The Bundesbank Hits Back
Germany's constitutional court in Karlsruhe is traditionally buried in complaints with every major new decision concerning the bailout regime and every major new policy initiative by the ECB. The court's modus operandi hitherto has been to largely adopt the position of the German government, but it will now and then add certain conditions. These conditions usually seek to ensure greater parliamentary oversight and/or attempt to ensure that government won't agree to anything on the European level that is clearly in conflict with the German constitution.
If one looks at these proceedings from outside, it seems obvious that the court wants to avoid handing down any rulings that might exacerbate the crisis. In fact, the government's arguments and briefs always stress the possibility that an uncontrollable crisis situation may result and that consequently, Germany would suffer great economic damage if the court were to substantially interfere with its course.
On the other hand, the complainants are not exactly dummies. Not only do they usually wield very strong legal arguments, they are also favored by the fact that their predictions regarding the euro have all come true. And so the court is walking a fine line – neither does it want to completely upset the European applecart, nor does it want to be seen as simply rubber-stamping the government's agenda.
Following Mario Draghi's OMT announcement, more complaints were filed. In June, the court will decide on the legality of the ESM and as part of the exercise, has also undertaken to examine the legal standing of the ECB's OMT program – which so far exists only in announcement form.
What makes this particular decision a lot more interesting than usual is an amicus curiae brief filed by the Bundesbank. German financial newspaper Handelsblatt reports that it has received a copy of the brief and its contents are quite explosive. We will summarize the Handelsblatt report below:
The Bundesbank is evidently strongly critical of the policies implemented to date in order to rescue the euro. It vehemently argues against any purchases of government bonds by the ECB.
It notes that “bonds of low credit quality are deliberately bought,” which increases the risks to the euro-system. Buying sovereign bonds might put the central bank's independence into doubt, which the BuBa considers the sine qua non for it to successfully pursue its price stability mandate.
“Once monetary policy is on this slippery slope, a reversal is difficult and only possible at great cost,” according to the BuBa. Wait, it gets even better.
"Monetary Transmission Mechanism" Broken? Tough Luck!
The BuBa notes that it doubts that purchases of sovereign bonds under "conditionality" will actually include strict reform demands of the countries concerned and points to Greece as a bad example that has shown that conditionality does not preclude sizable purchases in extremely dubious cases, which tends to redistribute risk across the balance sheets of the euro-system. Moreover, the BuBa has grave doubts about the justifications for the putative bond purchases. For one thing, it regards different levels of interest rates within the eurozone not as a very good reason to engage in such purchases – higher financing costs for the private sector may simply reflect higher fiscal risks in the countries concerned. That, says the BuBa, isn't a development that should be influenced by means of monetary policy, as it is a direct consequence of the fiscal policies of the countries concerned. These policies in turn are their own responsibility.
In other words, the Bundesbank doesn't believe in or support the whole "the monetary transmission mechanism is broken and must be fixed" theory forwarded by Draghi and the ECB's board.
"Preserving the Euro" Not Part of the ECB's Mandate
It gets even more interesting, though, as the Bundesbank also asserts that the "preservation of the euro" is not part of the ECB's mandate.
The BuBa argues that it is simply not the ECB's job to prevent the exit of a member nation from the euro area. Verbatim: “In view of the fact that it consists of sovereign nations, the current composition of the currency union cannot be guaranteed – at least not by the central bank.”
Otherwise, the ECB could become the chief source of financing for euro area governments. A categorical guarantee for countries that they will remain members of the euro area – which is implied by the design and the justification for the secondary market purchases of sovereign bonds – means that as a last resort, financing independent of the financial markets will be entertained in order to guarantee that a country remains in the currency union.
Obviously, this is a complete refutation of everything Draghi has said since his famous assertion at an investment conference in London, which preceded the OMT announcement. As Draghi said on that occasion:
“Within our mandate, the ECB is ready to do whatever it takes to preserve the euro – believe me, it will be enough.”
In order to buttress its case further, the BuBa criticizes the provision of ELA (emergency liquidity assistance) financing to banks in Greece, noting that this was an especially problematic case that highlights the fact that fiscal policy was being taken over by monetary policy. The ECB had run a great risk by providing this financing, as the exit of Athens from the currency union “could under no circumstances be assessed to be a low probability event at every point in time.”
The above is – apart from our comments - mainly a summary of the article that was published at Handelsblatt.
However, the BuBa's brief also contains an extensive discussion of the TARGET-2 imbalances in the euro system, in which the BuBa – quite in contrast to its previous public “nothing to see here” pronouncements on the topic - admits that the payment system surreptitiously finances inner-European balance of payments deficits.
It specifically mentions that capital flight from the crisis countries is financed via TARGET-2, and points out that no settlement procedure exists. Long-time readers know of course from our past discussions of the euro-system's payment mechanism that this is the case. It is mainly noteworthy because up to this point, the BuBa has tended to downplay the problems and risks of the TARGET imbalances in public. In its brief to the court, it explains clearly what is actually happening. In addition, it remarks that the recent narrowing of the imbalances may not mean much, because such phases of narrowing TARGET-2 imbalances have been seen several times before, namely whenever the crisis seemed to briefly go into hibernation. Similar to what we have always argued, the Bundesbank notes that the imbalances represent no problem as long as the currency union continues in its current form – however, in the event of a member state exiting, losses would likely have to be taken by the ECB (with the size of the losses depending on the ability and willingness of the national central bank concerned to pay up), which in the end would have to be borne by tax payers.
TARGET-2 liabilities and claims between NCBs and the euro-system; data via Germany's IFO Institute.
The Bundesbank's scathing assessment of the ECB's plans to save the euro via OMT certainly adds a new wrinkle to the upcoming deliberations of Germany's constitutional court. After all, it is not just any old expert witness condemning the ECB's policies here, but Germany's own central bank. Will the court dismiss this brief in the name of preventing a renewed flaring up of the crisis? That may well partly depend on actual market conditions in June. The court may be bolder than usual if the markets are still fairly calm when the time comes. Previously, it was forced to deliver verdicts at a time when crisis conditions were acute, and an adverse decision on the bailouts would almost certainly have made them more so.
We know, however, that Chief Judge Voßkuhle is not necessarily a pushover. He has made very critical remarks about the government's crisis related policies before and pointed out that the time may come when the court insists that any further measures will require a plebiscite. It can, therefore, not be ruled out that the court comes to the conclusion that the Bundesbank's assessment of the OMT program is correct. Any decision that disrupts Draghi's cunning plan to print will put the euro area back on square one – i.e., the time before the OMT announcement. "'Interesting times" would be almost certain to make a rude comeback, especially as it is well known that a number of countries continue to miss their deficit targets amid sharply worsening economic conditions.
The Bundesbank's brief can be downloaded here (pdf), note, however, that unfortunately, we have only a German version of it available at the moment.
Charts by IFO Institute