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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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