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Home > Blogs > Anthony Harrington > Stealth bail-outs – an economist’s furore with a twist. Part 2

Stealth bail-outs – an economist’s furore with a twist. Part 2

Bail-out | Stealth bail-outs – an economist’s furore with a twist. Part 2 Anthony Harrington

Many commentators on Hans Werner Sinn’s claim, that the stability of the euro is under threat from Target2 trade imbalances between the peripheral European States and the Bundesbank (see Part One of this series), point to the origins of this thought in a paper in March this year from John Whittaker of the Lancaster University Management School.

Whittaker’s very important, but largely underreported paper,  called “Intra-Eurosystem Debts”, stands as a kind of primer on how the relationship between the European Central Bank and the various national banks work. National central banks in each Eurozone country lend to their local banks through repos (repurchase agreements) supported by acceptable collateral. When someone in Ireland buys goods from someone in Germany, in theory funds flow out of the buyer’s Irish bank and into the seller’s German bank. In reality the flow is rather more complex, which is why we end up with Target2 imbalances.

There really is no short way of summarising the basics, so I provide an extensive “primer” quote from Whittaker’s paper which does the job:

"Retail banking transactions lead, in general, to debts between one bank and another. These wholesale debts may be cleared in the interbank market by unsecured loans, by loans secured against assets, or transfers of assets between the banks.  Wholesale debts between banks of the same country may also be cleared by transfers of the banks’ reserve deposits at the country’s central bank. When a retail transaction causes a debt between banks in different eurozone countries that is not cleared in the interbank market, this creates a claim between their respective NCBs.

Suppose a deposit is moved from an Irish bank to a German bank. If the German bank is unwilling to accept payment in the form of a claim on the Irish bank, directly or via another interbank counterparty, the debt is settled via their central banks. The Irish bank makes up for its lost deposit by obtaining greater refinancing from its NCB, i.e. the CBI (Central Bank of Ireland); the German bank acquires a claim on the Bundesbank (German NCB), recognised as a net fall in the amount of refinancing sought by the German bank; and the Bundesbank acquires a claim on the CBI.

Debts between NCBs created in this way are aggregated across the eurozone by TARGET2.”

There is a further level of complexity here, and this is key. In the euro system cross border claims against each other by national central banks (NCBs) are not bilateral. Instead such claims are mediated through the European Central Bank (ECB). In the above example, the Irish NCB (ICB) incurs a liability in its account with the ECB. The Bundesbank (Buba) gets a corresponding credit in its account with the ECB. The more such trades go on, the more the ICB’s liability with the ECB increases and the more Buba’s balance increases.  The Target2 settlement system, which all the NCBs are attached to, reflects those balances – or, as it may be, imbalances. Note that if the underlying transaction  was not a trade transaction but instead represented an Irish depositor withdrawing his/her funds from a dodgy Irish bank and depositing them in a sound German bank, the Target2/ECB accounting would look the same, except the Irish government balance of trade figure would not be hit by any import value, as it would in a trade between an Irish buyer and a German seller.

Really a bail-out?

So the imbalances in the Target2 system are swollen both by trade and by a flight of capital from EAPs (Euro Area Peripherals) to the core euro zone states. This is not quite the same thing as a stealth bail-out, which would have capital flowing to Ireland from Germany (unless “bail-out” has some meaning that escapes me...), which is one reason why opponents of Sinn argue that he is radically misinterpreting the meaning of Target2 imbalances.

Whittaker and, after him, Sinn, highlighted the huge deficits being run up in the Target2 system by European Area Peripheral (EAP) countries (the “GIPS”, or Greece, Ireland, Portugal and Spain, in Sinn’s terminology, or PIGS in most other commentators terminology – we prefer Citibank’s zero emotive acronym EAPs). Since these deficits are matched by massive credits to Buba, Sinn argues that what the Target2 figures reveal is a massive, and hidden, flow of funds to EAPs largely from the Bundesbank, via Target2.

Sinn argues that if these flows are real, then they are quite clearly unsustainable. He also makes a related argument about the way that the growing credit in Buba’s account supposedly “crowds out” the availability of credit to German banks. Note Whittaker’s point above that a German bank’s claim on Buba as a result of the Irish buyer’s transaction is “recognised as a net fall in the amount of refinancing sought by the German bank”, i.e. it does not need to borrow that money from Buba because it is its money by right, via the transaction.

Effect on the Eurozone

Does this actually mean that German banks are slowly being starved of credit? Absolutely not, say those who argue against Sinn. In reality German banks have all the liquidity they need. The way I read Whittaker’s point is that the German bank still gets the same amount of euros it would have got in a refinancing operation – it just owes Buba less, since some of that money is its by right, since those euros were destined to go to the account of one of its depositors (deposit money in a bank is, of course, a liability of the bank’s in favour of depositors, but that is a different point entirely). If the German bank gets the same amount of euros it would have got anyway from Buba in a refinancing deal, where’s the liquidity shortage? “Lowering its refinancing requirements” does not mean “not getting sufficient liquidity”, if you follow… Sinn apparently didn’t…

So, if that argument doesn’t hold, what about Sinn’s argument that the Target2 figures indicate an impending implosion of the Eurozone, with the EAPs running up ever increasing debts and the core NCBs ever increasing surpluses? Does it hold? Absolutely not, according to ECB chief economist Jurgen Stark. Citigroup chief economist Willem Buiter agrees with Stark but he points out that the Target2 imbalances are not exactly benign either, which, in a funny kind of way makes it look as if he’s saying Sinn was wrong on all the details but on target to some extent in highlighting something that the Target2 imbalances are pointing towards. For Buiter, that something is the inability of the EAPs to borrow in the private markets in the normal way. Only the ECB will touch the EAPs and only on its terms. But we will pick this point up in Part Three…

Further reading on austerity, bail-outs and the Eurozone:

Tags: austerity , bail out , bailout , Bundesbank , Central Bank of Ireland , central banks , Citibank , Citigroup , EAP , ECB , European Area Peripheral , European Central Bank , eurozone , Germany , GIPS , Greece , Hans Werner Sinn , Intra-Eurosystem Debts , Ireland , John Whittaker , Jurgen Stark , PIGS , Portugal , Spain , Target2 , Willem Buiter
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