The Euro’s day of reckoning

This August could prove to be a decisive month for the Euro. It is the month when the German Constitutional Court is set to deliver a final verdict on whether the European Central Bank (ECB) exceeded its mandate by engaging in a large-scale government bond buying program.

A thumb’s down to the ECB by the German court could very well mean the beginning of the end for the Euro. But a thumb’s up, or some compromise on the issue, could at the very least provide the Euro with a temporary respite.

Early last month, the German court in Karlsruhe dropped a bombshell by unexpectedly ruling that the ECB might have been acting beyond its legal authority by engaging in its large-scale quantitative easing program. The court indicated that unless it received a satisfactory explanation from the ECB within three months that this was not the case, it would instruct the Bundesbank, Germany’s central bank, to refrain from participating in future ECB bond purchase programs. That would in effect deliver a death knell to the ECB’s bond buying program, since the Bundesbank is by far the largest of the ECB’s member central banks. 

At the heart of the issue is whether the ECB violated Article 123 of the Treaty of Lisbon. That article explicitly prohibits the ECB from providing monetary financing for a member country’s budget deficit. While the European Court of Justice has ruled that the ECB has not acted in violation of the Treaty of Lisbon, the German Constitutional Court has expressed its strong doubts on the European court’s ruling. 

All of this legal wrangling is of the utmost significance for the Euro’s future given the dire state of Italy’s economy and its public finances. Even before the coronavirus pandemic chose Italy as its European epicenter, the Italian economy was beset by years of sclerotic economic growth, by a very weak banking system and by an uncomfortably high public debt level. After the coronavirus pandemic struck, there could no longer be any doubt that Italy’s public finances had become unsustainable.

The ECB is now expecting that in 2020 the Italian economy could contract by at least 10 percent. That in turn could cause Italy’s budget deficit to swell to around 10 percent of GDP and its public debt to skyrocket from 135 percent of GDP last year to around 160 percent of GDP by year-end.

The optimists are hoping that the German government and the Bundesbank will impress on the German court the critical role that the ECB will need to play to keep the Euro together in the midst of the coronavirus pandemic. They are hoping that need will induce the German court to back down from its hardline position and to seek a compromise with the ECB based perhaps on a commitment by the ECB to have its future decisions reviewed by the German parliament. 

The pessimists are noting that since the German court’s initial ruling, the ECB has taken action that is likely to further antagonize the German court. Not only did the ECB expand its government bond-buying program by EUR 600 billion. It also changed the operating rules of that program. Rather than being bound by a commitment to buy its member countries’ bonds in direct proportion to their share of the ECB’s capital key, the ECB will henceforth have complete discretion as to which member country’s bonds it chooses to buy. 

It would seem that what will particularly stick in the German court’s throat is the ECB’s decision to buy around EUR 50 billion in Italian government bonds over the past two months. That amount corresponded almost exactly to the Italian government’s gross borrowing needs during that period. One would think that the ECB’s decision to do so will only confirm the German court’s misgivings that the ECB is engaging in the monetary financing of government deficits in flagrant violation of the Treaty of Lisbon’s strictures. 

European policymakers have a long history of finding a way to waive the rules in a manner that allows them to muddle through seeming intractable challenges. One has to hope that German policymakers and the ECB will manage to do the same in their present standoff with the German court. If not, we should brace ourselves for another round of the European sovereign debt crisis later this year.

Desmond Lachman is a resident fellow at the American Enterprise Institute. He was formerly a deputy director in the International Monetary Fund’s Policy Development and Review Department and the chief emerging market economic strategist at Salomon Smith Barney.