On target – what’s really going on in the Euro area banking system?

I have to confess I was slightly nervous when I finally clicked on the “publish” button yesterday and put my post “The stealth bailout that doesn’t happen – debunking Hans-Werner Sinn” online.

In that post I claim that one famous German economist and two very influential economic journalists got it all wrong with regard to what’s currently going on in the European banking system.

(I could have easily added an economic laureate as well but I only later noticed that Paul Krugman had also published a post with faulty claims on that matter. )

They all claimed that the central banks were financing the state and that the solvency of  national central banks within the eurosystem was at risk. Krugman, for example, sober-mindedly claimed : “we’re now at the panic stage. (…)  We really are in meltdown territory.”

I basically said that this was rubbish.

On the one hand side, I was pretty sure that I had a good point. On the other hand? Well, you never know …

Today, three remarkable blog posts have been published – one by Felix Salmon and two  by Karl Whelan.

The one by Felix Salmon has a funny title: “Felix Salmon smackdown watch, European central bank edition”. He takes a second look at the issue. The arguments I put forward have not fully convinced him, but he writes:

“I’ll be the first to admit that I’m no expert on any of this, and that when I blogged Martin’s piece I didn’t know how controversial his position was, and that many if not most central bankers would consider him simply factually incorrect on many counts. I thought his piece was excellent as analysis; as argument, I’m not fully persuaded.”

Felix then asks:

“So if there’s a central-banking wonk out there who fancies adjudicating this dispute, I’m happy to put it up for arbitration. Wessel? Ip? Is Martin on to something here, or not?”

Well, yes, there is. Step forward Karl Whelan, Professor of Economics at the University College in Dublin.  After Felix published his request, Whelan wrote on the Irish Economy blog:

“Well, with 11 years experience working in central banks, I suspect I meet the job requirements. I wrote my post before seeing Storbeck’s but hopefully my arguments back his up to help counter Professor Sinn’s somewhat wilder claims.”

On the blog of the Institute of International and  European Affairs, Whelan published a piece entitled “Professor Sinn Misses the Target” where he debunks the claims of Prof. Sinn using similar but more precise arguments than I do.

Whelans conclusion is pretty straightforward:

“Professor Sinn’s analysis is incorrect and his policy prescriptions extremely dangerous.”

Among other things he takes issue with Sinn’s claim that Target2 balances represent bilateral claims of the Bundesbank on other central banks.  Whelan writes:

“[Sinn] says ‘it is as if the Bundesbank had lent money to the Irish Central bank for the purposes of extending a loan to an Irish bank.’ It’s not.  If I loan you money, that means that I lose money if you don’t pay back. The Bundesbank is not owed money by the Central Bank of Ireland. It is owed money by the ECB and it can only lose money if the ECB refuses to pay it back.”

His final sentence is pretty devastating with regard to the role Sinn is playing in the public debate:

“The Eurosystem has serious problems and the citizens of its member states have many reasons to question the wisdom of the decision to adopt a single currency. However, this situation isn’t helped by respected public figures making incendiary and specious claims about how the system works.”

From my point of view, Whelan is absolutely on target here.

To shed more light on the Target2 puzzle, I also asked  several european economists about their views on the matter. Until tonight, I got a reply from Elga Bartsch (Morgan Stanley’s Chief European Economist), and Holger Schmieding (Chief Economist with Berenberg Bank and former Chief European Economist with Bank of America).

Here’s what they told me:

Elga Bartsch, Morgan Stanley’s Chief European Economist:

“From my point of view the whole debate is a storm in a teacup.

The Target2 balances are resulting from the fact that the ECB distributes funding decentrally via its branches, i.e the national central banks.

These balances therefore do not reflect the risk position or lending of one central bank to another. Of course, there are risks involved in the ECB’s refinancing operations etc. Each national central bank/ country is exposed to those systemwide risks by its share in the ECB capital key.

It is the decision of the ECB council how much money is created, not of any national central bank.

Interestingly, Germany was running a big negative balance for the first ten years of the euro. In those days German banks accounted for 50% of the refinancing operations in the euro area (but has a share in the capital of around one quarter) but no-one seem to mind or to notice. Given the undercapitalised state of the German banking system  and the funding provided to international investment banks (such as Lehman Brothers)  this might also have been an issue worth discussing.

Remember though that losses for the Eurosystem only occur if a bank goes under and the collateral is not marked correctly. Given that the collateral is marked to market on a daily basis and has additional haircuts and that the ECB  ’s refi operations are heavily overcollateralised, I think the risk is very manageable provided that no now major systemic shocks emerge.

If you indeed want to go down the route of thinking the Euro and hence the  eurosystem could break up – a scenario that I personally would not endorse  as being plausible -  it  might actually turn out to be a good thing  to have a negative Target2 balance because it means that at the moment you got less risk locally  at the national central bank than you have systemwide in the eurosystem.

With these balances having little to do with actual accrual of risk or fund flows they also have little to do with capital exports. I also think that Sinn is wrong on the stealth bailout packages. What happened is that core Europe funded the periphery by borrowing money itself. If the EFSF issuance is anything to go by the packages are funded by reserve managers and Sovereign Wealth Funds in Asia and elsewhere in the emerging market domain, but not by  savings from core european  countries. “

“The target balances reflect payments imbalances in the Eurozone, but they do not create them.

Target2 is not a system to directly or indirectly finance governments. The balances are not short-term Eurobonds.

Of course, by helping to keep the banking system in the Euro periphery afloat, the ECB is indirectly helping the governments: if the banks were to collapse, the governments would have serious problems. But preventing a financial collapse is part of the mandate of a central bank.

Of course, if a major bank collapses and the collateral this bank has deposited with a central bank turns out to be worth very little, the central bank has a problem. In theory, such problems could be pronounced enough to erode the capital base of that central bank.

But in practice, it is highly unlikely that the ECB and its member central banks would allow a banking crisis to be come so pronounced as to trigger such a wave of dangerous bank defaults. As part of their mandate to safeguard financial stability, the central banks would simply prevent it.

The target balances do not distort the credit creation of the central bank. They reflect imbalances in the process. Persistent bidders for generous ECB liquidity come mostly from some peripheral countries. As a result, the share of ECB liquidity going to some countries is, because of the special liquidity needs of banks in these countries, higher than it used to be.

The way to tackle this is not to change the target system. Instead, the ECB and regulators gradually need to wean these persistent bidders off their dependence on the ECB.”

Felix, is this enough  to convince you? If not, stay tuned. There’s even more to come: Tom Mayer, Chief Economist with Deutsche Bank, told me that he is working on a paper dealing with the issue which is going to be published tomorrow.

Update: In an ealier version of this article Karl Whelan’s was erroneously affiliated to the  Trinity College Dubin. In fact, he’s with the University College. Apologies!