On the Impotence of Karlsruhe

If there is one single event that could derail the euro experiment it is the German Federal Constitutional Court ruling on the European Stability Mechanism (ESM) and Outright Market Transactions (OMT). We will take you through the different legal arguments used on both sides of the aisle, but first you need to understand the importance of this ruling.

Without the ESM and more importantly the OMT there would be widespread sovereign defaults within the euro zone. This would have dragged down banks, pension funds and financial markets in general. Alternatively, the troubled sovereign would simply pull out of the monetary union altogether and default in all but name through massive inflation of its own and newly established currency.

We estimate the Draghi put is worth around 400 basis points given the response in sovereign credit markets since he announced it. And it is simple to understand why! If , say, Spanish 10 year bond should once again yield anything close to 7 per cent, they would simply ask the ECB to intervene and promptly push the yield back down to around 4 per cent.

The investors that understood this back in 2012 bought Spanish bond at 7.62 per cent and made a handsome profit. It also window-dressed the Spanish banking sector balance sheet enough to silence skeptics for a while.

Draghi put for bloggAn alternative way to look at this is provided through the TARGET2 imbalance that shrank in the immediate aftermath of the OMT announcement.

Whilst the market tries to tell us that southern European capital consumption is unsustainable and should be reined in, Draghi has simply told investors that such nonsense is unnecessary. Ever since Keynes thought us that central banks can produce capital at will, we should not be concerned about those evil “causal-realist” economists; they belong on the scrapheap together with other barbaric relics.

Luckily for us, there are some barbaric “causal-realists” still in Germany, not just on the ether, that share our concerns. They have taken the OMT to court along with the ESM. If the OMT turns out to be illegal according to the German constitution, then the ECB would be forced to retreat, or Germany have to leave the Euro. We are not sure if humorless economists find Gerxit to be as enchanting as Grexit, but we are sure the “barbarians” would appreciate it.

The Federal Constitutional Court in Karlsruhe is mandated to uphold the Grundgesetz or basic law of Germany. In earlier rulings on the EFSF and also on a temporary injunction against the ESM we know how the Karlsruhe judges looks at this mandate.

Their underlying guiding principle is always to make sure that the eternity clause in the Grundgesetz is in no way jeopardized. For obvious historical reasons, the Grundgesetz was written with the concept of “unconstitutional constitutional amendments” at its core.

While this may seem to contradict our understanding of legal hierarchy at first, it does fit into the rules made by the constitution about amending it. And there is no way to amend the Grundgesetz guiding principle about the Federal Republic of Germany being a “democratic and social free state

Article 79 divides the Grundgesetz into amendable and un-amendable portions in which Article 20 stating that Germany is a democratic state is specifically mentioned as an un-amendable part. Article 38 is again part of Article 20. Article 38 (1) states that ”Members of the German Bundestag shall be elected in general, direct, free, equal and secret elections. They shall be representatives of the whole people, not bound by orders or instructions, and responsible only to their conscience.”

As an extension of this, we learn from the EFSF ruling issued September 7th 2011 that “members of Parliament must remain in control of fundamental budget policy… …when establishing mechanism of considerable financial importance which can lead to incalculable burdens on the budget, the German Bundestag must therefore ensure that later on, mandatory approval by the Bundestag is always obtained. They continue by stating that “the legislature… …is prohibited from establishing permanent mechanisms under the law of international agreement which result in an assumption of liability for others states` voluntary decisions, especially if they have consequences whose impact is difficult to calculate

In other words, the Bundestag cannot transfer budgetary power to institutions in Brussels, or Frankfurt for that matter, as this would violate the right of the German people to independently govern themselves. Any transfer of funds from Germany to any other institution must be approved by the Bundestag on a case-by-case basis, and they must always know exactly what amount they sign up for. The liability must be strictly limited and decisions regarding this liability can never be transferred to any non-German institution.

Now, let’s start with the European Stability Mechanism and see what legal difficulties it may face. In the ruling of September 122012 where the court refused the applications for the issue of temporary injunctions we got a good grasp on what the ESM ruling will be, but there are still caveats to be cleared.

First of all, in the preamble to the Treaty on the ESM (T/ESM 2012) it says that “The European Council agreed on 17 December 2010 on the need for euro area Member States to establish a permanent stability mechanism.”

As we learnt from the EFSF ruling of 2011, the Court specifically told the legislature that any permanent mechanisms would be un-constitutional.

Further, we read from the ruling of September 12 2012 that “it is required to ensure in the framework of the ratification procedure under international law that the provisions of the ESM Treaty may only be interpreted or applied in such a way that the liability of the Federal Republic of Germany cannot be increased beyond its share in the authorised capital stock of the ESM without the approval of the Bundestag and that the information of the Bundestag and the Bundesrat according to the constitutional requirements is ensured.”

The Court says this requirement is fulfilled by T/ESM 2012 Article 8 (5), but in Article 9 it states that the Managing Director of the ESM can always demand participating countries to pay in unpaid capital by simple majority decision to restore the level of paid-in capital if impairments or losses should occur. Admittedly, this does not in itself invalidate the limitation set forth by Article 8, but if we move to Article 25 (2) that outlines routines in case of losses we are amiss to distinguish between Article 8s limited liability concept as requested by the Court and the potential for unlimited liability.

Article 25 (2) specifically states that “If an ESM Member fails to meet the required payment under a capital call made pursuant to Article 9(2) or (3), a revised increased capital call shall be made to all ESM Members with a view to ensuring that the ESM receives the total amount of paid-in capital needed. The Board of Governors shall decide an appropriate course of action for ensuring that the ESM Member concerned settles its debt to the ESM within a reasonable period of time. The Board of Governors shall be entitled to require the payment of default interest on the overdue amount.    

It is not clear to us that Germany`s liability is limited and “easy to calculate” and apparently it is not clear to the court either. Thus, they explicitly made it clear that Article 8 will have to be interpreted in a way that it trumps both Article 9 and 25 in all respects! This cannot be done without changing the wording of T/ESM 2012.

Under the assumption this requirement can somehow be adhered to; the ESM will be approved more or less as is. The OMT on the other hand faces problems of its own.

On September 6 2012 the ECB issued a press release outlining the technical features of Outright Monetary Transactions. There are three things that stand out for the legal discussion

  1. OMT support is conditional on the country in question also engage the ESM; which comes with a macroeconomic adjustment program.
  2. OMT will predominantly, but not necessarily exclusively, be focused on the short end of the yield curve; defined as maturities of less than three years but more than one year.
  3. No ex ante quantitative limits are set on the size of the OMT – the program is potentially unlimited.

The problem with number 1 is obvious from the view that a central bank shall be independent. If a fiscal program is the condition for proper monetary policy, how can ECB policy be independent? What if the country in question fails to fulfill the adjustment program, will the ECB stop its OMT? Does that make sense from their mandated goals?

When it comes to number 2 and 3, we need to see these together and in conjunction with the EFSF-ruling regarding limited liability. If the ECB is free to buy unlimited amounts of sovereign bonds it violates the eternity clause in the Grundgesetz.

But, according to the Grundgesetz Article 88 “The Federation shall establish a note-issuing and currency bank as the Federal Bank. Within the framework of the European Union, its responsibilities and powers may be transferred to the European Central Bank, which is independent and committed to the overriding goal of assuring price stability.”

How can the Court rule against the OMT when the constitution itself says the ECB is independent.  Would that not be the very definition of irony? The Court that is mandated to uphold the Grundgesetz must violate the very same Grundgesetz to rule on the OMT.

In any case, the eternity clause should in theory trump Article 88 and the Court should could still vote no, despite violating the principle of monetary policy independence.

The OMT could also be said to violate the Treaty of the Functioning of the European Union (TEFU) Article 123 (1) which clearly states that “Overdraft facilities or any other type of credit facility with the European Central Bank or with the central banks of the Member States (hereinafter referred to as ‘national central banks’) in favour of Union institutions, bodies, offices or agencies, central governments, regional, local or other public authorities, other bodies governed by public law, or public undertakings of Member States shall be prohibited, as shall the purchase directly from them by the European Central Bank or national central banks of debt instruments.”

If so, the case need to be submitted to the European Court of Justice, as the Karlsruhe Court mandate is limited to the Grundgesetz.

The way out for Karlsruhe!

While the legal entanglements the OMT is in, seem to be insurmountable it is naïve to think politics does not play a big role here. The pressure on Karlsruhe is immense and they will have to come up with a way to get it through no matter what.

Here is how we think they will go about.

First of all, limit the OMT to the one to three year maturity range and make sure it only applies to bonds already issued at the time of OMT engagement. This takes care of two problems.

First of all, it is easy to calculate the potential liability beforehand as we know the size of the market.

Secondly, making sure the country under OMT help does not swap all its longer term bonds for newly issued shorter maturity bonds, the decision on the ultimate liability is no longer in the hands of non-German institutions.

Further, in order to keep the Bundestag nominally in control, maintain the connection between OMT and the ESM adjustment program.

Lastly, limit the OMT to secondary market interventions and claim Article 123 of the TFEU does not apply (it does, but they can at least pretend). If need be, the ESM can always make primary market interventions.

While these limitations on the OMT are noteworthy, they will probably not be large enough to undermine the Draghi put.

Alternatively the Court could use Article 88 of the Grundgesetz and give an all clear or send the case to the European Court of Justice. Legal proceedings here would probably take another year of two which buys even more time, just as the OMT was originally designed to do.


There are four alternatives for Karlsruhe, but given the importance of politics only one seems very likely at this point. Karlruhe options for blogg

The boom and bust cycle

As is clear to all with half a brain the production of un-backed fiat money distorts the economic system. Simply told, when an entity in society is given monopoly to manufacture medium of exchange at its own discretion they will harness this power. Slowly at first, unsure about its effects, but always testing the limits of the privilege bestowed upon them.

As always, they will overexploit the power. They will manufacture money and give it to the masters that coercively secure the continuation of the power. The masters will obviously spend the money, creating a transaction in which nothing is payment for something. These transactions are by definition unsustainable because they violates Say`s law. We call them “bubbles”

In a free market supply is used to create its own demand. When people spend fiat money they exercise demand without providing supply. Said in other words, spending fiat money is tantamount to capital consumption and makes society poorer.

While the boom that follows money spending feels good, it must inevitably come to an end because the economic system cannot maintain the constellation that was induced by the money printing in the first place. Within the boom lays the seed for the necessary bust.

We have made a metric that sums up fiat money in its purest sense and compared that to the underlying trend growth of nominal GDC.

Our hypothesis is simple: if money growth exceeds the GDC metric a deflationary busts will inevitably come. If authorities refuse to accept reality and print more fiat money at the first sign of bust, they may “save the day” but they will “ruin tomorrow”!

For every action taken there will be an equal and opposite reaction! When the fiat masters go too far they create the set-up for an imminent deflation.

We looked at this relationship and as the chart below show, a boom-bust cycle based on monetary expansion is clearly visible.

                        FMQ for blog

Source: Federal Reserve of St. Louis (FRED), own calculations

Our main concern is obviously what happens when the equal, but opposite reaction comes as a consequence to the monetary experiment dubbed the “Bernanke-put”.

A secondary concern is indirectly derived from this. Money printing tears the social fabric apart and people react by taking up massive amounts of debt; debt that will never be repaid in currency units of equal purchasing power.

Now, if the equal reaction comes, that will raise the real burden of outstanding debt, which consequently will bankrupt all debtors.

The next chart looks at various sovereigns’ roll-over risk for 2014. The exceptionally large amount of debt taken on since the financial bust in 2008 will forever constitute a massive risk for the issuing country as debt is never repaid, only rolled-over, that is old debt is paid with new debt.

Debt issuance for blog

Source: Bloomberg, International Monetary Fund (IMF – WEO), own calculations

 By this it is obvious to us that deflation simply cannot be allowed to happen! Our monetary masters will lose everything if they even flirt with the mere idea! Witness the taper scare this summer!

And since we are getting close to the next cycle low, why even bother try.

Emp cycle for blog

Source: National Bureau of Economic Research (NBER), Bureau of Labor Statistics (BLS), own calculations


Concluding Remarks

We leave the last word to the real Maestro

“There is no means of avoiding a final collapse of a boom brought about by credit expansion. The alternative is only whether the crisis should come sooner as a result of a voluntary abandonment of further credit expansion or later as a final and total catastrophe of the currency system involved.”

- Ludwig von Mises

Notes on US shutdown & debt ceiling

1)   There are two processes ongoing at the same time

a)    Budget resolution – cause of current shutdown

b)    Debt ceiling – potential leading to US default

2)   The two sides have reached an impasse

a)    Republicans believe they can get concessions from Obama and the Democrats; defund/delay Obamacare and further cut to projected spending

b)    Democrats and the President has changed tactics; “we will not negotiate until Republicans end shutdown AND raise debt ceiling”

c)     Compromise may be a short-term increase in debt ceiling while negotiations take place; say 1 – 3 months.

d)    Alternative I: put a clean CR vote / debt ceiling bill on the floor expecting 17 Republicans to join the Democrats. (R: 234, D:201, T:435). This violates the unwritten “Hastert rule” which says the Speaker shall not bring a bill to the floor without party majority! That said, the Hastert rule is often broken, but on an important issue like this, Boehner will probably end his career as Speaker!

e)    Alternative II: Republicans refuse to back down on shut-down, but agree to a clean debt ceiling bill.

3)   Dates to note; budget

a)    US FY runs from October 1st to September 30th.

b)    No budget nor continuing resolution bill was passed by start of FY14 – government must shut down all “non-essential discretionary spending”

c)     This has happened 17 times before with an average of 6.47 days. In 1995 – 1996 with Clinton President and both Senate and House Republican government was shut down for 5 days + 21 days. Note; budget was later balanced!

d)    Economic impact of “non-essential shutdown discretionary spending” is limited, but obviously grows for each day.

e)    This could therefore go on for a long time

4)   Dates to note; debt ceiling

a)    Debt ceiling was actually reached on May 18th 2013, but Treasury can resort to emergency funding under a so-called debt issuance suspension period (DISP) in order to postpone the day of reckoning.

i)       Divesting the Civil Service Retirement and Disability Fund

ii)    Suspend reinvestment of Government Securities Investment Fund

iii)  Re-allocate debt NOT subject to debt limit and debt subject to limit

iv)  In addition, Treasury got a massive injection of dividends from the bailed-out GSEs which gave them more leeway

b)    Treasury have publicly said October 17th is the day when they cannot operate safely

c)     However, by that date they will still have $30bn in cash, so Congress and President may want to continue the standoff

d)    Between October 22nd and November 1st ALL cash will be spent and some form of default will take place unless debt ceiling is raised.

5)   What happened during and after debt ceiling debate in 2011?

a)    Congress (House of Representatives) and the White House experienced the same situation in summer/fall of 2011

b)    The resulting compromise then was the Budget Control Act signed into law August 2nd 2011

i)       The act would allow a three-step increase in the debt ceiling provided certain milestones in deficit reduction was reached

ii)    A bi-partisan “super-committee” – A Joint Select Committee on Deficit Reduction – was established that would agree on reasonable deficit reductions.

iii)  If the committee could not agree, an automatic across the board sequester would take place on January 1st 2013

iv)  The committee did not agree and the sequester did take place (albeit delayed), leading to approximately $100bn annual reduction in projected spending

c)     Given the political wrangling over a serious issue like the debt ceiling, S&P downgraded US debt from AAA to AA+ (S&P was later investigated for misconduct during the financial crisis, Moody`s was not).

d)    US yields fell on the news, as investors still think US treasury debt is risk-free.

6)   What if no one gives in leading to the consequent default?

a)    First of all, this is relatively uncharted territory and no one knows for sure.

b)    In 1790 the US defaulted on debt, but managed to repay by early 1800.

c)     In 1979 a technical glitch caused a delay in interest payments with severe, but far from catastrophic, consequences. All debt, with interest was repaid shortly after.

d)    However, the world is different today and the most notable change is the emergence of shadow-banking that fund itself through collateral chains.

e)    When Lehman Brothers went bankrupt, a cascading chain of defaults occurred because one link in a highly complex chain of promissory notes was no longer eligible as collateral for funding.

i)       Estimated $2.8 trillion worth of Treasuries are used daily in the repurchase agreement market.

ii)    If these were by any instance rated “D” they would no longer be eligible for repo and financial funding would dry up – credit crush

iii)  In addition, sophisticated financial firms (criminals) re-hypothecate repos. In other words, they lend the treasury bonds received in repos to other market participants that repo them anew – credit crunch ^2

iv)  The Federal Reserve could no longer legally receive treasuries in their reverse repo activities. The Fed discount window would shut down

v)    Money market funds, active in these markets, would by mandate be obliged to sell

f)      Needless to say, this would put upward pressure on interest rates and drag down the phony economy with it.

7)   Other alternatives?

a)    Could the Treasury prioritize payments? For example delay social security checks and still pay bond holders?

b)    The Treasury pays on average 4 million bills every day and it will be fiendishly hard to prioritize between various creditors, not to mention the legal issue of Treasury making such judgments

c)     However, the bond market is operated on a separate system than the rest, and could probably be prioritized if need be

d)    Another alternative is for the Treasury to wait until it has enough cash for one full day worth of payments and pay it, and then start to accumulate cash again. Problem is that November is a high deficit month and this would soon mean days or weeks delay.

e)    Treasury could call it a “technical default” based on willingness to pay, NOT ability. This could give MMF, the Fed and possible the Repo-market an excuse to continue as nothing has happened. Or alternatively prompt the rating agencies to maintain current rating (highly unlikely).

f)      Platinum coin or the 14th amendment to the Constitution has been dismissed and if resorted to would lead to even more uncertainty in the future.

g)    If all other measures are exhausted, the Treasury must balance its books which are extra hard as FY Q4 is a high deficit period.

i)       We would probably see a 40 per cent reduction in government outlays and with GDP measuring consumption (GDC), its growth rate in Q4 would be massively impacted

ii)    1 week full shutdown; – 2 per cent in annualized GDC (-0.5 per cent quarter on quarter)

iii)   1 month full shutdown; – 8.4 per cent annualized (-2.16 quarter on quarter)

Update: We were just made aware of yet another alternative; Treasury could issue super-premium bonds – say a bond with price $275 and use the proceeds to fund government or alternatively retire old debt. The trick is based on the fact that the debt ceiling only counts debt at par value! More on another can-kicking devious scheme here; http://www.businessinsider.com/treasury-could-issue-super-premium-bonds-2013-10. Kudos to Mr.Koutsomitis!

What does the market think about the whole thing? 

T-bill greater Libor

T-bill greater Note

Quiz: Who said this?

Was it Tea-party darling Ted Cruz, Libertarian Ron Paul, his less radical son Rand Paul or maybe someone else?


President, I rise today to talk about America’s debt problem.

The fact that we are here today to debate raising America’s debt limit is a sign of leadership failure. It is a sign that the U.S. Government can’t pay its own bills. It is a sign that we now depend on ongoing financial assistance from foreign countries to finance our Government’s reckless fiscal policies.

Over the past 5 years, our federal debt has increased by $3.5 trillion to $8.6 trillion. That is “trillion” with a “T.” That is money that we have borrowed from the Social Security trust fund, borrowed from China and Japan, borrowed from American taxpayers. And over the next 5 years, between now and 20XX, the President’s budget will increase the debt by almost another $3.5 trillion.

Our debt also matters internationally. My friend, the ranking member of the Senate Budget Committee, likes to remind us that it took 42 Presidents 224 years to run up only $1 trillion of foreign-held debt. This administration did more than that in just 5 years. Now, there is nothing wrong with borrowing from foreign countries. But we must remember that the more we depend on foreign nations to lend us money, the more our economic security is tied to the whims of foreign leaders whose interests might not be aligned with ours.

Increasing America’s debt weakens us domestically and internationally. Leadership means that “the buck stops here.” Instead, Washington is shifting the burden of bad choices today onto the backs of our children and grandchildren. America has a debt problem and a failure of leadership. Americans deserve better.

I therefore intend to oppose the effort to increase America’s debt limit.


Seigniorage – the good old fashioned way!

When the Europeans published their upbeat retail sale report last week we asked a rather rhetorical question; where do you think all those ECB-money ends up?

Given Draghi`s broken monetary transmission mechanism is should come as no surprise that most of it ends up in the north.

As simple chart depicting a rebased retail sale series should help substantiate that claim!

     Retail Sales 2007 = 100 w Lux

Source: Eurostat, own calculations

In the new normal it pays to have a relatively large financial sector; unless you are Cyprus of course. More precisely; it pays to have a relatively large financial sector that caters to the elite!

And if it something tiny Luxembourg have an abundance of, it is financial service industries. The next chart breaks the Luxembourgian economy down to its components. As is obviously clear, the financial sector with its support functions have become a behemoth within a Leviathan.

The incredible growth of the financial sector has led to asset accumulation in excess of 8 times GDC! While this this is down from the heydays witnessed prior to the Lehman collapse, it is still among the worlds most bloated financial sectors.

Luxembourgian GDC

Source: Statec, European Central Bank (ECB), own calculations

Now, as we have shown extensively on these pages, the ECB is more or less designed to bail-out these too-big-to-fail institutions. However, there is one thing that we have until now neglected to mention, namely the issuance of banknotes; money printing in the literal sense of the word.

Within the euro system national central banks have been allocated a share of total currency outstanding as given by the “banknote allocation key” published by the ECB.

Out of the total, 8 per cent is a liability of the ECB itself, while the remaining 92 per cent outstanding is liabilities of the different national central banks.

For example, the National Bank of Greece has been allocated €22bn of the banknotes outstanding, while the mighty Deutsche Bundesbank has an allocation of €211bn, out of a total of €846bn.

However, the actual issuance does not necessarily correspond to the allocated amounts. If a national central bank has issued more than the allocated quota, it will accumulate a liability on its balance sheet called “Intra-euro system liability related to euro banknotes”. These liabilities will be counted against assets on central banks with issuance at quota or less.

At this point in our story we can almost feel the frustration and anger building inside our northern European readers. “Yet another way the euro system help siphon of my hard earned money to profligate southerners!

But that is NOT the case! Excessive note issuance is (almost) inversely related to sovereign bond yields! The deeper a country has sunk into the euro-quagmire, the less the NCB has resorted to excessive note issuance!

How come? We expect it to be demand driven and related to the deposit flight experienced by the southern European banking system.  As money moved from the south to the north demand for cash increased in the north!

Deposits flight

Source: European Central Bank (ECB), own calculations

That said, this can only explain why excessive note issuance has continued to grow in the period after 2008. But as the chart below show, note issuance above allocated quota has been going on since the start of the euro!

Germany has issued a whopping €211bn in excess of the allocated €210bn, or 100 per cent of quota. Still, no one beats Luxembourg! Our friends with financial acumen know the game of money printing better than anyone else. Per July 2013 the Banque central du Luxembourg reported more than €80bn in excessive note issuance, or 4,136 per cent above the stated quota of €1.9bn!


Issuance exceeding quota

Source: various national central banks, own calculations

Excessive issuance relative to quota

Source: various national central banks, own calculations


While many people, rightly so, focus a lot of attention on the TARGET2 bail-out, few adjust these numbers for the note issuance.

For example, the TARGET2 claim accumulated on the balance sheet of the Bundesbank has come down to €577bn from a peak of €751bn as a result of the OMT-promise. As the TARGET2 claim came down, note issuance kept rising so the net claim actually fell much more dramatically.

Bundesbank net claim

Source: Bundesbank, own calculations


All this make the euro-economy an oddity among peers. It is far more cash-based than, say the US and UK

Cash relative to GDC

Source: Eurostat, various NCBs, Bureau of Economic Analysis (BEA), Federal Reserve (Fed), Bank of England (BoE), Cabinet Office (CAO), Bank of Japan (BoJ), own calculations

Concluding remarks

The euro system has many peculiarities as we have shown extensively on our blog. To a large extent the system can be analyzed as a “tragedy of the commons” problem. As is well known in economics, when a shared resource can be exploited in full by individuals with no exclusive property right, the resource will be overexploited.

The euro is a shared resource. Every national central bank can exploit it to the fullest while the cost will be shared by every member state.

The incentive in such a system is obviously rigged to its disfavor and it will eventually break down.