How Greek debt relief would create risk for Germany

The German Finance Minister Wolfgang Schäuble has had enough. Greece, he says, cannot receive debt relief from European creditors because European official creditors are forbidden by European treaties to grant relief. But this cannot be true. Once a loan has been made, any lender exposes himself to a default risk. 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.

The European authorities can determine what the “appropriate rate of return” is since the Court provided no guidance. Presumably, we can all agree that if the net present value of debt owed to European creditors is reduced to zero, then Article 125 would be violated. So, the only question is how much can it be plausibly lowered. If the creditors would have received €100 five years from now if their money were invested in U.S. Treasuries and they were to instead receive €50 euros, would that be “appropriate?” How about €30 euros? The Court did not recognize that risk of default is inherent in a debt contract. And so did not comment on—or provide for—the contingency of default.

von Bogdandy, Fratzscher and Wolff argue that debt relief now in return for GDP-linked returns in the future skirts the Court’s criterion of an appropriate rate of return. Merely exchanging payments through financial engineering does nothing if the net present value is not reduced. (We are now mercifully past the point where, for months, commentators insisted that Greece needed only liquidity support, not debt relief.) If relief is to be provided, extending maturities is a more transparent and reliable mechanism of reducing net present value.

von Bogdandy et al. also argue that the ECJ’s June 2015 decision allows for the possibility that the ECB can make losses on its Outright Monetary Transactions operations. This, they say, creates an opening for losses on lending by sovereigns.

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 say, 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 ECJ decision 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? Bundesbank President Jens Weidmann has already raised questions about the future use of the ESM in view of recent developments. The exact same concern has been raised by the German Council of Economic Experts.

The German Interest

Debt relief for Greece creates the risk for Germany that an activist ECJ will make unlimited losses legally acceptable.  A conflict with the German constitution would follow. The German Federal Constitutional Court has been clear that open-ended and unpredictable demands on the German budget, which are triggered by the decisions of other sovereigns, are not compatible with the German Basic Law. The Federal Court’s rulings, therefore, limit the scope for Germany’s intergovernmental guarantees to specific designs and limited amounts (Schorkopf, 2009 and Mayer, 2012). For this reason, Germany has stood steadfastly against any concept of Eurobonds. In effect, now, if Article 125 says that significant losses on ESM lending are possible, we have a Eurobond by the backdoor. Put aside the legality for a minute, such a change in mindset would require a political revolution in Germany. Seen either from the European or German perspectives, Schäuble knows exactly what is at stake.

The Schäuble Proposition

For this reason, the real goal for Schäuble is to change the way the eurozone functions. And he has returned to another old theme. In the Intergovernmental Conference to negotiate the Maastricht Treaty, the “no bailout provision” was uncontroversial but the proposition that countries would face sanctions if they mismanaged their fiscal affairs was extraordinarily contentious. Even Jacques Delors, for whom the monetary union was the ultimate goal, rebelled against the idea of sanctions. Delors’ biographer, Charles Grant describes the negotiations:

“The Germans continued to argue for sanctions against countries with ‘excessive deficits.’ Only the strange alliance of Delors and [Norman] Lamont [British Chancellor of the Exchequer] argued against centralization of fiscal policy. Delors claimed that EC sanctions would breach subsidiarity and be unnecessary. …Lamont argued that markets would discipline profligate governments by demanding higher rates of interest.”

In practice, sanctions have been on the book but have never been triggered because a group of peers will not sanction another for fear that roles may be reversed.

Schäuble’s goal—under the framework of a European budget commission—is to create a system of enforceable sanctions. What was not achieved at Maastricht must now be completed for the necessary fiscal discipline will ensure a viable monetary union. To be clear, although the Schäuble idea is sometimes referred to as a “fiscal union,” there can be no presumption that fiscal transfers will be part of the deal.

This politically divisive system of fiscal rules and sanctions has little economic merit. The essential dynamics of divergence under a single monetary policy will remain intact. ECB Vice President Vitor Constâncio has explained that this crisis is the result of imbalances in the private sector; fiscal policy played a limited role during the years when the imbalances were building up. Even with the additional procedures instituted after the crisis, the current unworkable structure binds divergent nations too tightly. This or any other system cannot wish away a future crisis just as it was wished away when the monetary union was originally constructed.

The economic logic says that there are two different problems. Greece needs debt relief and the eurozone does not work. That requires two instruments. If the IMF is true to its word, then it should forgive Greek debt—not least to be accountable for its serial mistakes in the conduct of the Greek program and for delaying by six precious months a transparent discussion of a necessary debt relief. This would force the European authorities to contribute their share of further debt relief and may even induce them to repay the Fund on Greece’s behalf.

The solution to the eurozone’s more fundamental problem requires deeper reflection. French President François Hollande has invoked the vision of Delors to move Europe closer to a political union, a theme that has been reiterated by Italian Prime Minister Pier Carlos Padoan. Schäuble, in contrast, has made it politically legitimate to discuss the breakup of the euro area. The German Council of Economic Experts has now added its voice to that idea, suggesting that exit from the euro area now become integral to the way the euro area works (paragraph 8 of the Executive Summary). But if a euro break up is now open to discussion, some would argue the least disruptive way to do so is by Germany exiting from the eurozone. That will open up many possibilities for a new configuration.

Of course, the most likely outcome is that Greece will continue to borrow new money from the creditors to pay its old debts to those creditors. As it undertakes more austerity, Greek output and prices will fall, making its debt burden greater. That will be blamed on Greek intransigence. More weekends of high drama will lead to driblets of debt relief. The Greek tragedy and euro area fragility seem destined to continue.

References

Grant, Charles, 1994, “Delors: Inside the House that Jacques Built,” London: Nicholas Brealey Publishing.

Mayer, Heidfeld, 2012, “Verfassungs- und europarechtliche Aspekte der Einführung von Eurobonds,” Neue Juristiche Wochenschrift 422, February.

Schorkopf, Frank, 2009, “The European Union as An Association of Sovereign States: Karlsruhe’s Ruling on the Treaty of Lisbon,” German Law Journal 10: 1219-1240.

This article originally appeared on Bruegel Blog, the Brussels-based think tank. Publication does not imply endorsement of views by the World Economic Forum.

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Author: Ashoka Mody is Charles and Marie Robertson Visiting Professor in International Economic Policy at the Woodrow Wilson School, Princeton University.

Image: A Greek flag flutters atop the Greek Parliament as a full moon rises in central Athens. REUTERS/Yannis Behrakis.