6 objections against the AG’s opinion in ECB case

Introduction

The Advocate General Wathelet delivered his opinion in the case Weiss. The preliminary questions in that case relate to the extensive purchase of public sector debt (PSPP) by the ECB in the secondary market. According to the Advocate General those purchases didn’t transgress the ECB’s mandate and were in full compliance with the prohibition on monetary financing. This blog post makes a critical review of the main arguments made by the AG Wathelet.

Unconventional monetary policy

The ECB tries to achieve monetary stability, which it defines as inflation under but close to 2%. The central bank is mainly influencing the inflation level by expanding and contracting the monetary base. Usually this can be achieved by making it more or less attractive for banks to take out a loan with the central bank. The ECB attains this by lowering or raising the interest rates of those loans. Since the interest rate cannot be pushed any lower, the ECB used more unconventional means, namely the purchase of assets with new money (APP), to expand the monetary base in an attempt to increase price levels in the Eurozone. The (extended) APP buys both public debt instruments (PSPP; amendments 1, 2, 3, 4) and private debt instruments (CSPP a1, a2; CBPP3, a1, a2; and ABSPP, a1).

Judicial procedure

Weiss and others believed that this purchase program of the ECB violated both the German constitution and the European treaties and started a procedure before the Federal Constitutional Court (FCC) of the Federal Republic of Germany. The FCC followed the reasoning of the plaintiffs on the PSPP and asked the ECJ to review the compatibility of that subprogram with the European Treaties. In the FCC’s understanding of primary European law, the PSPP violated both the mandate of the ECB and the prohibition of monetary financing.  Accordingly, they asked five questions to the ECJ on the validity of the decisions of the ECB underpinning the PSPP program.

Older case law of the ECJ

The ECJ already reviewed another part of the unconventional monetary policy of the ECB a few years earlier (Gauweiler-case). The OMT-program promised, under certain conditions, to buy unlimited amounts of government bonds if the interest rates on those bonds rose to a level that was, according to the ECB, only rational if the investors would hold the self-fulfilling believe that the Eurozone would collapse. According to the FCC’s reasoning behind the preliminary question to the ECJ, the OMT-program had the potential to violate both the German constitution and the European Treaties, if no additional conditions would be respected. The ECJ answered that the program already had sufficient safeguards to guarantee full compliance with primary European law.

Criticism of the FCC

The FCC heavily criticized the reasoning of the ECJ in the OMT-case. First, they argued that ECJ created a standard of review that depends on the establishment of certain facts. However, the ECJ thereafter leaves the fact finding to the institution under review. Second, the ECJ standard wouldn’t allow any effective protection against the interference with the responsibility of the member states for the economic policies. Third, the FCC believed that the articles of the Treaties dealing with the competences of the ECB should be explained using principles embedded in the Treaty, namely democracy, subsidiarity, limited assigned powers and effective judicial review. However, the ECJ interpreted the articles on the economic and monetary union without taking those principles and related concerns of the FCC into account.

Reception of ECJ’s case law by FCC

The FCC added that the decision of the ECJ could however be interpreted as implicitly containing six specific conditions which should be respected when the ECB would implement the OMT-program. If those conditions were not fulfilled, the program was an unconstitutional ultra-vires act by an EU institution. In this interpretation-exercise the FCC raised the specific safeguards that were accepted by the ECJ as sufficient proof that EU treaty law was respected, to the level of being necessary conditions for the purchases of government bonds on the secondary market. The FCC reapplied those, in their view, necessary conditions when it reviewed to PSPP and concluded that the PSPP clearly violated them.

AG’s rejection of the reception

As one would expect, the advocate-general now rejects the FCC’s interpretation of the ECJ case law. He accepted other safeguards as sufficient proof that EU treaties were respected by the PSPP program of the ECB. In his reasoning the AG accepted specific safeguards for compliance to primary EU-law that seem to be unconvincing and will raise the same kind of criticism as the FCC already expressed when it received the ECJ’s judgement about the OMT-program. We will limit ourselves to a critical review of two main types of arguments that the AG used in his opinion and a small remark about two others arguments used by the AG.

First type of argument: Certainty

The AG argued that no certainty exists about the future behavior of the ECB. This prevents, according to him, (1) the market agents to behave as a middle man between the state and the central bank, allowing the ECB to circumvent the prohibition on monetary financing and  generating the same effects as if the ECB bought the bonds on the primary market and (2) the member states to have weaker incentives to uphold budgetary discipline, to change the conditions for the issuance of public debt and to undermine the principle of sound budget enshrined in the treaties.

Criticism 1: Expected values

The lack of an absolute certainty about future behavior of the ECB is a misleading variable to predict the behavior of economic agents (both member states and market participants). Those agents act according to their expected pay-offs. The expected pay-off is (except if the agent experiences Leontief utility for different states) not determined by the lowest possible pay-out in the worst possible scenario (as the AG seems to assume), but by the chance-weighted sum of expected pay-out over potential states (each influenced by the set of possible behavior stances of the ECB) minus a risk premium which depends on the likelihood and amount of those pay-outs.

Criticism 2: Unlikely

It is true that, as the AG mentioned, the ECB could in theory at any moment in time suddenly and unexpectedly stop buying bonds or even sell all the bonds on its balance sheet. However, it is in practice not very likely that this would happen. A sudden, unexpected and substantial change in the bond buying program would undermine the credibility of the central banks future announcements relating to future behavior, shock the market, disturb monetary transmissions and shrink the monetary base. Those effects of a sudden, unexpected and substantial change in bond buying activities would all go against its policy, its interpretation of its mandate and its mode of operation. The ECB doesn’t have the incentives nor, through behavior revealed, preferences that would create an expectation with market participants or member states that the ECB would suddenly reverse course in an unexpected and substantial way. Even the threat of doing so, is not credible for the aforementioned reasons. The agents, accordingly, act as if there is a high possibility that the ECB will buy and hold a substantial amount of bonds for a substantial period of time.

Criticism 3: Change in solvency risk

If the ECB buys up to one third of the government’s debt and is expected to hold it for some time, it has a similar effect as if it eliminated that part of the supply of those bonds for that period of time. This has a substantial effect on the chance of default by that government during that period because it creates a temporary relief of financial pressure. The remaining quantity can be distributed to a smaller group of suppliers of credit. It makes the issuer less dependent on the more risk averse buyers of bonds that would be less likely to extend credit. The enhanced chance of successful roll-over of debt makes creditors more willing to provide credit and provide that credit at a more attractive interest rate. In other words: the PSPP makes it more likely that the issuer can roll over the total debt (or even expand it) and also more attractive to do so.

Criticism 4: Change in interest rates

The change in the supply on the financial market lowers the price of debt for the governments and makes it more attractive to have a fiscal deficit, high debt levels and postpone budgetary cuts. The source of the reduction of the supply of bonds (purchases on the primary and secondary market) is not that relevant for the effects that such a purchase has on the impetus to have a sound budget. The difference in the effects on the incentives of sovereigns and their creditors, is not that strongly related with the fact that the bonds are bought on the primary and secondary market. It is rather determined by the question whether they give a signal that a substantial part of the supply of debt will be effectively kept out of the financial market for a longer time.

Second type of argument: Conditions

The ECB is only buying bonds that comply to specific criteria that safeguard the program from having the two effects that we mentioned in the first type of argument. The main criteria are that the ECB doesn’t buy bonds (1) in the first period after issuance, (2) at the end of their maturity and (3) above the amount that would give it a blocking minority according to the collective action clauses in the bonds. It is, however, willing to buy debt at negative interest rates and hold debt until maturity.

Criticism 5: Substitutes

If the ECB is not buying bonds of a specific type for a specific and undisclosed period around a new issuance of those type of bonds, the AG argues, this allows the formation of market prices that are not distorted. That would only be true if the issuance conditions are not influenced by the prices and available quantities of other bonds. Those other bonds are, however, substitutes and the effects of buying one kind of government bond at one point in time just spread through the system to the other government bonds (even if they are sold at another point in time) and their prices both on the secondary and primary market. Taking into account the difference in regulatory treatment of government and other securities, other securities are not perfect substitutes (creating an inelastic demand for government bonds) and the price- and supply-effects are partially contained in that part of the debt market.

Criticism 6: Positive first derivative

The amount of risk (deviations of expected payout of which the likelihood and amount is known) and uncertainty (deviations of expected payout of which the likelihood and amount is unknown) on the shoulders of the initial buyer exist out of the changes, that influence the expected value of the bond, that can take place between the moment that he buys the bond and the moment that he expects that he has a chance to sell them to the next guy. Both risk and uncertainty per unit of time should increase over time because the number of possible state of affairs increases exponential if you take a longer period. The effect is that if the market participant is expected to hold a bond for a shorter period of time, it should more than linearly decrease the risk on that bond and thus the sensitivity of the investor to lend to a state which doesn’t have a sound budget and for that reason a higher likelihood of default.

Other arguments

The AG also gives several other argument. We will address only two of them in this paragraph. (1) He argues that the government bonds were the only available assets class that could be bought in the volumes needed to increase inflation. However, as the BOJ demonstrates with buying ETF’s, and the discussions on helicopter money shows, this is not true. (2) The AG adds that the ECB upholds certain quality standards in purchasing government bonds. That would be more convincing if it wasn’t in the habit of changing and suspending them on a regular basis when sovereign debt crisis arises and would not influence the chance of the debt crisis with buying up one third of the debt (criticism 3).

The fifth question

The AG didn’t discuss the fifth preliminary question on the competence of the ECB’s Governing Council to raise the level of risk sharing if a sovereign or international organization would default on its debt. The AG believed that this question was “indisputable hypothetical” because the FCC didn’t demonstrate sufficiently that there was a likelihood that an unlimited sharing of risk would take place. Taking into account the high frequency with which programs and risk limiting collateral standards were adapted in times of crisis by the ECB, I would be inclined to disagree with that assessment.

Conclusion

The PSPP eliminates up to one third of the supply of government bonds. The announcements and the bond buying itself creates pay-outs for the ECB that make it unlikely for them to make any sudden, unexpected and substantial changes in their behavior. The announcements made by the ECB raised the expectation that a substantial amount of government debt would, for a substantial amount of time, not be financed by the financial markets but by the ECB. This expectation lowered the chance of default and raised the chance that bond holder will be able to sell their bond or hold them until maturity without having to incur to a loss. This lowers the cost of deficits and high debt levels for governments. To argue that the safeguards embedded in the PSPP program “prevent the conditions of issue of government bonds being distorted”, “prevent […] lessening the impetus of the Member States to follow a sound budgetary policy” and “does not give the ESCB’s intervention an effective equivalent effect to that of a direct purchase of government bonds” seems to overestimate the effects of remedies within the PSPP program.

Jitte Akkermans