A friend of mine has just made up his own version of Rembrandt’s 1632 oil painting The Anatomy Lesson of Dr. Nicolaes Tulp. Its name is The Economy Lesson and Dr Tulp would be German Bundesbank President. His attentive students would be the Chairman and members of the Constitutional Court of Germany. And the corpse becomes a patient representing the European Central Bank.
My friend has a powerful imagination, sure, but this analogy is perfect for today’s circumstances. Last December, the Bundesbank sent a sensible document to the German Constitutional Court regarding the creation of the European Stability Mechanism, ESM. This 90-page lesson has just been published by Handelsblatt, and it deserves some comments from The Corner. As expected, the German central bank objects the ECB’s program of buying unlimited debt (OMT) which was approved in September 2012 although the German bank voted against it. Its balance of TARGET2 continues to be constructive. None of the issues are new.
As for the Outright Monetary Transactions, OMT program, the Bundesbank is very critical about the ECB’s vow to buy up the bonds of euro zone countries that have signed with the ESM.
Ideally, monetary policy should be transmitted with a minimum of friction throughout the system–the eurozone, in this case. Chairman Draghi has expressly mentioned that high risk premiums demanded by the market and the unequal costs of financing of the real sector constitute enough anomalies to justify the intervention of the European Monetary Authority. Draghi announced not dogmatic but pragmatic principles, which the Bundesbank rejects, doubting that it’s worth making the effort to unify financial costs within the EMU: after all, the structural differences between member countries can justify very different levels of financial costs. And in any case, if they were to be corrected, why should it be precisely using monetary policy, whose aim is monetary stability and not the homogenisation of practices and conditions among countries?
The Bundesbank, it’s fair to say, has a point. Eurozone members still control important areas of their own economic policies. Governments have proven ability to generate risk factors, and markets have ample ability to incorporate those factors into the estimation of risk premiums. Political circumstances as well as economic management can be seen as a probability of monetary unification fragility and play against risk premiums: outside of Europe, and in Europe, many think that the eurozone shall not last forever. The Bundesbank explains to the judges that monetary policy is not adequate to combat such uncertainties.
The difference between the Bundesbank and Draghi’s positions is that the first stands for an ortodox, rigid monetary policy, and Mr Draghi suggests trying more daring policies in order to exit the crisis or at least gain a little time. It seems as if the German central bank was overflying reality whereas the ECB, covered with mud, was the only one trying to make its members–including the Bundesbank–go in the same direction.
Bundesbank criticism of OMT For the Bundesbank, it is easy to say conditionality does not work. Both the IMF and the World Bank are aware of it. But the German central bank is not suggesting a condition-free financing.
The ECB’s vow to purchase debt without limit of a country is based on a program of reforms agreed to and funded by the ESM. Of course it can happen that the country fails to comply with the ESM and the ECB has to consider the suspension of purchases or its commitment to unlimited debt buying, predictably causing the uncontrolled rise in the risk premium. The solution is not in any book, and the citizens trust their leaders will fix the situation. Unless the country is willing to exit the eurozone, I don’t see any reason why the ECB, ESM and the country’s leaders won’t find common ground to boost the reforms.
The Bundesbank perfectly knows this but it also remembers a recent case of conditionality not working. The ECB helped a country to reduce its risk premium thinking this country’s government had important reforms on the agenda. That country was Italy during the summer of 2011 and what happened was that politicians forgot their commitments. Fiscal policy killed monetary policy’s efficiency.
The ECB’s power This is a crucial question for the Bundesbank. The Treaty (article 123) is clear about the prohibition of purchases on the primary market. That is the way to preserve the ECB’s independence. But can it operate in the secondary market? For the Bundesbank the answer is yes, but. According to the ECB’s regulation, it can, as any other central bank, but for the Bundesbank those purchases must have monetary policy purposes instead of just helping indebted governments. Some limits to the fiscal policy were set in Maastricht (Germany’s top court members should bear in mind that the first countries to break this rule were Germany and France in 2003).
Anyway, the Bundesbank is right when it points out that the Emergency Liquidity Assistance ELA to the Greek banks actually served to monetize the deficit through Treasury bonds–but the way to avoid any error in crisis management is to reduce the ECB’s role to a mere observer’s. Neither Trichet nor Draghi have believed they had to be in charge of a passive institution. Nobody in the eurozone believes that either, except for one country.
Target2 balance German economists–led by the Director of the IFO Institute in Munich–have expressed their criticism about the meaning of the credit balances of the Bundesbank as a result of the TARGET2 settlement mechanism. The opinion of the Bundesbank is rather more nuanced and less alarmist than the experts’, and much less dogmatic than its own treatment of the ECB and the OMT program.
The Bundesbank analyzes the issue based on data from mid-2012, when total balances were above 1.1 trillion euros, and it had lent three-quarters of that amount (numbers have been significantly reduced since then). While monetary union continues, and Germany stays in, TARGET2 does not create serious risks for the country.
An eventual exit of a member would, naturally, mean to negotiate the settlement of the balance of that country’s central bank, and losses would only occur if the balance was completely unrecoverable. It is difficult to imagine that a country would refuse to negotiate with creditor countries as due to geography and tradition they will also continue to be major trade and financial partners.
Risks for the federal budget The final pages of the report systematize the discrepancies of the Bundesbank with the management of the ECB. The bank reminds to the Court that the ECB has softened, throughout the crisis, the quality of assurance required in refinancing operations, and in particular, the ones assigned in direct management to the national central banks, as in the above-mentioned example of provision of liquidity ELA to Greek banks. This laxity may adversely affect the objective of monetary stability and end up causing losses to the Bundesbank and finally to taxpayers. The report does include a theoretical scenario in which an under-capitalized Bundesbank would be recapitalized by the German government in order to safeguard the financial credibility of the institution.
The last paragraph of the report is particularly interesting. “Some argue,” the Bundesbank states, “that the ECB’s management aim, particularly the OMT program, is stabilization, since it can prevent the intensification of the crisis and, therefore, negative impact on taxpayers. But another approach would better accommodate the principles of EMU. Why not resorting to the financial stabilization mechanisms specially created, such as the EFSF and its successor, ESM, involving–against an independent ECB–governments and parliaments, whose decisions do not interfere with monetary policy?” This barrage against the ECB can have some positive consequences, since the Bundesbank values the mission assigned to the ESM within the institutional framework created during the crisis. Given all the criticism about ESM’s legality, the opinion of the Bundesbank can make all the difference.
So the Economics Lesson of Dr Tulp is not arbitrary. What is worrying is the Bundesbank attitude of permanent and frank opposition to the initiatives of the ECB to overcome the crisis, being against any flexibility and realism that the economy is needing. Given the technical and intellectual respect that–without a doubt–the Bundesbank deserves, I fear their position is spreading distrust towards the ECB, fueling euroscepticism in German media and among the public opinion. Belgian Professor deGrauwe asked the Bundesbank a few months ago to end its guerrilla war against the ECB. We totally agree with him.