Stuck Between a Rock and a Hard Place: the Eurozone Blues


In early February, the German Constitutional Court concluded that the program which saved the Eurozone from impending collapse, less than two years ago, violates the German constitution. The so-called ‘Outright Monetary Transactions’ (OMT) program – launched in October 2012, by Mario Draghi, governor of the European Central Bank (ECB) – has yet to be used in practice. But even the promise of unlimited purchases of government bonds by the ECB convinced markets to (finally) believe in the Euro lullaby; “we’ll do whatever it takes, to save the euro”.

So successful were the incantations of Draghi and his Frankfurt Drummers that even now – after the scheme has been ruled unconstitutional – everyone is still asleep. Almost no media coverage, and even less financial market reaction. With the OMT ruled unconstitutional, many would have expected that the political turmoil in Italy last week would have caused serious disruption of its capital markets. But a surge in yields on Italian sovereign bonds did not occur (in fact, the yields on Italian 10 year bonds fell a few basis points).

After the ruling of the German Constitutional Court, many observers find it unlikely that the OMT will ever be used; it’s “effectively dead”, in the words of Professor Marcel Fratzscher (president of the prestigious German research institute DIW Berlin) . But if that is the case, why is there so little reaction – from policymakers, in media, and in financial markets?

Perhaps the alleged ‘death’ of the OMT is just plain exaggerated? Maybe it’s a conclusion drawn by observers who know less about the matter than they would like to think? Sure, in politics life and death at times take surprising turns. But let’s nevertheless briefly assess just how dead the OMT is, or is not, at least for the time being.

The German Constitutional Court (GCC) considers the OMT a violation of the German constitution. The OMT extends beyond the ECBs mandate and undermines democracy, it says. Crucially, in the eyes of the GCC, the OMT constitutes debt monetization, whereby a central bank prints money to finance the debts of its sovereign(s).

In spite of these far-reaching conclusions, the GCC abstained from issuing a formal ruling that would directly constrain the Bundesbank and the German Parliament, and instead referred the case to the European Court of Justice, asking its opinion. So what is this? Is it really just a case of some “crimson-robed weirdoes in Karlsruhe”, barking a little, as a matter of principle, before they lie down (eventually) – in subservience to the brutal logics of abiding to whatever-it-takes-to-save-the-euro? This may be the common reading, but it is a misreading nevertheless. The German eurosceptics are already celebrating, and for a good reason, says Wolfgang Münchau:

“If you look back to all the previous German constitutional court case on the euro, the answer was always a variant of ‘Yes, but’. This ruling was the legal equivalent of ‘No, no, no’ – with one important addition. The court is asking the European Council of Justice to clarify important points of European law, including whether OMT is covered by the ECBs mandate; whether OMT needs to be capped; whether it violates the sovereignty of national parliaments; and whether it constitutes monetary financing of government debt” – from a European perspective.

So even if the ECJ sides with the ECB – which most commentators think they will – the OMT is by no means home safe. On the contrary, such an outcome would spell a constitutional crisis for Europe; EU law would be in direct contradiction with German constitutional law, Münchau points out.

Some suggest that the OMT will likely be revised and remolded, and eventually survive in amended form. But if the OMT is revised so as to no longer involve (potentially) “unlimited” purchases of government bonds, it will no longer be the OMT, except in name. If the OMT was to be relaunched with a cap, it would be a small miracle if markets did not engage in merciless testing of the European resolve to still do whatever-it-takes to save the euro.

All this is bad enough, but there is more. The ruling of the German constitutional court in effect outlaws much more than just the OMT. In the words of Marcel Fratzscher:

“The German court has ruled that the scheme can be legal only if it is limited in size ex ante, rules out losses on sovereign debt, and avoids ‘interferences with price formation on the market’. The problem is that almost all ECB policies would violate these principles”.

For Fratzscher this is the real reason why the ruling of the GCC is such a serious setback for Europe.

For the time being markets seem confident. No sign of panic, or unease even, in Europe’s debt markets. But it doesn’t require a big leap of imagination to envisage some tough ‘market tests’ for this complacency, coming up in the not-too-distant future. One could mention elections for the European Parliament in May (with eurosceptics on the rise) as well as the ECB’s upcoming review of the European banking sector as potential sources of less-than-great news for the Eurozone. But let’s concentrate here on a third potential ‘test’ of Eurozone resolve and resilience.

Until now, the ECB has abstained from Quantitative Easing (QE), contrary to its counterparts in US, UK and Japan. In Davos a few weeks ago, Mario Draghi still seemed less than keen to walk the QE path. Even if he were keen, it would be an uphill battle, given the fierce German resistance to anything that could be interpreted as monetary financing of government debt, or as involving fiscal transfers to countries in the periphery of the Eurozone (even if indirectly, through their banks).

But what if Europe edges even closer to deflation than it already is (which is not as unlikely as one might like to believe)? With interest rates already softly kissing the zero bound, conventional tools seem exhausted, so what exactly would the ECB do?

“What other assets would we buy?”, pondered Draghi in Davos. “One thing is bank loans . . . the issue for further thinking in the future is to have an asset that would capture and package bank loans in the proper way”.

Perhaps this is the bet financial markets are making: if challenged (further), Europe will launch a ‘QE with European characteristics’. Wolfgang Münchau sees no other way to avoid a deflation menace in the Eurozone:

“The only tools strong enough to stem deflation are unconventional. These could include purchases of sovereign and corporate bonds, bank bonds or even company shares. They could also include funding-for-lending schemes, support for small company loan securitisations or, in extremis, direct lending to companies. But the longer one waits and the longer deflation festers – the more it affects wage settlements and prices for goods and services – the harder and more costly it will be to get rid of”

If deflation shows further signs of taking hold of the Eurozone, the ECB will likely see no other option than engage in QE. Although the ECB is formally independent, and may argue that such a course of action is within its price stability mandate, the political repercussions are difficult to predict. For how long can Eurozone countries be expected to agree to back such a scheme, what reform ‘conditionalities’ will be negotiated and how will their electorates react?

Jakob Vestergaard, GEG Watch, 23/2-2014


References and suggested readings

Atkins, Ralph (2014, 13. February). Karlsruhe fallout highlights power of ECB

Chandler, Marc (2014, 17. February). ECB Update

Das, Satyajit (2014, 18. Febraury). The European Debt Crisis: Kahlsruhe & Quantum Physics

Fratzscher, Marcel (2014, 10. February). Germany’s Pyrrhic Victory

Granville, Brigitte (2014, 21. February). Poking the Eurozone Bear

Jones, Claire and Chris Giles (2014, 26. January). ECB poised for battle to ward off deflation

Lawton, Christopher (2014, 3. February). ECB Defends Bank Review, Stress Test

McGeever, Jamie (2014, 26. February). ECB to take the QE plunge this year…finally

Mody, Ashoka (2014, 11. February). The ECB’s Bridge Too Far

Münchau, Wolfgang (2014, 9. February). Germany’s constitutional court has strengthened the eurosceptics

Münchau, Wolfgang (2014, 23. February). Europe cannot afford to ignore its deflation problem

Sinn, Hans-Werner (2014, 9. February). Outright Monetary Infractions

The New York Times (2014, 17. February). Europe Flirts With Deflation

Wagstyl, Stefan and Claire Jones (2014, 7. February). German court refers ECB bond-buying programme to Europan justice

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