I’ve updated my TARGET2 paper. Here is a post with a link to the new paper and a discussion relating to a potential exit of Cyprus from the euro.
I’ve written a new paper on TARGET2. This post introduces and links to the paper.
Yesterday, I gave a presentation on “Target2 and the Euro Crisis” at the Bank of England’s Centre for Central Banking Studies. The slides from my talk are available here as a PowerPoint slideshow and here in PDF. Probably needless to say but the content of the presentations reflects only my own views and its presentation at the Bank of England does not imply their endorsement.
Hans-Werner Sinn has an article in today’s New York Times. The main point of the article is to rebut arguments from President Obama that Germany should be doing more to resolve the euro crisis.
Sinn argues that Germany has done enough:
Should the euro fail, Germany would lose over $1.35 trillion, more than 40 percent of its G.D.P. Has the United States ever incurred a similar risk for helping other countries?
Most of this $1.35 trillion potential loss figure comes from the possible loss of the Bundesbank’s Target2 credit, something which I have argued can be dealt without any new taxes on German citizens.
But, forgetting that for a moment, it appears that Sinn views “Has the United States ever incurred a similar risk for helping other countries?” as a rhetorical question to which the answer is “No”. In fact, I suspect the vast majority of US citizens are perfectly aware that the answer is “Yes”.
One example that the good professor has probably heard of: World War 2. Once the United States entered World War 2, defense spending rose from 1.64% of GDP in 1940 to 37.19% in 1945. The US debt ratio went from below 40% of GDP in 1941 to over 120% of GDP in 1946. And this doesn’t put a price on the tragedy of over 400,000 deaths of US troops.
The readers of the New York Times are likely to be aware that the freedom and prosperity that modern Europeans enjoy is due in no small part to the massive financial and human costs incurred by earlier generations of Americans. Perhaps Professor Sinn should consider an apology.
Another week, another academic hyperventilating about the crucial importance of Target2. This week’s entry is from Michael Burda of Humboldt University. It summarises the situation with Target2 balances as follows:
Bundesbank surpluses with the ECB have swelled to well over €700 billion, or about 30% of German GDP. Germany has now become a hostage to the monetary union, since a unilateral exit would imply a new central bank with negative equity.
However, there’s no follow-up explanation for what this means. Apparently “a new central bank with negative equity” is something so unthinkable that it means that Germany has no choice but to be a “hostage” to monetary union.
My assessment, as argued in this article is that the Bundesbank losing its Target2 credit would be no more than a minor inconvenience to Germany. We now live in a world of fiat currencies. The man that accepted that euro for your cup of coffee this morning didn’t do so because he believes the central bank has “positive equity”. He did so because it’s the legal tender of the land.
The post-EMU Bundesbank (it wouldn’t be a new central bank) won’t have to worry about its equity position because it won’t have the same kind of solvency concerns that you and I have because it has the power to print money. (See this recent Bill Mitchell blog post “The ECB cannot go broke – get over it”).
Another disappointing aspect of Burda’s article is that while there is a single mention of “capital flight”, the use of language in the article predominantly links Target2 balances with the traditional trade balances associated with David Hume specie-flow theory. I’m sure Burda knows this but it is worth reminding people again that the ever-growing Bundesbank Target2 balance relates far more to capital flight from the periphery than current account balances. Here’s a graph of current account deficits as a percent of GDP, including the EU Commission’s forecasts for 2012.
And here’s a nice graph from an FT blog post by Gavyn Davies from a few weeks ago. Note that current account imbalances are getting smaller while the Target2 balances are getting bigger. Capital flight, not trade imbalances, is what’s driving the Target2 balances.
I have written a new article on Target2 for Vox-EU titled “TARGET2: Not why Germans should fear a euro breakup.”
It is interesting to see how the debate about Target2 has changed over time. This is the third article I’ve written for Vox on this subject. The first two (here and here) largely dealt with serious inaccuracies that were being aired prominently, such as claims that the Target2 system was crowding out credit in Germany or that the Budesbank was being forced to sell securities to fund loans to the periphery. While new false claims about Target2 have since emerged (e.g. CESIfo’s claim that German commercial banks are having to alter the asset side of their balance sheet because of Target2) these particular stories appear to have been put to rest.
More recently, as the Euro crisis has escalated, the focus of discussions on Target2 has switched to the question of what would happen to the balances if there was a complete Euro breakup and those central banks with Target2 liabilities refused to honour their debts. This is a legitimate question and it is the one I address in today’s article.
My conclusion is that there will be no need to fiscally recapitalise the Bundesbank should its Target2 credit turn out to be worthless because the new-DM will, like the Euro, be a fiat currency and such currencies do not obtain their value from being backed one-for-one by hard assets held by the issuing central bank.
This conclusion will, I’m fairly sure, attract a lot of criticism, particular from the Northern European parts of the internets. However, I think much of the scare-mongering about Target2 reflects a general confusion about the nature of central bank balance sheets within a fiat currency system.
Consider, for instance, the constant stream of business press reports featuring various commentators worrying about the balance sheet of the ECB. As I’ve noted before, much of the commentary on the potential credit losses focuses on the wrong figures by discussing the ECB’s capital when, in fact, loss-sharing on monetary policy operations is shared across the full Eurosystem, which has nearly half a trillion euros in capital and revaluation reserves to absorb losses.
Even when these articles focus on the right figures, they usually greatly exaggerate the potential problems associated with the ECB’s potential “solvency.” Articles like this one, for instance, seem to be premised on the idea that the value of the euro as a currency depends on the Eurosystem having assets that “back” the currency: One euro more in assets than liabilities and the Eurosystem is fine, one euro less and disaster supposedly awaits.
The truth is that the euro is a fiat currency and its value as a medium of exchange does not stem from the public’s faith in the value of the assets held by the central bank. Commentary that hypothesises existential problems for the euro stemming from perceived issues with the Eurosystem’s balance sheet are simply based on false analogies between private sector and central bank balance sheets.
I’d like to be able to point to lots of other useful work on this topic but, unfortuantely, these issues are rarely discussed in mainstream economics textbooks or journals. Here though is a nice recent presentation by Columbia’s Ricardo Reis that touches on some important points in relation to central bank balance sheets. Hopefully Ricardo will produce a full paper on this soon.
CESIfo Group, the research Institute of which Hans-Werner Sinn is president, has developed a fondness for issuing anonymous press releases that claim to “explain” Target2 balances to the general public. Today, their new press release claims:
Target credit levels in the Eurosystem are rising ever more steeply … Who are the losers from this process? The savers in those remaining European countries that still have sound economies. Without their knowledge or consent, the marketable securities owned by their savings banks, commercial banks and life insurance companies that usually cover their savings have been transformed into mere claims against their central banks, which in turn have acquired claims against the ECB system and indirectly against the central banks of Spain and Italy.
Let’s leave aside for a minute the fact that those coloured pieces of paper in your wallet are “mere claims against central banks”. The idea that the assets of savings banks, commercial banks and life insurance companies have been altered by changes in Target2 balances is utterly false.
Target2 balances can only be accumulated (whether as a credit or a debit) by Eurosystem central banks. Take a look at any annual report of a German savings bank, commercial bank or life insurance company. You will not find that their marketable securities have been replaced by Target2 credits because this never happened and can never happen.
The anonymous person who wrote this press release has no clue what Target2 is or how it works. Its appearance should be a cause of great embarrassment to the CESIfo group and they should issue an apology and a retraction.
Anyone who has had the misfortune to read this press release and is now confused about what Target2 balances are should consult this short guide to the subject written by two Bundesbank economists and published (but then ignored) by CESIfo. Two other articles by me rebutting various CESIfo-inspired arguments can be found here and here.
A member of the fourth estate passed on to me a “Background Briefing” from the government on promissory notes.
It contains the following sentence: “The Central Banks (sic) had to borrow this Cash to give to Anglo and has a resultant liability that it must repay.”
This is not true. ELA funds were not borrowed by the Central Bank from the ECB or the rest of the Eurosystem. They were created by the Central Bank of Ireland and provided as a credit to Anglo’s reserve account. To the extent that Anglo used this money to pay off people with foreign bank accounts, the liability will have switched from being a reserve liability to an Intra-Eurosystem (i.e. Target2) liability.
Furthermore, as central bank economists throughout Europe have been saying time and again over the past year (e.g. this piece by two Bundesbank economists) Target2 balances simply reflect the outcome of private decentralised transactions and there is no system whereby a Target2 creditor is under an obligation to “repay” the Target2 liabilities under any particular time-frame.
The long-winded version of this point is on page 14 of my recent briefing paper:
The reason I have described Intra-Eurosystem transactions in such detail is that there has been some confusion in media and political circles in relation to the nature of the ELA issuance. A number of media stories have reported that “the ELA money was borrowed from the ECB”. This is not the case. The ECB does not issue money at all as this task is delegated in the Eurosystem to national central banks.
A more subtle version of the “ELA was borrowed from the ECB” claim was provided in an answer to a parliamentary question by the Irish Minister for Finance, Michael Noonan, on January 31, 2012. Mr. Noonan stated that “ELA is itself funded by the CBI through Intra-Eurosystem liabilities”.
The word “funded” can have an elastic meaning. However, this answer suggests an interpretation in which the appearance of an ELA asset on the Central Bank of Ireland’s balance sheet is accompanied by an increase in Intra-Eurosystem liabilities. It is my understanding that this is not the case. At the moment of “conception”, so to speak, of the ELA, the corresponding increase in liabilities is a credit to the reserve account of the bank receiving the ELA loans. Only if that bank then uses its ELA funds to transfer money to bank accounts outside Ireland does the Central Bank of Ireland’s balance sheet start to show an increase in Intra-Eurosystem liabilities.
Because the IBRC appears to have used the vast majority of its ELA loans to pay off foreign bondholders and people moving their deposits outside of Ireland, there is little doubt that the issuance of ELA has led to a significant increase in the Central Bank’s Intra-Eurosystem liabilities. However, it is not accurate to describe the ELA as having been either “borrowed from the ECB” or to describe an increase in “Intra-Eurosystem Liabilities” as the source of the funds.
There are lots of reasons why the ELA needs to be repaid, so why persevere with this false one? As far as I can see, there are two possible explanations for the continued use of this talking point. Either the officials who draft these briefing notes don’t understand how ELA works or else they do understand but feel that the “money was borrowed from the ECB” line will provide a good excuse on March 31.