ECB QE review

This week, the European Court of Justice (ECJ) will decide whether a European Central Bank bond-buying program called OMT, or Outright Monetary Transactions, is legal in light of European Union treaty law. The ECJ's decision has major implications for the future of the euro - the common currency used by 19 European Union member nations - and for the ability of several governments to fund themselves.

"OMT made it possible for the ECB to lend money - albeit indirectly - to individual eurozone member governments like Portugal, Spain and Greece that, in 2011-2012, were having trouble raising money on bond markets at affordable interest rates," said Philipp König, a macro-economist at the German Institute for Economic Research (DIW) in Berlin.

The ECB is prohibited by EU treaty from lending money directly to governments. German negotiators insisted on this prohibition when the euro was created, in order to prevent governments from being tempted to finance deficit spending by having the central bank print money - a practice that, taken to excess, can result in high inflation.

With OMT, the ECB proposed getting around the prohibition by the simple expedient of buying government bonds from secondary bond markets, rather than directly from governments. In effect, the ECB would tell institutional investors like pension funds that if they bought fresh bonds from troubled governments, the ECB would in turn buy those bonds from the investors. Some very influential German economists - including Jens Weidmann, now head of the Bundesbank, - strongly opposed OMT because they saw it as an attempt to weaken a rule they considered fundamental to guaranteeing a stable euro.

But the ECB wasn't proposing to buy government bonds in unlimited quantities under all circumstances. Instead, under OMT, the ECB would demand implementation of a list of economic reforms as a condition for making loans to illiquid governments applying for OMT program support - reforms intended to ensure those governments wouldn't become incapable of carrying their debt loads in future.

"It's analogous to central bank support of a bank which is illiquid - having trouble raising money on private capital markets - but not insolvent, i.e. its balance sheet is basically OK. The central bank acts as a lender of last resort to banks in that situation. Similarly, under OMT, the central bank would act as a lender of last resort to illiquid national governments - but only with conditions attached," König said.

German hard-currency enthusiasts didn't like OMT

The ECB's new OMT policy was very controversial, particularly in Germany. The German central bank's (Bundesbank's) representative at the ECB, Jens Weidmann, voted against adopting OMT at the central bank's governing council meeting in mid-2012. He argued that OMT would reduce the pressure on eurozone member states to implement needed economic reforms aimed at increasing their economic competitiveness and improving budget discipline. But Weidmann was outvoted by the majority on the governing council, and OMT was approved.

It wasn't long before OMT was challenged in the courts. Several members of the German parliament - including members of Chancellor Angela Merkel's own party, as well as members of the Left party - brought a legal action to the German Federal Constitutional Court, arguing that OMT was in conflict with a key European Union framework law, the Treaty on European Union. They said it effectively amounted to the ECB making fiscal policy - which is not its area of responsibility.

ECB isn't allowed to finance governments

In February 2014, the German court, strongly influenced by arguments made by the Bundesbank, issued a preliminary ruling saying OMT was illegal under EU treaty law.

But the supreme court didn't simply prohibit OMT - instead, it referred the case to the European Court of Justice in Luxembourg, asking the judges there to evaluate the German court's ruling. The ECJ will issue its own ruling on OMT this week in response to the German court's referral.

OMT: A policy aimed at calming bond markets

In early 2012, Europe's politicians, central bankers, and economic commentators watched with growing fear as interest rates on sovereign bonds issued by several eurozone member states in economic crisis - in particular Greece, Portugal, Spain, and Italy - were inexorably rising, in a self-reinforcing spiral.

Those countries had no choice but to raise large amounts of money on bond markets, because they needed to "roll over" part of their large accumulated national debts. As sovereign bonds they had previously issued came due, new bonds were issued to pay off the old ones - much like an indebted consumer paying off one credit card by taking up new debt on another credit card.

That's perfectly normal - even a powerhouse economy like Germany, the solvency of whose government isn't remotely in question, has to roll over its accumulated debts. What wasn't normal in 2011-12 was that bond market investors had begun to doubt whether certain European governments, mired in deep recessions, their tax revenues dwindling due to increasing unemployment, would be able to persuade bond markets to lend them billions in fresh euros at sustainable interest rates.

The doom loop

If old debts had to be paid off by incurring new debts at ever higher interest rates, that would lead to an explosion in the total interest burden weighing on the budgets of those governments. As the interest burden on their accumulated debt grew ever larger, there would be less room in the budget for other expenditures - like infrastructure investments, education or transfers to citizens.

But less real-economy spending means further decreases in aggregate demand and hence further increases in unemployment, leading to ever higher welfare payments and lower tax revenues. That would lead bond markets to impose even higher interest rates. It was a vicious cycle par excellence - a spiral that could, if uninterrupted, gradually push countries into insolvency, and Europe into economic depression.

OMT worked!

This economic doom-loop spiral was already well established when the ECB stepped in to calm bond markets on August 2, 2015, with its new OMT program.

The deal was simple: Countries could qualify for ECB support via bond purchases if they agreed to undertake economic reforms aimed at improving their competitiveness and public budget discipline, supervised by the ECB.

The ECB's move worked a treat. With the threat of sovereign bond default effectively removed - thanks to the ECB's offer to buy sovereign bonds under certain conditions - interest rates on sovereign bonds rapidly went down.

"Rates have stayed low and affordable ever since, for nearly all eurozone countries - Greece is the only exception - because the ECB's promise to be a buyer of last resort meant bond market investors no longer had to worry that countries like Spain or Portugal might be pushed into insolvency," König said.

Interestingly, the mere announcement of OMT did the trick, König added. The ECB has never purchased any bonds under the OMT program - and it seems quite unlikely to have to do so in future. By ending the panic-driven rising spiral in bond rates, the ECB's announcement of the program made actual purchases of bonds superfluous.

Will the ECJ topple OMT?

Probably not. In January 2015, one of the advocates-general of the ECJ, Pedro Cruz Villalon, provided an opinion on the legality of OMT at the request of the court, which concluded that the program is "in principle in line with the EU treaty".

"All signs are that the ECJ will give a green light for OMT, although it will insist that the ECB does not get involved in monitoring national adjustment programs - which means the ECB will have to leave the troika of institutions, i.e. the ECB plus the European Commission and the International Monetary Fund (IMF), which together have been overseeing the Greek structural adjustment program," said Andrew Watt, an economist who heads the Macroeconomic Policy Institute (IMK) in Düsseldorf.