It's almost 18 months since the president of the European Central Bank Mario Draghi unveiled his Outright Monetary Transactions (OMT) programme, the euro zone's proposal to mop up the bonds of troubled euro zone countries.
The proposal, and Draghi’s commitment to do “whatever it takes” to save the single currency, has been widely credited with calming the euro zone crisis.
Bond yields have narrowed, debt and equity markets across the euro zone have picked up, and the break up of the euro, once a real possibility, now appears remote.
The euro zone crisis, while not quite over, has subsided significantly. The judgment by the German constitutional court threatened to undo these developments.
By placing a question mark over the legality of the ECB’s main policy weapon, the German constitutional court threatened to wake the euro zone crisis from its slumber.
So far, financial markets appear to have taken the announcement in their stride.
After some initial turbulence last Friday, bond and equity markets have settled down in the wake of the judgment.
One of the primary reasons is that the decision to refer the judgment to the European Court of Justice simply continues the uncertainty that already existed around the issue.
Markets knew a judgment was coming; the decision to deflect the ultimate decision to Luxembourg means the question mark that already hung over OMT will continue until the Luxembourg court decides.
The reaction in Brussels and Frankfurt to the decision was predominantly one of relief, as the European Commission and European Central Bank were given a reprieve from any imminent decision on the legality of OMT.
Deeper ramifications
But the Karlsruhe decision has deeper ramifications for the euro zone.
Firstly, the ruling by the court that the process appears incompatible with German law means that the ECB is less likely to actually deploy OMT before the European court rules on the matter.
While cynics point out that OMT has never been used, and that Mario Draghi has skilfully avoided divulging details of how the process might work, the certainty that it could and would be used is what has comforted markets.
Secondly, the Karlsruhe decision is likely to discourage the ECB from engaging in other, more radical non-conventional measures such as quantitative easing.
With the ECB rapidly running out of policy options, having cut interest rates to 0.25 per cent and euro zone inflation refusing to budge from historically low levels of around 0.7 per cent, this is of particular significance at this juncture.
Even the most conservative analysts accept that the traditional option of cutting interest rates is fast disappearing as interest rates go lower, making so-called “non-conventional” measures more likely.
Those who have long criticised the ECB for its perceived ultra-conservatism , particularly in comparison with other central banks such as the Federal Reserve, will be dismayed that the German constitutional court is likely to scare off the ECB to engage in more radical policies.
The reality that a national court is subtly tying the hands of a bank that has a responsibility to prudently manage the monetary policy of the 18 different countries which share the single currency, is perhaps the most worrying outcome of the German ruling, particularly as the ECB exercises itself with the reality or falling inflation and threat of deflation.
While the German constitutional court decision has given the authorities invested with responsibility for managing the euro zone crisis in Brussels and Frankfurt breathing space, it still maintains the prerogative to ultimately rule on the judgment once it returns to the German court, an unsettling thought for the many EU officials who are quietly confident that the Luxembourg court will uphold the sanctity of OMT.
Nonetheless, that breathing space is important.
The next year is a vital one for the European Central Bank as it prepares for the biggest expansion of its mandate since its foundation, the establishment of its new supervisory arm.
By the end of the year the bank will take direct responsibility for supervising the euro zone’s largest 130 or so banks, and have oversight of all others.
As part of this transfer of responsibility, the ECB is engaging in asset quality reviews of the banks which will feed into European Banking Authority stress tests in the autumn.
Fears about what problems may lurk in the balance sheets of those banks is the next potential pitfall for the euro zone.
Mario Draghi used a speech in Brussels this week to again stress the need for a backstop to be in place to deal with any capital needs, particularly in the transition phase when the euro zone's €55 billion rescue fund, the single resolution fund, is being built up.
High alert
Nonetheless, the ECB also needs to be in a position to act should euro zone instability whirl up again following the results of the bank stress tests.
The Karlsruhe judgment has also put authorities in Brussels and Frankfurt on alert for its next judgment.
On March 18th the Constitutional Court is scheduled to rule on the status of the euro zone’s rescue fund, the European Stability Mechanism (ESM).
Any threat to the functioning of the fund would have major ramifications not only for the euro zone generally, but particularly for Ireland which is seeking retrospective direct recapitalisation for AIB and Bank of Ireland from the fund.
