Germany’s highest court issued a ruling that could threaten the existence of the euro with a constitutional court decision that said the European Central Bank’s bond-buying operations exceeded the ECB’s legal remit, and violated German constitutional law. The U.S. equivalent of this would be a state Supreme Court limiting the ability of the U.S. Federal Reserve to conduct purchases or sales of Treasury securities.
Even more extraordinary, the court decreed that it could “ignore an earlier ruling of the European Court of Justice in favour of the ECB,” which, in the words of Martin Wolf of the Financial Times, is tantamount to “an act of judicial secession.” To extend the U.S. analogy, that would be akin to a state Supreme Court holding that it would not be bound by U.S. Supreme Court precedent.
Still, “judicial secession” might be too strong a characterization. The European Union has been an evolving structure since its inception and does not have an explicitly federal constitutional framework as a backstop that could quickly eradicate any ambiguity and nip the problem in the bud.
Here’s the problem: the euro is the official currency of 19 out of 27 EU member countries, and its users are governed by a federal monetary system roughly analogous to the U.S. Federal Reserve system. On the other hand, the euro and the ECB are parts of an intergovernmental union, not a real federal state. Europhiles have been hoping that the EU would just develop into the latter organically. The German court has just inconveniently reminded everybody what the true state of affairs is. The very absence of a corresponding federal political structure is what constitutes the longstanding Achilles heel of the entire single-currency union. It can’t just be wished into existence, or created via judicial improvisation.
However understandable, this legalistic approach poses considerable risks for Berlin. As the largest creditor nation in the eurozone and its largest economy, Germany has much to lose if it ends up being the party responsible for the breakup of the single-currency union. After all, if the creditor does not respect the rules of the organization (or family) of which it is part and on which it holds claims, why would the debtor be beholden to that arrangement?
A brief comparison of the two systems helps to illuminate the challenges ahead for the eurozone. The U.S. Federal Reserve consists of a network of 12 Federal Reserve Banks and 24 branches that together comprise a system that operates under the general oversight of the Washington-based U.S. Federal Reserve. The U.S. Fed (via its Federal Open Market Committee—FOMC) sets interest rate policy. The New York Federal Reserve branch is then authorized to buy and sell Treasury securities to the extent necessary to carry out the most recent FOMC monetary policy directive. If a New York-based court sought to limit that ability of the New York Fed to conduct bond-buying operations on behalf of the U.S. Federal Reserve, this would be immediately be shot down by the U.S. Supreme Court on the grounds of ultra vires, i.e., the state court would be said to be acting beyond its legal power or authority. These rules are clearly established, governed, and backed by decades of legal precedent and the existence of a clear corresponding federal structure (that is replicated in the courts system). So, of course, this hypothetical would never arise in the U.S. (short of another act of secession).
The eurozone is ostensibly governed by a similar monetary structure: Just as the U.S. Fed uses the New York Fed to conduct purchases/sales of U.S. Treasuries, the ECB uses the various national central banks (e.g., the Bundesbank for German bonds, Banque de France for French paper, etc.) to purchase European government bonds. As the strains on the system have intensified, so has the scope of the ECB’s purchases, along with corresponding questions about the legality of its expanding operations. So, for example, even though the Maastricht Treaty—the international agreement responsible for the creation of the European Union (EU)—contains an explicit “‘no bailout’ clause” on sovereign bond-buying activities, the ECB has elided this particular legal obstacle in the past, suggesting that these purchases did not constitute bailouts as such, but were simply measures to help enhance the ECB’s ability to conduct its legally mandated monetary policies.
Both the European Court of Justice (ECJ) and German court rulings in the past have previously gone along with the ECB’s justifications. But that all appears to have changed in light of the recent German constitutional court decision succinctly summarized in the Financial Times:
“The court in Karlsruhe ordered the German government and parliament to ensure the ECB provided a ‘proportionality assessment’ of its bond-buying to check that its ‘economic and fiscal policy effects’ did not outweigh other policy objectives.
“Finally, it told the Bundesbank, Germany’s central bank, to stop buying bonds and to draw up plans to sell the more than €500bn it has bought if the ECB failed to comply within three months.”
The principle of proportionality in this instance means that the content and form of the actions undertaken by the ECB shall not exceed what is necessary to achieve the objective of the EU treaties. If the ECB fails to satisfy the German court that its actions are consistent with this principle, then further asset purchases (i.e., sovereign bond-buying operations) are impermissible. And existing ECB bond holdings would have to be sold, which would likely create carnage in the European bond markets.
The issue has urgency today, given the backdrop of the COVID-19 virus. In March, the ECB established the €750 billion Pandemic Emergency Purchase Program (PEPP) in response to the mounting economic challenges caused by the pandemic. While it is highly likely that the ECJ will move soon to re-establish its legal primacy against the German court ruling, Ana Bobić and Mark Dawson, two leading Berlin-based legal scholars, have questioned whether the new PEPP in fact meets the legal criteria established in previous court ECJ court rulings, given the absence of any of the ECB’s earlier-imposed constraints on sovereign bond purchases (such as restrictions on future government spending in exchange for the ECB’s help). Given the dire state of economies such as Italy, any legal encumbrance that interferes with the ECB’s bond-buying activities creates the potential for an Italian or Spanish bankruptcy.
Hence, it is highly problematic that the ECB will be undertaking new purchases against a backdrop of maximum legal ambiguity. To sustain its bond-buying operations under the new program, it will need to secure the cooperation of the Bundesbank. But Germany’s own central bank will be faced with two competing claims, given that the nation’s leading constitutional court specifically mandated that the Bundesbank could not continue to participate in the ECB’s asset purchase programs, until the ECB complied with the requested “proportionality assessment” of the program. Against that, as Wolf notes, the Maastricht Treaty “states that ‘neither the ECB, nor a national central bank… shall seek or take instructions… from any government of a member state or from any other body.’”
Imagine the next time the ECB initiates bond purchases under the PEPP, and the German Bundesbank hypothetically refuses to undertake these purchases on the ECB’s behalf, citing its national constitutional court ruling. What happens then?
The ECB could well initiate the program without the cooperation of the Bundesbank, but the lack of cooperation of the latter would be tantamount to initiating divorce proceedings with the rest of the eurozone. You would have a monetary free-for-all. And with no “United States of Europe” Treasury standing behind the ECB, Germany, as the largest creditor nation, would presumably be saddled with a substantial amount of the liabilities of the eurozone debtor countries. The latter (Italy, Spain, Portugal, Greece) would be on very solid grounds to refuse repayment if the violator of the European Monetary Union is Germany itself. So in that sense, an Italian bankruptcy largely creates problems for Berlin, not Rome. One could argue that the German court decision actually gives the debtor nations a “get out of jail free” card.
It is probably unlikely to come to that. If nothing else, the European Union overall has proven itself remarkably adept at kicking the can down the road and resolving difficulties only at the last possible moment. One possible solution is something that I have suggested before, namely “annual distributions of funds to the national governments (credited to their accounts at the national central banks) on a per capita basis… [, which would] give the national governments the fiscal latitude to cope with the pandemic and engender long-term economic recovery.” As the funds would be distributed on a per capita basis, the courts might deem the actions consistent with the proportionality principle, especially if Bundesbank officials were to sign off on such a program.
In any case, these kinds of legal challenges aren’t going away any time soon. Each legal clarification is clearly designed to define the limits of the ECB’s actions, and provide less scope for the kind of ambiguities that have enabled the member states to defer difficult long-term decisions that will truly make or break the union. Germany, in particular, has persistently castigated other nations who have been serial violators of the EU rule book. But much like Shakespeare’s Shylock, who literally insisted on his “pound of flesh” as security for his loan to Antonio, Germany’s rigorous legalism could ultimately backfire if and when the tables are turned.
Longtime economic powerhouses like New York and California understand the value of being part of a larger political union and have willingly subsidized the rest of the U.S. for decades, even patriotically. Will Germany again overreach and squander its historic position of influence in the EU? Or will it accept some form of fiscal transfer union that ultimately consolidates its position and saves the euro, but likely puts Germany in a position of a perpetual net contributor to a broader, but more sustainable European Union? It has its recent domestic parallel to consider, when it absorbed and developed Eastern Germany after the Cold War. It all depends on what Germany ultimately imagines its role in the region to be, builder or breaker.
Marshall Auerback is a market analyst and commentator.
This article was produced by Economy for All, a project of the Independent Media Institute.