The OMT’s fragile foundations

Ashoka Mody

Earlier this year, the German constitutional court declared the OMT programme to be inconsistent with EU’s law. This column reviews the legal framework and economic foundation of the OMT. Without any changes in the political structure, the OMT invokes moral hazard in the actions of the member states and unfairness in the distributing the burden of distress.

Earlier this year, the German Constitutional Court issued a strongly-worded opinion stating that the European Central Bank’s Outright Monetary Transactions (OMT) programme is inconsistent with the Treaty on the Functioning of the European Union (TFEU). The European Court of Justice (the ECJ) is to review this opinion.

The reaction to the German Court’s forceful stand has taken an idealised European perspective. Legal scholars have described the German Court as ‘confrontational’, with no competence in interpreting the TFEU (Pistor 2014). Economists – guided by a model of monetary and fiscal relationships within a political union – are also impatient. They see an overriding need for a lender-of-last resort for Eurozone sovereigns (de Grauwe 2011); any consequent implications for the ECB’s profits and capital (the joint property of member states) have technical solutions (de Grauwe 2014).

However, the Eurozone was consciously constructed as an incomplete monetary union – without a political union and with fiscal responsibility resolutely national. Absent that specific construction, there was no feasible political contract and, hence, no Eurozone. This unprecedented constellation left a gap -- it assumed that all countries would behave prudently and so member states would not experience acute financial distress. The OMT’s success has highlighted that gap in the Eurozone’s design.

But as long as the basic political contract remains unchanged, both the treaty and the economics warn that the OMT also generates the dual risks of moral hazard in the actions of member states and unfairness in eventually distributing the burden of distress across member states (Mody 2014a). The OMT’s proponents argue that the member state will be placed on a regimen of strict good behaviour to limit moral hazard (e.g., Miller and Zhang 2014). However, even if such conditionality were to meaningfully effective (rather than induce a self-defeating deflationary cycle), it is designed to come too late.

The legal framework

Notwithstanding the legal broadsides against the German Court, the ECJ will be sympathetic to its concerns. At the height of the crisis, the ECJ was asked to review the legality of the European Stability Mechanism (ESM), the vehicle established to ‘bailout’ sovereigns in financial distress. The ECJ’s decision gives us a preview on how it may react.

The ECJ found a narrow legal space to authorise the ESM. From Article 122 of the TFEU, which permits financial support to sovereigns in circumstances beyond their control, the Court inferred that ‘financial assistance’ was not prohibited. The Court then stretched the ‘no bailout’ interpretation of Article 125 to allow financial assistance in the form of a loan (‘credit line’) to be repaid with ‘an appropriate margin’. Even so, the ECJ was clear. The distressed member state retains the ultimate responsibility of repaying its debts -- others cannot take on that burden.

But in opening the door for the ESM, the ECJ also closed the door on the ECB. Though not called on to do so, the ECJ warned that Article 123 placed the ECB under by a stricter prohibition, denying it any form of lending (“overdraft or any other type of credit facility”) to a member state.

The spirit of the ECJ’s view is, therefore, clear. A member state cannot impose a financial burden on another member state; and even the limited form of financial assistance (inter-governmental loans with an ‘appropriate margin’) must be democratically authorised by national parliaments and cannot be routed through the ‘independent’ ECB.

To be legal, the OMT would need to be portrayed as a routine open market operation under Article 18 of the European Central Bank statute (Petch 2013). However, unlike generalised open-market transactions, the OMT is designed to support a particular, distressed sovereign. Any consequent losses incurred by the ECB would be imposed on other sovereigns, either through the recapitalisation of the ECB or through reduced profits transferred to national treasuries. For this reason, central banking practice, while encouraging the redress of market disruption, frowns on lender-of-last resort activities to support individual entities for fear of moral hazard (Capie 2002).

The economic case for the OMT

Markets are, at times, difficult to tame and can precipitate sovereign financial distress. Hence, to deal with market irrationality – which can cause liquidity to dry up and risk spreads to be bid up – the Eurozone needs a lender-of-last resort. While the principle is sensible, the German Court contended that the presumption of illiquidity did not apply to the circumstances intended for the OMT: the alleged market craziness, the so-called ‘fear factor’, was more likely to reflect a high probability of insolvency. It questioned the ad hoc nature of the ECB’s evidence. And, indeed, in a September 2012 speech justifying the OMT, President Draghi used a persistent outlier to make his point (Draghi 2012).[1] Similarly, scholarly evidence of market irrationality during late-2010 to mid-2011 (de Grauwe and Ji 2012) is unpersuasive. Market volatility during that period is well explained by policy decisions that sought to wish away real solvency issues (Mody 2014a and b).

The ESM programme and the associated OMT will be triggered when the threat of insolvency is high not least because the incentives are to delay action. Even as their normal remedies run out, countries have a strong tendency to defer the economic conditionality and accompanying loss of sovereignty associated with seeking international financial assistance. Moreover, because of the Eurozone’s implicit bailout guarantee, the authorities are also inclined to conclude that the country is solvent. This is how Greece played out.

In such a setting, the OMT’s pledge to buy ‘unlimited’ amounts of sovereign debt is tantamount to assuming the debt repayment obligations of the distressed government. And since the ECB has further committed to be pari passu with private lenders – to be treated on equal terms in the event of a default – the potential losses that arise become the liabilities of other Eurozone sovereigns.

For this reason, Christopher Sims, a long-time advocate of a lender-of-last resort for the Eurozone, warns (Sims 2012, p. 221):

“…sovereign debt assets [held by the ECB] could default. … 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 countries’ sovereign debts.”

At this point the treaty and the economics come together. The treaty was intended to avoid precisely the risk that the debt burden of one member state is imposed on another. The treaty aims to prevent such ‘grazing of the commons’, through a presumption of fiscal discipline (under central surveillance) and the threat of no bailout. But because the treaty does not anticipate acute distress, the crisis response has been to create ad hoc mechanisms to deal with such distress while attempting to stay within the letter of the treaty. Those mechanisms, however, inevitably lead to pressures for redistribution across member states – pressures that have no political sanction.

Where does that leave us?

The Greek bailout is almost certainly illegal by the ECJ’s benchmarks. To be legal under Article 125, the financial assistance must be repaid with an appropriate margin. The size of the appropriate margin is presumably a policy decision. But Greece will not repay the vast bulk of its official financial assistance. At the end of a grossly inefficient process, the burden of the sizeable eventual fiscal transfer to Greece will be shared without democratic accountability. In questioning the legality of the OMT, the German Court is essentially asking why the collective incentives will not lead once again to a Greece-like outcome.

Either the Eurozone authorities must have a clear and credible policy of imposing losses on private creditors -- so that solvency is achieved with high probability -- or they must create a politically-sanctioned method of sharing the burden of other member states’ debts. Neither seems on the cards. If the member states fail to move in either of these directions, and the ECJ – as its own logic dictates – does agree with the German Court, the Eurozone will be once again left without a safety net.

If the ECJ does authorise the OMT, it will need to draw on some broader notion of ‘solidarity’ in the treaty. That action would enshrine the new German-ECB alliance, which has relied on fiscal austerity, bailout of sovereigns, and the OMT for acute distress in lieu of a fiscal union. The ECB’s role in determining member state policies will become more intrusive. Without voting for a political union, the member states would be subjected to economic supervision by unelected authorities. It would be an odd kind of solidarity.

The conundrum arises because, as Wren-Lewis (2014) points out, the sharing of losses requires democratic authorisation, but the ECB’s independence in triggering the OMT is beyond democratic control. For this reason, Article 123 is not a curiosity. Even in adopting a generous interpretation of the OMT, the ECJ will need to deal with this dilemma.

The OMT is important because it highlights the economic and political fault lines in the Eurozone. It offers a technocratic solution to a political problem. But for that reason, it is politically fragile. A test by the markets may prove to more than it can bear.

Author’s note: I am most grateful to Shahin Vallee for many rounds of helpful exchanges.

References

Capie, F (2002), “Can there be an International Lender-of-Last-Resort?”, International Finance 1(2): 311–325.

De Grauwe, P (2011a), “The European Central Bank as a lender of last resort”, VoxEU.org, 18 August.

De Grauwe, P (2014), “Economic Theories that Influenced the Judges at Karlsruhe”, VoxEU.org, 13 March.

De Grauwe, P and Y Ji (2012), “Mispricing of Sovereign Risk and Multiple Equilibria in the Eurozone”, Journal of Common Market Studies 50(6): 866–880.

Draghi, M (2012), “Building the Bridge to a Stable European Economy”, The Federation of German Industries, Berlin, 25 September.

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: http://www.bverfg.de/entscheidungen/rs20140114_2bvr272813en.html.

Miller, M and L Zhang (2014), “Saving the euro: self-fulfilling crisis and the ‘Draghi put’”, VoxEU.org 26 June.

Mody, A (2014a), “Did the German Court do Europe a Favour?”, Bruegel Working Paper 2014/09.

Mody, A (2014b) “Europhoria, Once Again”, bruegel.org, 10 February.

Norman, P (1998), “German Court Rejects Emu Challenge”, Financial Times, April 3.

Petch, T (2013), “The Compatibility of Outright Monetary Transactions with EU Law”, Law and Financial Review, January: 13-21.

Pistor, K (2014), “German Court decision: Legal authority and deep power implications”, VoxEU.org, 25 January.

Wren-Lewis, S (2014), “Article 123.1 and the ECB”, mainlymacro.blogpost.in, 4 August

Footnote

“Convertibility Risk – Cherry Picking* Interest Rate Spreads”, 2012, available at: http://www.antehoc.com/2012/10/convertibility-risk-cherry-picking.html