On 14 January 2014 the German judges of the Constitutional Court in Karlsruhe came to a preliminary ruling: the European Central Bank’s government bond buying program (OMT) is illegal according to EU law. The judges referred the case to the European Court of Justice asking the Luxembourg judges to add conditions to the OMT program to make it possible for them to reconsider their judgment. These conditions, if implemented, would in fact rob the OMT program from its effectiveness and make it totally useless. This would create the risk of repeated crises in the government bond markets of the Eurozone (Giavazzi et al 2013).
“Practical men who believe themselves to be quite exempt from any intellectual influence, are usually the slaves of some defunct economist”. This well-known quote from Keynes applies to the judges of Karlsruhe, except for the fact that the judges may not be practical men. Who are the defunct economists that have influenced the minds of these judges? I will argue, first, that the efficient market theory has formed the cornerstone of one of the key arguments developed by the judges, thus making this judgment quite shaky. Second, that the judges’ view of the fiscal implications of the OMT program is based on an incorrect, yet popular view, of the functioning of central banks.
The judges of Karlsruhe and the efficient market theory
The first main argument used by the judges of Karlsruhe can be formulated as follows.
- When the ECB buys government bonds in the framework of the OMT program it aims at reducing the yields on these bonds.
However, these yields express the market’s view about the default risk of the government bonds. In the words of the court they reflect “the skepticism of market participants that individual Member States will show sufficient budgetary discipline to stay permanently solvent”.1 By buying government bonds the ECB is changing the yields and in doing so it counteracts financial markets’ assessments of the default probabilities of sovereigns. Thus, the ECB is not conducting monetary policy but economic policy. This is a transgression of its mandate that is restricted to monetary policy.
Implicit in this argument is that financial markets make a correct assessment of the default risk of sovereigns.
- This argument ultimately relies on the efficient market theory, i.e. that prices (yields) are based on all available information and thus represent the best possible assessment of default probabilities.
Authorities have no reason to oppose the judgment of the market since this is the best possible judgment that is available.
What’s wrong with the theory
While this view was very popular prior to the financial crisis, it has lost much of its appeal since the eruption of the crisis. It is now recognised that financial markets are imperfect, and may not reveal the underlying economic fundamentals correctly.
As I have argued in De Grauwe (2011), situations in which financial markets may not reveal underlying economic fundamentals correctly, arise in the government bond markets of the member states of a monetary union. National governments in a monetary union issue bonds in a currency over which they have no control. As a result, they cannot give a guarantee to bondholders that the cash will be available to pay them out at maturity. This contrasts with government of standalone governments that, because they can rely on a central bank as the ultimate backstop, can give this guarantee to bondholders.
The lack of a liquidity backstop for national governments in a monetary union can lead to self-fulfilling liquidity crises that can push governments into default. Thus, in a monetary union multiple equilibria are possible. Markets can push countries into a bad equilibrium solely because they fear payment difficulties of the sovereign. When such a fear arises the yields are pushed up and a sudden stop in liquidity supply forces the government into a liquidity crisis and, in the absence of outside financial support, into default. In contrasts in the absence of such fears, countries are kept in a good equilibrium: yields remain low and markets are willing to provide liquidity. Note that one does not need to assume irrationality of individual agents to reach this result. It is obtained in rational expectations models (see Calvo 1988, Gros 2012, Corsetti and Dedoal 2011).
There is now substantial empirical evidence sustaining the view that the surging spreads in the government bond markets during 2010-12 were the result of market sentiments of fear and panic, and that during this period these spreads were to a significant extent unrelated to underlying fundamentals such as the government debt ratios, external debt, competitiveness; etc. (see Beirne and Fratzscher 2012, De Grauwe and Ji 2013, and Gärtner 2013).
Multiple equilibriums, efficient markets and Lender of Last Resort
Thus, the main justification of the OMT-program lies in the view that financial markets can lead to self-fulfilling liquidity crisis and push countries into bad equilibira. When Draghi presented the OMT-program at his press conference, this was in fact the justification he gave:
"[T]he assessment of the Governing Council is that we are in a situation now where you have large parts of the Eurozone in what we call a “bad equilibrium”, namely an equilibrium where you may have self-fulfilling expectations that feed upon themselves and generate very adverse scenarios. So, there is a case for intervening, in a sense, to “break” these expectations, which, by the way, do not concern only the specific countries, but the Eurozone as a whole. And this would justify the intervention of the central bank”.2
The possibility of multiple equilibria is the single most important justification for the lender of last resort function of the central bank in the government bond markets (see De Grauwe(2011), Gerner-Beuerle, et al., (2014)). Without a promise of liquidity support in the government bond market, one can expect new liquidity crises to emerge in the future. Note that this argument only implies that the central bank should intervene in the secondary market. It does not need to intervene in the primary market, which, if the ECB were to do this, would be illegal according to the EU-law.
Thus the willingness to accept this role of the central bank ultimately depends on the kind of model one adheres to. The judges of Karlsruhe adhere to the efficient market theory that is now largely discredited. This theory not only implies that there is no need for a lender of last resort neither in the government bond market nor in the banking sector. If markets are efficient, they are capable of detecting whether a troubled government or for that matter a troubled bank experiences a liquidity or a solvency problem. If it is a liquidity problem financial markets will be willing to provide liquidity to governments and banks. There is no need for a central bank to step in, because markets will do it. If the troubled institution (government of bank) suffers from a solvency problem financial markets, quite correctly, will not be willing to provide funding. In that case the central bank should not provide funding either.
The conclusion is that in a world of efficient financial markets there is no need for a central bank that acts as a lender of last resort. This applies both to banks and sovereigns. I conclude from this that following its own logic the German constitutional court should have challenged the ECB earlier, i.e. when the ECB intervened in 2008 and later in 2011-12 to provide massive amounts of liquidity to banks (LTRO). In the efficient market logic to which the German court adheres, this was economic policy, i.e. the ECB was overruling the judgment of financial markets. Thus the liquidity support given to banks in 2008 and later in 2011-12 was illegal. One wonders why the German constitutional court did not want to apply its logic to the liquidity support given to banks.
The judges of Karlsruhe and central banking
The second main argument used by the German judges, which was very much influenced by the Bundesbank advice on OMT, can be summarised as follows.
- When the ECB buys government bonds it mixes monetary and fiscal policies.
The fiscal component of OMT arises from the fact that the government bonds bought by the ECB can lose value if the governments whose bonds are bought default. If that happens the ECB will incur a loss that can wipe out its equity. As a result, governments of the member countries will have to use taxpayers’ money to recapitalise the ECB. Thus, by buying government bonds the ECB puts future taxpayers at risk. The latter may be forced to pay taxes, without due democratic process. Indeed decisions to tax can only be taken by national parliaments, and not by a politically irresponsible bureaucracy like the ECB.
This sounds like a very weighty argument. If true, there is not much one can put in the way of the judges and one has to conclude that the OMT program undermines the basic democratic principle of “no taxation without representation”. The problem with this argument is that it is wrong.
- A first thing to note is that a central bank cannot default as long as it has the monopoly power to issue money.
Money is the “debt” of the central bank but the central bank can redeem this “debt” by issuing fresh money, i.e. by converting an old banknote into a new one. These banknotes do not constitute a claim on the assets of the central bank. As a result, the central bank does not need equity (in contrast to private companies). It can live with negative equity. As long as the central bank keeps its promise of price stability any amount of equity, positive or negative, is fine. Thus the constraint a modern central bank faces is unrelated to its equity position. The only constraint comes from its promise to maintain price stability.
Let’s return to the OMT program. Suppose the ECB buys Italian government bonds in the secondary market. Thus, the Italian government must have decided earlier to issue these bonds, and this must have passed due democratic process in Italy. As soon as the ECB holds these bonds on its balance sheet an interest rate transfer process is set in motion. The Italian treasury now has to pay interest every year to the ECB. (Note that before the ECB purchase the same Italian treasury was paying the same interest to private holders of these bonds. The ECB purchase of bonds does not affect the Italian taxpayer).
The next step is that the ECB transfers the interest revenues to the national central banks of the member states which pass these on to their national treasuries. This distribution is done according to the capital shares of the national central banks in the ECB. Thus Germany, which has the largest share receives the larges part of these interest revenues. Italy receives a fraction and is thus the net payer. The point is that the Italian taxpayer is not asked to pay more taxes because of the ECB bond purchase. The other member countries are at the receiving end. Thus, taxpayers in these countries, in particular the German taxpayer, are not asked to pay more taxes, either. On the contrary they could lower taxes as a result of the transfers from Italy. This goes on until the Italian bonds held by the ECB matures.
What happens if the Italian government defaults on its debt? Two things.
- First, the flow of interest revenues from Italy to the other member states stops. Again there is no increased taxation. Italian taxpayers just stop sending money to German, French, Dutch, etc. taxpayers.
- Second, following the Italian default the ECB has to write down the Italian bonds. This loss leads to a decline of the ECB’s equity.
If the decline in equity is sufficiently large, a recapitalisation of the ECB may be required. However, as argued earlier, the ECB can easily live with a lower equity because a central bank does not need equity to function properly.
But suppose that for reputational reasons the member states decide to recapitalise the ECB. Will that not inevitably involve taxpayers in Germany, France, etc? The answer is no. This will just be a bookkeeping operation without involving taxpayers. When national governments decide to recapitalise the ECB to make up for the loss from writing down the Italian bonds, they transfer bonds to the ECB, allowing the ECB to restore its equity. These transfers occur using the same capital shares. As a result, the ECB will receive interest payments from these governments in the same proportions. But at the end of the year the ECB transfers these interest revenues back to the same governments using the same capital shares.3
It will be clear that a recapitalisation of the ECB would be a pure bookkeeping operation. It would not require Eurozone interests to pay more taxes. Each government gets back from the ECB exactly what it has put into the ECB. The German and other taxpayers can sleep peacefully. In this whole operation, including the default by the Italian government, taxpayers would not be asked to pay one additional eurocent. The fact that a recapitalisation of the ECB can only be a bookkeeping operation should not come as a surprise. A government that can default cannot possibly be a fiscal backup of a central bank that cannot default.4
Risks of OMT
There are of course risks involved in the use of the OMT program. These risks have to do with potential inflation and with moral hazard. But none of these risks have anything to do with taxpayers that are being forced to pay a tax without a democratic vote in national parliaments. The inflation risk arises from the fact that a government bond purchase leads to a creation of money base. Elsewhere I have argued that this risk is small as the ECB will be called upon to activate the OMT program during moments of financial crisis when economic agents scramble for liquidity (De Grauwe and Ji(2013)). During such moments the greater risk is deflation, not inflation.
The risk of inflation lies in the future. When the ECB buys large amounts of government bonds during a liquidity crisis it may have to unwind the liquidity when the economy picks up again and when banks may use their excess liquidity position to extend too much credit. The ECB can then stop the banks from doing so by increasing minimum reserve requirements. The ECB has been given the legal authority to do so in the Treaty.
The risk of moral hazard is a real one. It arises because the OMT could give incentives to governments to be more relaxed about debts and deficits. In order to deal with this risk a separation principle should be applied. The responsibility of the central bank is to provide liquidity in times of crisis. The European Commission is responsible for containing the moral hazard risk. It has a legal mandate to do so through the Stability and Growth Pact that has been strengthened since the outburst of the sovereign debt crisis.
The German constitutional court has declared the OMT program to be illegal according to EU-law. I have argued that this ruling is based on economic theories that should be rejected. The first one is the efficient market theory. This theory implies that there is no role for the central bank as a lender of last resort, not only in the government bond markets but also in the banking sector. Financial markets will do the job of providing liquidity to illiquid but solvent banks and sovereigns. Who believes this theory these days? Apparently, the judges from Karlsruhe do.
The second theory is that central banks should have positive equity to be able to function. According to this view negative equity of the central bank implies that governments (taxpayers) will have to step in to save (recapitalise) the central bank. This view, on which the ruling of the judges of Karlsruhe is based, should be rejected. In a fiat money system central banks do not need equity. It makes no sense to claim that a central bank that cannot default should have a fiscal backing from governments that can default.
Author's note: I am grateful to Carsten Gerner-Beuerle and Edmund Schuster for comments and suggestions.
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Giavazzi F, R Portes, B Weder di Mauro and C Wyplosz (2013), "The wisdom of Karlsruhe: The OMT Court case should be dismissed", VoxEU.org, 12 June.
Gerner-Beuerle C, E Kücük and E Schuster, (2014), Law meets economics in the German Federal Constitutional Court, London School of Economics, unpublished.
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1 BvR 2728/13 of 14 January 2014 (OMT Ruling), para. 70
2 Draghi at the press conference on 6 September 2012 after the OMT Decision was taken, available at
3 If the interest rates on the bonds are different there could be transfers between countries resulting from a recapitalisation. In general countries with high interest rates would transfer interest to the low interest rate countries (like Germany). The ECB could offset this by a rule of “juste retour”.
4 Sometimes observers fail to see this because they are mired in bookkeeping conventions that creaate a fiction that equity of a central bank is real. See Kastner(2014).