I concur with Mody’s overall conclusion that the monetary union, even with the OMT programme, is incomplete and the issue of fiscal union remains unresolved. To permanently stabilise monetary union, the EU will need to agree on a small fiscal union. I am, however, less convinced by the criticism of the OMT programme as such (see also my previous piece providing evidence in favour of OMT).
Let me organise my comments into seven main points.
- To start with, I would like to emphasise that the OMT programme has been extraordinarily successful. Ahead of the European Central Bank’s summer 2012 announcement, financial markets were speculating against a number of EU governments. As Paul de Grauwe (2011) andGuillermo Calvo (1988) have convincingly shown, multiple equilibria in bond markets are possible. In the language of economists, markets were converging on a bad equilibrium, in which rising interest rates would render debt unsustainable. The only party that can move markets from the bad to the good equilibrium is the central bank. The ECB therefore rightly acted to move markets to the right equilibrium. The announcement of possible ECB intervention was sufficient to guide markets to the good equilibrium. The fact that the ECB did not have to buy a single bond to achieve this suggests that the problem was one of multiple equilibria.
- The OMT announcement was in line with the ECB’s mandate. The ECB’s task is, among others, to define and implement monetary policy and to promote the smooth operation of the payment system. In July 2012, monetary policy was arguably not properly implemented in a number of EU member states. The ECB’s interest rate signals did not get transmitted to the creditors and monetary conditions therefore became extremely tight in the countries under attack. The bad equilibrium in the sovereign bond market prevented the banking system from operating properly. The interbank market had broken down and only a very substantial increase in ECB liquidity prevented a liquidity run in the banking system. Target2 balances built up and ECB liquidity became heavily tilted towards the periphery banks. Banks stopped extending credit and therefore monetary policy decisions were not transmitted to the real economy. Even the payment system was starting to be seriously questioned. The ECB therefore had to act to fulfil its mandate according to Article 127. The fact that policy action would be local is totally in line with monetary policy objective of achieving a homogenous price stability goal across the union. The monetary policy mechanism therefore had to be repaired where it was broken. Announcing the OMT programme was successful in re-ordering market participants around the good equilibrium.
- The OMT discussion should not ignore the counterfactual. Not announcing a potential OMT programme could have much more significant fiscal consequences. In fact, the ECB is involved in a large number of standard monetary policy operations which all imply loss sharing across the ECB’s shareholders if there were losses. The aim of the OMT programme announcement was to stabilize markets in which monetary policy did not operate properly anymore. In doing so, the actual risk for the shareholders of the ECB decreased significantly.
A trickier question is under which circumstances implementation of an OMT programme and purchases of government bonds of countries under a European Stability Mechanism (ESM) programme would be legal, and under which conditions it would violate the no-bail-out (Article 125) and no-monetary financing rule (Article 123) of the Maastricht treaty. The core of the argument made by the German court and by Ashoka Mody is that government bond purchases in the context of an ESM programme are a fiscal operation and not a monetary operation, and should therefore be a political decision. If they were fiscal operations, they would violate Articles 123 and 125 and would certainly be against the spirit of the Maastricht treaty that aimed to establish a monetary union without a fiscal union. The authors argue that liquidity and solvency cannot be properly distinguished and therefore ECB intervention would necessarily become a fiscal operation in the context of an ESM programme. They also argue that the acceptance of pari passu by the ECB would contradict the ECB’s liquidity mandate and would therefore be an explicit acceptance of losses, making the operation a fiscal operation. I would counter this reasoning with a number of arguments:
- Article 13 (1b) of the ESM treaty requires that prior to an ESM programme, the European Commission in liaison with the ECB has to assess if public debt is sustainable. Wherever appropriate and possible, this assessment will be conducted together with the International Monetary Fund. So in principle, the ESM programme is only approved when debt is assessed to be sustainable. More importantly, the ESM programme is only granted if there is a unanimous agreement by all ESM members to do so. This means that there is not only a technical debt sustainability assessment but also a unanimous political agreement that debt is sustainable and that the recipient of the assistance will be able to honour its commitment. This political agreement between member states is very important for a number of reasons:
- First, the sustainability of debt under normal interest rate conditions, and therefore the solvency of a country, is primarily a political issue. The servicing of even very high debt levels when interest rates are low is a political decision because it implies cutting back on other spending. A political commitment to the partners is therefore a strong signal that, in fact, the problem the country is undergoing is one of liquidity and not of fundamental solvency.
- Unanimity also implies that all creditors agree that they believe in the country’s intention to honour its obligation. They therefore declare that they trust the country’s ability to service its debt.
- As a result, I would argue that the distinction between solvency and liquidity problems, which Mody argue cannot be made, is, in fact, made by a very strong political commitment on all sides.
- It is true, however, that ex post, this political commitment may disappear, for example after an election. Ex post, a country might decide to default on its obligation. The relevant question to assess the legality of the OMT programme is therefore whether the possibility of an ex-postdefault by a country makes an ECB action incompatible with the treaty. I would argue that this cannot possibly be the case. In fact, any ECB operation is carried out under the ex-antesupposition that the liquidity granted will be paid back. This is, for example, the case in standard main refinancing operations (MRO), and in asset-purchase programmes. The ex-ante guarantee, on which the ECB relies in the MRO, is a supervisory assessment of the solvency of the bank and, in the case of an asset purchase, it is based on ratings. In the case of an ESM programme, it would be based on the political and technical assessment of solvency. A strong ex-ante presumption that debt is sustainable should therefore be sufficient to justify ECB purchases.
- Mody argues that OMT pulls the ECB inevitably into making political choices. While I agree that the ECB currently is in a very uncomfortable position, in which the missing fiscal union increases the need for the ECB to be political, I would argue that the ESM programme is actually the best way of protecting the ECB from national politics. In fact, buying government bonds without an ESM programme, as some have advocated in the context of the quantitative easing debate, appears to me a much more delicate issue because the ECB would intervene in the pricing process of sovereign bonds without a prior political agreement on the fact that markets are mispricing sovereign debt. It would, in fact, mean that the ECB itself is making this judgement and therefore buys bonds, a much more political action.
- The trickiest issue is perhaps the pari-passu clause announced by the ECB. In fact, to be effective, the ECB had to announce pari passu. Pari passu, incidentally, is the standard format for monetary policy measures (in MRO and QE, the ECB also has pari-passu status). But announcing pari passu means that the ECB would have to accept losses in a case of sovereign default. I think I have convincingly argued that accepting losses ex post is unproblematic from the point of view of the EU treaty if ex ante one can be reasonably sure that they will not be suffered. It is, however, problematic that the ESM has the status of a senior creditor while the ECB is pari passu. This ordering of creditors appears to be inconsistent with the Pringle judgement of the ECJ (in the reading of Mody) which protects the ECB ahead of the ESM.
- A logical solution to the pari-passu problem in case the ECJ follows the reading of Mody of the Pringle judgement in its OMT judgment would be to make the ESM the junior creditor or at least pari-passu. In doing so, a number of important aims would be achieved. First, one would have a political agreement by fiscal authorities on burden sharing if a country defaults. This would be in line with Mody’s call for a political agreement on burden sharing. Second, one would grant a strong political incentive to only start an ESM programme if the likelihood of insolvency is very low. Third, it would be a clear step towards a fiscal union (even though other justifications for a fiscal union exist) in which, if member states decide that they assess a possible default of a country to be too costly, they can grant assistance, but only by taking on a substantial risk for their own taxpayers.
Arguably, while I believe the German court has stepped beyond its remit by taking this case and ruling on it, as has been convincingly argued by the outvoted German court judge Lübbe-Wolff and also by Professor Franz Mayer, the German court does Europe a favour on this point by forcing Europe to better define the boundaries of fiscal and monetary policy.
