Thursday, November 27, 2014

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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    1. CommentedMK Anon

      Hans is right: the southern countries should leave the Euro, as well as France and other countries who don't follow the 2% inflation target as a god.
      As a result, the german euro (why did we bother to call it Euro actually, since it was just a copy of the mark monetary policies and the ECB is in frankfurt) will apreciate dratidcally, anf finally rebalancing the german economy: less export, more unemployment and more purchasing power. Other european countries would benefit strongly from that.. because the internal devaluation that the author is indirectly asking is pure masochism. The awfull southern countries are still in the euro because it is to the northern countries' benefit ! Or at least the big banks from there.

    2. CommentedRocco Doni

      It says: "Subject to the interpretation by the Court of Justice of the European Union, the Federal Constitutional Court considers the OMT Decision
      incompatible with primary law; ..."
      "Subject to" means: the ECJ is the one who has the last word on that issue.
      If the German Constitutional Court did not comply with the powers reserved to the ECJ on the legality of the acts of the ECB compared to the EU primary law, it would act "ultra vires", that is: without any authority to do so.

    3. CommentedRocco Doni

      The ECB is an European institution based on EU treaties. The German (or French or Italian, etc.) Constitutional Court has not jurisdiction over the ECB or its acts. The only one court competent to judge ECB's acts is the ECJ. Point.
      If the ECJ deems that the OMT complies with the EU primary law (for example because the OMT is covered by art.18 ESCB Statute, and actually aims to restore the transmission of ECB's monetary policy and it is actually an act of monetary policy), the GCC can not overturn that judgment (otherwise the GCC acts ultra vires).
      At that point, the GCC may instead call into question the german law implementing the European Treaties. But, to do so, the GCC must change its argument scheme, and its task becomes much more difficult and politically dangerous, because the GCC should demonstrate the German primary law requires to prohibit an independent central bank:
      - not only monetary financing the states buying bonds in the primary market (as in art.123 TFEU),
      - but also any purchase of bonds in the secondary market (allowed by article 18 ESCB Statute), even if its purpose is not to finance member states
      - or any purchase of bonds not approved in its amount by the Bundestag...
      Not even the Buba was subject to such a limitation! In fact, no central bank can do a decent work with similar restrictions. So, at that point, the GCC would be forced to prove too much: to make the German primary law incompatible with any central bank set-up.
      In other words, if the ECJ deems the ECB's OMT legal, the GCC can no longer shoot directly against the ECB/OMT, it have to shoot against the german law implementing the European Treaties. Through that shield, however, it can no longer hit a selected target like the OMT, and must make a killing: to kill all possible central bank set-ups.

    4. Portrait of Michael Heller

      CommentedMichael Heller

      Sinn’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 Hans-Werner Sinn and Ashoka Mody 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.

    5. CommentedAvraam Dectis

      " No counterpart to the ECB’s lender-of-last-resort policy for a currency union’s regional political units can be found " .....
      It is shameful for such an excuse to be proffered.

      Those in economic leadership positions have the responsibility to design new solutions as needed. If they cannot or will not, then what good are they? An undergraduate with a textbook could do their job.

      Why cannot a policy be designed that provides " lender-of-last-resort policy for a currency union’s regional political units"?

      It would not be hard to implement a noninflationary policy that treats all the member states fairly and does not penalize anyone.

      Just shameful.

    6. CommentedMatt Herfort

      What is most disturbing about the constant wrangling and court battles, from my perspective, is that those who wish to preserve the EZ at any cost seem to be willing to trample all over the rule of law using any bureaucratic tools they can possibly think up. It's incredible to me that anyone is shocked by this. After creating a dysfunctional and politics-before-economics supranational bureaucracy, they now wish to run rough-shod over the rights of their own citizens. Keep in mind that every possible EZ policy, because of its supranational position, contains massive political implications. However this saga ends, it will not end well for the vast majority of EU citizens.

    7. CommentedMatt Stillerman

      Let's suppose that Greece exits the EMU and defaults. (They would be much better off if they did!) At that point, the insolvency of Germany's very highly leveraged large banks would be exposed for all to see. And the Bundesbank would be incapable of bailing them out.

      In that circumstance, just how quickly do you think that Prof. Sinn would become an advocate of ECB OMT?

    8. Commentedhari naidu

      IFO’s Prof Sinn, as a Court litigant, is making his libertarian case against OMT. That’s his right. However what the Court has done is really provide political fodder for next EP elections to Afd Eurosceptic. Ex-Richter’s of the Court are now openly supporting Afd party. So, one has to q’ the (political) intellectual audacity of Karlsruhe Court opinion and its presumed legal assumptions on OMT, as monetary or economic policy, based on German Basic Law vs. Lisbon Treaty. This a lengthy discussion and merits careful analysis because of its relevance (or lack of it) to macroeconomic framework of ECB mandate.

      Two of the Court Richter’s dissented (1) by demanding the case to be dismissed and (2) q’s qualification of Karlsruhe Court to opine on a case with extra-territorial dimensions. The dissenters claim ECJ (Lux) has sole legal jurisdiction on EU Lisbon Treaty and its Institutions (eg. ECB). More significantly, ECB is an independent institution, and the Court acknowledges it; therefore it’s presumptive of Karlsruhe to use its reasoned opinion on OMT as an instrument to subject ECB to an extra-territorial political pressure or outside interference in its monetary policy decision-making domain. What would happen if Courts in all member state tried to do the same….?

      The German Basic law is fundamental to Bundestag and its Federal Government. It could be that the Court is (also) challenging Berlin for political negligence on national sovereign rights and more. But is it forgetting that Merkel set-in-Council and enforced all its official decisions –>BTW OMT has not been operational or put into print, so far!

      However Draghi’s statement to EP [ is reproduced with the comment that it doesn’t provide any economic figures on the financial dimension of OMT….

      They rest their (political) case by requesting EJC to review it…followed, as they say, by their own further legal considerations.

      IMHO ECJ will (1) disregard the intervention by Karlsruhe Court in a case outside its (national) jurisdiction and/or (2) refuse to call the case on its docket or dismiss it outright.

    9. CommentedVal Samonis

      Typical EU: Another decision NOT TO MAKE A DECISION! And so on, und so weiter; until the deflationary vortex WILL make a decision and Europe WILL repeat its horrendous history!


      Val Samonis
      European of sorts

    10. CommentedJoshua Ioji Konov

      The OMT would work only if borrowing states maintain certain high growth or stern austerity policies, which both are questionable in soon EU future: if lower interest rate liquidity triggers such growth than the German court decision could be considered negative for the EU, however, the Southern States lower economic transmission-ability does not project any substantial growth? Structural reforms are needed for succeeding fluent transmission-ability, but such are not the measures suggested neither by the EU nor by the IMF that could bring only declining living standards and consumption!