If there is one single event that could derail the euro experiment it is the German Federal Constitutional Court ruling on the European Stability Mechanism (ESM) and Outright Market Transactions (OMT). We will take you through the different legal arguments used on both sides of the aisle, but first you need to understand the importance of this ruling.
Without the ESM and more importantly the OMT there would be widespread sovereign defaults within the euro zone. This would have dragged down banks, pension funds and financial markets in general. Alternatively, the troubled sovereign would simply pull out of the monetary union altogether and default in all but name through massive inflation of its own and newly established currency.
We estimate the Draghi put is worth around 400 basis points given the response in sovereign credit markets since he announced it. And it is simple to understand why! If , say, Spanish 10 year bond should once again yield anything close to 7 per cent, they would simply ask the ECB to intervene and promptly push the yield back down to around 4 per cent.
The investors that understood this back in 2012 bought Spanish bond at 7.62 per cent and made a handsome profit. It also window-dressed the Spanish banking sector balance sheet enough to silence skeptics for a while.
An alternative way to look at this is provided through the TARGET2 imbalance that shrank in the immediate aftermath of the OMT announcement.
Whilst the market tries to tell us that southern European capital consumption is unsustainable and should be reined in, Draghi has simply told investors that such nonsense is unnecessary. Ever since Keynes thought us that central banks can produce capital at will, we should not be concerned about those evil “causal-realist” economists; they belong on the scrapheap together with other barbaric relics.
Luckily for us, there are some barbaric “causal-realists” still in Germany, not just on the ether, that share our concerns. They have taken the OMT to court along with the ESM. If the OMT turns out to be illegal according to the German constitution, then the ECB would be forced to retreat, or Germany have to leave the Euro. We are not sure if humorless economists find Gerxit to be as enchanting as Grexit, but we are sure the “barbarians” would appreciate it.
The Federal Constitutional Court in Karlsruhe is mandated to uphold the Grundgesetz or basic law of Germany. In earlier rulings on the EFSF and also on a temporary injunction against the ESM we know how the Karlsruhe judges looks at this mandate.
Their underlying guiding principle is always to make sure that the eternity clause in the Grundgesetz is in no way jeopardized. For obvious historical reasons, the Grundgesetz was written with the concept of “unconstitutional constitutional amendments” at its core.
While this may seem to contradict our understanding of legal hierarchy at first, it does fit into the rules made by the constitution about amending it. And there is no way to amend the Grundgesetz guiding principle about the Federal Republic of Germany being a “democratic and social free state”
Article 79 divides the Grundgesetz into amendable and un-amendable portions in which Article 20 stating that Germany is a democratic state is specifically mentioned as an un-amendable part. Article 38 is again part of Article 20. Article 38 (1) states that ”Members of the German Bundestag shall be elected in general, direct, free, equal and secret elections. They shall be representatives of the whole people, not bound by orders or instructions, and responsible only to their conscience.”
As an extension of this, we learn from the EFSF ruling issued September 7th 2011 that “members of Parliament must remain in control of fundamental budget policy… …when establishing mechanism of considerable financial importance which can lead to incalculable burdens on the budget, the German Bundestag must therefore ensure that later on, mandatory approval by the Bundestag is always obtained”. They continue by stating that “the legislature… …is prohibited from establishing permanent mechanisms under the law of international agreement which result in an assumption of liability for others states` voluntary decisions, especially if they have consequences whose impact is difficult to calculate”
In other words, the Bundestag cannot transfer budgetary power to institutions in Brussels, or Frankfurt for that matter, as this would violate the right of the German people to independently govern themselves. Any transfer of funds from Germany to any other institution must be approved by the Bundestag on a case-by-case basis, and they must always know exactly what amount they sign up for. The liability must be strictly limited and decisions regarding this liability can never be transferred to any non-German institution.
Now, let’s start with the European Stability Mechanism and see what legal difficulties it may face. In the ruling of September 12 2012 where the court refused the applications for the issue of temporary injunctions we got a good grasp on what the ESM ruling will be, but there are still caveats to be cleared.
First of all, in the preamble to the Treaty on the ESM (T/ESM 2012) it says that “The European Council agreed on 17 December 2010 on the need for euro area Member States to establish a permanent stability mechanism.”
As we learnt from the EFSF ruling of 2011, the Court specifically told the legislature that any permanent mechanisms would be un-constitutional.
Further, we read from the ruling of September 12 2012 that “it is required to ensure in the framework of the ratification procedure under international law that the provisions of the ESM Treaty may only be interpreted or applied in such a way that the liability of the Federal Republic of Germany cannot be increased beyond its share in the authorised capital stock of the ESM without the approval of the Bundestag and that the information of the Bundestag and the Bundesrat according to the constitutional requirements is ensured.”
The Court says this requirement is fulfilled by T/ESM 2012 Article 8 (5), but in Article 9 it states that the Managing Director of the ESM can always demand participating countries to pay in unpaid capital by simple majority decision to restore the level of paid-in capital if impairments or losses should occur. Admittedly, this does not in itself invalidate the limitation set forth by Article 8, but if we move to Article 25 (2) that outlines routines in case of losses we are amiss to distinguish between Article 8s limited liability concept as requested by the Court and the potential for unlimited liability.
Article 25 (2) specifically states that “If an ESM Member fails to meet the required payment under a capital call made pursuant to Article 9(2) or (3), a revised increased capital call shall be made to all ESM Members with a view to ensuring that the ESM receives the total amount of paid-in capital needed. The Board of Governors shall decide an appropriate course of action for ensuring that the ESM Member concerned settles its debt to the ESM within a reasonable period of time. The Board of Governors shall be entitled to require the payment of default interest on the overdue amount.
It is not clear to us that Germany`s liability is limited and “easy to calculate” and apparently it is not clear to the court either. Thus, they explicitly made it clear that Article 8 will have to be interpreted in a way that it trumps both Article 9 and 25 in all respects! This cannot be done without changing the wording of T/ESM 2012.
Under the assumption this requirement can somehow be adhered to; the ESM will be approved more or less as is. The OMT on the other hand faces problems of its own.
On September 6 2012 the ECB issued a press release outlining the technical features of Outright Monetary Transactions. There are three things that stand out for the legal discussion
1) OMT support is conditional on the country in question also engage the ESM; which comes with a macroeconomic adjustment program.
2) OMT will predominantly, but not necessarily exclusively, be focused on the short end of the yield curve; defined as maturities of less than three years but more than one year.
3) No ex ante quantitative limits are set on the size of the OMT – the program is potentially unlimited.
The problem with number 1 is obvious from the view that a central bank shall be independent. If a fiscal program is the condition for proper monetary policy, how can ECB policy be independent? What if the country in question fails to fulfill the adjustment program, will the ECB stop its OMT? Does that make sense from their mandated goals?
When it comes to number 2 and 3, we need to see these together and in conjunction with the EFSF-ruling regarding limited liability. If the ECB is free to buy unlimited amounts of sovereign bonds it violates the eternity clause in the Grundgesetz.
But, according to the Grundgesetz Article 88 “The Federation shall establish a note-issuing and currency bank as the Federal Bank. Within the framework of the European Union, its responsibilities and powers may be transferred to the European Central Bank, which is independent and committed to the overriding goal of assuring price stability.”
How can the Court rule against the OMT when the constitution itself says the ECB is independent. Would that not be the very definition of irony? The Court that is mandated to uphold the Grundgesetz must violate the very same Grundgesetz to rule on the OMT.
In any case, the eternity clause should in theory trump Article 88 and the Court should could still vote no, despite violating the principle of monetary policy independence.
The OMT could also be said to violate the Treaty of the Functioning of the European Union (TEFU) Article 123 (1) which clearly states that “Overdraft facilities or any other type of credit facility with the European Central Bank or with the central banks of the Member States (hereinafter referred to as ‘national central banks’) in favour of Union institutions, bodies, offices or agencies, central governments, regional, local or other public authorities, other bodies governed by public law, or public undertakings of Member States shall be prohibited, as shall the purchase directly from them by the European Central Bank or national central banks of debt instruments.”
If so, the case need to be submitted to the European Court of Justice, as the Karlsruhe Court mandate is limited to the Grundgesetz.
The way out for Karlsruhe!
While the legal entanglements the OMT is in, seem to be insurmountable it is naïve to think politics does not play a big role here. The pressure on Karlsruhe is immense and they will have to come up with a way to get it through no matter what.
Here is how we think they will go about.
First of all, limit the OMT to the one to three year maturity range and make sure it only applies to bonds already issued at the time of OMT engagement. This takes care of two problems.
First of all, it is easy to calculate the potential liability beforehand as we know the size of the market.
Secondly, making sure the country under OMT help does not swap all its longer term bonds for newly issued shorter maturity bonds, the decision on the ultimate liability is no longer in the hands of non-German institutions.
Further, in order to keep the Bundestag nominally in control, maintain the connection between OMT and the ESM adjustment program.
Lastly, limit the OMT to secondary market interventions and claim Article 123 of the TFEU does not apply (it does, but they can at least pretend). If need be, the ESM can always make primary market interventions.
While these limitations on the OMT are noteworthy, they will probably not be large enough to undermine the Draghi put.
Alternatively the Court could use Article 88 of the Grundgesetz and give an all clear or send the case to the European Court of Justice. Legal proceedings here would probably take another year of two which buys even more time, just as the OMT was originally designed to do.
There are four alternatives for Karlsruhe, but given the importance of politics only one seems very likely at this point.