Friday, October 31, 2014
8

Germany’s Pyrrhic Victory

BERLIN – The German Constitutional Court has ruled against the European Central Bank’s pledge to buy potentially unlimited quantities of distressed eurozone countries’ government bonds, and has called on the European Court of Justice (ECJ) to confirm its decision. Until that happens, the “outright monetary transactions” (OMT) scheme is effectively dead, weakening the ECB’s ability to act as an effective and credible financial-market backstop at a time when European governments remain unwilling to fill the void.

The German court considers OMT a violation of the ban on monetary financing of governments. According to the court, the scheme can be legal only if it is limited in size ex ante, rules out losses on sovereign debt, and avoids “interferences with price formation on the market.” The problem is that almost all ECB policies would violate these principles, which is why the ruling represents a severe setback for Europe.

To be sure, the ECB could, in principle, still use OMT, at least until the ECJ rules on the case. In practice, however, rising opposition in Germany to OMT and other ECB policies will make it impossible to use the program as intended – that is, to intervene effectively in sovereign-bond markets to stem a panic.

Limiting the ECB’s purchases of government bonds ex ante, as the German court requires, would be nonsensical, because it could easily invite market speculation. As a result, the ECB will have to use alternative policy tools to deal with dysfunctional financial markets. That means focusing once again on supporting banks, as well as deploying new instruments that have a more direct effect on crisis countries’ firms and households.

The court’s ruling strengthens Germany’s government and those in its parliament who want less support for crisis countries and oppose a further transfer of sovereignty to Europe. Given the disagreement surrounding the OMT program and eager to avoid future court rulings, the German Parliament could be inclined to support only those rescue programs that rule out OMT support, such as the European Stability Mechanism’s “precautionary conditioned credit line,” instead of the more flexible “enhanced conditions credit line.”

This is ultimately bad news, as it will limit the European Stability Mechanism’s effectiveness. Portugal could be the first test case if it applies for an ESM backstop in the coming months, though its position may be sound enough not to require OMT support.

How financial markets will digest the German court’s ruling remains uncertain. There may be little initial reaction to the news, as there is no immediate threat to financial stability in the eurozone. But the big question is how markets will react in the future to bad news, whether about sovereigns or banks.

The tight feedback loop between sovereigns and banks in eurozone countries has become even more salient in recent years, as banks are holding an ever-larger share of their home countries’ government bonds. The ECB’s impaired ability to address sovereign and currency risks means that it will have to break the feedback loop via the banks – a more difficult and less effective approach that increases the likelihood of a market panic and a deeper crisis.

Nonetheless, limiting the ECB’s ability to address the interdependence of sovereigns and banks could put stronger pressure on eurozone policymakers to confront banking problems directly. The ECB’s coming asset-quality review and subsequent stress tests of European banks could be the last chance to repair Europe’s banking system and avoid Japanese-style long-term economic drag from the financial system. In this sense, the German court’s ruling highlights the need for swift completion of a European banking union, including well-functioning supervisory and resolution mechanisms.

Finally, the case highlights the need for a treaty change. The court’s decision to accept the case against the OMT program could unleash a flood of lawsuits against European institutions, such as the ECB and the ESM, whenever member states’ citizens disapprove of their actions. The ruling is a call on policymakers to pursue a thorough review of the European Union’s Lisbon Treaty, not just to strengthen the ECB and monetary policy, but with respect to all pending institutional reforms.

The German court’s ruling jeopardizes the ECB’s ability to act as an effective lender of last resort, thereby reducing its independence and ultimately undermining its ability to deal with market panics and crises – and thus to fulfil its primary mandate of price stability. The ruling makes it more urgent than ever that European governments establish a viable and effective banking union and strengthen the ESM as a backstop for countries in crisis.

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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.

  2. CommentedCarol Maczinsky

    The anti-europeans are those who break the agreed monetary rules nationally, who go for regulatory/tax forum shopping (Ireland), and promote monetary anarchy on the EU level. Eurobonds are possible but then the order policy conditions have to be laid first to prevent a hold up. The Schäuble litmus test proposal of an oversight competence for the Commission clearly revealed which nations do not intend to stick to agreed rules, so there is no point to trust those who want to compromise the European project by breaking rules, or even propose European rules without a governance framework. First comes governance, second comes the money. The other way just didn't work as nations lack discipline and undermined their trust, as the bond markets acknowledge. Markets seem to be smarter than some politicians.

  3. CommentedKir Komrik

    Thanks for the article,

    I'd like to increase the altitude a little here because the article would have been confusing to me if I had not had the context I do. Germany is the most powerful economy in Europe and probably one of the few if any with good economic fundamentals. They have been bailing other countries out for some time now.

    Under a "Union" of sorts this is the same kind of argument Connecticut might make against Maryland, for example, if we were some kind of Confederacy or worse, something akin to the European Union.

    The "ex ante", for those that are wondering, means that Germany is saying we are not going to agree to blank checks because they feel they are being fleeced. They want limits on what the ECB can do beforehand.

    Now, we see the obvious solution. Federalism. And I'd argue General Federalism (google it), but that might be a little too heterodox for Republicans and social conservatives in Europe. The problem with the EU in the last few years is rooted in its lack of a single monetary policy in which the currency has the full backing of Law and Equity. Basically, Europe needs a Federation, not this "treaty-based" confederacy wanna be.

    - kk

  4. CommentedRocco Doni

    "The problem is that almost all ECB policies would violate these principles" ... which is why the GCC ruling is absurd and cannot be confirmed by the ECJ, because it would make impossible for the ECB to comply with its primary mandate to mantain price stability, let alone to be indipendent and to preserve the euro.

  5. CommentedNichol Brummer

    You have to wonder .. how can you maintain that a central bank is 'independent' if lawyers and judges can make decisions that involve complex balancing of operational issues of the monetary system, while many possible solutions used by other central banks are forbidden by politicians. And this is a central bank of a system that is clearly more complicated than others, as it is the central bank of a monetary union. A union with many countries that each have their own independent bonds, with different interest rates, that in extreme situations completely lose their connection to the policy-rate that is set by the central bank. This central bank needs more handles to operate a system with more degrees of freedom. Not less.

  6. CommentedJose araujo

    I honestly don't see why ex ante bond buying is so different, you just put a gigantic limit on the purchases.

    Regarding the speculation, it would be quite stupid for someone to speculate to lose money.

    By the way,what would you speculate, that the ECB wouldn't buy debt,and short the sovereign, makes no sense... If you speculate that the ECB would buy debt, then you would be long, and actually would work in favor of ECB.

  7. CommentedVal Samonis

    Maybe pyrrhic but what is the solution if there is only one payer (Germany) except to dismantle the EZ asap?

    Val Samonis
    Vilnius University

      CommentedJose araujo

      And when has Germany ever paid anything may I ask?

      Unless you think that the ECB is the central Bank of Germany you make no sense.

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