This post is about something I don't understand.
Let's start out simple. There are two parallel imaginary worlds: the green world and the red world.
In the green world people use positively-valued green money as the medium of exchange. If I buy something I give the seller my green money in exchange. Green money flows in the opposite direction from all other goods and financial assets. I am not allowed to take green money from someone without their consent. Only the issuer of green money is allowed to create green money. The borrower of green money undertakes an obligation to give green money to the lender at some future date.
In the red world people use negatively-valued red money as the medium of exchange. If I buy something the seller gives me his red money in exchange. Red money flows in the same direction as goods and financial assets. I am not allowed to give red money to someone without their consent. Only the issuer of red money is allowed to destroy red money. The lender of red money undertakes an obligation to accept red money from the borrower at some future date.
There is a symmetry between the red and green worlds; one is the negative mirror-image of the other. But there is also one asymmetry: the red world has a fundamental problem. Each individual can increase his utility by buying more goods and selling less goods, thereby accumulating an infinitely large stock of red money. The bank that issues the red money needs to put some limit on each customer's holdings of red money, to ensure this does not happen. This is not a problem in the green world, because having zero stock of green money sets a natural limit that stops an individual buying, and the individual is fully aware of that limit.
The real world is a red/green world. It has both green money and red money. A positive balance in a chequing account is green money. A negative balance in a chequing account is red money. If I sell my car to Andy, who gives me a cheque for $1,000, the bank reduces my overdraft by $1,000 and increases Andy's overdraft by $1,000. The bank has transferred $1,000 of red money from me to Andy. IIRC my father nearly always used red money. He nearly always ran an overdraft, paying it off once a year when he sold the harvest, to keep the bank manager happy.
In a red/green world, we can define the stock of "gross money" as the absolute sum of red money plus green money, and we can define the stock of "net money" as green money minus red money.
The Bank of Canada.
Canadian commercial banks have chequing accounts at the Bank of Canada. It's a red/green system. If I bank at BMO, and Andy banks at TD, and I sell my car to Andy who pays by cheque, BMO now has a positive balance of $1,000 at the Bank of Canada, and TD now has a negative balance of $1,000 at the Bank of Canada.
But the Bank of Canada sets a 50 basis point spread between the interest it charges TD on red money and the interest it pays BMO on green money. So BMO and TD can both gain if BMO lends TD $1,000 to eliminate both balances, at a rate of interest that splits the spread between the Bank of Canada's two rates of interest. Which is what Canadian commercial banks normally do. So the gross money stock is small, and normally the same as the equally small net money stock, by the end of each day.
- If the Bank of Canada acted differently, and set the same rate of interest on both red and green money, so the spread is zero, then there would be no incentive for BMO and TD to trade in the overnight market. If BMO's customers always sold more to TD customers than vice versa, BMO's chequing account at the Bank of Canada would become more and more positive, and TD's chequing account at the Bank of Canada would get more and more negative. The gross money stock would rise without limit, though the net money stock would not change.
- Or if TD were a risky bank, and if that risk were bigger than a 50 basis point compensation would warrant, there would be no rate of interest at which BMO would lend to TD that TD would accept. Again it is possible for BMO's account at the Bank of Canada to become increasingly positive, and TD's account increasingly negative.
A red/green world faces the same fundamental problem as the red world. A commercial bank will put a limit on each customer's overdraft. Similarly, the Bank of Canada must, at least implicitly, place a limit on commercial banks' overdrafts.
The European Central Bank.
Eurozone national banks have chequing accounts at the European Central Bank. It's a red/green system. They call it TARGET2. But unlike the Bank of Canada's red/green system, there doesn't seem to be any functioning equivalent to the overnight market that eliminates negative balances every evening. The ECB can hold the net money stock fixed, but the gross money stock can rise without limit. Here is the recent data (pdf).
I think you can see where this is going. I don't understand how it is supposed to work.
Worthwhile Canadian Initiative 
Nick,
I already answered this question at the other thread, but I think you are seeking broader input, and understandably so. The Eurosystem is complicated.
That said, I think the answer to this is quite simple in concept, so I’ll try to paraphrase what I said before.
Yes, there is a structural similarity between a single central bank like the Bank of Canada and its set of orbiting Canadian commercial banks with that of the ECB and its set of orbiting national central banks.
But the two systems are very different for other reasons.
The Bank of Canada is the central bank for a set of capitalist commercial banks. That means that the pricing of imbalances needs to reflect that capitalist motivation in order for markets to be efficient. You know the rest.
The ECB is the super-central bank for a set of national central banks that have no similar independent direct capitalist motivation as institutions. In fact, it’s the opposite. The NCBs and their respective national governments each share in the net interest margin effect (or profit) of the entire Eurosystem of central banks in aggregate – according to their “capital key” or capital allocation shares. So there is no motivation for NCBs to clear imbalances with each for reasons of “market efficiency” – because the net result of the group all comes back to the same allocation to each national central bank of that aggregate result, regardless of the existence, distribution, and pricing of TARGET2 imbalances. Specifically, the pricing of inter-NCB imbalances has no net effect on aggregate or distributed profits because all of that pricing nets out within the group.
The system is designed to allow for such passive imbalances in the normal course. The expectation is that private capital flows working in an efficient market will minimize such imbalances on a cumulative basis. That obviously hasn’t happened. But that’s a flaw in the fundamental design of a system with a common currency but diffused fiscal policies. And the result has been a financial disaster with the ever lurking threat of national exits from the Eurozone. And such exits if they occur are where the resolution of these TARGET2 positions could really become a more serious issue than what was intended in the original design of the system.
I think you can see where this is going. I don’t understand how it is supposed to work.
Why isn’t the answer just that the liabilities underpinning Target2 balances require collateral and collateral haircuts (required by the national central bank of its domestic commercial bank)? Sure, these may ultimately prove insufficient in some cases and blow out transversality, but what else is new, right? That’s still the basic constraint on the gross money stock rising without limit, right?
JKH and dlr: very good on-the-ball comments.
I think I’m going to let the comments flow for a bit, maybe letting the commenters argue among themselves, while I mull it over (and teach my class!).
The national central banks aren’t really independent. They take orders from the ECB. At least, the Greek central bank did, at a time when it was painful to do so.
Note that in the event of a unilateral national central bank exit/default, the ECB would have the recourse of confiscating the NCB’s equity in the ECB. So up to a point, the ECB is protected from that (remote) risk.
Majro: “> Only the issuer of red money is allowed to create red money.”
Was that a typo? Did you mean to write “> Only the issuer of red money is allowed to destroy red money.”? (Which is what I said)
(If it was a typo, I will edit your comment to fix it.)
As long as limits on red money holdings are set somewhere in the system won’t this limit total Gross Money even at a higher level ?
For example: Suppose A and B have their own CB that sets a max red money balance of 100. C and D have a different CB with its own money that sets a similar limit. As long as the 2 CBs maintain their red-balance rule the maximum gross money has an upper limit of 200 per CB, and 400 in total. This can never be breached no matter what trades take place between AorB and CorD.
If the 2 CBs decide to form a currency union with each CB having accounts with a new SuperCB then isn’t the amount of Gross money in the system still bounded by the red-money limits set at the CB level (as long as all trades are initiated by A.b.C or d and and not the CBs on their own behalf)? The CB for AandB could end up with a red money balance of 200 at the SuperCB and the CB for green CandD could end up with a green money balance of 200 , but even if the SuperCB has no limit the Gross Money supply can never go beyond 400.
1.If the Bank of Canada acted differently, and set the same rate of interest on both red and green money, so the spread is zero, then there would be no incentive for BMO and TD to trade in the overnight market.
That would indeed kill the overnight market. But it wouldn’t have any effect per se on the amount of credit that commercial banks extended to their customers, would it? It would just become like your second point, just that the threshold is 0 for not lending. The CB would have to do the netting itself. Otoh banks’ inter-connectedness would be eliminated which in turn would decrease systemic risk. Warren Mosler is a fan of eliminating the inter bank market for that reason, I believe.
What do you mean exactly by an ‘implicit limit’ on overdrafts?
Nick’s dad was a trusted, faithful customer of the bank. The bank(er) may have grown rich over the years, partly due to the efforts of Nick’s dad who repaid his green/red loan every year with green/red money.
How could a situation arise that a bank would have the ability to control Nick’s dad’s life with requirements to borrow and repay green/red money every year?
I turn to the concept of a national-gift-certificate. The owner of a nation/store can pay workers with gift-certificates. The gift-certificate becomes green money. The notation that a gift-certificate has been issued becomes red money.
Of course the owner of the nation would be better known as the National Government. Only the National Government has the ability to create legally accepted money/gift-certificates. The need for a medium of exchange that holds value over time is so great that Nick’s dad can become dependent upon those who control issuance of money/gift-certificates.
Could this be the way it actually works?
Nick,
“Eurozone national banks have chequing accounts at the European Central Bank.”
I saw your twitter exchange with Whelan, and I think you’re more right than he is.
If the Bundesbank buys French bonds from a seller who gets credit in a French bank deposit account, that shifts TARGET2 positive balances from the Bundesbank to the Bank of France, other things equal. So it’s analogous to BMO buying a bond from a seller who banks with Royal, with reserves moving over in the same way.
That said, in the same way that a BMO bond purchase from a seller who happens to bank with BMO has no net effect on the reserve account, a Bundesbank bond purchase from a seller who banks with a German bank has no net effect on the Bundesbank TARGET2 position. So the chequing account function is less visible in that type of example, and he may not be seeing the analogy because of that and because of the large scope of internal transactions within a particular NCB sub-system.
He refers to the Interdistrict Settlement Accounts for the regional Feds. That is a mechanism that resolves imbalances, but not for reasons of the type of market efficiency I was referring to in my first comment.
Whelan in my view was on the wrong side of the debates with Sinn several years ago.
… and so one question is whether the NCBs actively use that chequing facility with the objective of managing their TARGET2 positions in an active way
and the answer is no – due to the deliberate design and economics inherent in the transfer pricing of balances and the allocation of system wide central banking profits to the Eurosystem NCB participants and their respective fiscal authorities
@Nick Rowe:
If we decide to call any negative balance red money, as Nick is wont to do, then the national negative T2 balances are red money. And of course Nick keeps pointing out in a red money system, there is the incentive to accumulate as large a red money balance as is possible before departing our glorious Earth, unless of course there is some means of sanction which dissuades from the accumulation of red money over the long term. This seems to be what’s happening in the EZ clearing system. There is no incentive to reduce red money balances. These T2 balances are in effect the capital and current account balances that would normally accrue between nations in goods trading and financial transactions. They would normally be settled by formal debt arrangements or the exchange of foreign currency. There would also be pressure to alter the course of these imbalances. Deficit countries would eventually be compelled to deflate. In the Euro system, there does not appear to be the economic imperative to do this. The EC can only threaten to send in the Troika and cut off funds as happened in the case of Greece. In the case of Italy for instance, it’s a case of too big to fail or too big to pressure and cause to fail.
T2 balance table also probably reflects the effects of the ECB’s QE programme, with Germany being the main beneficiary.
“These T2 balances are in effect the capital and current account balances that would normally accrue between nations in goods trading and financial transactions.”
Not quite.
They reflect only the extent to which the private sector fails to recycle such flows. There are some Eurozone countries where private sector recycling is reasonably efficient, with muted TARGET2 imbalance results.
“also probably reflects the effects of the ECB’s QE programme, with Germany being the main beneficiary”
Not quite.
QE is a centralized strategy that is almost entirely decentralized in implementation via NCB execution and booking. There is no TARGET2 disruption when the Bundesbank purchases securities from German sellers. That largely immunizes against the kind of disruption to TARGET2 imbalances that might otherwise result with implementation and booking at a central point.
JKH: Here is a link to a Bloomburg article (dated 2016-09-21) that covers the increase in TARGET2 balances in more detail.
Thanks Roger.
The linked ECB speech there is quite revealing in detail:
“It follows that when a national central bank purchases securities from a non-domestic bank, the purchase is likely to give rise to a cross-border flow of central bank money. As around 80% of Eurosystem purchases by volume have been carried out through non-domestic counterparties, cross-border flows of central bank money are happening on a large scale as a direct result of the asset purchase programme… so when Banco de España purchases securities from a German counterparty, or from a UK-based counterparty that participates in TARGET2 via Germany, it can give rise to a flow of central bank money from Spain to Germany and affect TARGET balances [Figure 2]. ECB staff estimate that around 60% of purchases by volume under the asset purchase programme have been made from counterparties that participate in TARGET2 via Germany, while only around 5% have been made from counterparties that participate via Spain. It is in this context that Germany’s TARGET claim has increased by around EUR 200 since end-2014 while Spain’s TARGET liability has increased by around EUR 125 billion over the same time period.”
I hadn’t realized there was so much cross-border purchasing by individual NCBs implementing QE. Haven’t been following it recently.
My previous comment was not entirely wrong, but Henry’s was much more right with respect to the effect on Bundesbank TARGET2 balances. Sorry Henry.
… that apparently was a change in the pattern from direct NCB effects on TARGET2, as the Bloomberg article says:
“In the run up to mid-2012, peripheral central banks were lending to banks in their own countries and those banks were then using that money to repay debts to banks in the core.”
Good comment thread. I’m still reading and mulling.
Anyone got any thoughts on dlr’s comment above? If the red money is always matched with colateral (my father’s bank manager won’t let him run an overdraft bigger than the value of the farm) that sets a limit.
Nick,
My comment at the other thread on the credit risk/collateral issue:
http://worthwhile.typepad.com/worthwhile_canadian_initi/2016/11/my-cunning-plan-to-reform-new-keynesian-macro.html?cid=6a00d83451688169e201bb095705e9970d#comment-6a00d83451688169e201bb095705e9970d
Is saying “the red money is always matched with collateral” more or less the same as saying “The bank that issues the red money needs to put some limit on each customer’s holdings of red money” (as you do in the post)? Even if the red money is sometimes issued without explicit collateral banks will probably limit red money issuance to what it believes it can get back from the borrower if push comes to shove.
But if everyone in a country obtained red money to the limits of their collateral (or credit worthiness) it would still be scary high number.
Regarding dlr’s comment
My first impression was that the limiting process he refers to relates to the growth in the gross money stock in the context of commercial banking money in a given NCB sphere.
I think that’s not quite the same as the limiting process that relates to the growth in gross TARGET2 balances. It’s certainly related – as an overall constraint on the origin of deposit migration from one NCB sphere to another. But its seems to me it’s not quite the same thing as a constraint on the process of capital migration itself. But I’d have to think about it a bit more.
“There is a symmetry between the red and green worlds; one is the negative mirror-image of the other. But there is also one asymmetry: the red world has a fundamental problem. Each individual can increase his utility by buying more goods and selling less goods, thereby accumulating an infinitely large stock of red money. The bank that issues the red money needs to put some limit on each customer’s holdings of red money, to ensure this does not happen. This is not a problem in the green world, because having zero stock of green money sets a natural limit that stops an individual buying, and the individual is fully aware of that limit.”
Of course, the same problem does exist in the green world for overdrafts and loans. Limits are still required.
(unless you prohibit overdrafts and loans – which I don’t think you did because you refer to borrowers of green money)
The problem is essentially no different – just the form of the liability to which it applies.
let’s say every italian depositor decided to move their money to german banks. and the italian banks replace these deposits with ECB borrowings. meanwhile the german banks receive all these new euro reserves and do who knows what. gross money has increased. what are the constraints to this increase in gross money outstanding?
first, the italian banks cannot do this indefinitely. they will only be able to borrow from the CB to the extent they can provide sufficient collateral and are deemed solvent. once every or more likely most (given haircuts and other obvious factors for anyone following SSM and italian banks) deposits are gone, they by definition will not be permitted to borrow (either directly or via the bank of italy) from the eurosystem. similarly, italian borrowers cannot take on overdrafts without limit for the same reason any other bank borrower can’t take on overdrafts without limit. thus, gross money cannot increase “without limit.”
second, the ecb’s inflation target may act as even stricter constraint. if an increase in gross money outstanding develops due to country flight, the increase will generate tightening from the ECB even before hitting the italian bank/borrower capital limit constraint, if it results in euro-area inflation rising above target. if it doesn’t, who cares that the gross money has increased? well, italy wouldn’t be too happy that its banks were entirely wholesale CB borrowers and had no depositors, but that is just a standard story of what happens when a bank faces a deposit run, and not a story about gross red/green money increasing indefinitely.
of course, it is more likely that the increase in gross money does not spark inflation in the first place. this is because (1) it is a mistake to think that gross money can increase without limit and so there is no reason to expect a self perpetuating inflationary effect (2) the increase in euro reserves outstanding will be accompanied by a dramatic increase in volatile deposits. german banks would probably just hold more reserves, and also the shit hitting the fan which usually a flight to safety (3) it would be a mistake in general to focus on gross money balances outside of the CB reaction function which would presumably be unchanged.
i don’t see how target2 is even interesting in this regard. when depositors started trotting away from WaMu and Indymac, those banks could replace deposits by borrowing from the Fed and paying those reserves to JP Morgan, i.e. the deposit recipient. just like T2, that can increase the gross money outstanding (and interbank lending was frozen so you can forget about netting effects spread or no spread) until WaMu and Indymac et al run out of borrowing base, which happens before infinity. so what.
Nick says:
“The ECB can hold the net money stock fixed, but the gross money stock can rise without limit”.
I take Nick’s intended meaning that there is no formal credit risk limit imposed in cases of TARGET2 deficit positions, or that there is no economic motivation to prevent an indefinite rise in such balances. I imagine Nick is quite aware that things generally stop before infinity is reached.
There is also a confusion in the comment discussion regarding gross money – a confusion that is not found in Nick’s post. Nick refers to gross money in the specific context of TARGET2 balances. In the broader context of Eurozone operations, that is most definitely not the same consideration as gross bank reserves. When the German banking system absorbs an inflow of money from the Italian banking system, it is a matter of standard function that the Bundesbank can take steps to drain those excess reserves from the German system. That requires no shift in ECB monetary policy. So that is not the same point as the one raised by Nick’s question about gross TARGET2 balances. Bundesbank reserve drains per se do not affect TARGET2.
I must say I’ve never understood how an elaborate explanation becomes proof that the elaborate is uninteresting.
From my perspective, this particular question is quite interesting because it revisits some very heated blogosphere discussions that took place several years ago on this very topic – or on questions that swirl around it. The big one is how does a TARGET2 deficit position get resolved if the country with the deficit exits the Eurozone. The EZ architecture, including transfer pricing of TARGET2 balances and allocation of aggregate Eurozone NCB profits, did not anticipate such an event.
JKH Nov. 26 at 01:02 PM :
If a country exits the Eurozone?
Am I correct that TARGET2 is recording the imbalances accumulated by the CB from each country? Am I still correct that the imbalances must equal zero within the TARGET2 balance sheet?
If this is correct, then the national CB’s with positive balances should be lending to the national CB’s with negative balances.
If my understanding is correct, a debtor country leaving would raise a repayment question for the creditor nations. This would be first a CB level problem, but private banks exist at the discretion of each CB, and individual bank depositors depend upon bank integrity. Repayment questions would reach all EU members and individuals.
Would the country leaving also be leaving the EU banking system? If so, I would conclude that it would be incumbent upon the leaving nation to establish a new banking system and attempt to reestablish trade patterns with other nations.
Those are good questions Roger.
I did a post on this 4 years ago.
http://monetaryrealism.com/target2-window-on-eurozone-risk/
Here’s an excerpt (near the end) that touches on some of the risk issues. You may be interested in other sections as well.
……….
Eurozone Risk Once Again
TARGET2 asset and liability positions reflect mismatches in the cross border flow of funds relative to normal patterns of private sector capital flows. These liquidity imbalances can indicate the reluctance of the domestic private sector (e.g. Germany) to assume foreign credit risk (interbank lending withdrawal), or risk averting behavior initiated by asset holders in other Eurozone jurisdictions who seek to move their assets (e.g. bank deposits) to a safer country (capital flight). This results in TARGET2 asset balances building up in “core” countries such as Germany and TARGET2 liability balances accumulating in the “periphery” countries such as Ireland, Greece, Spain, and Italy.
TARGET2 asset balances are associated with credit risk, but they do not incorporate credit risk. The related credit risk is found by tracking down the balance sheet assets of Eurozone national central banks and their commercial banking systems. For example, German commercial banks may withdraw from interbank lending to Spanish banks due to credit risk on the balance sheets of the latter group. Those banks turn to the Central Bank of Spain for replacement funding. This central bank replacement funding provided by the Bank of Spain absorbs some of the risk exposure that private sector depositors have fled. However, this risk is not for the account of the Spanish central bank alone. It is for the shared account of all 17 Eurozone national banks, according to the formula for such loss sharing by Eurozone members, based on the share of capital each NCB has invested in the ECB. And although TARGET2 asset-liability positions do not necessarily represent specific allocations of credit risk exposure, they do represent a type of intra-Eurozone liquidity imbalance that is attributable to private sector avoidance of risk in those areas whose central banks end up depending on TARGET2 funding.
A TARGET2 asset claim such the 727 billion euro position held by the Bundesbank (July 2012) has no contractual repayment characteristic. Its duration is indefinite. We simply don’t know how long it will be before this position is reversed. The existence of the position reflects a failure of proactive German capital outflows to recycle funding inflows on current or capital account. The German private sector is avoiding periphery risk (e.g. avoidance of interbank lending). And the periphery private sector in some cases is seeking shelter from their own domestic risk (e.g. cross border deposit outflows).
A future reversal of the German TARGET2 asset position would require a reversal of this general pattern of periphery risk avoidance. Given the current distribution of perceived risk across different Eurozone areas, it is unclear how or when such a reversal of capital flows would be forthcoming. A TARGET2 asset is extremely illiquid, due to its unknown duration and the challenge of extinguishing it through reversion to more normal financial flows.
We referred earlier to nonstandard transactions that the German central bank might itself undertake. For example, German TARGET2 asset balances might be “liquidated” in theory by direct exchange for actual reserves (or equivalent deposits) held by the Bundesbank with another Eurozone central bank. But actual reserves wouldn’t be much more useful than the TARGET2 balance (which can be interpreted as a loan of reserves). The German central bank as described earlier has the option in theory of purchasing foreign financial assets, which would create reserve credit for the account of another Eurozone NCB with a corresponding debit to the German TARGET2. Such a strategy would include taking on the credit risk specifically associated with such purchased assets. However, it is unclear how this would benefit Germany, since the result won’t necessarily change the credit risk exposure already existing on peripheral NCB balance sheets, for which the Bundesbank has shared accountability through the Eurosystem loss sharing formula.
It is not just TARGET2 asset holders who face credit risk exposure inherent in the ECB asset mix. All 17 national central banks face this risk, regardless of their individual TARGET2 positions. This is because any such losses are allocated according to the share that each of the 17 Eurozone members has in ECB capital. So the individual burden of credit risk exposure is the same, whether a particular TARGET2 asset is held by Germany or Luxembourg, for example. It is in this sense that there is a clear operational separation between the basic liquidity properties of a TARGET2 asset and the original credit risk exposure that may have been the risk catalyst for the creation of that asset.
But this intended separation of liquidity and credit risk according to Eurosystem design is not the end of the story. This is because in the worst credit risk scenarios, the intended Eurosystem function is itself at risk, meaning that the loss sharing formula is at risk. Germany’s outsized TARGET2 asset position indicates a deteriorating asymmetry of credit risk distribution across the Eurozone. While Germany is not exposed to a risk share that correlates exactly with the relative size of its TARGET2 asset, the size of its TARGET2 asset does indicate growth in the risk that it may be exposed to according to its committed share. So the fact that its TARGET2 asset is growing is not to be ignored.
And with growth in the depth and breadth of aggregate credit risk, there emerges the compounding complication that Germany’s formula share of loss absorption (currently about 27 per cent) may default into a de facto larger share, based on the risk that other Eurozone members may fall into circumstances in which they would not be able to meet their own loss share obligations. One must consider the scenario where larger events overtake intended system design, in which an NCB might end up defaulting on its shared obligation. This is conceivable when considering the possibility of Eurozone structural breakup, where a number of countries with outsized existing TARGET2 liability positions might leave the Eurosystem and fail to meet their liability obligations within it. Not only could the aggregate risk grow larger in such a scenario, but the number of countries capable of sharing in related losses could shrink as well. This suggests a potential negative convexity effect of accelerating aggregate losses combined with decreasing numbers of Eurozone members able to absorb them. Troubled countries may grow in number. And therefore the number of remaining countries capable of absorbing ever greater losses shrinks, and the share of those remaining countries in absorbing the losses grows. And this revised de facto loss distribution could be more concentrated than the original 17 member pro rata capital key formula.
Hans-Werner Sinn in his June 2011 paper described a TARGET2 “stealth bailout” of the periphery by the core. TARGET2 is not the immediate source of risk. But its imbalances reveal a flight from risk in peripheral asset portfolios. The Bank of Spain’s MRO asset positions for example transmit credit risk to the rest of the Eurozone, through the potential for losses and the subsequent activation of the loss sharing formula. The imbalance represented by Spain’s TARGET2 liability and Germany’s TARGET2 asset is symptomatic of German private sector avoidance of that risk. Critics of Sinn implicitly assume that the loss allocation and funding mechanism would function as intended under all circumstances, and that fiscal resolution of losses works according to formulae created under assumptions of continuing Eurosystem viability. This is a non-trivial assumption in the current environment.
In this connection, foreign exchange risk becomes a close relative of credit risk within the profile of comprehensive Eurozone risk. Some analogize the Eurozone as a fixed exchange rate system. The euro in this view is in effect a foreign currency for each of its 17 operational users, fixed by its original booking exchange rate to the predecessor currencies such as the Deutschemark. Structural foreign exchange risk may emerge with contingencies such as the departure of a member nation or broader Eurozone zone break up. Again, some analysts assume the ECB functions smoothly under such conditions, and that all operates according to plan regarding the allocation of risk and loss. But loss sharing formula itself may be at risk in the event of sufficiently disruptive losses.
Such a scenario probably underlies Sinn’s point about stealth bailout. Structural risk in the Euro system may include the possibility of exit and currency conversion for certain peripheral nations. This puts TARGET2 Euro claims of asset holders such as Germany at a new particular risk for a counterparty foreign exchange obligation. It creates an additional risk layer beyond that associated with a single currency. Indeed, some have suggested outcomes as radical as Germany itself exiting and converting to a new Deutschmark.
As already noted above, dismissing the relevance of central bank capital is generally short sighted. Central bank losses matter, despite the natural capacity of central banks to earn seigniorage income. And the popular argument that central bank solvency is not an issue because of built in recapitalization requirements also misses the point. It is mandatory that ECB capital must be replenished to required levels in case of losses. But this expected mechanism does not mitigate the importance of losses. The issue here is the substance of the fiscal connection between central banks and their sponsoring authorities. In the case of the Eurozone, the potential deficit impact is reflected across all 17 Eurozone government budgets in such a loss scenario, with the risk of more concentrated loss absorption than that in extreme outcomes, as described above.
The important thing about Target 2 is that it is about refinancing short term legacy debt. The (international) debt already exists – but private banks suddenly do not allow the debtor banks to roll over these existing debts anymore. The debtor banks however do pay (which the ECB wants to prevent the creditor banks from going bankrupt) and refinance this with a Target 2 overdraft. Mind that this is a net overdraft, the result of myriads of micro transactions! The ECB has to allow this because of its mandata (not the inflatin mandate, but the mandate to keep the payment system going. Again: the debts already existed (in the private sector).
An example is Italy. Italy has a current account surplus for a couple of years now. Despite this, its Target2 position is deteriorating – because legacy debt is not rolled over anymore by private banks. This is, however, implicitly financed by the Italian Central Bank. Which runs a Target 2 deficit because of this. As the Italian banks however paid the creditors, a matching surplus exists with the Centrla Baks of other countries. The point: there is no new net debt. Sinn is wrong (as is shown by the fact that Italy has a deteriorating Target 2 position despirte its current account surplus). And yes, Sinn is right that there will be a redenomination risk when the eurozone breaks up. As Goethe once stated: ‘Intelligent people are sharpest when they are wrong’. The situation is indeed complicated by QE. But that’s not what this discussion is about.
“Anyone got any thoughts on dlr’s comment above? If the red money is always matched with colateral (my father’s bank manager won’t let him run an overdraft bigger than the value of the farm) that sets a limit.”
Nick,
Isn’t the problem here that the overdraft is denominated in terms of green money (i.e. it has to be settled with green money) and then you want to call the overdraft red money.
The thing about red money is that it doesn’t have to be settled at all. Isn’t that correct? (That’s why you keep saying that it’s in everybodies interest to die with a mountain of red money.)
I am going to try to state it another way.
The movement between commercial banks and/or central banks is just that, movement. The banks are not trying to spend more than they earn. It is for their customers.
Entities spending more than their checking account contains are trying to spend more than they earn.
“Each individual can increase his utility by buying more goods and selling less goods, thereby accumulating an infinitely large stock of red money.”
Henry, this could also be partially true?
Each individual can increase his utility by buying more goods and selling less goods, thereby accumulating an infinitely large stock of green bonds denominated in green money.
“My previous comment was not entirely wrong, but Henry’s was much more right with respect to the effect on Bundesbank TARGET2 balances. Sorry Henry.”
JKH,
Whatever I got wrong is because I don’t really know what I am talking about. You actually know what you’re talking about.
Whatever I got right is because I fluked it.
My first comment about T2 balances reflecting intra Eurosystem balance of payments is not entirely correct because:
1. the location of the payee/payer within Europe determines how each NCB’s T2 balance is affected
2. some cross border (but within Euro system) payments made with commercial bank money ans some with central bank money (as you pointed out).
3.euro transactions involving non-euro area banks can be effected by accounts held by banks in euro area countries.
Thinking of the national central banks as commercial banks or even in any way distinct from the ECB just leads to a complete mess and is substantively quite wrong. Koning is right on target that the proper analogy is to Federal Reserve regional banks. As such the thing limiting money creation in the Eurozone is what’s limiting (or not limiting in some cases) money creation in the U.S. or Canada- macro-prudential regulation and capital requirements. The difference is that unlike the commitment to preserve the stability of the payments system central banks have in the rest of the world, the ECB doesn’t believe it has such a mandate. http://www.nakedcapitalism.com/2015/07/mario-draghi-the-ecb-has-no-mandate-to-ensure-checks-clear-or-credit-cards-work.html
This leads to the biggest messes outside of the denial of fiscal space to individual governments
Now if you’re asking how is such a system supposed to preserve macroeconomic stability and growth- the answer is it isn’t.
JKH: Very good post on TARGET2 four years ago! For what it’s worth (myself being a non-expert), I agree with you.
Your wording here bothered me slightly: “…that is attributable to private sector avoidance of risk in those areas whose central banks end up depending on TARGET2 funding”
The way I understand this, I wouldn’t say the (national) central banks (NCBs) depend on TARGET2 funding. Not to say it’s wrong to say so, but I feel this needs some clarification. (Which I think you provide in your broader discussion, but I just want to make sure we agree on this.)
Isn’t the NCB mainly a passive player in all this? If a Spanish person with a deposit in a local bank wants to convert it to a deposit in a German bank, then Spain’s TARGET2 deficit (assuming it has one) will automatically grow when the transaction is processed (real-time gross settlement?). There’s nothing Bank of Spain can do about it? That’s why I wouldn’t say Bank of Spain depends on TARGET2 funding.
Because of this kind of “deposit flight” and “roll-over flight” of private cross-border lending, the local commercial banks end up depending on NCB funding, and the NCB’s TARGET2 deficit (or negative balance) grows — I can see that this is funding for the NCB, but it’s “build in the cake”. Perhaps we could say that the whole national banking system depends on TARGET2 funding?
Was this what you had in your mind when you wrote the sentence?
I think they do depend on it Antti – in full institutional context.
When capital flees Spain to Germany, there is a reserve drain from the balance sheet of the Spanish NCB.
So by construction/deconstruction, it is short funding (in the form of reserves) for its assets.
There is a hole in its balance sheet that needs to be plugged.
Think of what happens if that hole isn’t plugged.
That means that the Bundesbank will have accepted new incoming liabilities (a reserve inflow) without being compensated for that with offsetting assets. And the Spanish NCB would have lost outgoing liabilities without having to replace them.
If that happened, the Spanish NCB would actually write up its equity and the German ECB would write down its equity. That sort of thing starts to matter when you think about things like interest margins and fiscal effects from CB profits, aspects which matter more and more if rates go back up again.
I.e. banks don’t like to take on new liabilities without being compensated with new assets.
So the ECB provides an offsetting asset to the Bundesbank – the TARGET2 asset.
And the ECB “forces” a new liability into the Spanish central bank – the TARGET2 liability.
And all of this happens through logical operational clearing of payments – which is the ground level effect of how what needs to happen does happen.
So the Spanish central bank depends on TARGET2 funding in the sense of making its balance sheet coherent in that way. That said – this is a dependency that’s forced on it – but for good reason and in somewhat the same way that a central bank LLR facility is forced on a commercial bank short of reserves (where there is a net liability in the reserve account – like red money (hello Nick)).
The cynic might say this is all bookkeeping.
The realist might say that the coherence of the monetary system depends on bookkeeping.
Having said all that, it’s only half the story in the Spain/Germany example.
The TARGET2 deficit funding for Spain plugs the hole from an equity coherence perspective.
But it doesn’t plug the hole from a reserve perspective.
The Spanish central bank must still take steps to ensure that the reserve drain due to the capital outflow is replaced in such a way to ensure continued functioning of its domestic banks. This can be done through some variation on OMO.
If the reserve loss is fully replaced, the balance sheet actually expands by the size of the TARGET2 deficit funding injection.
“There’s nothing Bank of Spain can do about it? That’s why I wouldn’t say Bank of Spain depends on TARGET2 funding.”
Have a look at the first comment I made under this post:
http://worthwhile.typepad.com/worthwhile_canadian_initi/2016/11/redgreen-money-bank-of-canada-settlement-balances-and-target2.html?cid=6a00d83451688169e201b8d23d71ba970c#comment-6a00d83451688169e201b8d23d71ba970c
One thought:
Suppose the Eurozone was the whole world (it isn’t, of course). Then Target2 balances would (I think) be like the cumulative balance on the Official Account of the balance of payments (the sum of current surplus plus capital account surplus). Target2 balances would be like the foreign exchange reserve position of the national banks.
But with (say) gold reserves in the gold exchange standard, gold reserves can’t go negative. But Target2 balances can go negative.
I think that’s right.
Antti (& JKH)…
Depending on how broadly we define “funding”, we actually have some examples where the ECB effectively forced the NCBs (and governments) to assume explicit responsibility over liquidity assistance to domestic banks.
The Irish central bank provided emergency liquidity assistance (ELA) to liquidity constrained domestic banks once it became clear they didn’t have enough collateral by which they might have simply borrowed funds from the NCB. Trichet (the ECB chief) threatened to cut off all such funding unless the Irish government applied for a bailout; effectively involving the balance sheet of the country’s public sector in the operation. The ECB also made Greek government bonds ineligible for OMOs and thus forced the Greek NCB and government into a similar kind of ELA-liability absorption.
The passivity of NCB-ECB funding, in regards to cross-border TARGET2 transfers/balances, is evident in cases where domestic banks have enough reserves or rather enough eligible collateral to fulfil cross-border transfers. But once there’s a crisis, the whole situation becomes murkier, especially if ECB-approved eligible collateral becomes scarce. That’s where “funding” turns out to also become contingent on how the ECBs assesses national funding schemes.
Nick
Wouldn’t that cumulative deficit translate to a cumulative outflow of gold for international settlement on a gold standard?
And so couldn’t the (residual) stock of gold reserves still be positive – notwithstanding a cumulative outflow of gold?
So I think the cumulative change that corresponds to the existing TARGET2 position can go negative under either fiat or gold. Under an international gold standard, that TARGET2 measure would not appear as a CB balance sheet liability the way it does now. It would only be the quantitative measure of the cumulative outflow of gold from gold reserves. And gold reserves would be less by that amount. But they might still be positive.
I could well be wrong though.
Now I’m wondering if what I just suggested partly depends on whether or not there is domestic gold production.
JKH said: “So the Spanish central bank depends on TARGET2 funding in the sense of making its balance sheet coherent in that way. That said – this is a dependency that’s forced on it”
Yes. The forcing part is what I meant with my mysterious “build in the cake” metaphor (where did I get that?! I even misspelled ‘built’). I don’t think we disagree on anything important, really.
One small thing bothers me slightly, though… You said: “There is a hole in its balance sheet that needs to be plugged.” That makes it sound like it needs to be actively plugged, although as you said, it is plugged automatically. I know this sounds like nitpicking, and it is, but we should be careful when the ‘need’ we talk about refers to logic, not to something someone needs to do. (The reason why I even bother to mention this is that this is a real problem in discussions about sectoral balances, where you hear people say things like “households need to get into debt, because the public sector and businesses run surpluses” — wrongly suggesting a clear, one-way causality, the direction of which iss known.)
Johan: Good point about ELA. I was talking about non-ELA situation, where you seem to agree that the NCB’s role is more or less passive.
Antti
Good point
In this case I mean need in the sense of system design with respect to sensible balance sheet outcomes from the clearing process
Johan raises some good points. Although I’m not sure that they relate directly to the “passive” mechanism whereby TARGET2 balance outcomes are determined. As far as I know, there is no way of interfering with actual outcome for reserve balances that are cleared from one NCB jurisdiction to another – regardless of the precipitating events that cause the capital flows. My understanding is that crisis-specific specialized arrangements such as ELA are ring fenced in the sense of how their fiscal consequences are allocated – i.e. the fiscal risk is for the account of the country in question as opposed to being pooled with the rest of the EZ central bank results and distributed according to normal capital key allocations. But I’m a bit hazy on this aspect.
Merijan Knibbe writes “…………Target 2 overdraft. Mind that this is a net overdraft, the result of myriads of micro transactions.”
I think Merijan is making an important observation.
I don’t know exactly how “myriads of micro transactions” can result in a national debt to a second nation but it seems to occur. The TARGET2 overdraft indicates that this is occurring but does not identify the mechanism.
This was happening in Greece. In Greece, it seems to have happened because the Greek government borrowed (and borrowed) so that it could pay generously. With generous pay, Greek citizens could buy German goods. The Greek government became a debt-enabler.
Is the same thing happening in Italy today? I don’t know.
JKH: “And so couldn’t the (residual) stock of gold reserves still be positive – notwithstanding a cumulative outflow of gold?”
Yes. It all depends how big the stock of gold reserves is when we start counting the cumulative losses.
The analogy is inexact, because with TARGET2 everyone starts from zero, and you can’t mine TARGET2 balances like you can mine gold reserves, as well as gold reserves being unable to go negative.
JKH:
“In this case I mean need in the sense of system design with respect to sensible balance sheet outcomes from the clearing process”
This was quite clear, and that’s why I called my commenting on it nitpicking 🙂
I very much like the way you focus on “sensible balance sheet outcomes”.
My interpretation of Eurosystem TARGET2 balances is:
It is the accommodating item in the balance of payments as opposed to autonomous items. The latter happen independent of other items (to first approximation). Accommodating items are the opposite.
To be more accurate … accumulated accommodating flows
This way of studying it … accommodating item vs autonomous item … is more accurate.
Gold sales for example is an accommodating item in the gold standard. But the stock of gold can’t be negative. If a central bank loses the stock of gold, it can anyway borrow in foreign currency and make a sale of the proceeds. So that would be accommodating flows.
“as well as gold reserves being unable to go negative”
bearing in mind that cumulative gold flows can go negative, which is part of the comparison
(a comparison using a selected common starting point)
This way of defining is due to James Meade:
Click to access econ30.pdf
Page 83 onward.