The Roots of the Euro Crisis Lie at the Doorsteps of the ECB

EconoMonitor: This column argues that deficiencies in the Eurosystem[1] monetary policy contributed to the “euro crisis”, which is, in reality, an intra-Eurozone balance of payments and external debt crisis.  It claims that the Eurosystem’s monetary policy instruments and procedures allowed intra-Eurozone external imbalances to accumulate since the start of the third phase of the EMU[2] in January 1, 1999. As a result, though the Eurozone has low levels of net external debt relative to its GDP, it presently confronts, in its midst, what is likely the largest peacetime external debt crisis the World has ever seen (Das et al., 2012; Reinhart et al., 2003).  Moreover, it points out that the Eurosystem’s monetary policy has always had large fiscal effects[3]and currently results in financial transfers from Eurozone creditor countries (the GNLF[4]) to Eurozone debtor countries (the GIIPS) that may amount to 1.3% of the GIIPS’ combined GDP per year.

The Debate on the Euro Crisis

Since 2008, capital flight from the GIIPS, driven mainly by the banking sector, has led to a pronounced rise in the Eurosystem’s TARGET2[5] imbalances (Figure 1), which translate into large imbalances in the net external debt position of Eurozone NCBs[6](Table 1).

Figure 1: TARGET2 Imbalances (Chart from Institute of Empirical Economic Research – Universität Osnabrück)

Table 1: Total, Banking, and Central Bank Net External Debt (+/- for net debtor/creditor)[7]

Sinn (2011) and Sinn and Wollmershäuser (2012) argued that there was a link between TARGET2 imbalances and (cumulative) current account deficits of the GIPS[8] and that TARGET2 funding of the GIPS’ central banks represented a “stealth bailout” by the Eurosystem. They also pointed out that the Bundesbank faced the risk of large losses on its claims vis-à-vis TARGET2 should there be a euro breakup (Whelan, 2012; De Grauwe and Ji, 2012).

In response to Sinn, Whelan (2011) and Buiter et al. (2011), among others, argued that the rise in TARGET2 balances likely simply reflected private-sector capital flight.

Gros and Mayer (2012) looked at the causes of those TARGET2 imbalances, i.e., at what explained the high current account deficits in the first place. They noted the rise in German surplus savings from the historical 1%-2% of GDP to 6% of GDP since the introduction of the euro. They argued that the introduction of the euro led German banks to believe that exchange rate risk was gone and to channel German surplus savings to the GIIPS countries.

After 2008, German banks realized that exchange rate risk had not disappeared and refused to rollover loans (Dor, 2012), which explains the capital flight and the growth in TARGET2 imbalances (Table 1).

The Role of Monetary Policy in the Eurozone’s Balance of Payments and External Debt Crisis

This column argues that flaws in the design of the Eurosystem monetary policy instruments and procedures played a larger role in the GNLF banks’ lending to the GIIPS banks (Figure 2) – and to the euro crisis – than the elimination of exchange rate risk:

• The Eurosystem monetary policy instruments reduced the credit risk of Eurozone banks. Banks could, if necessary, obtain liquidity by using a wide range of financial assets as collateral in the Eurosystem main refinancing operations transactions. This means that inter-bank lending became less risky.
• GNLF banks did not need to have GNLF families’ deposits to lend abroad. Credit money creation is endogenous (Moore, 1979; Borio and Disyatat, 2010; Cabral, 2012). Banks create deposits as they make loans, which they can do as long as they have sufficient excess reserves (and capital ratios above minimum requirements). GNLF banks used their excess reserves to lend to the GIIPS banks or to buy the GIIPS’ corporate and public debt. GNLF banks could then use this GIIPS’ debt as collateral in the Eurosystem reverse transactions (and in the private repo market)[9] to obtain further liquidity (excess reserves) in order to extend additional loans. This process could be repeated over and over again.
• A substantial portion of the GIIPS’ domestic financial assets could be used as collateral in the Eurosystem’s liquidity providing operations (Fels, 2005; Buiter and Sibert, 2005). Thus, the Eurosystem’s monetary policy instruments, by increasing the acceptability of the GIIPS countries’ financial assets, weakened balance of payments constraints (Pivetti, 1998; Andini and Cabral, 2012) and meant that the large and recurring GIIPS’ current account deficits could be financed for far longer than would have otherwise been possible.
• That is, the Eurosystem’s monetary policy design facilitated the growth in the GIIPS countries’ net external debt to unprecedented levels (Table 1).

Figures 2a and 2b: German Banks’ Claims on GIIPS’ Banks (2b: marked as private risks) and Bundesbank TARGET2 Claims (2b: marked as Public risks) (Charts from Carmel Asset Management).

The Fiscal Effects of the Eurosystem’s Monetary Policy

The Eurosystem’s main monetary policy instruments differed from central bank best practice (Buiter and Sibert, 2005; Hamilton, 2008; Cheun et al., 2009).

In fact, traditionally, central banks essentially managed the composition of public liabilities: central bank liquidity providing operations either acquired outright or required the delivery of sovereign debt (or agency debt) as collateral against the provision of currency (Hamilton, 2008; Cheun et al., 2009). Thus, traditional liquidity providing operations did not materially increase net public liabilities,[10] since they consisted in replacing private sector holdings of sovereign debt (a form of public liabilities) with currency (another form of public liabilities).

This was the modus operandi of, for example, the Federal Reserve prior to 2007 (Cheun et al., 2009).

However, the ECB decided[11] to accept a broad range of private and public debt securities as collateral in the context of the Eurosystem’s temporary liquidity providing operations (ECB, 1998), which were much larger than those of the Federal Reserve.

As a result of this choice by ECB policy makers, the Eurosystem’s monetary policy has very large fiscal effects (MacKenzie and Stella, 1996) because:

• The Eurosystem’s refinancing operations with private sector debt collateral and outright purchases of private sector debt in the secondary market increase net public liabilities (temporarily and outright, respectively). This is done without prior authorization by the European Parliament or by the National Parliaments;[12]
• In addition, with the traditional monetary policy instruments format, if a counterparty (i.e., a bank) failed and could not return a loan, the central bank could hold on to the collateral – the sovereign debt. This means that the failure of a monetary authority counterparty resulted only in a change in the composition of public liabilities: more currency but less sovereign debt held by the private sector (Hamilton, 2008). In contrast, the Eurosystem’s monetary policy operations create a loss risk to the taxpayer. This occurs because some of the collateral may be private sector debt, which may not fully cover the outstanding loan;[13]
• The Eurosystem monetary policy – like fiscal policy – has large redistributive effects. It benefits Eurosystem counterparties, which thus gain a competitive advantage. For example, on the one hand, banks and several corporations with bank subsidiaries are able to obtain loans from the Eurosystem at much lower rates than their own market funding costs. On the other hand, these Eurosystem counterparties benefit from an unlimited deposit guarantee over the totality of their deposits with the Eurosystem;
• The Eurosystem also accepts non-sovereign public debt as collateral, specifically, debt securities of various Eurozone public sector entities (including local and regional governments). This feature of the Eurosystem’s monetary policy instruments and procedures likely weakened national controls on public spending. Private sector banks were likely more willing to finance a part of the public sector entities borrowing in the knowledge that they could refinance it with the Eurosystem;

• Finally, in a country or a federation of states, financial transfers between regions are implemented through fiscal policy. In contrast, in the Eurozone, these transfers have, to a large extent, been accomplished through monetary policy. Presently, this occurs through TARGET2 lending between Eurozone current account surplus and deficit countries’ NCBs, at subsidized interest rates (Table 1). As of July 2012, the GIIPS’ large – structural – TARGET2 balances represented approximately 31% of the GIIPS’ combined GDP (Figure 1). In the 12 months ending in July 2012, these balances grew at approximately 1.6% of the GIIPS’ combined GDP per month (i.e., by €52 bn per month).

On the one hand, the TARGET2 funding results in lower balance of income deficits for the countries whose NCBs have large TARGET2 liabilities (Cabral, 2011) because the interest rate on TARGET2 balances – currently at 0.75% – is much lower than market interest rates.[14] In fact, the interest subsidy on the GIIPS’ TARGET2 outstanding liabilities currently may represent 1.3% of the GIIPS’ combined GDP per year.[15] That is, the interest subsidy on TARGET2 balances is equivalent to a large fiscal transfer from the GNLF countries to the GIIPS countries.

On the other hand, several of the GIIPS countries will have to restructure their (external) debt in the future (Cabral, 2010). This includes their NCB’s outstanding TARGET2 liabilities, which represent a growing share of these countries’ net external debt. Future losses on this Eurosystem lending would be equivalent to a de factofiscal transfer above and beyond the interest subsidy identified above.

Conclusions

The Eurosystem monetary policy strategy, instruments, and procedures have contributed to an unprecedented intra-Eurozone external debt crisis and presently result in large “stealth” transfers from the GNLF to the GIIPS, among other fiscal effects.

Therefore, in responding to the euro crisis, one important step forward lies in addressing the deficiencies in the Eurosystem monetary policy. In my view, this could be accomplished through measures that reduce the presence of the Eurosystem in financial intermediation. In short, the Eurosystem, in its liquidity providing operations, should only accept as collateral sovereign debt of Eurozone member countries. Moreover, open market operations should be based almost exclusively on outright operations on the sovereign debt of Eurozone member countries. These could be conducted on the basis of the ECB adjusted capital key. Temporary refinancing operations should be slowly winded down, and ultimately removed altogether from the monetary policy toolkit of the Eurosystem.

References

Andini, Corrado and Cabral, Ricardo (2012), “Further Austerity and Wage Cuts Will Worsen the Euro Crisis”, IZA Policy Paper No. 37.

Borio, Claudio and Disyatat, Piti (2010) “Unconventional monetary policies: an appraisal,” Manchester School, 78, pp. 53-89.

Buiter, Willem, Michels, Juergen, and Rahbari, Ebrahim (2011), “Making Sense Of Target Imbalances”, VoxEU.org, 6 September.

Buiter, Willem, and Sibert, Anne (2005), “How the Eurosystem’s Treatment of Collateral in its Open Market Operations Weakens Fiscal Discipline in the Eurozone (and what to do about it)”, CEPR Discussion Papers No. 5387.

Cabral, Ricardo (2010), “The PIGS’ external debt problem”, VoxEU.org, 8 May.

Cabral, Ricardo (2011), “There Are Better Ways Forward for the EU”, VoxEU.org, 20 October.

Cabral, Ricardo (2012), “A perspective on the symptoms and causes of the financial crisis”, Journal of Banking and Finance, forthcoming, https://dx.doi.org/10.1016/j.jbankfin.2012.08.005.

Cheun, Samuel, von Köppen-Mertes, Isabel, and Weller, Benedict (2009), “The Collateral Frameworks Of The Eurosystem, The Federal Reserve System And The Bank Of England And The Financial Market Turmoil”, ECB Occasional Paper Series No. 107, December.

Das, Udaibir, Papaioannou, Michael, and Trebesch, Christoph (2012), “Sovereign Debt Restructurings 1950–2010: Literature Survey, Data, and Stylized Facts”, IMF Working Paper No. 12/203.

De Grauwe, Paul and Ji, Yuemei (2012), “What Germany should fear most is its own fear. An Analysis of TARGET2 and Current Account Imbalances”, CEPS, 12 September.

Dor, Eric (2012), “Changing causes of the rocketing TARGET2 accounts imbalances in the Eurosytem and the balance of payments of Germany”, IÉSEG School of Management Working Paper Series No. 2012-ECO-12.

ECB (1998), The Single Monetary Policy In Stage Three: General Documentation On ESCB Monetary Policy Instruments And Procedures, Frankfurt am Main: European Central Bank.

Ewing, Jack (2012), “European Central Bank to Recover Most of Its Lehman Loans”,DealBook, NY Times, 19 January.

Fels, Joachim (2005), “Markets Can Punish Europe’s Fiscal Sinners“, Financial Times, 1 April.

Gros, Daniel and Mayer, Thomas (2012), “A German Sovereign Wealth Fund to save the euro”, VOXeu.org, 28 August.

Hamilton, James (2008), “Federal Reserve Balance Sheet”, Econbrowser blog, 21 December, available at <https://www.econbrowser.com /archives /2008/12/federal_reserve_1.html>.

Mackenzie, George, and Stella, Peter (1996), “Quasi-Fiscal Operations of Public Financial Institutions”, IMF Occasional Paper No. 142.

Moore, Basil (1979), “The endogenous money stock”, Journal of Post Keynesian Economics, 2, pp. 49-70.

Pivetti, Massimo (1998), “Monetary Versus Political Unification in Europe. On Maastricht as an Exercise in ‘Vulgar’ Political Economy”, Review of Political Economy10:1, pp. 5-26.

Reinhart, Carmen, Rogoff, Kenneth, and Savastano, Miguel (2003), “Debt Intolerance”, Brookings Papers on Economic Activity 2003, pp. 1-74.

Sibert, Anne (2010), “Love Letters from Iceland: Accountability of the Eurosystem”, VoxEU.org, 18 May.

Sinn, Hans-Werner (2011), “The ECB’s Stealth Bailout”, VoxEU.org, 1 June.

Sinn, Hans-Werner, and Wollmershäuser, Timo (2012), “Target Loans, Current Account Balances and Capital Flows: The ECB’s Rescue Facility”, International Tax and Public Finance 19:4, pp. 468-508.

Whelan, Karl (2011), “Professor Sinn Misses the Target”, VoxEU.org, 9 June.

Whelan, Karl (2012), “TARGET2: Not Why Germans Should Fear a Euro Breakup”, VoxEU.org, 29 April.