Wednesday, October 3, 2012

What if the dollar loses its reserve status?


Ramanan said...

"That's the only way the rest of the world to get down to zero dollar holdings ... goods that American workers made"

Not right.

Take a simple case. The rest of the world acquires $1.2897 starting from zero by selling goods to the United States.

It can get rid of it with an American bank (or any other sector) getting into debt denominated in Euro as a result of a transaction.

American net indebtedness reduces by $1.2897 and increases by €1.00 and the rest of the world dollar assets decreases by $1.2897 (and goes back to zero) and increases by €1.00.

Ignacio said...

Oil is the big question here yes. Is the fundamental problem beyond any 'reserve currency' or 'balanced trade' discussion.

That's why its of utter importance to abandon an economy based on oil and carbon based fuels ASAP. If this does not happen the world will end falling off a cliff in a few decades. Every path should be explored right now to accomplish that objective via funding, this should be a first priority.

And the proof about this is that is a top concern for most militaries worldwide.

Unknown said...

Take a simple case: yes and just stay there, because it is a simple-minded case. It will not extrapolate into the real world. And realism was really the thrust of Mike's point.

mike norman said...


Yes, world dollar assets decrease by $1.2897. That was my point.

Matt Franko said...

Ramanan said...
This comment has been removed by the author.
Ramanan said...

And United States' liabilities in Euro increases.

Matt Franko said...


Is this what is meant by "double entry accounting"?


JKH said...

Current account deficits are useful for exporting the reserve currency and current account surpluses are useful in accumulating it. It certainly suits the empirical story for the US situation.

I suppose in theory a reserve currency could be made available to the rest of the world as a result of private sector capital outflows from the currency issuing nation, with the capital importer accumulating reserves as a result of central bank FX transactions with its private sector. E.g. China could accumulate dollar reserves by importing private dollar capital flows instead of exporting goods and services.

But the supporting dollar outflows would have to be cool (e.g. FDI) rather than hot money in order to provide reasonably assured backing for reserves in the rest of the world. That’s an accepted part of liquidity management in banking, for example, where longer term funding can support a liquid asset portfolio.

That said, a world of tranquil current account imbalances would probably require lower levels of reserves. One goes with the other. Maybe a good question is what becomes the criterion of choice for a reserve currency if the world’s current account balances become more matched somewhere down the road.

Ryan Harris said...

Europeans, Asians, Indians and others all are making plans to import cheap American natural gas while several US distribution companies are trying to get the DOE to allow more exports. Currently only one terminal run by Cheniere and a second one being built are permitted to export. But many more would like to.

If the DOE allows exports from more facilities, it would create a big change to our balance of payments and maybe the biggest threat to the reserve status of the US Dollar. Each of the Natural Gas Terminals being built and permitted can export an amount equivalent to about, maybe 5 ~ 10% of our trade deficit at capacity depending on price, of course. And we have huge amounts of gas that could be exported for a very long time quite profitably. Combine this with our rapidly rising self sufficiency in crude oil, and it isn't too far fetched to imagine that the United States no longer provides the world with a steady and growing supply of dollars within a decade or so through trade deficits. When the US doesn't meet the needs for savings, reserves, collateral and trade, the mercantilist nations will simply use and accumulate reserves from other countries.

At least that is what I was thinking for the medium term.

Sort of speculative but if the Republicans take control they probably won't allow the exports for "national security" reasons. Democrats however are controlled by the unions that that work for energy companies directly and indirectly manufacturing equipment. So long as it doesn't rile up the enviro base on the east and west coasts, the Dems will allow more development because they have strong support on this issue from the swing states, like Ohio, Colorado and Michigan.

Ramanan said...


"Is this what is meant by "double entry accounting"?"


Ramanan said...


Yes FDI is one route. The Indian PM (great man) recently removed some caps on FDI recently because its exports slowed and imports rose faster if you are thinking of such situations.

Btw ...unrelated to this: There was an article recently on The Guardian on TARGET2:

The author tweeted:

"My column on why Target 2 really does matter, despite what Paul De Grauwe says"

Ramanan said...

Sorry that was The Telegraph.

JKH said...

good article, R.!

Ryan Harris said...
This comment has been removed by the author.
Matias Vernengo said...

Not a chance of that happening anytime soon. Dollars are used because the key commodities (oil) are priced in dollars (Cartalism), not because of confidence (Mettalism). See on this topic the paper linked here

Matt Franko said...


"And United States' liabilities in Euro increases"

Isnt this just the "other side" of the transaction?

Also, as far as US entities borrowing in foreign currencies enough to offset the current foreign USD reserves... this chart looks like perhaps an approximation of how many foreign USD reserves are out:

You can see that just between China and Japan, they have about $2.5T. Is it reasonable to think that some US bank or Non-Fncl Corp could go over there and borrow the foreign currency equivalent of $2.5T from these 2 countries? rsp,

Jose Guilherme said...

Just read the Telegraph's article on TARGET2, cited by Ramanan.

The author mentions Germany as being on the hook for financing of current account deficits of the south and for the massive transfers of deposits from the periphery to core Europe.

But he fails to mention the third element for which Germany and the other surplus countries will also be on the line, via TARGET2.

That will be the financing of the budget deficits of the PIIGS - as soon as one or several of their governments wants it.

A PIIGS' government could simply order a loan and place government bonds as assets on the balance of a government-owned commercial bank. Then transfer the corresponding deposit to pay up a maturing bond held in, say,Germany by a German commercial bank. Then, at the end of the day, the creditor will be satisfied - and the debt will show up as a debit of the NCB of the periphery country and a credit on the balance of the Bundesbank.

Repeat this every time a bond matures abroad and "voilà", the periphery country has recaptured monetary sovereignty without leaving the euro.

There is nothing that Germany or the ECB can do about it except perhaps for trying to expel that country from the eurozone. Oh, wait, it's not possible - expulsion is not allowed under the treaties, since the euro is supposed to last forever.

There you have it. The eurozone is a prison not only for debtors. The creditors/guards cannot leave the prison's premises either.

It's up to the periphery governments' to start using the prison's own rules for their benefit. Escape from austerity now, thanks to TARGET2! This should be the war cry coming from the PIIGS from this moment on.

And, you know, it'll be lots of fun to watch.

Anonymous said...

I have a slight problem with MMT's argument about imports being worth the dollar price that we pay for those goods and that increasing the access to real goods is equal to the value loss in dollars.

Domestic goods have the cost value captured in the domestic currency in the pricing of the domestically sourced inputs but imported goods do not have the cost value captured in the equal amount of dollars so the price of the imports only reflects the amount of dollars the seller is willing to accept rather than real and necessary cost in dollars.

Those dollars are lost to the domestic sector rather "re-used" to pay for inputs which destroys the domestic pricing mechanism for the inputs market (i.e. labor) because you are gaining real goods from foreign countries which compete with domestic goods but have no dollar cost in terms of the real inputs.

I believe this traditionally called demand leakage and the typical MMT/Keyesian solution in order maintain free trade is have deficit spending to offset the loss of dollars.

However, I have my biggest problem with MMT in claiming that this solution of increasing spending will fix the problem.

Dollars drained by the imports affect the velocity of the money in the domestic producing sectors and government has no means to calculate those value changes for the domestic sector inputs by simply increase deficit spending because the drains reflect good specific real costs and the government can't track displacement of domestic sales produced by each imported good in real terms.

The input valuation mechanism is destroyed because large amount of importation is essentially adding the labor standards and inputs pricing structure of another country to your domestic market and you can't have that same information. The only choice is to tax imported goods i.e. tariffs.

I believe this the reason that Kudlow's growth laws reflect the universal historical fact that all developed coutries developed under a protectionist system built around manufacturing and that all imperial importation based economies collapsed.

MMT's flaw is the assuming that (X – M) offset each other in correctly reflecting equal input cost in the market sale price but they do not because the cost inputs of one aren't in dollars therefore trade deficit accounting doesn't reflect real costs thus overstates real gains.

I would also make an environmental argument as to evidence for this fact but I believe every one here is aware of the environmental situation so I won't beat that dead horse.

JKH said...

Jose G.,

That’s true, although the specific “advantage” due to TARGET2 has to do with the refunding of existing debt, not new budget deficits. TARGET2 is the default channel for capital outflows that repay that debt when the foreign holders don’t renew it. The failure of foreign bond holders to roll over their holdings is a type of private capital flight in that sense. That form of capital flight is limited to repayment of the existing foreign held debt – not to new deficits. (You sort of said that but seemed to hint at more than that).

Matt Franko said...


furthermore, would not the foreign lender require the borrower to have local collateral for the loan?


Matt Franko said...


Agree, it's like the M in (X-M) is a quantity based on a manipulated currency exchange rate.

imo, if we didnt import this "cheap stuff", we would be domestically producing "more expensive stuff" and this probably has sig contributed to the change in wealth distribution over the last decades... can fiscal really adjust for this? I guess perhaps...


paul meli said...

"can fiscal really adjust for this? I guess perhaps..."

Maybe, but I don't like how it's worked out for us.

Matt Franko said...

But Paul I would point out that fiscal policy has not been conducted with this phenom in view... so perhpas if we had a HUGE bottom up tax cut/rebates, a lot of this inequality in financial outcomes could be averted.... rsp,

Unknown said...

Iraq started selling its oil in euros in 2000. The US invaded them and made them sell it in dollars again.

paul meli said...

Matt, true but ultimately those dollars would end up in the possession of those at the top if only our taxes are cut. Their taxes must be raised at the same time.

In the (distant) past we had a more fair tax code and profits accrued to wages as well as capital.

Personally, it doesn't matter to me how much wealth rich folks have, only that they can afford to buy anything and anyone.

By permitting them to have massive wealth we are undermining our own power.

Jose Guilherme said...


You're right that it's only for refunding of existing debt and only for the part held abroad - which btw may be 50% of outstanding debt or more, meaning that by itself the process could spare governments from going to the markets to roll over maturing debt for many, many years to come.

But then consider how the foreign creditor - paid with no fuss year after year every time a periphery bond matures - will react.

For said creditor it will mean the periphery bonds have become risk-free for all practical purposes. So he will be willing to lend again to the periphery government at very low rates.

And the government has thus managed to escape from the troika's (ECB/EC/IMF) stranglehold and from their austerity policies that prevent the economy from growing.

paul meli said...


This is a fascinating argument that I've never seen anywhere else. Please keep making it, until someone finds a flaw, if ever.

JKH is probably the guy to find something if it's there.

JKH said...


Some interconnections I see among your points:

The foreign bond holder gets repaid if the periphery government is capable of repaying it. This basic credit risk aspect is unaffected directly by TARGET2.

TARGET2 clearing doesn’t imply that the foreign creditor still gets paid if the specific counterparty (a periphery government) can’t pay. It means that if the counterparty peripheral government DOES repay, but the foreign lender chooses NOT to renew, there’s no resulting cross border banking system risk to the periphery nation. In other words, the fact that the foreign lender stops refunding the periphery government doesn’t mean that the periphery nation stops getting funded at the macro level. An equivalent size cross border capital flow will still occur by default at the macro level – but via foreign public sector TARGET2, rather than via foreign private sector funding of periphery government debt.

If foreign bond holders are paid off and choose not to renew, periphery governments must refund domestically. Ironically, or so it seems, with this, periphery reliance on TARGET2 funding actually increases at the macro level, as per above. Conversely, if foreign bond holders choose to refund the debt, TARGET2 positions remain unchanged from before.

Separately, ECB purchases of periphery debt may well improve credit risk perceptions, which may encourage continued foreign funding of periphery debt. I think that may be more to your point. But that’s quite a different issue than any associated TARGET2 mechanics. TARGET2 itself won’t cause foreign bond buyers to re-evaluate credit risk. Bond repayments still depend on counterparty credit risk, not TARGET2 mechanics.

I covered this sort of thing in some detail here:

(Intentionally comprehensive, intentionally lengthy, and therefore unintentionally annoying to some)


Mosler claims that the ECB’s newly committed involvement in sovereign bond buying takes insolvency risk off the table. I disagree. The ECB still requires fiscal conditionality. That means, in effect, it won’t allow an outright assumption of insolvency by the market or by periphery governments, since that carries the moral hazard potential (ECB style) to release peripheral governments from their fiscal commitments. Mosler’s assumption would be correct if Mosler was running the ECB, but Draghi is instead.

P.P. S.

I thought the Telegraph article was really quite good. Certainly no journalist on the other side of the Atlantic could have written something like that, although I guess that’s understandable. Of course, my paper above largely agrees with the article’s point of view. There is one minor point in the Telegraph article I do disagree with, although it is highly technical, so I’ll defer on it for now (but it’s in my paper).

JKH said...

above, should have said something more like:

"That means, in effect, it won’t allow an unqualified assumption of solvency by the market or by periphery governments"

Jose Guilherme said...


"The foreign bond holder gets repaid if the periphery government is capable of repaying it."

The periphery government will always be capable of repaying if it is the owner (single shareholder) of a commercial bank.

That is precisely the case with many if not most periphery countries.

The periphery government may simply order its bank to provide it with a loan. The corresponding new government deposit is then transferred abroad to pay for a maturing bond held by a foreign bank - say, Deutsche Bank.

At the end of the day, the Target2 software will have generated:

1. An advance from the periphery NCB to the government-owned commercial bank (replacing the initial government deposit as a liability on the bank's books)

2. A "due to" of the NCB to ESCB (European System of Central Banks).

3. An advance of the Bundesbank to the Deutsche Bank as a liability on this bank's books (to drain the excess reserves that resulted from the periphery bond's payment at maturity).

4. A "due from" the ESCB as an asset of the Bundesbank.

5. A "due from" the NCB and a "due to" the Bundesbank as, respectively, an asset and a liability of the European Central Bank.

So the whole process of regaining monetary sovereignty via TARGET2 depends on the periphery government owning a commercial bank, that will be "forced" to buy the T-bonds of the shareholder.

A simple act of political will.

Ironically, this will also provide a nice spread for the government-owned bank. Say the government offers a coupon at 3% annually. The bank will have, at the end of the day, a liability to the NCB at a much lower rate. It's 0.75% at present.

It will thus gain a 2.25% spread.

All neat and clean, and there is not much the ECB can do about it, because messing around with TARGET2 means endangering the eurozone as a currency area where all cross-border payments between banks must take place smoothly. That's what irrevocably unifying the former national currencies means.

So, I have just one question:

Why doesn't a periphery government start using this mechanism in its own and its population's benefit - tomorrow morning?

Jose Guilherme said...


Thanks for your support.

I find it almost unbelievable that in a world full of highly paid experts no one has yet noticed apart from a few specialists who've uncovered the matter only to leave it almost buried inside a couple of paragraphs of their lengthy technical papers) a major - yet inevitable - loophole in Target2 that allows the periphery to escape its current predicament at the hands of a sadistic "core Europe".

Ramanan said...


My comment was aimed at the frequently said points that foreigners as a whole cannot redeem assets denominated in the domestic currency by purchases of goods and services from residents and that this can only help the resident economy. My example was to point that it isn't true - at least the first part. The second part is also not true but won't discuss here.

I wanted to write more but I have been sick since yesterday and can't even open my eyes properly (but I didn't miss seeing Indian stocks having a flash crash live!) so let us discuss this further later. (Anyway we keep discussing such things)

Ramanan said...

"as a whole cannot"

should read "as a whole can only"

JKH said...


OK, I think I see more clearly what you’re saying about domestic monetary operations, (which is analytically separate from the issue of international TARGET2 operations).

I think what you’re proposing in effect is similar to what would happen if the periphery government somehow retook strategic control of its national central bank and began to monetize its debt that way. In your proposal, it’s using a government owned commercial bank for a similar operational purpose. The deficit is “money financed” either way. And the government owned commercial bank is providing an LLR function similar to what it’s denied in the NCB arrangement. Its arbitraging away the usual central bank prohibition on money financed deficits.

Your additional argument is that the core nations would continue to buy peripheral bonds on the basis (implicitly) that the peripheral government owned bank will always make a market in them (i.e. buy them at least). That’s another assumption, somewhat risky, but not unreasonable given your assumption about what the government owned bank can do in the first place. Given both those assumptions together, the TARGET2 issue becomes moot. It’s a sideshow anyway; as I said, it has nothing directly to do with whether or not foreign holders of peripheral government bonds get paid.

(BTW, the TARGET2 accounting you describe in your last is fairly standard. But one of your steps (# 3) is opposite to what occurs. If a German bondholder gets paid at maturity, there is a reserve credit to the German bank via TARGET2. The Bundesbank would subsequently be draining reserves in that case, not supplying them as in your example. And the German commercial bank would be repaying MRO liabilities to the Bundesbank in that case, not assuming them. That in fact is what has been happening to German balance sheets all along during the TARGET2 balance buildup. This is the German domestic reserve draining function that follows the German system reserve liability increase (and TARGET2 asset creation) on Bundesbank books, due to the bond repayment. This is a point I made in my paper - in that people sometimes conflate or mix up the international TARGET2 reserve transfer function with the follow up domestic reserve add and reserve drain functions at each end of the TARGET2 transfer. One is an international transaction. The other two are domestic rebalancing functions.)

I don’t know the answer to your question as to why the peripheral government wouldn’t do that. But I suspect there must be something in the Treaty or somewhere that precludes them doing that and remaining in the Euro. And as a result I’d expect that the ECB would simply shut down the Euro reserve account of such a peripheral government owned bank at the NCB in short order, or threaten to do so, if the peripheral government attempted that sort of LLR function. In effect, they’d be kicked out of the Euro for failing to adhere to the law that governs the ECB and NCB Eurozone configuration. But I don’t know exactly what the legal argument would be.

It’s an interesting question overall, and I’d also be interested in the answer from the legal perspective. You would think that something beyond a handshake must be preventing it. I have this feeling that there is an obvious legal answer to this, but I can’t think of it right now.

Jose Guilherme said...


I know it’s tedious, but we’ll have to go through the accounting entries at the Bundesbank and Deutsche Bank, so that you I may demonstrate that the process can be implemented – and that there is no contradiction between my point 3 in the previous post and what you say.

Let’s imagine it all concerns Germany and Portugal, a periphery country whose government really owns (100% shareholder) a commercial bank.

The Portuguese government starts the process by ordering his bank to provide it with a new loan, using the corresponding deposit to pay off a maturing Portuguese T-bond held by Deutsche Bank.

(What follows is a description of the ending position, at each step, on the books of the several participants in the process, including the ECB).

Step 1 – the deposit is transferred from Portugal to Germany’s Deutsche Bank, to pay off the maturing Portuguese bond held by said bank.


Asset – Advance to Portugal’s NCB; Liability – deposit of Portugal’s commercial bank

and then (next moment, to transfer the deposit to Deutsche Bank)

Asset – (stays the same); Liability – deposit of Deutsche Bank

Deutsche Bank:

Asset – Reserves; Liability – deposit of Portugal’s commercial bank

Step 2 – Deustche Bank liquidates (at maturity) the Portuguese T-Bond it held as an asset, and the Bundesbank settles its account with the ESCB (European System of Central banks).

Deutsche Bank:

Asset – minus the Portuguese T-bond; Liability – minus the deposit of Portuguese commercial bank


Asset – “Due from” the ESCB; Liability (stays the same)

European Central Bank:

Asset – “Due from” Portugal’s NCB; Liability – “Due to” Bundesbank

Step 3 – Excess reserves at Deutsche Bank (from step 1, above) are drained; Deutsche bank reduces its overdraft position at Bundesbank.

Deutsche Bank:

Asset – Minus reserves; Liability – Minus advance from Bundesbank


Asset – Minus advance to Deutsche Bank; Liability - Minus deposit of Deutsche Bank

That’s it.

At this moment, of course, Portugal’s NCB will have an advance to the government-owned commercial bank as an asset and a “Due to the ESCB” as a liability.

The government-owned commercial bank in Portugal will have the newly-issued Portuguese T-bond as an asset and an advance from Portugal’s NCB as a liability.

This completes the description of the whole process of using TARGET2 to issue "money" inside the eurozone.

Tedious? Yes.

But neat - and 100% according to TARGET2 rules.

And what´s really relevant: Portugal has just regained its monetary sovereignty!

JKH said...


OK. You’re assuming Deutsche Bank holds the bond that is being repaid.

Step 3 from your penultimate comment:

3. An advance of the Bundesbank to the Deutsche Bank as a liability on this bank's books (to drain the excess reserves that resulted from the periphery bond's payment at maturity).

My point was – that description is incorrect. The Bundesbank doesn’t advance funds (an MRO asset) to Deutsche Bank (an MRO liability) to drain reserves. Deutsche Bank use its reserves to repay a pre-existing MRO liability, which has the reserve draining effect.

Step 3 from your last comment:

Step 3 – Excess reserves at Deutsche Bank (from step 1, above) are drained; Deutsche bank reduces its overdraft position at Bundesbank.

Deutsche Bank doesn’t have an overdraft - it is long the reserves that have been paid to it by TARGET2. It will use those reserves to repay pre-existing MRO funding from the Bundesbank, as I described.

BTW, your step 1 in your last comment is not entirely accurate either. If Deutsche Bank holds the bond, there is no necessary transfer of a deposit from the Portuguese commercial bank to Deutsche Bank. There is a payment whereby the Portuguese Treasury repays the bond – but not a deposit transfer. The payment results in a debit to the Treasury balance at the Portuguese bank, and an increase to Deutsche Bank reserves. At the same time, there is a decrease in the Deutsche Bank asset account holding the bonds – because they have matured. That is the offset. There is no necessary transfer of a deposit to Deutsche Bank.

So your subsequent point is also not necessary:

Deutsche Bank:

Asset – Reserves; Liability – deposit of Portugal’s commercial bank

There is no such liability. It’s just a payment that gets settled in reserves through TARGET2.

Apart from that, at the level of the NCBs and the ECB, your TARGET2 cycle looks correct.

So it’s the same point regarding the domestic reserve accounting that I noted in my previous comment. No change in status from that comment. Apart from that small point on accounting, your basic point is a good one – regarding the operational potential to “money finance” peripheral deficits using a government owned commercial bank rather than the NCB. I’m still interested in the nature of the legal prohibition on this.

Jose Guilherme said...


I agree that the accounting details are minor points compared to the substance of the matter where, as you say, the
“basic point is a good one – regarding the operational potential to “money finance” peripheral deficits using a government owned commercial bank rather than the NCB. I’m still interested in the nature of the legal prohibition on this.”

IMO, there is no legal prohibition because the ECB may not mess around with the clearing and settlement system of the eurozone.

Cross-border payments between banks in two countries of the eurozone automatically generate balancing credit claims between the NCBs involved and the ECB. This principle is a core component, a building block of the single currency area.

It is the necessary mechanism that irrevocably unifies the former national currencies.

It ensures that the eurozone is not merely a set of currencies whose exchange rates are fixed at par: that, instead, it is really a single currency.

Unfortunately (from the ECB’s austerian viewpoint) it also ensures that any eurozone country may draw vast credit from the others, via the ECB.

That’s what has already happened with the financing of current account deficits after the collapse of the overnight market in 2008 and the recent, massive capital/deposit flight from the south to the core, to the tune of the hundreds of billions of euros.

And it could happen tomorrow with the financing of periphery deficits via government-owned banks of the periphery. If only the periphery wills it.

The ESCB will necessarily lend (has already, but in this case it would all be initiated by a government-owned commercial bank) against the collateral of sovereign debt of countries under pressure; this is an automatic feature - not a bug - of the system.

As for your technical accounting points – that, as you say and I agree, do not affect the substance of the argument - just a couple of brief comments.

The idea having the Deutsche Bank reduce its overdraft position I took from a paper by Marc Lavoie who says that a German commercial bank may “use its positive clearing balances (or reserves) to reduce its overdraft position vis-à.vis the Bundesbank”. Unfortunately, I am no accountant and thus not entitled to elaborate on this point, but perhaps you may want to check this detail directly with him.

As on what concerns a possible direct payment from the Portuguese Treasury, I believe you are assuming that the Portuguese government starts by transferring its deposit at the commercial bank to the Treasury account at the NCB, before proceeding to the transfer to Germany - but perhaps this is not strictly necessary.

Couldn't the government just order a direct transfer from the commercial bank to Germany?

This would have the added beauty of being the exact accounting equivalent of the massive capital flight that has recently occurred within the euro zone – all of it already and efficiently processed by that equally beautiful mechanism, TARGET2.

JKH said...


Agree with your overall summary, which is good.

Are you quite confident nothing in the Treaty, etc. precludes this? If there’s no prohibition, I’m wondering why Ireland, Greece, Portugal, Spain, or even Italy wouldn’t have considered this already? I’m not familiar enough at this point with these state owned bank arrangements to guess at this.

“The idea having the Deutsche Bank reduce its overdraft position I took from a paper by Marc Lavoie who says that a German commercial bank may “use its positive clearing balances (or reserves) to reduce its overdraft position vis-à.vis the Bundesbank”.

No problem with that as a statement of marginal activity and corresponding bank reserve management response, which is what Lavoie is probably referring to. It assumes the existence of a temporary overdraft due to some other source – a net draining outflow from the reserve account, which can happen at any point for numerous reasons. But the ongoing balance sheets of the commercial banks feature structural MRO funding as opposed to ongoing overdraft positions.

Overdrafts are in effect just temporary negative reserve positions – interspersed time wise throughout daily and near-close of business settlement. Banks settle up those overdrafts on an intraday and/or end of day basis. That’s different from the ongoing structural MRO funding position. If they didn’t have that MRO funding, other things equal, there would be an ongoing structural overdraft. But that sort of permanent funding is not the intention of the overdraft facility.

Again, the marginal effect of a given reserve inflow from TARGET2 would be a long reserve position. Yes, it could repay a coincident overdraft from some other source, but the trend effect and the natural cumulative effect over time is to repay previous MRO funding rather than a cumulative overdraft position (which doesn’t really exist in the same way as a cumulative MRO funding position). This sort of effect where MRO funding is reduced due to TARGET2 reserve inflows is evident from the Bundesbank balance sheet. The Bundesbank's swollen TARGET2 balance has displaced previous MRO funding provided to its commercial banks.

“As on what concerns a possible direct payment from the Portuguese Treasury, I believe you are assuming that the Portuguese government starts by transferring its deposit at the commercial bank to the Treasury account at the NCB, before proceeding to the transfer to Germany - but perhaps this is not strictly necessary.”

I’m not assuming that, but that issue of transfer is an interesting point on its own.

First, I’m not assuming that sort of transfer. I’m assuming what I interpreted to be the assumption in your example, which was that the government deposit was on the books of the government owned commercial bank rather than the NCB. When the Portuguese Treasury makes payment to Deutsche Bank for the bond maturity, it just makes a payment in funds. It doesn’t transfer a deposit. So its commercial bank (which it owns in your example) would debit Treasury’s deposit account and make payment in reserves, which is transmitted by the Portuguese central bank through the TARGET2 mechanism. The Portuguese commercial bank reserve account (asset) is reduced and its deposit liability to the Portuguese Treasury is reduced. On the Portuguese Treasury books, its deposit asset with its bank is reduced, and its bond liability is reduced. That’s the end of the story as far as the Portuguese Treasury is concerned, just looking at the bond repayment transaction considered on its own. So there’s no transfer of a deposit.

... cont'd

JKH said...

cont'd ...

The same thing would happen in effect if the Portuguese Treasury held the same deposit on the books of the Portuguese central bank. In this case, the CB would reduce its deposit liability to the Portuguese Treasury, reserves would be credited to the Deutsche Bank account, and the TARGET2 circle of accounting would come back to provide TARGET2 funding for the Portuguese central bank, replacing the Treasury deposit it lost. The elimination of an asset and a liability on the Treasury books is similar.

The existence of two separate Treasury accounts is an interesting question on its own. The question there is whether the Portuguese banking system has the same sort of arrangement as the US system. I.e. are there accounts that correspond to the Treasury general account at the Fed and the Treasury tax and loan accounts at the commercial banks? That arrangement comes in handy in managing the system reserve effect of all sorts of Treasury transactions in the case of the US.

That’s just a minor operational point of interest. It doesn’t really affect the substance of what we’re discussing here.

Jose Guilherme said...


"If there’s no prohibition, I’m wondering why Ireland, Greece, Portugal, Spain, or even Italy wouldn't have considered this already?".

You've raised the key point: if there is an immediate and perfectly legal way out of austerity for the periphery why aren't these countries using.

I think the answer is a mixture of ignorance and awe at the supposed power of Germany, the ECB and the European ideology combined.

They don't dare to question anything they're ordered to do and their mindset tells them that the answer always has to be "more Europe" (a sentence uttered again and again by no less a person than Mr. Rajoy).

Lacking self-confidence they are unable to react, just as if they were well-behaved medieval servants with their minds captured by the feudal ideology.

You have to live there, in Europe - as I did, for many, many years - to understand the pervasiveness of this attitude among Europe's elites.

But perhaps the protest demonstrations, if allied to heterodox, new ways of thinking will finally start to overcome this massive handicap.

That's where our knowledge of monetary operations can help: to give ideological support in order to change the game in Europe.

Also, a minor detail concerning your accounting.

I thought the entries on the Portuguese commercial bank's books could also be - alternatively, when there is a scenario of lack of liquidity and massive capital flight such as we now see - the following:

Liabilities: minus deposit of the government, plus advance form the Portuguese NCB.

At least this is the way Karl Whelan showed the accounting entries in the presentation on TARGET2 that he made last June for the Bank of England.

JKH said...


“Liabilities: minus deposit of the government, plus advance form the Portuguese NCB.”

Quite right – I described it as a reduction in the reserve account (asset), which suggests a positive balance to start. It could as easily be a zero balance, which would become negative, and result in an overdraft, unless covered by other means. That’s probably the more representative case, as you suggest. MRO funding would then become the sustained replacement source of funds.

Jose Guilherme said...


Great discussion and I think we van now agree that this is operationally feasible.

The only and major missing link is the political will of the countries of peripheral Europe

Now the question is: what can we do in order to help said countries implement their return to monetary sovereignty and thereby change the name of the game in the euro zone?

If we achieve this we can rest assured that monetary sovereignty will be much better understood everywhere in the world - and that the neoclassical school of thought, so well represented inside the euro zone institutions will have suffered a major, and perhaps decisive blow.

Ramanan said...


Doesn't work.

A public sector credit institution is allowed by the treaty but the ECB didn't give a banking license to the ESM.

Even if it is somehow created, an independent fiscal policy implies that the public credit institution's assets and liabilities rise without limit relative to gdp (for weaker nations).

This is because the public debt will keep rising due to continuous rise to the current account deficit of the nation.

Also, the NCB's balance sheet keeps rising. On the assets side the important items will be claims on the public sector bank and in liabilities claims of the ECB.

This cannot happen forever because the public sector bank will run out of collateral. (The government bonds it holds won't be sufficient).

This game could alternatively go for some time if foreigners ignore the rise in the government debt for a while but one has to pretend that it will never matter to them.

So even in the situation you are thinking, fiscal policy has to give in. You don't create a boom and bust like that!

The above is an extreme situation to illustrate but not too much of an exaggeration. In real life, Greek banks and the NCB and the government try to game but the banks run out of collateral. So Greece requires aid.

But it isn't an exaggeration. Some Euro Area nations have picked up about 80-100% of GDP of net indebtedness to foreigners in just 10 years or so.

Jose Guilherme said...


TARGET2 operates on a "no limit" principle.

That's the only way the euro zone can work as a unified single currency area.

With TARGET2, there is no limit on the amount of "other liabilities within the eurosystem" that a NCB can incur and these can be carried indefinitely since there is no time prescribed for settlement of imbalances.

That's the reason 224 billion euros in bank deposits could fly away – smoothly, with no problem - from Spain to Germany, being replaced on the Spanish banks' books by advances from Spain's NCB. Said NCB correspondingly increased its liabilities to the eurosystem.

All - repeat, all - the deposits in Spain could be transferred to Germany this way. TARGET2 can and in fact will automatically absorb all of this.

Similarly, a government can finance its deficit via a commercial bank in order to rollover existing debt held abroad - without worrying about what will happen to its NCB balance sheet.

At the end of the day, the ECB will have effectively replaced the old creditors of the sovereign and the lender for ongoing deficits - indirectly via the collateral at the NCB.

So, a peripheral government will always be able to borrow from its own commercial bank, because this bank will be able to borrow from the NCB and, in turn, the NCB will be able to borrow from the ECB - as long as the country stays in the euro.

And if the ECB does not condone this increase in backdoor funding to the peripheral government via the eurosystem, there is little that it can do.

Yes, the ECB could make it hard for the NCB to refinance the government-owned bank by ruling that the sovereign's T-bonds are no longer eligible as collateral. But then the NCB could extend its use of the ELA (Emergency Liquidity Assistance) which is not subject to the ECB's collateral rules.

(The Irish NCB, for instance, has been using ELA since at least 2009 and has lent tens of billions of euros to the country's commercial banks via this route).

And if the ECB went so far as to prohibit ELA for the peripheral country (and it would presumably have to explain why this could be so, having enabled the very same mechanism in the case Ireland since 2009) the NCB would have no option other than to defy the ECB and continue to lend anyway - because the consequence of not doing this would be the closure of the country's commercial banks for lack of liquidity.

The only effective for the ECB to block this process of indirect lending to the government, then, would be by ordering other NCBs to refuse further credit to the NCB of the peripheral country, shutting it out of the TARGET2 system.

But this would prevent clearance of cross-border payments out of the country and be tantamount to expelling the country from the eurozone. The free flow of credit between eurozone NCBs is an essential feature of monetary union: it's what keeps a euro in a peripheral bank legally equal to a euro in banks elsewhere in the system.

An expulsion would be both illegal (the euro treaties do not include an expulsion clause) and politically explosive if attempted by a technical, apolitical institution like the ECB.

To sum up: if a peripheral government decides to use its commercial bank to get financing for rolling over debt held abroad, there is nothing the ECB can do against this short of expelling the country from the eurozone.
And expulsion would be a totally illegal – as well as politically outrageous – move. It can’t happen.

It follows that there is nothing to stop peripheral governments from financing their deficits via government-owned commercial banks.

They simply have to decide one thing: to just do it.

Ramanan said...


I understand that there is no limit to how much TARGET2 claims can grow. There is explicitly no limit on TARGET2 as per the legal documents which I quote here:

That is not an issue as you rightly point.

The issue will be the lack of collateral the public sector bank can provide to the home NCB - which will be required by ESCB laws.

Imagine a situation in the future:

Spain private sector net financial assets = €500bn

(non-bank private sector holds €500bn of Spain's public debt for simplicity)

Spain's net international investment position (ignore gold etc) = minus €2,500bn

Spain's public debt = €3,000bn.

Assume that the foreign private sector has flown.


Banco de Espana's liabilities to the rest of the Eurosystem = €2,500bn

Banco de Espana's claim on the public sector bank = €2,500bn

Public sector bank's assets = €2,500bn of Spanish govt debt

Public sector bank's liabilities = €2,500bn due to the BdE

(assume settlement balances, other banks indebtedness vis-a-vis BdE etc are minor compared to figures above)


The market value of the public debt can fall (because of the fall in the price of the security) and will require margin calls from the BdE according to the Eurosystem rules even if haircut is assumed to be zero. The public sector bank would not be able to provide it and has to be closed down.

(The above example can be made more realistic with Spanish residents holding securities abroad etc)

The whole system will be like a house of cards is my point.

Ramanan said...

Some points I didn't address were:

ELA - I am not sure if the arrangement is permanent, it can be called "Emergency Liquidity Assistance".

Here is from Buiter's article on the ELA:

“14.4. National central banks may perform functions other than those specified in this Statute unless the Governing Council finds, by a majority of two thirds of the votes cast, that these interfere with the objectives and tasks of the ESCB. Such functions shall be performed on the responsibility and liability of national central banks and shall not be regarded as being part of the functions of the ESCB.”

Jose Guilherme said...


I understand what you mean when you state that the "system will be like a house of cards" - but, in a sense it already is a house of cards.

In fact, a system that can provide for massive transfers of deposits from one country to another - a totally abnormal situation, generated by widespread panic - and "solve" the issue by treating it as mere accounting entries is in a sense an unsustainable system.

But this is philosophy for the long term. I'm worried about what's happening now. Massive, irrational austerity imposed by troikas on helpless populations, failed by their own governments.

This can be stopped now if only periphery governments start paying off debt held abroad via financing by a government-owned bank.

Simply by using the full potential of TARGET2.

It's simply criminal for a periphery government to refrain from using it, and meekly accept the troika diktats instead.

Plus, the periphery governments, by using the mechanism, would score an important tactical and possibly strategic victory, one that would put the ECB on the defensive.

This could mean a major shift in the balance of power between the elected governments of the eurozone and the unelected, technocratic ECB.

I believe that, despite your doubts concerning sustainability in the long run, you agree that this mechanism for financing is legal and can be implemented for the short term.

So my proposal is: let's just give our thanks to Keynes for insisting on the basic irrelevance of the long run and proceed to implement TARGET2 right now.

Because it's the welfare of millions of people that is at stake.

Ramanan said...


Yes possible short term.

If they manage to do it, the "stronger" countries can actually be made to negotiate with terms unfavourable to them!

Jose Guilherme said...


Great conclusion.

It's very important to have obtained your confirmation that the whole process is technically feasible.

JKH said...

Again, I think we have to be careful to separate out analytically and appropriately the issue of a government owned bank loading up on government bonds from the issue of TARGET2.

E.g. in Ramanan's example, if the bank owns 2.5 trillion in bonds, financed by 2.5 trillon from the ECB, TARGET2 is not even an issue. It's unaffected. There is no capital flight with TARGET2 effect possible, from that starting position. The issue under discussion there as Ram pointed out is one of collateral management, not TARGET2.

JKH said...


Isn’t this partly a question of degree?

Banks in general were doing what you suggest using LTRO funding.

You’re suggesting extending that specific asset activity in a much more aggressive fashion, using the full balance sheet capacity of a government owned bank.

Ramanan said...


Yeah. Issuance of debt and the purchase by the commercial bank is a resident to resident transaction and doesn't affect intra-Eurosystem claims.

However, the fiscal expansion has an adverse effect on trade and I am assuming foreigners repatriating the proceeds of their exports which affects the TARGET2 claims.

JKH said...

Right R - fiscal policy expansion effect in general on current account and TARGET2, but not directly connected to the government bank financing mechanism as such

Ramanan said...


What I meant was it seems plausible (for short term) and if carried out can be good.

However I am not 100% sure if it can work. If suppose Greece creates a nationalized bank with the exclusive purpose of buying government bonds, won't it look strange if it is bidding at auctions at say 5% for 10y when the issues in the secondary markets are trading at something 15-20%?

I think the basic issue is that Germany wants a full union but others don't want to surrender their powers to the EU.

Jose Guilherme said...

JKH and Ramanan,

" Ramanan's example, if the bank owns 2.5 trillion in bonds, financed by 2.5 trillion from the ECB, TARGET2 is not even an issue. It's unaffected" (JKH).


"Issuance of debt and the purchase by the commercial bank is a resident to resident transaction and doesn't affect intra-Eurosystem claims. (Ramanan)

I agree. Both statements are correct, 100%.

But what I'm suggesting is that the periphery government use its own commercial bank in order to pay off maturing bonds held abroad (underline "abroad"). In this case, TARGET2 is a central tool of the whole process. A process that ends up transferring the credit from a private foreign owner (say, Deutsche Bank who was holding the bond before maturity) to the ESCB/ECB.

"Banks in general were doing what you suggest using LTRO funding." (JKH)


But in this case there is a difference in kind. The periphery government seizes the initiative by ordering its commercial bank to "buy" newly-issued T-Bonds and then transfer the corresponding government deposit to pay a maturing bond abroad. Every time there is a debt rollover the government does this. It ceases being passive - and thereby automatically causes a financing flow via ECB to NCB to government-owned commercial bank.

As JKH rightly puts it, I'm proposing "extending… (periphery government) activity in a much more aggressive fashion, using the full balance sheet capacity of a government owned bank".

"However, the fiscal expansion has an adverse effect on trade..." (Ramanan)

Yes, I agree.

Increased government deficits financed via a government-owned commercial bank, the NCB and the ECB (in that sequence) will increase the peripheral country's aggregate demand, which will cause net imports and the current account deficit to increase, because relative prices won't change via currency depreciation - it's a single currency area we're talking about.

This is of course great news from said country's perspective. Its population will benefit from a higher standard of living, courtesy of TARGET2.

And even Germany will benefit (objectively, though probably not subjectively) because it will increase its current account surplus, a "good" thing according to the country's official ideology of mercantilism. Again, this is all possible because of TARGET2.

In a sense, I'm proposing that TARGET2 really means that the EMU is already a transfer union – or will be, as soon as the periphery governments will it.

No need for treaty changes to achieve that. The governments of the eurozone may freely (OK, almost freely) finance their deficits via the ECB, whether the ECB likes it or not. And this will mean increased current account deficits, again financed via TARGET2.

And, you know: this is a good thing, because a currency union can only survive in the long run if it becomes a transfer union.

So, the full utilization of the TARGET2 mechanism - at the initiative of the periphery governments, currently handicapped by needless austerity - may well introduce a transfer union into the inner workings of the EMU, through the back door of course.

Jose Guilherme said...


"it seems plausible (for short term) and if carried out can be good. However I am not 100% sure if it can work..."

I agree we cannot be 100% sure. Maybe the ECB will react in unpredictable ways; maybe it holds instruments for putting pressure on periphery governments that we do not know about. Maybe.

But in real life we can never be 100% sure of anything. This process seems to be technically robust enough to hold on its own and I think we can agree that the forecast for its success is excellent.

In the case of Portugal, for instance, its government already has a large commercial bank. If it issues bonds that it would "sell" to the bank with a coupon of, say 3% while the secondary markets are pricing old bonds at 9% it would be a good thing. The new bonds will preserve the government from going to the bond markets for financing; and they will be used to pay off foreign creditors.

After a couple of such rounds of refinancing via the government-owned banks the secondary markets would likely start pricing Portuguese bonds at lower yields. Because for all practical purposes they would observe that the Portuguese bonds are now virtually without default risk - after all, the foreign creditors are now being paid smoothly and on time.

Again, this is to be expected. Portugal is regaining monetary sovereignty which means that, in the long run, its T-Bond yields will tend towards yields very close to the ECB rate.

Tom Hickey said...

I think the basic issue is that Germany wants a full union but others don't want to surrender their powers to the EU

Probably more like the basic issue is that Germany wants a full union [on its terms] but others don't want to surrender their powers to the EU [under German control]?