Target 2: Liquidity and Capital Flight Post author By Philip Lane Post date March 7, 2012 Fabian Bornhorst and Ireland-expert Ashoka Mody have a good piece here. Categories In Banking Crisis, EMU, Uncategorized 30 Comments on Target 2: Liquidity and Capital Flight ← Public Lecture – The Economics of the Fiscal Compact → Is Ireland a tax haven? 30 replies on “Target 2: Liquidity and Capital Flight” An excellent paper. The truth at last. It is not Prof Sinn’s tractor sales that are at the root of the Target2 balances. It is a combination mobile financial capital, particularly German, being disinvested in peripheral Europe and brought home. One has to wonder why financial flows, unrelated to productive investment or jobs or the gerneral good of economies, are not restricted or ringfenced from the economies that they inhabit for such brief periods. ‘ German investment positions in the rest of Europe are being unwound but private funds are not easily available to finance these payments. As such, banks in stressed economies are turning to their central banks, who in turn obtain liquidity through the system of interconnected European national central banks.’ OK. So the LTRO is about bailing out failed German finaancial sector investments in the periphery, and shifting the losses onto the ECB, which can in turn, inflate them away. Which is going to be a fraught exercise http://prudentbear.com/index.php/creditbubblebulletinview?art_id=10637 The referenced paper below this piece strikes me as complementary to our understanding of this : Global savings glut or global banking glut? by Hyun Song Shin It harks back to that BIS paper that Yves Smith is always banging on about. The Heart of Darkness appears not in the US – its in Europe. Perhaps the EMU experiment of 1987 and beyond is the primary mechanism for the various malinvestment episodes we see both in America China and the mini me experiments in Europe as once semi captured banks caged withen national boundaries can produce unlimited credit for the production of international Grot limited only by natural resourse constraints. This isn’t much different to what I was banging on about last year: http://www.irisheconomy.ie/index.php/2011/11/14/the-ecb-on-bank-bonds/#comment-192592 @ Paul Quigley, “shifting the losses onto the ECB, which can in turn, inflate them away” It would be nice if this happens, but I don’t see this yet. At present I’d say it’s pushing the losses on to the periphery’s taxpayers. And the following step is up for grabs, though at that stage the periphery is in a much weaker negotiating position. @all ‘Germany, though still enjoying a current-account surplus with the world (and with other European economies), has become a net recipient of capital from the world (Figure 5), especially from the financially-distressed economies in Europe.’ [Fabian Bornhorst and Ashoka Mody, IMF] German Capital flows – out to the periphery – no bondholder left behind (minor few bob to the Greeks) – then more from the periphery to Germany – and they sit on it and sit on it … and their big black hole remains silent … and gift of a skelp of the trillion from Draghi …. so the Deutsche FinSys in a plus-plus on those capital flows …. I appreciate this illustrative intervention from our pragmatic friends in the IMF. Now back to pragmatic Germans in the Bundesbank … Jens Ulbrich & Alexander Lipponer of the Bundesbank comment here [probably in the form of a tutorial to Herr Weidmann who made a slight ‘error of judj… er .. fact’ recently – (bit like the Bundestag it was leaked)] http://www.cesifo-group.de/portal/pls/portal/docs/1/1213644.PDF I appreciate this illustrative intervention from pragmatic and savvy members of the BundesBank. @Herr Professor Sinn ‘The kind of person who always insists on his way of seeing things can never learn anything from anyone.’ [Tao Te Ching, #24] @Karl Whelan Have a kit-cat! Take a break. The only real problem with this paper is the following sentence; “Attention has focused principally on the current-account financing needs of Eurozone countries. The implication of this focus is that regaining TARGET system balance will require further reduction in the current-account deficits – especially of countries facing market scrutiny and elevated interest rates. However, a more important development in Europe has been the reversal of capital flows, which has created new financing pressures”. This point is not correct and the argument is, in any case, a circular one. No real distinction can or should be drawn between current account deficits and capital flows as the two as they are self-evidently inextricably linked. The reversal in capital flows is a result of a collapse in confidence in the economies of the periphery, their sovereigns and their banks, which can only be corrected, ipso facto, by restoring it. The means are to hand and involve a tedious process of (i) negotiation in relation to areas where countries have agreed the EU should act (ii) improved coordination where they have insisted on retaining national control (economic and social policy) combined with (iii) economic stimulation measures through the more effective use of EU funds devoted to economic and social cohesion. Politicians do not like tedium. They have a preference for waving magic wands of one kind or another. Sarkozy is using a wide variety at the moment. At least one leader, Mario Monti, knows the detail of what is required as he wrote the Strategy Paper on the Single Market at the request of Barroso and presented it at the end of 2010. http://ec.europa.eu/bepa/pdf/monti_report_final_10_05_2010_en.pdf P.S. It is advisable for those interested not to try and read it at one go as the failure to act on its recommendations or to do the opposite of what it recommended is likely to bring on a bout of extreme pessimism regarding the capacity of the EU to emerge from the current crisis. So, eh, what’s teh gist of all this? Is the official sector lending to the periphery to fund their ca deficits or not? This is not surprising, it shows that the money lent to Irish banks to finance the reckless property lending of the past decade has been recalled. If the LTD ratio (Loans to Deposits) was legally required to be 1 minus the capital ratio (as I would imagine was the original intention of a capital requirement) we would never have had any of this crisis. The regulator must act to make all banks have a max LTD of 90-92% depending on capital requirement. Otherwise as soon (if ever) as we get out of the current crisis, the banks will be brewing another one. Target2 imbalances: “Are Irish farmers are making it easier for German shopkeepers to get a loan from their local retail bank? That proposition is no less valid than suggesting Ireland is recieving a back door bail-out from Germany”…..Sinn’s world turned upside down! http://www.acassconsult.com/attachments/File/Acass_Economic_Monitor_-_February_2012.pdf @DOCM “This point is not correct and the argument is, in any case, a circular one. No real distinction can or should be drawn between current account deficits and capital flows as the two as they are self-evidently inextricably linked.” I think the whole point of the article is that current account deficits and capital flows are not linked. You may be correct that they are linked in an obtuse way to ‘confidence’ on the part of the investors but they are not linked in such a way as to make the surplus or deficit in trade or services the primary driver of that link. @All It is also worth noting in the context of Target2 that of the often reported ~150 billion ECB ‘support’ to Irish bank, ~70 billion is in respect of the covered banks. One wonders if the pejorative language describing the ECB ‘support’ for Irish banks will now change due to the fact that the ECB has pumped approx one trillion [€1,000,000,000,000] euros into mostly (I assume) core EZ banks. Or perhaps the 1 trillion is not ‘support’. It will come packaged in a much more positive phrase. Was wondering where the resident Target 2 expert Prof Whelan was…. http://karlwhelan.com/blog/?page_id=22 Looks like a new blog in town folks…. @ Joseph Ryan I was referring only to the two in the context of membership of the euro which is not clear, I must admit, from what I have written. The capital flows are a function of a breakdown of confidence in the sovereigns and banks of the periphery which is in turn linked to the fact that they are importing more goods than they are capable of paying for. In fact, this so obvious I wonder why it is even under discussion cf. the view of the two officials from the Bundesbank. “This would require that the confidence in the banking sector in the euro area and in the individual banks is restored and the problem banks are rehabilitated or exit the market. For the Eurosystem it is decisive in this context that the corresponding responsibilities between monetary policy and fiscal policy are preserved. In concrete terms this means that the shortterm special liquidity measures of the Eurosystem aimed at containing the acute crisis-like developments must not delay the necessary restructuring process or even replace it. For this reason alone a timely reduction of the special measures is a must”. Draghi has created the necessary breathing space. But both Merkel and Sarkozy are barking up the wrong tree with regard to how to avail of it. There are exceptionally strong vested interests in both their countries which remain totally adverse to following the correct route as sketched out by Monti. The use of Cameron as the whipping boy to reject it is coming from both the left and the right in both countries. There are innumerable examples in the Monti Report that confirm that embarking on the euro was foolhardy undertaking without a fully functioning single market. The road transport market in Germany, for example, is tied up tighter than a drum. Can you imagine a concept such as “cabotage” (the – restricted – freedom for truckers to compete for business across Europe) in the US? Maybe the Teamsters have it equally sown up but I doubt it. The debate should come down out of the clouds of academic theorising and start addresing the issues impacting on the real economy. Sarko l’Américain is certainly going ‘low’ … that guy in Nepal better watch out! http://www.spiegel.de/international/europe/0,1518,819914,00.html @David O’Donnell re Sarkozy “A new survey released on Wednesday found that, were Sarkozy to go head-to-head against Hollande in the second round of elections, he would receive 46 percent to his challenger’s 54 percent.” Closer than I thought or would have liked to see. Sarkozy not out of it yet. @DOCM Point taken re confidence being important to capital flows. Still it is unfortunate that we have a system whereby the ‘confidence’ or lack of it can in a short time cause such devastating problems for economies. It seems that ‘free market’ economies are built on very ephemeral capital flows subject to an illusive feeling of confidence. While Draghi is doing an excellent job, I doubt we will ever see the return of the interbank markets and I hope he is preparing for that. It will take a very brave or foolish banker to lend 10 billion to another bank on a six month basis for a long time to come. In fact the replacement of the interbank system with ECB loans, as Draghi is now doing is the way forward for the banking system. Draghi also seems to understand that despite all the talk of solidarity, the only people likely to invest in sovereign bonds at this time were the banks of the sovereign and he has given them the money to do so. But while the single market may improve the situation, it is unlikely to have much impact in the short term and meantime the unchecked capital flows will continue to wreak havoc throughout the continent. It is a strange way to run economies or societies. Bundesboy, Well spotted. Continuity Or Provisional Irisheconomy.ie?. Should we all go over there and hang out. @Bundesboy Does Prof Whelan allow you to make comments on his new blog? We haven’t been allowed to on this one lately. Complete documentation of the TARGET2-debate: http://www.robertmwuner.de/materialien_euro_literatur_target2.html @ Wolf Great link. Thanks! The interesting development with regard to the Target 2 debate is that it has moved from the plumbing to the house that the plumbing is serving. Wolfgang Munchau’s article – listed in the material linked to by Wolf – moves the process a little further. http://www.spiegel.de/wirtschaft/0,1518,819819,00.html His conclusions; (i) the Target 2 system is simply the payments plumbing and a symptom not a cause (ii) the fundamental problem is a balance of payments one and surplus countries have a responsibility equal to that of deficit countries in resolving it (iii) the idea put forward by Sinn (shared by Weidmann?) of seeking collateral is unrealistic and calls the very existence of the euro into question (iv) Germany has no choice but to stick with the euro (v) the US experience suggest that a fiscal union is an essential element. On the last point, he agrees with Frank Barry and the general academic consensus in relation to what the requirements are for an optimal currency area. The only difficulty with his approach as that this is a completely unrealistic goal, at least in the short term, as far as Europe is concerned. He rather jumps over the question of what is feasible with regard to tackling the balance of payments difficulty. The tedium of the hard slog advocated by Monti is clearly still a problem. But facts are obstinate cf. http://www.number10.gov.uk/news/statement-on-european-council/ It may be noted that Kohl would never have allowed the situation to deteriorate to the point that it has reached. A measure of the capacity of Merkel is her petulant refusal to receive Hollande because he had the temerity to suggest adding a growth strategy to her most recent ‘oeuvre d’art’, the fiscal pact. @DOCM (ii) the fundamental problem is a balance of payments one and surplus countries have a responsibility equal to that of deficit countries in resolving it Keynes singled this out at Bretton Woods as the single most important phenomenon that should underpin international economic relations if economic crises were to be avoided. His views fell on deaf ears at the time. The previous article i posted noted that US-China relations work only because China reinvest a huge portion of their surpluses back into US bonds – who would buy those bonds at those rates otherwise? Surplus countries often do not see the imbalance as their problem. Germany have completely ignored the principles underpinning the single currency concept as enshrined in the Maastricht treaty, especially solidarity of purpose. Instead they are focussed on belatedly trying to finally adopt the recommendations of the 1989 DeLors report – if you haven’t done so, it is well worth looking back on now almost a quarter of a century later – the themes are frightening prescient. @DOCM “(ii) the fundamental problem is a balance of payments one and surplus countries have a responsibility equal to that of deficit countries in resolving it” Keynes singled this out at Bretton Woods as the single most important phenomenon that should underpin international economic relations if economic crises were to be avoided. His views fell on deaf ears at the time. The previous article i posted noted that US-China relations work only because China reinvest a huge portion of their surpluses back into US bonds – who would buy those bonds at those rates otherwise? Surplus countries often do not see the imbalance as their problem. Germany have completely ignored the principles underpinning the single currency concept as enshrined in the Maastricht treaty, especially solidarity of purpose. Instead they are focussed on belatedly trying to finally adopt the recommendations of the 1989 DeLors report – if you haven’t done so, it is well worth looking back on now almost a quarter of a century later – the themes are frightening prescient. “who would buy those bonds at those rates otherwise?” lots of people – at least at slight;y higher rates – surely its the marginal consumer that determines the price – teh end of QE showed us this did it not? @ christy don’t think there is anything between us – i said at “those” rates. Can you quantify ‘slightly higher’ in the counterfactual taking out what is currently 25% of the market for T-bonds @ V Barrett well i’d say the price is not determined by who is the buyer – so maybe somewhere between a few basis points and half a percent on a ten year @ christy by no means an expert in this area but i would have thought the required mobile capital, circa 2% of Global Gdp, is a lot of slack to have be picked for just half a percent @Wolf: useful links, thanks. http://www.voxeu.org/index.php?q=node/7708 Another article by Sinn. Obviously he does not mention earlier criticisms that have refuted his ideas. @Colm O’Leary “If the LTD ratio (Loans to Deposits) was legally required to be 1 minus the capital ratio (as I would imagine was the original intention of a capital requirement) we would never have had any of this crisis.” Really? None of the bubble was funded by overseas deposits that have now disappeared? If my aunt had nuts… @DOCM (summarising Munchau) “(v) the US experience suggest that a fiscal union is an essential element.” One bit I don’t understand about this oft-repeated nugget. The US is a federal system, but state and local arrangements often have a more direct impact on day-to-day activities. The states compete between each other for businesses, they set their own taxes and deliver their own services. They share a common currency and a common transfer mechanism (from richer to poorer states) to grossly simplify, but I do not see dramatic instances of difference between the fiscal setup in the US and that of the EU beyond the size differential of the federal government. Comments are closed.