The eight judges of Germany’s Constitutional Court were dressed in elegant red robes, including red caps, as if they were Roman Catholic cardinals entering a papal conclave that would decide the future of the church.
Their mission is, of course, was secular in nature but no less important: Determining whether sovereign bond purchases, real and theoretical, by the European Central Bank are legal under German law.
The court hearing began Tuesday in Karlsruhe, near Stuttgart in Western Germany. It is to finish Wednesday, though a decision is unlikely before September, for this is an exceedingly complex case, full of nuance and powerful witnesses on both sides with powerful arguments.
If the judges rule that the ECB, in effect, has no right to buy the bonds, the 17-country euro zone could be in a whole lot of trouble. That’s because the ECB’s newish bond-purchasing program, known as Outright Monetary Transactions, or OMT, has been credited with sparing the euro from oblivion even though not a single bond has been bought under the program.
If OMT were removed because Germany could not sponsor it, one of Europe’s most important crisis-fighting tools, perhaps the most important, might have to be substantially overhauled or delivered to the scrapyard.
First, a bit of history. A year ago, the euro zone was on the verge of falling apart. A dangerous bank run was under way in Greece ahead of the general election. The Spanish and Italian economies were sinking, sending their bond yields so high they were in danger of getting shut out of debt markets. In late July, ECB boss Mario Draghi went to London and delivered this message to buy some time: “Within our mandate, the ECB will do whatever it takes to preserve the euro. And believe me, it will be enough.”
In September, Europe learned that “whatever it takes” meant OMT. The program would see the ECB buy unlimited amounts of short-dated bonds of struggling countries (read: Italy and Spain) if those bond yields were approaching painful levels. The bonds would be bought in the secondary markets using the ECB’s own balance sheet.
The mere threat of OMT has worked wonders. Sovereign bond yields of all shapes and sizes have plummeted. On Wednesday, Spain’s 10-year yield was 4.67 per cent. While still high by British and German standards, it’s down two full percentage points in the last year. Spain, as a result, can still finance itself.
No wonder Mr. Draghi recently boasted that his baby was “the most successful monetary policy that has been taken” (though it should be noted that the ban on naked sovereign credit default swaps played a big role in ending the bond crisis too).
Enter the sober-minded Germans. The Bundesbank, the German central bank, led by Jens Weidman, always argued that the OMT was not on the up and up.
Why? Because, it argued, it blurred the lines between monetary and fiscal policy; the latter amounted it to the financing of governments, which was not within the ECB’s mandate. Furthermore, the OMT would expose the German taxpayer to potentially enormous losses. If the ECB were to buy clapped-out sovereign bonds, and their values sank even further, the ECB would have to eat the losses. The central bank would have to be replenished by capital injections from the member states, that is, their taxpayers.
Guy Foster, strategist in London with Brewin Dolphin, made a good point in a Wednesday research note: “We certainly believe the risk of losses to taxpayers is reduced following the announcement of the OMT, creating an element of perversity to the overall [German] case.”
Indeed, but as far as the German Constitutional Court goes, that’s not the point. The point is that its job is to interpret the letter of the law, not the outcome of the OMT program.
In its defence, the ECB argued that even though the OMT is described as “unlimited,” it is in truth the opposite because it applies only to short-term bonds – 10-year bonds would not be bought.
Furthermore, the OMT program has not been triggered. But perhaps its most important point is that its primary job is to stabilize the currency, an impossible task if the euro zone were not stable. In other words, if Italy and Spain could not finance themselves and were forced into hideously expensive bailouts, or exodus from the monetary union, there would be no monetary policy because there would be no euro. In the constitutional court hearing on Tuesday, Jorg Asmussen, Germany’s member on the executive board of the ECB, defended the central bank with the argument that “only a currency whose existence is not in doubt can be a stable currency.”
What decision the eight men and women in red will make is anyone’s guess, giving the compelling arguments on both sides and the fact that the German Constitutional Court has no jurisdiction over the ECB itself. If it does decide the OMT is unconstitutional under German law, it might have to take its case to the European Court of Justice or push Germany into rewriting the European treaties that govern the ECB.
Euro zone governments will pray that the court gives its effective blessing to the OMT program. The region might not exist without it.