Has the European Central Bank Been Handing Out Illegal Bailouts?
The German Constitutional Court might think so, and it might be right—and that would spell trouble.
The German framers of the Treaty of Lisbon, which governs the way the Euro area is supposed to operate, must be beside themselves as the European Central Bank (ECB) flagrantly flouts the spirit, if not the letter, of that treaty.
By so doing, the ECB is putting itself on a collision course with the German Constitutional Court. Even before the ECB’s latest round of monetary policy largesse, the court expressed concerns that the bank had exceeded its legal remit, and there’s every reason to think that it has become even more uncomfortable following the ECB’s new round of monetary easing.
At the time of its drafting, largely to assuage German concerns, the Treaty of Lisbon included two articles aimed at precluding reckless budget behavior in the Eurozone, dissuading free riders from living beyond their means and expecting the more fiscally responsible governments to save them. Article 123 precluded the ECB from direct government deficit financing. Article 125 precluded the ECB from bailing out any individual member country.
Over the past decade, despite the treaty’s strictures against ECB government financing, the hallmark of the ECB’s monetary policy has been its massive government bond buying programs. Between 2009 and 2019, the ECB increased its balance sheet by a staggering $2.5 trillion. Then, in response to the COVID-19 pandemic, it doubled that amount in just the past nine months.
To avoid the charge that it was directly financing a member country’s budget deficit, the ECB has been careful to restrict its bond purchases to the secondary rather than the primary market—i.e. from existing bondholders rather than directly from the governments. Similarly, until recently, the ECB was careful to buy all of its member countries’ bonds in direct proportion to their relative ECB capital contribution. That way the letter, if not the spirit, of the Lisbon Treaty was respected, and no individual member state got special treatment.
In response to the pandemic, the ECB has taken further steps that seem to violate both the spirit and the letter of the treaty. Not only has the ECB dramatically expanded the size of its government bond buying program, but it also now feels free to buy whatever quantity of an individual country’s bonds are needed to keep that country’s borrowing costs low regardless of that country’s ECB capital contribution.
The ECB’s support of the Italian economy offers the most striking illustration of its disregard for the Lisbon Treaty. As a result of the pandemic, Italy’s public finances are on an unsustainable path. Its budget deficit has ballooned to around 12 percent of GDP while its public-debt-to-GDP ratio has skyrocketed to 160 percent, its highest level in the past 150 years. Even more worryingly, this ratio is bound to increase further since Italy will have great difficulty in reducing its budget deficit while stuck in the Euro.
Contrary to the Lisbon Treaty’s spirit and despite the dismal state of Italy’s public finances, the ECB has been effectively bailing Italy out by buying huge quantities of Italian bonds in the secondary market, which in some months have been equal to the Italian government’s gross borrowing needs. It has also been sending the market the implicit message that the ECB stands ready to buy as many Italian bonds as are needed to keep Italian interest rate spreads low. This has led to a remarkable situation: Italian public finances are patently unsustainable, yet the government can now at a zero interest rate.
In December 2018, the German Constitutional Court sent shivers through international financial markets when it expressed the view that the ECB had been exceeding its mandate and that the German Bundesbank might have been violating German law by participating in the ECB’s bond buying program.
But the ECB has continued its monetary policy activism undeterred. It’s likely only a matter of time before the court once again challenges the legality of the ECB’s and the Bundesbank’s activities. If the court had problems with the ECB’s bond buying program in 2018, how could it look more favorably on the bank’s interventions today? And if the ECB’s bond buying program can’t bail out Italy because the Bundesbank can’t participate, who will?