Greek Complications

As many other market observers have pointed out recently, 2015 is going to be an important year for the euro area. On the one hand, there are a number of elections the outcomes of which could seriously jeopardize the monetary union and the currently agreed on policy prescriptions.

The temporally closest is the election in Greece, which is likely to bring Syriza to power. As Mish has pointed out recently, bank runs have already started again in Greece. This is not too surprising, as the election creates a lot of uncertainty for depositors and savers. No one with money in the bank in Greece wants to see it transformed into drachma overnight. Given that the ECB has in the meantime openly threatened to cut off funding to the Greek banking system should the new government stray from the agreements with the troika, this danger is very real.

Later this year, the election in Spain is also liable to produce some fireworks (see “A Political Earthquake is Coming in Spain” for some background information), as another crypto-Marxist party, Podemos, has become a contender for power in Spain. It should be pointed out that the economic plans of these parties are purest pie-in-the-sky stuff, which mainly depend on spending money these governments simply don’t have. This is not to say that we would disagree with every point in Syriza’s 40 point program, which contains laudable initiatives like acknowledging Greece’s insolvency and wiping the slate clean, cutting military spending, decriminalizing drugs, and negotiating a stable accord with Turkey (Greece and Turkey are age old enemies).

However, its economic program includes vast tax increases (emulating inter alia Mr. Hollande’s 75% “super tax”, which France has just dropped because of the economic damage it has inflicted), nationalization of various industries, re-regulation of labor markets back to their sclerotic old self, and numerous other leftist shibboleths which have predictably failed wherever they have been tried.

The senate of the European Court of Justice Photo credit: European Court of Justice

These plans are obviously in conflict with the bailout agreement, and as an unexpected positive side effect, they are likely to complicate the ECB’s plans with respect to “quantitative easing”. Market participants are currently expecting Mr. Draghi and company to announce a QE program involving sovereign debt at the ECB council meeting on January 22, which is just a few days before the election in Greece.

It seems possible that in light of the uncertainties surrounding the Greek election, the announcement will have to be postponed. Possible, but not certain: if the ECB chooses the version of QE in which every national central bank in the euro system is responsible for purchasing the bonds issued by its own government, the plans could conceivably still go ahead, as it could then be argued that Greece itself will bear the risk of any central bank purchases of Greek government bonds.

This is probably an oversimplification though: if Greece were to exit the monetary union, it would likely also default on liabilities with respect to the euro system (such as TARGET 2 balances). There is no way in which a “Grexit” and default can be handled in a painless manner and without harming the finances of the other member states, which have issued financial guarantees in connection with Greece’s bailout. To what extent these possible complications will influence the ECB’s QE plans remains to be seen though.

Syriza leader Alexis Tsipras, the spanner in the euro-works. Photo credit: Syriza

An Important Court Decision Looms

More important to the ECB’s widely expected QE program is probably the decision to be handed down by the European Court of Justice (ECJ) tomorrow. The ECJ will decide on the legality of the ECB’s “OMT” (Outright Monetary Transactions), the program Mario Draghi announced at the secondary peak of the euro area’s sovereign debt crisis. OMT was never put into practice, as the mere announcement was sufficient to bring the sell-off in euro area sovereign bonds to a halt.

Germany’s constitutional court has heard a legal challenge against OMT and has ultimately delegated the decision to the ECJ. The German court was of the opinion that OMT may actually be in conflict with the European treaties, but didn’t have the guts to simply declare it illegal – as it may have been accused of torpedoing the euro in the wake of such a decision.

The most important legal problem with OMT actually has to do with the conditionality clause. Mr. Draghi introduced conditionality specifically in order to get Germany and the BuBa to go along with the decision. By tying OMT to a bailout program under the supervision of the ESM (European Stability Mechanism), he tried to assure everyone that no unbridled fiscal financing by the ECB would take place. Instead, OMT was merely supposed to remove the imbedded “re-denomination premium” from peripheral sovereign bonds, so as to guarantee a smooth transmission of monetary policy in the euro area as a whole.

This, according to Draghi, was in the ECB’s remit, as the central bank’s mandate allegedly also includes the “preservation of the euro”. The BuBa by the way rejected this line of argument by noting that it was not the ECB’s job to guarantee that specific member states remain part of the common currency area. As an aside, Germany’s constitutional court disagreed with the “ensuring transmission of monetary policy” argument as well, by stating that this was incidental to the question whether the ECB is actually in violation of its mandate with OMT.

The following points were held to represent a transgression of the ECB’s mandate by the German constitutional court court in line with the arguments forwarded by the plaintiffs. Our comments are interspersed in brackets:

1.) with OMT the ECB aims to neutralize risk premia on the debt of certain sovereigns which are market results.

[We don’t believe the ECJ will see this as a problem: market manipulation is what central banks do; it is practically their job description]

2.) an approach that differentiates between member states does not fit with the monetary decision-making framework for a monetary union.

[This could indeed be seen as problematic by the court: the ECB is not allowed to favor certain member states over others]

3.) The linkage to the conditionality of an ESM program of the member states indicates that it reaches into the realm of economic policies reserved to Member States.

[This is the biggest problem by far. Conditionality has made OMT palatable to Germany, but it also means that the ECB will directly interfere with the fiscal policy of member states, which is clearly beyond its remit.]

4.) That the purchase of government debt as outlined in the OMT exceeds the support of the general economic policies in the European Union that the European System of Central Banks is allowed to pursue. The reason being the ECB would make an independent economic evaluation that could imply removing the support when conditions are not met.

[The part about the fact that the ECB could use the conditionality clause to withdraw its support ties into point three. However, we believe that “QE” as such, if distributed according to the central bank “key”, i.e., the percentage of the ECB’s share capital held by each member state – would in principle be legal if the ECB can show it is needed to pursue its “price stability” mandate. Since HICP inflation in the euro are has recently dipped into negative territory, the ECB can argue it must “fight deflation”, and with the main repo rate at only 0.05%, rate cuts no longer suffice to achieve this objective.]

In short, sovereign QE as such – without conditionality and without being aimed solely at certain member states – is probably legal. “Support of general economic policies in the EU” could be used as a justification for a form of QE in which no bonds of specific member states are favored over others. After all, the ECB can always point to its price stability mandate and the alleged “danger” of deflation in defending adoption of the policy.

Here is what the treaty says about financing of governments by the ECB:

21.1. In accordance with Article 123 of the Treaty on the Functioning of the European Union, overdrafts or any other type of credit facility with the ECB or with the national central banks in favor 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 ECB or national central banks of debt instruments.

In our opinion, this restriction does not explicitly prescribe the purchase of government bonds in secondary markets. The ECB may only not buy them directly from issuing governments in the primary market, but it is certainly allowed to buy them from banks and other bondholders.

However, the ECJ decision could throw a monkey wrench into the ECB’s QE-related plans, because it may well hand down a stricter interpretation of the above treaty passage. Essentially, the law is now “tested” by these court proceedings – it will now be decided what it actually means in practice.

The ECJ building. Photo credit: BBC documentary screenshot

This is obviously quite important, as a stricter interpretation could result in the court handing down a general prohibition of QE involving sovereign bonds. If that were to happen, market participants would have to quickly reassess their expectations. Yields on the government bonds of Italy, Spain, Portugal, Ireland and Greece would probably rise sharply, as a good portion of their recent decline was likely due to market participants expecting a deep-pocketed, price-insensitive buyer entering the scene shortly.

Spain’s 10 year government bond yield: if the court ruling keeps the ECB from providing the OMT backstop or engaging in QE, these yields will likely rise sharply – click to enlarge.

Italy’s 10 year government bond yield – the same applies in this case – click to enlarge.

Conclusion

Although the OMT announcement has “worked”, as bond yields in the periphery have dropped sharply without the program being implemented even once, Mr. Draghi may well have scored an own goal by tying OMT to “conditionality”. Without this feature, the German constitutional court may well have let the whole thing slide, and the plaintiffs would have gone home empty-handed.

However, since conditionality seems to directly interfere with fiscal policy, the court had good reason to doubt that OMT is actually in line with the European treaties. Naturally we don’t expect that the ECJ will really upset the apple cart with its decision, but it is possible. If the ECJ should find that sovereign QE as such is in conflict with the ECB’s mandate, there will be considerable turmoil in the markets.

Lastly, even if the ECJ finds no fault with OMT and sovereign QE, the German constitutional court will still have the last word regarding its compatibility with the German constitution. The court has in the past already shown a willingness to challenge agreements on the European level if it found them to be in conflict with Germany’s constitution. Although we believe the court will side with whatever decision the ECJ makes (after all, it would otherwise not have needed to delegate adjudication of the case to it), it is a good bet that the plaintiffs in Germany will continue to bring law suits against the ECB’s policies – especially if sovereign QE is indeed announced. So the German court will definitely get another opportunity to deal with the topic.

The inner workings of the European Court of Justice

Stay tuned.

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