Draghi's German nightmare: and tensions could worsen.

• Author: Engelen, Klaus C.

The German Constitutional Court may have put the brakes on Mario Draghi's OMT bond-buying program on the grounds that the European Central Bank is grossly overstepping its mandate.

However, since the ECB will assume the role as lead bank supervisor for the euro area in November 2014, the occupants of Frankfurt's Eurotower become more powerful by the day.

Earlier this year we learned that Draghi, president of the ECB, is so obsessed with the limits of the ECB's powers that he dreams about monetary policy--though always within the ECB mandate. His surprising (and fitting) revelation comes from an exclusive interview at the World Economic Forum when Philipp Hildebrand, former governor of the Swiss National Bank and now vice chairman of BlackRock, asked Draghi whether he dreamed about monetary policy in Italian or German.

Draghi's nightmares featuring "pervasive German angst" about the ECB overstepping its monetary mandate and the prospect of the upcoming ruling of the German constitutional court on the ECB's Outright Monetary Transaction program may have entered the Davos session, judging from how he answered Hildebrand's somewhat mischievous question. "It is hard to say in which language I dream, but the objective always is price stability, that's our mandate, everything we've done so far is in the mandate," was Draghi's response. The unlimited but conditional OMT bond-buying program that Draghi announced in the summer of 2012 is widely credited with having calmed the markets and saved the integrity of monetary union.

As Europe's most important crisis manager, the former economics professor, financial official, investment banker, and Bank of Italy governor has much more to worry about than overstepping the ECB mandate.

After all, the monstrous mega-project of becoming the euro area's lead bank supervisor, the emerging ECB role in the eurozone's bank resolution program, and the ECB's entanglement in ongoing euro area rescue operations are mindboggling challenges that can cause a lot of nightmares for those responsible.

GERMANY'S EUROSKEPTICS FEEL VINDICATED

Some of Draghi's bad dreams in German might have been justified, since it did not take long for some of his premonitions became a bitter reality.

On February 7,2014, the German constitutional court, in forty tightly printed pages, issued a harsh judgment: "There are important reasons to assume that [OMT] exceeds the European Central Bank's monetary policy mandate and thus infringes the powers of the member states and ... violates the prohibition of monetary financing of the budget." Monetary financing of government debt is prohibited under Article 123 of the European Treaty. This is also the position of the Bundesbank, Germany's central bank. The judges said that they were inclined "to regard the OMT decision as an ultra vires act"--meaning "beyond the powers"--implying that this creates an obligation for German authorities to refrain from implementing it.

With a majority of six judges--two judges dissented--the German constitutional court in effect rejected Draghi's "whatever it takes" OMT program as a blatant violation of German constitutional law. But the court in Karlsruhe passed the case to the European Court of Justice for clarifications on a long list of issues relating to the ECB mandate and the OMT bond-buying program. Although the German constitutional court never before passed a case to the Luxembourg judges, Karlsruhe did not give the case away, insisting that it would come up with the final verdict. As Ambrose Evans-Pritchard wrote in the British newspaper Telegraph, "It referred the case to the European Court instead, but only after having pre-judged the issue in lacerating terms that effectively bind German institutions." Udo di Fabio, a former judge at the German constitutional court who participated in major rulings on the euro, argued that "the court is deliberately fencing in the European Court of Justice, constraining its room for maneuver by issuing its own prior judgment."

Transferring the case for clarification to the European Court of Justice raised hopes that the European Union's highest court would look more favorably at OMT. Whether the Luxembourg court will use the fast track to get a ruling this year or whether it will come up with a ruling much later is not yet clear.

By keeping the case for a final judgment, the Karlsruhe judges made clear that they would stick to their key objections but would be willing to incorporate changes in the OMT program that would make it compatible with EU law.

For Clemens Fuest, head of Germany's ZEW institute, the Karlsruhe verdict "is a massive attack on Europe's rescue strategy." Hans Redeker from Morgan Stanley told the Telegraph that the German constitutional court "had crippled the ECB" since they have "taken away the ECB's weaponry, and greatly increased the hurdle for a future program of quantitative easing." And Ebrahim Rahbari from Citicorp argued that "Although the European Court may eventually validate OMT, it cannot deviate far from the German verdict without provoking a political backlash."

Marcel Fratzscher, president of the German Institute for Economic Research (DIW), sees the German constitutional court ruling as "Germany's pyrrhic victory" since limiting the ECB's ability to address the interdependence of sovereigns and banks could put stronger pressure on eurozone policymakers to confront banking problems directly. The ECB's coming asset quality review and stress tests of the major euro area banks could be the last chance to repair Europe's banking system and avoid a Japanese-style long-term economic drag from the financial system.

Since the German court intends to stick to its core objections, the interim verdict strengthens the euroskeptics, especially the anti-euro Alternative fur Deutschland party. Bernd Lucke, head of the AfD, sees the ruling as "wise and highly effective." He argues that "If the ECJ rejects the arguments of the German constitutional court, we would be in a position of direct confrontation. It would boost all the anti-euro forces in Germany in the core argument that the European Union is breaking fundamental EU laws. The ECJ is thus in a dilemma."

Wolfgang Munchau, editorialist for the Financial Times and Spiegel Online, argues that "the OMT is effectively suspended as a result of this ruling--not so much for formal legal but for political reasons. The whole point about the OMT was to send a signal to the markets that the whole force of the system would support the euro."

Hans-Werner Sinn, president of Ifo Institute, argues in a Project Syndicate piece under the headline "Outright Monetary Infraction": "The Constitutional Court is not asking the ECJ to decide whether the OMT scheme is compatible with EU primary law. but rather to limit the program in ways that make it compatible with EU treaties." Sinn is of the opinion that the German constitutional court ruling effectively suspends OMT, as the ECB will not dare launch it in view of the legal controversy. For the Ifo president, "[T]he ECB's market-calming gimmick of shifting default risk from clever investors to trusting taxpayers worked. The OMT scheme amounts to free insurance against a default by southern eurozone countries, thereby subsidizing the return of private capital flows to places where they were squandered before. But that is not enough to legitimize the program."

As the German constitutional court stated in the preliminary verdict: pari passu for secondary market purchases for the OMT would definitely amount to a breach of the monetary financing prohibition enshrined in the EU treaties.

And how did the Eurotower react to the blow from the German court? The ECB stuck to Draghi's mantra that "the OMT program falls within its mandate." From the office of German Chancellor Angela Merkel came the statement that the Karlsruhe judgment "was an intermediate step in a very complex legal process." Investors reacted calmly to the news from Karlsruhe as most market actors seemed to think the European court will wink OMT through when the time comes.

GERMANY'S OMT SCHISM CONTINUES

Draghi's pledge to rescue European monetary union "whatever it takes," that is, with all the ECB's defensive central bank arsenal, was welcomed by euro area governments, EU leaders, and by the Eurogroup of finance ministers. So far, the OMT bond-buying program has never been used. It served as insurance coverage for euro area sovereign debt markets. With OMT, the ECB has in place a backstop scheme for Spanish or Italian bonds if Europe's debt crisis flares up again.

This was also the prevailing stance within the old and new German coalition governments under Merkel. With a hefty dose of hypocrisy, Merkel and her Finance Minister Wolfgang Schauble justified the unlimited OMT bond-buying pledge as a monetary policy decision by independent ECB central bankers. This left the Bundesbank under President Jens Weidmann--which took the position that OMT was a blatant violation of the German constitution and in breach of EU law--in not-so-splendid isolation.

As one of the few euroskeptic members of the Bundestag, Frank Schaffler, whose liberal Free Democrats were coalition partners of Merkel, openly sided with the Bundesbank. Schaffler accused the Merkel government and his legislative colleagues of acting as accomplices in a blatant breach of German and EU laws. "While ignoring the European Central Bank overstepping its mandate, the German government and the German legislators were proclaiming the high principal of central bank independence and were happy to leave the task of saving the euro to the ECB," says Schaffler.

Where the German government failed and what the Bundesbank couldn't do, was done by several groups defending the German Constitution and EU law. They organized a petition filed by 37,000 German citizens before the German constitutional court questioning OMT's legality.

To put the controversy about the case in...