"It Is High Time That Central Banking Is Recognized For The Disease It Is"

Winners and Losers

In a recent editorial at German newspaper Frankfurter Allgemeine Zeitung (FAZ), Hans-Werner Sinn, president of Germany's IFO Institute and a prominent critic of the ECB and the euro area bailouts, revisits the topic of the euro-systems payment imbalances that are expressed in TARGET-2 claims and liabilities. The reason why Sinn felt compelled to write this editorial is that another economist, Marcel Fratzscher of the DIW in Berlin (another economic research institute), recently asserted that 'Germany is the big winner' in the events surrounding the TARGET system.

The main reason why there is even a debate over the euro-system's payment procedures is in fact that Sinn pointed out two years ago that the system was abused as a 'stealth bailout' mechanism for the euro area periphery and that Germany was exposed to huge risks because of it.

This provoked angry reactions from courtier economists and even the Bundesbank, who tried in vain to put the genie back into the bottle by arguing that it all didn't matter. It was merely an accounting artifact, and no further implications were to be inferred. Naturally, even people who don't understand how exactly the system works were compelled to ask: if it 'doesn't matter', then why does the chart look like this?

In view of this chart, which had begun to depict vast and growing imbalances precisely since the beginning of the crisis period, the argument that it 'didn't means anything' and entailed no risks for anyone just didn't sound very credible. People also wondered why a prominent economist like Sinn would risk his reputation by opposing this consensus view dispensed from on high.

 What Was Financed?

To begin with, Sinn was perfectly correct. He has not once misrepresented the risks posed by the system. Curiously, even Fratzscher admits in his editorial that yes, it is indeed a stealth bailout. He argues however that the potential costs are outweighed by the benefits, since in his opinion, the imbalances mostly reflect 'capital flight by German investors from the periphery', which the TARGET system enabled. Moreover, he argues that it is a good thing that credit that was previously extended by private investors is now de facto extended by the central bank, as it keeps all sorts of companies in the periphery in business. These would have been cut off from credit otherwise.

Sinn counters that first of all, it cannot be determined with certainty just whose capital flight was financed. The TARGET balances themselves cannot tell us anything about that. Sinn points out, that 'in effect, the North's printing press was lent to the South' and notes that this fact – and the attendant risks for the holders of TARGET claims – is obviously no longer in contention. The only bone of contention is 'just what was financed with it'.

Sinn concedes that German capital flight was in part financed by the TARGET system, but notes that the DIW calculations (which are actually based on IFO's numbers) are wrong. For one thing, DIW confuses gross with net amounts, as there were flows in the opposite direction as well. In fact, from 2008 to 2012, Germany has altogether exported a net €170 billion in capital! Instead of €400 billion as assumed by DIW, Sinn contends that at most €200 billion were recalled by German investors from the periphery. And even so, argues Sinn, it was not the business of the central bank to protect German banks: 

“[Capital flight] does not explain the build-up of Germany's TARGET claims, and even if it did, it wouldn't have been the ECB's job to protect German banks and financial institutions from losses. Such fiscal aid measures are the responsibility of finance ministers, and not the ECB board.” 

Sinn then explains that TARGET was for the most part used as a kind of vendor financing system – Germany's export surplus was partly financed by the TARGET system, partly by Germany's private sector capital exports and partly by aid packages granted in the course of the bailout. 

In short, it is mainly Germany's trade surplus that is reflected in the BuBa's TARGET claims. He argues furthermore that there are a number of complex business structures at work, and the TARGET liabilities of the crisis countries cannot be fully explained by the balance of payment deficits of these countries. He notes that in some countries like Portugal and Greece, TARGET liabilities and current account deficits are very closely linked, while in others like Spain and Italy, capital flight is the main factor. However, it is not necessarily capital flight to Germany. Other foreign investors such as British investors were enabled to recall their investments due to the TARGET mechanism as well (for instance, there may be a circular flow such as this one: UK investors remove capital from the EU periphery, then lend money to US buyers of cars, who in turn use the funds to import cars from Germany). 

Perpetuating Imbalances and Robbing Savers

Sinn then points out that the ECB, via its lowering of credit rating standards for  central bank refinancing, enabled the national central banks in the periphery to undercut capital markets. Much higher interest rates were demanded in the capital markets, reflecting the higher risks in the crisis countries.

The conditions offered by the ECB in terms of refinancing were such that banks in the still healthy countries could no longer compete with it. In short, the ECB has driven away private sector competition in the capital markets of the periphery. This has contributed to the further fragmentation of European capital markets, since without the lure of higher interest rates, private investors have no good reason to take the risk of investing in the crisis countries. Higher interest rates would however have forced these countries to save more and enact sweeping structural reforms of their labor markets and government finances, which would ultimately have made them more competitive and lowered their ingrained balance of payment deficits. Sinn points out that most of the crisis countries are still far from having regained competitiveness, which can be largely deemed an unintended consequence of the ECB's interventions.

Since private capital markets have been undercut via the printing press, Germany's banks and insurers are no longer able to earn interest rates that adequately reflect risk. Insurers have been forced to recall the return guarantees that have traditionally extended to their policyholders.

Sinn stresses that the advantages accruing to German debtors via low interest rates must be seen in the context of the fact that Germany is actually a net creditor to the world, not a debtor. Creditors are losing out when interest rates are artificially lowered. It is as though “the ECB were acting as a purchasing agent of German savings, which it then services and distributes to the crisis countries at whatever conditions it deems appropriate”. Sinn estimates that the crisis countries have enjoyed €205 billion in interest savings due to the ECB's interventions, interest that exporters of capital such as Germany would otherwise have earned.

Sinn concludes that “it is not entirely wrong in this context to talk about the expropriation of German savers by means of low interest competition via the printing press.”

Indeed, central banks are ultimately robbing savers everywhere these days. The prudent are forced to pay for the mistakes of those who have been irresponsible and have squandered their capital. 

Are Lower TAREGT Imbalances A Sign of Improvement?

Over the past few years, investors have rearranged their portfolios, causing among other things a construction boom in Germany. Meanwhile, the EU and the ECB have organized a giant flow of public funds into the crisis countries to replace private capital flows. All of this will only perpetuate the misallocation of saved capital. Capital will continue to be consumed.

Sinn then points out that Germany and other Northern countries have been regularly outvoted at the ECB board since May of 2010. In his opinion, the ECB board's actions are in conflict with article 125 of the EU treaty, as they have created a giant volume of public credit and public guarantees in favor of the Southern countries, which could eventually get the ECB itself into trouble. In a worst case scenario, the write-offs may well exceed the ECB's capital of €500 billion.

Even though the central bank could continue to function even if its capital base were  wiped out, it would be a devastating signal to the capital markets if part or all of its capital were lost. We agree with this assessment, for one thing because write-offs of a part of a central bank's assets mean that its flexibility with regard to lowering the extant money supply is curtailed. Secondly, in the minds of investors and users of the euro, it would look as though some of the 'backing' of the central bank's liabilities was gone. Although fiat money is irredeemable anyway, this would likely have a psychological impact that could severely damage the euro.

The most interesting part of Sinn's editorial however concerns the recent decline in the TAREGT-2 imbalances (see the chart above). This will probably be regarded as controversial and we expect it will ignite further debate. Sinn writes: 

“If one adds up the purchases of government bonds by the central banks of the still healthy countries in the euro area and the TARGET credits in favor of the six crisis countries (Greece, Ireland, Portugal, Spain, Italy and Cyprus) for which the ECB board is responsible and deducts the claims of the crisis countries arising from a slightly under-proportional issuance of banknotes, then one gets a total of € 747 billion in ECB financed rescue loans. That is about two times the sum of the already granted fiscal rescue measures of the community of € 385 billion, for which the national parliaments are responsible.

The loans of the community are economically indistinguishable from ECB credit, but they arrived on the scene much later and are basically follow-on loans designed to relieve the ECB. In view of the advance payments made by the ECB, parliaments are essentially forced to push through a fiscal rescue architecture in the form of the European Stability Mechanism ESM and other measures, since if they were to deny the ECB such follow-up financing, the entire euro-system may well collapse. The strong insistence on a recapitalization of banks with ESM funds, which ECB president Draghi has recently expressed in a letter to the EU commission, is also explained by his panic-like fear of the ECB's own losses.

Since the TARGET liabilities of the crisis countries have been a great deal higher at one point than the € 681 billion remaining today, some observers feel that there is no longer cause for alarm. They have perhaps not yet understood that the fiscal rescue loans extended by the community replace the TARGET liabilities of the crisis countries directly and fully. This is an automatic process resulting from the TARGET system's very nature. Without the fiscal rescue measures on the part of the community, the TARGET liabilities of the crisis countries would ceteris paribus not be at € 681 billion today, but at € 1,066 billion.

In the construction of the rescue architecture, Europe's parliaments are confronted with decisions without alternatives, which have been prepared years ago already by the ECB board. They have been degraded to rubber-stamping agents. To me it is questionable whether the fiscal regional policy that has been decided behind closed doors by the ECB and for which there are no parallels in the US Federal Reserve system, is still compatible with the rules of parliamentary democracy and the German constitution” 

Obviously, Sinn isn't prepared to shut up and let them get away with this unchallenged. 

Conclusion:

The notion that the euro area crisis is over has recently been heavily propagated  by EU politicians and the mainstream media. However, it is way too early for such victory laps. The fat lady is still waiting in the wings.

Hans-Werner Sinn is perfectly correct in pointing out that the ECB's attempts to restore the 'monetary policy transmission mechanism' by suppressing interest rates in the periphery is going to perpetuate capital malinvestment and delay the necessary reforms. He is also correct when he states that these interventions have actually scared private capital away, as investors require adequate compensation for the risks they are taking. Meanwhile, savers are ultimately paying for this ongoing waste of scarce capital.

It is high time that central banking is recognized for the disease it is. Without central banks aiding and abetting credit expansion, this situation would never have arisen. Even a free banking system practicing fractional reserve banking could not possibly have created such a gigantic boom-bust scenario. Money needs to be fully privatized – the State cannot be trusted with it.

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