Broken Bond

The German Constitutional Court’s decision to uphold the new European Stability Mechanism last week was greeted with a sigh of relief throughout the world. If the court had enjoined Germany’s entry into the treaty establishing the $900 billion bailout fund for the eurozone, the resulting panic could have led to a truly Great Depression. With stock markets soaring on the news, Chancellor Angela Merkel assured her parliament that "[t]his is a good day for Germany, a good day for Europe." But first impressions are misleading. The court’s decision creates big problems in both the middle- and long-run. 

Middle-run first. While the justices upheld the new bailout fund aimed at providing loans to euro states in need of financial help, their opinion explicitly called into question something even more important: the recent decision by the European Central Bank (ECB) to engage in massive bond purchases from countries like Spain or Italy, whose debt was becoming unsustainable at market interest rates. By buying up bonds from third parties, including big banks, the ECB aims to lower interest rates to acceptable levels. Its plan to purchase bonds on the secondary market also tries to avoid a direct conflict with the EU Treaty, which prohibits the ECB from buying bonds directly from member states. Before beginning this program, however, each affected debtor-state must negotiate a "conditionality agreement" with EU authorities under which it accepts stringent restrictions to guarantee against future fiscal misconduct.

The ECB’s bond-buying initiative stretched its mandate, which is limited to monetary stabilization and does not authorize U.S. Federal Reserve-style interventions to expand the money supply. ECB President Mario Draghi recognized that large-scale purchases would have an expansionary impact, but explained they were necessary to restore confidence in the euro and thereby allow the bank to perform its mission. Since it would take European leaders a lot more time to hammer out long-range solutions, the ECB’s intervention provides the only feasible short-term measure to save the single currency.

The German court’s opinion, however, challenges the ECB’s common-sense approach to its mandate. Even though the text of the EU treaty contains no express prohibition, the court declared that it was "beyond the ECB’s powers to acquire" government bonds on the secondary market. While this declaration played no role in the court’s reasoning in upholding the new bailout fund, it casts a large shadow on the ECB’s dramatic plan to buy up state debt. For starters, the court’s legal challenge to the bank’s bond-buying program will put Merkel under pressure domestically to block the conditionality agreements required before the bank can begin its initiative. While she currently appears to back the ECB’s plan, it remains to be seen how she will weather the storm.

Worse yet, the court will soon decide cases that directly attack the legality of the ECB’s bond-buying plan. Unless the justices modify the position they announced in the bailout case, they will be obliged to make good on their premature declaration questioning the ECB’s bond-buying initiative. Under this scenario, they will have little choice but to issue an order requiring Germany to leave the ECB and the euro, a move that could well endanger the European Union itself.

Once financial markets recognize this risk, they will be reeling under a cloud of uncertainty. Since the court’s recent opinion technically operated as a provisional judgment denying a temporary injunction, the justices should use their final decision to revisit and revise their ill-considered pronouncement.

Even if the court does reconsider, and upholds the bank’s plans, its increasing reluctance to countenance deeper European integration raises a long-run problem. On some future occasion, the court may well find that further integration measures violate the German constitution. Under this scenario, the only way Germany can move forward is through a popular referendum by the German people. If this is to happen in an orderly fashion, the court should make it clear in advance the kind of measures that require approval by popular vote. But the justices remained vague on this crucial matter, leaving political leaders uncertain whether the next round of integration measures must involve ordinary Germans in critical decisions. Until the court provides clear guidelines, their decisions will continue to feed the uncertainty that is destroying the euro.

When put to the test, the German people might vote Europe down, as the French did in 2005 when they rejected a proposed constitution for Europe. Since that time, governing elites have been creating European solutions behind the backs of a population increasingly skeptical about deeper integration. This cannot continue much longer. If leaders continue to take large steps forward Europe without the consent of their citizens, nationalists will increasingly erode popular support for the integration project. A vicious cycle threatens, in which top-down institutional engineering escalates the appeal of hard-right parties aiming to destroy the entire European project.

By casting doubt on the ECB’s initiative to save the euro, without providing a clear path toward a popular resolution of further unification measures, the German Constitutional Court is preparing the ground for more serious crises in the future. It imposes clear limits on technocratic solutions, but fails to define a pathway through which the European project can be saved by popular decision. The court should use its first opportunity to offer a way out of the dead-ends it has created. The longer this crisis goes on, the harder it will be for Germany’s leaders to convince their fellow citizens to continue down the European path that has led to such great success for Germany in the post-war period.