The past few days have seen economic crisis management — if not the political landscape in the Eurozone — change fundamentally. On September 6, the ECB announced it would buy-back unlimited government bonds if need be. One week later, the German constitutional court ruled that the European Stability Mechanism (ESM) is largely in line with German law.
The ECB’s decision against the German vote to make unlimited purchases of government bonds in secondary markets comes with the necessary condition that involved countries operate under a “strict and effective conditionality attached to an appropriate European Financial Stability Facility/European Stability Mechanism (EFSF/ESM) programme … provided that they include the possibility of EFSF/ESM primary market purchases”.
Thus, the so-called Outright Monetary Transactions (OMT) would not have been affected even if the German constitutional court had said no to the ESM, as they could have been conducted under EFSF conditionality anyway. Of course, with the ESM in all likelihood going ahead, OMTs will now be linked with ESM conditionality. In effect, the ECB has now — at least partly — assumed the controversial role of a lender of last resort.
The German constitutional court has based its decision on the ESM on key conditions, which are guided by the principle of re-enforcing and securing the budget sovereignty of the German parliament. One condition is that the total amount of German liabilities in the ESM must be strictly limited to €190 billion. Any further increase must be accepted by the German parliament. This implies the idea of providing the ESM with a banking license and thus “unlimited firepower” has been rejected. If the Eurozone wants a lender of last resort, this has to be the ECB. The second condition stipulates that the ESM should also be allowed to provide German parliamentarians with comprehensive information about its operations.
These conditions have implications on economic stability and democratic legitimisation of economic and fiscal policy in the Eurozone.
To start with the good news: sovereign debt interest rates have been coming down drastically in the last week, providing debt service relieve to debtor countries.
As long as the new ECB policy is perceived as credible, the ECB might not even have to make bond purchases to bring the rates down. The announcement of the new policy could be sufficient and the ESM might not be needed. But this optimistic scenario is only likely if countries make fast progress in bringing down their debt-to-GDP ratios.
But how realistic is this scenario?
Simple debt arithmetic tells us that successful deleveraging requires a nominal GDP growth exceeding the nominal average interest rate paid on the outstanding debt. If this condition is not met a primary government budget surplus (a surplus excluding the interest payment on debt) must be achieved.
Consequently, bringing down interest rates helps, but a workable combination of an often painful austerity and sufficient nominal growth is needed. As the latter depends on the former and may be impaired by a too strict and too front-loaded austerity, successful deleveraging is all but ensured.
It is an almost costless and “non-intrustive” strategy, which may allow debtor country to keep its full budgetary sovereignty. But for it to be successful, certain conditions must be filled.
Firstly, there must be a shift from the current short-term focus of austerity program towards a credible long-term strategy – which may require some bridge financing to stabilize long-term economic growth. Secondly, there also needs to be a banking union that short-cuts dangerous feedback loops between bank and sovereign debts. Thirdly, highly competitive Eurozone countries, such as Germany, need to accept somewhat higher inflation rates. Lastly, there needs to be a favourable economic environment within and beyond the Euro zone.
Lacking one or more of these conditions, some countries (notably Spain) may soon need to undergo an ESM program and give up important elements of their budgetary sovereignty. In that case, the ECB will need to start buying bonds. If the program fails to bring fast results and or fails to convince the electorates about their long-run benefits, this may tempt policymakers to violate the conditions.
Economics writer Martin Wolf warns that the new combination of ESM conditionality with ECB interventions in the bond markets could in fact threaten the proclaimed irreversibility of the Eurozone. If the ECB was to stop buying bonds in the case of a violation of conditionality, the bond markets could implode. If the ECB continues to buy in such cases – which Wolf finds the more likely scenario – the ECB’s credibility will be at risk. In both cases, this will threaten the existence of the whole Eurozone.
Wolf continues arguing that the debtor countries need more growth and jobs to grow out of debt so that they can stick to the conditions. This could be supported from the ECB by “stepping harder on the monetary accelerator” which, however, would confirm German fears of inflation and be just another, if not the final blow against the ECB’s credibility.
Nevertheless, a well-designed ESM operation could help reduce the dangers described above. Recent IMF research has shown that long-term and growth-oriented deleveraging strategies are usually more successful than front-loaded. Such strategies can be “agreed upon” rather than imposed. Long-term public debt targets are therefore needed, rather than detailed and deeply intrusive policy prescriptions which would severely violate the budget sovereignty of the debtors. And from extensive IMF and World Bank experience, it is well known that “program ownership” in the country is essential for success.
The German constitutional court has rightly stressed the importance of democratic control and budget sovereignty, but a break-up of the Eurozone would increase the cost to the German taxpayer far above the €190 billion now at stake in the ESM. However, these European core values claimed for Germany also apply to debtor countries and their governments who are finally responsible to their electorates. A less intrusive long-term oriented conditionality could reduce the risks of the current strategy and would be more likely to succeed the earlier it is supported by a new Eurozone governance structure and pan-European growth policy.
The Eurozone faces not only a stability problem, but also a dramatic challenge of preserving democratic self-determination in the debtor countries. Its future depends on effectively securing both. It is also in these respects that both the ECB and ESM need solid democratic and constitutional European foundations.