The Little Red Riding Hoods from Karlsruhe

May 10, 2020

 

On May 5, the German Constitutional Court – based in Karlsruhe – has issued a ruling about ECB actions during the debt sovereign crisis. The European Court of Justice already had ruled in 2018 that these actions were legitimate. It was then responding to a question put forward by the Court of Karlsruhe, which then reserved the right to review the case once it had heard from Luxembourg. This is what just happened.

 

The ruling from Karlsruhe is harsh. It asserts that the ECB actions are dubious. It requests that the ECB explain, within three months, how its purchases of public debts to the tune of hundreds of millions of euros can be seen as ‘proportional’ to the issue at stake. If it isn’t satisfied with the answer, now in future cases, it may forbid the Bundesbank from taking part in future interventions, in effect tearing apart the Eurozone. The ruling raises judicial, economic and political issues.

 

It is for legal experts to evaluate the ruling from the judicial angle. It seems that several delicate issues are involved. First, what does the ruling imply for the independence of the ECB? Next, is the German Court challenging the primacy, established by the European treaties, of the European Court over national courts? And then, is it possible that the Karlsruhe Court compel the German government and the Bundesbank to follow its injunctions in a matter, monetary policy in the Eurozone, which does not fall under its jurisdiction?

 

From an economic angle, and ignoring the legal issues, the situation is both simple and baroque. The Maastricht Treaty forbids the ECB from directly financing government spending. At the same time, it explicitly allows the ECB to buy and sell Treasury bonds issued by the governments of its member states. In fact, buying and selling bonds is the most basic routine of the ECB. It is the normal procedure for a central bank to control its policy instrument, the interest rate (following elementary demand-and-supply principles). The Karlsruhe judges are concerned that such purchases may also allow the ECB to indirectly finance governments, which would be a way of circumventing the ban on direct financing. This is plausible and, in fact, a well-known and much-studied possibility. The answer is that it is intentions that matter.

 

In normal times, central banks intensely resent friendly pressure by their governments to indirectly finance their deficits. No one believes that they conduct their routine interventions for any other reason than controlling the interest rate. Intentions are beyond doubt. Matters are more complicated during financial crises. The large-scale purchases of Italian Treasury bonds by the ECB in 2012 were officially carried out to assuage the ‘risk of redenomination’, a code word for the possibility that Italy might leave the Eurozone. In practice, the objective was to bring speculation against Italian bonds to an end. To do so, then ECB President Mario Draghi uttered his famous ‘whatever it takes’ to signal that the central bank was ready to buy, if need be, all the Italian debt. As it turned out, no purchases at all were necessary. Speculation immediately stopped because no one can beat a central bank at this game. Intentions were transparent. When a central bank intervenes in last resort, it fulfils its essential responsibility of preserving financial stability. It seems that this logic escapes the judges of Karlsruhe.

 

What has followed the Karlsruhe ruling is quite telling. The Luxembourg Court stated that national courts are not meant to accept or not its rulings. The ECB let it be known that it is accountable to the European Parliament and therefore that it does not intend to justify its actions to any other body, be it national courts. It left it to the Bundesbank to decide whether it wishes to explain proportionality. The German Finance Minister informed his colleagues that this is a domestic issue, which the government will take care of. The financial markets jacked up interest rates on the Italian public debt.

 

Finally, comes the political issue. The Karlsruhe Court has the (bad) reputation of playing politics. This is what it just did. Initially, it was responding by a complaint lodged by German legal scholars with clear anti-European sentiments. It did not want to offend a non-negligible segment of German public opinion that is deeply hostile to anything that might resemble financing wasteful foreign governments. Appearing tough, the Court believed that it was politically savvy. It merely showed just how confused it is about monetary policy and it opened a rift about the European judicial order. More importantly, perhaps, it misread the deep commitment of current European governments – including its own government – to the integrity of the monetary union.

 

This is not to say that the Little Red Riding Hoods from Karlsruhe just got lost in the forest. Their ruling may well constrain the ECB. It is currently dealing with a historical economic crisis. Like the other central banks, it must design unprecedented policy measures. Among other things, it must prevent the outbreak of a financial crisis, so lending in last resort is again surfacing as a necessary tool. The Karlsruhe ruling is creating unhealthy background noise. The increase in Italian interest rates is a clear warning.