What does an extraordinary intervention by German judges mean for Europe’s monetary union?

Germany’s constitutional court is a power in the land. The court may be tucked away in the sleepy city of Karlsruhe close to the Black Forest in south-western Germany, but politicians in Berlin respect and fear the scarlet-robed judges who hand down constitutional rulings. The court derives its authority from Germany’s baleful history, since it acts as a guardian against any threats to the principles of democracy and human rights set out in the Basic Law of 1949.

But, in another response to its disastrous history in the first half of the 20th century, Germany is deeply enmeshed in European integration, especially through its membership of the monetary union. That makes for a potential turf war with the European Court of Justice (ECJ) based in Luxembourg, when German citizens bring cases challenging the legitimacy of Germany’s participation in European projects. Until this month the Karlsruhe court acknowledged (through gritted teeth) the ECJ’s primacy in interpreting European law, including in a notably fractious case about the policy of the European Central Bank (ECB) giving substance to Mario Draghi’s “whatever it takes” pledge to save the euro.

All that changed on 5th May, when the judges issued an extraordinary ruling on Germany’s participation in another controversial monetary policy initiative, the quantitative easing through buying financial assets that the ECB has undertaken since March 2015. Despite expressing misgivings, the court did not accept the claim that the main purchase programme, buying public sector bonds, was “monetary financing,” in which central banks create money to fund government borrowing. But the judges (with one dissenter out of eight) found fault with the ECB on grounds of “proportionality” since it had failed to take account of the wider effects of the purchases, illegitimately widening its role to economic as well as monetary policy.

The Karlsruhe judgment packed a punch. The court called upon the German government and Bundestag to take steps to ensure that the ECB conduct a “proportionality assessment” of the public sector purchase programme. It set a deadline of three months for the ECB to demonstrate that its monetary policy objectives were “not disproportionate” to its economic and fiscal policy effects. Failing that, the Bundesbank should cease to participate in the programme, which was restarted late last year.

The ruling came as a shock because the court had already referred the case to the ECJ, which upheld the legal validity of the purchase programme in December 2018. As a consequence the German judges necessarily had to reject the ECJ’s ruling, arguing that the court had erred in its interpretation of the treaties that underpin the EU. Like the ECB, the judges in Luxembourg had been remiss in failing to weigh up the wider economic policy effects of the purchase programme. In so doing, they had breached the requirement for proportionality to be demonstrated by European institutions in ensuring they do not stray beyond the powers bestowed on them in the treaties.

Although the decision was a surprise, the German court had previously insisted on its right to consider whether a European institution is overreaching itself. Even so, the language it used was stark and confrontational. Describing the member states of Europe as “masters of the treaties,” it highlighted the risk of “a continual erosion” of their authority over economic and fiscal policy. Planting its flag squarely on the ground of national democratic legitimacy, the court said it was vital to maintain the balance of powers (“competences”) between the EU, which “has not evolved into a federal state,” and the member states.

There is nothing sacred about the German court’s judgment. Indeed it appears deeply flawed both legally and economically. Yet the judges in red do pose a crucial question about European integration and national democracy.

The main legal criticism of the ruling is that it is the German court that is exceeding its powers, by trampling over the ECJ’s domain. Though similar courts in Denmark and the Czech Republic have also overruled the ECJ, the prominence of the German court means that it is setting an example that could be the death knell for European integration. The ECJ has said pointedly that “like other authorities of the member states, national courts are required to ensure that EU law takes full effect”; otherwise, the unity of the EU legal order would be placed in jeopardy.

Just as questionable is the economic reasoning of the German judges. It is impossible to draw a clear and precise distinction between monetary and economic policy. When a central bank cuts interest rates, the immediate effect in reducing financing costs has much wider economic consequences affecting demand and jobs that work their way through to the ultimate inflation goal. Likewise, quantitative easing works through multiple financial and economic channels to raise inflation when it is too low.

The German judges may be presumptuous in their challenge to the ECJ and their distinction between monetary and economic policy may be largely spurious, but they have a point in their disquiet about the accretion of power to the ECB. Over the past two decades and especially since the euro crisis of 2010-12, the central bank has waxed in influence among the European institutions. Under the leadership of first Draghi and now Christine Lagarde, its interpretation of its remit has become ever more expansive. The ECB now bears little resemblance to the limited conception of an independent central bank envisaged in the founding Maastricht treaty of 1992.

The ECB has not been alone in reinventing itself. Central banks around the world have marched into unorthodox territory and beyond since the financial crisis. The crucial difference is that the ECB sets policy for a monetary but not a fiscal and political union. As it sucks up power it leaves a vacuum at national level even though its actions matter more and more.

The financial markets have largely brushed aside the German court’s intervention, which does not concern the ECB’s big new quantitative easing programme launched in response to the economic crisis caused by the coronavirus pandemic. On past experience, political fudge is what investors and traders expect and fudge is almost certainly what will happen, allowing the show to carry on.

But the judges in red have put down a marker. The ECB may want to act in the same way as America’s Federal Reserve or the Bank of England. Yet it cannot do that if the Bundesbank is forced to step aside from its policies, creating a rift at the heart of the monetary union. That in turn reflects the fact that the euro is a half-built house because its member states and their citizens do not want to face up to the federal logic of creating the single currency. If nothing else, the German court’s judgment exposes just how unsatisfactory and dysfunctional this state of affairs is.