06 August 2015

Bruegel: Wolfgang Schäuble, Debt Relief, and the Future of the Eurozone

The reason Schäuble is concerned is that the carefully constructed but fragile crisis management system—intended to insulate Germany from paying the bills of others—is now under threat. If Greece creates a precedent, then either the crisis management system goes, or a transfer union is effectively in place, with Germany on the hook. Hence his call for Greece’s exit is accompanied by an equal vigorous effort to control the budgets the euro area sovereigns. Acrimony is bound to follow, creating deeper divisions in Europe.

The Legality of European Bailouts

Creditors forgive debt because both the creditor and the debtor gain. For that reason, it is both economically right and legally correct to forgive some claims. Karl Whelan and Armin von Bogdandy, Marcel Fratzscher and Guntram Wolff make the mistake of arguing the case for debt relief on the basis of European law.  Despite their thoughtful arguments, the authority granted under Treaty on the Functioning of the European Union (TFEU) for member states to loan funds to other member states and for the ECB to conduct its Outright Monetary Transactions (OMT) has a fragile legal basis. That authority skirts the limits of the Treaty and goes against the intent of original signatories. The authority was created as a response to the crisis and Greek debt relief threatens to unravel that structure.

Article 125 of the TFEU says that a member state cannot pay another’s debts. This is the “no bailout” clause that was agreed to at Maastricht. Its meaning was self-evident to the signatories. That was also true for Article 123, which prohibits monetary financing of a sovereign by the ECB.  Put simply, if they had disagreed, there would have been no euro.

When the Irish parliamentarian Thomas Pringle challenged the European Stability Mechanism (ESM), the European Union’s bailout fund, the European Court of Justice (the ECJ) agreed that Article 125 prohibits a member state’s debts being paid by another. But the ECJ allowed that a member state could receive a loan from other member states, provided it was repaid “with an appropriate rate of return.” It is the repayment with an appropriate rate of return that protects the ESM from violating Article 125.

[...]

That interpretation would create a cascade of losses. Recall that the OMT can only be activated if an ESM program with a sound economic recovery strategy is in place. Such a program would—it is hoped—make the likelihood of a loss on the ECB’s operation negligibly small. If that presumption is valid, the ECJ says, the OMT would not be financing operation. This is crucial because, unlike the ESM, the ECB is not even allowed to provide financing to euro area sovereigns. The OMT, protected by ESM financing and policy conditionality, is a monetary policy operation, much as its multitude of daily transactions. Losses on monetary operations are permissible, not on loans to sovereigns. If von Bogdandy et al. are right that the ECB can make losses on its holdings of sovereign bonds, then this is the perfect moment for the ECB to forgive much of its claims through Greek bonds purchased under the Securities Markets Program.

In practice, the ECB has added one further layer of protection. In its so-called quantitative easing operation, the burden of first loss on the ECB’s purchase of national sovereign bonds falls on the national central banks. If this is so for QE, then it must be all the more so for OMT, which is decidedly a more risky venture.

The steady debt forgiveness of Greek debt since the European Council meeting on July 21, 2011 has steadily lowered the rate of return to creditors. When the legality of the Greek bailout is tested before the ECJ—as it inevitably will be—the ECJ will, at the very least, need to add: “creditor beware.” If so, ESM programs will come under a further cloud and so will the OMT. If that makes the possibility of debt relief a material risk, then will the ESM, in effect, be frozen? [...]

Full article on Bruegel

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