In the previous post in this series The Eurosystem: Part 2, I discussed cross-border flows within the Euro Area. With exceptions, most of these flows are current balance of payments and balance of payments financing flows. Of course there are other flows with the world outside the EA17 and these flows flow via the correspondent banking arrangements banks have put in place and not the topic of discussion in this series.
The cross-border flows are important for the Euro Area since as a whole, the Euro Area’s balance of payments is almost in balance.
So the Euro Area current account was in a deficit of €11.7bn in 2011Q3 and a net indebtedness of €1.35tn to the rest of the world at the end of Q3, or 14.5% of GDP. So most of external imbalances of the EA17 nations are within the Euro Area.
Back to TARGET2 flows: there was a debate among some economists on various matters related to these flows. Some even went on to suggest that these flow affect credit in Germany because the nation was financing the current account of the other nations. From an exogenous money viewpoint, this reduces banks’ ability to provide loans to their customers! (which is incorrect because money is not exogenous). The replies tried to disprove it by using the argument that attempted to prove that the NCBs were not financing the current account. Sorry no links.
This is a small post and my point is to show that since TARGET2 is designed to automatically change the balance sheets of the NCBs, the debate whether the NCBs finance the flows or not is a bit counterproductive. Of course having said this, I wish to highlight the fact that the item “Claims within the Eurosystem” (in either assets or liabilities) is definitely recorded in the balance of payments and the international investment position as can be seen below for the case of Spain.
Of course, the “Claims Within the Eurosystem” is just one item in the financial account and the international investment position, so not the whole of the current account deficit is financed this way. One minor advantage is that this part of the gross indebtedness of a whole deficit nation is at the ECB’s main refinancing rate, which is much lower than the effective interest rate deficit EA nations are paying on their gross liabilities to foreigners. This is not worthy of further attention, though.
How long can these flows continue? As long as the banks have sufficient collateral to provide to their home NCB. When banks run out of collateral (eligible for borrowing from the Eurosystem), emergency measures have to be taken and a future post in this series will discuss the Emergency Loan Assistance Program (ELA) used by NCBs.
[I welcome your comments. I have a “Zero Comments Policy” as opposed to a “No Comments Policy”. I like being notified of a comment.]
The OECD released its Economic Outlook recently. The preview is available here but download is for subscribers. Else if you are an FT subscriber, you can get it from FT Alphaville’s Long Room.
A few interesting charts (at least for me):
(click to enlarge)
Most Economists (except a few good ones), following the work of Mundell, Fleming and Friedman believed that in floating exchange rate regimes, the invisible hand will work to remove imbalances. Unfortunately, this has not happened and it has taken the crisis for them (most of them actually!) to realize that there is no mechanism and it is still unclear if they understand this.
There are some dissenters among Post Keynesians, such as Randall Wray, who do not consider current account deficits as an imbalance. See this blog post. Also see Reserve Bank of Australia’s Guy Dibelle’s speech In Defense of Current Account Deficits from July 2011.
An intuition I see often displayed in blogs is that these numbers are small and hence not problematic! My view is that these imbalances are kept low by keeping demand low. More importantly, these imbalances (deficits) add to the stock of external debt (because a deficit in the current account increases net indebtedness to foreigners) and this gets out of control sometimes leading to deflation of demand and/or seeking help from the IMF. So “low” imbalances accumulate to a huge net indebtedness.
There is an informative graph on the financing needs of Greece, Ireland and Portugal:
The report also charts sectoral balances for the Euro Area!
(click to enlarge)
The Euro Area as a whole seems healthy, and it is imbalances within that are causing the troubles.
It seems Italy’s current account is worsening:
Turkey’s current account attracts a lot of attention and challenges look like this:
Turkey’s currency Lira has depreciated a lot recently
In Post Keynesian theory, the exchange rate is determined in a beauty contest in addition to demand and supply for financial assets. Sudden movements can be very painful and hence nations face a balance of payments constraint – success of nations depends on how producers do in international markets. In words of Wynne Godley,
For growth to be sustainable, it is essential that the management of domestic demand be complemented by the management of foreign trade (by whatever policies) in such a way that the net balance of exports less imports contributes in parallel to the expansion of demand for home production.
At the global level, since not everyone can be net exporting, the problem of global imbalances affects everyone, and new changes are required on how the global economy is run.
The UK Office of National Statistics released the 2011 editions of the “Blue Book” and the “Pink Book” recently.
The UK Gross Domestic Product was £1,394 billion in 2009 and £1,458 billion in 2010.
In the last 20-40 years, external assets (and liabilities) have grown to a huge multiples of GDP. Hyman Minsky worried about gross assets and liabilities in addition to net assets/liabilities and showed the importance of “gross”. At the end of 2010, according to the Pink Book, total value of assets held abroad by UK residents was equivalent of £9,961 billion while liabilities to foreigners was £10,159 billion, leaving the United Kingdom with a net asset position of minus £197 billion.
With talks of a Eurocalypse not so unthinkable these days, countries’ exposure to the Euro Area is the natural question to ask. Since London is a financial center and the United Kingdom is close to the Euro Area, it is likely to have more exposure to the Euro Area than other nations. The Pink Book 2011 edition gives the geographic breakdown of assets and liabilities only till 2009, unfortunately. Anyway the statistics below
by type:
(click to enlarge)
and in more detail on countries but consolidated across all resident sectors:
(click to enlarge)
Needless to say, huge!
The column for “Derivatives” shows assets valued less than £1,000 billion but here too there may be hidden exposures, since there can be a lot of netting, even though Derivatives appear in both Assets and Liabilities.
If there are problems in the Euro Area, assets held by residents will be impaired (such as due to defaults) and this is already happening at a lesser scale compared to the “unthinkable”. A depreciation of the Euro to the Pound Sterling will also cause revaluation losses for UK residents. On the other hand, to maintain credit ratings, it will be difficult for the UK to default on its liabilities, increasing UK’s net indebtedness to the rest of the world by a huge amount. It is really difficult to forecast how severe the crisis can be, but these numbers suggest it can be devastating to the extreme.
There are second order effects. For example, UK residents hold assets in the United States and if these assets fall in market value due to a crisis situation, there could be a further deterioration in the gross value of UK Assets held abroad.
With EFSF bonds not appealing to investors even in a flight to quality environment, and European politicians’ plans losing credibility, and the ECB’s Securities Markets Programme losing its effect, the only way forward is for the ECB to put explicit ceilings on government bond yields. The reason it is hesitant in doing it is because it creates a moral hazard problem. (See Mervyn King’s Got A Point).
Of course, there seems to be no alternative (except rumours of a €600 billion bailout for Italy!), so challenging times ahead for the ECB.
Update: Wolfgang Münchau of FT thinks the Eurozone has only a few days! Link
Economists are increasingly recognizing the Euro Area problems as a balance-of-payments crisis, in addition to realizing that the Euro Area national governments cannot finance their deficits by making a draft at the Eurosystem in extreme emergency.
With a few exceptions, the benchmark cost of credit in each euro-zone country is related to the balance of its international debts. Germany, which is owed more than it owes, still has low bond yields; Greece, which is heavily in debt to foreigners, has a high cost of borrowing (see chart 2). Portugal, Greece and (to a lesser extent) Spain still have big current-account deficits, and so are still adding to their already high foreign liabilities. Refinancing these is becoming harder and putting strain on local banks and credit availability.
The higher the cost of funding becomes, the more money flows out to foreigners to service these debts. This is why the issue of national solvency goes beyond what governments owe. The euro zone is showing the symptoms of an internal balance-of-payments crisis, with self-fulfilling runs on countries, because at bottom that is the nature of its troubles. And such crises put extraordinary pressure on exchange-rate pegs, no matter how permanent policymakers claim them to be.
The magazine also had another nice article recently: Is this really the end?. Here is a collection of covers from the magazine in recent times on the Euro.
Paul Krugman has a blog post today titled Death By Accounting Identity, commenting on Martin Wolf’s FT Article Why cutting fiscal deficits is an assault on profits, where Wolf talks about the sectoral balances identity made famous by Wynne Godley. I guess the better way to put it is that Martin Wolf is trying to make the accounting identity famous.
A Damascene Moment
In his book with Marc Lavoie, Wynne Godley wrote in his part of Background memories (by W.G.)
… In 1970 I moved to Cambridge, where, with Francis Cripps, I founded the Cambridge Economic Policy Group (CEPG). I remember a damascene moment when, in early 1974 (after playing round with concepts devised in conversation with Nicky Kaldor and Robert Neild), I first apprehended the strategic importance of the accounting identity which says that, measured at current prices, the government’s budget deficit less the current account deficit is equal, by definition, to private saving net of investment. Having always thought of the balance of trade as something which could only be analysed in terms of income and price elasticities together with real output movements at home and abroad, it came as a shock to discover that if only one knows what the budget deficit and private net saving are, it follows from that information alone, without any qualification whatever, exactly what the balance of payments must be. Francis Cripps and I set out the significance of this identity as a logical framework both for modelling the economy and for the formulation of policy in the London and Cambridge Economic Bulletin in January 1974 (Godley and Cripps 1974). We correctly predicted that the Heath Barber boom would go bust later in the year at a time when the National Institute was in full support of government policy and the London Business School (i.e. Jim Ball and Terry Burns) were conditionally recommending further reflation! We also predicted that inflation could exceed 20% if the unfortunate threshold (wage indexation) scheme really got going interactively. This was important because it was later claimed that inflation (which eventually reached 26%) was the consequence of the previous rise in the ‘money supply’, while others put it down to the rising pressure of demand the previous year. …
I believe Wynne Godley discovered this identity while working for the British Treasury in the ’60s – at least the identity relating two sectors – domestic private sector and the government sector, but the damascene moment happened in 1974. The accounting identity is also used heavily in his 1983 book Macroeconomics, with Francis Cripps.
Charles Goodhart
Charles Goodhart also seems to be making use of the accounting identity (and a mental model built around this identity) in his recent Voxeu post Europe: After the Crisis. The difference is that in Charles Goodhart’s writing, fiscal policy is given less importance than monetary policy.
He talks of three implicit and incorrect assumptions:
The first, and most important, incorrect assumption was that a private-sector deficit in any country, matched by a capital inflow (current account deficit), should not be potentially destabilising.
The thinking was that the private sector must have worked out how to repay its debts before incurring them.
The second misguided assumption was that, in a single monetary system, local current account conditions not only cannot be calculated, but do not matter.
The third was that the public sector deficit of a member country is just as damaging when it is matched by a national private sector surplus, as by capital inflows.
I think each of these points is really insightful.
The first assumption is reminiscent of the economic agent in models who has a perfect foresight. The agent must have seen the future very well and would have calculated well in advance that things will go well. Consolidate all agents and we have the first assumption.
The second assumption is extremely well presented. People, especially economists asked – if the states in the United States used the same currency, why not Europe? The pitfall in this assumption is assuming away the U.S. Federal Government which makes fiscal transfers without anyone noticing.
The third assumption has to do with the lack of understanding the various causalities linking the three financial balances.Goodhart also goes into providing ideas for the design of “The fiscal counterpart to a monetary union”. One point I liked was on transfer dependency:
For a stabilisation instrument to be pure and effective, three principles are key (see Goodhart and Smith 1993 for details):
The instrument should be triggered following changes in economic activity but its intervention should be halted as soon as no further changes occur, irrespective of the level at which the economy has again become stable.
Otherwise, the instrument would perform not only a stabilisation function, but also play a redistributive role. Such an ‘impurity’ is typical for traditional fiscal policy measures, but should be avoided in the Community context as it may perpetuate adjustment problems and induce transfer dependency.
….
Goodhart also makes a nice point on Japan – something (a part of it) you can see me writing in the Chartalists’ blogs’ comments section:
This analysis implies that the Eurozone needs a wholesale reorientation of the stability conditions. They must be refocused towards concern with external debt, and deficit, conditions and much less single-minded focus on the public sector finances.
If a member country is in a Japanese condition with a huge public-sector debt, but fully financed domestically, with a current-account surplus and large net external assets, then its debt should entirely be its own concern, and not subject to censure or control by any outside body, whether in a monetary union, or not. Of course, such greater attention to external, especially current-account, conditions needs to be more nuanced, since deficits, and external debts, incurred to finance tradeable goods production subsequently should provide the extra goods to sell to pay off such debts.
Japan’s public debt of 200% of GDP is quoted in rhetoric about public debt, but it is forgotten that Japan is a creditor nation and hence not always great to compare it with other nations.
Another recent article by Goodhart starts off well:
There are two main problems to be faced in any attempt to improve the architecture of international macro‐economic and financial oversight. The first is structural; the second is analytical. The first difficulty resides in the discord between having a system of national sovereignty at the same time as an international market economy, …
I had some discussions with someone on yesterday’s post Today’s Auction Fail, which led me to find out how the German Finance Agency acting for the account of the German Government, through the Deutsche Bundesbank acted with confidence in rejecting a good proportion of bids in yesterday’s auction.
It seems, the German government holds a lot of financial assets, which could meet its financing needs for a good amount of time.
The Bundesbank Monthly Report, September 2011, Statistical Section, III, Consolidated financial statement of the Eurosystem, Liabilities shows that the German government has only €0.2 billion of deposits.
(click to enlarge)
However, it has a large amount of deposits at MFIs – Monetary and Financial Institutions, or banks in short. Page 116 of the same report shows that the German government deposits at banks was €35.6 billion:
According to Item III, the Government of Germany (which does not include the Bundesbank) held assets equivalent of €229.8 billion abroad at the end of 2010.
Some of the data is not the latest but to conclude, the German government has sufficient assets to not worry about auction failures and can reject bids easily.
Big deal has been made out of today’s auction of 2022 bonds of the Federal Republic of Germany. How it affects the markets or will in the near future is not the point of discussion here. Rather, this post has to do with some misleading description given by Izabella Kaminska of FT Alphaville.
Izabella is writing as if the bonds which were not absorbed by the markets were purchased by the Deutche Bundesbank, which is not allowed by the Treaty governing the Euro Area.
The Bundesbank website gives a description of the auction. Same as the capture below:
So of the €6,000 million of securities on auction, only €3,644 million was alloted. The remaining €2,356 million was “set aside for secondary market operations”
What is that supposed to mean? It simply means the German government is the owner of the €2,356 million of German bonds (i.e., it appears in its Assets as well as Liabilities!) and it will sell them in the secondary markets later at some point.
Some have interpreted it as the Bundesbank having bought €2,356 million of the securities(!), which is not allowed by law. As if nobody is watching!
So nothing unusual there. The issuer is not credited with the amount set aside for secondary market operations until the securities have actually been sold on Eurex Bonds or the stock exchanges.
Izabella writes:
The uncovered technicality comes from the fact that the Bundesbank habitually retains some of the paper from every major bond auction for the purpose of its ‘market operations’. But to understand why this is important one first has to explore how central banks actually set rates.
That is confusing “(open) market operations” of the Bundesbank with the “secondary market operations” of the German Treasury! (The Finance Agency of The Federal Republic of Germany – Bundesrepublik Deutschland – Finanzagentur GmbH)
In 1992, Wynne Godley wrote a terrific London Review of Books article Maastricht And All That pinpointing the exact defect in the Maastricht Treaty. He wrote about an “incredible lacuna”:
… The incredible lacuna in the Maastricht programme is that, while it contains a blueprint for the establishment and modus operandi of an independent central bank, there is no blueprint whatever of the analogue, in Community terms, of a central government …
The New York Times has Wolfgang Schäuble, the German federal minister of finance, for the Saturday Profile this weekend.
According to the article he will push for a treaty change:
MR. SCHÄUBLE said the German government would propose treaty changes at the summit of European leaders in Brussels on Dec. 9 that would move Europe closer to the centralized fiscal government that the currency zone has lacked. The ultimate goal, Mr. Schäuble says, is a political union with a European president directly elected by the people.
and also that
He sees the turmoil as not an obstacle but a necessity. “We can only achieve a political union if we have a crisis,” Mr. Schäuble said.
Schäuble had penned an Opinion piece on the Financial Times, a couple of months ago
where he wrote
Hence my unease when some politicians and economists call on the eurozone to take a sudden leap into fiscal union and joint liability. Not only would such a step fail to durably solve the crisis by addressing only its most superficial symptoms, but it could make it worse in the medium term by removing a key incentive for the weaker members to forge ahead with much-needed reforms. It would also go against the very nature of European integration.
Wolfgang Schäuble, failed to see the crisis coming, but he has a point – it is the other side of the debate to the recent calls to the European Central Bank to act as a lender of the last resort to national euro area governments. Mervyn King made a similar point recently. Schäuble, however wants to manufacture a crisis to force national governments to implement reforms while he gives a blueprint for increasing the powers of the European Parliament. A bit sadist isn’t it?
Seems it is too late! There is a new buzz phrase in financial markets: “redenomination risk”.
German finance minister Wolfgang Schauble – the most dangerous man in the world – is imposing a reactionary policy of synchronized tightening on the whole eurozone through the EU institutions, invoking a doctrine of “expansionary fiscal contractions” that has no record of success without offsetting monetary and exchange stimulus. What is abject is that EU bodies should acquiesce in this primitive dogma.
In a post last week – The Eurosystem: Part 1, I went into the Euro Area payment system TARGET2 and touched upon domestic payments and implementation of monetary policy in the Euro Area. This post takes off from their to discuss cross-border flows. There are two reasons for looking into this is:
to understand the flow-of-funds in the Euro Area – in particular current balance of payments and balance of payments financing flows;
to understand how the Eurosystem – the ECB and the 17 National Central Banks (NCBs) work together.
Suppose a Firm F (F for France) banking at BNP Paribas wants to send a payment of €1m to a Firm G (G for Germany) banking at Deutsche Bank. How do the funds flow? In Part 1, I discussed how funds flow for domestic payments, but here two nations are involved and hence is likely to be more complicated. The various institutions involved in this transaction are
Firm F
BNP Paribas
Banque de France, France’s NCB
Deutsche Bundesbank, Germany’s NCB
Deutsche Bank
Firm G
European Central Bank (ECB)
To work out how the funds flow and what effects it has on the balance sheets of these institutions, it is again useful to get into the Eurosystem legal framework as we did in Part 1.
According to the Guideline of European Central Bank of 30 December 2005 on a Trans-European Automated Real-time Gross settlement Express Transfer system (TARGET) (ECB/2005/16) Article 4(b)1&2 (link):
and according to Article 4(c)2:
Further, according to Article 4(d)2:
So the NCBs and the ECB have accounts at each other and grant each other unlimited and uncollateralized credit! i.e., they allow all funds to go through. This was shocking when I first discovered this from the same document but later realized it makes sense. There is one more rule that is still missing – how the NCBs settle with each other.
Intra-ESCB transactions are cross-border transactions that occur between two EU central banks. Intra-ESCB transactions in euro are primarily processed via TARGET2 – the Trans-European Automated Real-time Gross settlement Express Transfer system (see Chapter 2 of the Annual Report) – and give rise to bilateral balances in accounts held between those EU central banks connected to TARGET2. These bilateral balances are then assigned to the ECB on a daily basis, leaving each NCB with a single net bilateral position vis-à-vis the ECB only. This position in the books of the ECB represents the net claim or liability of each NCB against the rest of the ESCB. Intra-Eurosystem balances of euro area NCBs vis-à-vis the ECB arising from TARGET2, as well as other intra-Eurosystem balances denominated in euro (e.g. interim profit distributions to NCBs), are presented on the Balance Sheet of the ECB as a single net asset or liability position and disclosed under “Other claims within the Eurosystem (net)” or “Other liabilities within the Eurosystem (net)”. Intra-ESCB balances of non-euro area NCBs vis-à-vis the ECB, arising from their participation in TARGET2, are disclosed under “Liabilities to non-euro area residents denominated in euro”.
Using these rules and procedures, we can work out the example presented at the beginning of this post.
At the initiation of the payment of €1m by Firm F, BNP Paribas will debit Firm F’s account €1m, Banque de France will debit BNP Paribas’ account €1m, Deutsche Bundesbank will credit Deutsche Bank’s account €1m and Deutsche Bank will credit Firm G’s account €1m. There remains the settlement between Banque de France and Deutsche Bundesbank and intraday, they settle bilaterally and then settle at the ECB at the end of the day. An important point however is that when NCBs settle with the ECB, they do not need to provide collateral. Also, in principle the overdraft facility provided by the ECB is unlimited.
Some clarifications. How did NCB provide intraday credit to BNP Paribas? The answer is quite simple: Ex Nihilo, at the stroke of a pen, rather automatically via the system’s computers! The same with Deutsche Bundesbank – it provided Deutsche Bank with settlement balances in the same manner, and so did Deutsche Bank provide €1m of extra deposits to its customer Firm G. And finally at the end of the day, the ECB does the settlement between the NCBs on its books.
However, this is not the end of the story. During the day, there are payments in all directions but let us ignore that. So BNP Paribas finds itself with a positive intraday credit of €1m from Banque de France. Intraday overdrafts were discussed in Part 1 and I repeat the relevant part here. Toward the end of the day, banks may want to instead borrow from the rest of the financial system, instead of relying on central bank credit because the latter is free of interest only intraday and is charged an interest rate equal to that of the marginal lending facility overnight. Typically, this poses no problem because some banks may have excess reserves which they may want to lend out because keeping it deposited at the central bank will pay an interest equal to that of the deposit facility which is lower. So typically, banks would retire intraday credit toward the end of the day and borrow funds from the rest of the financial system.
In this case, BNP Paribas would have to borrow abroad because other banks do not have excess reserves in the example. Deutsche Bank will be looking to lend the funds at a higher rate than depositing it at Bundesbank which pays lower interest and we have a situation in which BNP Paribas will borrows funds from Deutsche Bank. The interest rate on this lending/borrowing will likely be the near the ECB main refinancing rate – else, the ECB will intervene to bring the EONIA to the main refinancing rate – its target. It is important to remember that this causes the reversal of the balance sheet changes of the ECB and the NCBs – changes which happened when funds flowed from Firm F to Firm G.
All this is when there is no stress in the markets. During periods of crisis, banks in some affected regions may see deposits flowing out due to worries about credit risk. Banks which are losing funds are unable to borrow funds from abroad and this leaves banks indebted to their home NCBs and the NCBs have a large Other liabilities within the Eurosystem (net).
The Bundesbank Monthly Report March 2011 has a special topic The dynamics of the Bundesbank’s TARGET2 balance on Page 34 and has a good discussion. It has two nice charts, one of them is settlement balances of each NCB in the Eurosystem
This was at the end of 2010 and would have worsened in recent times and shows the amount of stress in the banking system.
In Part 3, I hope to discuss the implementation of monetary policy – i.e., the ECB procedures on setting the interest rate and the differences and similarities with the American system.
Hopefully there is a Part 4 which goes into the “sovereign debt” crisis – which really is a balance of payments crisis worsened by the fact that Euro Area national governments do not have a lender of the last resort.
Alastair Marsh at FT Alphaville discusses the Euro Area problems looked through the prism of net international investment position (NIIP), quoting Goldman Sachs economist Lasse Holboell Nielsen:
When considering the causes of the ongoing Euro area debt crisis, it is natural to focus on public debt and deficits as the primary sources of market tensions. However, as the Irish experience demonstrates, private-sector debt can rapidly migrate onto public-sector balance sheets in the event of a financial crisis. It may therefore be more meaningful to look at the aggregate indebtedness of an economy, consolidating the public- and private- sector positions, in assessing a country’s vulnerability to sovereign yield tensions. [Italics not in original]
Nielsen is apparently trying to model government bond yields using NIIP data for some of the EA17 nations.
This blog had discussed this earlier in the post Eurozone Indebtedness. I re-did the graph and is below
A nation which is running a current account deficit and is highly indebted (proxied by the NIIP-GDP ratio) has to borrow from the international banking system, money markets and capital markets and refinance the debt and faces the risk of a run on its liabilities if the debt gets out of hand. The chart above gives an insight on why some EA17 nations face more troubles than others.
