Yesterday I suggested that the Eurozone could be safely and usefully dismantled by allowing the stressed economies to exit the Euro and launch new currencies tied to the Euro via currency board arrangements. This, I argued, would allow these countries to grow without setting off a monetary free-for-all, without losing many of the real benefits of a single market, and probably at a far lower cost to the rest of Europe's banking systems than the current death-march strategies promise.
Today I want to suggest one of the ways this could be implemented, technically, whilst preserving much of the current financial infrastructure of the Eurozone. But it also provides an opportunity to draw your attention to a really rather remarkable row which has been paddling along under the water for nearly six months now, and which finally broke surface in the November ECB Monthly Bulletin.
Although seemingly abstruse, this argument is dangerous, and – though I hope not – possibly symptomatic of a selective blindness among Germany economists and policymakers which we would be wise not to ignore. So far as I can trace, the row started in June this year with this piece, 'The ECB's Stealth Bailout' by Hans-Werner Sinn. Now Prof Sinn could scarcely be more august: he's the Professor of Economics and Public Finance at the University of Munich, and he's also President of Ifo Institute for Economic Research. One crosses him with great reluctance and considerable trepidation.
His paper asserted:
- that a large (Eu326bn by end-2010) Bundesbank surplus with the Eurosystem's Target2 real-time settlement system, was a 'stealth bailout' of peripheral economies by Germany;
- that it financed continuing current account deficits in the peripheral economies;
- that it dwarfed the official bailout packages;
- that the size of the Bundesbank's position was crowding out lending that might be made to the German economy;
- and that essentially this represents a major unrealized risk to the Bundesbank.
So august is Prof Sinn that in all likelihood he probably has momentarily forgotten more about economics than I actually know just now. And yet, his paper is . . . . . wrong. And wrong which suggests a blindness to the way banking markets work which I cannot imagine he would have encountered looking simply at Germany's banking system alone.
I'll try and explain in simple terms what the argument is about. However, there are other explanations here and here which you may find more satisfactory (and to which I am indebted).
Probably the simplest way to understand the problem is to think for a moment about how a banking system works, and a central bank's role within that system. Every day, commercial banks receive and make payments between each other: those payments can be the result of current flows (me using my debit-card at the supermarket), or it can be the result of capital flows (me selling shares or a house, and depositing the proceeds in the bank). At the end of every day, imagine all the commercial banks sitting round and netting off the transactions. The resulting netted total is the net clearing balance (NCB), checksummed at their accounts with the central bank.
In a closed economy, the NCB should be fairly stable, (provided there has been no sudden major change in the real capital stock of an economy). If for some reason there is a significant unanticipated fluctuation in the NCB (ie, if short-term rates spike), the central bank will probably feel it is playing a useful and normal role in acting in the market to smooth it out by supplying short-term liquidity. Alternatively, if it intends to implement a monetary policy change, one of the ways it can do that is to use money market operations to try to expand (or contract) the NCB.
Note that within this system, there may be very serious imbalances between banks, which could develop either as a result of slow underlying market-share changes, or because of more dramatic and destabilizing market-share changes. For example, if in England deposits left Lloyds HBOS to enjoy the relative security of HSBC, then for a while HSBC could find itself having a sharply positive balance with the Bank of England, whilst Lloyds would have a sharply negative balance with the central bank. However, as far as overall monetary control of the system is concerned, what matters is not the composition of the bilateral balances, but rather the movement of the NCB.
Such a situation would certainly suggest trouble at Lloyds/HBOS, and ought to attract the attention of regulators (although, given the FSA's negligence on Northern Rock, who know what they were capable of sleeping through). Nonetheless, there are several conclusions it would be difficult to draw:
- You wouldn't think that HSBC's ability to lend was being curtailed by its large surplus with the Bank of England. You'd assume very much the opposite, in fact – that they were having difficulting finding someething useful to do with all these deposits they have sudden acquired.
- You wouldn't think that there's a 'stealth bailout' going on, being funded by the Bank of England. Far from it: you'd think the money markets were operating efficiently, and in a way which is rather uncomfortable for Lloyds/HBOS.
- You wouldn't think HSBC is exposing itself to great risk in accumulating deposits in the Bank of England. Again, the opposite is likely to be the case – you'd assume these deposits in Bank of England would be the safest asset on their books.
Now consider the institutional set-up of the Eurozone. Essentially, it is a system in which the national central banks settle their fluctuating bilateral claims through their accounts at the European Central Bank. (Together, the collection of Eurozone national central banks, plus the European Central Bank, is known as the 'Eurosystem'.) The ECB, then, can be seen as the central bank for the Eurozone's central banks, and the backoffice system through which it (and many others) settles and establishes the net clearing balance of eurozone is called Target2 (a mercifully short acronym for Trans-European Automated Real-time Gross settlement Express Transfer system). It's a busy system: last year, Target2 saw an average daily turnover of about Eu2.3 trillion.
As the financial crisis in the Eurozone peripheral economies has developed, so, quite unsurprisingly, deposits have left banking systems deemed to be at risk, and fled to the ones that isn't. Deposits in Irish banks have transferred to German banks. And this has resulted in Germany's surplus with the Target2 system. Since the build-up of Germany's Target2 surpluses are greater than the cumulative peripheral current account deficits, it's clear that what's happening is a measure and response to predictable capital flight.
And as such, it is also very strange to assert that as German banks build up this surplus that this represents a 'stealth bailout' or a loss of lending capacity by German banks to the German economy. It also curious to see the Bundesbank being exposed by these surpluses, to the financial fragility of the peripheral economies – if there is a liability, it is to the ECB itself.
It has been reported that there's a certain amount of tut-tutting in Brussels these days about peripheral countries resenting German tutelage: 'But don't you know, this is what you signed up to!' And that is the answer also to Prof Sinn: this is precisely what Germany signed up to when it established the Eurozone and the ECB. This is how it's meant to work. Didn't you know?
This row, though, has at least this merit: that it alerts us to the possibility that the Target2 mechanism could precisely be used to institute and patrol the workings of Euro-linked currency board regimes established by Euro-peripherals needing to exit the Euro. For the fundamental point of the currency board is precisely that if the net clearing balance of a currency-board banking system is to expand, it must and can only be done so when a financial institution deposits the stipulated amount of Euros with whatever body is charged with operating the currency board.
Prof Sinn would be delighted to find that as the currency board re-established financial stability as a function both of predictable monetary discipline and of sharply improved medium-term growth prospects, there would be every likelihood that the current Target2 imbalances would . . . . correct themselves naturally as deposits flowed back into the peripherals banking systems again. The way it would happen would be simplicity itself: since the capital attracted back into the currency-board financial systems could not, by definition, push up the value of the New Lira, more New Lira would have to be printed. And, under the rules of the currency board, this could only be done by depositing Euros at the declared rate, with the central bank. Which in turn would result in an exactly matching run-down in Germany's Target2 surplus and Peripheral Target2 deficit.
That's how it's meant to work.