Opinion

The ECB’s bridge too far

The line between audacity and hubris is a fine one. Rather than constituting a great success, OMT may well be remembered as an error born of expediency. Worse, it could undermine the ECB’s hard-won independence and credibility. That is an outcome that the eurozone might not survive.

By: Date: February 13, 2014 Topic: Macroeconomic policy

This article was published by Project Syndicate.

The German Constitutional Court’s recent decision to refer the complaint against the European Central Bank’s so-called “outright monetary transactions” to the European Court of Justice (ECJ) leaves the scheme’s fate uncertain. What is clear is that the economics behind OMT is flawed – and so is the politics.

The OMT program arose in August 2012, when months of relentlessly rising risk premiums on Spanish and Italian sovereign bonds were threatening the eurozone’s survival and endangering the world economy. To restore confidence and buy time for governments to reduce borrowing, ECB President Mario Draghi pledged to do “whatever it takes” to preserve the eurozone – and that meant potentially unlimited purchases of distressed eurozone members’ government bonds.

Draghi’s declaration worked, prompting a sharp decline in risk premiums across the eurozone’s troubled economies. But Bundesbank President Jens Weidmann, a member of the ECB’s Governing Council, immediately challenged OMT, asserting that the program exceeded the ECB’s mandate and violated Article 123 of the Lisbon Treaty, which bars monetary financing of distressed sovereigns. Before OMT was ever activated, Weidmann took his case to the German Constitutional Court.

OMT supporters were aghast at Weidmann’s attempt to overturn the arrangement. After all, the mere announcement of the program had provided relief to struggling governments and may well have saved the monetary union, at least temporarily. Draghi audaciously described OMT as “probably the most successful monetary-policy measure undertaken in recent time.”

But the German Constitutional Court remains dubious. While it has withheld a final judgment in deference to the ECJ, it has upheld the Bundesbank’s view that OMT, in its current form, violates the Lisbon Treaty. OMT may still survive; but, if it does, it will likely be diluted, allowing the problems that inspired it to reemerge.

However problematic this might be for OMT’s supporters, it should not have come as a surprise. The program was ill-conceived and sold by sleight of hand. The court was right to question the factual basis of the ECB’s claim that the risk premiums reflected an unfounded market fear – a claim that was based on cherry-picked evidence. Indeed, the program’s public defense rests shakily on a presumption of baseless speculative pressures.

The program’s design, however, conceded that the market’s assessments of creditworthiness reflected a real default risk. As a lender of last resort to sovereigns, a central bank must stand ready to purchase sovereign debt unconditionally, in order to neutralize the effects of temporary market disruptions. But OMT is intended to operate more like the International Monetary Fund’s lending – that is, to rescue a particular government conditional on its pursuit of fiscal belt-tightening. If the ECB were truly convinced that risk premiums were unreasonably high, and that distressed countries’ debt was sustainable, conditionality would have been unnecessary.

Moreover, by tackling default risk, the OMT program created a new problem: private creditors, assured that the ECB would prevent governments from defaulting, were encouraged to lend with greater abandon. Reading the decline in risk premiums as a sign of renewed market confidence in distressed sovereigns’ creditworthiness was another self-serving misinterpretation.

A similar situation has unfolded before. In the pre-euro era, propping up the Italian lira invited unrelenting speculative pressure. With the lira eliminated, holding down yields on sovereign debt can be a fool’s errand.

Just as untenably high exchange rates must ultimately depreciate, default is necessary in cases of unsustainable sovereign debt. This is all the more important in view of the ECB’s disinclination to reverse near-deflationary conditions, which raise the effective debt-repayment burden further.

Sovereign-debt attorneys Lee Buchheit and Mitu Gulati warn that markets could “mercilessly test the ECB’s willingness to persist in buying unlimited quantities of peripheral sovereign bonds.” This test will be all the more severe if, as the ECB has conceded to the German Constitutional Court, the bond purchases would actually be limited.

The eurozone must allow for selective default on sovereign debt, with the ECB acting as a lender of last resort for solvent governments. Of course, solvency can be difficult to assess during a crisis. But pretending that sovereigns are never insolvent serves only to compound the problem. As the German court pointed out, the prospect of default will help to maintain financial-market discipline.

By attempting to create a quick fix for the eurozone’s deep-rooted problems, the ECB has stepped into a political quagmire. Even if the ECJ gives OMT the benefit of the doubt, the program’s legitimacy will remain plagued by qualms, leaving the ECB – if only behind the scenes – locked in political jockeying with distressed sovereigns.

The line between audacity and hubris is a fine one. Rather than constituting a great success, OMT may well be remembered as an error born of expediency. Worse, it could undermine the ECB’s hard-won independence and credibility. That is an outcome that the eurozone might not survive.


Republishing and referencing

Bruegel considers itself a public good and takes no institutional standpoint.

Due to copyright agreements we ask that you kindly email request to republish opinions that have appeared in print to [email protected].

Read article More by this author
 

Podcast

Podcast

A decade of economic policy

Guntram Wolff looks back at the past decade of Bruegel contribution to economic policy in Europe.

By: The Sound of Economics Topic: Banking and capital markets, Digital economy and innovation, European governance, Global economy and trade, Green economy, Inclusive growth, Macroeconomic policy Date: June 30, 2022
Read about event More on this topic
 

Upcoming Event

Jul
5
12:30

Green public investment after COVID-19

How can the public sector meet the climate funding needs of the EU?

Speakers: Zsolt Darvas, Elena Flores, Louise Skouby and Laurent Zylberberg Topic: Macroeconomic policy Location: Bruegel, Rue de la Charité 33, 1210 Brussels
Read about event
 

Upcoming Event

Jul
6
12:30

Shifting taxes in order to achieve green goals

How could shifting the tax burden from labour to pollution and resources help the EU reach its climate goals?

Speakers: Heather Grabbe, Femke Groothuis, Carola Maggiulli, Niclas Poitiers and Kinga Tchorzewska Topic: Green economy, Macroeconomic policy Location: Bruegel, Rue de la Charité 33, 1210 Brussels
Read about event More on this topic
 

Past Event

Past Event

Autonomous, digital and green Europe: a conversation with Margrethe Vestager

At this event Margrethe Vestager will touch on strategic autonomy, digital regulation and the implications of the Green Deal on competition.

Speakers: Guntram B. Wolff and Margrethe Vestager Topic: Macroeconomic policy Location: Bruegel, Rue de la Charité 33, 1210 Brussels Date: June 29, 2022
Read article More on this topic More by this author
 

Blog Post

The implications for public debt of high inflation and monetary tightening

Expected increases in interest rates and reductions in real GDP growth rates will result in relatively small increases in public debt-to-GDP ratios, but inflation will reduce debt ratios very substantially

By: Zsolt Darvas Topic: Macroeconomic policy Date: June 29, 2022
Read article More by this author
 

Blog Post

European governance

Discretion lets Croatia in but leaves Bulgaria out of the euro area in 2023

Crucial decisions about whether a country can join the euro area depend on questionable discretionary decisions.

By: Zsolt Darvas Topic: European governance, Macroeconomic policy Date: June 22, 2022
Read article Download PDF More on this topic
 

Working Paper

Measuring macroeconomic uncertainty during the euro’s lifetime’

The basic idea is that observable forecasts of macroeconomic variables are transformations of the sets of macroeconomic information, which are so complex as to be unobservable, prevailing when the forecasts are made.

By: Monika Grzegorczyk and Francesco Papadia Topic: Macroeconomic policy Date: June 20, 2022
Read article More by this author
 

Podcast

Podcast

Growth for good?

Can economic growth be a force for good and help in the fight against climate change?

By: The Sound of Economics Topic: Green economy, Macroeconomic policy Date: June 15, 2022
Read article Download PDF
 

Working Paper

Raising EU productivity through innovation: Lessons from improved micro data

Combining recent unique firm-level data and state-of-the art research methodologies, MICROPROD research provides a better overview of which firms are most likely to adopt digital technologies and to innovate, and to turn these investments into productivity growth.

By: Reinhilde Veugelers and Frederic Warzynski Topic: Digital economy and innovation, Macroeconomic policy Date: June 13, 2022
Read about event
 

Upcoming Event

Sep
6-7
09:00

Bruegel Annual Meetings 2022

The Annual Meetings are Bruegel's flagship event which gathers high-level speakers to discuss the economic topics that affect Europe and the world.

Topic: Banking and capital markets, Digital economy and innovation, European governance, Global economy and trade, Green economy, Inclusive growth, Macroeconomic policy Location: Palais des Academies, Rue Ducale 1
Read article Download PDF More on this topic More by this author
 

Working Paper

Technology, trade, work councils and income distribution: new insights from MICROPROD

Using various micro datasets, Work Package 5 of the MICROPROD project made significant contributions to our understanding of the distributive implications of trade and technological change.

By: Zsolt Darvas Topic: Macroeconomic policy Date: May 31, 2022
Read about event More on this topic
 

Past Event

Past Event

MICROPROD Final Event

Improving understanding of productivity, its drivers and the way we measure it.

Speakers: Carlo Altomonte, Eric Bartelsman, Marta Bisztray, Peter Bøegh Nielsen, Italo Colantone, Maria Demertzis, Wolfhard Kaus, Javier Miranda, Steffen Müller, Hannu Piekkola, Verena Plümpe, Niclas Poitiers, Andrea Roventini, Gianluca Santoni, Valerie Smeets, Nicola Viegi and Markus Zimmermann Topic: Macroeconomic policy Location: Bruegel, Rue de la Charité 33, 1210 Brussels Date: May 31, 2022
Load more posts