The Hidden Significance Of The German Constitutional Court Ruling

This week the German Constitutional Court (GCC) ruled that the Bundesbank must clarify that its participation in unconventional, ECB-mandated bond-buying programmes does not violate the German Constitution, or Basic Law (Grundgesetz). While the decision is highly technical and has already been interpreted in multiple ways by those on either side of the dispute, it highlights the unique role that the Bundesbank plays in EMU. Indeed, it strengthens my long-held view that, notwithstanding its de jure subordination to the ECB since 1999, the Bundesbank retains a huge amount of ‘soft’ monetary and political power – enough to potentially bring down the euro in a crisis.

A Brief History of EMU

During the 1950s, and more so during the 1960s and 1970s, the contrast between Germany and southern Europe, and even with France, became increasingly stark. On the one hand, the Mediterranean countries responded to economic weakness with the occasional currency devaluation. Germany, however, grew faster notwithstanding a strong currency primarily as a result of higher rates of business investment and associated productivity growth. Indeed, this combination became a virtuous circle: a strong currency meant that German firms could grow their global market share and profits only to the extent that they increased productivity. So they invested in infrastructure, capital goods, education, research and technological development. When the going got tough, the Bundesbank would not devalue the mark to ease the pressure. If German industry faced a squeeze, they would need to find another way out: to reorganise and innovate. Frequently this was done with the blessing and involvement of the government but, regardless, profit-seeking German firms, not politicians, were in the driver’s seat.

When EMU was conceived, the general assumption was that, once wearing the single-currency “straightjacket”, the Mediterranean countries, unable to devalue their way out of periods of weak growth, would focus instead on increasing their competitiveness. A German-style, independent monetary policy and associated hard currency would widen the German virtuous circle to include all participating countries. But, following the introduction of the euro, something else happened. As was the case in the 2000s in many countries around the world, asset bubbles began to form, in particular in real estate and euro peripheral debt.

From the early 2000s, peripheral borrowing costs converged rapidly down toward the German level. Previously funding their debt at several percentage points above Germany, countries ranging from Ireland in the European northwest to Greece in the southeast discovered that their borrowing costs were less than one percent greater than Germany’s. Faced with this windfall of sharply lower borrowing costs, these countries governments had the option of reducing deficits and paying down debt.

In a few cases, such as in Ireland, Italy and Spain, they did just that for a while. With governments requiring less savings to fund deficits, there was more available for private sector investment. But this led, in time, to large real estate bubbles in several of these countries. Underneath the surface, something sinister was afoot: While public sector finances were looking rather better for a time and property prices were booming, workers’ wages were rising fast and their economies were losing competitiveness. By the mid-2000s, there had been up to a 20% appreciation of the real effective exchange rates in these “windfall” economies, implying a 20% loss of competitiveness vs Germany. Yet, with borrowing costs low and asset prices rising, no one seemed to care.

At the time, I was working as a bond strategist for a major US investment bank in London and it was my job, among other things, to have a view on the relative attractiveness of the various euro-area government bond markets. Ever since EMU had begun, spreads for euro-area sovereign bonds relative to German Bunds had generally continued to converge even for the least competitive countries. In 2005 and 2006, borrowing costs narrowed to as little as 0.25%. This was completely inconsistent with the 20% loss of competitiveness in these countries, which implied far lower relative growth rates and difficulty with debt service in future. As such, I began to recommend that investors aggressively underweight these bonds. Beginning in 2007, these trades began to pay off as peripheral spreads exploded and the euro sovereign debt crisis began.

‘Whatever it Takes’: Does That Include Violating the German Constitution?

The euro sovereign debt crisis dragged on for years, and all the while the ECB stood by to do ‘whatever it takes’ to protect the currency union – the famous words of former chairman Mario Draghi, uttered in 2012. Around that time, however, a movement began in Germany to press for the German Constitutional Court to consider whether various unconventional measures implemented by the ECB, and the Bundesbank’s associated, essential role as a member of the Eurosystem, violated the German Constitution.

Also around that time, several prominent German economists began openly advocating that Germany reconsider participation in EU-bailout arrangements that do not require a substantial debt restructuring. Perhaps the most outspoken of these was Dr. Hans-Werner Sinn, President of the prominent IFO Institute and member of the German Council of Economic Advisers (colloquially known as the “Five Wise Men”).

In a 2010 paper, ‘Rescuing Europe’ (a summary of which is here), he argued that not only had various euro-area countries taken advantage of low borrowing costs to artificially amplify growth by failing to deliver meaningful cuts in fiscal spending; but also that the capital that flowed into housing and unsustainable government spending in the “windfall” economies was German capital that should in fact have stayed in Germany, where investments would have been less speculative and ultimately more sustainable. In other words, German capital has been misallocated and is now at risk of being outright squandered by German participation in ill-conceived bailouts which do nothing to remedy the underlying malaise of the bail-out recipients. Rather, such bailouts create a massive moral hazard problem which virtually ensures that German capital will continue to be misallocated around the periphery.

Needless to say, the paper caused quite a stir in European financial and political circles. Martin Wolf of the Financial Times, arguably the most influential European financial columnist, proclaimed Mr. Sinn’s views as being both dangerous and wrong, arguing that Germany is a huge beneficiary of EMU and of European integration in general. But ultimately his argument can be reduced to circular logic: Germany’s neighbours, using German capital, buy German exports, thereby helping Germany. Everybody wins, right? Wrong. That capital has multiple potential uses. That portion that goes to wasteful, unsustainable bubbles and other misallocations could be deployed elsewhere, including in Germany itself, or perhaps in the more competitive European East.

The Bundesbank’s Underestimated, Underappreciated ‘Soft Power’

To outside observers, the prolonged German Constitutional dispute may seem rather odd. Following the introduction of the euro, the Bundesbank ceded de jure power over German monetary policy and, by extension of the German mark’s previous role as anchor currency, over euro-area monetary policy as well. (The Bundesbank retains an important regulatory and supervisory role with respect to German financial institutions.) So how is it, exactly, that I nevertheless believe the Bundesbank is somehow in a position to resist what has now become a near universal euro-area march toward some form of debt mutualisation and monetisation?

Well, as it happens, the German public hold the Bundesbank in rather high regard. Most Germans know the Bundesbank long presided over Europe’s largest economy, maintaining price stability and fostering a sustained relative economic outperformance. Many Germans probably recall how, on multiple occasions, the Bundesbank successfully resisted inflationary government policy initiatives. Older Germans recall how the Bundesbank contributed to the Wirtschaftswunder (economic miracle) of the 1950s and 1960s. And Germans old and young alike know that the ECB, based in Frankfurt, was supposedly modelled on the Bundesbank and the euro on the German mark.

So when the Bundesbank speaks, Germans listen. And when the Bundesbank voices concern over ECB or German government policy, Germans become concerned. And so it was back in 2012. It was widely reported in the German press at the time that Bundesbank President Jens Weidmann had threatened to resign at least once in protest over some proposed bailout actions by the ECB and governments. Apparently Chancellor Merkel pleaded for Weidmann to remain at the helm, and obviously she succeeded.

But what will Weidmann do now, given this most recent GCC ruling requiring an explanation from the Bundesbank that its participation in the most recent unconventional ECB policy measures is constitutional? Is he willing to argue against his conscience to defend the ECB? What if Weidmann does indeed resign in protest at some point? His former colleagues Axel Weber and Juergen Stark have already done so (in Stark’s case from the ECB, not the Bundesbank). What if some of his Bundesbank board colleagues join him?

I can’t emphasise this point enough: the institution of the Bundesbank is held in such high regard among the German public that should Weidmann and any portion of his colleagues resign in formal protest of bailouts in whatever form, it may well bring down the German government, throw any disputed ECB policy arrangements into complete chaos, spark a huge rout in distressed euro-area sovereign and bank debt, and quite possibly result in a partial or even complete breakup of the euro-area. The Bundesbank therefore represents the normally unseen foundation on which the entire euro project rests. Should it remove its support, perhaps with cover from the German Constitutional Court, it may all come crashing down.

But why would the Bundesbank ever do such a thing? Isn’t it just a bureaucracy like any other, expected to serve the government? Well, no. Consider the unique role of the Bundesbank under German Law. It is not answerable to the government. It is its own regulator. Its board members are appointed by the president, the head of state, not the chancellor, who is the head of the government. Its employees are sworn to secrecy during both their active service and in retirement. The Bundesbank alone determines whether its employees have infringed its code of conduct and determines what disciplinary actions, if any, should be taken. Moreover, with its most recent ruling the GCC has clarified that, according to the Constitution, Bundesbank officers are personally liable for the costs associated with any actions taken by the Bundesbank that are subsequently ruled unconstitutional.

Weidmann’s intransigence is therefore entirely in line with German law and tradition. The Bundesbank, by design, will confront the government if it believes that such action is necessary to carry out its mandate. And what is that mandate? As per the original Bundesbank Act, “The preservation of the value of German currency.” Previously the mark, the euro is now the German currency and the Bundesbank’s mandate is to preserve its value. Needless to say, open-ended bailouts of euro-area banks and sovereign countries would, without question, threaten that value.

You can be certain that when President Weidmann said back in 2012 that what was being proposed by the ECB “violated its mandate,” he chose his words very, very carefully. In a subsequent speech on the same topic, he quoted from Goethe’s Faust, arguably the most famous play in German literature and a classic warning against hubris and temptation, including that of the monetary variety. You don’t do that if you are not deadly serious. The implication, no doubt, is that Weidmann was sending a message that the Bundesbank is independent of the ECB with respect to determining whether or not ECB policies are consistent with “the preservation of the value of German currency,” which now happens to be the euro. The Bundesbank thereby re-assumed this dormant but ultimate power over German monetary policy. Under just what circumstances it will choose to exercise it, I don’t know, but this most recent ruling by the GCC raises the stakes considerably.

Has the GCC Placed the ECB in a Box?

While I would stop short of predicting the crisis described above, a clear implication of the GCC ruling is that it significantly strengthens Weidmann’s hand when it comes to negotiating with his ECB colleagues. And, for that matter, it strengthens his hand against the governments applying pressure for the Bank to do ‘whatever it takes’ this time around, yet again, and indefinitely. Other factors equal, it will now be far harder for the ECB to reach a consensus to do something radically new. Indeed, some recent actions, like buying corporate debt such as the LVMH bonds issued to finance acquisitions, may already be perceived by the Bundesbank as having crossed yet another important constitutional line.

With the ECB’s freedom for future action thus freshly circumscribed, the pressure on peripheral sovereign debt spreads may well rise anew. Spreads remain historically tight, notwithstanding some volatility of late. The markets for some peripheral bonds are not particularly liquid, and so shorting these issues can be difficult and costly in terms of the implied negative carry. However, from a risk/return perspective, there would appear to be much asymmetry to capture.

Nowhere else might this be as asymmetric in this regard as French OATs. Unlike both Italy and Spain, which have taken deep and prolonged measures to try and get their respective deficits under control and regain some competitiveness, France has continued to drift along the same path of declining competitiveness on which they have been for many years. France has always been perceived by the financial markets as a ‘core’ member of EMU, thereby rewarding it with among the tightest of spreads, but one wonders whether, in light of the major constitutional showdown now brewing in Germany and possibly spilling over to the ECB, France will retain this qualitative distinction relative to those markets perceived as ‘peripheral’ instead.

John Butler has 25 years experience in international finance. He has served as a Managing Director for bulge-bracket investment banks on both sides of the Atlantic in research, strategy, asset allocation and product development roles, including at Deutsche Bank and Lehman Brothers.

(The commentary contained in the above article does not constitute an offer or a solicitation, or a recommendation to implement or liquidate an investment or to carry out any other transaction. It should not be used as a basis for any investment decision or other decision. Any investment decision should be based on appropriate professional advice specific to your needs.)