My last post explored some of the apparent German constitutional fault lines in the Eurozone crisis. Most importantly, these included the dividing line between commitments that are democratically acceptable under the German Basic Law (i.e., those entailing supranational supervision of fiscal discipline, enforcing prior commitments) and those that are not (i.e., anything amounting to open-ended or joint and several liability for other member states’ debts). The French ratings downgrade over the weekend has prompted some additional—admittedly speculative—questions in my mind on the application of this dividing line.
Let’s begin by recalling the following statement of Udo Di Fabio in his interview in Der Spiegel, the subject of my last post: ‘If financial guarantees were to become colossal or Germany were to be made liable against its will, then the judges [on the German Federal Constitutional Court (FCC)] would perhaps say: This can no longer conceivably be regarded as covered by the principle of democracy’. This, according to Di Fabio, is the ‘sticking point’ in the FCC’s approach to Germany’s participation in European Monetary Union (EMU).
My first question relates to the implications of the French downgrade for the strategy pursued by the Eurozone to date, via the European Financial Stability Facility (EFSF) and eventually the future European Stability Mechanism (ESM): the leveraging of the blended credit of the Eurozone members in order to reduce overall borrowing costs. As Dan Alpert recently noted on Nouriel Roubini’s Economonitor blog: ‘The S&P downgrade puts more pressure on Germany to support EFSF and ESM, as the credit of its fellows in the EMU is diminished’. But as Alpert also notes, the logic of the blended-credit strategy ultimately could lead to precisely the sort of open-ended or joint-and-several-liability measures that the FCC believes are constitutionally out of bounds: ‘the problem in the Eurozone ultimately rests in the unwillingness of the core, especially Germany, to monetize the problem debt and start over with greater fiscal integration (and the corresponding restrictions on sovereignty) and a better capitalized banking system. Until that changes – more of the same’.
My second question relates, then, to implications of the weekend downgrades for the ultimate stability and solvency of the European Central Bank (ECB), for which Germany and other core members may similarly have to serve as the financial back-stop, at least if they want to preserve the common currency. Would Germany’s ultimate back-stop responsibility, whether in law or fact, ever cross the ‘colossal’ threshold or amount, in effect, to a liability ‘against its will’, in the sense that it was not covered in a predictable manner by earlier democratic commitments under the FCC’s case law? In extremis, is Germany’s ultimate, de facto backstop role (on which the EMU may now functionally depend) unconstitutional?
This second set of questions flows from a recent report put out by UBS economist Larry Hatheway (key excerpts of which are reprinted on Zerohedge). Hatheway considers why the risks associated with the debt-bloated balance sheets of central banks throughout advanced economies, although troublesome, are dramatically less worrying than the unusual risks posed by the case of the ECB. The problem relates to the difficulties of any needed future ECB recapitalization in a diffuse and fragmented structure like the EMU, in which member states have both variable credit ratings (and hence capacities to access the capital markets), as well as differential political willingness and/or legal ability (read Germany) to make up the short-fall in needed recapitalization:
‘The Eurozone is a special case because there is no central (or federal) government that stands ready to recapitalize the ECB. Moreover, some of the ECB shareholders (the national central banks) might find themselves in a pinch at the same time that the ECB needs a capital top-up. That’s because some Eurozone national central banks have similar or worse ‘risk asset’ exposures than the ECB. For example, via the Emergency Liquidity Assistance (ELA) facility, several national central banks have extended considerable collateralized lending to banks in their countries, reportedly accepting even weaker collateral than the ECB has in its own operations. Accordingly, it is possible that a series of Eurozone sovereign or banking defaults could simultaneously erode the capital position of the ECB and those of some of its shareholding national central banks. That outcome would imply that central bank recapitalization would have to be led by a subset of creditor countries (i.e., Germany). That’s potentially a problem—recent history reminds us that Europe’s creditors have a proclivity for prevarication where asymmetric bailouts are involved’.
As Zerohege itself then concludes (in its typical, understated style):
‘Food for thought indeed as EFSF structural support is worn away by ratings agency downgrades (requiring perhaps explicit central bank support and lower collateral standards), ESM subordination concerns pressures existing sovereign bond holders to unwind/hedge exposure (requiring non-economical buyers of last resort), and increasingly complex agency relationships as ponzi-bonds are swapped into and out of national and super-national central banks’.
I doubt it would ever come to such extreme financial demands, but then I am no economist or expert in public finance and central banking (readers chime in with any help you can offer). Posing these questions, however, helps us better understand the type of nightmare scenario in which Germany would find itself either legally required to leave the Eurozone (thus allowing EMU to collapse) or to radically change its constitution to override its high court’s constitutional jurisprudence in order to allow the Eurozone to survive.