This post is based on my statement on the ECB’s bond purchase program before the German Federal Constitutional Court on 11 June.
How Far Does ECB Mandate Go? This was the key question at issue in the hearings before the Federal Constitutional Court of Germany in Karlsruhe on June 11 and 12, 2013. Policy statements “on the ECB’s monetary policy mandate and the potential impact of the ECB’s measures on national budgets” have been requested. Behind this is the dispute over whether the European Central Bank has exceeded its competence with its announcement to buy government bonds, known as Outright Monetary Transactions (OMT), from member states.
The experts were instructed to evaluate several dimensions:
- Are the ECB’s objectives with OMT in line with its mandate?
- Does the OMT program set the wrong incentives for financial policy-makers in the crisis countries?
- Does it increase the risk for Germany?
- Does it breach the budget law of the Federal Parliament by having the ECB transfer high risks to Germany?
- Is the OMT program compatible with a lived democracy?
My answers? Yes, yes and no, no, no, and absolutely not.
The primary objective of the ECB is price stability, and this has never been so endangered in the member states of the euro area—and also in Germany—since the global financial crisis in 2007/2008. One main reason for this is a failure of the monetary policy transmission mechanism in some member states: the money spent by the ECB no longer reaches businesses and private households in sufficient quantities. The ECB has, therefore, only very limited direct control over price stability with conventional measures, such as cuts in the base rate. It must resort to unconventional measures, such as the OMT program, to carry out its mission.
One central criticism of the OMT program is that it implicitly aims to help member states continue to have access to capital markets and be able to finance themselves more cheaply. This is forbidden by law because such an attempt can lead to disaster in the long term if governments take advantage of this support and build up debt. But the facts indicate that the ECB is right and shows that the announcement of the OMT program has not done this: there are clear signs that income earned in mid-2012 not only reflected the real economic differences between the member states, but also liquidity problems and other risk factors. It is the ECB’s task to combat them, even though they are created by an unjustified reversibility risk, if they interfere with the monetary policy transmission mechanism and therefore threaten price stability. And there is clear evidence that the OMT announcement was extremely effective in reducing these market failures.
Moreover, preventing downward spirals is also an important task of the ECB and its OMT program. The European crisis consists of four intensifying crises: a sovereign debt crisis, a banking crisis, an economic crisis, and a crisis of confidence. In such situations, the ECB has a responsibility to stop such downward spirals by providing liquidity and a functioning monetary policy transmission mechanism.
To achieve this, it needs functioning instruments to provide unlimited liquidity or the ability to intervene in the market process in case of an emergency. Only then is it credible and in a position to inspire confidence in the markets. Being bound to an ESM program ensures that, as a result, the solvency problems of individual countries are not resolved.
Do OMT set the wrong incentives for the lax financial policies of the countries in crisis? All monetary measures always impact the markets of government bonds and thereby set—intentionally or unintentionally—incentives for fiscal policy. But the OMT program is trying to reduce the negative incentive effects. Under these conditions, the ECB is committed to only buying bonds from a country if it fulfills the conditions of an ESM program and also has market access. The bonds are not purchased directly from the government, but on the secondary market from other investors, and only short-term bonds with remaining terms of one to three years. Together with the required market access, it should be ensured that the market continues to impact and exert a disciplining effect on government finances.
Will the OMT program increase risks for the euro area and individual countries? Monetary policy measures usually have asymmetric effects beyond countries, regions, and market participants. There is now a strong concentration of securities from crisis countries on the ECB’s balance sheet which is reflected in TARGET2 balances that have grown significantly since 2010. But here, too, you have to look at the conditionality of the OMT program: although it increases risk asymmetry on the ECB’s balance sheet, at the same time, it reduces overall risk because it improves the financial stability and the economic outlook of the country. The success of the OMT announcement means, therefore, that the overall risk on the ECB’s balance sheet has already been reduced, thus relieving the burden on Germany in particular.
However, there are also important limits for the ECB and its OMT program. The short-term success does not yet mean that an OMT program will be permanently effective. In fact, there is evidence that short-term success eventually leads to significant costs and risks over the medium and longer term. In particular, there is the danger that if unconventional measures were to fail, this would damage the credibility and, consequently, the effectiveness of the ECB permanently. In addition, there are signs that high liquidity in the euro area has led to some banks avoiding the necessary adjustments and taking excessive risks. This could lead to new instability in the medium term and in extreme cases to new financial crises.
But it is primarily the duty of policy-makers to create institutional, legal, and economic policy frameworks to ensure that these risks do not materialize, and thus ensure the sustained success of the integration of the euro area.
Marcel Fratzscher participated as an expert in the hearing of the German Federal Constitutional Court over the legality of the European Central Bank’s bond buying program from 11- 12/06/2013. The original statement “Zum Währungspolitischen Mandat der EZB sowie den möglichen Auswirkungen von Maßnahmen der EZB auf die nationalen Haushalte“ can be downloaded from the website of DIW Berlin.