Decisive Days for Euro

High Court Considers ECB Bond Buys

By Melanie Amann, Thomas Darnstädt and Dietmar Hipp

Germany's highest court is currently reviewing the European Central Bank's controversial bond-buying program to shore up euro-zone crisis countries. A decision in Karlsruhe could determine the common currency's fate.

Somebody at the European Central Bank (ECB) must have pressed the wrong button. A fire alarm went off at the bank's high-rise headquarters in Frankfurt, everything was shut down, including the elevators, and firefighters rushed to the scene.

The false alarm hit the monetary watchdogs last September shortly before ECB President Mario Draghi made the dramatic announcement that he would purchase sovereign bonds in "unlimited quantities" to help debt-ridden countries like Italy, Spain and Greece.

Now, alarm bells are again ringing inside the ECB tower -- only this time it's no drill. On Tuesday and Wednesday of this week, Germany's Constitutional Court in Karlsruhe will rule on the euro crisis aid measure that Draghi announced last fall. As Draghi and his monetary experts on the executive floor of the bank were told by their constitutional experts long ago, this court decision could have an enormous impact on the bank's policies -- and potentially spell the end of the euro.

Over the past few months, Draghi and the heads of government in the European capitals have felt confident about the outcome of the impending ruling. After all, the judges in Karlsruhe have always ultimately endorsed Germany's contributions to euro-zone bailout programs. Nevertheless, the list of questions compiled by the judges for this week's deliberations indicates that everything may be at stake this time around.

When Draghi recently visited French President François Hollande in Paris, the main topic of discussion was not the state of the French economy or Southern Europe, but rather the question of what will happen in Karlsruhe. Only one hour by train away from Frankfurt, a conflict is brewing that already appeared to have been resolved last autumn.

"This is good, very good news," then-Italian Prime Minister Mario Monti said in response to the announcement that the Federal Constitutional Court had refused to issue a temporary injunctionagainst the European Stability Mechanism (ESM), the permanent European bailout fund, and the fiscal pact. Over the following days, the euro climbed to its highest exchange rate in months. The court still had to decide on the main constitutional complaint, but a pragmatic decision in favor of the bailout measures seemed to be nothing more than a technicality.

Now, it appears they were celebrating too soon.

'People at the ECB Are Really Afraid'

The plaintiffs in Karlsruhe -- led by euroskeptic Peter Gauweiler, a member of parliament with the conservative Christian Social Union, the Bavarian sister party to Chancellor Angela Merkel's Christian Democrats -- returned with a more comprehensive constitutional challenge to Draghi's unlimited bailout pledge. The battle over the euro resumed. For the last few days, ECB head Draghi has constantly consulted with his aides on the latest developments in the debate in Karlsruhe and what people in Germany are saying about it. Insiders in the southwestern German city have picked up on this frantic need for information: "The people at the ECB are really afraid," says an official in Karlsruhe.

As well they should be. Indeed, leading authorities on this area of German law say that the European Central Bank's bond buying program is barely covered by the ECB's mandate -- and thus exceeds the constitutional limits established for Germany's role as a member of the euro zone. The critical view of the legal experts is largely shared by the German central bank, the Bundesbank, which says the ECB is overstepping its authority. According to one Bundesbank official, decisions to bail out EU states or even rescue the monetary union "are reserved for other actors, primarily governments and parliaments."

The fact that the three letters "ECB" play a central role in a decision by the German Constitutional Court is in itself a historical turning point for Europe. This is the first time that the constitutional judges are taking a critical look at the work of a key European institution. Previously, only the role of the German parliament or the German government had come under fire. "There is no way to avoid this," according to the official in Karlsruhe.

Concerns for German Taxpayers

The fact that the announced bond-buying program could involve hundreds of billions of euros which -- if things go wrong -- German taxpayers could also be held accountable for makes an examination of the independent central bank's actions unavoidable.

According to the EU treaties, it is not explicitly prohibited for the bank to purchase sovereign bonds as long as they are not bought directly from the issuing states themselves, but rather from financial service providers. But already back in its decision last September the Federal Constitutional Court declared: "An acquisition of government bonds on the secondary market by the European Central Bank aiming at financing the members' budgets independently of the capital markets" is "prohibited".

The European Court of Justice (ECJ) in Luxembourg, the European Union's high court, also recently ruled that monetary policy does not include supporting the budgets of ailing member states -- and monetary policy, not financial policy, is the domain of the ECB. "Bailing out countries is not part of the ECB's mission," says Freiburg law professor Dietrich Murswiek, who represents Gauweiler's complainants.

Murswiek contends that the key difference between permitted monetary policy and prohibited national budget financing lies in the goal of a given initiative. "Does it safeguard price stability? This indicates monetary policy," he says. "Or is it designed to help one or more countries by creating financing conditions that do not reflect current market prices? This would then be a prohibited type of state financing," he concludes. The professor's views on this issue are backed by most experts on European law.

Criticism from Bundesbank President

Even Draghi basically admitted that the goal of the initiative is not price stability when he said that he wanted "to do everything necessary to save the euro." And isn't it perfectly normal, pragmatists at the ECB may ask, that their bank be able to do everything in its power to prevent individual countries from exiting the common currency? Still, Bundesbank President Jens Weidmann also opposes such pragmatism. In a statement submitted to the court, he chose clear and critical words: "In view of the fact that it still consists of sovereign nation states, the current composition of the monetary union cannot be guaranteed -- at least not by the central bank."

The ECB has appointed Frank Schorkopf, a professor of European law in the central German town of Göttingen, to present its view of the matter in Karlsruhe. He argues that the common currency has been established for an unlimited amount of time, and that this forms the basis of the objectives and mission of the ECB and the national central banks of the euro system. Schorkopf concludes that there can be no objection to Draghi's initiative.

He goes on to say that the ECB's bond-buying program merely aims to counteract disturbances on the financial markets. The idea, he insists, is to prevent "excessively high risk premiums" that are introduced when market players fear a "collapse of the monetary union." Furthermore, he argues, there simply aren't that many junk bonds that could be purchased by the ECB on today's market.

By contrast, the experts at the Bundesbank point out that crisis-ridden countries could be encouraged to launch more sovereign bonds on the market "because financial market players can be sure that they can sell newly issued securities for a minimum price to the euro system." They argue that trading would heat up even more if the ECB "directly" purchased bonds.

Potential to Blackmail System

Bundesbank experts are highly critical of Draghi's by-any-means-necessary pledge. They say that merely suggesting a guarantee for the continued existence of the monetary union gives governments a certain potential to blackmail the euro system. The Bundesbank officials say that this could have a dramatic impact and jeopardize the independence of monetary policy.

According to the plaintiffs, these are not academic questions posed by monetary bankers. Murswiek argues that the purchasing program to date has already allowed banks to dump junk bonds on the ECB, transforming the central bank into "Europe's bad bank," as he calls it. Furthermore, the Bundesbank, and thus the German national budget, will be partly responsible for covering losses that the ECB has to absorb.

Unlike the central banks in many countries, such as the United States and Japan, the ECB is allowed "to target the acquisition of bonds from countries with poor credit ratings." This leads to significant risks on the bank's balance sheets. Large losses by the ECB, though, would place a burden on the budgets of the member states. The Bundesbank has already increased its level of risk provisioning, which will diminish the returns enjoyed by the German government.

Consequently, on Tuesday and Wednesday of this week there will be a European family row of sorts before the court in Karlsruhe, with the ECB pitted against the Bundesbank. One thing is certain, the judges are likely to ask endless questions.

An Air of Secrecy

Monetary policy and legal objectives tend to clash, as witnessed by the judges' attempt to find out from the central bankers exactly what lies behind Draghi's nebulous announcement to buy unlimited quantities of sovereign bonds -- and a lack of information about when the purchasing is slated to begin. The ECB is treating the decision as a classified matter. "Until now, we have had to make do with a press release," complains someone closely involved with the case.

This air of secrecy is maintained on purpose: Monetary policy relies on psychology, and precision is generally damaging. Indeed, Draghi correctly notes that his announcement accompanied by a fire alarm last September was enough to achieve a resounding impact all on its own as interest rates on sovereign bonds immediately declined.

Does this mean that there is nothing concrete for the court to decide on? Or is it too early to say that the case in Karlsruhe is a grave matter of national importance?

The legal experts in Karlsruhe are annoyed. How are the judges supposed to verify whether the ECB's program remains within the established legal framework if they haven't received a copy of the controversial decision? And insiders realize that it is hardly relevant whether or not the bond-buying program has been launched. After all, monetary policy tools are like instruments of torture: It's often enough just to demonstrate their existence.

Case Likely To Be Referred to European Court

If the judges in Karlsruhe still have any doubts following this week's hearings, it's clear what is likely to happen next. To avoid risking any unnecessary conflict with their European colleagues in Luxembourg, the constitutional judges will have little choice but to refer the matter to the ECJ.

This would be new. There has never been such a referral, but it is to be expected, and can be gleaned from the court's statements on previous decisions. Whenever Karlsruhe has "doubt" concerning the correct interpretation of European treaties, in the spirit of friendly cooperation it is essential to have the ECJ in Luxembourg vote on the matter.

"I see no reason why Karlsruhe should not refer the matter," says Juliane Kokott, an advocate general at the top EU court. In any case, involving the European judges would be a clever move by the judges in Karlsruhe. The court in Luxembourg would then have the choice of either siding with Karlsruhe's criticism and trying to get the ECB to see reason, or attempting to convince the judges in Germany that the central bank is still acting within the scope of the treaties.

It would be difficult for the Luxembourg court to decide in favor of the ECB, though. Karlsruhe has made it clear in diverse rulings that it intends to decide for itself what is compelling and what is not. Only placating arguments by Luxembourg that respect "the usual jurisprudential frameworks for debate" and are methodologically acceptable will be recognized in Karlsruhe, according to an insider. Measured according to these standards, it's possible that the decision of the European Court, which is known for its sweeping justifications and dogmatic rulings, could be rejected out of hand by Karlsruhe.

And after that?

Constitutional judges have already outlined what might happen in such a case. The constitutional court would have to determine that not only the ECB but also the ECJ is operating beyond the limits of the treaties, or ultra vires. This would entail a break between Karlsruhe and Luxembourg -- an escalation that some experts are no longer prepared to rule out.

Former constitutional judge Udo Di Fabio, who was responsible for questions concerning European law at the court in Karlsruhe until 2011, warned of further consequences in a legal opinion published last Monday for the Munich-based euro-skeptic Foundation for Family Businesses. If European institutions stubbornly stick to their position, he wrote, and the German government does not manage to force them to yield, "then the court must, in the most extreme case, decide" that Germany is "no longer allowed" to take part in the monetary union.

It would, according to Di Fabio, be "the push-button" for the end of the euro.