How Much Should We Worry about the Fate of the ECB’s OMT?

On Wednesday, January 14, 2015, the European Court of Justice (ECJ) Advocate General Pedro Cruz Villalon will publish his opinion on the European Central Bank’s (ECB) “Outright Monetary Transactions” (OMT) program. The Advocate General’s opinion will give us important clues and is likely going to shape the court’s later ruling on the matter. What is at issue?

The OMT program played a critical role in calming the markets since the height of the euro panic in the summer of 2012. ECB president Mario Draghi kicked off the counterattack on the markets by dropping his by now famous “whatever it takes” hint in a speech in late July in London. A few days later, on August 2, 2012, the ECB announced that “the Governing Council, within its mandate to maintain price stability over the medium term and in observance of its independence in determining monetary policy, may undertake outright open market operations of a size adequate to reach its objective.” The technical details of the OMT were then published on September 6, 2012, when the bank also terminated its earlier Securities Markets Programme (SMP) under which it had purchased fairly small quantities of government debts issued by euro crisis countries. Moreover, any purchases were sterilized to preempt “monetary financing” accusations (see here).

Rather predictably, like in the case of the earlier SMP, the OMT immediately came under sharp attack by Germany’s monetary orthodoxy. As a result, the OMT is also under review by Germany’s own Constitutional Court (GCC). In early 2014, the GCC referred the matter to the ECJ, not without publishing its own preliminary assessment though. Largely following the Bundesbank’s critical assessment of OMTs as persistently argued by its president Jens Weidmann, the GCC criticized the OMT on a number of counts, suggesting that the ECB may be overstepping its own monetary policy mandate and the OMT may also be in conflict with the “monetary financing” prohibition (TFEU Article 123).

For instance, the GCC challenges the selectivity of OMT; as a supposed monetary policy measure that would only set out to purchase the debt securities of particular members facing funding pressures. It takes issue with the conditionality of OMTs (the supported member state must be in an ESFS/ESM “stabilization” program and adhere to its rules). It is also worried about the unlimited volume of the OMT and the assumption of default risk on the part of the ECB (fearing a euro “transfer union” and risks for German taxpayers). And, given the ECB’s claims that it was fighting any irrational components in observed risk spreads, the GCC also questions whether a central bank is able to separate interest rate spreads into rational and irrational components.

The last point illustrates that the ECB made some strategic mistakes in selling OMT. In the context of the euro break-up discussions at the time, the ECB referred to irrational market bets leading to explosive risk spreads. The ECB was keen to send out the message that the euro was here to stay, as Mr. Draghi’s famous promise made clear. And that was probably an important part in making OMT work without actually having to activate it. The point is that in the context of the EU treaties, the ECB has exclusive responsibility for monetary policy with its primary price stability mandate, but not for economic policy. One can make the argument that preventing euro breakup is a precondition for maintaining price stability in the euro area. But then one could argue the same for preventing a nuclear war or climate change. Clearly the political authorities and not the ECB are ultimately in charge of keeping the euro whole. It may be laudable for the ECB to step in when the political authorities fail to live up to the task, but, strange as it may seem, it is the ECB rather than the political authorities that ends up facing legal challenges for its conduct (supposedly for overstepping its mandate when the political authorities have been failing to take the necessary steps to heal the euro all along).

Be that as it may, OMT served its purpose well, and without actually ever being activated. I called it a bluff at the time, but it turned out to be a hugely successful one. I called it a bluff, among other things, because it seemed clear to me that the “more-of-the-same” conditionality attached to OMT could only push the euro area ever deeper into the mess rather than rescue anyone, and even with more accommodative monetary policy. I turned out to be partly right and partly wrong. Certainly the state of the euro area economy today, despite years of freeloading on global growth, remains extremely fragile. But, entranced by Mr. Draghi’s promise, the markets have stayed calm all along and played along watching the euro area sink into outright deflation. So does OMT still matter today then?

First of all, and contrary to the widespread view that the ECJ won’t ever do anything that could threaten the euro or ECB, it is perfectly conceivable that the Advocate General’s opinion will be critical of certain aspects of the OMT. After all, the GCC’s reasoning followed closely an earlier ECJ ruling on a related matter, namely on the ESM (the Pringle case). In that case, the ECJ went out of its way to declare the ESM purely a matter of economic but not monetary policy. Now the issue is the opposite: is OMT purely a matter of monetary but not economic policy? The ECJ will want to make sure not to contradict itself. And that won’t be as easy as just saying that OMT is brilliant and flawless.

At this point, the OMT verdict is mostly relevant because the ECJ ruling might imply constraints for the ECB’s design of any “quantitative easing” (QE) strategy, the option of purchasing government bonds in particular. For sure, QE is not OMT. The ECB intends to buy the debts of all member states rather than of a few. As usual, there will be minimum quality standards (credit rating) of what the ECB is willing to buy, which may be an issue in the case of Greece. But there will be no explicit conditionality of the kind featured in the OMT. And with EONIA at zero (or even slightly negative) and the euro area as a whole officially in a state of deflation today, there is no longer any difficulty justifying QE as nothing else but a monetary policy measure designed to meet the ECB’s price stability mandate (on which it currently fails conspicuously). With QE now conventionally accepted as the unconventional monetary policy tool of last resort, the monetary financing issue can also be put to rest more easily. It is noteworthy that the ECB stopped sterilizing its purchases under the SMP in the summer of last year, even before officially embarking on QE …