nep-mon New Economics Papers
on Monetary Economics
Issue of 2014‒08‒20
twenty-six papers chosen by
Bernd Hayo
Philipps-Universität Marburg

  1. Financial Stability, Monetary Policy, Banking Supervision, and Central Banking By Martin F. Hellwig
  2. Non-Standard Monetary Policy Measures – Magic Wand or Tiger by the Tail? By Ansgar Belke
  3. Asian Monetary Integration : A Japanese Perspective By Masahiro Kawai
  4. How has empirical monetary policy analysis changed after the financial crisis? By Francis, Neville; Jackson, Laura E.; Owyang, Michael T.
  5. Optimal Monetary Responses to Oil Discoveries By Samuel Wills
  7. Stability and Identification with Optimal Macroprudential Policy Rules By Jean-Bernard Chatelain; Kirsten Ralf
  8. Financial Shocks and Optimal Monetary Policy Rules By Fabio Verona; Manuel M. F. Martins; Inês Drumond
  9. Paths to a Reserve Currency : Internationalization of the Renminbi and Its Implications By Yiping Huang; Daili Wang; Gang Fan
  10. Liquidity Trap and Excessive Leverage By Anton Korinek; Alp Simsek
  11. The Power of International Reserves: the impossible trinity becomes possible By Layal Mansour
  12. Estimating the Expected Duration of the Zero Lower Bound in DSGE Models with Forward Guidance By Mariano Kulish; James Morley; Tim Robinson
  13. Assessing the Link between Price and Financial Stability By Christophe Blot; Jerome Creel; Paul Hubert; Fabien Labondance; Francesco Saraceno
  14. The Rise of the “Redback†and the People’s Republic of China’s Capital Account Liberalization : An Empirical Analysis of the Determinants of Invoicing Currencies By Hiro Ito; Menzie Chinn
  15. Rented vs. Owner-Occupied Housing and Monetary Policy By Margarta Rubio
  16. Monetary Policy and the Economic Recovery : a speech at the Economic Club of New York, New York, New York , April 16, 2014 By Yellen, Janet L.
  17. Monetary Policy and Financial Stability : A speech at the 30th Annual National Association for Business Economics Economic Policy Conference, Arlington, Virginia, February 25, 2014 By Tarullo, Daniel K.
  18. Did the German court do Europe a favour? By Ashoka Mody
  19. A Simple General Equilibrium Model of Large Excess Reserves By Ennis, Huberto M.
  20. Competition and Credit Control By C.A.E. Goodhart
  21. Income inequality and monetary policy: a framework with answers to three questions By Bullard, James B.
  22. Rescues Violating the German Constitution:The Federal Court Decides on a Theory of Finance By Adalbert Winkler
  23. Central bank independence and sovereign debt crisis. Any link? By Kari Heimonen; Aleksandra Maslowska-Jokinen
  24. US Monetary Policy and Commodity Sector Prices By Shawkat Hammoudeh; Duc Khuong Nguyen; Ricardo M. Sousa
  25. Central bank macroeconomic forecasting during the global financial crisis: the European Central Bank and Federal Reserve Bank of New York experiences By Alessi, Luci; Ghysels, Eric; Onorante, Luca; Peach, Richard; Potter, Simon M.
  26. Lost at Sea:The Euro Needs a Euro Treasury By Jörg Bibow

  1. By: Martin F. Hellwig (Max Planck Institute for Research on Collective Goods)
    Abstract: The paper gives an overview over issues concerning the role of financial stability in monetary policy and the relation between banking supervision and central banking. Following a brief account of developments in the European Monetary Union since its creation, the systematic treatment contains four parts, first a systematic discussion of how a central bank’s operations differ from those of an administrative authority; second, a discussion of how the shift from convertible currencies to paper currencies has affected our understanding of monetary policy and the role of financial stability; third, a discussion of moral hazard in banking and banking supervision as a threat to monetary dominance and to the effective independence of central bank decision making in an environment in which financial stability is an essential precondition for reaching the central bank’s macroeconomic objective, e.g. price stability; finally, a discussion of the challenges for institution design and policy, with special attention to developments in the euro area.
    Keywords: Banking Supervision, financial stability, monetary policy, central banking, bank resolution, independence of central banks and supervisory authorities
    JEL: G18 G28 E58 E44 E42 E51 E52 G33 H63
    Date: 2014–07
  2. By: Ansgar Belke
    Abstract: This paper briefly assesses the effectiveness of the different non-standard monetary policy tools in the Euro Area. Its main focus is on the Outright Monetary Transactions (OMT) Programme which is praised by some as the ECB’s “magic wand”. Moreover, it discloses further possible unintended consequences of these measures in the current context of weak economic activity and subdued growth going forward. For this purpose, it investigates specific risks for price stability and asset price developments in the first main part of the paper. It is not a too remote issue that the Fed does have a “tiger by the tail”, as Hayek (2009) expressed it, i.e. that the bank will finally have to accept either a recession or inflation and that there is no choice in between. Furthermore, it checks on whether the OMT programme really does not impose costs onto the taxpayer. Finally, it comes up with some policy implications from differences in money and credit growth in different individual countries of the Euro Area. The second main part of the paper assesses which other tools the ECB could use in order to stimulate the economy in the Euro Area. It does so by delivering details on whether and how the effectiveness of the ECB’s policies can be improved through more transparency and “forward guidance”.
    Keywords: central bank transparency, euro area, forward guidance, non-standard monetary policies, Outright Monetary Transactions, Quantitative Easing, segmentation of credit markets
    JEL: E52 E58
    Date: 2014–04
  3. By: Masahiro Kawai (Asian Development Bank Institute (ADBI))
    Abstract: This paper discusses Japan’s strategy for Asian monetary integration. It argues that Japan faces three major policy challenges when promoting intraregional exchange rate stability. First, there must be some convergence of exchange rate regimes in East Asia, and the most realistic option is for the region’s emerging economies to adopt similar managed floating regimes—rather than a peg to an external currency. This requires major emerging economies—particularly the People’s Republic of China (PRC)—to move to a more flexible regime vis-à-vis the US dollar. Second, given the limited degree of the yen’s internationalization and the lack of the renminbi’s (or the prospect of its rapid) full convertibility, it is in the interest of East Asia to create a regional monetary anchor through a combination of some form of national inflation targeting and a currency basket system. Emerging economies in the region need to find a suitable currency basket for their exchange rate target, such as a special drawing rights-plus (SDR+) currency basket—i.e., a basket of the SDR and emerging East Asian currencies. Third, if the creation of a stable regional monetary zone is desirable, the region must have a country or countries assuming a leadership role in this endeavor. There is no question that Japan and the PRC are such potential leaders, and the two countries need to collaborate closely with each other. To assume a leadership role, together with the PRC, in creating a stable monetary zone in Asia, Japan needs to make significant efforts at the national and regional levels and further strengthen financial cooperation. Practical steps that Japan could take include (i) restoring sustained economic growth through Abenomics; (ii) transforming Tokyo into a globally competitive international financial center; (iii) further strengthening regional economic and financial surveillance (Economic Review and Policy Dialogue and ASEAN+3 Macroeconomic Research Office) and regional financial safety nets (Chiang Mai Initiative Multilateralization) and creation of an Asian currency unit index; and (iv) launching serious policy discussions focusing on exchange rate issues to achieve intraregional exchange rate stability.
    Keywords: Asian monetary integration, Japan, currency, exchange rate regime, East Asia, SDR, currency basket, monetary zone, PRC, Chiang Mai
    JEL: F31 F32 F33 F42
    Date: 2014–04
  4. By: Francis, Neville (University of North Carolina, Chapel Hill); Jackson, Laura E. (University of North Carolina, Chapel Hill); Owyang, Michael T. (Federal Reserve Bank of St. Louis)
    Abstract: In the wake of the Great Recession, the Federal Reserve lowered the federal funds rate target essentially to zero and resorted to unconventional monetary policy. With the nominal FFR constrained by the zero lower bound (ZLB) for an extended period, empirical monetary models cannot be estimated as usual. In this paper, we consider whether the standard empirical model of monetary policy can be preserved without breaks. We consider whether alternative policy instruments (e.g., the size of the balance sheet) can be considered substitutes for the FFR over the ZLB period. Furthermore, we construct a shadow rate via the method proposed in Krippner [2012] to represent an alternative measure of the stance of monetary policy and compare this with the shadow rate of Wu and Xia [2014]. We ask whether the shadow rate is a sufficient representation of the policy instrument or if the financial crisis requires other modifications. We find that, if using a dataset that spans the pre-ZLB period throughout the ZLB environment, the shadow rate acts as a fairly good proxy for monetary policy by producing impulse responses of macro indicators similar to what we’d expect based on the post-WWII, non-ZLB benchmark. However, the linear model exhibits a significant structural break at the onset of the ZLB and the shadow rate may still be insufficient for examining the ZLB period in isolation.
    Keywords: zero lower bound; affine term structure
    JEL: C32 E44
    Date: 2014–08–01
  5. By: Samuel Wills (Oxford Centre for the Analysis of Resource Rich Economies (OxCarre), Department of Economics, University of Oxford; Centre for Macroeconomics (CFM); Centre for Applied Macroeconomic Analysis, Australian National University.; Centre for Macroeconomics (CFM))
    Abstract: This paper studies how monetary policy should respond to news about an oil discovery, using a workhorse New Keynesian model. Good news about future production can create a recession today under exchange rate pegs and a simple Taylor rule, as seen in practice. This is explained by forward-looking inflation. Recession is avoided by a Taylor rule that accommodates changes in the natural level of output, which closely approximates optimal policy. Central banks have an incentive to exploit oil revenues by appreciating the terms of trade, creating “Dutch disease” and a deflationary bias which is overcome by committing to future policy.
    Keywords: Natural resources, oil, optimal monetary policy, small open economy, news shock
    JEL: E52 E62 F41 O13 Q30 Q33
    Date: 2012–10
  6. By: Lukasz Topolewski (Nicolaus Copernicus University)
    Abstract: The work concerns the transparency of monetary policy selected central banks. The significance of this issue is growing and has a huge impact on the policy pursued by the central bank. There are also increasing importance of other aspects of quality. This article presents the transparency of monetary policy being carried out by the central bank. During the preparation work is based mainly on the analysis of the literature on a selected topic. The paper cites studies by other authors. Research shows that transparency is determined by many factors, which among others include: applied monetary policy strategy, experience, associated with a history of banking crises, as well as part of the supervision of the banking system. The conducted considerations that the level of transparency of the analyzed banks increased significantly, and this trend will probably continue in the future. Banks completely changed their attitude in this regard and are becoming more open to providing information to the public. It has been shown that among the subjects analyzed, the Czech National Bank and the National Bank of Hungary lead the most transparent monetary policy.
    Keywords: monetary policy, central bank, transparency
    Date: 2013–02
  7. By: Jean-Bernard Chatelain (CES - Centre d'économie de la Sorbonne - CNRS : UMR8174 - Université Paris I - Panthéon-Sorbonne, EEP-PSE - Ecole d'Économie de Paris - Paris School of Economics - Ecole d'Économie de Paris, UP1 - Université Paris 1, Panthéon-Sorbonne - Université Paris I - Panthéon-Sorbonne - PRES HESAM); Kirsten Ralf (Ecole Supérieure du Commerce Extérieur - ESCE)
    Abstract: This paper investigates the identification, the determinacy and the stability of ad hoc, "quasi-optimal" and optimal policy rules augmented with financial stability indicators (such as asset prices deviations from their fundamental values) and minimizing the volatility of the policy interest rates, when the central bank precommits to financial stability. Firstly, ad hoc and quasi-optimal rules parameters of financial stability indicators cannot be identified. For those rules, non zero policy rule parameters of financial stability indicators are observationally equivalent to rule parameters set to zero in another rule, so that they are unable to inform monetary policy. Secondly, under controllability conditions, optimal policy rules parameters of financial stability indicators can all be identified, along with a bounded solution stabilizing an unstable economy as in Woodford (2003), with determinacy of the initial conditions of non- predetermined variables.
    Keywords: Identification; Financial Stability; Optimal Policy under Commitment; Augmented Taylor rule; Monetary Policy.
    Date: 2014–04–12
  8. By: Fabio Verona (Bank of Finland, Monetary Policy and Research Department, and University of Porto, cef.up); Manuel M. F. Martins (University of Porto, Faculty of Economics and cef.up); Inês Drumond (Banco de Portugal, Financial Stability Department, and University of Porto, cef.up)
    Abstract: We assess the performance of optimal Taylor-type interest rate rules, with and without reaction to financial variables, in stabilizing the macroeconomy following financial shocks. We use a DSGE model that comprises both a loan and a bond market, which best suits the contemporary structure of the U.S. financial system and allows for a wide set of financial shocks and transmission mechanisms. Overall, we find that targeting financial stability – in particular credit growth, but in some cases also financial spreads and asset prices – improves macroeconomic stabilization. The specific policy implications depend on the policy regime, and on the origin and the persistence of the financial shock.
    Keywords: financial shocks, optimal monetary policy, Taylor rules, DSGE models, bond market, loan market
    JEL: E32 E44 E52
    Date: 2014–07
  9. By: Yiping Huang (Asian Development Bank Institute (ADBI)); Daili Wang; Gang Fan
    Abstract: In this paper we try to address the question of what could help make the renminbi a reserve currency. In recent years, the authorities in the People’s Republic of China (PRC) have made efforts to internationalize its currency through a two-track strategy : promotion of the use of the renminbi in the settlement of cross-border trade and investment, and liberalization of the capital account. We find that if we use only the quantitative measures of the economy, the predicted share of the renminbi in global reserves could reach 12%. However, if institutional and market variables are included, the predicted share comes down to around 2%, which is a more realistic prediction. By reviewing experiences of other reserve currencies, we propose a three-factor approach for the PRC authorities to promote the international role of the renminbi : (i) increasing the opportunities of using renminbi in the international community, which requires relatively rapid growth of the PRC economy and continuous liberalization of trade and investment; (ii) improving the ease of using renminbi, which requires depth, sophistication, and liquidity of financial markets; and (iii) strengthening confidence of using renminbi, which requires more transparent monetary policy making, a more independent legal system, and some political reforms. In general, we believe that the renminbi’s international role should increase in the coming years, but it will take a relatively long period before it plays the role of a global reserve currency.
    Keywords: liberalization of the capital account, renminbi internationalization, global reserve currency, three-factor approach, transparent monetary policy
    JEL: F30 F33 F36 F42
    Date: 2014–05
  10. By: Anton Korinek; Alp Simsek
    Abstract: We investigate the role of macroprudential policies in mitigating liquidity traps driven by deleveraging, using a simple Keynesian model. When constrained agents engage in deleveraging, the interest rate needs to fall to induce unconstrained agents to pick up the decline in aggregate demand. However, if the fall in the interest rate is limited by the zero lower bound, aggregate demand is insufficient and the economy enters a liquidity trap. In such an environment, agents' exante leverage and insurance decisions are associated with aggregate demand externalities. The competitive equilibrium allocation is constrained inefficient. Welfare can be improved by ex-ante macroprudential policies such as debt limits and mandatory insurance requirements. The size of the required intervention depends on the differences in marginal propensity to consume between borrowers and lenders during the deleveraging episode. In our model, contractionary monetary policy is inferior to macroprudential policy in addressing excessive leverage, and it can even have the unintended consequence of increasing leverage.
    Keywords: Macroprudential Policy;Monetary policy;Liquidity;Demand;Borrowing;Debt markets;Economic recession;Equilibrium. Econometric models;Leverage, liquidity trap, zero lower bound, aggregate demand externality, efficiency, macroprudential policy, insurance
    Date: 2014–07–21
  11. By: Layal Mansour (Université de Lyon, Lyon, F-69007, France ; CNRS, GATE Lyon St Etienne,F-69130 Ecully, France)
    Abstract: This aim of the present paper is to measure first, the degree of trilemma indexes: exchange rate stability, monetary independence capital account openness while taking into account the increase of hording IR ratio over GDP, over External Debt and over Short Term External Debt. The evolution of the trilemma indexes shows that countries applying de facto flexible Exchange Rate Regime (ERR) take advantage of the IR and become able to adopt a managed ERR that consist of achieving the three trilemma indexes simultaneously without renouncing to anyone of them. We found that different IR ratio could have different interpretations and different directions of monetary policies, where external debt should be taken into consideration in such study while using the IR. As for country that is applying a de facto fixed exchange rate regime, the IR (different ratio) do not play any role in changing the patter of the Mundell trilemma and do not intervene in monetary authority policies. This paper treats as well the normative aspects of the trilemma, relating the policy choices to macroeconomic outcomes such as the volatility of output growth. We found different results from country to another, while taking different ratios of measuring IR, concluding that the impact of IR on the output volatility could change due to the level of external debt and adopted exchange rate regime.
    Keywords: Monetary policy, International Reserve, External Debts, Impossible Trinity, Managed Exchange Rate, Quadrilemma, Output Volatilily
    JEL: E52 E58 F31 F34
    Date: 2014
  12. By: Mariano Kulish (School of Economics, Australian School of Business, The University of New South Wales); James Morley (School of Economics, Australian School of Business, The University of New South Wales); Tim Robinson (Melbourne Institute of Applied Economic and Social Research, The University of Melbourne)
    Abstract: Motivated by the increasing use of forward guidance, we consider DSGE models in which the central bank holds the policy rate fixed for an extended period of time. Private agents’ beliefs about how long the fixed-rate regime will last influences current output and inflation. We estimate the structural for US data and infer the expected duration of the zero lower bound regime. Our results suggest that the average expected duration is around 3 quarters and has varied significantly since the onset of the zero lower bound regime, with changes that can be related to the Federal Reserve’s forward guidance.
    Keywords: Zero lower bound, forward guidance
    JEL: E52 E58
    Date: 2014–07
  13. By: Christophe Blot (OFCE - Sciences Po); Jerome Creel (OFCE - Sciences Po, and ESCP Europe); Paul Hubert (OFCE - Sciences Po); Fabien Labondance (OFCE - Sciences Po); Francesco Saraceno (OFCE - Sciences Po, and LUISS)
    Abstract: This paper aims at investigating first the (possibly time-varying) empirical relationship between the level and conditional variances of price and financial stability, and second, the effects of macro and policy variables on this relationship in the United States and the Eurozone. Three empirical methods are used to examine the relevance of A.J Schwartz's "conventional wisdom" that price stability would yield financial stability. Using simple correlations, VAR and Dynamic Conditional Correlations, we reject the hypothesis that price stability is positively correlated to financial stability. We then discuss about the empirical appropriateness of the "leaning against the wind" monetary policy approach.
    Keywords: Price Stability, Financial stability, DCC-GARCH, VAR
    JEL: C32 E31 E44 E52
    Date: 2013–02–01
  14. By: Hiro Ito (Asian Development Bank Institute (ADBI)); Menzie Chinn
    Abstract: We investigate the determinants of currency choice for trade invoicing in a cross-country context while focusing on the link between capital account liberalization and its impact on the use of the renminbi (RMB). We find that while countries with more developed financial markets tend to invoice less in the US dollar, countries with more open capital accounts tend to invoice in either the euro or their home currency. These results indicate that financial development and financial openness are among the keys to challenging the US dollar dominance in general, and to internationalizing the RMB for the People’s Republic of China (PRC). Our model also suggests that the share of the RMB in export invoicing should have been higher than the actually observed share of less than 10%. The underperformance of RMB export invoicing can be attributed to the inertia in the choice of currency for trade invoicing; once a currency is used for trade invoicing or settlements, it becomes difficult for traders to switch from one currency to another. This same phenomenon was also observed in the cases of the Japanese yen and the euro at their inceptions as international currencies. Our model predicts that the share of RMB invoicing for the PRC’s exports will rise to above 25% in 2015 and above 30% in 2018, whether or not the PRC implements drastic financial liberalization. As the near future path of RMB use is also expected to be inertial, these forecasts are probably at the upper end of the actual path of RMB export invoicing.
    Keywords: Capital account liberalization, renminbi (RMB), PRC, export invoicing currency
    JEL: F32 F41
    Date: 2014–04
  15. By: Margarta Rubio
    Abstract: The aim of this paper is to show how housing tenure (rented vs. owner-occupied) affects monetary policy. In order to do that, I propose a dynamic stochastic general equilibrium model with housing, both owned and rented. First, I analyze how, in the model, preference parameters, fiscal incentives and institutional factors determine the rental market share and the residential debt-to-GDP ratio. Then, within this framework, I study how the transmission and optimality of monetary policy differ depending on these factors. From a positive perspective, impulse responses illustrate differences in the monetary transmission mechanism. In normative terms, results show that when the relative size of the rental market is larger, monetary policy is more stabilizing. An optimal monetary policy analysis also suggests that in this case, monetary policy should respond more aggressively to inflation and disregard output, since the financial accelerator effects are weaker.
    Keywords: Housing market, rental, owner-occupied housing, monetary policy
    Date: 2014
  16. By: Yellen, Janet L. (Board of Governors of the Federal Reserve System (U.S.))
    Date: 2014–04–16
  17. By: Tarullo, Daniel K. (Board of Governors of the Federal Reserve System (U.S.))
    Date: 2014–02–25
  18. By: Ashoka Mody
    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 Asmussen, Jörg (2013) 'Introductory Statement by the ECB in the Proceedings before the Federal Constitutional Court', 11 June Black, Jeff (2012) 'ECB Is Said to Swap Greek Bonds for New Debt to Avoid Any Enforced Losses', 17 February Capie, Forrest (2002) 'Can there be an International Lender-of-Last-Resort?' International Finance 1(2): 311â??325 Cotterill, Joseph (2012) 'The OMT and "limits"', Financial Times Alphaville, 18 September Craig, Paul (2013) 'Pringle: Legal Reasoning, Text, Purpose and Teleology', Maastricht Journal of European and Comparative Law 20 (1): 3-11 De Grauwe, Paul (2014) 'Why the European Court of Justice should reject the German Constitutional Courtâ??s ruling on Outright Monetary Transactions' De Grauwe, Paul and Yuemei Ji (2012) 'Mispricing of Sovereign Risk and Multiple Equilibria in the Eurozone', Journal of Common Market Studies 50(6): 866â??880 De Witte, Bruno (2013) 'Using International Law in the Euro Crisis', Centre for European Studies, University of Oslo, Working Paper 4 Draghi, Mario (2012a) 'Verbatim of the Remarks made by Mario Draghi', Global Investment Conference in London, 26 July Draghi, Mario (2012b) 'Introductory statement to the press conference (with Q&A)', Frankfurt am Main, 2 August Draghi, Mario (2012c) 'Building the Bridge to a Stable European Economy', The Federation of German Industries, Berlin, 25 September Draghi, Mario (2013) 'Questions and Answers at Press Conference', 6 June, Frankfurt am Main European Central Bank (2012) 'The OMT Press Release' European Court of Justice (2012) 'Judgment of the Court (Full Court): Thomas Pringle v Government of Ireland and The Attorney General', 27 November Federal Constitutional Court (2014) 'Principal Proceedings ESM/ECB: Pronouncement of the Judgment and Referral for a Preliminary Ruling to the Court of Justice of the European Union', judgment; press release Grimm, Dieter (1997) 'The European Court of Justice and National Courts: the German Constitutional Perspective after the Maastricht Decision', Columbia Journal of European Law 3: 229-242 Kenen, Peter (1969) 'The Theory of Optimum Currency Areas: An Eclectic View', in Robert Mundell and Alexander Swoboda (eds) Monetary Problems of the International Economy, Chicago: University of Chicago Press Mody, Ashoka (2014) 'Europhoria, Once Again' Norman, Peter (1998) 'German Court Rejects Emu Challenge', Financial Times, 3 April Pistor, Katharina (2014) 'German Court decision: Legal authority and deep power implications' Steen, Michael (2012) 'Weidmann isolated as ECB Plan Approved', Financial Times, 6 September Steinkamp, Sven and Frank Westermann (2014) 'The Role of Creditor Seniority in Europeâ??s Sovereign Debt Crisis', forthcoming in Economic Policy, 29(79): July Wearden, Graham (2012) 'Eurozone crisis live: Merkel backs ECB rescue plan as markets remain cheerful â?? as it happened', The Guardian, 12 September *** [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.
    Date: 2014–07
  19. By: Ennis, Huberto M. (Federal Reserve Bank of Richmond)
    Abstract: I study a non-stochastic, perfect foresight, general equilibrium model with a banking system that may hold large excess reserves when the central bank pays interest on reserves. The banking system also faces a capital constraint that may or may not be binding. When the rate of interest on reserves equals the market rate, if the quantity of reserves is large and bank capital is not scarce, the price level is indeterminate. However, for a large enough level of reserves, the bank capital constraint becomes binding and the price level moves one to one with the quantity of reserves.
    JEL: G21
    Date: 2014–08–06
  20. By: C.A.E. Goodhart
    Abstract: The Bank of England’s ‘consultative document’ on Competition and Credit Control was published on May 14th, 1971. It was a landmark occasion, representing a decisive break with the prior system of maintaining direct controls over the, main components of the, UK banking system; the intention was now to achieve the monetary authorities’ objectives of policy via the operation of market mechanisms, notably adjustments in interest rates and open market operations. Although the ‘credit control’ aspect was, over the next few years, notably less successful than the encouragement of competition amongst the banks, (where the London Clearing Banks previously had maintained a restrictive cartel with the support of the authorities), nevertheless the direction of travel towards a more liberal, market based system, remained, despite a partial reversion towards a partial direct control system in the guise of the ‘corset’, introduced at the end of 1973, and finally laid to rest in June 1980.
    Date: 2014
  21. By: Bullard, James B. (Federal Reserve Bank of St. Louis)
    Abstract: June 26, 2014. Remarks. "Income Inequality and Monetary Policy: A Framework with Answers to Three Questions." C. Peter McColough Series on International Economics, Council on Foreign Relations, New York, N.Y.
    Date: 2014–06–26
  22. By: Adalbert Winkler
    Abstract: The Federal German Constitutional Court has made it clear that it considers the OMT program to be in violation of the ECB’s mandate. This paper argues that the Court’s decision reflects an endorsement of the efficient-market hypothesis. If financial markets are efficient, interference of any kind in these markets cannot be regarded as monetary policy and hence violates the ECB’s mandate. In 1962, Helmut Schmidt, who was then Minister of the Interior of the city-state of Hamburg, violated the German constitution by making use of the Federal Armed Forces [Bundeswehr] within the country’s borders in a non-military context, specifically to rescue fellow citizens during the great North Sea flood of that year. However, despite acting unconstitutionally he was seen as being in compliance with his mandate. This contrasts with Mario Draghi who – without having yet bought a single sovereign bond – has been accused of violating the German constitution because the Court ignored alternative theories of finance which have been put forward in the debate among economists about the proper conduct of monetary policy in a financial crisis.
    Date: 2014
  23. By: Kari Heimonen (School of Business and Economics, University of Jyvaskyla); Aleksandra Maslowska-Jokinen (Department of Economics, University of Turku)
    Abstract: In this paper we ask if central bank independence could lead to a bad fiscal position of some countries. Introducing autonomous central bank without changing other policy habits could expose the country to greater temptation to borrow money. We think that introducing high degree of CBI creates illusion that these countries are of similar credibility as a borrower. It opens new possibilities to borrow money and to increase consumption, thus leading to greater indebtedness. We analyse if the size of improvement in CBI was connected with country's increase in debt. We hypothesise that some countries could misuse the benefits coming from CBI, would not introduce discipline in other parts of economic policy and not only continue spending but also increase their volumes thanks to wider options for borrowing. Panel data estimations results using EMU-14 confirm our hypotheses. Greater increase in CBI was related to greater increase in debt, both public and private. These results are confirmed with alternative models and varying definitions of central bank independence.
    Keywords: central bank independence, sovereign debt, private debt, sound money, panel data
    JEL: C33 E02 E58 E61
    Date: 2014–07
  24. By: Shawkat Hammoudeh; Duc Khuong Nguyen; Ricardo M. Sousa
    Abstract: This study examines the effects of the monetary policy of the United States on commodity prices. Using a Bayesian Structural VAR, we identify the interest rate shocks as a measure of the stance of the U.S. mon- etary policy and evaluate their impacts on different types of commodity prices. The empirical evidence suggests that a U.S. monetary contraction has a negative and significant effect on the aggregate commodi- ty prices, which takes place with a substantial lag (i.e., eight quarters after the shock). However, the ag- gregate response masks the existence of significant heterogeneity in the responses of the different types of commodities. More specifically, a positive interest rate (contractionary) shock leads to: i) an initial in- crease in the prices of non-fuel commodities, which later reverts path and becomes negative (as in the case of the prices of agricultural raw materials); ii) a positive and persistent rise in the food prices; iii) a fall in the beverage prices; and iv) a persistent reduction in the prices of metals and the prices of fuel (en- ergy) prices.
    Keywords: monetary policy, commodity prices, Bayesian Structural VAR.
    JEL: E37 E52
    Date: 2014–07–24
  25. By: Alessi, Luci (Federal Reserve Bank of New York); Ghysels, Eric (Federal Reserve Bank of New York); Onorante, Luca (Federal Reserve Bank of New York); Peach, Richard (Federal Reserve Bank of New York); Potter, Simon M. (Federal Reserve Bank of New York)
    Abstract: This paper documents macroeconomic forecasting during the global financial crisis by two key central banks: the European Central Bank and the Federal Reserve Bank of New York. The paper is the result of a collaborative effort between the two institutions, allowing us to study the time-stamped forecasts as they were made throughout the crisis. The analysis does not focus exclusively on point forecast performance. It also examines density forecasts, as well as methodological contributions, including how financial market data could have been incorporated into the forecasting process.
    Keywords: macro forecasting; financial crisis
    JEL: B41 E32 G01 N20
    Date: 2014–07–01
  26. By: Jörg Bibow
    Abstract: The euro crisis remains unresolved even as financial markets may seem calm for now. The current euro regime is inherently flawed. Recent reforms have failed to turn the dysfunctional euro regime into a viable one. The investigation is informed by the “cartalist” critique of traditional “optimum currency area” theory (Goodhart 1998). Various proposals to rescue the euro are assessed and found lacking. A Euro Treasury scheme operating on a strict rule and specifically designed not to be a transfer union is proposed here as condition sine qua non for healing the euro’s potentially fatal birth defects. The Euro Treasury proposed here is the missing element that renders sense to the current fiscal regime that is unworkable without it. The proposed Euro Treasury scheme would end the currently unfolding euro calamity by switching policy from a public thrift campaign that can only impoverish Europe to a public investment campaign designed to secure Europe’s future. No mutualization of existing national public debts is involved. Instead, the Euro Treasury is established as a means to pool eurozone public investment spending and have it funded by proper eurozone treasury securities.
    Date: 2013

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