Monday, June 4, 2012

Marshall Auerback — Two views of the Euro Zone

So why did the founders of the euro fail to establish an exit mechanism for the weaker constituent parts of the eurozone?  For the most cogent explanation, let’s turn to our friend, Greek economist Yanis Varoufakis:
Read the rest at Pinetree Capital | MacroBits
Two views of the Euro Zone
by Marshall Auerback
(h/t Kevin Fathi via email)

Key paragraph:
“To our knowledge, the only one to challenge this benign view was Peter Garber in a 1998 paper on the role of TARGET in a crisis of monetary union (Garber, 1998). The paper insightfully recognized that the federal structure of the Eurosystem and the corresponding continued existence of national central banks with separate individual balance sheets made it possible to imagine a speculative attack within monetary union. According to Garber, the precondition for an attack “must be skepticism that a strong currency national central bank will provide through TARGET unlimited credit in euros to the weak national central banks”. His conclusion is that “as long as some doubt remains about the permanence of Stage III exchange rates, the existence of the currently proposed structure of the ECB and TARGET does not create additional security against the possibility of an attack. Quite the contrary, it creates a perfect mechanism to make an explosive attack on the system”.
Source: “Sudden Stops In The Euro Area”, Silvia Merler and Jean Pisani-Ferry, (Bruegel Policy Contribution, March 2012)

35 comments:

Ramanan said...

Very interesting paper by Peter Garber from 1998!

The documents from ECB indeed say that the NCBs and the ECB have unlimited and uncollateralized overdraft facility at each other. The article/paper seem to suggest it was done highly consciously (okay, lack of words).

Ramanan said...

There's another interesting article called "It Can't Happen, It's A Bad Idea, It Won't Last - U.S. Economists On The EMU And The Euro, 1989-2002"
on the Euro

Tom Hickey said...

Ramanan: "The documents from ECB indeed say that the NCBs and the ECB have unlimited and uncollateralized overdraft facility at each other."

But an ECB LLR function seems to be precluded. So a liquidity crisis got turned into a solvency crisis?

Tom Hickey said...

Thanks, Ramanan. Here's a link to "It Can't Happen, It's A Bad Idea, It Won't Last - U.S. Economists On The EMU And The Euro, 1989-2002"
http://econjwatch.org/articles/the-euro-it-happened-its-not-reversible-so-make-it-work

Dan Kervick said...

So why did the founders of the euro fail to establish an exit mechanism for the weaker constituent parts of the eurozone? For the most cogent explanation, let’s turn to our friend, Greek economist Yanis Varoufakis:

It's the Hotel Eurofornia. You can check in any time you want, but you can never leave.

Ramanan said...

Tom,

Thanks for the link. Interesting references in that paper which I once thought will read but forgot about it.

Yes the ECB LLR is missing but a few years back when trying to figure out the Eurosystem, I was shocked to find this at the ECB website about TARGET (although it made a lot of sense):

“The ECB and each of the NCBs shall open an inter-NCB account on their books for each of the other NCBs and for the ECB. In support of entries made on any inter-NCB account, each NCB and the ECB shall grant one another an unlimited and uncollateralized credit facility.”

“To effect a cross-border payment, the sending NCB/ECB shall credit the inter-NCB account of the receiving NCB/ECB held at the sending NCB/ECB; the receiving NCB/ECB shall debit the inter-NCB account of the sending NCB/ECB held at the receiving NCB/ECB”

The Garber paper seems to give a background on this - at least looks like on a cursory look. ("VSTTF" etc)

I think Garber is not aware of the unlimited overdrafts of NCBs although in recent articles he got it. He seems to be thinking that creditor nations' NCBs will stop providing TARGET credit to debtor nations' NCBs which isn't right.

The 1998 paper is "Notes On The Role Of TARGET In A Stage III Crisis". If I link, the spam filter will block me :)

Tom Hickey said...

NBER Working Papers by Peter M. Garber

JKH said...

LTROs shouldn’t be expected to stop or slow down deposit runs.

E.g.

LTROs change the form of financing from the ECB/Greek central bank to the Greek commercial banks – short term replaced by long term.

But they don’t change the TARGET liability of the Greek central bank.

And they don’t change or displace private sector deposit liabilities of Greek commercial banks, and therefore they don’t reduce the run exposure.

But the point is certainly correct that TARGET is a natural operational facilitator for bank runs.

Ramanan said...

JKH,

I think the LTRO does change the TARGET liability of the NCBs indirectly.

As Mario Draghi has mentioned in many of his press conferences, banks used the funds advanced from the two big LTROs to pay off their liabilities to their debt holders (who could be abroad).

So a bank takes advance from LTRO then as some short term liability matures, instead of rolling over, they sell assets (i.e pay by reserves they get from LTRO) instead of refinancing them. So this leaks reserves to creditor nations and increases the TARGET liability of debtor nations' NCB.

JKH said...

Ramanan,

The inference of the post is that one might expect the availability of LTRO to improve the TARGET liability position, not that it should deteriorate further. In your example, it deteriorates further.

Also, I suggested that LTRO simply replaces short term RO. And that is the case in your example.

E.g. a Greek commercial bank loses reserves (asset) and debt funding (liability) as a result of a debt maturity that is held by a foreigner and not rolled over by that foreigner. The Greek central bank loses reserves as “funding” but “refunds” that position by increasing the size of its TARGET liability to the ECB.

The Greek commercial bank is nevertheless “flat” from a nominal balance sheet perspective. It has lost reserves and funding. The question is whether or not it needs more reserves. If it needs more reserves, it can get them through either LTRO or short term RO. LTRO is an alternative to short term RO in this respect, but LTRO does nothing to alleviate TARGET exposure as implied (as an expectation) in the post. And this is proven in your example by the fact that TARGET deteriorates notwithstanding LTRO. Also, that deterioration is not “caused” by LTRO availability any more than a coincidental improvement in the TARGET position would be “caused” by LTRO. LTRO is an asymmetric and neutral influence on TARGET exposure.

Please forward this to Draghi so that he may respond to it.

:)

JKH said...

Ramanan,

"LTRO is an asymmetric and neutral influence on TARGET exposure."

don't know why I added that in there; ignore it

Ramanan said...

JKH,

Agreed.

I was actually thinking of situations in which a bank decides to take LTRO instead of trying to refinance say a 3y bond from the markets - abroad but within the EA - by paying a higher because the former is the easy way out. (Refinancing it via the marginal lending facility is a bit of a pain because it needs to be done daily).

"LTRO is an alternative to short term RO in this respect, but LTRO does nothing to alleviate TARGET exposure as implied (as an expectation) in the post"

Yeah realize the point of your first comment.

Ramanan said...

Someone sent me a link on my blog.

He has collected all the links on Target:

http://www.robertmwuner.de/materialien_euro_literatur_target2.html

JKH said...

Good link, thx.

Re subject here:

Put another way, whether or not a Greek commercial bank needs more reserves as a result of losing a funding liability is somewhat separate from the question of whether or not its central bank will incur a TARGET liability as a result of the funding in question being lost to a foreigner. Similarly, whether or not a Greek commercial bank chooses to fund new reserves through LTRO or short term RO is somewhat independent of the question of whether or not its central bank has incurred a TARGET liability as a result of the previous funding in question being lost to a foreigner.

Ramanan said...

JKH,

Say that again ... as in rephrase ...?

JKH said...

R,

another version:

LTROs provide funding for commercial banks.

They don't provide funding for central banks (i.e. NCBs)

So they don't replace TARGET funding

Ramanan said...

JKH,

June 5, 2012 7:39 PM was too fast and June 5, 2012 9:33 PM was too slow :)

I think what you mean is that the original post seems to suggest that ECB did the LTRO with the intention of improving the TARGET balances of the NCBs but that wasn't their intention.

The ECB would have known that its action could change TARGET2 liabilities in either direction.

Is that right?

JKH said...

R.,


The degree to which I’m not making myself clear almost certainly indicates I’m not clear myself on what it is I think I’m trying to say.

:)

But, let me try “cruising speed”:

Suppose a Greek commercial bank loses a deposit to a German commercial bank.

That immediately creates a Greek central bank TARGET liability and a German central bank TARGET asset.

So, define that situation as a “problem” that manifests itself in capital flight – due to concerns about the Greek banking system, concerns about Greece remaining in the Euro, etc. etc.

What I’m saying (I think / I hope) is that there is no reason at an operational level for us to expect that LTRO as a long term refinancing operation as it applies specifically to Greek banks will be any sort of “solution” to that problem – particularly at the operational level.

Why would it be? The only thing it resolves potentially is to act as a source of funding for the Greek bank IF it needs more reserves as a result of that capital flight. (It may already have reserves available from other sources.)

IF the Greek bank needs reserves, then it must repo collateral with the Greek central bank (operationally) in order to obtain the funding and the reserves that come with it.

And in that sense, LTRO is an alternative for short term RO.

But that is exactly the situation that the Greek bank would be in if the original deposit had been withdrawn and gone to another stronger bank in Greece, in which case there would be no effect on TARGET.

Now, if you want to say that the introduction of LTRO would somehow increase the confidence of the Greek depositor in the Greek banking system, and forestall capital outflows that way, that is a different argument. I’m focusing on the operational perspective. That said, I’m not sure why central banking LTRO would suddenly be a confidence booster for the Greek depositor who is worried about the overall trend of things and the possibility that his Euro might be converted into new Greek currency and devalued from there.

JKH said...

I should have referenced this earlier - the pertinent reference in the post:

"We have all wondered what triggered the two LTROs. It may be that when the deposit run spread to Italy and Spain in the second half of 2011 the ECB was provoked to take these measures.

Based on all the data we have on the ECB lender of last resort financing of these five peripheral European countries, the deposit run has accelerated despite the LTROs."

My point being, that I see no reason why LTRO introduction should have been expected to forestall a deposit run, according to my operational interpretations above.

And I think any strategic benefit interpretation would have been quite wobbly as I just noted in my previous comment also.

Ramanan said...

JKH,

I think it wasn't just the two 3y LTROs but also that the ECB relaxed the standards for collateral for them such as on ABS and they also were allowing banks to just pledge plain vanilla loans (satisfying some requirements) as collateral.

Also around the time, they also decreased the reserve requirements from 2% to 1% which frees up some reserves which can be used elsewhere.

The refinancing with the Eurosystem is better compared to other sources because the interbank market was effectively shut for both secured and unsecured funding for some banks. So banks could fund themselves at their NCBs by giving collateral which would not have been accepted by private markets. Also government bonds. I don't know what the haircuts for government bonds in private markets were/are but I would imagine that the ECB's standard is more relaxed compared to private markets on haircuts.

Also since there is a shortage of funds in the debtor nations, foreigners have to be necessarily relied on - there is a limit to which residents can be relied to fund (for example Australian banks fund a lot from abroad).

But that still leaves LTRO with the usage of marginal lending facility.

In some of the Fed's articles it is stressed that somehow banks prefer to avoid the discount window and hence they had facilities which were aimed directly at the banks during the crisis. Maybe the same is true for banks in the Euro Area who may not want to go to the marginal lending facility daily.

But even without using the above moral suasion argument, IMO the LTROs helped (of course it is not the solution for everything). Once banks are able to pay their lenders by borrowing from their NCB, the credit markets ease because CDSs drop and hence equities/debt markets also improve which prevents liquidation of assets in the debtor countries preventing flight out of these nations and as a result helping the banks.

I understand that LTRO by itself (except relaxing collateral standards which would have been applicable for short term borrowing as well) is similar to simply lending via the marginal lending facility.

Maybe one can argue that it removes some uncertainty. Banks do not know in advance how much outflows there may be and may try to sell assets in advance in panic - because they are unsure as to how much collateral they may be left with - with which they may have to borrow from the NCB.

I actually found this questionable:

"So why haven’t the ECB and EU authorities acted again, and more forcefully, to stop the deposit run?"

In my opinion, the ECB has been trying hard. If the hidden message in the above quote from the original article was to ask the ECB to announce more rounds of government bond purchase or "distribute $2T on a per-capita basis" :) then it provokes me. The ECB is not such an institution. That is to be decided by a large number of people - preferably a few institutions with fiscal powers and such decisions are based on many factors such as what the wages policy will be etc not some random $2T drop.

Okay the last part was slightly beside the point.

The argument I have for LTRO versus Marginal Lending Facility is that the latter involves uncertainty on part of banks who may be forced to sell assets in advance leading to a panic in broader markets.

Of course the ECB would not have expected it to solve all problems (didn't pretend either) but it was trying hard so it doesn't help to critique the ECB saying that "the deposit run has accelerated despite the LTROs." (as in the original article).

So I think I agree with you about the somewhat on your points on the original quote in the article but from a slightly different perspective.

Ramanan said...

Hmm ... probably said some vague things about LTRO vesus short term borrowing from the Eurosystem, so ignore - although I think I am less vague about changing the collateral standards before the LTRO.

Ramanan said...

I guess I should have said it like this:

A Euro Area bank may use the marginal lending facility in extreme emergency and from the Eurosystem there is no limit to the usage as the monetary policy documentation shows. However a bank also needs unsecured funding and since in such scenarios liquidity is a big issue, lenders may also want to know or get to know the borrowing bank's liquidity. Else the lender is not sure if the borrower bank has adequate collateral to be presented to the Eurosystem when payment comes due and other source of payment is not available.

When LTRO is done and the results are out, everyone knows that the liquidity is good. Also individual banks can try to boast that they have sufficient reserves (by declaring how much they have) instead of just claiming they have collateral for recourse to the marginal lending facility. This leads to opening up of an interbank market which was effectively shut down.

JKH said...

R.,

I think your general point is that LRTO improves domestic liquidity conditions, which I agree with.

My point is that an LTRO operation has no operational effect on TARGET balances. TARGET balance improvement requires international (including intra-European) capital inflows. LTRO is not a private international capital inflow.

However, if LTROS by improving domestic liquidity conditions have the knock on effect of improving international confidence in a particular domestic Euro market (e.g. Greece), then capital inflows and TARGET balancing might be improved at the margin. I think that might be a point you are making implicitly, which I also agree with.

Ramanan said...

JKH,

Yeah by LTRO is done by NCBs with domestic banks and hence is a transaction between residents and hence has no effect on TARGET.

"However, if LTROS by improving domestic liquidity conditions have the knock on effect of improving international confidence in a particular domestic Euro market (e.g. Greece), then capital inflows and TARGET balancing might be improved at the margin. I think that might be a point you are making implicitly, which I also agree with."

Yeah that's what I meant.

JKH said...

R.,

Can you make sense out of this -

"The Target 2 balances understate the extent of the run, as the ECB somehow finances ELA claims on periphery banks and ECB repos have to some degree financed deposit runs from these banks as well."

from:

http://www.nakedcapitalism.com/2012/06/marshall-auerback-beware-german-trojan-horses-more-europe-might-mean-more-fiscal-austerity.html

Ramanan said...

JKH,

Yes, I don't think it understates it.

In fact these (ELA and increase in TARGET2 liabilities) are simultaneous when there is a cross-border outflow.

So if there is a large outflow from a nation during a day: at the first instance banks would go into an intraday overdraft at their NCB. At the end of the day, the NCB may realize that banks do not have sufficient collateral and hence may be force to do an ELA where banks may be required to get some government guarantees.

The idea that there may be capital outflow which is understated may be true although this has nothing to do with ELA directly.

Can you see page 35 here (page 36 in the pdf)?

http://www.ecb.int/pub/pdf/mobu/mb201110en.pdf

You have to filter out the downplay by the ECB in that doc!

This is because payment systems may not necessarily go through TARGET2 and can be an internal flow of funds between subsidiaries.

I doubt if someone has looked at the data and analyzed - how small or large this is can be seen by looking the item "Other Investment" in the balance of payments although a statistical analysis may be needed instead of just looking at the numbers.

Ramanan said...

One can however combine these two ideas into something.

Say a nonresident liquidates Greek securities and repatriates funds. At first instance, this involves the transfer of funds between the buyer of the securities and his bank's affiliate in Greece. This leads to Greek banks going into ELA when they run out of collateral - in which case the government has to step in and issue promissory notes to banks which can be given as collateral to the Greek NCB. The branch in Greece of this foreign bank will settle via TARGET2 but no cross border movement is involved at this stage.

Once this happens, there is a movement of funds is between the Greek branch of this foreign bank and home branch which doesn't flow via TARGET2 and hence doesn't increase the TARGET2 liability of the Greek NCB.

Ramanan said...

"At first instance, this involves the transfer of funds between the buyer of the securities and his bank's affiliate in Greece"

Sorry meant transfer of funds between the buyer's (of the securities) bank and the seller's bank's affiliate in Greece.

Ramanan said...

So to summarize TARGET2 liabilities of NCBs may actually understate the amount of capital flight.

Ramanan said...

Damn .. so much hodgepodge in my comments and claims.

I think it is true that TARGET2 may understate the capital flight. It is also true that ELA is related to this indirectly because of arguments given.

JKH said...

R.,

The way I see it ELA, LTRO, and short term RO are all just functional alternatives that have the same monetary effect.

ELA just involves different collateral requirements (maybe) and different risk/loss sharing arrangements vis a vis the Euro system share structure (definitely).

So ELA is no different than the other two in terms of its basic monetary functionality.

And it’s no different therefore in terms of its functional relationship to TARGET.

So what I wrote before holds.

There’s no operational connection.

It’s the same category of “error” in the post. The same conclusion holds.

So I agree with your initial comment:

“So if there is a large outflow from a nation during a day: at the first instance banks would go into an intraday overdraft at their NCB. At the end of the day, the NCB may realize that banks do not have sufficient collateral and hence may be force to do an ELA where banks may be required to get some government guarantees. The idea that there may be capital outflow which is understated may be true although this has nothing to do with ELA directly.”

Regarding your banking example:

I’d say that the transaction of a Greek depositor with a German bank subsidiary who requests that his deposit be redomiciled with the German bank parent of that subsidiary will have no net effect on TARGET. From an international capital account perspective, the capital outflow represented by the deposit will be offset by a capital inflow represented by funds advanced from the parent to the subsidiary (to offset the transfer out). It is all internal, and therefore does not impact TARGET, but that’s consistent with the fact that there is NO net capital outflow (or bank run in that sense).

Similarly, I’d say that the transaction of a Greek depositor with any bank in Greece who transfers his deposit to the subsidiary of a German bank in Greece will have no net effect on TARGET. From an international capital account perspective, there is no capital outflow. And the inter-bank clearing occurs within the sphere of the Greek central bank. There is no bank run out of Greece in that sense.

BUT, the transaction of a Greek depositor with any bank in Greece who transfers his deposit to any bank in Germany (other than the parent bank for the existing deposit) WILL have a net effect on TARGET. From an international capital account perspective, there is definitely a net capital outflow. And there is clearing of funds through TARGET.

So it is all consistent:

TARGET captures all net private capital outflows by offsetting them with net “public” capital inflows.

Ramanan said...

JKH,

Yes generally agree.

In the example I have there is an outflow matched by an inflow as you said. My stress was that there is a gross outflow so worsens the situation in Greece. So even though the transaction doesn't change the financial account balance, it is bad for Greece.

While operationally the things not related are not related, my point was that as story these things become related.

Regarding TARGET, one way to look at it is using

CAB + KAB + OSA = 0

where OSA is the official settlement account and TARGET in this case.

In the German bank example, CAB = 0, KAB = 0 and OSA = 0

While in another case, KAB is balanced by OSA.

The statement "The Target 2 balances understate the extent of the run, as the ECB somehow finances ELA claims on periphery banks and ECB repos have to some degree financed deposit runs from these banks as well." which you quoted from NakedC

seems to suggest that somehow ELA directly leads to a lessening of TARGET balances or something of that sort - which is not right because ELA itself is a transaction between residents and doesn't affect TARGET.

.. which reminds me - a lot of times I have seen MMTers say that the ECB is involved in transactions in which it is not actually involved. I remember a lot of times it is said around here that if a government bond is purchased, the NCB and the ECB have some sort of transaction which is not fully correct because if only residents purchase domestic government bonds in an auction, the ECB is not involved.

Ramanan said...

Here for example - probably in the same category as you point:

http://www.levyinstitute.org/pubs/hili_113a.pdf (page 4)

"The problem with the eurozone is that each nation gave up its sovereign currency in favor of the euro. National central banks have to get euro reserves at the European Central Bank (ECB) for clearing purposes, and the ECB in turn is prohibited from buying the public debt of governments. This is similar to the situation of individual U.S. states, which, along with the euro nations, need to tax or borrow in order to spend."

JKH said...

Some confusion may result from people not fully recognizing or understanding that the TARGET system is a clearing system for NCB reserves.

As such, TARGET surplus and deficit balances can be viewed as long and short positions in "the money" that is used to clear CB reserves.

BUT, "the money" in this case is NOT normal central bank money. "The money" that is manifested in a TARGET long position in particular - e.g. the Bundesbank long position is NOT NCB reserve money.

It might be categorized conceptually as something like "super-central reserves".

The relationship of bank reserves to TARGET long balances is "isomorphic" to the relationship between commercial bank deposit liabilities to bank reserves.

Bank reserves are used to clear commercial bank deposit balances.

TARGET balances are used to clear NCB reserves.

Both types of clearing can be viewed as the settling of bank liabilities - commercial and central respectively.

TARGET money is yet one step higher on the “hierarchy” of the general idea of money than bank reserves.

(I don’t mind using the term “hierarchy”.)

:)

Haven’t seen this explained elsewhere in quite this way. Have you?

Ramanan said...

Yeah that's the way I imagine too sometimes. Haven't seen it explained it that way though anywhere.