By Marek Mora (Hospodářské noviny, 12 May 2020, page 8, Panorama section)
Economists do not usually pay much attention to constitutional courts. This certainly cannot be said of last week’s verdict of the German Federal Constitutional Court pointing to errors in the monetary policy of the European Central Bank (ECB). The ruling is in many ways ground-breaking – and perhaps even revolutionary – from the economic as well as the legal point of view. It will certainly have repercussions for the further integration of the European Union and the euro area and raises questions for central banking as well, all at a time when central banks are significantly influencing the running of the global economy amid the COVID crisis.
What’s the issue? Following the Great Financial Crisis in 2008–2009 the euro area slipped into recession and the ECB did its job and started pumping money into the economy, first in the traditional way – by lowering interest rates, i.e. the price of money – and then less traditionally by cutting interest rates below zero and launching purchases of various types of securities, primarily government bonds. However, some German politicians, economists and lawyers took against the second step. They challenged the ECB’s action before the Federal Constitutional Court in Karlsruhe, arguing that the ECB was financing – albeit indirectly – the governments whose bonds it was buying, action that is prohibited. The complainants were also unhappy about the ECB overstepping its mandate and seeking to achieve goals it has no right to pursue, such as the cohesion of the euro area.
Last week, the Federal Constitutional Court arrived at a conclusion that can be summed up broadly as follows: the ECB is not breaching the prohibition of monetary financing of governments, but its action is partly in conflict with the German constitution. The conflict lies in the ECB’s failure to prove convincingly that the instruments it uses to achieve its goals are proportionate. In other words, it seems to the Federal Constitutional Court that the ECB is using a sledgehammer to crack a nut – rarely hitting the nut but doing a lot of collateral damage. Unless the ECB proves within three months that this is not the case, the Federal Constitutional Court will prohibit the Bundesbank (the German central bank) from participating in these operations.
The decision immediately sparked a big debate not just in the legal community, but also among economists. The debate will certainly continue for a long time to come, as the issue is not trivial and the ruling runs to 110 pages. When presenting his ruling, Federal Constitutional Court President Andreas Vosskuhle himself said that many will no doubt consider it irritating.
Who interprets European law?
To a practising economist, albeit one lacking a law degree, it seems that the biggest blow has been dealt to the design of the European legal system. The Federal Constitutional Court heard many experts and also solicited an opinion from the European Court of Justice (ECJ), which did not find any errors in the actions of the ECB. Up to now, the ECJ has been regarded as having a monopoly on the interpretation of European law. According to legal experts, it is therefore surprising that the constitutional court of one country has dared to interpret European treaties by itself and challenge the ECJ’s opinion. This in itself raises many questions and introduces many uncertainties into the decision-making system of the EU.
The German constitutional judges justify their approach by arguing that the ECJ is overstepping its competences, so they are not bound by it. In addition, the Federal Constitutional Court is known for being careful to ensure that there is always an option to review how the EU works from the point of view of the democratic principle, one of the pillars of the German post-war constitution. According to legal experts, however, this approach may cause the European legal system to come undone. In the extreme case, the functioning of the entire EU may gradually be called into question.
Central bank independence
To me as a central banker, the second important message of the Federal Constitutional Court’s ruling concerns central bank independence. Since the end of the last century, central banks have become authorities with a clearly defined objective, most often price stability. In some countries, among them the Czech Republic, new competences have started to be added to this objective. However, in the domain of monetary policy, which remains central banks’ core competence, constitutions and laws dictate that central banks should be completely independent and not take instructions from anybody, least of all other state bodies, in the pursuit of their objectives. The fact that the Federal Constitutional Court is turning to an independent central bank and imposing obligations on it in an area considered up to this point to be its sovereign right, namely the conduct of monetary policy, is ground-breaking.
If my memory serves me right, this is the first time anything like this has happened in the history of modern central banking. It is perhaps logical that the Federal Constitutional Court is addressing the ECB through the Federal government and the Bundestag, which are supposed to forward the message to the ECB and ensure that the task is performed. There was probably no other way, as the Federal Constitutional Court may only address German authorities. As a result, the issue of central bank independence is gaining even more prominence.
This is all the more interesting as it was the Germans who advocated the concept of central bank independence after World War II and succeeded in incorporating a very independent ECB into European law. Besides making monetary policy, many central banks, including the Czech National Bank, operate in a number of other areas as administrative bodies, areas where the central bank and the courts routinely interact.
Unconventional bank instruments
Regardless of how the Federal Constitutional Court has addressed the ECB, the key issue for economists is the content of its ruling. The content is also ground-breaking, as it goes to the very core of monetary policy in recent years. It forces the ECB to lay its cards on the table and justify the proportionality of its policy. This means showing that the instruments it uses match its monetary policy objectives, as central bank independence goes hand in hand with transparency. If the ECB fails to demonstrate this, the Bundesbank cannot participate in these operations.
At least since the Great Financial Crisis, economists have been debating the use of unconventional monetary policy instruments. Some of the participants in this debate claim that the more such instruments are used, the less effective they are and the bigger are their side effects. I should note here that the ECB’s monetary policy regime – inflation targeting – has never been very popular among many German economists. They were willing to tolerate it as long as its logic forced central banks to lower inflation when it was too high. But in a situation where inflation is too low and central banks are supposed to increase it, and to do so at any cost (as expressed in former ECB president Mario Draghi’s famous utterance “whatever it takes”), it was too much for them. To pay “any price” for raising inflation is simply something the Germans have difficulty understanding.
This applies all the more when the price – the unintended costs – of achieving inflation in too dogged a fashion include growth in property and share prices and sustained low returns on pension funds and savings. Or when the ECB gives the impression that, by taking such action, it wants to cut the costs of financing heavily indebted governments or rescue inefficient banks. In the view of the Federal Constitutional Court, if these side effects predominate, they constitute economic policy. This is something which goes beyond the framework of monetary policy and which central banks have no right to do. Let’s not forget that Mario Draghi in his famous 2012 speech said that the ECB would do whatever it takes to preserve the euro, which is a broader goal than achieving the inflation target.
Future of the euro area
The last revolutionary message from Karlsruhe relates to the functioning of the euro area going forward. In its ruling on the application of the proportionality principle, the Federal Constitutional Court has de facto prohibited the Bundesbank from participating in “whatever it takes” exercises. The ECB may theoretically continue to conduct monetary policy without the Bundesbank, but politically this is difficult to imagine. One could even argue that it is impossible with regard to the euro area’s credibility.
Although the Court’s ruling formally concerns the bond purchases commenced in 2015 and not those which the ECB launched in connection with the COVID crisis, the proportionality principle will never again be easy to ignore. This, however, significantly limits the ECB’s room for manoeuvre. In particular, it seems almost impossible that ECB presidents might say in the future that they will do whatever it takes to save the euro so that the markets believe it.
This limited room for manoeuvre for the ECB will ramp up the pressure on the euro area to strengthen its cohesion and resilience, an issue that has been discussed since the Great Financial Crisis. The greatest effort will no doubt go into establishing a fiscal union. Such a union has never been defined entirely clearly. In principle, however, the goal is for the stronger euro area members to provide financial support to the weaker ones. This can be achieved in many ways, for example through a single European tax that will become a source of the European budget, or through the introduction of a single European debt (a single “European” bond).
However, the introduction of a fiscal union in whatever form is creating political tensions inside the euro area. Everybody knows that the countries with weak economic performance, and hence weak finances, lie in the south of Europe, while the stronger ones are in the north, and that the fiscal union will therefore result in the redistribution of resources from the north to the south, a state of affairs that will last a long time, maybe forever.
An alternative to the fiscal union would be for the countries in the south of Europe to achieve higher productivity and higher growth. The need to redistribute funds inside the euro area would decline significantly if all the euro area countries were equally productive and hence roughly equally wealthy.
What will be easier politically: to push through economic reforms in the south of Europe, or to persuade the Dutch and Germans to start sending cheques to the south? The answer is not clear, but from an economist’s point of view the first option is clearly better for the sustainability and stability of the euro area.
What next?
The decision taken in Karlsruhe raises a number of questions. For example, it is not at all clear who will ultimately assess how the ECB has evaluated the proportionality of its policy and who will ultimately prohibit or permit the Bundesbank to continue participating in this policy. Much will also depend on what stance the European institutions take on the matter.
The initial impression is that the European authorities want to ignore Karlsruhe. The ECJ has stressed repeatedly that no one except the ECJ has the right to interpret European law. The European Commission, via its President Ursula von der Leyen, has even mentioned the option of opening an infringement procedure against Germany. There have also been unofficial reports that members of the ECB Executive Board intend to ignore the Karlsruhe ruling. This is unlikely to happen, because, no matter how legally and formally complicated this is, it is clear that the Federal Constitutional Court has expressed something that many economists and EU citizens are thinking. If the verdict is ignored, it will turn into a dangerous political issue. After all, even ECB representatives themselves have often complained that they bear a heavier burden than they should. No one enjoys doing things under pressure, and the timing is not entirely ideal either.
COVID-related challenges lie ahead of central bankers, and not just them. The representatives of the euro area therefore now have no other option than to face the Karlsruhe verdict head on and deal with it somehow. It’s likely to be a very bumpy road.