The Bank, the Bond, and the Bail‐out: On the Legal Construction of Market Discipline in the Eurozone
| DOI | http://doi.org/10.1111/jols.12015 |
| Date | 01 March 2017 |
| Author | Harm Schepel |
| Published date | 01 March 2017 |
JOURNAL OF LAW AND SOCIETY
VOLUME 44, NUMBER 1, MARCH 2017
ISSN: 0263-323X, pp. 79±98
The Bank, the Bond, and the Bail-out: On the Legal
Construction of Market Discipline in the Eurozone
Harm Schepel*
The `logic of the market', so holds the Court of Justice, is the standard
of legality of financial assistance to indebted member states under EU
law and, ultimately, the legal justification for strict conditionality and
the imposition of austerity. This logic of the market, though, is different
from actual market behaviour. Austerity, it turns out, is not the
inevitable response to market pressures but a function of political
substitutes for market discipline (Pringle) and technocratic truth
seeking about the `correct' price of debt (Gauweiler) which the Court
has frozen into law. The perverse consequence of making the modali-
ties of financial assistance dependent on the `logic of the market' is,
moreover, to render the assistance as ineffective and expensive as
possible. `The logic of the market' in the Court's case law is best seen
as punitive and cynical politics masquerading as inept economics.
We must not simply abandon interest rates as a disciplinary mechanism.
Governments need the markets. Markets tell governments things that
governments don't want to hear. And they force governments to do the right
thing.
Wolfgang SchaÈuble
1
79
*Kent Law School and Brussels School of International Studies, University
of Kent, Espace Rolin, Boulevard Louis Schmidt 2a, 1040 Brussels, Belgium
hjcs@kent.ac.uk
1 W. SchaÈuble, `A Comprehensive Strategy for the Stabilization of the Economic and
Monetary Union', speech at the Brussels Economic Forum, 18 May 2011, at
ec.europa.eu/economy_finance/bef2011/media/files/speech-brussels-economic-
forum-schauble.pdf>.
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INTRODUCTION
The power of market discipline to constrain spendthrift states is, by now,
widely seen as an indispensable complement ± or alternative ± to the legal
mechanisms in the Treaty and beyond to enforce the limits on member
states' debts and deficits in Economic and Monetary Union.
2
Its legal
anchoring is said to be in the `no bail-out' clauses of Articles 123 and 125
TFEU, prohibiting monetary financing of national debt by the European
Central Bank (ECB) and national central banks, and the assumption of
liability for the debts of any member state by other member states and the
Union. In one of its least contested observations in Pringle, the Court of
Justice of the European Union held that the purpose of these `no bail-out'
clauses is to ensure that member states `remain subject to the logic of the
market when they enter into debt, since that ought to prompt them to
maintain budgetary discipline.'
3
Accordingly, the `logic of the market' is the
standard of legality of financial assistance to indebted member states under
EU law and, ultimately, the legal justification for strict conditionality and the
imposition of austerity. This logic of the market, though, is something
different from actual market behaviour. This was necessarily so in the two
grand Eu ro-cris is judg ments of t he Court . The Euro pean Sta bility
Mechanism (ESM) gives assistance only to member states who have lost
access to markets in the first place, leaving the Court in Pringle with the task
of deciding whether the conditions the ESM imposed on beneficiaries
prompted budgetary discipline according to the logic of the market. The
Outright Monetary Transactions (OMT) of the ECB were explicitly meant to
correct the `excessive' interest rates charged on indebted member states in
the sovereign debt market, leaving the Court in Gauweiler with the arduous
task of deciding whether the market behaved according to the logic of the
market.
4
The logic of the market also has little bearing on the history of the
cost of debt in the Eurozone; the markets have clearly got it `wrong' time
and again,
5
which makes the proposition that they can `force governments to
do the right thing' tenuous at best.
80
2 On the hardening of these legal constraints, see, for example, M. Adams, F. Fabbrini,
and P. Larouche (eds.), The Constitutionalization of European Budgetary Constraints
(2014).
3 C-370/12 Thomas Pringle EU:C:2012:756, para. 135. Compare M. Herdegen, `Price
Stability and Budgetary Restraints in the Economic and Monetary Union: The Law as
Guardian of Economic Wisdom' (1998) 35 Common Market Law Rev. 9, at 22: `[T]he
no bail-out provision of the EC Treaty cannot sweep away the fact that the euro area
will constitute a solidarity compact, the members of which are under a de facto
obligation to rescue defaulting members.'
4 C-62/14 Peter Gauweiler EU:C:2015:400.
5 `The story of the Eurozone is also a story of systematic mispricing of the sovereign
debt': P. de Grauw and Y. Ji, `Mispricing of Sovereign Risk and Macroeconomic
Stability in the Eurozone' (2012) 50 J. of Common Market Studies 866, at 879.
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This article is not concerned with the implications of the judgments in
Pringle and Gauweiler on the constitutional structure and legal integrity of
the European Union.
6
It focuses, instead, on the way the Court constructs
`market discipline' in its very absence as a legal requirement. It is a case of
obscene politics masquerading as bad economics making for terrible law,
rendering any financial assistance in the Eurozone both as ineffective and as
painful as possible.
THE MARKET IN SOVEREIGN DEBT IN EUROLAND, PART I
The logic of the market in sovereign debt is cruel and clear. The worse a
state's economic policy, the higher the debt, and the greater the risk of
default. The higher that risk, the costlier borrowing becomes, and the more
expensive the debt. The only way for states to get out of this vicious cycle is
to pursue `sound' budgetary policies, lower the debt, and be rewarded with
lower interest rates. For this virtuous mechanism of market discipline to
work, it is vital that government debt is priced `correctly', which necessitates
markets processing information about `market fundamentals' to estimate
credit risk. The importance of the `no bail-out' clauses lies there: if the
market expects states to be bailed out in case of trouble, they will price
government debt accordingly and cr eate `moral hazard' for debtors:
borrowing will be cheap, and governments will pile up debt rather than
making the hard and politically unpopular choices required under `sound'
budgetary policy. In sum: disaster can only be avoided if disaster is a
credible prospect. This price formation takes place on secondary markets:
bonds from sovereigns considered under risk will get sold at lower prices
than their nominal value. Since the interest on these cut-price bonds remains
the same, the return on investment, the yield, goes up. To be able to attract
investors for new bonds, states will naturally have to offer interest rates that
match the yield. Figure 1 plots the debt-to-GDP ratios of Germany and the
PIIGS
7
in relation to long-term yields on their sovereign bonds in the years
leading up to the introduction of the Euro and the `good years' thereafter
until 2007.
81
6 See, for example, M. Dawson and F. de Witte, `Constitutional Balance in the EU after
the Euro-crisis' (2013) 76 Modern Law Rev. 817; E. Chiti and P. Teixeira, `The
constitutional implications of the European response to the financial and public debt
crisis' (2013) 50 Common Market Law Rev. 683; K. Tuori and K. Tuori, The Eurozone
Crisis: A Constitutional Analysis (2015); B. de Witte, `Euro crisis responses and the
EU legal order: increased institutional variation or constitutional mutation?' (2015) 11
European Constitutional Law Rev. 434; M. Ioannidis, `Europe's New Transforma-
tions: How the EU economic constitution changed during the Eurozone crisis' (2016)
53 Common Market Law Rev. 1237; and, especially, MeneÂndez in this volume.
7 Portugal, Italy, Ireland, Greece, and Spain.
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82
Figure 1. The Price of Debt, Part I
Source: Ameco
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For all the crudeness of the measures, it is obvious that the figure shows
exactly the opposite of what the market was supposed to do. Convergence of
yields started before the introduction of the Euro, and by 2002 the spread of
yields between member states with vastly divergent debt burdens steadied on
scant decimals of percentage points. Greek and Italian debt ratios remained
perilously close to double the 60 per cent prescribed by EMU, and yet the
cost of their debt was nearly identical to that of Germany. Spanish and Irish
debt went down significantly, and significantly below German debt levels,
and yet the cost of their debt was nearly identical to that of Germany.
Whatever else the market s may have been punishing or r ewarding,
`budgetary discipline' or lack thereof was clearly not on their minds.
8
If the markets were creating moral hazard among debtor states, one of the
causes was clearly the moral hazard created among creditors by European
banking regulation. Banks operate under capital requirements limiting their
leverage and exposure. The capital ratio is expressed as a percentage of the
regulatory capital banks are to hold in relation to their lending and invest-
ment. That lending and investment, in turn, is `risk-weighted', forcing banks
to have higher capital ratios for `riskier' assets. Exposure limits seek to
diversify risk by limiting the proportion of lending and investment to
particular assets. These regulatory requirements have proven spectacularly
ineffective, of course, with banks and other financial institutions finding
ways above, beyond, and around almost any regulatory limit imposed on
them.
9
For sovereign debt, however, there has never been any need at all to
be creative. Exposure to member states' central governments is assigned a
risk weight of 0 per cent.
10
Limits to exposure to sovereign debt are non-
existent. Banks can pile up as much sovereign debt as they please.
Regulating risk away from sovereign debt seems a strange way to ensure
that markets correctly price risk. And yet, perversely, the rationale behind
the regulatory treatment of sovereign debt seems to have been to render
markets more, not less, attuned to the risk of insolvency of member states.
One of the factors polluting price formation, so the theory goes, is `liquidity
risk': if investors fear that they will not be able to re-sell their bonds, their
83
8 But see C. Rommerskirchen, `Debt and Punishment: Market Discipline in the
Eurozone' (2015) 20 New Political Economy 752 (finding that membership of EMU
reduces market punishment but increases policy makers' responsiveness).
9 See, for example, A. Admati and M. Hellweg, The Bankers' New Clothes ± What's
wrong with banking and what to do about it (2013).
10 Article 114 (4), Regulation 575/2013 on prudential requirements for credit institu-
tions and investment firms, (2013) OJ L 321/6. Frankfurt has had enough: see J.
Weidmann, `Stop encouraging banks to load up on state debt' Financial Times, 1
October 2013; C. Buch, M. Koetter, and J. Ohls, `Banks and sovereign risk: a granular
view' (2013), Deutsche Bundesbank Discussion Paper 29/2013; and Deutsche
Bundesbank, Annual Report: Reducing the privileged regulatory treatment of
sovereign exposures (2014). See, also, European Systemic Risk Board (ESRB), ESRB
Report on the regulatory treatment of sovereign exposures (2015).
ß2017 The Author. Journal of Law and Society ß2017 Cardiff University Law School
appetite for sovereign bonds will go down and the cost of debt will go up.
The zero-risk weighting, by increasing demand for sovereign debt, will
increase liquidity and hence `free' markets to price risk `correctly'. With a
bit of effort, one could still see `the logic': that demand for the asset class of
sovereign debt will go up and the return on the asset class of sovereign debt
will go down does not necessarily mean that financial institutions will not be
able to distinguish between the sovereign debt of Germany and that of, say,
Greece or Italy. Except that banks will want to make some money even on
zero-risk-weighted assets. As long as there is some spread left between
Italian and Greek bonds and German bonds, periphery debt will be the more
rewarding. As the spread decreases, banks will need more and more of
periphery debt for it still to be worthwhile, thus increasing demand further,
and decreasing the yield further still until the spread is all but gone. At this
point banks find themselves with enormous leveraged exposure to sovereigns
whose budgetary policies are blissfully unaffected by any market discipline.
It is here that the final perversity kicks in: in what Mark Blyth has called `the
mother of all hazard trades', banks decided to buy up still more periphery
debt at still higher leverage (and at still lower yields) until they became so
big as to virtually ensure that they would be `too big to fail' and be bailed out
in case their sovereign assets should lose value and the house of cards come
tumbling down.
11
A few odd rogue banks that are `too big to fail' can, of
course, be bailed out without getting states into insurmountable trouble. An
entire banking system that is collectively `too big to fail' will, however,
become `too big to bail'.
12
And so the banking crisis transforms into a
sovereign debt crisis.
13
84
11 M. Blyth, Austerity ± The History of a Dangerous Idea (2013) 81. See, also, more
formally, V. Acharya and S. Steffen, `The ``greatest'' carry trade ever? Understanding
Eurozone bank risks' (2015) 115 J. of Financial Economics 215. The plot thickens
when one factors in the repo market, or the way banks use sovereign debt as collateral
in borrowing cash: see D. Gabor and C. Ban, `Banking on Bonds: The New Links
Between States and Markets' (2016) 54 J. of Common Market Studies 617.
12 See, for example, A. Mody and D. Sandri, `The Eurozone crisis: how banks and
sovereigns came to be joined at the hip' (2012) 27 Economic Policy 199, and V.
Acharya, I. Drechsler, and P. Schnabl, `A Pyrrhic Victory? Bank Bailouts and
Sovereign Credit Risk' (2014) 69 J. of Finance 2689.
13 Cumulated support measures to banks in the Eurozone as a whole amounted to 8 per
cent of GDP. See ECB, The fiscal impact of financial sector support during the crisis,
ECB Economic Bulletin, Issue 6/2015, at
eb201506_article02.en.pdf>. This is a common pattern in history. Even without large-
scale bail-outs, Reinhart and Rogoff estimate that government debts `typically' rise
about 86 per cent in the three years following a systemic financial crisis, largely
owing to collapsing revenues: C. Reinhart and K. Rogoff, `From Financial Crash to
Debt Crisis' (2011) 101 Am. Economic Rev. 1676.
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PRINGLE AND WHAT THE MARKET WOULD SAY
In an attempt to address t he ensuing crisis, the Eur opean Stability
Mechanism was set up to provide financial assistance to member states in
severe difficulties. Not unreasonably, the matter of the compatibility of
financial assistance with the `no bail-out clause' was raised widely, and
came before the Court of Justice in Pringle.
14
The Court derived from
Articles 122 and 123 TFEU that the purpose of Article 125 TFEU cannot be
to prohibit all financial assistance by one member state to another.
15
To
divine the precise meaning of the prohibition, then, the Court decided to look
at the purpose of the provision, which it formulated as follows:
The prohibition laid down in Article 125 TFEU ensures that the Member
States remain subject to the logic of the market when they enter into debt,
since that ought to prompt them to maintain budgetary discipline. Compliance
with such discipline contributes at Union level to the attainment of a higher
objective, namely maintaining the financial stability of the monetary union.
16
From this, the Court held it to follow logically that the reach of the `no bail-out'
clause is limited to forms of financial assistance that `diminish' the `incentive'
for member states to pursue sound budgetary policies.
17
From that, in turn, it
follows for the Court that bail-outs are perfectly compatible with Article 125
TFEU as long as the beneficiary member state `remains responsible for its
commitments to its creditors' and if they are subject to `strict conditions'.
18
The aim of Article 125 TFEU is thus to ensure the proper working of the
market in sovereign debt. Now, as such, the link between the `no bail-out'
clause and correct price formation on sovereign bond markets is fairly
straightforward: unless default is a credible prospect, the risk of default is
never to going to be priced properly, and the market will not be able to
provide the correct incentives to indebted states. In other words, for the
`logic of the market' to exert its magic, it is vital that creditors live in fear of
losing their money,
19
and that debtors live in fear of full-blown disaster. If
85
14 See, generally, for example, T. Beukers and B. de Witte, `The Court of Justice
approves the creation of the European Stability Mechanism outside the EU legal
order: Pringle' (2013) 50 Common Market Law Rev. 805; P. Craig, `Pringle: Legal
Reasoning, Text, Purpose and Teleology' (2013) 20 Maastricht J. of European and
Comparative Law 3; G. Beck, `The Court of Justice, legal reasoning, and the Pringle
case-law as the continuation of politics by other means' (2014) 39 European Law
Rev. 234.
15 Pringle, op. cit., n. 3, para. 132.
16 id., para. 135.
17 id., para. 136.
18 id., para. 137.
19 See Q. Peel and R. Atkins, `Financial Markets ``do not understand the euro''', inter-
view with Wolfgang SchaÈuble, Financial Times, 6 December 2010. (`Mr. SchaÈ uble
warned that if private bondholders did not bear some risk, as well as the reward, of
investing, it could destroy the legitimacy of the market economy and even ``our
political order''.')
ß2017 The Author. Journal of Law and Society ß2017 Cardiff University Law School
we take the Court seriously, then, we are to believe that a credible threat of
financial instability in the monetary union contributes to the `higher
objective' of financial stability in the monetary union. For the compatibility
of the ESM with Article 125 TFEU, the disastrous implication of the `logic
of the market' is that a bail-out is only lawful if everyone behaves as if there
were no bail-out. That, in turn, leads to an obligation on the ESM to be as
ineffective as possible, and to inflict as much pain and misery on the
populations of debtor states as feasible.
The distributional consequences of the requirement that any financial
assistance may not intervene in the relationship between the debtor state and
its creditors are clear enough: by granting loans to debtor states with which
these are then to service their debt to private creditors in full, taxpayers from
creditor states are effectively transferring money to (their) banks. This may
not be fair, but it could still conceivably be useful to citizens from debtor states
if the loans were plentiful enough to guarantee creditors payment: in that case,
risk premiums would disappear, debt would become cheaper, and the debtor
state could perhaps start thinking about allocating some of its very scarce
resources to purposes other than paying off banks. But Article 125 TFEU will
not actually allow loans to be that useful. Advocate General Kokott explains:
Direct support of the creditors is prohibited, while indirect support, which
arises as a result of the support to the debtor Member State, is not prohibited.
The creditors of a Member State will therefore as a rule benefit from support
given to that Member State. There remains however for the potential creditors
of a Member State an additional uncertainty as to whether possible financial
assistance to a Member State may actually lead to the satisfaction of their
demands. To that extent, the voluntary support of a Member State need not
inevitably be accompanied by either a complete or even partial satisfaction of
the Member State's creditors. That uncertainty is intended to promote the
objective that Member States have differentiated interest rates on the capital
markets.
20
It is an astonishing piece of logic that will make the legality of a financial
assistance programme conditional upon its being useless.
The Court itself is much less candid, or just less clear. For loans and
purchases of bonds on primary markets, the requirement poses no problem:
here, the beneficiary member state contracts new debt, and remains respon-
sible to its original creditors for existing debt.
21
Article 18 of the ESM
Treaty, however, also makes provision for the purchase of sovereign bonds
on secondary markets. If it does not exactly or necessarily constitute `sup-
port', such a transaction surely does at least `benefit' the original bond-
holder: after all, if she couldn't see any benefit in the sale, she wouldn't be
selling. In addressing this, the Court pens one of the more mysterious
passages in Pringle:
86
20 Pringle, op. cit., n. 3, view of A.G. Kokott, para. 148 (emphasis added).
21 id., paras. 139±140.
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Next, as regards the purchase on the secondary market of bonds issued by an
ESM Member, it is clear that, in such a situation, the issuing Member State
remains solely answerable to repay the debts in question. The fact that the
ESM as the purchaser on that market of bonds issued by an ESM Member pays
a price to the holder of those bonds, who is the creditor of the issuing ESM
Member, does not mean that the ESM becomes responsible for the debt of that
ESM Member to that creditor. That price may be significantly different from
the value of the claims contained in those bonds, since the price depends on
the rules of supply and demand on the secondary market of bonds issued by the
ESM Member concerned.
22
The Court obviously thinks it is important that the price of the bonds be
determined under normal market conditions, but it is a little cryptic as to why
this is. Thankfully, the Advocate General provides some help in the exegesis:
Although in the event of such a purchase of bonds the funds of the ESM flow
directly to the creditor, in my opinion the prohibition on directly benefiting
creditors continues to be observed if the bonds are acquired on normal market
terms. The reason is that, in that case, the previous bondholder obtains his
money as he would from any ordinary third party and does not derive any
specific advantage from the capacity of another Member State. When an
ordinary purchase is made on the securities market the creditor would also be
unaware that the purchaser of the bond is a Member State. Such a bond
purchase is therefore not designed to build up the confidence of potential
creditors of a Member State in the capacity of another Member State.
It is not evident that the deployment of financial assistance instruments
under Article 18 of the ESM Treaty would necessarily deviate from the
circumstances described. The purchase of bonds by the ESM in accordance
with that provision therefore is not a priori necessarily incompatible with
Article 125 TFEU; rather there exists in any event the possibility of effecting
those purchases in a way that complies with its provisions.
23
If this is really the reasoning behind the Court's reference to the laws of
supply and demand, it is easy to see why it wouldn't necessarily want to spell
it out more clearly. By the time the ESM is triggered, the threat of insolvency
of a state in need of help will be such that bond holders are selling off to save
what they can. The price will be down, and the yield will be up. This is
vulture fund territory: at a few cents to the Euro, investment in junk bonds is
very risky, but potentially very profitable if the state should be able and
willing (or forced) to pay the full nominal value of the claim. According to
the Court's logic, purchases of bonds in such circumstances are perfectly
fine under Article 125 TFEU: the debtor state will still have to repay its debt,
and the previous bond holders do not derive any benefit up and above
`normal' market prices. As long as the ESM conducts these purchases by
stealth and without upsetting the market, the transactions may conceivably
be considered compatible with the no bail-out clause.
Assuming that the ESM wasn't set up as a vulture fund, however, it is
hard to see what the benefit would be to anyone for it to act the way the
87
22 id., para. 141 (emphasis added).
23 id., view of A.G. Kokott, paras. 158±159.
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Court instructs it to conduct its business: a financial assistance programme
that is not allowed to make either creditors or debtors better off is not likely
to be of much use to anyone. The very purpose of purchasing bonds on
secondary markets is to upset `normal market conditions': restore con-
fidence, increase demand, get the price up, get the yield down, and get the
cost of debt down. And as Mario Draghi would show to dramatic effect in
the OMT saga, this is best done not in secret but by waving a bazooka
around.
If the `logic of the market' makes the ESM as ineffective as feasible, it
also makes its assistance as painful as possible on the recipient state and its
population. It may be worth recalling how the Court gets from a `no bail-out
clause' to a requirement of strict conditionality ± and thereby freezes the
enactment of austerity measures into a legal obligation for states in financial
distress. On the Court's construction, Article 125 TFEU does not actually
prohibit financial assistance, it exists only to preserve `the logic of the
market' in sovereign debt. Article 125 TFEU does not actually impose
budget discipline; the impetus to pursue sound policies is merely a con-
tingent by-product of `the logic of the market'. That logic, in turn, depends
on price formation not being polluted by expectations of bail-outs. Once a
facility is in place to in effect `bail out' debtor states, that logic is obviously
out of the window, and the markets are not going to exert any disciplinary
power. The Court's fundamental move, then, is to sanction the substitution
of political decisions on austerity for the `logic of the market' and to force
assisted states to behave as if they were headed for insolvency. The purpose
of this exercise is not to work out the most sensible path to the restoration of
growth and financial health for the assisted state but to restore some
semblance of `the logic of the market' to the sovereign debt markets of other
member states: if not by the discipline of unpolluted markets themselves,
states will have to be deterred from pursuing unsound budgetary policies by
the prospect of having to live through the same amount of pain and misery
inflicted on states assisted by the ESM. The measure of punishment inflicted,
then, is not a matter of market forces but of a political decision whose
legality is bounded by theoretically contested and empirically unfounded
assumptions about the `the logic of the market' and about the sacrifices the
markets would have demanded of debtor states had they not been unable to
meet the demands of the markets in the first place.
24
All of this comes totally
unhinged when the Court will have to admit, as a matter of EU law, that the
markets get it `wrong'.
88
24 As Michelle Everson puts it: `the most di sturbing feature o f crisis-busting
jurisprudence is its legal ossification of a violently disputed economic theory of
market-disciplined structural renewal at a time of radicalized protest against austerity
at national level.' M. Everson, `A Technocracy of Governing: Power without the
State; Power without the Market' in The European Crisis and the Transformation of
Transnational Governance, eds. C. Joerges and C. Glinski (2014) 229. See, also,
Kaupa in this volume.
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THE MARKET IN SOVEREIGN DEBT IN EUROLAND, PART II
After the collapse of Lehman Brothers, sovereign debt markets in the
Eurozone woke up from their slumber and for the fateful years between 2008
and 2012 seemed to be doing what the `logic of the market' would predict.
As Greek sovereign debt spiralled out of control, so did the yield on Greek
bonds. Rapidly rising Portuguese debt was duly punished with increased
borrowing costs. As Spain and Ireland recapitalized their banks and turned a
financial crisis into a sovereign debt crisis, they too were hit hard.
25
And
even Italy ± which largely remained as sluggish and indebted as it had been
for a long time ± came in for harsh treatment. As Figure 2 shows, whatever
the markets woke up from or to, the reaction was abrupt and violent. The
disciplinary power of the market was finally unleashed.
With the power of financial markets acutely felt, it became an article of
faith that discrimination between member states was a good thing, and that
the spread was a vital mechanism to have spendthrift states live up their
responsibility and engage in the austerity policies of `adjustment' and
`consolidation'. The Bundesbank rejoiced: `market discipline ± if actually
exercised by market actors ± offers a decisive incentive to guarantee
sustainable long-term finances in the euro area.'
26
The moral, political, and macroeconomic argument was won so
decisively that the only space for viable contestation of austerity politics
seemed to become econometrics. It was not the power of financial markets
in itself that was questioned, but their wisdom: what if they got it `wrong'?
An enormous literature spawned fairly soon from central banks and think
tanks on the question of whether the markets were `right', or more
modestly, whether the `correction' or `revaluation' could plausibly be
explained by `market fundamentals'
27
or rather at least partly also by
89
25 There are, of course, enormous differences between banking systems in the various
member states, which go a long way in explaining the different paths towards
sovereign debt crises (or not). See, for example, I. Hardie and D. Howarth, `Die Krise
but not La Crise? The Financial Crisis and the Transformation of German and French
Banking Systems' (2009) 47 J. of Common Market Studies 1017; I. Hardie and D.
Howarth (eds.), Market-Based Banking and the International Financial Crisis (2013);
and L. Quaglia and S. Royo, `Banks and the political economy of the sovereign debt
crisis in Italy and Spain' (2015) 22 Rev. of International Political Economy 485. The
bigger the banking sector, the greater the effect on sovereign bond yields: S. Gerlach,
A. Schulz, and G. Wolff, `Banking and sovereign risk in the Euro area' (2010)
Deutsche Bundesbank Discussion Paper 09/2010. The bigger the bail-out, the greater
the effect on sovereign bond yields: see M. Fratzscher and M. Rieth, `Monetary
policy, bank bailouts and the sovereign-bank risk nexus in the Euro area' (2015)
Centre for Economic Policy Research (CEPR) Discussion Paper 10370.
26 Deutsche Bundesbank, Monthly Report (June 2011) 44 (emphasis added).
27 The econometric models are complex, largely because of the need to avoid the almost
inevitable endogeneity of nearly every conceivable set of correlating variables. See,
for example, M.-G. Attinasi, C. Checherita, and C. Nickel, `What explains the surge
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90
Figure 2. The Price of Debt, Part II
Source: Ameco
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panic and fear.
28
A lot hinged on the matter: after all, `if markets can stay
irrational longer than a country can stay insolvent, their disciplinary power
is considerably weakened.'
29
Dominant theory for quite some time held on
to the central role of country-specific weak fundamentals, and of increased
scepticism regarding peripheral states' solvency ± rather than contagious
fears of a contagious break-up of the Eurozone. The Bundesbank at one
point even suggested that the financial markets were sophisticated enough
to price sovereign bonds according to the now infamous thesis of the 90
per cent debt-to-GDP `cliff' above which growth was nigh impossible:
30
The at times abrupt and massive revaluations can also be explained by the
nonlinear relationship betw een the credit risk and the aforementi oned
fundamentals. . . There could be a type of threshold value with regard to
fundamentals such as the debt ratio where ± once surpassed ± the markets are
especially critical of any further increase.
31
The debate settled when the European Central Bank espoused the theory of a
`bad equilibrium' ± `namely an equilibrium where you have self-fulfilling
expectations that feed upon themselves and generate very adverse scenarios'
± and Mario Draghi announced the OMT programme in September 2012
with the assurance of doing `whatever it takes' to reverse these expecta-
tions.
32
As can be gleaned readily from Figure 2, it worked rather well, and
spreads were brought down despite periphery debt levels rising unper-
91
in Euro area sovereign spreads during the financial crisis of 2007±2009?' (2009) ECB
Working Papers 1131; S. Barrios, P. Iversen, M. Lewandowska, and R. Setzer,
`Determinants of intra-euro area government bond spreads during the financial crisis'
(2009) European Economy Economic Papers 388/2009; M. Arghyrou and A.
Kontonikas, `The EMU sovereign-debt crisis: Fundamentals, expectations and
contagion' (2012) 22 J. of International Financial Markets, Institutions and Money
658; J. Beirne and M. Fratzscher, `The pricing of sovereign risk and contagion during
the European sovereign debt crisis' (2013) ECB Working Papers 1625; C. Chiarella et
al., `Fear of Fundamentals? Heterogenous beliefs in the European sovereign CDS
market' (2015) 32 J. of Empirical Finance 19.
28 A thesis brought to prominence by Paul de Grauwe. See, for example, P. de Grauwe
and Y. Ji, `Self-fulfilling Crises in the Eurozone: An Empirical Test' (2013) 34 J. of
International Money and Finance 15.
29 C. Favero and A. Missale, `Sovereign spreads in the eurozone: which prospects for a
Eurobond?' (2012) 27 Economic Policy 231, at 267.
30 C. Reinhart and K. Rogoff, `Growth in a Time of Debt' (2010) 100 Am. Economic
Rev. 573, notoriously undermined by T. Herndon, M. Ash, and R. Pollin, `Does high
public debt consistently stifle economic growth? A critique of Reinhart and Rogoff'
(2014) 38 Cambridge J. of Economics 257 and, perhaps even more painfully, by A.
Pescatori, D. Sandri, and J. Simon, `Debt and growth: is there a magic threshold?'
(2014) IMF Working Paper 14/34.
31 Deutsche Bundesbank, op. cit., n. 26, pp. 40±1.
32 ECB, Introductory statement to the press conference (with Q&A), 6 September 2012,
at .
ß2017 The Author. Journal of Law and Society ß2017 Cardiff University Law School
turbedly. So much for `fundamentals'.
33
Yet, spreads remained decidedly
higher than they had been before the crisis, leading to contentment in
Frankfurt. In 2014, the Bundesbank reiterated its hardwiring of the EMU
rulebook, proclaiming that spreads are not `proof of a lack of integration but
represent an acceptable, if not to say highly desirable state of affairs which
re-affirms the central role played by individual national responsibility within
the euro area's regulatory framework.'
34
The debate about the markets' rationality played out differently in
different policy contexts. Fears of `moral hazard' were enough to stifle any
serious discussion about the mutualization of debt through the issuing of
Eurobonds.
35
When first launched in the early days of the Euro, the idea was
driven by worries about market fragmentation and lack of liquidity.
36
Latter-
day iterations, on the other hand, bent over backwards to devise schemes,
mechanisms, and institutional arrangements to square the circle of mutual-
ized debt, market discipline, and individual responsibility.
37
The Com-
mission's own short-lived proposal of `stability bonds' is a good example of
this. The proposal admits to `possibly some degree of overshooting' on the
part of the markets, but puts such faith in their disciplining power none-
theless, that `moral hazard' is to be avoided at all cost.
38
And thus:
While yields of Stability Bonds would be market-based, funding costs might
be differentiated across Member States depending on their fiscal positions or
fiscal policies, or their market creditworthiness, as reflected by the risk-
premium of national issuances over common issuances. This would provide an
incentive for sound fiscal policies within the system and would mimic market
discipline though in a smoother, more consistent fashion than markets. Such an
incentive . . . could be further enhanced with `punitive' rates in case of
slippages from plans.
39
92
33 See, for example, P. de Grauwe and Y. Ji, `Disappearing government bond spreads in
the Eurozone: Back to normal?' (2014) CEPS Working Document 396; and M. Chang
and P. Leblond, `All In: Market expectations of Eurozone integrity in the sovereign
debt crisis' (2015) 22 Rev. of International Political Economy 626.
34 Deutsche Bundesbank, Monthly Report (January 2014) 75.
35 See M. Matthijs and K. McNamara, `The Euro Crisis' Theory Effect: Northern Saints,
Southern Sinners, and the Demise of the Eurobond' (2015) 37 J. of European
Integration 229.
36 Report of the Giovannini Group, `Co-ordinated Public Debt Issuance in the Euro
Ar ea ' ( 20 00 ) , at < ht t p: // ec . eu ro p a. eu / ec on o my _f i na nc e/ p ub li c at io n s/
publication6372_en.pdf>. The report, remarkably for post-crisis sensitivities, does
not once mention the concepts of `moral hazard' or even `market discipline.'
37 See, for example, J. Muellbauer, `Conditional Eurobonds and the Eurozone sovereign
debt crisis'(2013) 29 Oxford Rev. of Economic Policy 610; A. Hild, B. Herz, and C.
Bauer, `Structured Eurobonds: Limiting Liability and Distributing Profits' (2014) 52
J. of Common Market Studies 250; R. Beetsma and K. Mavromatis, `An analysis of
eurobonds'(2014) 45 J. of International Money and Finance 91.
38 European Commission, Green paper on the feasibility of introducing Stability Bonds,
COM(2011)818 final, 7.
39 id., p. 23.
ß2017 The Author. Journal of Law and Society ß2017 Cardiff University Law School
With conditional financial assistance functioning as ersatz `logic of the
market', the problem over the last few years has been that financial markets
have been defeating the economic theory behind austerity policies.
40
Peri-
phery countries are caught in a spiral of fiscal contraction, lower growth,
higher debt, higher borrowing costs, more fiscal contraction, and so on. This
may seem perfectly intuitive, but it was not supposed to be like this. Ecofin
ministers, the European Commission, and the ECB have all been under the
spell of the theory of `expansionary fiscal consolidation' according to which
serious spending cuts and deep structural reform may lead to short-term
contractions, but will, after a year or so, actually return indebted countries to
sustained growth.
41
The blatant failure of austerity policies to deliver
anything of the kind has led to a fierce debate between institutional creditors.
For a chastened IMF, exaggerated growth forecasts and projections stem
from a radical underestimation of the `fiscal multiplier'.
42
The European
Commission will have none of that, however. For them, the problem is
simply that financial markets are `short-sighted', with sovereign debt spreads
and borrowing costs frustrating any gains from fiscal consolidations.
43
In
other words, the financial markets just don't `get it'.
93
40 Markets do not welcome austerity: I. McMenamin, M. Breen, and J. Mun
Äoz-Portillo,
`Austerity and credibility in the Eurozone' (2015) 16 European Union Politics 45.
41
The groundwork of the theory lies in F. Giavazzi and M. Pagano, `Can Severe Fiscal
Contractions be Expansionary? Tales of Two Small European Countries' in NBER
Macroeconomics Annual 1990, Vol. 5, eds. O. Blanchard and S. Fischer (1990) 75; A.
Alesina and S. Ardanga, `Tales of Fiscal Adjustment' (1998) 13 Economic Policy 489.
On how Alesina swayed the powers that be, see M. Blyth, Austerity ± The History of a
Dangerous Idea (2013) 169±77; S. Dellepiane-Avellaneda, `The Political Power of
Economic Ideas: The Case of ``Expansionary Fiscal Contractions''' (2015) 17 Brit. J. of
Politics and International Relations 319; and O. HelgadoÂttir, `The Bocconi boys go to
Brussels: Italian economic ideas, professional networks and European austerity' (2016)
32 J. of European Public Policy 392. Incredibly, the European Commission is still a fan:
see European Commission, Report on Public Finances in EMU 2014 (2014), rehearsing
episodes of successful consolidations, concluding that revenue-based consolidations do
not work nearly as well as expenditure-based consolidations, and recommending, on p.
134, that `cuts should concentrate on the more rigid and persistent components of
government expenditure, namely compensation of employees and social benefits.'
42 See O. Blanchard and D. Leigh, `Growth Forecasts and Fiscal Multipliers' (2013)
IMF Working Paper 13/1. On the development of policy in the IMF, see C. Ban,
`Austerity versus Stimulus? Understanding Fiscal Policy Change at the International
Monetary Fund since the Great Recession' (2014) 28 Governance 167.
43 See, for example, European Commission, Report on Public Finances in EMU 2012
(2012) 115; J. Boussard, F. de Castro, and M. Salto, `Fiscal Multipliers and Debt
Dynamics in Consolidations' (2012) European Economy Economic Papers 460/2012;
K. Berti, F. de Castro, and M. Salto, `Effects of fiscal consolidation envisaged in the
2013 Stability and Convergence Programmes on public debt dynamics in EU Member
States' (2013) European Economy Economic Papers 504/2013. The plot thickens in a
theory that holds that the large presence of public creditors with real or perceived
seniority pushes up yields in the market: S. Steinkamp and F. Westerman, `The role of
creditor seniority in Europe's sovereign debt crisis' (2014) 29 Economic Policy 495.
ß2017 The Author. Journal of Law and Society ß2017 Cardiff University Law School
GAUWEILER AND HOW THE MARKET SHOULD BEHAVE
With the OMT programme, the ECB signalled its readiness to buy up
massive quantities of government bonds of periphery countries from
secondary markets. Not unreasonably, the compatibility of the programme
with the ECB's mandate and Article 123 TFEU was raised widely, and came
to the Court of Justice via an extraordinarily didactic preliminary reference
from the Bundesverfassungsgericht in Gauweiler.
44
The first task at hand was to find a way to classify OMT as falling within
the ECB's mandate as an instrument of `monetary', rather than `economic'
policy. Since the Court had stated categorically in Pringle that `financial
assistance to a member State clearly does not fall within monetary policy',
45
the imperative was to cast the ECB's intervention ± which rather obviously
had as its immediate objective to lower spreads and rates and so to lower
refinancing costs for indebted member states ± as something other than
`assistance'.
To this end, the Court had little choice but to side with the ECB against
both the Bundesverfassungsgricht and the Bundesbank. It thus took over the
ECB's theory of having to clear noise f rom the system: since the
effectiveness of monetary policy depends on the transmission of `impulses'
sent out across the money market to the various sectors of the economy, the
concept of `monetary policy' has to include any measures designed to repair
that transmission mechanism in case it is disrupted.
46
The Court also
accepted the ECB's analysis that the economic situation in the euro area was
characterized by `high volatility and extreme spreads', spreads that:
were not accounted for solely by macroeconomic differences between the
States concerned but were caused, in part, by the demand for excessive risk
premia for the bonds issued by certain Member States, such premia being
intended to guard against the risk of a break-up of the euro area.
47
The next step was, then, simply, to classify `excessive' interest rates as
noise:
It is undisputed that interest rates for the government bonds of a given State
play a decisive role in the setting of interest rates applicable to the various
economic actors in that State, in the value of the portfolios of financial
institutions holding such bonds and in the ability of such institutions to obtain
94
44 See, generally, D. Adamski, `Economic Constitution of the Euro area after the
Gauweiler preliminary ruling' (2015) 52 Common Market Law Rev. 1451; M.
Wilkinson, `The Euro is Irreversible! . .. Or Is It?: On OMT, Austerity and the Threat
of ``Grexit''' (2015) 16 German Law J. 1049; V. Borger, `Outright monetary
transactions and the stability mandate of the ECB: Gauweiler' (2016) 53 Common
Market Law Rev. 139; P. Craig and M. Markakis, `Gauweiler and the legality of
outright monetary transactions' (2016) 41 European Law Rev. 4.
45 Pringle, op. cit., n. 3, para. 57.
46 Gauweiler, op. cit., n. 4, para. 50.
47 id., para. 72.
ß2017 The Author. Journal of Law and Society ß2017 Cardiff University Law School
liquidity. Therefore, eliminating or reducing the excessive risk premia
demanded of the government bonds of a member State is likely to avoid the
volatility and level of those premia from hindering the transmission of the
effects of the ESCB's monetary policy decisions to the economy of that State
and from jeopardizing the singleness of monetary policy.
48
This is not the kind of economic engineering that finds much favour in
Frankfurt and Karlsruhe. Probably the most significant argument against the
ECB's theory is the one the Court of Justice completely ignores. As the
German constitutional court points out, it is hard to conceive of any debt
crisis where the `monetary policy transmission mechanism' is not disrupted:
A critical deterioration of the solvency of a state typically coincides with a
corresponding deterioration of the solvency of the national banking sector (so-
called bank-state nexus). As a result, in this situation, the lending practices of
the banks tend to hardly reflect the reductions in the key interest rate anymore;
the monetary policy transmission mechanism is disrupted. If purchases of
government bonds were admissible every time the monetary policy trans-
mission mechanism is disrupted, it would amount to granting the European
Central Bank the power to remedy any deterioration of the credit rating of a
euro area Member State through the purchase of that state's government
bonds.
49
Even if the argument here seems unaffected by the question of the
rationality of spreads and rates, the more visible and notorious disagreement
between the two Courts consisted largely of a rehearsal of the econometric
debate about the role of `fundamentals' in the spreads. The Bundes-
verfassungsgericht had no trouble working this seamlessly into an argument
about the role of `market discipline' in the incentive structure of EMU, and
throwing Pringle back in the face of the Court of Justice:
According to the European Central Bank, these spreads are partly based on
fear ± declared to be irrational ± of investors of a reversibility of the euro.
However, according to the convincing expertise of the Bundesbank, such
interest rate spreads only reflect the skepticism of market participants that
individual Member States will show sufficient budgetary discipline to stay
permanently solvent. Pursuant to the design of the Treaty on the Functioning
of the European Union, the existence of such spreads is entirely intended. As
the Court of Justice of the European Union has pointed out in its Pringle
decision, they are an expression of the independence of national budgets,
which relies on market incentives and cannot be lowered by bond purchases by
central banks without suspending this independence.
50
The Bunderverfassungsgericht surely opens itself up to justified criticism
embracing a theory that is demonstrably false: the convincing expertise of
Paul de Grauwe and his collaborators does a fine job undermining the
95
48 id., para 78.
49 BVerfG, Order of the Second Senate of 14 January 2014, 2 BvR 2728/13, BVerfGE
134, 366, para. 97.
50 id., para. 71.
ß2017 The Author. Journal of Law and Society ß2017 Cardiff University Law School
assertion that spreads are only a function of public debt ratios.
51
But this
criticism ignores the way the constitutional court later on develops a stance
separate from the `convincing expertise' of the Bundesbank that is rather
more interesting. Where the court first references `explanations' given by the
Bundesbank according to which `one cannot, in practice, divide interest rates
into a rational and an irrational part',
52
it subsequently dismisses the dis-
tinction entirely as not just `impossible to operationalise', but as `irrelevant'
and `meaningless':
Spreads always only result from the market participants' expectations and are,
regardless of their rationality, essential for market-based pricing. To single
out and neutralise supposedly identifiable individual causes would be tanta-
mount to an arbitrary interference with market activity.
53
The Bundesverfassungsgericht, in other words, has no difficulty at all in
conceiving of markets as social and political institutions consisting of
operators and participants with hopes, fears, and interests. It may be `market
fundamentalist', but its faith and loyalty is to markets as they actually
behave. What the Court of Justice does is altogether more insidious: this is
market fundamentalism loyal not to actual market behaviour, but to some
mysterious equilibrium reached by hypothetical markets that we have never
actually witnessed in real life, that we have no particularly compelling
theoretical reason to believe could ever materialize, and that we have to
accept on the force of our faith in the expertise of the ECB.
54
By accepting
the theory of `excessive' interest rates, the Court also embraces the concept
of `right' and `proper' interest rates that can be discerned and engineered by
technicians. This is not just an academic exercise: this elusive equilibrium is
the dividing line between admissible monetary policy and prohibited
economic policy, and the exact measure of how much austerity is legally
required of debtor states.
When the ESM buys up bonds on secondary markets, it is `economic
policy.' When the ECB does the same, and makes these purchases
conditional on compliance with the ESM's `macroeconomic adjustment'
demands, it is `monetary policy.' In this regard, the Court holds, it is the
difference between the objectives of the respective operations which is
decisive.
55
By accepting the ECB's objective of `repairing' a `disrupted'
monetary policy transmission mechanism, and by demanding that OMT
96
51 See P. De Grauwe, Y. Ji, and A. Steinbach, `The EU debt crisis: testing and revisiting
conventional legal doctrine' (2016) LSE `Europe in Question' discussion paper 108/
2016.
52 BverfGE, op. cit., n. 49, para. 71.
53 id., para. 98 (emphasis added).
54 Gauweiler, op. cit., n. 4, para. 75 (`nothing more can be required of the ESCB apart
from that it use its economic expertise and the necessary technical means at its
disposal to carry out that analysis with all care and accuracy').
55 id., para. 64.
ß2017 The Author. Journal of Law and Society ß2017 Cardiff University Law School
cease `as soon as these objectives have been achieved',
56
the magical
moment when `the market' will be restored to its purified `logic' is the
precise boundary of the legality of the programme.
57
That equilibrium is also the the measure of exactly the right amount of
`market discipline' member states ought to be subjected to. Pulling the plug
on OMT as soon as the noise has been cleared means
(i) that the Member States cannot, in determining their budgetary policy, rely
on the certainty that the ESCB will at a future point purchase their government
bonds on secondary markets and (ii) that the programme in question cannot be
implemented in a way which would bring about a harmonisation of the interest
rates applied to the government bonds of the Member States of the euro area
regardless of the differences arising from their macroeconomic or budgetary
situation.
The adoption and implementation of such a programme thus do not permit
the Member States to adopt a budgetary policy which fails to take account of
the fact that they will be compelled, in the event of a deficit, to seek financing
on the markets, or result in them being protected against the consequences
which a change in their macroeconomic or budgetary situation may have in
that regard.
58
Before that moment is reached, however, we still need conditionality and
austerity, lest OMT should be perceived `as an incentive to dispense with
fiscal consolidation'.
59
More disastrously still, the Court demands ± as it did in Pringle ± that the
ECB's intervention ± which has as its objective to return irrational markets
to the `logic of the market' ± takes place according to the `logic of the
market'. And that means ± as it did in Pringle ± that the legality of the
intervention depends on its being as ineffective as possible. This comes out
clearly in the Court's treatment of Article 123 TFEU's prohibition of
monetary financing. This outlaws purchases on primary markets, but not
purchases on secondary markets. The Court, however, in view of the
objective of `encouraging' sound budgetary policies, will not allow the ECB
to go on a buying spree that would have `an effect equivalent to that of direct
purchases of government bonds'.
60
That means, in turn, that the ECB will
have to disrupt the functioning of the irrational market according to the logic
of the irrational market. And thus `safeguards' have to be built in to OMT:
enough time should be left between issues on primary markets and purchases
on secondary markets for `normal' price formation to take place; there may
not be any prior announcement of whether and how much the ECB plans to
buy where, lest `normal' price formation is corrupted;
61
the ECB may not
97
56 id., para. 82.
57 id., paras. 82 and 112.
58 id., paras. 113±114.
59 id., para. 120.
60 id., para. 97.
61 id., paras. 104±107.
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claim seniority creditor status lest OMT would affect `normal' price
formation.
62
In one of the most startling passages of the judgment, the Court
notes with apparent regret that `it is true that, despite those safeguards, the
ESCB's intervention remains capable of having . . . some influence on the
functioning of the primary and secondary sovereign debt markets', only to
remember, almost as an afterthought, that such an effect is the very purpose
of the OMT programme.
63
CONCLUSION
At the time of writing, the ECB has purchased, through its Public Sector
Purchase Programme, close to a trillion Euros' worth of central government
bonds, almost a quarter of which from Germany.
64
The only Eurozone
country excluded from the extravaganza is Greece, whose `credit quality'
does not meet the Bank's exacting standards. It is inherent in `the logic of the
market' that credit is readily available and cheap for those who don't really
need it, that it gets more expensive the more you need it, and that it slides out
of reach altogether for those who cannot do without it. In theory, one can see
how a well-functioning sovereign debt market (if such a thing could ever
exist) might exercise some discipline that could be useful to keep states from
getting themselves into trouble. As a recipe to get states out of the trouble
they did not cause themselves, however, `the logic of the market' is just
punitive and cynical politics masquerading as inept economics. To freeze
political substitutes for market discipline (ESM) and technocratic truth-
seeking about the `correct' price of debt (OMT) into law as the standard of
permissible assistance and as the measure of austerity is rather worse than
just bad law. This is how we live in Euroland.
98
62 Cryptically, id., para. 126.
63 id., para. 108.
64 See .
ß2017 The Author. Journal of Law and Society ß2017 Cardiff University Law School
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