In order to judge the arguments made by Sinn and his detractors, it is necessary to appreciate how a
This transaction would result in the farmer's Irish bank current account being drawn down and the same sum credited to the tractor dealer's German bank current account, while the Irish bank would make a payment to the German bank via the interbank fund transfer system that settles in their respective current accounts at their central bank.
In most monetary areas, both banks would hold their current accounts at the same central bank, and settlement would involve a simple reallocation of current account credit from the payer bank to the payee bank, with no change in the nature of the central bank's liabilities. In a regionally distributed central bank system, however, like the Federal Reserve System or the Eurosystem, banks deal only with their regional central bank. In this case, the counterpart of the decrease in the payer bank's current account balance, which represents a liability of its regional central bank, is a negative contribution to that central bank's cumulative position with the rest of the central bank system, while the counterpart of the increase in the payee bank's current account balance is a credit to its own regional central bank's cumulative relative position. In the Eurosystem, these relative positions are recorded as balances with the ECB in the interbank fund transfer system TARGET2 (Trans European Automated Real time Gross settlement Express Transfer system 2). In the absence of an existing cumulative position, the farmer's tractor purchase would generate a TARGET2 deficit at the Central Bank of Ireland and a TARGET2 surplus at the Bundesbank.
Because these bank current, or reserve, accounts at their central bank play a vital role in monetary policy operations, how banks accommodate interbank payments depends on how monetary policy is conducted in their currency area. Since these indirect effects are central to the debate stirred up by Sinn, an understanding of monetary policy operations is necessary to evaluate the arguments, so some principles and details relevant to the present discussion are explained here. Readers who believe that they are already familiar with monetary policy operations may skip the following four paragraphs. For a more complete
Positive balances in banks' current accounts at the central bank represent a secure and liquid asset and are known as "reserves". However, any interest rate paid on reserves is typically relatively low, and is not always paid on the whole balance. Banks therefore usually try to minimise their holding of reserves, subject to a constraint provided either by a ban on overdrafts or by a requirement to hold an amount of reserves representing some minimum fraction (in the eurozone, 2%) of deposits for regulatory reasons, leading banks to aim to hold on average a slightly higher level of reserves than the constraint to allow for the unpredictability of payment flows.
Monetary policy ensures that the aggregate stock of reserves held by the banks is as large as needed, and the banks distribute this stock between themselves via a money market wherein banks with surplus reserves lend to those with a shortage, typically for one day at a time. As any transaction between the banks and the central bank is also settled with reserves, the central bank can use designated transactions to adjust the overall stock of reserves. And because there is, other things equal, a
Naturally, if there are significant disparities in creditworthiness between banks, the money market may make allowance for this by requiring less creditworthy borrowers to pay a higher interest rate to compensate lenders for the greater risk of loss. Alternatively, loans may be secured in the form of repurchase agreements (repos) to practically eliminate credit risk. To ensure access to such loans as needed, banks tend to hold some debt securities which are readily acceptable as repo collateral, notably government and
Although the importance of monetary policy means that OMOs tend to attract the most attention, the archetypal transaction between the central bank and banks is actually the supply of banknotes. While the aggregate stock of reserves is always greater than zero, in normal market conditions banknotes are by far the largest liability on the central bank's balance sheet, as banks draw down their reserves to pay for banknotes to meet customer demand. This demand for banknotes tends to be fairly stable, typically growing roughly in line with nominal economic activity. The result is that the central bank is structurally a net lender to the money market, regularly renewing its loans as they mature, which provides frequent opportunities to adjust interest rates. Simply renewing less than the full amount of loans maturing would usually be sufficient to adjust money market interest rates upwards; only rarely, between such opportunities, might the central banks need to borrow in the money market to adjust interest rates. As will be explained later, it is this structural central bank position as a lender to the money market that leads Sinn to argue that the size of the "stealth bailout" is limited, on the presumption that the ECB would be reluctant to become a large routine money market borrower.
The reader should now be in a position to appreciate the indirect effects of the payment generated by the Irish farmer's tractor purchase from Germany.
Assuming that the Irish bank had been managing its balance sheet to minimise its reserves holdings, in the absence of any other flows, the payment would leave the Irish bank with less reserves than it needs, because the drain on its reserves is equal to the contraction in its demand deposits and a bank's holding of reserves is typically a fraction of its deposits. The Irish bank therefore might be expected to borrow in the money market to replenish its reserves. The German bank, meanwhile, would be left with excess reserves. In the eurozone, although interest is paid on officially required reserves, no interest is paid on amounts in excess of this; the ECB does provide an overnight deposit facility, but this is intended for emergency use and, at present (since 13 May 2009), yields ¾% less than the refinancing rate. The German bank therefore might be expected to lend reserves in the money market to earn a return on its excess holding. Note, however, that the sizes of the Irish bank's shortage of reserves and the German bank's surplus, though still equal, are a little less than the value of the tractor, because the Irish bank has lost deposits and therefore needs fractionally less reserves than before, while the German bank has gained deposits and therefore needs fractionally more reserves.
Ideally, it might be expected that a bid for funds by the Irish bank at a slightly higher interest rate than generally prevailing in the money market (assuming, for the sake of argument, that money market loans are secured) reflecting its need for reserves, and an offer of funds by the German bank at a slightly lower interest rate reflecting its excess reserves, would be sufficient to ensure that the money market rebalances via a loan from the German bank to the Irish bank. In that case, the payments imbalance arising from the initial transaction would be largely offset by the opposite payment imbalance arising from the subsequent
Since the onset of the financial crisis, however, eurozone money market conditions have not been ideal. The creditworthiness of Irish banks was in question right from the beginning, meaning that their money market counterparties became extra careful to ensure that loans to them were well collateralised. In an attempt to reassure lenders to Irish banks and forestall deposit flight, the Irish government fully guaranteed Irish bank liabilities. Naturally, this undermined the creditworthiness of the Irish state itself, initiating a series of downgrades by the credit rating agencies which prompted the money market to require larger haircuts on Irish government and government-guaranteed bonds pledged as repo collateral. Unfortunately, despite the progress towards an integrated eurozone capital market, there is still a home bias in banks' bond holdings in favour of their own country's government and government-guaranteed bonds. For Irish banks, this has meant that the main repo collateral that they are able to provide is not only less valued in the money market generally, but also less acceptable from them in particular, because its credit risk is positively correlated with their own.
For whatever reason, the ECB treated the financial crisis as a liquidity problem, and chose to continue accepting Irish government and
As Sinn and other commentators on this issue have noted, interest at the ECB refinancing rate is payable on TARGET2 liabilities and paid on TARGET2 claims, but this is should not simply presumed to be the consolidated national (ie public sector, including the central bank, plus private sector) return for the countries involved. The designers of European monetary union were scrupulous to ensure that the revenue derived from supplying the monetary base (ie reserves plus banknotes) is pooled and shared out between the national central banks following an agreed formula, rather than according to where banks choose to be formally established (and hence which national central bank they deal with), and the geographical vagaries of the demand for banknotes. According to Article 32 of the Statute on the European System of Central Banks and the European Central Bank, the sum of the national central banks' "monetary income" (ie seigniorage) derived from "assets held against notes in circulation and deposit liabilities to credit institutions", less interest paid on reserves and operating costs, is "allocated to the national central banks in proportion to their paid up shares in the capital of the European Central Bank" (ie the "capital key"). For the purposes of this redistribution, the national central banks are required to "earmark" their monetary assets and liabilities according to ECB instructions which specify that positive and negative TARGET2 balances should be counted as monetary assets and liabilities respectively. The monetary income received by a national central bank is therefore independent of the size of its own TARGET2 balance and the interest rate on that balance. In fact, the consolidated national returns on payment imbalances derive from the way in which they are accommodated by private sector banks. Because the payment deficit bank and the payment surplus bank reset their reserves position by borrowing more and less respectively in the ECB refinancing operations, the return to their adjustments is indeed the refinancing rate. As explained above, however, the size of these adjustments is fractionally smaller than the size of the TARGET2 balances because of reserve requirements.
Although the payment deficit countries may pay the same interest rate on their
Does the present configuration of TARGET2 balances represent the "ECB's stealth bailout" of the payment deficit countries as Sinn contends? Though a bit polemic, the description is not unreasonable. Firstly, ECB lending is shielding those countries from the full market cost of their accumulated payments deficits. Without ECB lending, to cover its payment deficit in the eurozone money market a country like Ireland would have to sell assets to foreigners at whatever price can be obtained, such as
Sinn is also correct that the diversion of ECB refinancing towards payment deficit countries is constraining credit creation in Germany. German banks are not constrained in their access to as much base money as they want at the ECB refinancing rate. However, this interest rate is set to meet an inflation objective for the whole eurozone, so to the extent that the relaxation of the ECB collateral rules marginally eases monetary policy in the payment deficit countries, monetary policy must be marginally tighter elsewhere. In other words, the refinancing rate is set higher than it would be if no collateral concessions were made to payment deficit countries. This, given the
And as Sinn argues, the size of the stock of ECB refinancing does constitute a restraint on the total size of the TARGET2 deficits. Once the payment surplus country banks have paid down their entire initial share of the stock of ECB refinancing (the liability counterpart to their required reserves then being customer deposits only), it ceases to be possible for them to invest the reserves inflow from payment deficit countries any further in this way. Although the ECB's overnight deposit facility in theory provides an unlimited
Finally, assuming that the present chronic TARGET2 imbalances are problematic because the obscure subsidy involved is undesirable, how can they be constrained? Clearly, in a monetary union,
Addendum on July 12th 2011
To make the relationship between TARGET2 payments and the adjustment of banks' usage of ECB refinancing operations clearer, a numerical example of the changes in the balance sheets of the institutions involved may be helpful. Continuing with the example of an
The figures in this stylised example may be taken to be in some notional monetary unit like billions of euros. The German bank and central bank are, in balance sheet terms, about twice the size of the Irish bank and central bank. In the example, the interbank payment represents half of the existing stock of deposits held at the Irish bank. For simplicity, it is assumed that no TARGET2 balances exist before the payment is made. Both private sector banks and central banks have some equity which is invested entirely in securities which could be used as loan collateral as necessary. The only type of monetary asset held by central banks is refinancing loans to the banks. Although banknotes may have originally entered circulation by being purchased by the banks to meet customer withdrawals from their deposits, and were paid for at the time out of the banks' reserves borrowed from the central bank, it is assumed that all banknotes are now held by the public. The banks are subject to a reserve requirement of 20% of their deposits. In case it is not obvious, "secs" is securities, "depo" is deposits, "refi" is ECB refinancing loans, "res" is reserves and "o/d" is an overdraft in a bank's current account at the central bank.
Addendum on December 9th in reply to umarmung: Why debt default need not necessarily lead to euro exit
On 16 November, in response to a comment I made on Olaf Storbeck's Economics Intelligence blog, commenter umarmung asked why I believe that Greece could remain in the eurozone after defaulting on its government debt, and whether banknotes can provide an unrestricted channel for capital flight, as suggested in an FTalphaville post. Since my answer became quite long as I considered it, and since it may interest others who might not read the comments, I include it here as an addendum, rather than in the comments.
Thanks for your appreciation and good questions, umarmung. Sorry to be so slow to reply to your comment. I needed to
The reason why I say that a eurozone member country which defaults on, or more realistically, restructures its government debt need not give up the euro is that such a credit event does not necessarily disrupt that country's participation in the euro payment system, including
In practice, however, because of the home bias of EU banks' government bond holdings, especially in the peripheral eurozone countries most at risk of default, a government default is likely to substantially depreciate, if not wipe out, the value of the collateral that its country's banks normally provide for central bank loans. Nevertheless, it may still be possible for the country's banks to carry on making euro payments. If a bank has sufficient capital to cover the loss on its government bond holdings, it may be able to supply supplementary collateral to top up the cover for its loans from the central bank. If the bank cannot provide sufficient new collateral, and cannot repay its loans from the central bank, the central bank is supposed to be able to liquidate the collateral already given by the bank to recover what it owes. Unfortunately though, the ECB's failure to tighten collateral standards and haircuts enough to reflect the true risk of eurozone government defaults means that the central bank is likely to suffer a credit loss in the event of bank failures triggered by a government default. This loss is shared by all the eurozone members in proportion to their capital key, but since the loss is then a bygone, there is no reason why the defaulting country's surviving banks should not continue to use the euro. Government defaults tend to be selective such that the government concerned keeps making some priority payments, and unlike companies, bankrupt governments are not liquidated, so that, if a defaulting government is determined that its country should remain in the eurozone, it may nevertheless be able to find the resources – eg by using its gold and foreign exchange reserves – to recapitalise its banks to allow them to replenish their stock of eligible collateral if necessary.
Of course if, regardless of such mechanisms, depositors do associate government default with withdrawal from the eurozone and the introduction of a weaker national currency, a growing likelihood of default can be expected to prompt capital flight from nominal assets like bank deposits. In that case, the banks have to find sufficient collateral to allow departing depositors to be paid off as long as the run lasts. How much money is required to ride out this run depends on the stock of bank deposits, the proportion of them which are demand or maturing deposits, and how long the run persists. Naturally, if the banks run out of sufficient eligible collateral and even the government cannot provide more, then in effect, the whole country, and not just its government, is bankrupt. Even then, the country could continue using the euro with exchange controls that restricted the value of outgoing euro payments to no more than the value of incoming payments.
I think the issue of banknotes is a red herring. As Clemens Jobst describes in the VoxEU column mentioned by lostgen above on 22 July at 01.04, the balance sheet effects of
It is of course true that, if the ECB permits the government bonds of a dangerously indebted or even defaulted country to be pledged as collateral in eurosystem money market operations, that country can fund itself effectively without limit via the eurosystem by selling its government bonds to its banks which then borrow from the eurosystem using these bonds as collateral at their national central bank. But this would clearly be an abuse of the eurosystem which the other members would be foolish to allow to progress very far, and could stop by either capping or suspending the acceptability of the offending country's bonds as eligible collateral.
Hopefully that explains my remark on Economics Intelligence and answers your questions satisfactorily.