This article was first published on Project Syndicate on 10 February 2014.
The German Constitutional Court has ruled against the European Central Bank’s pledge to buy potentially unlimited quantities of distressed eurozone countries’ government bonds, and has called on the European Court of Justice (ECJ) to confirm its decision. Until that happens, the “outright monetary transactions” (OMT) scheme is effectively dead, weakening the ECB’s ability to act as an effective and credible financial-market backstop at a time when European governments remain unwilling to fill the void.
The German court considers OMT a violation of the ban on monetary financing of governments. According to the court, 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, which is why the ruling represents a severe setback for Europe.
To be sure, the ECB could, in principle, still use OMT, at least until the ECJ rules on the case. In practice, however, rising opposition in Germany to OMT and other ECB policies will make it impossible to use the program as intended – that is, to intervene effectively in sovereign-bond markets to stem a panic.
Limiting the ECB’s purchases of government bonds ex ante, as the German court requires, would be nonsensical, because it could easily invite market speculation. As a result, the ECB will have to use alternative policy tools to deal with dysfunctional financial markets. That means focusing once again on supporting banks, as well as deploying new instruments that have a more direct effect on crisis countries’ firms and households.
The court’s ruling strengthens Germany’s government and those in its parliament who want less support for crisis countries and oppose a further transfer of sovereignty to Europe. Given the disagreement surrounding the OMT program and eager to avoid future court rulings, the German Parliament could be inclined to support only those rescue programs that rule out OMT support, such as the European Stability Mechanism’s “precautionary conditioned credit line,” instead of the more flexible “enhanced conditions credit line.”
This is ultimately bad news, as it will limit the European Stability Mechanism’s effectiveness. Portugal could be the first test case if it applies for an ESM backstop in the coming months, though its position may be sound enough not to require OMT support.
How financial markets will digest the German court’s ruling remains uncertain. There may be little initial reaction to the news, as there is no immediate threat to financial stability in the eurozone. But the big question is how markets will react in the future to bad news, whether about sovereigns or banks.
The tight feedback loop between sovereigns and banks in eurozone countries has become even more salient in recent years, as banks are holding an ever-larger share of their home countries’ government bonds. The ECB’s impaired ability to address sovereign and currency risks means that it will have to break the feedback loop via the banks – a more difficult and less effective approach that increases the likelihood of a market panic and a deeper crisis.
Nonetheless, limiting the ECB’s ability to address the interdependence of sovereigns and banks could put stronger pressure on eurozone policymakers to confront banking problems directly. The ECB’s coming asset-quality review and subsequent stress tests of European banks could be the last chance to repair Europe’s banking system and avoid Japanese-style long-term economic drag from the financial system. In this sense, the German court’s ruling highlights the need for swift completion of a European banking union, including well-functioning supervisory and resolution mechanisms.
Finally, the case highlights the need for a treaty change. The court’s decision to accept the case against the OMT program could unleash a flood of lawsuits against European institutions, such as the ECB and the ESM, whenever member states’ citizens disapprove of their actions. The ruling is a call on policymakers to pursue a thorough review of the European Union’s Lisbon Treaty, not just to strengthen the ECB and monetary policy, but with respect to all pending institutional reforms.
The German court’s ruling jeopardizes the ECB’s ability to act as an effective lender of last resort, thereby reducing its independence and ultimately undermining its ability to deal with market panics and crises – and thus to fulfil its primary mandate of price stability. The ruling makes it more urgent than ever that European governments establish a viable and effective banking union and strengthen the ESM as a backstop for countries in crisis.