Despite having a positive effect on the economic situation within the Eurozone, the European Central Bank’s Outright Monetary Transactions (OMT) program has proved controversial, with the German Constitutional Court in Karlsruhe recently deeming it illegal under EU law. Paul De Grauwe argues that the ruling reflects a serious misunderstanding of central banking on the part of the German Court, and that the European Court of Justice should reject its conclusions. Failure to do so would undermine the effectiveness of the OMT program and risk reigniting the Eurozone crisis.
Two weeks ago the German judges of the Constitutional Court in Karlsruhe came to a preliminary conclusion: 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 of its effectiveness and make it totally useless. This would create the risk of repeated crises in the government bond markets of the Eurozone.
The main argument used by the German judges, which was very much influenced by the Bundesbank advice on OMT, can be summarized 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 recapitalize 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 perfectly with negative equity. As long as the central bank keeps its promise of price stability any amount of equity, positive or negative, is fine.
Let’s return to the OMT program and let us develop an example. I will show that at no time during and after the implementation of the program taxpayers’ money of member countries is at stake.
Suppose the ECB buys €1 billion of Italian government bonds with a coupon of 4 per cent. These are government bonds bought 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 every year €40 million to the ECB. (Note that before the ECB purchase the same Italian treasury was paying the same €40 million 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 €40 million of 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 largest 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 mature.
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 by €1 billion. A recapitalization of the ECB appears to be necessary. 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 reasons of reputation the member states decide to recapitalize 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 recapitalize the ECB to make up for the loss of €1 billion, they transfer bonds to the ECB worth 1 billion, allowing the ECB to increase its equity by €1billion. These transfers occur using the same capital shares. Thus the ECB holds government bonds worth €1 billion. As a result, each government pays interest to the ECB in the same proportion to its capital share. But at the end of the year the ECB transfers these interest revenues back to the same governments using the same capital shares.*
It will be clear that a recapitalization of the ECB would be a pure bookkeeping operation. It would not require Eurozone citizens 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 recapitalization 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.
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. During such moments the greater risk is deflation, not inflation.
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.
One can conclude that an important argument used by the judges of Karlsruhe to declare the OMT illegal testifies to an appalling lack of understanding of the basics of central banking. The OMT program does not create a risk that Eurozone citizens will have to pay taxes arising from losses of the ECB. It is quite terrifying that such an important judgment that could destroy the ECB’s necessary responsibility of lender of last resort is based on ignorance. One can only hope that the judges of Luxembourg will not show the same degree of ignorance.
*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”.
The author is grateful to Carsten Gerner-Beuerle and Edmund Schuster for comments and suggestions
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Note: This article gives the views of the author, and not the position of EUROPP – European Politics and Policy, nor of the London School of Economics.
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Paul De Grauwe – LSE European Institute
Professor Paul De Grauwe is the John Paulson Chair in European Political Economy at the LSE’s European Institute. Prior to joining LSE, he was Professor of International Economics at the University of Leuven, Belgium. He was a member of the Belgian parliament from 1991 to 2003. His research interests are international monetary relations, monetary integration, theory and empirical analysis of the foreign-exchange markets, and open-economy macroeconomics. His published books include The Economics of Monetary Union (OUP, 2010), and (with Marianna Grimaldi), The Exchange Rate in a Behavioural Finance Framework (Princeton University Press, 2006).
Prof De Grawe, your comment implies that not only German Constitutional judges but also senior staff at the Bundesbank and their economic advisors (including some respectable senior German economists), many market commentators and practitioners as well as scholars at important EU Think Tanks are all ignorant about the basics of simple monetary economics that you outlined in your article above.
However, it seems to me that you have either not read the pronouncement of teh German Court or you have not understood the ruling. The key profile of illegality in the Court’s ruling is not just the risk of fiscal transfer (which undoubtly exist if any of the countries whose debt is purchased by the ECB under the programme defaults as the ECB capital, conferred pro-quota by existing member states, would be reduced accordingly whether new capital should or should not be raised) but is the usurpation of the responsibility of economic policy for which the ECB is not in charge as this power needs to be excercised according to the principles of representation and of distribution of powers. Also, there’s the issue of monetary financing. This has been a critical aspect of the debate on the OMT since it was announced as it was for the SMP. The fact is that by targeting individual issuers and restricting the maturty range to up to 3 years, the ECB is effectively ensuring that trouble countries are able to refinance in the primary market as long as investors will continue to have the option of hitting the ECB bid in the secondary market in case of need. This leads to a number of consequences: intereference with economic and budgetary discipline of which other EU institutions are in charge (including the administration of assistance measures), distorsions in the capital allocation process (risk premia would be altered and would not adequately reflect the actual credit risks entailed by the issuers and its differentiation across issuers) and material risks of an indirect monetary financing by the ECB (which could even risk of becoming a direct monetaization and therefore illegal should the amount of tradable debt in the bucket where the OMT drops massively leaving the issuer as the only supplier of bonds in this segment of the curve with the ECB on the buying side).
Also, it surprises me that your arguments are so naive, obvious and yet misleading. The point is not whether an activation of the OMT imposes additional costs to the target member states’ taxpayers (incidentally, it does if you look at what has been the cost of the “aid plans” for the Greek taxpayers and whcih financial consequences a default on its offical loans would imply), but which would be the cost of such a programme to all other member states in case of default and whether the decision of bearing it is taken by democratic institutions or by unelected bureauctrats at the Eurotower.
Finally I’m surprised of your statement that the ECB could operate even with negative equity. This could be true in theory but clearly doe not seem to be practicable given that the ECB has progressively raised its capital in the past in order to meet the increase in its risk exposure that as the ECB balance sheet expanded and to sustain the adequacy of its capital base to support its operations.
Perhaps there is a not so hidden agenda: Subsume the Eurozone national reserves into the ECB in due course.Prof. de Grauwe may not be so naive as he is cabbage-looking.
Would not wiping out capital of the CB leave the currency exposed to the forex market attacks?
It is a measure of the state we are in that the EU operators have gone this far to defraud those who will be picking up the tab eventually for these ongoing pea and thimble trickeries,.. and a measure of the indifference on the part of those whose political and economic interests are undermined that there is so little outcry against this jiggery-pokery.It puts the so-called European Court of Justice on the spot.However,many Germans (and others in the EU ) may not recognise the authority of the European Court of Justice anyway.
If central banks could always stay solvent just by printing money AND there would be no other consequences, then governments could dispense with taxing citizens and just borrow. Unfortunately, Frederic Bastiat told us centuries ago to look for “The Seen and the Unseen”. Buy gold; the EU is about to go over the cliff, and someday the rise in the price of gold will tell the tale.
Very clever article, I have to say.
The author attacks the judges on their own ground. Legally, inflation is not a tax. In economics, the field the author claims to affiliate himself with, the answer is less clear. Given his views on issues concerning left vs right expressed elsewhere, and given the usual distributive consequences of inflation, I am surprised how the author tends to argue implicitly in favour of an inflation tax. But it comes very handy to ignore economics when you are arguing with lawyers about central banking.
The article is clever for another reason. It presents the potential benefits of a policy as deterministic and the costs only as a “risk” of a “potential” inflation. It may sound like a free lunch to most people. Hey, Paul, why don’t we buy all government debt of all countries like this? Just wipe it out, have a fresh start for the union, with the omnipotent Commission as the guardian against moral hazard. There are these huge certain gains and only a “risk” of “potential” inflation after all.
I am amazed how a reputable LSE professor could publish a paper including such elementary mistakes. Upfront, if Prof. de Grauwe’s point was to show that a Central Bank like the ECB can function even with a negative equity, he has made that point sufficiently clear. I suspect, though, that most everyone involved with finances knows that.
To suggest that interest received by the ECB flows through to national Central Banks is baffling. The ECB has its own P+L statement. Its pay-out to owners comes out of net profit; not out of gross revenue! If there is no profit (for instance because it had to write down bonds), there are no pay-out’s. Check back with Switzerland’s Central Bank which could not make a pay-out for 2013 because it had taken losses on its gold holdings. As long as the ECB has a negative net worth, it cannot pay out dividends.
Prof. de Grauwe seems to overlook that, contrary to the ECB, the national Central Banks, owners of the ECB, CANNOT operate with a negative equity (because they cannot print Euros). Should national Central Banks be required to recapitalize the ECB, that may well require recaps on their own and that, dear Professor, is indeed tax payers money.
Theoretically it is true that the ECB could, in fact, buy ALL Eurozone sovereign bonds out there, I take it 8-10 trillion Euros, and simulatenously forgive all issuers the debt. All that would mean is that the ECB would run a 8-10 trillon Euro negative net worth but that would not hamper its operations. In fact, it could do that until doomsday. That’s the theory. Anyone suggesting that the practice would unfold the same way should take a walk outside the ivory tower.
If Prof. Grauwe feels that the GCC lacks understanding how central banking works, he should take note that courts are not required to understand central banking. Courts are required to understand things like statutes of the ECB, EU law and, in this case, German law. If its statutes do not allow the ECB to fully act like a Central Bank should, then the founders of those statutes did not sufficiently understand central banking. Then those statutes should be changed.
Paul De Grauwe cites the German Constitutional Court’s decision as follows:
“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 recapitalize the ECB.”
And he maintains that this is the Court’s “main argument”.
This representation of the Court’s argument is erroneous. In fact, while concerned about the potential write-off losses on government bonds if held until maturity, the Court did not go into the details of how, and through which mechanisms, the losses would be transferred into the budgets of member states. Its reasoning is legal, rather than economic. At no stage does the Court argue that the ECB needs to be recapitalized to compensate for the losses.
The economic argument, on the other hand, is trivial. If the ECB has to book write-off losses because a state goes bankrupt, an eternal stream of interest stops flowing to the finance ministries of the Eurozone whose present value is equal to the write-off losses. Given the planned monetary policy stance, or to be more precise, given the time path of the monetary base, the ECB cannot recoup the interest losses by giving more refinancing credit to the banks or buying new bonds, since this would inflate the monetary base. This argument is independent of whether or not the ECB needs to be recapitalized or could even operate with negative equity capital.
The Eurosystem’s true economic equity capital is the sum of the accounting equity capital and the present value of seignorage, the latter being the monetary base if calculated under static conditions. By the end of 2013, the accounting equity was € 353 billion, and the present value of seignorage under static conditions was € 1.262 trillion, giving a sum of € 1.615 trillion. Under dynamic conditions the sum would even be larger, perhaps more than € 3 trillion. The Eurosystem’s true economic equity capital is the present value of the interest income of the Eurosystem to which national treasuries are entitled. Write-off losses would reduce this present value one-to-one and would have to be made good by the taxpayers or through cuts to the income of the recipients of government transfers.
I am in need of tutoring.
Why do you say that national treasuries are entitled to interest income of the Eurosystem? Which interest income flows directly to national treasuries?
I am certainly prepared to completely ‘unlearn’ but what I have learned in my banking career is that interest income flows to the ECB and/or national central banks which hold the interest-earning asset. If, at the end of the year, the ECB has more revenues than expenses, it can distribute profits to its owners, the national central banks. If, in a second step, the national central banks have more revenues than earnings, they can distribute profits to national treasuries. Where am I wrong?
I would appreciate a clarification. Thank you.
Dear Mr. Kastner,
What you write is correct, and it is what I meant. The interest revenue from lending out self-made money, of course net of expenses, must be distributed to national treasuries via the national central banks.
Thank you for the clarification. I think it would be quite useful if economists wrote more about how central banks operate (i. e. prepare their financial statements) and how different central banks operate differently. The ECB strikes me like a classic central bank because it cannot become illiquid (it can create Euros on its own) and it cannot become insolvent (its statutes do not require a minimum capital nor do they require equity replenishment. Thus, the ECB could function quite properly even with a negative net worth). The national central banks, so I am told, operate quite differently in as much as they cannot create Euros on their own (thus, they could technically become illiquid) and several of them, so I am told, are not allowed to operate with negative equity (thus, they could become insolvent).
The Schweizer Nationalbank (SNB) is structured differently. While it cannot become illiquid in CHF, it can become insolvent because its statutes require it to prepare its financial statements “according to the regulations applying to public corporations”. Thus, and technically speaking, the SNB would have to file for bankruptcy if its net worth became negative. This seems to be quite a risk when considering that the SNB has about 90% of its assets (about 40 times its equity) in foreign currency subject to potential devaluation. Let those currencies devalue by 20% and the SNB’s equity is wiped out. Its owners are 60% Kantons and their banks and 40% private parties. They are unlikely to have sufficient reserves to replenish equity.
Until my retirement after 40 years in banking, I thought that central banks operated in the same fashion (i. e. prepared their financial statements in the same way) as normal banks. Thanks to the Euro-crisis, I now understand a bit better how central banks work, but I am still learning. My sense is that many, many people do not really know how central banks work and the more education on the matter, the better for all.
Hans-Werner Sinn has some more explaining to do.If a state (Whose bonds the ECB holds) goes bankrupt,the eternal stream of interest stops,not to the Eurozone national treasuries,but to the ECB which bought the bonds with money created from seignorage.This,if we assume that the bonds bought by the ECB run forever and that the interest payable on these bonds is positive,not negative.If the interest on the bonds were negative,the ECB would be paying,not collecting,interest.This concept is not as strange as it sounds.The Eurozone governments in need of support from the ECB’s OMT program could sell bonds to the ECB on an indefinite term,rather than three or five years and be supported by negative interest until such time as support is become superfluous,in which case the country in question can start buying these indefinitely termed bonds back.
As it stands,however,the need for OMT support from the ECB derives from the fact that these countries such as need this support are technically insolvent.This kind of support been instituted to prevent these countries defaulting,no more no less.
Legally,this is a questionable practice.To interfere in the bond market in this manner has repercussions beyond those of moral hazard.The ECB knowingly extends financial support to a country whose bonds in the market are threatening to become worthless due the technical insolvency of the country in question.Hence,the ECB is interfering in the market beyond its brief and trading with a country which it knows is technically insolvent,insolvent but for the fact of ECB’s OMT support.
The interests paid to the ECB on these bonds,moreover,are paid by the ECB itself,rather than the technically insolvent country which sold the bonds to the ECB.This cannot be reckoned a legal construct,but maybe Hans-Werner Sinn can explain.As it stands,if the ECB decides not to buy more bonds next year,and on into the future,the country which is in this fix cannot but fail to pay the interest,as it is positive interest,we recall.This would constitute a loss to the ECB,not the Eurozone national treasuries.
The ECB cannot recoup these losses by giving more refinancing credit to the banks or buying more bonds,” unless it were to inflate the monetary base”.
At any rate,the ECB’s seignorage,in sofar as it is exercised,inflates the monetary base as such,as it is the creation of money supply sui generis.However:
Maybe Mr Sinn,or even Paul De Grauwe,could enlighten us regarding this economically trivial matter.
“As it stands,however,the need for OMT support from the ECB derives from the fact that these countries such as need this support are technically insolvent.This kind of support been instituted to prevent these countries defaulting,no more no less… Hence,the ECB is interfering in the market beyond its brief and trading with a country which it knows is technically insolvent,insolvent but for the fact of ECB’s OMT support.”
I don’t mean to be rude, but are you familiar with what a lender of last resort actually is? The entire purpose of having a lender of last resort is that it intervenes when there is no other route to meet a demand for liquidity. In every case where a lender of last resort fulfills this role the financial institution/market would be “insolvent but for the fact of support”. That’s the whole point.
The question is whether it is right for the ECB to effectively use OMT as a means to act as a lender of last resort given this is not specifically in its mandate. It’s a legitimate debate with arguments on both sides, but what you’ve written here is essentially criticising the principle of having a lender of last resort itself.
Also let’s be clear that countries like Italy and Spain were *not* insolvent prior to the announcement of OMT. What we had was a situation in which, largely due to the lack of a credible lender of last resort, there was speculation in the bond markets in these countries. No country can remain solvent long-term if the cost of lending spirals out of control in this way: it doesn’t matter how healthy their economy actually is in reality. We’re not discussing a rule change to help bail out failed states by the back door, we’re talking about a failed institutional structure in the Eurozone that almost brought down otherwise serviceable economies. That’s a completely different thing from what you’ve described above.
Yes,I do know what a lender of last resort is.My knowledge of the EU and the Euro derives from mainstream newspapers and magazines.I must admit that right from the start I was dead set against the Euro.I thought it would lead to corruption of economic principles.At the time of the introduction of the Euro I was still in favour of the EU.Since the GFC and revelations about Goldman Sachs and various financial dodgy bookkeeping,especially Greece,I have come round to the final conclusion that the EU is beyond correction,that it is utterly unaccountable and destructive of democracy and civil rights.It has become all thesis and no nomos,in the words of Hayek,as far as lawmaking is concerned-not that I support Hayek.
Now,as for the OMTs,the ins and outs have been done over in the press as well as in earlier comments here.In my view,this is entirely a political matter.It makes economic nonsense de rigueur,normative.If you want to argue that in this case the OMTs and a strategy of last resort rather than a financial fraud of stupendous proportion and a political tool to drive the EU into a dictatorial federated entity I fully disagree.
The economics in the nations in need of support in the bond market due to high interest rates need fixing badly.The OMTs are not a fix,they are like throwing money into a bottomless pit.Seignorage is not to be used for that purpose.Frankly,I think it shameless that the ECB has seignorage,but that is another matter.
So,I will argue till the cows come home that this is not a matter of lending as a last resort at all.Besides,the response to the GFC by European governments and the EU commissars,or whoever was/is really in charge,made it quite clear that there is a rout going on of unprecedented scale and effect.I cannot for the life of me see how one can isolate the this OMT strategy by the ECB from the rest of the EU dictatorship’s shenanigans.This is a political project steamrollered over the people of sovereign democratic nation-states.However,I open to discussion.May I quote some authors who have more expertise in these things?Bernard Connolly,say.I can make a list if you are interested.