Throwback to the Karlsruhe vs ECB fight, one year ago

In this article, Alexandre VERLET (ESSEC Business School, Grande Ecole Program – Master in Management, 2017-2021) explores the legal thriller of 2020, in which the opposition between German orthodoxy and the flexible monetary policy came to light.

On May 5th 2020, the Constitutional Court of Karlsruhe released a decision. It stated that the government debt purchase programme performed by the European Central Bank was not in line with the ECB’s mandate under the European treaties. This decision came at a critical time when the ECB implemented a second large-scale quantitative easing programme in response to the Covid-19 economic crisis. You might have just heard the story in the media, but such an event is a key element of 2020’s economic and financial news, as the future of the ECB and the quantitative easing programme are at stake here.

Which part of the ECB’s action is being criticised by the German constitutional court?

Basically, the quantitative easing programme and its public debt paybacks are being targeted in the legal decision. Let us recall what the ECB did exactly. On 22 January 2015, the European Central Bank announced the implementation of an Expanded Asset Purchase Programme (APP or EAPP). This programme provided for asset purchases amounting to €60 billion per month in the secondary market. It aims to provide monetary support to the economy at a time when the ECB’s key interest rates have reached their zero lower bound, by easing financing conditions for companies and households. Investment and consumption should ultimately contribute to a return of inflation to levels close to 2%, in line with the objective of the ECB’s mandate. It should be noted that this programme is distinct from the Outright Monetary Transactions (OMT) initiated in 2012, the primary objective of which is financial stability by reducing the cost of financing for euro area countries. On 4 March 2015, in the context of the EAPP, the ECB Governing Council established a substantial sub-programme of purchases of Member States’ securities, the Public Sector Purchase Programme (PSPP). The PSPP provides for each national central bank to purchase eligible securities from public issuers in its own country according to the capital key for the ECB’s capital subscription. This sub-programme is by far the largest component of the ECB’s unconventional quantitative easing (QE) policy, accounting for almost 84% of the ECB’s net purchases in July 2019, with the remainder split between the other three sub-programmes – the asset-backed securities purchase programme (ABSPP – 8%), the covered bond purchase programme (CBPP3 – 1%) and, since March 2016, the corporate sector purchase programme (CSPP – 7%). 90% of purchases under the CSPP are made in domestic sovereign bonds and 10% are allocated to supranational issuers (international organisations, development banks, etc.).

A highly political decision

The recent decision by the Constitutional Court in Karlsruhe echoes the case brought by German businessman Heinrich Weiss at the start of the PSPP in 2015, which accused the ECB of overstepping its mandate by financing eurozone states – particularly the less creditworthy ones. The Karlsruhe court referred the case to the Court of Justice of the European Union (CJEU) in 2017, which found that the PSPP did not infringe the ECB’s prerogatives. In its decision of 5 May 2020 , the Constitutional Court in Karlsruhe now considers itself competent to rule on the non-compliance of the ECB programme, to contradict the CJEU and to question the Bundesbank’s participation in the PSPP. There is a political significance to this decision, which reflects a real split between Germany and the ECB since the European sovereign debt crisis. The Karlsruhe decision should therefore be understood as the latest disagreement between the traditional German and ECB views, which have been increasingly diverging since 2011. Initially, the ECB’s structures were modelled on the Bundesbank, both in terms of its political independence and its hierarchical mandate. Price stability is the ECB’s primary objective, enshrined in Article 127 of the TEU. To achieve this, its strategy combines both quantitative monetary targeting – again a legacy of the Bundesbank – and inflation targeting. The TEU also provides that “without prejudice to the primary objective of price stability, the ESCB [European System of Central Banks] shall support the general policies in the Union”; the ECB’s mandate thus does not exclude the possibility of a policy whose secondary effects support the growth and employment objectives defined by the Member States. Indeed, the ECB’s bulletins and communiqués show that growth and employment are constant concerns, and the sovereign debt crisis and the arrival of Mario Draghi endorsed a broader interpretation of the ECB’s mandate.The growing divergence between the Bundesbank and the ECB was marked by the recurrent clashes between Mario Draghi, the new ECB head from 2011, and Jens Weidmann, who was appointed President of the Bundesbank in the same year. Jens Weidmann was appointed by Angela Merkel following the resignation of Axel Weber, who was known for his sharp criticism of the debt buyback programme for fragile eurozone states, which would have cost him the ECB presidency for which he was a candidate. Considered at the time of his nomination as less dogmatic than his predecessor, Jens Weidmann nevertheless continued the fight of his predecessor and systematically criticised the ECB’s debt buyback programmes. Shortly after Axel Weber’s resignation, Jürgen Stark, the ECB’s chief economist, had himself resigned in protest at the accommodating policy then being pursued by Jean-Claude Trichet, considering that “a fiscal stimulus would only increase the level of debt and therefore only increase these risks”.

What could explain the German exception?

Germany is the Euro Zone’s most powerful member, so it is one of the few countries that can actually rebel agains the ECB. But France never did, so there is a clearly a German exception linked to Germany’s economic culture and financial history. When the ECB announced the resumption of quantitative easing on 12 September 2019, the dissension became even stronger. Sabine Lautenschläger, one of the six members of the ECB’s Executive Board, resigned shortly after Christine Lagarde, recently appointed as successor to Mario Draghi, indicated that she wanted to continue her predecessor’s policy. In an interview with the German tabloid Bild in September 2019, the Bundesbank President openly criticised the resumption of quantitative easing; the article in question was also made famous by its illustration depicting Mario Draghi as Count Dracula ready to “suck the blood of German savers”. Interestingly, concern about the adverse effects of lower rates on savers is a constant in German concerns, as is the sovereign debt of fragile eurozone states. German households save on average more than 18% of their income in 2019, one of the highest rates in Europe. From 2015 to 2020, the real interest rate was -0.9% in the eurozone, which may explain German dissatisfaction with the negative rate effects partly caused by quantitative easing. German public opinion was therefore unfavourable to the resumption of the programme in September 2019. In addition to this, there were some high-profile decisions, such as the Munich Savings Bank, which at the same time decided to pass on these negative rates to some of its customers’ deposits. It is therefore these concerns combined with the trauma of the sovereign debt crisis that have pushed German opinion towards support for a more orthodox monetary policy, which the Karlsruhe ruling has materialised, and all the more so after the announcement of the large-scale €750bn Pandemic Emergency Purchase Programme on 18 March 2020 by the ECB.

Is Karlsruhe right about the ECB not respecting its mandates?

Through the PSPP, the ECB fulfills its second objective of supporting Member States’ economic policies by enabling convergence of inflation rates but also convergence of the long-term interest rates of the euro area Member States and a more sustainable public debt path than in the absence of the PSPP (see above): in short, the fulfillment of the convergence criteria. In particular, the PSPP has led to a significant reduction in Member States’ sovereign bond yield spreads (see sovereign bond yield spreads graph): the standard deviation of different sovereign bond interest rates has fallen from almost 5% in 2015 (and 3% in 2016) to 1% in 2018 and 2019. So the ECB’s action via the PSPP and the PEPP seems today to live up to expectations from an economic point of view. Nevertheless, Karlsruhe considers that there is a potential violation of European treaties because the ECB and the European court of justice – which approved the PSPP in December 2018 – did not provide evidence that proportionality had been duly considered.  Karlsruhe cites easier financing conditions for member states or the banking system, and ‘penalizing’ savers, but the court seems to ignore that the PSPP’s effects are not any different from those of other ECB instruments. Either the PSPP does not violate the proportionality principle, or all ECB instruments do. What’s more, if for instance, in considering an interest rate rise to counter inflationary pressures, the ECB found this would produce losses for bondholder or increase unemployment, then the ECB’s would be considering objectives that are explicitly out of its mandate. What the German court reproaches the ECB is rather paradoxical and the economic basis of the legal decision is weak , but it definitely show that there is a need for a redefinition of the ECB’s mandate. It could become a non-hierarchical dual mandate, more similar to the US Federal Reserve model. The ECB would thus have a clear function of pursuing a price stability objective combined with a full employment objective. The mandate could be materialized not by the definition of a monetary target, the evolution of the monetary aggregate M3 and inflation, as it currently is, but by the establishment of an implicit nominal anchor on the so-called “neutral” rate theoretically allowing the euro area to reach its potential growth. Nevertheless, such evolution of the ECB’s mandate will have to wait until the end of the Covid-19 crisis, and nothing has prevented the Bundesbank from implementing the ECB’s policy since Karlsruhe released its decision one year ago. Adding to that, the possible return of inflation might jeopardize the sustainability of further quantitative easing programmes. To be continued..

About the author

Article written in July 2021 by Alexandre VERLET (ESSEC Business School, Grande Ecole Program – Master in Management, 2017-2021).