The Bank of England released the semiannual Financial Stability Report, December 2011 today. Complete book here. These reports have a lot of information, in addition to being well-written, well-formatted and colourful.
The following graph shows how international banks’ funding from US Money Market Mutual Funds changed during the year.
It also plots the Net International Investment Position (the negative of a nation’s debt) – which I have plotted many times in this blog (see here and here for example) and linked to other sources who have plotted it recently and is the reason for my writing this post!
It also has a chart on global imbalances with a focus on EA imbalances
Nice report. Go read.
Update: FT Alphaville’s post BoE charts, UK banks’ gloom also discusses some (different) charts from the report.
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 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, …
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.
Nils Pratley from The Guardian quotes Mervyn King from the Bank of England’s Inflation report press conference.
This phrase ‘lender of last resort’ has been bandied around by people who, it seems to me, have no idea what lender of last resort actually means, to be perfectly honest. It is very clear from its origin that lender of last resort by a central bank is intended to be lending to individual banking institutions and to institutions that are clearly regarded as solvent. And it is done against good collateral, and at a penalty rate. That’s what lender of last resort means.
That is a million miles away from the ECB buying sovereign debt of national countries, which is used and seen as a mechanism for financing the current-account deficit of those countries, which inevitably, if things go wrong, will create liabilities for the surplus countries. In other words, it would be a mechanism of transfers from the surplus to the deficit countries. That’s why the European Central Bank feels, and with total justification, that it is not the job of a central bank to do something which a government could perfectly well do itself but doesn’t particularly want to admit to doing.
I think it’s very important to recognise that there are circumstances where governments will try and put pressure on central banks to do things that they would like central banks to do in order to avoid their having to own up to the actions that they actually would like someone else to carry out. So I have every sympathy with the European Central Bank in this predicament …
The only circumstance in which looking at the data for the euro area as a whole has merit is in realising that actually the euro area does have the resources, if you were to regard it as a single country, to make appropriate transfers within itself. It doesn’t actually need transfers from the rest of the world. But the whole issue is, do they wish to make transfers within the euro area or not? That is not something that a central bank can decide for itself. It is something that only the governments of the euro area can come to a conclusion on. And that is the big challenge that they face.
Mervyn King has some good insights about global imbalances and I will right something on this sometime soon. I am glad someone came out so openly about the LLR function of the Eurosystem. In my view this comes with tremendous risks. The ECB is carrying out it’s Securities Markets Program by which it intervenes in secondary markets to prevent government bond yields from running away. It doesn’t seem to work, given that there is no explicit ceiling on yields. While it is true that the ECB has the powers to put ceilings on government bond yields, there is nothing preventing governments from taking advantage of this and postpone reforms. Neither is there any institutional means by which fiscal policies are coordinated and the competitiveness gap between Euro Area nations reduced. For the ECB to take such a drastic step, there needs to be some credible commitments from nations to achieve this.
Some proposals were given by Philip Arestis in an excellent article titled European Economic And Monetary Union Policies From A Keynesian Perspective, Ch8, A Modern Guide to Keynesian Macroeconomics and Economic Policies, ed. Eckhard Hein, Engelbert Stockhammer, Edward Elgar Publishing. (Publisher’s book website here)
The Eurosystem consists of the European Central Bank (ECB) and 17 National Central Banks (NCBs) of the member nations. The purpose of this post (and some that will follow) is to explain how the RTGS payment and settlement system called TARGET2 works in order to understand the flow of funds within the Euro Area. The purpose is also to show that money is endogenous in the Euro Area, that it cannot be otherwise and describe the Euro Area economic dynamics in the money endogeneity framework
First consider payments within a nation, i.e., domestic payments. In the Euro Area, it happens exactly in the way as in any nation. I had a post covering this – Payment Systems And Settlement. An example illustrates this:
Suppose a household A holding deposits in Bank A in Spain wishes to make a payment of €100 to an institution B banking at Bank B. The household A will give an instruction to her Bank A to transfer funds to Bank B. Assuming this goes through, the Spanish central bank Banco de Espana will debit Bank A’s account and credit Bank B’s account. Bank B will credit institution B’s account €100. If Bank A has insufficient funds at Banco de Espana, the latter will provide the former intraday credit free of charge.
So transactions such as the above give rise to payment flows in all directions. To understand how the Eurosystem handles this, it is useful to go into some rules.
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) 3(f) 1 says (link)
and 3(f)3 says
and finally 3(f)5 says
So within the day banks can go into overdraft at the home central bank by pledging collateral. In practice, banks have more collateral at the central bank to cover for daily fluctuations. Also, in the Euro Area, banks need to satisfy a reserve requirement of 2% which means that the amount of reserves deposited at the NCB should be at least 2% of the deposit liabilities. How do banks get the reserves when they lose reserves? During the day, the intraday credit itself provide the reserves. (Loans make deposits!). However 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.
An exception to the above arises during periods of market stress or crisis, when banks prefer to not lend the excess funds due to credit risks and are happy to keep funds deposited at the central bank despite earning lower interest.
As banks create more money by lending (more credit to be precise), the reserve requirement of the whole banking system would increase. How do banks in the Euro Area get more reserves?
It is useful here to distinguish between two types of monetary systems – overdraft and asset-based. In the former, banks as a whole get all the reserves directly by borrowing from the central bank (provided they pledge good collateral) and in the latter, the central bank would create reserves required by the banking system by engaging in permanent open market operations or outright operations, typically purchasing government bonds. The Euro Area monetary system is best described by the former and Anglo-Saxon monetary systems such as one in the United States is best described by latter. Even in the latter, the Federal Reserve does provide direct credit to banks but these are retired quickly. The distinction can be made by looking at the balance sheet of the central bank.
We are yet to see the Eurosystem being described as a whole, but for our purpose of clarifying how an overdraft system looks, it is sufficient to just take a glance at the consolidated balance sheet to verify. The Eurosystem balance sheet near the end of 2006 looked like this (link):
(click to enlarge)
The item rounded in red is €450, 540 million which is a big proportion of the total size of the balance sheet, and one doesn’t see this for the Federal Reserve (in normal circumstances).
Since the Eurosystem is an overdraft type, the funds obtained have to be provided by direct lending by the Eurosystem. This is done mainly via two types of operations – Main Refinancing Operations (MROs), and Long Term Refinancing Operations (LTROs), where the Eurosystem conducts an auction to lend the whole banking system. For the former, the auctions are held weekly and the lending is for one week. LTROs, it is typically conducted every month and the duration of refinancing is three months. As the names suggest, MROs are used mostly.
This will conclude my post. The posts following this will look at cross-border flows of funds and government accounts. They (either one post or two) will attempt to provide the reader an idea of how cross-border dynamics are important for the Euro Area.
Update: Corrected the discussion on frequency and duration of LTROs in the second last para.
