| Abstract: |
Contributions from, and collaboration with, Will Levine of Union Square Group
Capital have greatly enriched this paper. For generous comments, the author is
grateful to Kevin Cardiff, Paul de Grauwe, Aerdt Houben, Dan Kelemen, Rosa
Lastra, Karl Whelan, Jeromin Zettelmeyer, and especially to Peter Lindseth and
Guntram Wolff.
The European Central Bankâ??s Outright Monetary Transactions
(OMT) programme was a politically-pragmatic tool to diffuse the euro-area
crisis. But it did not deal with the fundamental incompleteness of the
European monetary union. As such, it blurred the boundary between monetary and
fiscal policy. The fuzziness of this boundary helped in the short-term but
pushed political and economic risks to the future. Unless a credible
commitment to enforcing losses on private creditors is instituted, these
conundrums will persist. The German Federal Constitutional Court has helped by
insisting that such a dialogue be conducted in order to achieve a more durable
political and economic solution. A study of the European Union Court of
Justiceâ??s Pringle decision (Thomas Pringle v Government of Ireland, Ireland
and The Attorney General, Case C-370/12, ECJ, 27 November 2012) suggests that
the ECJ will also not rubber-stamp the OMT â?? and, if it does, the legal
victory will not resolve the fundamental dilemmas.
Working paper 2014/09
As the risk premia on Spanish and Italian bonds soared in the summer of 2012,
Mario Draghi, the President of the European Central Bank, promised on 26 July
to do â??whatever it takesâ?? to restore confidence in the euro area (Draghi,
2012a). In successive announcements in August and September, the Outright
Monetary Transactions (OMT) programme was rolled out. Governments benefiting
from the programme would be required to step up their fiscal discipline; in
return, the ECB would buy their bonds in unlimited quantities to place a
ceiling on their interest rates. Markets calmed down, the risks spreads began
a steady fall, the lingering crisis abated and a nascent recovery began.
Draghi (2013) himself later described the programme as â??probably the most
successful monetary policy measure undertaken in recent timeâ??.
On 14
January 2014, Germanyâ??s Federal Constitutional Court (the German Court) made
news. It determined that OMT is prima facie incompatible with the Treaty on
the Functioning of the European Union (TFEU), the legal basis for the European
Union[1]. However, before delivering its final judgment, the German Court
chose â?? for the first time â?? to seek the opinion of the European Court of
Justice (the ECJ). The eventual resolution of the questions raised will have
wide-ranging implications for the economics and politics of the euro, and for
European integration.
ECB action via the OMT was needed because the fiscal
options to deal with the crisis had been narrowed down to austerity, which was
not paying dividends. European policymakers had determined that they would not
â?? other than in exceptional circumstances â?? allow euro-area sovereigns to
default on their debt to private creditors, although the option of such
default was implied in the Treatyâ??s so-called 'no bailout' clauses (Articles
123 and 125). There was, moreover, no political will to compromise national
interests in a fiscal union with a sizeable pool of budgetary resources. That
placed the entire burden on austerity. While budget trimming would eventually
reduce public debt-to-GDP ratios to acceptable levels, markets were losing
confidence.
The OMT was politically attractive. The German Chancellor, Angela
Merkel, lent it her support even though the Bundesbank President, Jens
Weidmann, steadfastly opposed it. For Merkel, who had bought into the ECBâ??s
opposition to imposing losses on private creditors, the OMT was the only way
to distance her actions in support of Europe from a sceptical German public.
The heart of the German Courtâ??s case is that the OMT could spread the losses
across governments in the euro area. It thus creates a de-facto fiscal union,
which is contrary to the political contract. The TFEU authorises a common
currency shared among European Unionâ??s member states but consciously leaves
fiscal sovereignty and responsibility at the national level since the member
states have remained unwilling to pay for the mistakes of other member states.
The TFEU achieves economic consistency by permitting â?? arguably encouraging
â?? that the burden of these mistakes be shared by the sovereignâ??s private
creditors. But this outlet was closed by a policy decision.
To the supporters
of the OMT, the activist German Court is endangering a fragile economic and
financial calm, while overstating the limits set by the political contract.
The ECBâ??s position is that the OMT was required mainly to correct
distortions in financial markets, which were pricing in unwarranted fears of
euro-area exits by stressed countries[2]. Since this market fear blunted the
ECBâ??s ability to conduct monetary policy, the OMT was designed to remove the
threat of exit and, thereby, improve liquidity to countries under stress.
Along with greater fiscal discipline on the part of the distressed sovereign,
the OMT would achieve stability without imposing costs on other sovereigns.
The German Courtâ??s decision has forced a crucially-important discussion on
the state of monetary and fiscal integration in the euro area. Put simply,
does the survival of the euro require that the political contract be
rewritten? In other words, do member states need to â?? and are they willing
to â?? transparently subordinate their national fiscal interests to help
distressed member states? Or, can creative flexibility within the existing
framework allow reliance on OMT-like measures that skirt the limits of the
TFEU?
The ECJ might seek to appease many parties â?? as is common in European
decisions â?? and matters might remain confused. However, a clear eventual
judgment by the ECJ would have far reaching consequences for the legal and
economic basis of the euro area.
Also at stake is the relationship between
national constitutional courts and the ECJ. The German Court has often been
caricatured as biased against the monetary union and prone to nationalistic
decisions. Some have read the latest decision in that light as politically
confrontational (Pistor, 2014). However, this reputation and interpretation
are ill-deserved. In October 1993, as much of Europe held its breath, the
German Court determined that the Bundestag, the German parliament, had the
authority to determine Germanyâ??s participation in the monetary union as
conceived in the Maastricht Treaty. Later when prominent German economists
tried to again the stir the Court in a final bid to stop the euro, the judges
summarily dismissed their case (Norman, 1998).
In this latest instance, by
forcing the discussion, the German Court has done Europe a favour. The
Courtâ??s uneasiness arises from the culture of quick fixes since the crisis
started. An opening has been created for a more durable political and economic
solution, necessary for the euro to survive. The issues raised by the German
Court should not be viewed as reflecting a Germany-versus-Europe divide.
Rather, they raise questions central to the design of the euro area.
Specifically, does the TFEU permit a fiscal union? More controversially, can
such a fiscal union be implicitly located in the ECB without the political
willingness to transparently achieve that elusive goal?
On process, the
German Courtâ??s deference to the ECJâ??s opinion could be read as an effort
to proactively build a cooperative relationship. The legal scholar and former
judge of the German Court, Dieter Grimm, proposed some years ago that when
national constitutional courts are concerned that European policies are
creating national obligations greater than intended in the Treaty, it is best
to ask the ECJâ??s opinion rather than act unilaterally (Grimm, 1997). This
approach makes particular sense since the OMT has not been reviewed or
authorised by the Bundestag.
The rest of this paper makes the following
arguments. The euro is the common currency of an incomplete monetary union and
the OMT was needed to plug the holes that became apparent at the height of the
crisis. The German Court is concerned that the OMT blurred the boundary
between monetary and fiscal policy defined in the TFEU. The ECJ, based on its
so-called 'Pringle decision', will be sympathetic to the philosophy and
details spelled out in the German Courtâ??s decision. The German Courtâ??s
position is supported not only by the TFEU but also by a traditional view on
the role and limits of central banks as lenders-of-last resort. I conclude by
speculating on the prospects and possibilities that lie ahead.
The OMT in an
incomplete monetary union
On 1 January 1999, the euro became the common
currency of an incomplete monetary union. The monetary union remains
incomplete because the member countries â?? having given up independent
monetary policy â?? lack reliable alternative mechanisms for adjustment when
under economic stress. Although there are no legal barriers to the movement of
people, labour mobility across the countries of the euro area is limited.
Since economic adjustment through a moderation in wages is also unreliable,
Peter Kenen had proposed in 1969 that a fiscal union is needed to pool
budgetary resources for providing relief to countries in distress. An
additional problem is that as the central bank of the common currency, the ECB
is not clearly authorised to act as a lender-of-last resort to sovereigns
(Sims, 2012); such support is needed when access to market financing is
temporarily lost and the sovereign needs to be tided over till confidence is
restored.
Despite the fall in the sovereign risk premia prompted by the OMT
announcements, the President of the German Bundesbank, Jens Weidmann â?? also
a member of the ECBâ??s Governing Council â?? openly criticised the programme.
On 2 August 2012, when Draghi spoke of possibly unlimited purchases of
sovereign bonds under the OMT, he also reported that Weidmann was opposed to
the initiative (Draghi, 2012b). The Bundesbank publicly expressed concerns
(Steen, 2012). First, by 'printing' reserves to finance the bond purchases,
the ECB would ease the pressure on governments to maintain fiscal discipline.
Second, ECB actions might ultimately impose costs on German and other
taxpayers if the bonds purchased were not repaid in full.
In contrast to
Weidmann, the German Chancellor, Angela Merkel, lent the programme her
implicit support. On 7 September, a day after the operational details of the
OMT were unveiled, she helpfully noted that the ECB was an independent
organisation and the risks to the OMT would be limited since the countries
whose bonds were purchased would need to maintain strict fiscal discipline
(Wearden, 2012). Merkel was echoing Draghiâ??s themes of enforcing country
responsibility[3].
Despite the German Chancellorâ??s continued support of the
OMT, in December 2012, the Bundesbank submitted an extensive critique of the
OMT to the German Court[4]. That critique significantly influenced the
Courtâ??s views.
The future of the OMT is so important because even as it
eased market fears, it exposed key fault lines in the architecture of the
euro. In creating a temporary fix for the incompleteness of the euro-area
monetary union, the OMT blurred the line between monetary and fiscal policy.
As the Bundesbank correctly stated in its submission to the German Court, the
European monetary union was created as â??â?¦ a community of countries which
have assigned responsibility for monetary policy over to the supranational
level, but which continue to decide on fiscal and economic policy primarily at
a national level, and which deliberately did not enter into a liability or
transfer unionâ??[5]. This structure was embodied especially in Articles 123
and 125 of the TFEU.
The legal and economic question of interest is whether
the OMT tried to bypass the intent of the Treaty by creating a de-facto fiscal
union (a liability or transfer union in Bundesbank terminology). If so,
without their explicit authorisation, countries had become fiscally
responsible for the mistakes of other member countries.
The boundaries of
monetary and fiscal policy in the euro area
The TFEU requires that the ECB
must not 'print' money to finance the government. This is the so-called
'monetary financing' concern. In particular, the ECB must not finance a
specific government and, in the process, impose an eventual financial
obligation on the taxpayers of another government. The Treatyâ??s intent is to
prohibit one member state from 'bailing out' another member state and,
thereby, enforce national responsibility of fiscal affairs.
The German
Courtâ??s position is straightforward. The ECBâ??s mandate is to conduct
monetary policy for the common currency area. However, the OMT would operate
by selectively lowering interest rates for particular countries. The OMTâ??s
focus on support for a particular country is not incidental â?? it is integral
to the OMT. ECB financial capacity is intended to leverage lending to the
distressed member state by the European Stability Mechanism (the ESM) under
condition of prudent fiscal behaviour. For this reason, the German Courtâ??s
position is that OMT is not an instrument of monetary policy. Instead, it
pursues economic policy in the interest of a particular member state and,
hence, â??manifestly violatesâ?? the distribution of authority between the
central bank and member states. As such, it goes beyond the authority accorded
to the ECB under Articles 119 and 127 of the TFEU. In addition, the OMT
circumvents Article 123 of the TFEU, which prohibits the monetary financing
and bailout of governments by the ECB.
A widely-held presumption is that the
ECJ, since it leans towards 'more Europe', will rule in favour of the OMT,
possibly with some inconsequential restrictions to appease the German Court.
However, there may be rather more common ground between the German Court and
the ECJ than is generally presumed. The ECJâ??s Pringle decision (ECJ, 2012)
â?? which confirmed the legal standing of the European Stability Mechanism
(the ESM) â?? suggests that the ECJ will be predisposed to support the German
Courtâ??s interpretation of the OMT. The ECJâ??s room for manoeuvre will be
limited by the positions it has taken on Articles 123 and 125 of the TFEU,
which enshrine the fiscal sovereignty of the member state.
The ESM was an
intergovernmental agreement â?? and did not involve the ECB. As such, the
issue at hand was Article 125, the 'no-bailout' clause that prohibits a member
state from taking on the financial obligations of another member state. In
July 2012, Irish parliamentarian, Thomas Pringle, claimed before the Irish
Supreme Court that the ESM violated this provision. The Supreme Court referred
the matter to the ECJ. In November 2012, the ECJ determined that the ESM did
not violate Article 125. In doing so, the ECJ allowed rather more scope for
bailout than had been generally presumed, but arguably that was appropriate in
a critical phase of the crisis. The German Court similarly acted in sympathy
with the policy objectives of the ESM. That makes the German Courtâ??s
concerns on the OMT particularly significant.
By finding space between
Articles 122 and 123 of the Treaty (paragraphs 131 and 132 of the judgment),
the ECJ arrived at a creative interpretation of Article 125 to validate the
ESM (Craig, 2013). But that very creativity implied clear restraints on the
ECB. In essence, the ECJ found latitude in the Treaty for governments â??
responsible to their own taxpayers â?? to assist other governments. But the
ECB, as the independent central bank, has no such leeway. Moreover, the German
Courtâ??s argument implies that the OMTâ??s reach transcends even the latitude
within which the ESM operates.
Article 122 allows for the possibility that
the European Union or a member state may provide financial support to another
member state facing exceptional circumstances beyond its control. In May 2010,
the European Financial Stability Mechanism (the EFSM) was established on the
basis of Article 122. However, because 'exceptional' circumstances could not
be invoked readily for a permanent body such as the ESM, and because it was
not straightforward to claim that problems on account of excessive sovereign
debt were beyond the memberâ??s control, Article 122 was not used directly to
establish the ESM (de Witte, 2013). Instead, the ECJ used it mainly to note
that Article 125 could not have prohibited financial assistance of any sort
because then Article 122 would have been inconsistent with the Treaty
(paragraph 131).
To define the space for the ESM, the ECJ also highlighted
that Article 123 of the TFEU creates a stricter prohibition on the ECB,
denying it any form of lending (â??overdraft or any other type of credit
facilityâ??) in favour of member states. Specifically, the ECJ found that the
ESM could do what the ECB could not. Thus the ECJ allowed for latitude in
governmental action authorised by national parliaments. But it insisted that
the ECB is still bound by the limits set in the TFEU.
Thus, although not
called on to comment on Article 123, the ECJ did so to highlight the
difference between the ECB and the ESM. Importantly then for the OMT, just as
the ECJ opened the door for the ESM, it went out of its way to warn that,
under Article 123, the ECB is barred from similar action. Presumably, when
financial assistance to a specific member state becomes necessary, it must be
a political decision since it implies a fiscal action.
The ECJâ??s reasoning
in the Pringle decision is consistent with the German Courtâ??s concern that
the OMT blurs the distinction between common monetary and national fiscal
policy.
Moreover, the ECJ identified limits on the ESM, which place further
question marks on the scope for OMT. Article 125 allows for â??financial
assistanceâ?? but prohibits the Union or a member state from taking on the
commitments of another member state.â??Financial assistanceâ?? can take the
form of a loan (â??credit lineâ??) to a distressed member state provided it is
repaid over time with â??an appropriate marginâ?? (paragraph 139). The fine
distinction, presumably, is that financial assistance is to be repaid, but if
commitments are assumed, the distressed member state is relieved of the burden
of honouring its obligations. Thus, even if the OMT were to jump the hurdle
set by Article 123, it would need to be deemed â??financial assistanceâ??
rather than the assumption of a governmentâ??s obligations and, hence, a
'bailout'. Importantly, the definition of 'no bailout' requires that the
member state being assisted pays an â??appropriate marginâ??.
Supporters of
the OMT contend that it is a monetary policy tool. It would be triggered under
extraordinary circumstances when the marketâ??s risk assessments are distorted
by an unwarranted 'fear' that a member state might leave the euro. Assistance
under the OMT would be provided by helping the distressed member state regain
market access at interest rates that are more in line with its economic
fundamentals. This task is rightfully undertaken by the ECB because returning
markets to normal functioning is essential for the conduct of euro-area
monetary policy.
While the Bundesbank took the strong position that the ECB
should not be in the business of guaranteeing that a member state remains in
the euro area, the basic contention of the German Court â?? a contention that
finds support in the ECJâ??s Pringle decision â?? is that a fiscal union
cannot be created by the backdoor. That is a political decision and must occur
through a change of the Treaty and not through its creative reinterpretation.
Specifically, the German Court asked:
Whether the â??fear factorâ?? alleged
to cause an â??undueâ?? rise in sovereign spreads could be differentiated from
a real threat of insolvency;Whether the OMT's offer to buy â??unlimitedâ??
amounts of sovereign debt implied assuming the debt repayment obligations of
the distressed government; and, moreover, whether the ECBâ??s commitment to be
pari passu with private lenders â?? ie in the event of a default, being repaid
on the same terms as private lenders â?? created additional risk that the ECB,
and, by extension, to other sovereigns would incur losses.
The next two
sections elaborate on these concerns expressed by the German Court and argue
that the ECJ will likely concur with them.
The fear factor and monetary
transmission
The German Court sums up the ECBâ??s position on the OMT in this
way:
â??[The ECBâ??s] monetary policy is no longer appropriately implemented
in the Member States of the euro currency area because the so-called monetary
policy transmission mechanism is disrupted. In particular, the link between
the key interest rate and the bank interest rates is impaired. Unfounded fears
of investors with regard to the reversibility of the euro have resulted in
unjustified interest spreads. The Outright Monetary Transactions were intended
to neutralise these spreads.â??
But the German Court was unconvinced by this
argument. Citing the Bundesbank and other experts, the German Courtâ??s
assessment reads: â??â?¦such interest rate spreads only reflect the scepticism
of market participants that individual Member States will show sufficient
budgetary discipline to stay permanently solvent. â?¦one cannot in practice
divide interest rate spreads into a rational and an irrational partâ?¦â??
The
key empirical and analytical question, therefore, is whether the spreads can
be decomposed into components representing 'fear of disruption' and 'country
credit risk'. The ECBâ??s evidence on this has been less than persuasive. For
example, in a September 2012 speech justifying the OMT, President Draghi chose
a persistent outlier to make his point (Draghi, 2012c).He referred to rates on
Spanish mortgages in the 5-10 year maturity range as having a larger risk
premium than comparable German mortgages. However, an examination of that
evidence shows that â??both longer and shorter maturities had much lower rate
differences than did his chosen category[6]. Strikingly, the chosen maturity
category has de minimis volume in Spainâ??. This example is all the more
curious because the OMT intends to target sovereign debt at maturities of 1-3
years; the link from there to mortgages of 5-10 years is a tenuous one.
The
scholarly evidence for market sentiments as drivers of risk premia is also
unpersuasive. It is commonly stated that markets were unduly optimistic before
the crisis and became excessively pessimistic towards the end of 2010 (for
example, de Grauwe and Ji, 2012). But the roller-coaster movements in
euro-area sovereign spreads are better explained by incoherent policy. Before
the crisis, markets did not believe the threat that losses would be imposed on
private creditors â?? and, hence, the Irish paid lower risk spreads than the
Germans in 2007. After the crisis started, the countries receiving official
assistance came under particularly severe market pressure because
privately-held debt was now subordinated to the senior, official debt. The
rise in spreads between late 2010 and mid-2011 is almost entirely explained by
the subordination of private debt (Steinkamp and Westerman, 2013, and Mody,
2014). The fall in spreads, thereafter, is explained by the policy steps to
subordinate official to private debt. In July 2011, the terms of official
lending to the assisted countries were eased, sending a signal that official
creditors will bear the initial burden of further sovereign distress. When
that proved insufficient for Italy and Spain, the OMT was needed in the second
half of 2012 to spread the Europhoria (Mody, 2014).
The German Court goes on
to argue that an ill-conceived attempt to make a distinction between a
countryâ??s real solvency risk and the marketâ??s ill-founded fear and to act
on that basis to lower the risk premia runs the risk of violating the core
intent of the TFEU â?? and, in doing so, it invokes the ECJâ??s Pringle
decision:
â??â?¦ the existence of such [risk] spreads is entirely intended.
As the Court of Justice of the European Union has pointed out in its Pringle
decision, they are an expression of the independence of national budgets,
which relies on market incentives and cannot be lowered by bond purchases by
central banks without suspending this independenceâ??.
In his submission to
the German Court, former ECB Executive Board member, Jorg Asmussen, conceded
that the OMT was not just trying to dampen the 'fear factor' (Asmussen, 2013).
The two-fold objective of the OMT programme, he said, is â??protecting the
market mechanism so as to urge the Member States to make the necessary
reformsâ??. But if this is so â?? and since the OMT is to act in concert with
ESM lending â?? the German Court and the ECJ are not so far apart. The German
Court is concerned that rather than conducting 'monetary' policy, the ECB is
also engaging in 'economic' policy â?? urging member states to undertake
reforms, in Asmussenâ??s terms.
There is, moreover, an operational problem.
Even assuming that a 'fear' factor exists, its size and significance will
depend on the countryâ??s creditworthiness. Hence, in each instance, the ECB
will be required to make a judgment. No simple rule, such as a transparent
threshold, is possible. The ECB will, therefore, be necessarily drawn into
making country-specific judgments and decisions.
That, of course, is the
antithesis of what the central bank should be doing. Especially because the
OMT cannot be triggered unless a country asks for ESM support, governments and
their creditors could pursue an unsustainable strategy until it is too late.
At that point, the ECB will inevitably be sucked into political judgments.
No bailout
The ECB contends that by only purchasing bonds on the secondary
market, it is neither extending credit nor is it influencing the market
pricing mechanism, and, it is, therefore, not assuming a sovereign commitment.
But the German Court is only stating the obvious when it notes that even if
the ECB allows some time distance from the sovereignâ??s primary bond issue,
the OMT â??encourage[s] third parties to purchase the government bonds at
issue on the primary market by providing the prospect of assuming the risk
associated with the acquisitionâ??. In other words, the German Court is saying
that the OMT is either providing credit or a free 'put option' to investors.
That interpretation leads to a violation of Article 123. It is hard to see how
the ECJ could conclude otherwise.
In his submission, Asmussen acknowledged
the limits set by Article 123:
â??Article 123 of the Treaty prohibits
monetary financing. In particular, we are not allowed to buy any government
bonds directly, i.e. on the primary market. Government bonds can only be
purchased if they are already on the market and traded freelyâ??.
But he did
not clarify how the limits set by Article 123 would be honoured. The OMT was
also sold as an 'unlimited' programme â?? the 'whatever it takes' bazooka.
Along with being pari passu with creditors (discussed below), the promise of
unlimited purchases helped calm markets. Once again, Asmussen reflected this
tension in his submission.
â??No ex ante quantitative limits are set on the
size of Outright Monetary Transactions. ...we announced that our OMT
interventions would be ex ante â??unlimited.â?? We have no doubt that this
strong signal was required in order to convince market participants of our
seriousness and decisiveness in pursuing the objective of price stability. At
the same time, however, the design of OMTs makes it clear to everyone that the
programme is effectively limited, for one by the restriction to the shorter
part of the yield curve and the resulting limited pool of bonds which may
actually be purchasedâ??.
Perhaps, unlimited purchases at the short-end are
sufficient to eliminate the so-called 'redenomination' risk â?? the risk that
the euro could break up. The German Court is concerned:
â??The â??factualâ??
limitation of the volume of bond purchases by the amount of the government
bonds issued already in the currently scheduled maturity spectrum of one to
three years â?? highlighted by the European Central Bank in the proceedings
before the Federal Constitutional Court â?? is not likely to sufficiently
ensure an adequate quantitative limitation. By changing their refinancing
policies, the Member States that benefit can increase the volume of government
bonds that are currently covered by the OMT Decision; it is unclear what would
follow from the European Central Bankâ??s intention to observe the emission
behaviour of individual Member Statesâ??.
To this, the ECB response has been
that the conditionality that accompanies the ESM programme could require that
countries continue to issue longer maturity bonds. In addition, it will
monitor countries subject to the OMT to ensure that they donâ??t begin issuing
all of their new debt in the OMT-eligible 1-3 year maturity bucket (Cotterill,
2012).
Thus, at least implicitly, the ECB recognises that 'unlimited
purchases' violate Article 123 but limited purchases dilute the value of the
programme. Moreover, once again, the intent of monitoring a countryâ??s debt
issuance strategy exposes the ECB to political terrain.
But, perhaps, the
most important German Court concern is the risk of default on the ECBâ??s
holdings acquired under OMT. This could be rephrased in the ECJâ??s Pringle
terminology to ask whether the ECB is being compensated with an appropriate
margin.
Recall that in its expansive interpretation of Article 125, the ECJ,
while determining that loans made by the ESM are consistent with the TFEU,
required that the loan pay an adequate return to the lender. The ECJ was clear
that the ESM Treaty â??in no way implies that the ESM will assume the debts of
the recipient Member Stateâ?? (paragraph 139). The ECJ notion of return to the
lender was a narrow one: it did not include the benefits achieved by providing
systemic financial stability and resilience. Indeed, it reaffirmed the
conventional TFEU interpretation that the goal of financial stability is to be
achieved by the member states maintaining the needed fiscal discipline for
honouring their debts. For this reason, if a particular OMT transaction were
to face losses, it could not be legitimised on the basis of financial
stability or a similarly broad dividend to the Union.
By accepting losses on
account of a particular sovereign, the ECB would be imposing a fiscal burden
on the other member states â?? without the necessary political authorisation.
In a country with a single fiscal authority, the central bank has recourse to
fiscal support in the event of a loss. With multiple fiscal authorities, the
authors of the TFEU were rightly concerned that such recourse would create
incentives for fiscal indiscipline.
In a recent, much-read, position, Paul De
Grauwe (2014) claimed that a central bank cannot incur losses. Were a
sovereign to default on its obligations to the ECB, the member states would
recapitalise the ECB by lending it money. Over time, the ECB would pay
interest to the member states for that loaned money. This process, De Grauwe
asserts, is costless to all parties[7].
But, of course, the interest that the
ECB pays to the member states would come from its profits. Thus, those profits
would have been used, in effect, to pay for the losses incurred by the ECB. In
so doing, the ECB would have acted to favour a particular sovereign, and
thereby would have created a fiscal transfer mechanism. That transfer would be
particularly costly if the assisted member state eventually left the euro
area[8].
This matter is aggravated by the pari passu feature of the OMT. The
ECBâ??s holdings of Greek debt acquired earlier under its Securities Markets
Programme (SMP), starting May 2010, were effectively granted senior status to
private creditors. When Greek debt was restructured in March 2012, the ECB
exchanged its holdings for bonds that were not subject to the losses imposed
on private creditors (Black, 2012). Thus, the ECB remained whole.
However,
since ECB seniority under SMP increased the losses borne by bondholders whose
securities were not purchased by the ECB, the SMP was not popular in the
market. For this reason, to further reassure market investors, the seniority
claim was apparently relinquished under the OMT. In the OMT press release, the
ECB said
â??The Eurosystem intends to clarify in the legal act concerning
Outright Monetary Transactions that it accepts the same (pari passu) treatment
as private or other creditors with respect to bonds issued by euro area
countries and purchased by the Eurosystem through Outright Monetary
Transactions, in accordance with the terms of such bondsâ??.
Note, therefore,
in highlighting its pari passu status, the ECB recognised that it was moving
beyond the central banking domain of managing liquidity disruptions into space
were insolvency to become a real market concern.
The German Court has
concluded that such equal treatment in creditor status probably renders the
OMT unconstitutional. Their interpretation of Article 123 of the TFEU is that
â??the possibility of a debt cut must be excludedâ??. Thus, the court is
concerned not with the seniority issue per se but by the possibility that the
ECB will not be repaid in full, in which case, the ECB would have acted to
bailout the sovereign creditor in contravention to Articles 123 and 125.
It
is possible that the ECJ may invoke a broader community goal in validating the
OMT. But that would be a departure both from how the OMT has been sold and how
the TFEU has so far been interpreted. It would imply an interpretation that
the TFEU permits a fiscal union.
The economic analysis of the lender of last
resort
The ECJ will also need to contend with well-established central
banking practices, which are implicit in the German Courtâ??s reasoning. A
central bank must address systemic liquidity risk arising from short-term
financial disruption; it should not address solvency problems that are at the
heart of the OMTâ??s design.
The legal analysis, therefore, parallels an
economic logic. At its centre is the distinction between liquidity and
solvency. Temporary market disruption leads to short-term funding requirements
that are met through liquidity provision by the central bank acting in its
capacity as a lender of last resort. The risk of sovereign insolvency,
however, is a fiscal problem. This is never an easy distinction to make in
practice, requiring a presumption one way or another.
Is the OMT intended to
solve a solvency or liquidity problem? The way it is designed, the solvency
concern looms large and, at best, the solvency and liquidity threats are
rolled into one. The OMT is to be triggered precisely when a member state
faces a real threat of insolvency; the market merely amplifies that threat
into a broader financial panic. A central bankâ??s liquidity operation in such
a situation places it in an untenable position.
The strong preference of
private creditors that they receive same treatment as the ECB in the event of
a default, and discussion of the financial options in that event, reflect the
concern that the OMT is designed for conditions in which a default risk is
non-trivial. The German Courtâ??s reservations on these matters mirror those
voiced by central banking experts (Capie, 2002).
The situation is clearly
aggravated in the euro area since, were there to be insolvency, the losses
would be distributed among member states whose governments and taxpayers were
not party to the decisions made. A central bankâ??s role as a lender of last
resort also requires that it not undertake operations primarily to assist
specific entities in distress (Capie, 2002), because that creates the
so-called 'moral hazard' risk that lenders will lend with reckless abandon in
the knowledge that they will be protected. Thus, Sims (2012, p. 221) notes:
â??â?¦ with the expanded balance sheets of the central banks, returns on their
assets will no longer necessarily move in parallel to the rate on reserve
deposits. In the case of the ECB, sovereign debt assets could default. For
both these reasons, future monetary tightening could require the central bank
to ask for a capital injection from the treasury. For the ECB, there is no one
treasury to respond. There is a formal â??capital key,â?? a set of proportions
according to which countries of the euro zone are required to share in
providing capital to the ECB when needed. But if this were required, Germany
would bear a large part of the burden, and it would be clear that German
financial resources were being used to compensate for ECB losses on other
countriesâ?? sovereign debtsâ??.
Once again, the German Courtâ??s concerns
with 'selectivity' have echoes in the central banking literature. A thought
experiment helps clarify the salience of the selectivity issue in an
incomplete monetary union. Should the ECB tailor its policy rates to a
particular member state? During the boom years, should interest rates have
been raised to dampen the real estate booms in Ireland and Spain? The argument
can be made that the failure to do so had systemic consequences. Or consider
Italy today. The OMT is a promise to place a floor on the price of Italian
bonds. If that falls within the authority of the ECB, then should the ECB have
pursued more aggressive reduction of its policy interest rate early on to
pre-empt deflationary conditions in the weakest economies; and should it not
have long since being pursuing unconventional methods to prevent Italian
deflation? Deflation can be at least as serious a risk to debt dynamics as
excessively high interest rates. Fiscal austerity in a deflationary condition
can be debilitating.
Because the member states chose to move ahead with a
monetary union without a fiscal union to backstop such eventualities, the TFEU
is based on the promise of fiscal discipline by each member state to prevent
such risks from arising in the first place. Where the presumed discipline
proves insufficient, the TFEUâ??s intention â?? expressed in Article 125 â??
is that the country would not repay its private creditors. The effort today is
to square a circle: sovereigns must repay private creditors (barring
exceptional circumstances) but without the pooled resources of a fiscal union.
The OMT steps into that breach.
Prospects and possibilities
The German Court
has challenged the OMT on the basis of its congruence with European law. In
the end, the German Court may, indeed, restrain Germany from cooperating with
the OMT because it implies obligations that are not permitted by the German
constitution. But for now, the task is very much on how to interpret the
TFEU.
The ECJ may be less fussy than the German Court in determining the
circumstances under which the OMT could be triggered. The ECB may then be able
to use that flexibility and not hang its OMT trigger on the fuzzy 'fear
factor'. But a general state of financial instability, which creates a
legitimate role for a central bank, does not imply support for a particular
member state. That the ECB, nevertheless, has chosen to link the OMT to
conditional lending by the ESM suggests that the ECB is aware that the OMT is
not a proper lender-of-last resort function. It bridges into lending to
sovereigns facing solvency risk.
If so, the ECJ is very clear. It has
interpreted Article 123 as strictly prohibiting any lending to a sovereign by
the ECB. There appear no exceptions to fall back on for breathing new life
into Article 123. This is all the more so since the economic conditions under
which the OMT is to be operational are more dire than those stipulated for the
ESM and, as such, might not even meet the standards of Article 125. The ESM
was given the green light by the ECJ on the basis that the support would be
through a loan that would be paid back with an appropriate return. In the case
of the OMT, the support is to be provided when the ESM has proved insufficient
and the conditions expressly raise the prospect of a loss to be borne by the
ECBâ??s balance sheet and its shareholders. It, therefore, directly violates
the 'no-bailout' intent of Article 125. Moreover, it does so by lowering the
interest rate paid by the sovereign and, hence, raises the concern that market
discipline is being diluted.
The problem is a simple one. The authors of the
TFEU wrote a document that was consistent with the vision of the euro as an
incomplete monetary union. That construct was intended to work on the basis of
fiscal discipline by countries accompanied by default on debt held by private
creditors where the discipline proved insufficient. The threat of the default
was intended to focus the minds of both the lenders and the borrowers.
Decision makers today have concluded that default is too costly but the
alternative of completing the monetary union through a fiscal union is not
politically feasible.
The fact that the OMT was successful in dampening
market concerns is testament to the need for a fiscal union. It also is an
indication of the size of such centralised fiscal resources that would be a
credible bulwark against market speculation.
A democratically-validated,
political path to a fiscal union has proven to be a receding target. This
should not have been a surprise to those who have observed the evolution of
the euro. The OMT, in effect, offers an apparently elegant technocratic
solution to the euro-areaâ??s fiscal union conundrum.
In highlighting the
tensions between the TFEU and the OMT, the German Court is basically concerned
that the OMT is a fiscal union by the backdoor. The ECJ could validate the
current design of the OMT â?? locating the fiscal union in the central bank
â?? in which case, the nature of the euro area will be fundamentally altered
and the ECB will become a more political institution. Alternatively, if the
ECJ were to determine that the German Courtâ??s concerns need to be addressed
by changes to the OMT â?? by imposing serious limits on purchases of sovereign
bonds and requiring the ECB to claim seniority to private creditors â?? the
OMT will be rendered ineffective.
There is a third option. And that would be
to agree that the OMT is needed as temporary support because an incomplete
monetary union creates intolerable risks. The ECJ would ask the political
actors to meet their responsibility by providing a transparent and legitimate
mandate for a permanent OMT. They would do so by jointly guaranteeing the ECB
against losses incurred if a particular transaction ends in a default. That
guarantee may never be needed. But it would focus the minds and clarify who
bears the cost. Then Europe would have taken a real step forward.
References
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Capie, Forrest (2002) 'Can there be an International
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***
[1] The Lisbon Treaty, signed on 13 December
2007, consolidated the texts of the European Union Treaties, the Treaty of the
European Union and the Treaty on the Functioning of the European Union.
[2]
Euro exits fears were, in no small measure, sparked by threats emanating from
ECB and other euro-area officials. See 'European Officials as Source of
Convertibility Risk'.
[3] In August and September 2012, Draghi repeatedly
insisted on national fiscal discipline.
[4] The English translation of the
Bundesbank submission to the German Court.
[5] The English translation.
[6]
'Convertibility Risk â?? Cherry Picking* Interest Rate Spreads', 2012.
[7]
The process of calling capital from the member countries is, moreover, far
from straightforward. For instance, a vote on loss-sharing is required, not to
mention the obstacles to sharing losses in the event of an exit from the euro.
See 'Loss Sharing in the Eurosystem â?? excluding Target2 Losses'.
[8] These
same problems arise also in the context of ECB exposure to banks that are
insolvent, and for the same reason â?? insufficient clarity on the policy and
willingness to institute losses on private creditors. This may change, but the
extent to which it will remains unclear. |