The €uropean crisis and monetary policy

The €uropean crisis and monetary policy

Sergio Cesaratto

Dipartimento di economia politica e statistica Cesaratto@unisi.it

http://politicaeconomiablog.blogspot.it/

Index

• I) Origin of the crisis

• II) Monetary policy in the crisis

I) Origin of the crisis

Optimal currency areas

• Should the EMU be created?

• OCA (e.g. Meade 1957, Mundell 1961, Fleming 1971) generally said no.

• Mundell 1961: economically dishomogeneous regions contitute an OCA if there is labour mobility. Otherwise:

• either the C/A surplus/full employment/low inflation region accepts to sustain domestic AD and accepts higher inflation,

• or C/A deficit/less-than-full-employment/inflation-prone regions accept deflation

• But in the second hypothesis there will be a deflationary bias in the global economy.

• Other alternative: inter-regional transfers

• Final alternative (that justified the EMU): endogenous OCA

Barba De Vivo: federal budget irrelevant in the Eurozone

(EZ)

Is a federal Europe possible?

• What is the next question?

• Hayek 1939  only a minimum-State/federal State is possible amongst regions that are culturally and economically

dishomogeneous

• Hayek was therefore in favour of a federal State

• 5 Presidents report: no federal budget but central controll of nacional finances

• The actual Europe is precisely what «they» wanted: «federal»

monetary policy in controll of inflation; no federal fiscal policy and national balanced budgets; full employment to be ursued through

«competitive deflation»

• Influence of the long-period consuensus on the ineffectiveness of monetary policy (not to speak of fiscal policy)

• «tie your hands» argument

The influence of standard theory

• Monetary theory ineffectual in the long run

• Governments not credible in promising of not using monetary policy etc.

• The promise to keep the exchange rate fixed (and so inflation at the level of the virtuous countries) is not credible

• With a currency union monetary policy is transferred to foreign hands for good.

• In more practical terms: France was fed up to let Germany (the

leading country in the EMS) to fix the interest rate only looking at its own interests; in the EMS Germany decided monetary policy,

perhaps with a currency union the other countries would have a say.

• Italy and others would have liked to import the German labour market discipline.

• Political reasons (German unification)

Prescent analyses

• The American economists warned that the EZ was not an “optimal currency union” (they were accused of conspiracy against the

European challenge to the US $).

• Kaldor and Godley warned that you must have a political union ahead of a monetary union

• “Functionalism”, the Monnet method, prevailed

• As we said, however, a real, solidaristic political union is impossible in Europe

What happened? There is a consuensus view now

in my opinion some economists like DE Grauwe create confusion)

• Spain, Ireland, Greece: Frenkel’s cycle (or This time is different or An unfortunate sequence of events…)

• Portugal: it had it earlier

• Italy (and France): slow erosion of competitiveness

• Outside the EMU the Baltic countries, Hungary and perhaps others that pegged their currency to the Euro had their unfortunate

sequence of events

disappearance of devalution risk + financial liberalisation. Interest rates on long-term treasuries affect also credit conditions

Source: http://www.voxeu.org/content/eurozone-crisis-consensus-view-causes-and-few-possible- solutions

Source: http://www.voxeu.org/content/eurozone-crisis-consensus-view-causes-and-few-possible- solutions

First explanation: diverging REERs

Second explanation: diverging ADs

Housing bubble

Sudden stop of capital flows

http://www.economonitor.com/blog/2011/12/which-graph-best-summarizes-the-eurozone-crisis/

An ECB fault?

• The ECB monetary policy (one fist all, or what fits the core fits all) is often blamed for the crisis:

German mercantilism

• Germany since Bretton Woods has always found fixed exchange rate arrangements perfectly suited to her mercantilist stance: since the time of Erhard the German strategy was to maintain the inflation rate a little below that of competitors to sustain exports while

enjoying a strong currency, what has been named ‘Monetary Mercantilism’ (Holtfrerich)

Criticism to German (presumed) mercantilism is not new . Few examples*

- The German stabilisation policies of the late 1940s/early 1950s were criticised by the American economists.

- Also in the 1950s Germany preferred to blame the others:

‘inflationary policies’ abroad led to the German export upsurge and obliged her to ‘sterilise ‘imported inflation’ by pursuing a fiscal

surplus. The surging of the German trade surplus led, after the American and French criticism, to the DM revaluation in 1961

- The case of the ‘locomotive theory’ is well-known: in the late 1970s chancellor Schmidt reluctantly accepted the idea that Germany had to pull the world economy along the US and Japan. The 2° oil shock came: he swore that never again Germany would have played the domestic expansion game.

At the origins of the German policy stance: monetary mercantilism?*

• The pre-miracle German policy choices that shaped post-war Germany, in oarticular the centrality of price stability, have been denominated ‘monetary mercantilism’ by the historian Carl-Ludwig Holtfrerich.

• Holtfrerich, as others (e.g. Bibow), denies that the obsessive

objective of price stability by the Buba is due to the memory of the great hyperinflation of 1922.

• Indeed, some economists maintain that this “memory” is a well

fabricated invention by the Buba (memories are a social construct).

An independent central bank is not even a German tradition (the

opposite is true), and indeed Adenauer opposed it (he thought that a CB should be accountable!)

• Why price stability then? Holtfrerich: “found the clue” in the early German policy decisions.

Monetary mercantilism (cont)*

In the early 1950s “As protectionist tools could not be used…a different way of achieving mercantilism, namely export surpluses, had to be found. The solution was to keep domestic demand

restrained by monetary and fiscal policies, thus keeping imports and domestic inflation low and freeing production resources for more exports. This strategy was contingent on a system of fixed

exchange rates…The early Bretton Woods system…left countries the opportunity to gain in international competitiveness by realising relatively more price stability than abroad”.

(The main Holtfrerich’s paper is published in a book edited by the Buba celebrating the 50° DM anniversary!)

• Observe the combination of lower domestic inflation and fixed exchange rates! The same combination Germany obtained later through the EMS and the EMU!

Monetary mercantilism (cont)*

• Monetary mercantilism was “conceived and planned” particularly by the president of the Bank deutsche Lander (the Buba was created in 1957) Wilhelm Vocke “as a long-term strategy for German monetary policy” : “keeping domestic affairs tight in order to strengthen

exports”. Vocke was lucky:

• 1) the Allies forced for an independent CB in 1949 when a Federal gvt was not existing yet; 2) Erhard endorsed Vocke’s policy; 3) the Korean war gave a big push to German exports and the opportunity to keep inflation lower than the competitors.

• Erhard: “A great opportunity for the future of German exports has arisen out of the current situation. If, namely, through internal

discipline we are able to maintain the price level to a greater extent than other countries, our exports strength will increase in the long run and our currency will become stronger and more healthy, both internally and with respect to the dollar”

Monetary mercantilism and Ordoliberismus*

Price stability was also the obsessive policy target of Ordo- liberismus (or Freiburg school or social market economy), the

dominant economic school in the reconstruction and miracle period.

Price stability was associated by the ordo-liberals to the smooth functioning of the price mechanism. In practice, price stability is synonymous of wage and social discipline.

• Wage and social order imply that exports, rather than wage

consumption, become the natural debouche of the surplus (in the classical-marxian sense). Indeed, income distribution has never been particularly favourable to labour in Germany.

• An export-oriented economy becomes in turn a powerful political instrument to obtain labour consent and discipline (reinforced by the German trade unions pursue of co-determination rather than strong wage claims why German trade unions have been so docile in the post-WW period is not clear to me yet).

The German model*

• The success of the model in leading to improved standards of life (although income distribution, not surprisingly, has never been particularly fair in Germany) and the traditional paternalist

Bismarkian welfare state did the rest.

• Erhard, declared in 1953: “Foreign trade is quite simply the core and premise of our economic and social order”.

• This declaration seems to allude to an export-led model as a way to enforce social order, and to social order as a way to sustain export- led growth:

Social order export led growth

Price stability

Economic surplus and aggregate demand (AD) in capitalism

• From a theoretical point of view we may now vindicate the mercantilist obsession with a trade surplus.

• They (albeit imperfectly) grasped the idea that net exports might render a low N and a high S sustainable from the point of view of aggregate demand.

• S = P – N; P = C + (X – M) = N + X; S = X - M

• The German model has a strong ideological content by making the obsession of a trade surplus the “sacred cow” of German politics.

• The Buba was the watch-dog of the model.

• The government has trade policy as the highest priority (as one German President confessed, “we are in Afghanistan for

commercial reasons”).

The pillars of the German model and why they do not want to give it up

• The three institutions pillars of “monetary mercantilism”: neo-

corporativism, mercantilist micro, meso and macro institutions and policies, and …the Bundesbank.

• The former implied a direct involvement of the labour movement both at the micro and the macro level in the maintenance of a competitive system, particularly in the export sector.

• At the micro-level Germany has a excellent training, educational and R&D system; at the meso-level the reliance on export-led growth creates an ideological climate that induce cooperation and discipline (Crouch 2008); at the macro level the system keep wage-growth

below or in line with productivity growth. The government domestic and foreign policies have the promotion of German export as the priority. Paternalism is a traditional attitude of the German

government; the sense of the national community, traditions and nature (heimat) is the main component of the “German ideology”.

This perfectly suit the mercantilist tradition (Heckscher), particularly in its German version (Cameralism, Historical School)

• This model has brought welfare and order in Germany: would you easiliy give it up?

Arsenic and Buba

• But, of course, as Voltaire said: “Incantations will destroy a flock of sheep if administered with a certain quantity of arsenic”

• Just in case, the watchdog role of the model was assumed by the Bundesbank in a unique wage bargaining process directly involving the central bank and the leading trade union IG-metall (Franzese and Hall 2000: 182-83).

• This role of the Bundesbank as the watchdog of the German mercantilist model is very important to understand the German opposition to the reform of the ECB from its present “monetarist”

constitution.

The Buba and the labour market*

• A ‘credible’ CB was a central element of the German economic

policy, where by credibility is meant that the trade unions considered the German CB commitment to fight inflation at any cost as

convincing.

• According to Franzese and Hall the centralised wage bargaining in Germany, led by the IG-Metall, made a peculiar interaction between the German CB and the trade unions possible: “The highly public pas de deux between the Bundesbank and the principal wage bargainers, which occurs at the time of every wage round in Germany, is a

prominent feature of politics. The bank often issues pointed

comments on the initial wage demands made by the union involved in the leading settlement, accompanied by detailed commentary about the state of the economy and warnings about the policy

consequences of overly inflationary wage settlements. ... this kind of dialogue between wage bargainers and the central bank is

completely absent from U.S. economic politics. … The Federal

Reserve and the Bundesbank speak differently because they have audiences with different institutional structures”. …

Corporative social-democracy and mercantilism

• Interestingly, the Bundesbank’s credibility was reinforced by the export- led model, given the concentration of the strongest trade union in the export sectors: “The German case also suggests that the effectiveness of such signalling mechanisms may be enhanced when the export

sector is large and plays a pivotal role in wage bargaining (…). The metalworking sector, which produces the lead bargain in most years, has a high export concentration. In itself, this induces lower settlements because wage bargainers in export sectors are especially concerned to maintain unit labor costs at internationally competitive levels. Actors in such sectors are also especially sensitive to signals from the central bank, however, because the restrictive monetary policies that the bank wields not only depress the level of economic activity but also tend to appreciate the exchange rate, thereby threatening export sectors

especially severely by rendering their products more expensive in world markets.” The direct involvement of the German CB in wage bargaining has been inherited by the ECB. Just recall again the two infamous rate increases in July 2008 and April 2011.

• Is it a case that most (all?) northern corporative social-democracies are export-led economies (Colin Crouch)? This might be due to the

smallness of those countries, but this is not the case of Germany.

Corporative social-democracy and mercantilism

• Interestingly, the Bundesbank’s credibility was reinforced by the export- led model, given the concentration of the strongest trade union in the export sectors: “The German case also suggests that the effectiveness of such signalling mechanisms may be enhanced when the export

sector is large and plays a pivotal role in wage bargaining (…). The metalworking sector, which produces the lead bargain in most years, has a high export concentration. In itself, this induces lower settlements because wage bargainers in export sectors are especially concerned to maintain unit labor costs at internationally competitive levels. Actors in such sectors are also especially sensitive to signals from the central bank, however, because the restrictive monetary policies that the bank wields not only depress the level of economic activity but also tend to appreciate the exchange rate, thereby threatening export sectors

especially severely by rendering their products more expensive in world markets.” The direct involvement of the German CB in wage bargaining has been inherited by the ECB. Just recall again the two infamous rate increases in July 2008 and April 2011.

• Is it a case that most (all?) northern corporative social-democracies are export-led economies (Colin Crouch)? This might be due to the

smallness of those countries, but this is not the case of Germany.

Social-democratic mercantilism*

• As seen, export led-growth is also functional to secure labour

acquiescence and discipline, solving therefore the second Kaleckian concern about the inconsistency of full employment and capitalism.

• Germany appears as a high-productivity/low wage economy. This is a classic definition of a mercantile country.

• The model, in the German case, is self sustained in the sense that it brings about social and distribution discipline (associated to decent standards of living), that in turn supports the model.

• The question is the international sustainability of the model, but perhaps Germans see themselves as a small player at the global level so that they expect the world to tolerate this policy. But they have to solve the European situation first.

• There is no reason why Germans (of any social class) would like to abandon the model, so be politically realist and do not talk of

European solidarity.*

• *See my The European crisis: political and institutional failures or method in

the madness? In www.networkideas.org, re-published by www.irishleftreview.org

Rigid fixed exchange rate are inconsistent with national

independent full-emplyment policy…

…with democracy and even with financial stability

Rigid fixed exchange rate are inconsistent with national independent full-emplyment policy with democracy and even with financial stability.

Comments

• In a currency union CA deficit countries suffers of higher interest rates given the “covertibility risk”, as in a fixed exchange rate regime.

• Fixed exchange rate regimes require wage and social right repression, that is they are inconsistent with democracy.

• Fixed exchange rate regimes and financial liberalisation stimulate the indebtness of deficit peripheral countries leading to financial crisis. This “this time is different” sequence has happened since the gold standard age.

References

• Cesaratto, S. 2015. ALTERNATIVE INTERPRETATIONS OF A STATELESS CURRENCY CRISIS, ASIMMETRIE, WP 2015/08, http://www.asimmetrie.org/working-papers/wp-201508- alternative-interpretations-of-a-stateless-currency-crisis/

• Cesaratto, S. 2015. Balance of Payments or Monetary Sovereignty? In Search of the EMU's Original Sin - a Reply to Lavoie, International Journal of Political Economy, vol. 44, no. 2, WP:

Asimmetrie, WP 2014/06 (December), http://www.asimmetrie.org/wp- content/uploads/2014/12/AISWP201406.pdf

• Cesaratto, S. (2015) Fra Marx e List: sinistra, nazione e solidarietà internazionale a/ working papers 2015/02 www.asimmetrie.org

• Cesaratto, S. (2013c): The implications of TARGET2 in the European balance of payment crisis and beyond, European Journal of Economics and Economic Policies: Intervention, 10, 2013 (3), versioni working paper: http://www.deps.unisi.it/it/ricerca/pubblicazioni-deps/quaderni-

deps/anno-2013/681the-implications-target2-european-balance e http://www.networkideas.org/featart/sep2013/fa03_TARGET_2.htm

• Cesaratto S. (2013). Controversial and Novel features of the Eurozone Crisis as a Balance of Payment Crisis. in Febrero E. et al., editors, Post Keynesian Views of the Economic Crisis and its Remedies, Routledge, 2013. Working paper:

http://www.econpol.unisi.it/dipartimento/it/node/1649.

• Cesaratto S. (2013). The endless Eurozone crisis, where do we stand? A Classical-Kaleckian overview, Studi Economici, n.2, 2012 (pubblicato nel 2013) Working paper availabe at:

http://www.deps.unisi.it/it/ricerca/pubblicazioni-deps/quaderni-deps/anno-2013/671-endless- eurozone-crisis-where-do-we-stand (n.671) e

http://www.networkideas.org/featart/feb2013/fa27_Sergio_Cesaratto.htm

References

• Cesaratto S., Stirati A. (2011) Germany in the European and Global Crises, International

Journal of Political Economy, vol. 39, no. 4, Winter 2010–11, pp.56–87; working paper version:

http://www.econ-pol.unisi.it/dipartimento/it/node/1267

• Cesaratto S. (2011), Europe, German Mercantilism and the Current Crisis, in Brancaccio E., Fontana G. (a cura di), The Global Economic Crisis. New Perspectives on the Critique of Economic Theory and Policy, Routledge, London. Working paper version Quaderni del Dipartimento di Economia politica,, n. 595 (www.econpol.unisi.it/dipartimento/it/quaderni)

• Frankel, J.A., Rose, A.K. (1996), The Endogeneity of the Optimum Currency Area Criteria, National Bureau of Economic Research Working Paper 5700.

• Friedman M. (1953), The Case for Flexible Exchange Rates, in Friedman M. (ed.), Essays in Positive Economics, University of Chicago Press, pp. 157-203. [due significativi passaggi del testo sono riportati qui: link]

• Godley, W. (1992), Maastricht and All That, London Review of Books, Vol.14, No. 19.

[Goodhart, C.A.E. (1998), The Two Concepts of Money: Implications for the Analysis of Optimal Currency Areas, European Journal of Political Economy, Elsevier, vol. 14(3), pp. 407-432. [link]

• Kaldor, N. (1971), The Dynamic Effects Of The Common Market, in the New Statesman, 12 Marzo 1971; anche in Further Essays On Applied Economics, Cap. 12, pp 187-220, in The Collected Economic Essays series of Nicholas Kaldor, Vol 6. [link]

• Kenen, P.B. (1969), The Theory of Optimum Currency Areas: An Eclectic View, in R.A. Mundell and A.K.Swoboda (eds.), Monetary Problems of the International Economy, Chicago University Press, pp. 41-60.

• Mundell, R.A. (1961), A Theory of Optimum Currency Areas, American Economic Review, 51, pp. 657-665.

• C.A.E. Goodhart (1998), The two concepts of money: implications for the analysis of optimal currency areas, European Journal of Political Economy, 14, 407-432;

References (consensus view)

• Matthew Higgins and Thomas Klitgaard The Balance of Payments Crisis in the Euro Area Periphery, Fed Current Issues in Economics and Finance, Vol.20, N. 2, 2014

• Richard Baldwin, Thorsten Beck, Agnès Bénassy-Quéré, Olivier Blanchard, Giancarlo Corsetti, Paul de Grauwe, Wouter den Haan, Francesco Giavazzi, Daniel Gros, Sebnem Kalemli-Ozcan, Stefano Micossi, Elias Papaioannou, Paolo Pesenti, Christopher Pissarides, Guido Tabellini and Beatrice Weder di Mauro. Rebooting the Eurozone: Step 1 – Agreeing a Crisis narrative, november 2015, http://www.voxeu.org/article/ez-crisis-consensus-narrative 014

• Richard Baldwin, Francesco Giavazzi , The Eurozone Crisis: A Consensus View of the Causes and a Few Possible Solutions, September 2015,

http://www.voxeu.org/content/eurozone-crisis-consensus-view-causes-and-few-possible-solutions

II) Monetary policy in the crisis

Three overlapping aspects of the crisis: banking, sovereign and foreign debt crises

• The crisis has not a fiscal origin (with the possible exception of Greece).

• Once the housing bubbles exploded in Spain and Ireland the crisis became a banking crisis

• Once banks were bailed out the crisis became a sovereign crisis

• The fiscal crisis magnifies the banking crisis (given that banks own a lot of sovereign bonds)  doom loop between banking and

sovereign crises.

• Since private and public debts are held also by (European) foreigners, the EZ crisis is also a foreign debt crisis.

• On some degree, the lack of a lender of last resort (a pro-active ECB) facilitated the contagion of the PIGS crisis to Italy that also entered in a sovereign debt crisis (the debt was pre-existing)

The three monetarist pillars of European economic policy

• Balanced budget constraints (fiscal policy is viewed as a subtraction of private resources)

• Monetary policy managed by an independent Central bank (differences with the FED).

• Employment policy is a national matter.

Monetary policy: objectives and pillars

• The Eurosystem as the central banking system of the euro area comprises the ECB; and the national central banks (NCBs) of the 17 EU Member States whose common currency is the euro.

• Two main characteristics of the ECB: independence with (below but close to) 2% inflation target; no bail-out clause

• Two pillars of the ECB monetary policy ( determination of the interest rate):

• M3  quantitative theory of money (less important)

• A variety of economic and financial indicators (including indicators of the real activity, current and expected inflation, exchange rate,

financial markets indicators, agents’ expectations, labour market indicators) that may influence expected inflation

• How monetary policy works?

• We move from the concept of endogenous money that is by now increasingly accepted in monetary economics and macroeconomics (the CB fixes the interest rate and let the market decide how much money it wishes at that rate).

Loans create deposits

Suppose now that customer 1 orders CBA to move 20 Euros of her deposit to another current account (own or of another customer) at

CBB; what happens?

Interbank market

• CBA has now zero reserves. By contrast, CBB has excess reserves of 18. This is at the origin of the inter-bank loan market: banks with excess reserves will lend to banks that lack reserves.

• that the excess of reserves of the CBB is precisely equal to the reserves needed by CBA (8 as mandatory reserves plus 10 to be returned to the CB).

The interbank mkt, the corridor and monetary policy

In our example, CBB will lend 18 to CBA at approx 0.05% that will thus be able to return the overnight loan to the CB and reconstitute its

reserves.

EONIA (Euro Overnight Index Average)

The updated corridor

The Eurosystem balance sheet before the crisis

ECB monetary policy instruments

• We focus upon:

• OMO:

• 1) MRO and LTRO

• 2) Structural operations  outright purchases

• Standing facilities:

• MLF and DF

• From 2008 the ECB (like the FED and BoE) inflated its balance sheet.

The same the Fed (QE)

And the BoE (QE)

ECB (no QE)

Main monetary policy actions undertaken by the ECB

• Interest rate policy

• Fixed rate full allotment MRO and LTRO (2008…)

• Covered bonds purchases (2008 and 2010)

• SMP (May 2010 and Summer 2011)

• 3y VLTRO (beginning 2012)

• OMT (September 2012)

• Forward Guidance (June 2013)

• TLTRO (June 2014)

• QE

ECB https://www.ecb.europa.eu/pub/pdf/other/art01_eb201504.en.pdf

• Classificazione manovre della balance sheet intraprese in seguito alla crisi:

• - azioni passive En.Cred.Support, VLTRO, TLTRO

• - azioni attive SMP, CBPP, QE

• - azioni condizionate OMT

Why this expansion of liquidity? And where it ends up?

• Given the break up of the interbank market banks wanted to frontload possible liquidity needs

• Peripheral banks were losing reserves as a result of the sudden stop and capital flows reversal, that is the repatriation of loans from the periphery to core EZ countries.

• The TARGET 2 saga.

After VLTRO, before whatever it takes

TARGET2. What is it?

• Acronym: Trans – European Automated Real- time Gross settlement Express Transfer System.

• TARGET2 has to be used for all payments involving the Eurosystem. Operated by the Eurosystem.

• TARGET2 mainly settles operations of monetary policy and money market operations.

In essence, TARGET2 makes possible the transfer of bank deposits and reserves between countries within the Euro Zone.

International payments outside a CU (from Cesaratto 2013)

International payments in a CU (phase 1)

International payments in a CU (phase 2)

International payments in a CU (phase 2/post-crisis)

- The Spanish bank needs 10 monetary units as the reserve corresponding to its 100 m.u.

of deposits.

- The demand for reserves is rather inelastic. A deficit of reserves in Spain would lead to a rocketing interest rate there.

- If the interbank market has dried up, only the Eurosystem can provide required reserves.

TARGET2. How does it work? (exposition by Eladio Febrero)

• When a bank deposit is transferred from Spain to Germany, it has to be done with central bank money.

• At the end of the day, the Banco de España acquires a liability against the Eurosystem (T2 liability) whilst it reduces the Reserve account held by the Spanish bank. Simultaneously, the Buba increasese the reserve account of the German bank when it acquires a claim against the Eurosystem.

TARGET2. Implications for MP implementation

• After the deposit transfer, the Spanish bank does not comply with the reserve requeriment (10% deposits). However, the German bank has excess reserves, amounting to 9 monetary units.

TARGET2. Implications for MP implementation

• The German bank will not lend in the interbank money market its excess reserves at a rate below the MLF.

• The Spanish bank will not borrow in the interbank market at an interest above the MCF.

• Under normal circumstances, banks agree on an intermediate interest rate, which is in the middle of both facilities.

TARGET2. Implications for MP implementation

• TARGET2 claims and liabilities (almost) cancel each other out when the German bank lends its excess reserves to the Spanish bank.

• The Spanish bank complies with the reserve requirement.

• The interest rate that prevails at the interbank market is that of MRO.

TARGET2. Implications for MP implementation

• What happens when the German bank does not wish to roll over its lending to the Spanish bank?

(Hyp: the maturity of the loan granted by SPB is longer than that of the loan granted by GPB to SPB)

– TARGET2 imbalances return, and…

– The Spanish bank does not fulfil the reserve requirement.

TARGET2. Implications for MP implementation

• The Spanish bank needs 10 monetary units as the reserve corresponding to its 100 m.u. of deposits.

• The demand for reserves is rather inelastic. A deficit of reserves in Spain would lead to a rocketing interest rate there.

• If the interbank market has dried up, only the Eurosystem can

provide required reserves.

TARGET2. Implications for MP implementation

• The Banco de España, part of the Eurosystem, lends reserves to the Spanish banking system. It has no other option if :

– NCBs have to contribute to the smooth working of the payment system.

– The interest rate has to be the same in the whole Euro Zone.

– All banks must have the same access to CB funding.

N.B. MROs are implemented by National Central Banks.

• What happens with the excess reserve in Germany?

– The German bank can pay back prior liabilities to the Buba.

– It may try to lend them at an interest rate below the MRO official rate, but this means that the Eurosystem loses control of the interest rate.

– They remain deposited in the deposit accounts at the ECB

TARGET2. Some evidence.

• There is a large correlation between GIPS’ T2 liabilities and

Germany’s T2 claims. When we add Italy to GIPS, the degree of

correlation is a little lower. This indicates financial capital flights from the EZ periphery towards Germany.

TARGET2. A stealth bailout?

• Hans Werner Sinn, president of the highly influential CES Ifo, Munich based Economic Research Institute, has pressed the alarm buttons in the mass media, arguing that TARGET2 imbalances are a stealth bailout of the Euro Zone (EZ) periphery by the ECB.

• Sinn interprets the current crisis in the EZ as a typical balance of payments crisis in a pegged exchange rate system.

• According to Sinn, peripheral countries (PIIGS) are experiencing a BoP crisis (capital outflow) and, therefore, they should adopt the usual measures of economic policy to solve this problem: fiscal austerity –cum- devaluation, with temporary interest rate hikes.

• In his view, T2 liabilities are Eurosystem loans to the EZ periphery, providing them with some relief in a protracted balance-of-payments crisis.

TARGET2. A stealth bailout? Sinn is not wrong (although he had a number of silly considerations aimed to depict Germany as the euro-

victim)

• In a fixed exchange rate system (FERS) a country can finance its current

account deficit either by depleting the Official Reserves or by foreign loans.

In case of sudden stops and once the OR are depleted, it must adjust the CA by domestic deflation and currency devaluation.

• In a currency union, as seen, a country can continue to finance a CA deficit by collecting T2 liabilities with its banks reserves re-created by the

Eurosystem.

• In a FERS international payments lead to a loss of reserves; in a CU it is the same and the loss is counted as a T2 liability (and the gain of reserves as a T2 claim) while the lost reserves are re-created by the ECB.

• The Eurosystem has to lend reserves as the logical consequence of fixing an interest rate which has to be the same across the whole EZ. Moreover, unless it lended reserves, German investors could not repatriate their funds to Germany.

• Similarity with the currency/clearing union proposed by Keynes in the

1940s in which the IMF should automatically recycle the CA surpluses that surplus countries do not want to lend.

TARGET2. A stealth bailout? And a risk for Germany?

• TARGET2 loans are a potential source of risk for Germany in the case of a disorderly euro break up.

• Reserves gained in a CU are T2 claims, not dollars or gold. Reserves lost in a CU are T2 liabilities, not dollars or gold.

• TARGET2 claims yield an interest rate to the holder, paid by the debtor to the Eurosystem (GIIPS). And TARGET2 claims are part of the net international investment position (financial wealth) of a nation, like gold reserves. In the event of a euro breakup, the Banco de España may renege on its international debts (T2 liabilities) so that the Bundesbank will make a capital loss.

• Sinn suggests the ECB should stop lending to the EZ periphery and cancel T2 liabilities with marketable assetsm (gold etc).

TARGET2. A stealth bailout? And a risk for Germany?

• TARGET2 loans are a potential source of risk for Germany in the case of a disorderly euro break up.

• Reserves gained in a CU are T2 claims, not dollars or gold. Reserves lost in a CU are T2 liabilities, not dollars or gold.

• TARGET2 claims yield an interest rate to the holder, paid by the debtor to the Eurosystem (GIIPS). And TARGET2 claims are part of the net international investment position (financial wealth) of a nation, like gold reserves. In the event of a euro breakup, the Banco de España may renege on its international debts (T2 liabilities) so that the Bundesbank will make a capital loss.

• Sinn suggests the ECB should stop lending to the EZ periphery and cancel T2 liabilities with marketable assetsm (gold etc).

TARGET2. A critique.

• What are the true risks for Germany?

In the event of a disintegration of the EZ, or if non-performing loans increase in debtor countries:

– Germany will lose the interest rate on its T2 claims (an ownership income paid by the rest of the world).

– Germany will lose part of its financial wealth (net international investment position NIIP) if debtor nations renege on their T2 liabilities (i.e it is as if Germany had dropped its gold bullion reserves into the ocean).

– According to Sinn, German tax payers should pay for the recapitalization of the Buba.

Target 2/rifinanziamento ECB dove finiscono i soldi?

Liquidity needs and excess liquidity

TARGET2. A critique.

Sinn is right when he claims that the German economy will experience a loss, because the income balance, in the current account balance, will fall, due to a fall in the interest on T2 claims. And there will be a loss of financial wealth as well.

But:

– T2 claims change the composition of NIIP without making it to rise:

German private banks reduce their exposure to PIIGS banks whilst the Buba increases its exposure to the Eurosystem (only 27%).

Dullien and Schieritz, 2012.

– A capital loss may happen if loans are not paid back in the EZ periphery. If the Eurosystem stops providing liquidity, the banking systems will collapse in the periphery and with them their whole economies. Sinn’s recommendations are a self- fulfilling prophecy.

– The value of the Buba’s reserves (denominated in new Deutsche Mark, fiat money) is not backed by its assets; and the Buba can

‘monetize’ as much public spending as needed.

‒ The real risk is that Germany’s new D-mark shall appreciate with regard to the already existing currencies. This is a threat for an exporting country.

Target 2 references:

http://www.ecb.int/pub/pdf/mobu/mb201305en.pdf (chapter on T2)

http://www.bruegel.org/nc/blog/detail/article/731-sudden-stops-in-the euro-area

Febrero E. Uxo J. http://www.uclm.es/dep/daef/DOCUMENTOS%20DE%20TRABAJO/DT- 2013/2013-2%20DT-DAEF.pdf Excellent

http://www.deps.unisi.it/it/ricerca/pubblicazioni-deps/quaderni-deps/anno-2013/681the- implications-target2-european-balance

http://www.cesifo-group.de/ifoHome/policy/Spezialthemen/Policy-Issues-Archive/Target.html Cour-Thimann, P. (2013), Target Balances and the crisis in the Euro Area, CESifo Forum,

vol.14 (april). THIS IS THE BEST PAPER

http://www.cesifo-group.de/ifoHome/publications/docbase/details.html?docId=19088305 Bindseil, U. and P.J. König. (2011) The Economics of TARGET2 Balances, SFB 649

Discussion Paper 2011-035, Humboldt University

Cecioni, M., Ferrero, G. (2012) Determinants of TARGET2 imbalances, Questioni di economia e finanza (Occasional Papers), No. 136, URL:

http://www.bancaditalia.it/pubblicazioni/econo/quest_ecofin_2/qef136;internal&ac tion=_setlanguage.action?LANGUAGE=en)

Sinn, H.W. and T. Wollmershäuer. 2012. “TARGET2 loans, current account balances and capital flows: The ECB’s rescue facility.” International Tax and Public Finance 19 (4):

468-508.

Target 2 references:

Cesaratto, S. (2013c): The implications of TARGET2 in the European balance of payment crisis and beyond, European Journal of Economics and Economic Policies: Intervention, 10, 2013 (3), versioni working paper: http://www.deps.unisi.it/it/ricerca/pubblicazioni-deps/quaderni-deps/anno- 2013/681the-implications-target2-european-balance e

http://www.networkideas.org/featart/sep2013/fa03_TARGET_2.htm

Whatever it takes

After whatever it takes

All’alba del QE

Where is Europe going?

• Austerity is now the main cause of the crisis and one main destabilising factor of the global economy.

• Debate on the size of income multipliers

• Germany does not want to give up its model.

• QE by the ECB – that should buy 1 trilion of sovereign bonds - might help by devaluating the euro (what it will not be liked abroad given that the EZ already is a trade surplus area) and by assuring financial

markets that sovereign debt are safe. Devaluation would stop deflation

• Still, with the structural unbalances brought about by the monetary unification (the EZ is not an OCA), and with austerity still in place, tis will help but not solve the problems.

• Even a consensual Euro break up is difficult, let alone a unilateral

separation. Only a dramatic financial-political crisis will bring about the end of this creazy experiment.

References monetary policy

• Cesaratto, S. 2015. L’ORGANETTO DI DRAGHI: QUATTRO LEZIONI CRITICHE SULLE MISURE NON CONVENZIONALI DELLA ECB SINO AL QUANTITATIVE EASING, WP 2015/10: http://www.asimmetrie.org/working-papers/wp-201510- lorganetto-di-draghi/ (further references here)

• in questo post:

http://politicaeconomiablog.blogspot.it/2015/10/target-due-sulla-natura-della-crisi.html vi sono riferimenti e link a paper e altri interventi relativi alla mia discussione con Marc Lavoie sulla natura della crisi europea. Il mio paper di critica a Lavoie dovrebbe

essere scaricabile (sino a 50 copie) qui:

http://www.tandfonline.com/eprint/UbSXuQVeSkjssMqQmPpB/full

Further references monetary policy

• ottimo manuale www.ecb.int/pub/pdf/other/monetarypolicy2011en.pdf?

d51bad0288e53a9d35f77c3a3f6674df

• Cour-Thimann & Winkler 2013 The ECB’s non-standard monetary policy measures, the role of institutional factors and financial structure, ECB Working Paper SerieS NO 1528 / april 2013, http://www.ecb.europa.eu/pub/pdf/scpwps/ecbwp1528.pdf

• Fabian Eser, et al, The role of The central bank balance, sheet in monetary policy, ECB OCCASIONAL PAPER SERIES, NO 135 / AUGUST 2012,

http://www.ecb.europa.eu/pub/pdf/scpops/ecbocp135.pdf

• ECB Economic Bulletin, Issue 4 / 2015,

https://www.ecb.europa.eu/pub/pdf/other/art01_eb201504.en.pdf