[This is an invited guest post by Jens van 't Klooster, who is a FWO Postdoctoral Fellow in philosophy at KU Leuven and a member of the research group A New Normative Framework for Financial Debt at the University of Amsterdam.--ES]
Last week the ECB announced a new Pandemic Emergency Purchase Programme (PEPP). The purpose of the programme, as I explain here, is to support fiscal measures taken by individual member states. This puts it in conflict with the infamous monetary financing prohibition spelled out in the ECB’s mandate. The PEPP is, in this regard, a new chapter in the decades long titanic struggle over the interpretation of this one article from the EU’s 1992 Maastricht Treaty. Following my earlier blog, I will draw on my current historical work on ECB risk management to explain just how much the PEPP breaks with the ECB’s earlier approaches to government debt.
Currently known as Article 123 TFEU, the monetary financing prohibition prohibits the ECB from providing credit to individual member states and also, crucially, the “direct” purchase of government bonds.[1] The latter qualifier was originally introduced to allow for so-called sale and repurchase transactions (or “repos”).[2] Article 123 is meant to prohibit actual (so-called “outright”) purchases.
Beyond Article 123, the ECB’s legal mandate does not say much about sovereign debt. The main issues are for the ECB itself to decide, which it avoids doing for the first years of its existence. In 2005, the ECB commits itself to a strict market-based approach. For one, the objective of the ECB’s collateral policy, also in relation to government bonds, is from then on only to protect the ECB from financial risk. Moreover, its risk management strategy is meant to follow, rather than shape, market practices. The ECB’s conservative French president Jean-Claude Trichet announces that the ECB would from then on only accept a government bond “at its market value, so that if the markets would assess that the paper was less credible and the spreads would augment, then the value of the paper that we would take as collateral would diminish.” To this end, the ECB makes the collateral eligibility of government bonds conditional on a sufficiently high credit rating issued by Moody’s, S&P and Fitch.
The ECB’s reluctant approach to government bonds is a driver of the 2010-12 Eurozone crisis. The core financial dynamic of the crisis is a self-enforcing negative spiral between the individual member states and the stability of their domestic banking sector. Stopping it requires restoring trust, which only a strong market participant can do. The ECB is very reluctant to do this. Instead, its market-based collateral rules amplify the effect of private credit rating downgrades on the crisis-struck member states. Moreover, in evaluating the eligibility of sovereign bonds solely from a risk management perspective, the ECB leaves open the possibility of ineligibility,--none of this helpful to crisis-struck member states.
The ECB only reluctantly gives up its market-based approach to government debt. In July 2012 Mario Draghi ends the Eurozone crisis with the (then improvised now famous) words “within our mandate, the ECB is ready to do whatever it takes to preserve the euro. And believe me, it will be enough.” Anticipating a legal challenge, the programme that the ECB unfolds rests on quite a narrow interpretation of that mandate. Outright Monetary Transactions (OMT) is a programme that allows the ECB to buy bonds of member states that get into trouble. It side-lines the monetary financing prohibition by buying bonds from other financial market participants, rather than directly from governments (it buys in “secondary markets”). Moreover, on the ECB’s own account, OMT should be understood not just as part of its monetary policy, but in fact merely instrumental in allowing it to achieve its price stability objective.
A group of German lawyers indeed became very angry over the OMT programme and took the ECB to court. Although the case is unsuccessful, the European Court of Justice does rule that “sufficient safeguards must be built into its intervention to ensure that [the ECB] does not fall foul of the prohibition of monetary financing”. The Court leaves it to the ECB to decide those safeguards.
The OMT is never used, but in 2014 the ECB starts purchasing government bonds. This time not to help individual member states, but rather as a part of a quantitative easing programme (or QE). In quantitative easing, the central bank purchases government bonds and other financial assets to stimulate the economy. In designing this programme, the ECB imposes a range of constraints on itself to ward off further legal challenges. The most important constraints are that government bond purchases should follow the ECB’s capital key, which is determined by the population and GDP of individual member state. The ECB also takes various measures to ensure that secondary markets continue to shape interest rates paid by individual member states.
Finally, the programme also becomes subject to the minimum credit rating that the ECB applied to eligible collateral in its repo operations. To be eligible for ECB QE, the main requirement on issuers was that they had an investment grade rating from Moody’s, S&P or Fitch for eligibility. This leads to the exclusion of Greece and the inclusion of Shell and other highly rated multinational firms. To include Portugal despite it lacking an adequate rating, the ECB adds a fourth rating agency which applies more lenient conditions.
So, in what sense does the PEPP constitute a radical break with ECB’s previous crisis-fighting measures? As I already explained in my earlier blog, the key passage in the ECB’s announcement of PEPP comes at the end:
"To the extent that some self-imposed limits might hamper action that the ECB is required to take in order to fulfil its mandate, the GC will consider revising them to the extent necessary to make its action proportionate to the risks that we face."
In contrast to earlier crisis-fighting measures, the ECB has given up the attempt to shoehorn everything it does under price stability. The ECB also asserts that most limits hitherto applied to its tools were self-imposed and can be revised in light of its objectives of price stability and supporting the economic policies in the EU. With this justification the ECB permits itself to give up the capital key, the earlier secondary market restriction and the minimum credit rating. The ECB now considers adequate financing for government expenditures itself a necessary condition for achieving the objectives spelled out in its mandate.
There are some procedural worries about all of this, which the German lawyers to their credit have amply highlighted. My article on the ECB’s response to the 2010-12 crisis from two years ago already looks dated but contains some things worth reiterating. It compares the ECB’s crisis response to the Roman emergency law, where I note that the latter was subject to quite sophisticated check and balances. The ECB is for now alone. It determines what constitutes an emergency, what it is allowed to do in an emergency, does its thing in the emergency and gives only a very formal accounts of why it did that thing when the emergency is over. That raises all sorts of procedural concerns. There is also a quick fix. Article 125 (2) TFEU allows the EU to specify the definition of monetary financing. This offers a clear avenue for a more adequate approach, which should also be kept in mind when we return to thinking about the climate crisis.
[1] To get a feel for how visceral this article was supported before the crisis, consider central bankers invocation of Faust and Otmar Issing’s claim that “[t]he prohibition of monetary financing is an obvious precaution when one bears in mind that virtually all lost currencies – and there are a lot of corpses in this ‘graveyard’ – can be laid at the door of government misuse.”
[2] Although from a legal perspective a repo is a purchase, from an economic perspective it is a collateralized loan. In a repo, the central bank buys a government bond from a bank. At the same time, the bank enters into a contractual obligation to purchase that bond from the central bank at a slightly higher price. The bond serves as collateral, which the central bank only gets to keep if the bank defaults. A repo is thus very different from an outright purchase of a government bond.
Comments