Have markets misunderstood the German Court’s decision on OMT?

Helmut Siekmann, Volker Wieland

In February 2014, the German Federal Constitutional Court declared the Outright Monetary Transactions (OMT) programme to be inconsistent with EU law. However, this did not have a negative impact on the OMT and sovereign risk premia continued to decline. This column argues that the benign response of financial markets may be due to an expectation of a likely compromise between the European and German Courts.

Not least the ECB itself has declared that the Outright Monetary Transactions (OMT) announcement played a major role in reducing the sovereign’s financing costs. By 2013, when questioned about the upcoming hearings of the German Federal Constitutional Court, ECB President Draghi noted, “When we all look back at what OMT has produced, frankly when you look at the data, it’s really very hard not to state that OMT has been probably the most successful monetary policy measure undertaken in recent time. … OMT has brought stability, not only to the markets in Europe but also to the markets worldwide” (ECB Press Conference, June 2013). Altavilla et al. (2014) provide empirical support for the effect of OMT, particularly for Spain and Italy.

Yet, after the German Constitutional Court announced on 7 February, 2014 that it considers the ECB’s OMT inconsistent with EU primary law, many commentators declared the OMT programme ‘effectively dead’ (see, for example, Fratzscher 2014 and Münchau 2014). Nevertheless, sovereign risk premia in Spain, Italy, Ireland, Greece, and Portugal continued to decline (see Figure 1).

Figure 1. Ten-year sovereign debt spreads versus Germany

Notes: the following dates are indicated in format day/month/year by vertical bars in the panels: 21.11.10 Ireland announced request for EFSF/ESM support, 7.4.11 Portugal announced request for EFSF/ESM support, 25.6.12 Spain announced request of ESM financial assistance, 26.7.12 Mario Draghi’s “whatever it takes” speech, 2.8.12 ECB announces OMT program, 6.9.12 ECB publishes technical details of OMT program, 11.6.13 Constitutional Court hearings on OMT, 15.12.13 Ireland exits ESM program, 17.5.14 Portugal exits ESM program.

Of course, by February 2014 the improvement of sovereign premia might simply have reflected the progress achieved in economic fundamentals due to lower deficits, improved competitiveness, and the successful conclusion of European Financial Stability Facility (EFSF) and the European Stability Mechanism (ESM) programmes in Spain and Ireland. However, in light of very high unemployment rates and high debt to GDP ratios, it remains easy to argue that the situation is still fragile, the banking systems of several member states unsound, and the sovereign debt crisis far from over.

Another possibility is that the judicial process involving the German Court and the European Court of Justice might be expected to come to a conclusion that would leave room for a modified but still reasonably effective OMT programme. This possibility is explored in more detail in CEPR Policy Insight 74 (Siekmann and Wieland 2014).

German Constitutional Court versus European Court of Justice: Who has the last word?

On 7 February, the German Federal Constitutional Court announced that it had separated the charges concerning the OMT decision of the ECB from the other matters (insertion of Art. 136 (III) TFEU, establishment of the permanent support mechanism – ESM, ‘fiscal compact’). It suspended the proceedings concerning OMT and referred a list of questions regarding the interpretation of EU law to the European Court of Justice for a preliminary ruling, thereby demonstrating respect for the procedures foreseen in the treaties. Regarding the European Stability Mechanism and fiscal compact, a decision was handed down on 18 March, dismissing all remaining complaints and, thus, confirming again its principally friendly attitude towards European integration.

The questions presented to the European Court deal with the problem whether the OMT is consistent with EU primary law. However, the German Constitutional Court clearly signalled its own judgement, namely that the OMT may well exceed the mandate given to the ECB and would be inconsistent with the prohibition of monetary financing of member states. Even if the European Court would rule favourably towards the ECB, the German Constitutional Court made it clear that it reserves its own judgement and that it would not automatically follow the European Court’s opinion.

The task of the European Court is to ensure that the law is observed in the interpretation and application of the Treaties, whereas the German Constitutional Court is installed as the ‘guardian’ of the German Federal Constitution, the ‘basic law’ (Grundgesetz). The domain of the European Court of Justice is the enforcement of EU law; the domain of the German Constitutional Court – the compliance with the basic law. In particular, the German Constitutional Court has the power to control whether a statute is in accordance with the constitution. Its competences are, however, limited to acts of German authorities and do not include the control of institutions and organs of the EU.

This demarcation of powers has been blurred by a series of decisions, in which the German Constitutional Court has held that acts of institutions and agencies of the EU only have a binding effect in Germany within certain limits. It has reserved the right to review whether these acts are based on manifest transgressions of powers or affect the area of constitutional identity, which may not be transferred or infringed in another way. If a transgression is manifest and entails a structurally significant shift in the allocation of powers to the detriment of the member states, it would have to be judged as a violation of German constitutional law – it would not be covered by the legislative Acts of Assent to the Treaties conferring powers on the EU. Also the protection of the ‘constitutional identity’ is considered a task of the Federal Constitutional Court alone.

The German court “will take the interpretation which the Court of Justice gives in a preliminary ruling” as a basis for its deliberations, but it shall be the German Constitutional Court which “determines the inviolable core content of the constitutional identity, and to review whether the act interferes with this core”. Thereby, the German Constitutional Court claims to have the last word in extreme cases. Its decisions are binding for all German authorities, including the Bundesbank, its President as a member of the ECB Council, and the German federal government. If not, legal actions against them could ensue.

Similarly, if the European Court of Justice were to decide that OMT conforms to EU law and the Bundesbank would not implement Eurozone policy appropriately, the ECB could sue the Bundesbank in a specific procedure before the European Court.

The German Court’s view on OMT

The German Constitutional Court points out that the mandate of the ECB is limited to monetary policy, while other economic policies are reserved to member states. In its view, the OMT announcement interferes with the member states’ competences for the following reasons:

OMT aims to neutralise risk premia on the debt of certain sovereigns, which are market results;

An approach that differentiates between member states does not fit with the monetary decision-making framework for a monetary union;

The linkage to the conditionality of an European Stability Mechanism programme indicates that it reaches into the realm of economic policies reserved to member states;

The purchase of government debt, as outlined in the OMT, exceeds the support of the general economic policies in the EU that the ECB is allowed to pursue, because the ECB would make an independent economic evaluation that could imply removing the support when conditions are not met.

In addition, the German Court expressed a broad interpretation of the prohibition of monetary financing of budgets. It holds that the explicit interdiction of the direct purchase of government debt on the primary market also applies to functionally equivalent measures that are simply intended to circumvent that prohibition. In this context, it also views the total or partial forgiveness, i.e. acceptance of haircuts on sovereign debt, as in-admissible monetary financing.

The key argument used by the ECB to justify its actions – “disruption of the monetary policy transmission mechanism” – was rejected by the Court as being irrelevant.

From this perspective, the OMT may have to be considered as ‘ultra vires’ (i.e. outside the competences given to the EU and the ECB in line with the EU treaties and thus outside democratic legitimation) and could constitute a violation of German constitutional law.

The Constitutional Court delineated an alternative version of OMT that it would consider consistent with EU primary law. Specifically, there would be:

No acceptance of possible haircuts on member states’ debt by the ECB,

The amount of purchases would be limited; and

Interference with price formation for debt instruments on the market would be avoided as much as possible.

The Court had concluded from the statements of the ECB’s representatives presented in the hearings in June 2013 that the objectives of OMT could be achieved within such constraints.

Outlook

The reputation of both courts would suffer from a conflict. The judges of both institutions know each other and meet often in a variety of settings. Though the courts may well disagree, they certainly understand where each is coming from in its analysis. The German Constitutional Court, so far, has not halted a step towards more integration but has provided a voice for concerns about flaws associated with those steps, for example, deficits in democratic legitimation, in particular in budgetary matters.

If the European Court were to completely ignore the German Court’s analysis and the arguments presented without providing substantially new arguments or evidence, the German Court could consider itself well-justified to rule that the OMT are beyond the ECB’s mandate and forbid German authorities to support them.

Thus, the Court of Justice has an incentive to adopt at least some of the limitations held essential by the German Court. However, it could announce its own interpretation that would incorporate only a subset of them. The German Court might find it difficult to reject such a compromise.

The ECB has already made clear that the OMT is not literally unlimited. Thus, some more formal limits need not destroy its effectiveness. After all, the real resources at the disposal of the ECB in terms of real income are quite limited in any case.

The ECB’s decision to forego seniority status on OMT was a crucial feature. If the European Court of Justice were to rule it consistent with EU primary law, the German Constitutional Court would face a difficult decision. Even so, one could imagine adjustments to keep the OMT programme effective, such as Eurozone governments or the European Stability Mechanism guaranteeing losses on ECB holdings.

In conclusion, the continued decline of sovereign premia could be reconciled by an expectation of a likely compromise outcome in the judicial process involving the European and the German Courts.

References

Altavilla, C, D Giannone and M Lenza (2014), “The Financial and Macroeconomic Effects of the OMT Announcements”, CEPR Discussion Paper 10025, June 2014.

Fratzscher, M (2014), “Germany’s Pyrrhic Victory”, Projectsyndicate.org, February 10, 2014.

Münchau, W (2014), “Germany’s Constitutional Court has Strengthened the Sceptics”, Financial Times, February 9, 2014.

Siekmann, H and V Wieland (2014), “The German Constitutional Court’s decision on OMT: Have markets misunderstood?”, CEPR Policy Insight 74 , October 2014.