The OMT Goes to Court

Imagine a scheme that would transfer money from Spain, Greece, and Italy to Germany. According to Paul De Grauwe and Yuemei Ji, this is precisely what the European Central Bank's Outright Monetary Transactions (OMT) program has the potential to do. Yet 35,000 Germans have filed complaint against the scheme.

The Federal Constitutional Court of Germany is undergoing deliberations on the legality of the European Central Bank's OMT program. The program was announced last August, when the ECB announced that it would be willing, in certain scenarios, to buy government bonds without limit. Even though the ECB has not yet purchased government bonds under this scheme, the announcement alone reduced problematically-high bond yields in Italy and Spain, leading Mario Draghi to declare the program a big success.

Andreas Vosskuhle, president of Germany's Federal Constitutional Court, however, said Tuesday that the court will not take the success of the OMT into account when deliberating its legality or constitutionality. Andreas Wiedemann has written an excellent summary of the hearings on June 11 and 12. The court is expected to make a ruling some time after the German elections on September 22.  Mark Thoma links to a note by Helmut Siekmann and Volcker Wieland on the legal issues of the case. They begin by explaining several types of criticism of the OMT.

The first criticism is that "the ECB has ventured too far into the terrain of fiscal policy by announcing such potentially unlimited government bond purchases. The announcement itself is likely to cause delays in the implementation of necessary fiscal and structural adjustments by national governments, because it has reduced market pressures via government financing conditions." Moreover, the "strict and effective conditionality" prerequisites for OMT measures "can also be interpreted to indicate that the envisaged measures fall outside the area of monetary policy as these conditions serve to achieve other economic and fiscal objectives." An additional point of contention is that "critics fear that the independence of the ECSB and of the members of their decisionmaking bodies is jeopardized by the large-scale transfer of credit risks from the private and public sector to the ECSB."

In "Fiscal implications of the ECB’s bond-buying programme," De Grauwe and Ji argue that the fears that German taxpayers may have to cover losses made by the ECB are misplaced--based on a misunderstanding of solvency issues facing central banks. They say, in fact, that German taxpayers are the main beneficiaries of such a bond-buying program. They begin by explaining that a private company is said to be solvent when its losses do not exceed the value of its equity, which is the expected present value of future profits, but the same is not true for a central bank.

"A central bank can issue any amount of money that will allow it to 'repay its creditors', i.e. the money holders... Contrary to private companies, the liabilities of the central bank do not constitute a claim on the assets of the central bank. The latter was the case during gold standard when the central bank promised to convert its liabilities into gold at a fixed price. Similarly in a fixed exchange-rate system, the central banks promise to convert their liabilities into foreign exchange at a fixed price. 

The ECB and other modern central banks that are on a floating exchange-rate system make no such promise. As a result, the value of the central bank’s assets has no bearing for its solvency. The only promise made by the central bank in a floating exchange-rate regime is that the money will be convertible into a basket of goods and services at a (more or less) fixed price. In other words the central bank makes a promise of price stability. That’s all. 

Thus it makes no sense to state that the limit to the losses a central bank can make at any point in time is given by the present value of future profits (seigniorage). There is no such limit. The central bank can make any loss provided the loss does not endanger its promise to maintain price stability."

De Grauwe and Ji discuss the situation of a central bank with one sovereign, then discuss a central bank in a monetary union with many sovereigns. Consider the central bank of a stand-alone country buying government bonds in the secondary market:

"Government debt that carries an interest rate and a default risk becomes debt that is a monetary liability of the central bank (money base) that is default-free but subject to inflation-risk. To understand the fiscal implications of this transformation, it is important to consolidate the central bank and the government (after all they are separate branches of the public sector).
After the transformation the government debt held by the central bank cancels out. It is an asset of one branch (the central bank) and a liability of another branch (the government). As a result, it disappears. The central bank may still keep it on its books, but it has no economic value anymore. In fact the central bank may do away with this fiction and eliminate it from its balance sheet and the government could then eliminate it from its debt figures. It has become worthless because it was replaced by a new type of debt, namely money, which carries an inflation risk instead of a default risk. 

This is why it makes no sense to say central banks lose when the market price of the government bonds drops. If there were a loss for the central bank it would be matched by an equal gain of the government (whose market value of the debt has dropped in the same proportion). There is no loss for the public sector... 

When the central bank has acquired government bonds, a decline in the market value of these bonds has no fiscal implications."

What about in a monetary union (that is not a fiscal union) like the Eurozone? De Grauwe and Ji ask us to imagine the ECB buys €1 billion of Spanish bonds with a 4% coupon. Then the ECB would receive €40 million interest annually from the Spanish Treasury and return this €40 million every year to the national national banks according to national equity shares in the ECB. So 11.9% of the €40 million would go back to the Banco de España. The rest would go to the other member central banks, with 27.1% (or €10.84 million) going to the German Bundesbank. In short, the authors say, "An ECB bond-buying programme leads to a yearly transfer from the country whose bonds are bought to the countries whose bond are not bought."

I'm not sure if it is fair to call the example above a transfer away from Spain. Sure, Spain would make an interest payment to the ECB and receive only 11.9% of it back. But without the program, Spain would make an even larger interest payment to other lenders and receive none of it back. The ECB purchase would be a net gain for Spain. And I agree that it would benefit Germany, but not because of the €10.84 million, small change in the scheme of things. The real benefit is compared to the counterfactual of a member state sovereign insolvency and contagious financial instability. Remember that no bonds have been purchased under the OMT so far, so no interest payments have been made, and the hope is that "a credible commitment alone is sufficient to eliminate the speculative equilibrium." Also remember that according to De Grauwe and Ji's earlier logic, if the ECB wanted to give Germany €10.84 million, they don't need the corresponding asset backing of a Spanish interest payment to do so.

So, while I agree with De Grauwe and Ji that German taxpayers benefit from the OMT, and hope for the program to continue, I don't think interest payment transfers are the main point to emphasize. Rather, as Holger Schmieding of Berenberg Bank writes,

"Critics claim that the OMT redistributes risks within the euro zone and that the ECB has no mandate to do so. That is disingenuous. First, the major effect of the OMT is to reduce the level of risk for everybody in the euro zone. An economic depression with a chaotic collapse of the euro would have been much more expensive even for the German taxpayers than any risk that may come with the OMT. Second, due to the OMT announcement, the ECB balance sheet has contracted and improved in asset quality, reducing risks for German taxpayers. Third, it is the very nature of monetary policy to change relative prices and hence risks in financial markets. That is how monetary policy sets incentives for households and companies to adjust their behaviour. Outlawing this feature would mean outlawing monetary policy itself."

In a week from today, I will start working as a graduate student instructor for an undergraduate macroeconomics course at Berkeley. It will be fun to bring up this court case when they are learning about the standard textbook distinction between fiscal and monetary policy and see what they think.