Testing the Eurozone’s safety net
By Ashoka Mody
former mission chief for Germany and Ireland at the International Monetary Fund, is currently Visiting Professor of International Economic Policy at the Woodrow Wilson School of Public and International Affairs, Princeton University.
On October 14, as yet another financial storm gathered over Europe, the European Court of Justice convened in Luxembourg. In the coming months, the ECJ will assess the German Constitutional Court's ruling that the European Central Bank's "outright monetary transactions" (OMT) scheme - which allows the ECB to purchase weaker eurozone countries' government bonds, in exchange for compliance with the rules of the European Stability Mechanism (ESM) - is illegal.
The mere announcement of OMT - the eurozone's most potent crisis-management tool - immediately calmed panicked markets in the summer of 2012, prompting ECB President Mario Draghi to describe it as "the most successful monetary-policy measure undertaken in recent time[s]." That is why the German court's ruling earlier this year that OMT oversteps the ECB's authority under the Lisbon Treaty was met with consternation.
The German court did, however, pause to ask the "Europe-friendly" ECJ - the ultimate arbiter of European law - for its opinion. And, once the 2012 financial-market panic subsided, it seemed possible that OMT may have served its purpose, without ever having to be called to duty.
Then, earlier this month, amid slowing global growth, German economic indicators swooned, the risk premium on Greek sovereign bonds spiked, and ECB statistics showed that investors were pulling out of Italy. Europe may be facing another moment of reckoning, and the scenarios are bleak. Suddenly, the ECJ's deliberations have become much more important.
Of course, this storm may blow over. But others will undoubtedly arise. The eurozone economy faces a grimmer outlook than at any time since the start of the global financial crisis in 2008. Growth prospects have been steadily downgraded; public debt/GDP ratios have risen dramatically, despite - or, some might argue, because of - unrelenting fiscal austerity; household debt burdens are not falling; and Italy's vicious circle of rising debt and falling prices will soon be the fate of other stressed eurozone economies.
Moreover, all feasible policy options to jump-start growth - including a bold, eurozone-wide (not just German) fiscal stimulus and substantial, internationally coordinated euro depreciation - have been ruled out. Simply put, the eurozone is fragile, and it lacks a reliable safety net.
The OMT scheme could provide that safety net. But the German court's case against it is strong. Indeed, it is based on the ECB's own judgment validating the ESM (the eurozone's existing effort to create a firewall against financial crises).
The German Constitutional Court and the ECJ agree that the Lisbon Treaty prohibits the ECB from taking action to support a sovereign on the verge of insolvency; that is a fiscal and political issue. Central-bank best practice follows the same view. The ECB's argument that the OMT program's primary purpose is to prevent a eurozone breakup is unconvincing to the German court, for only a nearly insolvent sovereign would risk breaking up the union.
The ECJ may ask the ECB to dilute its OMT promise. Even Jorg Asmussen, former member of the ECB Governing Council, conceded to the German court that the "unlimited" purchases pledge contravened the treaty and would thus have to be limited. After all, once such purchases are initiated, the market will likely test the ECB to find out where it will draw the line.
Worse, the ECB has made an ambiguous promise to share losses with private creditors if a distressed sovereign does not eventually repay its debts. If the ECJ reverses this provision, OMT is unlikely to survive.
If, instead, the ECJ finds a legal argument to validate the scheme - and the German court, sensitive to current financial uncertainties, acquiesces - the ambiguities will be pushed aside, to be addressed later. A loss incurred by the ECB on an OMT operation would create a fiscal liability for Germany (and others), with far-reaching political consequences. (The recently leaked minutes of the ECB's Governing Council meetings highlight the differences between Draghi and Bundesbank President Jens Weidmann's views, adding to operational concerns about OMT.)
The problem is that none of these discussions addresses the fundamental flaw in the eurozone's structure: It is an incomplete monetary union. Eurozone countries surrendered monetary sovereignty, but remain loath to pay for one another's fiscal mistakes.
Unwilling to confront that issue, the eurozone authorities are consumed with tweaking trivialities like the degree of "flexibility" in the fiscal rules and the ECB's dubious plan to purchase asset-backed securities. All the while, they are relying on Scarlett O'Hara's credo: "Tomorrow is another day."
A financial guarantee like OMT can work wonders to dampen market fears and ease pressure, but only if it is credible. If it is not, it is likely to fail spectacularly.
To avoid such an outcome, Europe's leaders should agree to share, with full transparency, whatever losses the ECB incurs from its OMT operations, thereby giving OMT the political legitimacy it needs to serve as an effective safeguard for the eurozone. Such an agreement could, however, prompt a public referendum in Germany, at which point all bets would be off.
Whatever its flaws, OMT is the closest thing to a safety net the eurozone has. The authorities have pulled the eurozone back from the brink before. Is it too late to do so again?