Some Quick Takeaways from the ECJ Opinion of Advocate General Cruz Villalón on the ECB’s OMT

The Advocate General (AG) has spoken on the ECB’s OMT program today. Apparently the markets were more concerned about the latest U.S. retail sales numbers than delighted about the “okay in principle provided that” signal sent from Luxembourg to the German triangle of euro power (Frankfurt, Berlin, and Karlsruhe).

First of all, in the AG’s view, OMT constitutes monetary policy but not economic policy. That was one of the critical issues. The German Constitutional Court (GCC) had preliminarily concluded that the ECB may be stepping outside the monetary policy domain, for which it enjoys exclusive competence. In its previous judgment on the Pringle case the ECJ found that the ESM constitutes economic policy, which remains primarily a national responsibility in Europe’s Economic and Monetary Union, and does not encroach on the ECB’s territory. On OMT the opposite verdict was reached, based on the following evaluation:

“in order for a measure of the ECB actually to form part of monetary policy, it must specifically serve the primary objective of maintaining price stability and it must also take the form of one of the monetary policy instruments expressly provided for in the Treaties and not be contrary to the requirement for fiscal discipline and the principle that there is no shared financial liability. If there are isolated economic-policy aspects to the measure at issue, the latter will be compatible with the ECB’s mandate only as long as it serves to ‘support’ economic policy measures and is subordinate to the ECB’s overriding objective” (AG 2015, No. 132).

In other words, the AG sides with the ECB’s argument that OMT is about “unblocking” the monetary transmission mechanism, and hence monetary policy, rather than a measure designed to facilitate the funding of certain member states, which would make it economic policy instead. OMT is judged to be an unconventional monetary policy instrument designed to meet the exceptional challenges of the day.

“Despite the efforts of the European Union (‘the Union’) and the Member States, the risk premia for bonds of various euro-area States rose sharply in the summer of 2012. In the face of investors’ doubts about the survival of monetary union, the representatives of the Union and of the States of the euro area repeatedly stressed that the single currency was irreversible. It was at that time that the President of the ECB, in words that were subsequently repeated over and over again, stated that he would, within his mandate, do whatever it took to preserve the euro” (AG 2015, No. 20).

While the objective of “preserving the euro” would seem to go well beyond the supposedly narrow monetary mandate of maintaining price stability, the ECB, in a way, merely promised to back up with money what the political leaders had declared to be their ultimate economic policy objective: the irreversibility of the common currency. This would seem to also make it an incident of ECB “support” of the union’s general economic policy: supportive words on words of support. A less generous observer might be tempted to say that failure on the part of the political authorities to establish sound institutions and policies that would foster area-wide prosperity and the sustainability of the common currency gets temporarily plastered over by the threat of meeting speculative attacks by throwing central bank money at it.

The AG has interesting things to say on market speculation. The GCC, largely relying on the expertise of the Bundesbank, pushed a market fundamentalist line on the matter: whatever risk spreads may be, they reflect nothing but market fundamentals. Hence, the central bank should not mess with them as that would undermine market discipline, distort prices, provoke moral hazard, etc. The AG takes a candidly different view, on numerous occasions referring to market speculation as undermining economies and preventing fundamentals from asserting themselves. In such instances the ECB is justified to step in and correct destabilizing excesses and price distortions. The AG dodges the issue of how to determine “correct” market prices. The ECB should simply use its discretion. The AG goes out of its way to defend the ECB’s independence (i.e., unchecked discretion), suggesting that no court should challenge its expertise or question its intentions:

“The ECB must accordingly be afforded a broad discretion for the purpose of framing and implementing the Union’s monetary policy. The Courts, when reviewing the ECB’s activity, must therefore avoid the risk of supplanting the Bank, by venturing into a highly technical terrain in which it is necessary to have an expertise and experience which, according to the Treaties, devolves solely upon the ECB. Therefore, the intensity of judicial review of the ECB’s activity, its mandatory nature aside, must be characterised by a considerable degree of caution” (AG 2015, No. 111).

It was of course always something of a curiosity that Germany, the world champion of central bank independence, should see its constitutional court challenge the ECB’s independent judgment, and with the Bundesbank, the ECB’s blueprint, as its “chief advisor” by its side. So much for the realities of today’s intra-European power politics.

Be that as it may, the AG identifies one important condition that would see the ECB cross the line into the economic policy domain, namely when acting as part of the troika. The ECB can continue doing anything it does right now, but once OMT gets activated it cannot be involved on the troika side of the program country as well, as such a “dual role” would bring it into conflict with the treaties. Interestingly, this call was not made based on criticisms put forward by the usual suspects (Germany’s monetary orthodoxy), but by Die Linke.

This part of the AG’s opinion may have important implications for the future of the troika. But it does not seem to provide any serious obstacles regarding the ECB’s widely expected QE initiative.

That still leaves the other key issue though, the monetary financing prohibition, and whether ECB purchases of government bonds might be in conflict with said prohibition. Of course the whole monetary financing discussion is one big muddle, and unsurprisingly the AG doesn’t cut through the Gordian knot either. But it clarifies at least a couple of points. The key message seems to be that the ECB’s interventions in the secondary market must not be linked in any known and obvious way with developments in the primary market. The ECB must be careful about the timing of its interventions and aim at disrupting the normal functioning of the market as little as possible.

Of course price formation in the primary market (the flow of new issuance) and the secondary market (trading of the outstanding stock) is inevitably linked. With regard to OMT, it means that the ECB must not let the timing of its interventions be known and keep the markets guessing as to what the actual pain threshold for its interventions may be. The key thing is that once the markets know that there is a pain threshold somewhere that will trigger ECB intervention in the secondary market, risk spreads will not easily explode anymore and funding dry up in the primary market. The lender of last resort in the background must apply a little constructive ambiguity, the late Tomaso Padoa-Schioppa might say.

In the case of QE, matters are different of course because it would be the ECB playing the active part in pushing down yields in general (rather than containing particular risk spreads). The AG cleared the pari passu clause and also clarified that taking on risk as such does not constitute monetary financing. The important issue is whether there is uncertainty about outcomes at the time the ECB enters any particular transaction. If the ECB knowingly entered into some transaction in government debt (or on behalf of the government) on which it expects to make a loss, that would amount to monetary financing. But if it enters a risky trade in ignorance and good faith, though based on sound assessment — and the AG emphasizes that all monetary policy transactions carry some risk — which later on turns out to involve a loss, this would not constitute any obvious case of monetary financing. So how does the ECB make sure that it gets properly remunerated by means of risk spreads for the risks it is taking on? Supposedly this is for the independent ECB and not any court to judge.

In any case, the ECB will want to design its QE in ways that avoids explicit losses or transfers, especially cross-border ones, so as to preempt any future challenges on the matter as far as possible. For future challenges will surely arise. A closing note of caution: Cruz Villalón’s opinion is not the ECJ’s final ruling on the matter, nor are the GCC and the Bundesbank likely to quietly throw in the towel as yet. And Germany’s two most revered public institutions will continue to shape German public opinion and thereby constrain the government’s leeway in important ways.