A German court may have just weakened European Central Bank President Mario Draghi's most potent weapon in the battle to save the euro.
Back in July 2012, Draghi calmed panicked markets with a pledge to do "whatever it takes" to defend the euro and with a program, known as outright monetary transactions, to stabilize interest rates throughout the euro area by buying the bonds of financially distressed governments. The move was a game changer, shifting the crisis in Europe from acute to chronic. European markets have been relatively calm ever since.
There has always, though, been a significant caveat: The German Constitutional Court had to rule on whether the bond-buying program complied with German law, which forbids monetary financing of the budget. Following a closely-watched debate in the court last September, most analysts expected it would offer a "yes, but" ruling that accepted the bond buying was legal, pending a few small revisions to make the Germans feel they had more control.
Instead, the German court has surprised many analysts by offering a "no, but" ruling: It thinks the bond-buying program violates German law, but recognizes that the European Court of Justice should determine whether the ECB is acting within its mandate. The European court must now investigate whether the program falls within the ECB's mandate as a form of monetary rather than economic policy. This will take at least 18 months.
So what happens in the meantime if a country gets in trouble and the ECB wants to buy its bonds? One possibility is that the program will be put on hold until the European court deems it legal -- meaning that the central bank's most powerful policy tool will be completely defunct. This should worry Portugal, which is due to exit its bailout program later this year and is taking some comfort that there is a safety net if things go horribly wrong. Other financially challenged countries in Europe should be concerned as well: Both Greece and Italy have unstable governments that could collapse over the next 18 months, possibly triggering investor panic.
More likely, the bond-buying program will be considered in force and then ruled on retroactively. Given the German court's position, the Bundesbank could refuse to participate in any bond purchases until the program is adjudicated. The eurozone doesn't have a banking union, a fiscal union or a political union, but at the very least it can claim to have a fully functioning monetary union. If the largest national central bank refuses to participate in an ECB program, that claim could be called into question, to the great dismay of investors.
Furthermore, what happens if a government defaults on the bonds purchased by the ECB? The central bank can in theory make up entries on its balance sheet to carry those losses forward, but realistically it will want to raise more capital from its member countries. If the Bundesbank refuses to pay for any losses resulting from what a German court considers to be an illegal program, the losses will be spread across the other euro-area countries, many of which can ill afford them.
In referring the case to the European court, the German court highlighted three amendments that would convince it that the bond-buying program is in accordance with the ECB's mandate and German constitutional law: "this would probably require that the acceptance of a debt cut must be excluded, that government bonds of selected Member States are not purchased up to unlimited amounts, and that interferences with price formation on the market are to be avoided where possible."
If the European court agrees, it will take all of the teeth out of the bond-buying program. The promise to buy government bonds was successful because betting against an ECB with unlimited firepower was never going to pay off for investors. Limiting the ECB's firepower changes the calculus. Speculators could test its resolve, sending borrowing costs for weak euro area countries soaring again. Borrowing costs would also rise if the ECB were made a preferred creditor in an effort to avoid losses. Investors would demand a higher yield on sovereign debt, knowing they would be first in line to suffer losses in the event of a debt restructuring.
More likely, the European court will rule that the ECB program is legal without the German court's proposed amendments. In this case, the ECJ's ruling will be binding, but there will be overt disagreement between Europe's highest court and its largest member state's highest court on the most important policy tool in the region. It is hard to believe investors won't wonder about the program's effectiveness if and when it is eventually activated.
Part of the beauty of the ECB's pledge to buy bonds has always been its vagueness. No one, including the program's architects, really has a clear sense of how it will be carried out if a country actually needs it. Its credibility was always going to be tested. Now, though, the German court has undermined its credibility in a different way, by bringing to light political feuds over its legality. It will be extremely difficult for the program to work smoothly amid clashes between the ECB, the Bundesbank, and the highest courts of Germany and Europe.
(Megan Greene is the chief economist at Maverick Intelligence and a senior fellow at the Atlantic Council.)
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