereigns are never insolvent serves only to compound the problem. As the German court pointed out, the prospect of default will help to maintain financial-market discipline.

By attempting to create a quick fix for the eurozone’s deep-rooted problems, the ECB has stepped into a political quagmire. Even if the ECJ gives OMT the benefit of the doubt, the program’s legitimacy will remain plagued by qualms, leaving the ECB – if only behind the scenes – locked in political jockeying with distressed sovereigns.

The line between audacity and hubris is a fine one. Rather than constituting a great success, OMT may well be remembered as an error born of expediency. Worse, it could undermine the ECB’s hard-won independence and credibility. That is an outcome that the eurozone might not survive.

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    1. Commentedhari naidu

      "The ECB is completely independent. Neither the ECB, the national central banks in the Eurosystem, nor any member of their decision-making bodies can ask for or accept instructions from any other body. All EU institutions and governments must also respect this principle."

      Now, if above is the law under Lisbon Treaty, hubris makes it a prerequisite that GCC and its counterparts (ALL) defer their arguments on OMT - i.e. if it's monetary or fiscal policy - to ECJ to decide.

      And, if you've followed ECJ legal history, it seldom postulates or consents to national hubris of any member state, let alone GCC, in a case in which fundamental macro competence resides with ECB and its Executive Council.

      Weidman (Bundesbank) has now come out officially supporting GCC decision on OMT. Recall Bundesbank was the original litigant in the case followed by Sinn, etc. And Weidmann sits on the ECB Executive Council. Should he continue to sit in ECB decision-making Council or muster all his (political) energy to re-introduce DM?

      Merkel said after her Sept (2013) re-election that Germany needs more Europe ( or less Germany!). Is she prepared now, after GCC intervention, to derogate the power of ECB on OMT and (also) find ways and means of nominating jurists on GCC who are in tune with Lisbon Treaty and current developments inside EU. In other words, if GCCs principle responsibility is to interpret German Basic Law, it should avoid getting into a conflict (resolution) with ECJ.

    2. CommentedJason Gower

      Of course OMT was flawed and wasn't the long-term answer just like QE will never be the "answer" in the U.S. But it did its job at the time. Now we're just waiting for politicians to do their job (crickets....). No easy answers here so expect to hear nothing until the market does indeed test the ECB and this whole arrangement and then we will be back in EZ crisis mode.

    3. CommentedMatt Herfort

      In my original post, I was intentional both in my specificity and my lack of political bent. The reality is that long before Maastricht, there were multiple currency pegging schemes involving the Mark and a Franc separately and in unison as anchor currencies. They were politically motivated, and exacerbated economic problems already being experienced by those countries.

      I understand there is very little information available on those situations, at least online, which is puzzling considering their importance. My point is simply that those who developed and implemented the Euro currency were ignorant, willfully or otherwise, of the effects of previous attempts to peg their currencies in a large union. Now, after years of malaise and political gnashing of teeth, they are considering violating their own laws and treaties in an attempt to save the Euro. In my opinion: This is bad.

    4. Commentedhari naidu

      Herfort (below) is misinformed or an impassioned Eurosceptic.

      I was in the midnight seminars during the Maastricht sessions when pegging of Euro was discussed and Lady Thatcher's appointed Lord was, in fact, in-charge...(!) and Euro was finally pegged to existing rates under ECU (European Currency Unit) under EBI (European Investment Bank) in Luxemburg.

      If you really wish to debate merits of ECB/OMT, it's relevant and useful to get your facts right.

    5. CommentedMatt Herfort

      In response to the poster below me: While I don't support the EU's version of austerity, nor do I think that there could ever be a "libertarian" europe, I completely disagree with you. Frankly, there is no place more ripe with macroeconomists and their damaging predictions than the EU and its bureaucracy. The whole foundation of the Eurozone was built upon bending macroeconomic trends to political whims. Look at the failed European currency pegs of the decades prior to the Euro currency for an example of this. Of course now that the bed has been made and the people of Europe have to sleep in it, the EU and ECB are trampling over their own laws to try and save their ill-advised butts. The fact of the matter is that when you sell your own laws for limited and fragile safety, you are lost and very far from home.

        CommentedCarol Maczinsky

        This is not about austerity or not, it is about fiscal prudence and reliability. Growth policies are a code word for excessive spending at the expense of European solidarity.

    6. Commentedhari naidu

      Macroeconomists were the biggest academic losers when the financial meltdown took over global agenda (c.2008). They are becoming (like) bean counters of a ledger book. And they have the intellectual audacity to challenge OMT - based on (sovereign) German Basic Law. Without ECB leadership, and in spite of Bundesbank, EU political economy would have ended up in a totally different macro scenario.

      Thanks to non-weighted voting mechanism in ECB Council, there is no German veto possible. And recall Bundesbank
      (Tietmeyer) wanted to retain DM - not introduce Euro as a single currency - under Maastricht Treaty and EMU.

      May I suggest to the libertarians/austerians don't trust your foolish economic model analysis which got us into the mess to begin with; get smart and try to understand the fundamentals of the political economy of EU-28 or 29 now.

      There is no alternative, in the final analysis, to the ECB becoming the lender of last resort - GCC and its tribal mates notwithstanding - and will ultimately learn to betray their inability to digest the concept of EU supra-nationality inherent in EMU - unless you wish to resurrect DM with all its consequences.

    7. Portrait of Michael Heller

      CommentedMichael Heller

      Mody’s article is an excellent contribution to the debate. With their rapid carefully considered and constructive responses to a suddenly reemergent issue of profound importance for Europe’s future both Ashoka Mody and Hans-Werner Sinn have powered ahead of sluggish media commentators and somewhat less forward-looking economist colleagues whose knees have jerked anxiously in ideological support of OMT. These two contributions reflect well on Project Syndicate.

    8. CommentedMatt Stillerman

      Pardon me, but this is just nonsense. Any sovereign government that borrows in its own currency cannot ever be forced to default. Ever.

      The Eurozone countries do not control their own currency, and are thus vulnerable. However, if the ECB really became their lender of last resort, lending unconditionally to any member, then, again, they could never be forced into default.

      What does it even mean for a sovereign that can create its own money to be "insolvent"?

        CommentedGreg A

        Hopefully, central bankers have a completely different opinion than the one expressed in the article, otherwise, Japan would have defaulted long ago. The author has learned nothing from the european crisis as it has shown the importance and relevance of having a lender of last resort. Right now, Europe should be asking itself how to get out of the mess that euro has created in the least hurtful way, instead of making sure that their hands are tied the next time there is a serious financial crisis...

        CommentedCarol Maczinsky

        That would not be a problem first place if nations had budgetary discipline enforced and meet their agreements made. If you break the deal don"t complain about default risks. If you take guarantees of other nations because you broke your agreements don"t put the blame on them. Now, we can think about a coordination mechanism but so far all the institutions on the European level, even Parliament, are severely biased against Germany. A vote of a German tax payer is less worth than any other citizen of Europe in European elections.

    9. CommentedUwe Alschner

      If you want to assess risks related to the OMT case, It is important to understand two things: the announcement has been successful, if only preliminary. It is, secondly not challenged with respect to EU primary law. It is challenged with respect to the German constitution. The question of the ECB overstepping its mandate is a double edged sword: if the ECJ confirms alignment with EU law, this will trigger an ex-ante violation of German Basic law. Because, as you can read between the lines of the German Constitutional Courts decision, the Bundestag would not have been authorized to vote on any measure by which Bundesbank-Involvement could pose a threat to Bundestag's Budgetary autonomy. Effectively, this means: there is an upper limit for risks the German Constitutional Court is willing to accept being incurred by EU institutions without a public referendum on a new constitutional foundation. The decision is not designed as an act to blow up European Integration, but as an end to integration by inter-governmental deliberation. In other words: if governments don't think their peoples fit to agree on a European Constitution, those Governments must not take risks which those citizens can not comprehend and calculate.

        CommentedCarol Maczinsky

        "Moreover, the risk for germans taxpayers deriving from this ECB action should be compared to the risk deriving from the ECB non-action, i.e.: the cost of the break-up of the eurozone for Germany."

        Also known as "hold up", of course we can"t accept that blackmail and extortion. I think it is better to make way for a true political union but if nations don"t want to stick to agreed rules, they cannot take their mistakes on others and promote monetary anarchy. The set up of the scheme which gives Germany improportionate voting rights shows how the very design is set for extortion and undermines the European spirit.

        Commentedzoe keller

        ".. the Bundestag would not have been authorized to vote on any measure by which Bundesbank-Involvement could pose a threat to Bundestag's Budgetary autonomy. "
        You are right, this is the potential threat set by the GCC decision, but this means that Germany can not be part of any monetary union, because the OMT program risks are, a priori, about the same a central bank takes acting as a lender of last resort for banks, accepting collateral of government securities, ect.

        Moreover, the risk for germans taxpayers deriving from this ECB action should be compared to the risk deriving from the ECB non-action, ie: the cost of the break-up of the eurozone for Germany. And, as 2 judges out of 8 have pointed out, these issues can not be resolved by courts: the Bundestag should be free to react according its political discretion. It's not democracy when a court pretend to replace politics.

    10. Commentedzoe keller

      It's quite evident: "The announcement of the OMT programme in the summer of 2012 is one of the most skilful and successful monetary policy communications in decades. Without spending a single euro, the ECB has succeeded to enhance liquidity, to prevent a bank run, to reduce uncertainty and volatility in financial markets, to lower borrowing costs for sovereigns, banks and corporations (in particular in its most vulnerable countries), and to improve confidence and trust in the sustainability of the euro and the prospects of the euro area economy." This statement was signed by more than 200 distinguished economists from around the world ( )

      Frankly, it is the very effectiveness of the program to demonstrate it was well-designed to address the specific problem of a bad equilibrium dynamic (see here: ), especially if you compare it to the previous SMP, which was not unlimited, had no conditionality and did not calm the crisis.
      By the way: the OMT conditionality is to push countries to take action to reform, but the ECB has never given up its power to act regardless. The ECB remains completely independent from what governments do in its action to preserve the euro.

    11. CommentedJose araujo

      "ECB hard-won independence".... Professor Mody is clueless, maybe he's been living in Mars this past years.

      Euro with selective default is an absurd, if any country defaults on his debt, the EURO will be dead.

      And why would the markets "mercilessly test the ECB willingness to persist in buying "peripheral sovereign bonds, may I ask. Just because B&G say so,... Why would the market test if there is no gain in the strategy...