Winner of the New Statesman SPERI Prize in Political Economy 2016

Monday, 4 August 2014

Article 123.1 and the ECB

123.1. 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, offices 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.

This post will not be about the the legal interpretation of this article of the European Union Treaty. Ashok Mody does a much better job of that than I ever could, and he comes to the conclusion that the European Court of Justice (ECJ) could well decide that this Article, combined with other parts of the Treaty, makes OMT illegal. As OMT is widely credited with ending the debt funding crisis in the Eurozone, this would represent an existential threat.

The same treaty article may be crucial in deciding whether the ECB institutes a programme of Quantitative Easing (QE) to help revive the Eurozone economy. As Willem Buiter reminds us (in a paper which I discussed an earlier version of before in a different context) a combination of fiscal expansion and QE is a certain way to boost demand and raise inflation. He writes: “there always exists a combined monetary and fiscal policy action that boosts private demand—in principle without limit. Deflation, 'lowflation' and secular stagnation are therefore unnecessary.” He goes on to say that if the Eurozone Treaty prevents this policy, yet the Eurozone wants to avoid the kind of deflationary trap it is currently in, then the Treaty should be changed.

Ashok Mody’s view is nicely summarised in these two paragraphs.

“In highlighting the tensions between the TFEU and the OMT, the German Court is basically concerned that the OMT is a fiscal union by the backdoor. The ECJ could validate the current design of the OMT— locating the fiscal union in the central bank—in which case the nature of the eurozone will be fundamentally altered and the ECB will become a more political institution. Alternatively, if the ECJ were to determine that the German Court’s concerns need to be addressed by changes to the OMT—by imposing serious limits on purchases of sovereign bonds and requiring the ECB to claim seniority to private creditors—the OMT will be rendered ineffective. 

There is a third option. And that would be to agree that the OMT is needed as temporary support because an incomplete monetary union creates intolerable risks. The ECJ would ask the political actors to meet their responsibility by providing a transparent and legitimate mandate for a permanent OMT. They would do so by jointly guaranteeing the ECB against losses incurred if a particular transaction ends in a default. That guarantee may never be needed. But it would focus the minds and clarify who bears the cost. Then Europe would have taken a real step forward.”

I have a lot of sympathy for that view. I have argued that for the Eurozone to survive in something like its current form (and not to have to become a fiscal and political union), the decision about whether to implement OMT must never be automatic (default must be possible), and should be based on transparent and informed advice. However it also seems sensible that the ultimate responsibility for such a momentous decision should lie with member states and their elected representatives.

The issue I want to highlight here is the position of the ECB. At present, as I understand it, the ECB would have the right not to implement OMT, even if governments were happy with it. It also has complete authority about whether to introduce QE - member states get no say. The reasoning behind this is that the ECB’s control over inflation is absolute. As OMT could in theory compromise this control, it must be allowed a say in whether it goes ahead. Article 123 is designed to protect that control, and ensure that the ECB cannot be subject to fiscal dominance. The same mentality can explain why the ECB feels so free to tell member states what they should be doing with fiscal policy. Fiscal policy has a bearing on inflation, so the ECB has a right - indeed a duty - to speak out.

Discussion about the ECB often focuses on the difficulties it faces because its decisions may or may not lead to redistribution among member states. These difficulties would disappear, of course, if the Eurozone became a political union. However, as Ashok Mody points out, the ECJ seems content with this kind of redistribution if it is sanctioned by the democratic representatives of the member states involved. This could happen with OMT, or QE. But this cannot happen if the ECB is designed to be independent of any democratic control. If the ECB can take decisions independently of member states, and those decisions can redistribute income among member states, then the ECJ may say those decisions are illegal and cannot be made. We have a problem, because the ECB is beyond democratic control.

When economists extolled the virtues of central bank independence, did they really have this in mind? Should governments really have no say in what monetary policy’s targets should be, and what mechanisms it should or should not use to achieve them? If the monetary policy institution is completely autonomous, how do we guard against incompetence? Perhaps the perceived need to outlaw inflation using the constitution or by treaty is an attempt to solve a problem of the past, which is stopping us dealing with the problems of today.


  1. Perhaps the Eurozone will need to go into deflation before the lessons learnt from Japan are applied?

  2. Banning OMTs seems excessively restrictive. You could have a simple rule that the ECB couldn't own more than 10% of any issuer's debt.

  3. I agree with the Buiter style “combination of fiscal expansion and QE”. But I don’t agree with Simon’s subsequent sentence which says the above is a “way to boost demand and raise inflation”. That suggests that higher inflation is a desirable objective. And that’s about the five hundreth time I’ve seen it suggested that inflation is desirable. It isn't – or have I missed something?

    There was actually an article on the Coben Centre site recently criticising those who portray inflation as being desirable. CC is very much Austrain and I nearly always disagree with Austrians, but I agreed with that particular article.

  4. When is lowflation a problem? When you have high unemployment (compared to history!) and/or high public debt.
    The eurozone countries facing this problem are a minority, the ECB is never going to follow a policy targeted upon countries that represent a small part of eurozone GDP.
    And as political union is not going to happen anytime soon, it always goes back to the question if certain countries wouldn't be better off outside the eurozone. A political question the ECB can't solve.

  5. When is lowflation a problem?

    When there is a savings and liquidity glut.


Unfortunately because of spam with embedded links (which then flag up warnings about the whole site on some browsers), I have to personally moderate all comments. As a result, your comment may not appear for some time.