Thursday, September 12, 2013

German Economists Against ECB Bond Buying on the Secondary Market

The Bundesverfassungsgericht (German Federal Constitutional Court) will rule within a month if and up to what scope the Bundesbank is allowed to participating in secondary market bond buying schemes like OMT. 136 German economics professors signed a plea letter claiming that these are against the law. Specifically, they mention Article 123 of the Lisbon Treaty which prohibits direct bond purchases by the ECB. So, buying bonds on the secondary market is allowed. The economists therefore had to undertake significant intellectual gymnastics to also pretend that these are illegal, too. It was an answer to a similar open letter by for the most part foreign economists.

First things first: Manfred Neumann, who signed the new letter, called the first one a stupid "attempt at publicly putting pressure on the Bundesverfassungsgericht". I just love German economists; really honest people who live by their principles.

 The signatories claimed that buying bonds on the secondary market is only legal if a "representative portfolio of bonds of all countries" is bought. This assumption completely fails to recognize the special position of the ECB as a central bank for more than one country. The bank realized that the premiums on interest rates in the program countries did not reflect the actual risk; and therefore were not part of the disciplinary function of bond interest rates on state finances, but in the ECB's view the sign of an irrational fear of of a break up of the eurozone. The interest rates on two year bonds were higher than they should be in these countries by up to two percent according to the ECB's models. A situation like this can only arise within a monetary union like the eurozone. In the US a state may go bankrupt, but this in no way also poses the threat of e.g. California leaving the the "dollar area". Hans-Werner Sinn - who signed the second letter - compared the ECB to FED in his opinion for the German constitutional court, anyways . He just forgot to mention that most of the social transfers come from the federal government in the US, which is a completely different sitiuation to the one the ECB has to deal with. A local crisis in Europe stays local and transfers which in any actual country automatically shift large parts of the burden to all tax payers do not happen in the eurozone. This is the key difference. The bankruptcy of a state in the US is in no way similar to one of a country in the eurozone.

Had the ECB bought bonds from all countries, then it would not have addressed the fear of a break up through one or more country in the south leaving the eurozone. The announcement of an OMT program - not coupled with the ESM -  which would instead have included German bonds would not have solved the issue at all. It is quite clear that the OMT in the form the ECB chose had exactly the effect that the central bank was aiming for; not only that it has until now not cost a single euro cent. The economists do not even mention this fact. They give no explanation, why the ECB should not be allowed to react to local crises by using local measures.

Not only is the assertion on the alleged illegality of the ECB's actions flimsy flamsy, because there just is no article in the treaty that says so, it is also absolutely awful economics. Hans-Werner Sinn  really liked to talk about Target2 last year. The maximum German net position was reached in August last year. In the Beginning of that month Draghi announced OMT. Here is what happened:

So, just saying that the ECB would be willing to do whatever it takes reduced the actual possible losses for Germany significantly. But let's be fair. Unlike Weidmann, Sinn made many good points in his  opinion. Weidmann only talked about some future fantasy stability which might or might not be endangered by the ECB actually saving the union to begin with. It just does not make sense to be against stability now, in order to preserve stability in the future.

The fight over the future of the eurozone is on. If the German federal constitutional court makes it illegal for the Bundesbank to participate in a possible OMT program (or sets a low limit on the size of the OMT), then the next German government will be forced to actually make a decision if it is willing to do what it takes to save this union. Since, Merkel will likely be chancellor again it just wont happen, for she has not made a single forward looking choice. Germany has only reacted as little as possible as late as possible. That wont be enough anymore should the ECB be taken out of the picture. Also expect the economist now calling for a fiscal solution to denounce it once it is needed. Interesting times.

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