The key axis in Europe is between creditors and debtors. Each pushes their own interests. The regime of austerity in Europe indicates that the creditors have had the upper hand. However, there have been two developments in the last two days that suggest the tide is turning.
Today's preliminary, non-binding opinion by Advocate General of the European Court of Justice rules in favor of the Outright Market Transaction facility that had been challenged in a German court. The key element of the opinion was that the ECB should be given extensive leeway in conducting monetary policy. There should not be a pre-determined cap on its purchases. It can buy bonds with lower credit ratings. The ECB does not necessarily need to be a "preferred creditor" in case of debt restructuring; thus endorsing the financial principle of pari passu.
The clear implication is that a sovereign bond purchase program, which the ECB is expected to launch at one of its next two meetings, does not violate the controlling treaties. ECB President Draghi could have hardly hoped for a more favorable opinion. It is true that the final decision in 4-5 months may be different than the Advocate General's opinion, but this is not often the case. The German Constitutional Court, where the case was first heard, could also decide differently. However, as it referred the case to the European Court of Justice, it would seem to have to respect what it says about the ECB. The German court may add some requirements for the role of the German parliament.
Monetary union is still a relatively new development. The institutional relationships are still being developed. The U.S. had a similar experience after it was founded. It was not clear the relative power of the judicial branch or its authority to review the constitutionality of legislative or executive actions. It took several years to work this out (see Marbury vs. Madison), and even then it did not go unchallenged. Much of the New Deal was ruled unconstitutional, and Franklin Roosevelt tried to dilute the Supreme Court's hostility by expanding its size. He was defeated in this attempt.
The bottom line is that the preliminary opinion supports the ECB's authority to determine the appropriate monetary policy and tools necessary to implement it. The principles would seem to recognize its right to buy sovereign bonds. A sovereign bond purchase program appears to draw the most support from the debtors, not creditors, in EMU. That said, the German government did not seem as opposed to OMT as was the Bundesbank. BBK President Weidmann presented before the German Constitutional Court objecting to the OMT.
[Read: EU Court and Greek Elections May Block QE From the ECB]
The other development this week that supports the debtors is more subtle than a court decision. It was a bureaucratic adjustment that requires neither member government approval nor support from the European parliament. It was the European Commission updating its budget enforcement rules.
The thrust of the change is to grant more fiscal flexibility to countries who make greater efforts in structural reforms. While it retains the principle of equal treatment, the EC wants to allow some countries greater flexibility. For example, it is willing to accept investment initiatives if a country can show its growth is significantly below potential. Countries can earn "credit" or goodwill for enacting structural reforms or pursue smaller fiscal adjustments in time of economic weakness.
France and Italy have been given until March to convince the European Commission of the credibility of its 2015 budgets. The new flexibility that was announced yesterday would seem to offer these two countries in particular a carrot. Germany was quick to push back. The budget spokesperson for the CDU in parliament cautioned against diluting the commitment to fiscal reform and consolidation. The spokesman (Berthle) was quoted on the news wires saying "Instead of thinking again about more flexible application, all member states should focus on getting their budgets under control sustainability."
The interests of the creditors and debtors in EMU need to be balanced to ensure a return to a sustainable grow path. The balance of power shifted in recent years to the interest of the creditors. Although it is commonplace to see references to how Greece was bailed out or another peripheral country was bailed out in the various aid programs. However, this is a misrepresentation of what happened. More often than not, it was the creditors, including official creditors, that were bailed out. The economic activity, the levels of unemployment and the other social costs suggest that the debtors where not bailed out, and in fact are in more debt now than prior to the crisis. Leaving aside some private sector creditors in Greece, the creditors have not failed to receive a single interest payment.
In the tug-of-war between creditors and debtors, the flag is still favoring creditors. The two developments discussed here, the ECJ preliminary decision and the more formal fiscal flexibility suggested by yesterday's EC announcement, move the flag a little bit. The adjustment process, including a weaker euro will continue. Over time, the decline in the euro, interest rates, and commodity prices, especially oil, will help EMU find a stronger growth path.
