The measures adopted to safeguard financial stability of the Eurozone have been highly controversial. Lawyers often question the compatibility of the measures with the no-bailout principle (which prohibits the assumption of commitments of another Member State) and the ban on monetary state financing through the European Central Bank’s (ECB) bond purchases. More recently, the issue has led to open opposition between the European Court of Justice and the German Federal Constitutional Court on the Outright Monetary Transactions (OMT) programme which allows the ECB to buy states’ bonds under certain conditions.
We challenge the conventional legal doctrine adopted by the German Court, the German Bundesbank, and many commentators. According to their interpretation of the above legal principles, there is a stable and causal relationship between a country’s debt situation and the corresponding spreads. The doctrine further presupposes that only debt matters for a country’s refinancing situation, ie that no other determinants, such as liquidity, impact a country’s refinancing conditions. In addition, this doctrine reflects the underlying notion that governments have exclusive control over their refinancing situations, as they decide on their deficit conduct, so that non-market interventions are undesirable.
In our paper, we test the hypotheses implicit in conventional legal reasoning by using econometric techniques. We find evidence that a significant part of the surge in the spreads of the peripheral Eurozone countries was disconnected from underlying fundamentals, and, particularly, from a country’s debt position, and was instead associated rather strongly with market sentiments and liquidity concerns. More specifically, we find that the changes in the government debt to GDP ratio observed during the period of crisis contributed very little to the surge of the spreads. This surge is mainly explained by market sentiments, and, to a lesser degree, by the deterioration of other fundamentals (economic growth and competitiveness). This suggests that the surge of the spreads during the crisis was unrelated to the movements of the most important fundamental variable, ie government debt to GDP ratio.
Hence, there is no stable and causal relationship between a country’s debt position and its refinancing possibilities, particularly not in times of crises, when the impact of debt indicators becomes marginal. Rather, non-debt related factors and market sentiments play a major role. Those factors can hardly be influenced by governments – liquidity shortages reflecting market fears are disconnected from governments’ policy influence. A purely debt-focused interpretation of these norms is thus not in line with empirical evidence.
We apply our empirical findings to the legal principles. We argue that a purely debt-focused interpretation of the no-bailout principle and the ban on monetary financing should be abandoned. Rather, these core principles of EU law should extend to capture non-debt related factors. Most importantly, a legal regime governing the lawfulness of financial assistance cannot be limited to debt parameters, but must consider the impact of other fundamentals on spreads and, in particular, the liquidity situation as a result of market sentiment. Taking into account non-debt related factors suggests an application of the no-bailout principle and the ban on monetary financing to the effect that crisis instruments allowing liquidity supply (OMT) and financial assistance (European Stability Mechanism - ESM) can be justified empirically, and should be considered lawful. Future application of legal standards should consider the legal basis in the European Treaties that allow for exceptional financial assistance to account for factors out of a country’s control causing financial distress (eg extreme market fears) – the so-called ‘emergency clause’ in the European Treaties could be an appropriate basis. Finally, the dominance of liquidity concerns as drivers for government spreads underscores that a lender of last resort is necessary to intervene in times of liquidity dry-up. The ban on monetary financing should thus be interpreted as compatible with the ECB acting as lender of last resort in order to reduce the impact of non-fundamental variables on government spreads.
Paul De Grauwe is John Paulson Chair in European Political Economy, European Institute, London School of Economics, Yuemei Ji is a lecturer in Economics at the University College London, and Armin Steinbach is a Senior Research Fellow at the Max Planck Institute for Research on Collective Goods, Bonn (Germany).