Eurozone breakup risk at new high

The German Constitutional Court made an unexpected and significant ruling last week against the ECB and Quantitative Easing.

QE Deemed Illegal

In the midst of a pandemic and an important presidential election, it is very easy  to miss globally significant events. 

Here is one that is way under the radar: The German Constitutional Court ruled the ECB's QE Program Could be Illegal.

That is a landmark ruling that challenges the independence of the ECB and the authority of the Court of Justice of the European Union (CJEU).

In announcing the ruling, German Chief Justice Andreas Voßkuhle said the CJEU had approved a practice that “was obviously not covered” by the ECB’s mandate. Voßkuhle spent months crafting the 77-page decision, announcing the ruling just a day before his official retirement on Wednesday. "

Dismissing a 2018 CJEU decision to allow the bond purchases, the German court ordered the ECB to provide Germany with adequate justification for the program within the next three months. Should it fail to do so, the Bundesbank, Germany’s central bank, would no longer be permitted to participate in the program.

What it Means for the Future of the EU

Eurointelligence explains What it Means for the Future of the EU.

The ruling raises complex and potentially troubling issues for the EU as a whole. The German constitutional court has accused the ECB and the CJEU, the court of Justice of the European Union, of abusing their power, and of acting beyond their assigned competences. That concept is known in German constitutional law as acting ultra vires. In the German legal interpretation of European integration, all sovereignty still rests with the member states. The EU is clearly not a federal state, but a deferred power. Member states have transferred certain rights to the EU. The German court said it accepts that it is bound by CJEU rulings, but only those that occur within the EU's agreed competences. All bets are off it the CJEU goes ultra vires. And, crucially, the German court decides if and when that happens. 

This is the most serious challenge to the EU's legal framework we have yet come across. In the UK, the courts operated under the assumption that conflicts between EU and UK law would always be settled on the basis that EU law is supreme. 

The ruling is unusually explicit about the breach of competences on the part of the CJEU. It criticised the CJEU's positive ruling on the asset purchases as implausible, and objectively arbitrary. It accused the EU court of an evident neglect to investigate the wider consequences of the ECB's programme. The word evident crops up many times in the ruling. It is a legally more loaded word than it appears at first sight. Moreover, the ruling accuses the CJEU of a breach of EU treaty law.

The German court's interpretation will have important consequences if other national courts follow suit, which we think is very likely. Poland's deputy justice minister already declared that member states have regained their position as the masters of the EU treaties. We expect the ruling to strengthen the determination by the Polish government to press ahead with judicial reform, and to resist interference by the EU into what they consider domestic legal affairs.

Surprise 7-1 Ruling

Perhaps the biggest surprise was the 7-1 ruling. 

Price to Pay

In the ECB’s view, the negative effect of lower interest rates was the price to pay for keeping the euro intact. 

That price to pay keeps rising and rising. 

This Eurozone Crisis Will Be Even Worse Than Last Time

Please consider The shock of coronavirus could split Europe

The economic fallout of Covid-19 hits all members of the currency bloc. But no mechanism exists that allows the governments of the eurozone to respond jointly to such a shock. The result is that the policy reactions to the pandemic are so far overwhelmingly national – accentuating differences rather than bringing Europe together in a time of crisis. Even in the face of a symmetric shock, the eurozone responds asymmetrically.

Germany reacted forcefully to Covid-19. Berlin abandoned its cherished debt-brake – which sharply constrains its government borrowing – and legislated a €750bn rescue package for the German economy. Italy, the country with the highest number of infections and deaths from the virus, does not have the same fiscal leeway. Its response to Covid-19 amounts to a mere €28bn – about 4% of the size of the German package.

This substantial disparity in the policy response is exacerbated by differences in initial conditions. In 2019, Italian output was still 4% lower than in 2007 while German GDP was 16% higher. Owing to the ongoing GDP collapse, the Italian public debt ratio will soon approach 150% of GDP – even without a new support package. Yet despite their comparatively tepid response, Italian policymakers already have to nervously watch the interest rate differential between Italian and German government bonds. The spread widened substantially in recent weeks. 

The writing is on the wall: without solidarity from its fellow eurozone members, Italy will not be able to respond to the crisis in the same way that other countries can. It is at risk of an economic depression on top of a humanitarian catastrophe.

Negative Interest Rates

In March of 2015, ECB president Mario Draghi forced more reserves into the system, via a Quantitative Easing QE program. 

The ECB also forced interest rates negative then required the banks to pay the ECB interest on those reserves.

In contrast, the Fed paid interest on excess reserves. In the process, the Fed slowly recapitalized US banks over time.

The ECB's negative interest rate policy further damaged European banks that were in terrible shape to begin with. 

Why?

Before he served as ECB president, Draghi was president of the Italian central bank from 2005 through 2011. 

What better way to get Eurobonds and debt commingling than cripple the entire European banking system with negative rates and massive QE programs?

If the European banking system went down, including Deutsche Bank, wouldn't Germany be forced to go along with banking changes?

My counter-argument is on grounds of Occam's Razor which suggests when stupidity is one of the possible answers it is highly likely to to be the correct one.

Actually, Occam's Razor says simpler explanations are more likely to be correct, but what is simpler than stupidity?

Surprise, Surprise

The EU is not used to surprises. But the German court ruling makes three in a row.

1. Brexit Vote
2. Brexit Vote Success
3. German Court Ruling

I am surprised too. 

Why?

Because in every case to date, the German Constitutional Court looked the other way, There have been numerous ECB-related challenges which the German court threw to the CJEU with obvious consequences. 

And there was no indication that the German court would suddenly reverse course. 

So I am not only surprised by the ruling, I am shocked that it was 7-1.

Even Those Who Filed the Suit Were Surprised

“I was surprised by how clear the ruling was," said Peter Gauweiler, a 70-year-old Eurosceptic lawyer who has been waging a legal war against the EU and ECB for almost three decades.

Debt Mutualization

What Germany fears now and has from the outset is "debt mutualization" in which Germany would bailout Greece, Spain, Portugal, and Italy. 

That is why Germany insisted the Maastricht Treaty, which founded the Eurozone, prohibit debt mutualization.

But time and time again, politicians and the ECB found ways to chip away at the treaty.

And they still do even in the wake of the German court ruling.

New Battle Cry - Step Up or Risk Extinction

Today, Spain’s Deputy PM Calls for EU to Step Up or Risk Extinction

Pablo Iglesias, Spain's Deputy PM. says a “certain [level of] debt mutualisation is a [necessary] condition of the [continued] existence of the EU”.

He also wants Portugal and Italy to join the a pan-EU minimum income guarantee cause to “establish European standards of dignity and to protect consumption”. 

"Everyone now understands you need an activist state," says Iglesias.

What "Everyone" Understands

Given the 7-1 ruling might I suggest there is a major flaw in the Iglesias' understanding of the word "everyone". 

Germany Pays One Way or Another

I understand where Germany is coming from. And I expected this outcome all along. 

But one way or another, creditor states pay through the nose. Either Germany agrees to debt mutualization or Target-2 liabilities go up in smoke. 

Target-2 Imbalances 

Chart from the ECB Data Warehouse Target Balances.

Target is a measure of capital flight and purchases of goods by debtor nations that cannot possibly be paid for.

Italy and Spain owe nearly a trillion euros to Germany. That's an amount that can never be paid back. 

But everyone pretends the debt is good because the ECB guarantees the debt. And those guarantees represent a fundamental flaw in the Eurozone that allowed this debt to pile up in the first place.

If Italy were to withdraw from the eurozone, its banks’ assets and liabilities would be redenominated in its new currency. Germany would not get paid back in in euros, but rather Lira or some new currency, assuming Germany got paid back at all.

For further discussion, please see my August 2018 article, Debate Over Target2 Continues: Twilight of the Euro 

The question is not whether Italy should pay its Target2 deficit, but how it possibly could. The Bank of Italy would almost certainly default on a bill for half a trillion euros.

As long as everyone can pretend these claims are good and no one will leave the Eurozone, then everything is fine. 

But what if Italy or Spain jumps ship? And what are the other options?

Three Alternative Paths 

1. Germany and the creditor nations forgive enough debt for Europe to grow 
2. Permanently high unemployment and slow growth in Spain, Greece, Italy, with stagnation elsewhere in Europe 
3. Breakup of the eurozone 

Pick Your Poison

• The German court signaled it has had enough of the current path towards more mutualization.
• It is unreasonable to expect #2 to last forever. 
• The only door remaining is door #3. 

Option 3 can be planned or chaos. Germany is arguably in the best shape to suffer the consequences so it would be wise for it to leave the Eurozone rather than have Spain or Italy default, setting off a cascade of defaults. 

I outlined those three alternate paths in my 2016 post Michael Pettis Calls Surplus Trade Statements by German Finance Minister “Utter Lunacy”

Kick the Can - How Long Can It Last?

The court ruling comes in the midst of a pandemic, Brexit, the rise of the German Greens, a eurosceptic Italian government, and an EU judicial clash with Poland. 

Yet, these can kicking episodes last far longer than anyone expects. The difference this time is the unexpected ruling by the German constitutional court. 

The ECB cannot do more, nor can the CJEU, nor will there be coronabonds or eurobonds unless Germany agrees.

Undoubtedly, the path of least resistance is still door number 2: Germany will talk solidarity but act against it.  

The result will be a continuation of high unemployment and slow growth in Spain, Greece, Italy, with stagnation elsewhere in Europe .... until the major unexpected happens, Italy or some other country decides it has finally had enough.

Mish