Germany’s constitutional court hearing – a ticking time bomb for the euro?

About nine month ago, in a preliminary ruling, Germany’s constitutional court rejected complaints to stop Germany from joining the EMS and thus paved the way to calm the debt and currency crisis in the eurozone. However, a final ruling after closer examination of the case was still outstanding. The second factor to calm the debt and currency crisis was the decision by the ECB to announce the OMT program of buying government bonds in the secondary market. Constitutional complaints had also been filed at Germany’s constitutional court against the ECB. This past week, the court located in the city of Karlsruhe held a two day hearing on the two cases, the EMS and the ECB’s announcement of OMT.

The Bundesbank, although a member of the system of European central banks and thus part of the ECB, opposes the OMT program, which it regards as being direct state financing and thus violating the Lisbon treaty. Also the German professors of economics, which the court invited as experts followed the argument of the Bundesbank or regarded OMT as being in a legally gray area. It is understandable if lawyers and the seven judges of the court have difficulties to understand economic terms. However, the president of the Bundesbank and the professors should know what the term financing means. But as the DSGE models those professors and the Bundesbank applies does not even include a financial sector, how can one expect they know what this term means. However, a closer look in a dictionary of economic terms might have helped.

There are two ways of financing, either by debt or equity. The later is not possible for a state and can thus be neglected. State financing then implies that a state entity is borrowing from another party, which is the lender. Furthermore, it requires that funds flow from the lender to the borrower. If borrowing is conducted in the form of issuing securities (bills, notes or bonds), then the financing process takes place in the primary market. Transactions in the secondary market don’t constitute financing because no funds will flow to the issuer of a debt instrument but only from the buyer to the seller. However, in the government bond market there is one subtle exemption that government funding agencies retain a part of the issue volume for open market operations and could sell this paper in the secondary market. But the OMT is not designed to trade directly with funding agencies of governments. The counterparts are banks and as long as banks have to purchase the securities first before they can sell them to the ECB, the ECB only operates in the secondary market, which is explicitly allowed by the Lisbon treaty. Thus, the ECB and the German finance minister were absolutely right in their statement that OMT is within the framework of the EU treaty.

If the interpretation of the Bundesbank were correct, then the final consequence would be that all transactions of the ECB with banks refunding loans to government entities were forbidden and would violate the ECB mandate. Also interest rate cuts reduce the funding costs of some governments and thus were indirect state financing according to the Bundesbank argumentation.

The ECB is an EU institution and therefore, any ruling whether the OMT program is compliant with the Lisbon treaty is only in the competence of the European Court. The president of the German constitutional court indicated this also in his opening remarks. However, he also stated that OMT might violate the German constitution and thus, the court is hearing the case because it would be a complicated legal matter. The questions of the judges and their remarks during the hearing had been interpreted by many commentators as an indication that the court would tend towards regarding the OMT program as not in line with the German constitution.

In this respect, the other arguments brought forward by those who filed the legal complaint deserve closer inspection. The first argument refers to the risk of OMT for the national budgets. In the case of a default of a government on its bonds, the ECB would suffer a loss, which would have to be covered by the other governments. Thus, OMT would violate the budget rights of national parliaments. This argument is not convincing for two reasons. First, OMT reduces the risk that a country leaves the eurozone and defaults on obligations denominated in euro. The foreign exchange markets no longer speculate that the eurozone would fall apart. Furthermore, also funding costs of countries like Spain and Italy came down since the market no longer beliefs in a collapse of the euro. And this all took places without OMT being activated. Second, risks for losses exceeding the equity capital could also result from devaluations of other assets held by the ECB. Thus, also holding foreign reserves and gold could be a potential risk for national budgets and had to be forbidden according to the logic of the opponents to OMT.

Another argument put forward by those filing the complaint against the ECB is that the European Central Bank would lack any democratic legitimacy. True, the ECB council members are all not elected by the people of the eurozone directly. However, this is also the case of every national central bank. Furthermore, the ECB is politically independent and not controlled by a parliament. However, this is also the case with the national central banks, which are also independent and not responsible for their decisions to any parliament or government.   

The markets did not show much reaction to the hearing at the German constitutional court. The euro even strengthened against the US dollar in the weekly comparison. On the one hand, a decision is not expected to be announced before September. On the other hand, markets expect that the German constitutional court would not rule against the ECB. However, the court in all its rulings on rescue measures for the euro always emphasized the right of the parliament. Thus, it could not be ruled out that the majority of the judges decide that the Bundesbank is not allowed to participate in OMT. Such a ruling would most likely cause renewed tensions in the eurozone. But more important would be the question how could Germany stay in the EU and the eurozone if the German constitutional court rules that OMT would violate the German constitution while the European Court confirms the ECB’s position that OMT is fully compliant with the Lisbon treaty?

Thus, precious metals might be a good insurance against a negative surprise from the German constitutional court later this year.