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On the Impotence of Karlsruhe

Posted by Eugen von Bhm-Bawerk

If there is one single event that could derail the euro experiment it is the German
Federal Constitutional Court ruling on the European Stability Mechanism (ESM) and
Outright Market Transactions (OMT). We will take you through the dierent legal
arguments used on both sides of the aisle, but rst you need to understand the
importance of this ruling.
Without the ESM and more importantly the OMT there would be widespread
sovereign defaults within the euro zone. This would have dragged down banks,
pension funds and nancial markets in general. Alternatively, the troubled
sovereign would simply pull out of the monetary union altogether and default in all
but name through massive ination of its own and newly established currency.
We estimate the Draghi put is worth around 400 basis points given the response in
sovereign credit markets since he announced it. And it is simple to understand why!
If , say, Spanish 10 year bond should once again yield anything close to 7 per cent,
they would simply ask the ECB to intervene and promptly push the yield back down
to around 4 per cent.
The investors that understood this back in 2012 bought Spanish bond at 7.62 per
cent and made a handsome prot. It also window-dressed the Spanish banking
sector balance sheet enough to silence skeptics for a while.

An alternative way to look at this is provided through the TARGET2 imbalance that
shrank in the immediate aftermath of the OMT announcement.
Whilst the market tries to tell us that southern European capital consumption is
unsustainable and should be reined in, Draghi has simply told investors that such
nonsense is unnecessary. Ever since Keynes thought us that central banks can
produce capital at will, we should not be concerned about those evil causalrealist economists; they belong on the scrapheap together with other barbaric
relics.
Luckily for us, there are some barbaric causal-realists still in Germany, not just on
the ether, that share our concerns. They have taken the OMT to court along with
the ESM. If the OMT turns out to be illegal according to the German constitution,
then the ECB would be forced to retreat, or Germany have to leave the Euro. We are
not sure if humorless economists nd Gerxit to be as enchanting as Grexit, but we
are sure the barbarians would appreciate it.
The Federal Constitutional Court in Karlsruhe is mandated to uphold the
Grundgesetz or basic law of Germany. In earlier rulings on the EFSF and also on a
temporary injunction against the ESM we know how the Karlsruhe judges looks at
this mandate.
Their underlying guiding principle is always to make sure that the eternity clause in
the Grundgesetz is in no way jeopardized. For obvious historical reasons, the
Grundgesetz was written with the concept of unconstitutional constitutional
amendments at its core.
While this may seem to contradict our understanding of legal hierarchy at rst, it
does t into the rules made by the constitution about amending it. And there is no
way to amend the Grundgesetz guiding principle about the Federal Republic of
Germany being a democratic and social free state
Article 79 divides the Grundgesetz into amendable and un-amendable portions in
which Article 20 stating that Germany is a democratic state is specically
mentioned as an un-amendable part. Article 38 is again part of Article 20. Article
38 (1) states that Members of the German Bundestag shall be elected in general,
direct, free, equal and secret elections. They shall be representatives of the whole
people, not bound by orders or instructions, and responsible only to their
conscience.
As an extension of this, we learn from the EFSF ruling issued September 7 th 2011
that members of Parliament must remain in control of fundamental budget
policy when establishing mechanism of considerable nancial importance which
can lead to incalculable burdens on the budget, the German Bundestag must
therefore ensure that later on, mandatory approval by the Bundestag is always
obtained. They continue by stating that the legislature is prohibited from
establishing permanent mechanisms under the law of international agreement
which result in an assumption of liability for others states` voluntary decisions,
especially if they have consequences whose impact is dicult to calculate
In other words, the Bundestag cannot transfer budgetary power to institutions in

Brussels, or Frankfurt for that matter, as this would violate the right of the German
people to independently govern themselves. Any transfer of funds from Germany to
any other institution must be approved by the Bundestag on a case-by-case basis,
and they must always know exactly what amount they sign up for. The liability must
be strictly limited and decisions regarding this liability can never be transferred to
any non-German institution.
Now, lets start with the European Stability Mechanism and see what legal
diculties it may face. In the ruling of September 122012 where the court refused
the applications for the issue of temporary injunctions we got a good grasp on
what the ESM ruling will be, but there are still caveats to be cleared.
First of all, in the preamble to the Treaty on the ESM (T/ESM 2012) it says that
The European Council agreed on 17 December 2010 on the need for euro area
Member States to establish a permanent stability mechanism.
As we learnt from the EFSF ruling of 2011, the Court specically told the legislature
that any permanent mechanisms would be un-constitutional.
Further, we read from the ruling of September 12 2012 that it is required to ensure
in the framework of the ratication procedure under international law that the
provisions of the ESM Treaty may only be interpreted or applied in such a way that
the liability of the Federal Republic of Germany cannot be increased beyond its
share in the authorised capital stock of the ESM without the approval of the
Bundestag and that the information of the Bundestag and the Bundesrat according
to the constitutional requirements is ensured.
The Court says this requirement is fullled by T/ESM 2012 Article 8 (5), but in
Article 9 it states that the Managing Director of the ESM can always demand
participating countries to pay in unpaid capital by simple majority decision to
restore the level of paid-in capital if impairments or losses should occur.
Admittedly, this does not in itself invalidate the limitation set forth by Article 8, but
if we move to Article 25 (2) that outlines routines in case of losses we are amiss to
distinguish between Article 8s limited liability concept as requested by the Court
and the potential for unlimited liability.
Article 25 (2) specically states that If an ESM Member fails to meet the required
payment under a capital call made pursuant to Article 9(2) or (3), a revised
increased capital call shall be made to all ESM Members with a view to ensuring
that the ESM receives the total amount of paid-in capital needed. The Board of
Governors shall decide an appropriate course of action for ensuring that the ESM
Member concerned settles its debt to the ESM within a reasonable period of time.
The Board of Governors shall be entitled to require the payment of default interest
on the overdue amount.
It is not clear to us that Germany`s liability is limited and easy to calculate and
apparently it is not clear to the court either. Thus, they explicitly made it clear that
Article 8 will have to be interpreted in a way that it trumps both Article 9 and 25 in
all respects! This cannot be done without changing the wording of T/ESM 2012.
Under the assumption this requirement can somehow be adhered to; the ESM will

be approved more or less as is. The OMT on the other hand faces problems of its
own.
On September 6 2012 the ECB issued a press release outlining the technical
features of Outright Monetary Transactions. There are three things that stand out
for the legal discussion
1. OMT support is conditional on the country in question also engage the ESM;
which comes with a macroeconomic adjustment program.
2. OMT will predominantly, but not necessarily exclusively, be focused on the
short end of the yield curve; dened as maturities of less than three years but
more than one year.
3. No ex ante quantitative limits are set on the size of the OMT the program is
potentially unlimited.
The problem with number 1 is obvious from the view that a central bank shall be
independent. If a scal program is the condition for proper monetary policy, how
can ECB policy be independent? What if the country in question fails to fulll the
adjustment program, will the ECB stop its OMT? Does that make sense from their
mandated goals?
When it comes to number 2 and 3, we need to see these together and in
conjunction with the EFSF-ruling regarding limited liability. If the ECB is free to buy
unlimited amounts of sovereign bonds it violates the eternity clause in the
Grundgesetz.
But, according to the Grundgesetz Article 88 The Federation shall establish a
note-issuing and currency bank as the Federal Bank. Within the framework of the
European Union, its responsibilities and powers may be transferred to the European
Central Bank, which is independent and committed to the overriding goal of
assuring price stability.
How can the Court rule against the OMT when the constitution itself says the ECB is
independent. Would that not be the very denition of irony? The Court that is
mandated to uphold the Grundgesetz must violate the very same Grundgesetz to
rule on the OMT.
In any case, the eternity clause should in theory trump Article 88 and the Court
should could still vote no, despite violating the principle of monetary policy
independence.
The OMT could also be said to violate the Treaty of the Functioning of the European
Union (TEFU) Article 123 (1) which clearly states that Overdraft facilities or any
other type of credit facility with the European Central Bank or with the central
banks of the Member States (hereinafter referred to as national central banks) in
favour of Union institutions, bodies, oces or agencies, central governments,
regional, local or other public authorities, other bodies governed by public law, or
public undertakings of Member States shall be prohibited, as shall the purchase
directly from them by the European Central Bank or national central banks of debt
instruments.

If so, the case need to be submitted to the European Court of Justice, as the
Karlsruhe Court mandate is limited to the Grundgesetz.
The way out for Karlsruhe!
While the legal entanglements the OMT is in, seem to be insurmountable it is nave
to think politics does not play a big role here. The pressure on Karlsruhe is
immense and they will have to come up with a way to get it through no matter
what.
Here is how we think they will go about.
First of all, limit the OMT to the one to three year maturity range and make sure it
only applies to bonds already issued at the time of OMT engagement. This takes
care of two problems.
First of all, it is easy to calculate the potential liability beforehand as we know the
size of the market.
Secondly, making sure the country under OMT help does not swap all its longer
term bonds for newly issued shorter maturity bonds, the decision on the ultimate
liability is no longer in the hands of non-German institutions.
Further, in order to keep the Bundestag nominally in control, maintain the
connection between OMT and the ESM adjustment program.
Lastly, limit the OMT to secondary market interventions and claim Article 123 of the
TFEU does not apply (it does, but they can at least pretend). If need be, the ESM
can always make primary market interventions.
While these limitations on the OMT are noteworthy, they will probably not be large
enough to undermine the Draghi put.
Alternatively the Court could use Article 88 of the Grundgesetz and give an all clear
or send the case to the European Court of Justice. Legal proceedings here would
probably take another year of two which buys even more time, just as the OMT was
originally designed to do.
Conclusion
There are four alternatives for Karlsruhe, but given the importance of politics only
one seems very likely at this point.

2 Replies

November 3, 2013

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Arend Lammertink on November 4, 2013 at 14:13

But, according to the Grundgesetz Article 88 The Federation shall

establish a note-issuing and currency bank as the Federal Bank. Within the
framework of the European Union, its responsibilities and powers may be
transferred to the European Central Bank, which is independent and
committed to the overriding goal of assuring price stability.
How can the Court rule against the OMT when the constitution itself says
the ECB is independent. Would that not be the very denition of irony? The
Court that is mandated to uphold the Grundgesetz must violate the very
same Grundgesetz to rule on the OMT.
In any case, the eternity clause should in theory trump Article 88 and the
Court should could still vote no, despite violating the principle of monetary
policy independence.

I think a 5th scenario is possible, and even most likely. Article 88 says that
the responsibilities and powers of the Federal Bank, The Bundesbank, may
be transferred to the ECB. If the eternity clause should trump this article,
then the Court should be able to determine some limits and/or
interpretations for its applicability.
The idea embodied in the Grundgesetz is that the Bundesbank is
responsible for Germanys monetary policy:
en.wikipedia.org/wiki/Deutsche_Bundesbank

In the wake of the Fall of the Berlin Wall, the Federal Republic of Germany
and the German Democratic Republic signed a treaty on 18 May 1990, that
created an economic, social and currency union between the two German
nations; it came into force on 1 July 1990, and made the Deutsche Mark the
sole legal tender in both German states. The Bundesbank was made
responsible for money and currency policy within the whole of the currency
union.
Now if the eternity clause should partially trump article 88, then ultimately
the Bundesbank should remain responsible for maintaining the stability of
the German currency. And therefore, the Court can rule a yes, but..
whereby it essentially gives the Bundesbank the power to do whatever it
deems necessary to fulll its responsibilty of assuring the price stability of
the German currency, including exiting the euro system if that is what it
deems necessary.
That way, it would NOT rule in favor nor against the OMT, which indeed is
not her decision to make, BUT it would rule that the Bundesbank MUST
remain in control of federal scal policy, just like the Bundestag MUST
remain in control of the federal budget.
That way, it would put the controlling power right there where it belongs:
within the German republic, without interfering in the responsibilities of
said institutions
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