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Outright Monetary Infractions

MUNICH – The German Constitutional Court has delivered its long-awaited decision on the European Central Bank’s “outright monetary transactions” program. Since its launch in 2012, the OMT program has allowed the ECB to buy, if necessary, unlimited amounts of troubled eurozone countries’ government bonds, provided the affected countries subscribe to the rules of Europe’s rescue fund, the European Stability Mechanism.

Thousands of Germans appealed to the Constitutional Court against the OMT program, arguing that it violates Article 123 of the Treaty on the Functioning of the European Union, which bars monetary financing of eurozone governments, and that it imposes substantial risks on German citizens as taxpayers. The Court has now declared that it fully endorses the plaintiffs’ arguments, and that the OMT program does indeed violate EU primary law.

But, rather than issuing a formal ruling that would constrain the Bundesbank and the German parliament, as it could have done, the Court asked the European Court of Justice for its opinion. At first sight, this might seem promising for markets, which most likely expect the ECJ to rubber-stamp the OMT program. But things are not so simple.

Germany’s Constitutional Court has not waived its right to the final word about whether European institutions’ actions are compatible with the German constitution. If it finds that the ECJ is interpreting the treaty in a way that violates the German constitution, it has the power to force the German government and parliament to renegotiate the treaty or ask for a referendum.

Thus, it is important to note that the Constitutional Court is not asking the ECJ to decide whether the OMT scheme is compatible with EU primary law, but rather to limit the program in ways that make it compatible with EU treaties. The German court suggests that this would require that “government bonds of selected member states are not purchased up to unlimited amounts,” along with the assurance that the ECB would not run the risk of write-off losses at maturity.

The latter would imply senior status for the ECB relative to private bondholders, as in the case of the Greek “haircut” imposed on creditors. However, this would overwhelm the OMT program’s stabilizing effects, which rest on the assumption that the ECB, not private investors, would foot the bill should a country declare bankruptcy. Thus, investors’ initial euphoria over the German court’s decision may prove to be short-lived, giving way to rising interest-rate spreads.

The German court’s decision to hand the case over to the ECJ will also dampen the OMT program’s efficacy, because the ECB will not dare to buy government bonds before a ruling is issued. The reason is simple: the OMT scheme has never been triggered; to use it now would deprive the ECJ of the possibility of declining the appeal on the grounds that no action has actually been taken.

As to the substance of the case, the German court is right to argue that the OMT program may lead to a significant redistribution of wealth among eurozone member states if the acquired bonds are held until maturity. Write-off losses on such bonds would hit taxpayers in other countries, owing to the erosion of national finance ministries’ profits from lending self-printed money (seigniorage). And, obviously, any fiscal transfers needed to prevent such write-off losses would also hurt taxpayers.

Yes, the ECB’s market-calming gimmick of shifting default risk from clever investors to trusting taxpayers worked. The OMT scheme amounts to free insurance against a default by southern eurozone countries, thereby subsidizing the return of private capital flows to places where they were squandered before. But that is not enough to legitimize the program.

The German court is also right to argue that purchases of troubled countries’ government bonds cannot be considered monetary policy – and thus exceed the ECB’s mandate. No counterpart to the ECB’s lender-of-last-resort policy for a currency union’s regional political units can be found, for example, in the United States or the Swiss Confederation. The US Federal Reserve buys federal government bonds; it does not buy the bonds of financially troubled states like California or Illinois.

Finally, the Court is right to object to the ECB’s goal of reducing interest-rate premiums on government bonds. The ECB argues that it wants to improve the transmission of monetary policy. But interest-rate premiums are the main mechanism by which excessive debt in the eurozone can be avoided. If states borrow too much, the probability that they will be able to repay falls, and creditors demand higher interest rates in exchange. This, in turn, reduces their inclination to borrow.

The economic crisis in southern Europe stemmed from an inflationary credit bubble that resulted from the absence of interest-rate premiums, and that robbed the afflicted countries of their competitiveness. Interest-rate differentials – including premiums reflecting the heightened risk of a eurozone exit and exchange-rate realignment to reestablish competitiveness – are crucial for the monetary union’s long-term existence, stability, and allocative efficiency.

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