Sunday, November 11, 2012

Prof. de Grauwe's one-sided view of Target2

Prof. Paul de Grauwe argues in the article, among others, that:

* If a breakup of the EZ were to materialize, this will lead to losses for Germany, independently of the existence of Target2.
* Germany could have avoided this by reducing its current account surpluses; it refused to do so and thus the responsibility for this risk is Germany’s, and not some obscure system like Target2.
 * German banks were willing to lend vast amounts of money to peripheral countries without doing a proper credit risk analysis. No one other than Germany itself is responsible for taking on these risks.
 * With or without TARGET2, the risk that arises from reckless lending by German banks will have to be borne by Germany.

I agree with Prof. de Grauwe’s partial diagnosis but emphasize that is indeed only a partial one. It does not speak for Prof. de Grauwe that he only paints one (convincing) side of the picture while ignoring the other (equally convincing) side. 

Prof. de Grauwe admirably discovers that a country’s Balance of Payments must balance. For mathematical and not for economic reasons, that is. Thus, a surplus in the current account must be offset by a deficit in the capital account. The price which Germany had to pay for its horrendous surpluses in the current account with the rest of the world in the last decade or so was having to make loans to the rest of the world. The same goes for China.

The question is only: what does one do when that problem erupts like it erupted with Greece in late 2009? Does one try to cure it by prolonging it or would it have been better to cure it at the source? Target2 massively contributed to prolonging the problem and, thus, turning it into a potential powder keg.

From the beginning of this blog, I have argued that one should have cured the problem at the source. In the case of Germany, that would have meant: stop Target2-funding for Greece; have the German banks write down their Greek claims to low market values; have them ‘beg’ for a government bail-out; have the government save those banks which justified saving and close the others.

The cost to German tax payers would initially have been similar to the cost which they have not recognized to date. However, the tax payers would have gotten something in exchange for that. They would have gotten temporary ownership of those banks and the hope that upon re-privatization, they could recover some of those losses. The banks' shareholders would have been wiped out (and possibly some bondholders, too). Prof. de Grauwe suggests that 'Germany' is 'Germany'. In actual fact, there are Germans as tax payers and there are others (not only Germans) who own German banks. Prof. de Grauwe seems to support a method where tax payers are called upon to not only save their banks but also their shareholders and speculative investors.

Target2 (and the rescue loans) made it possible that this decision could be avoided. Thus, the deficit countries never really experienced the type of financial crisis which a country normally experiences when it hits external payment problems: as the funds flow from abroad stops, the current account must be brought into balance virtually overnight. Instead, the deficit countries could continue with their current account deficits, this time not financed by reckless banks but, instead, by tax payers.

Prof. de Grauwe exclusively focuses on imbalances in current accounts. He completely ignores imbalances within the capital account. The massive deposit flight in deficit countries, which exceed the deficits in current accounts since the crisis erupted, was only possible because of Target2. Tax payers’ money was de facto automatically transferred to, say, Greece so that wealthy Greeks could take their money out of Greek banks.

Prof. de Grauwe might argue that this, again, is a circular mechanism: whatever German tax payers transferred to Greece was returned by those wealthy Greeks to German banks. Is he not aware that there are places like London, Switzerland, Singapore & Co. (none part of Target2) which also attracted a lot of Greek money?

Prof. de Grauwe completely ignores that a huge part of commercial/financial transactions in the Eurozone took place with counterparties outside the Eurozone. Since the Euro, Greece’s current account deficit with Germany accounted for only 15% of its total deficit. How about the other 85%? For example, Greece’s current account deficit with Germany was in the same magnitude as its deficit with China. Have Chinese tax payers been called upon to contribute their fair share? They would have, had there not been the Target2-system. Instead, the Duchy of Luxembourg became the most overexposed country (with Target2-claims of almost 3-times its GDP). Did Luxembourg have current account surpluses in that magnitude? Or how about Finland? How about Holland?

The relationship between current account surpluses, deficits and cross-border lending is a bit like a chicken-and-egg process. What comes first? If Germany had not lent to Greece, then Greece could not have imported so much from Germany; Germany’s current account surplus would have been smaller and, thus, its banks could not have lent so much to Greece… Target2 did not cause the process but it certainly accelerated the problem once the crisis erupted.

Prof. de Grauwe completely ignores one of the pillars of finance: lending/borrowing is a joint responsibility of lenders/borrowers. The lenders (among them the German banks) messed it up real good and they and their shareholders (and, in consequence, the German tax payers) should have been made accountable for that.

The argument is made in some places (I hasten to add that Prof. de Grauwe does not make it!) that fast-talking foreign bankers literally forced those loans down the throats of financially illiterate Greeks. Similar to those fast-talking mortgage salesmen who bullied unemployed Americans into taking up loans to buy a house. To even put such suspicions in writing  is a giant act of irresponsibility.

The decision to take up Greece’s foreign debt was taken by a very small group of people: executives at the government’s debt management agency, at the Greek banks and at the Bank of Greece. Direct foreign loans to Greek borrowers are virtually not in existence. Certainly the executives at the government’s debt management agency and at the Bank of Greece were professionals of very high international regard. I cannot judge the competence of the bank executives’ competence but I have to assume that they knew more about banking than the above-mentioned unemployed Americans. 

Prof. de Grauwe is correct when arguing that Germany, actually since WWII but specifically since the Euro, pursued an economic model of current account surpluses (the expression “export champion” is something which Germans are proud of). Enormous current account surpluses carry the same risks as enormous deficits. Germany has ignored that and will, thus, inevitably pay the price for it.

However, Prof. de Grauwe is intellectually less than honest when he argues that this is exclusively a responsibility of Germany (and not of Target2). Someone who robs a bank is responsible for that. If the bank left its doors open, it, too, is responsible for that. Target2 left the doors wide open to extend enormous current account deficits on the part of Greece & Co. after the crisis erupted and, above all, to facilitate enormous deposit flight. Deposit flight is natural in any financial crisis. It takes the existence of something like Target2 to turn it into a fuse cord towards possible future economic wars.


  1. It seems to me that, indeed, professor de Grouwe is less than honest in his argumentation. For a man who is professor of economics, frankly, this is rather a shame.

  2. How could it be that so many most learned professors of economics cannot come to a common understanding of this issue.

    Could it be that they don't understand, or are they just flying kites, parading like peacocks with shimmering feathers displayed as a fan - look at me, look at me - I am so clever, I am so pretty - I just got another paper published - of which I believe not a word - ha ha ha.

    They're all charlatans.


    1. I think the answer is that there a clearly two different explanations of the problem, each explanation has enthusiastic followers and the mindset of learned people is often to focus their energies on arguing their points instead of focusing on solutions.

    2. But its a 'bookkeeping issue' isn't it. Why don't Draghi & Weidmann just come out and say what will happen w.r.t. T2 in the event of a Grexit, or a collapse of the euro, etc - surely they have discussed this and made decisions.

      It would give the markets what they are said to crave - certainty. And it would thwart the media, who crave the opposite - fear, uncertainty and doubt.

      Then the likes of Sinn, Whelan, de Grauwe etc can get back to contemplating angels and pins.

      I still don't get why the EMU has these sort of problems yet the Central/West African Currency Union (CWACU) doesn't - maybe we just don't hear as much. One of the biggest economies in that union collapsed a couple of years ago - Cote d'Ivoire - the currency seemed to provide a source of stability to the region. CWACU has existed in one form or another since Bretton Woods!

      I'm wondering whether the Europeans elites are deliberately prolonging the crisis in lieu of their more traditional means of getting attention - fighting wars amongst themselves and dragging the rest of the world into their conflict.


  3. The complete documentation of the Target2-debate:

    1. Wow! Is there possibly another subject which has attracted so much attention? Perhaps the subject of how to get real economies going again... (sorry for this cynic point!).

  4. What are you suggesting exactly? That Target2 should be disabled? It can't, if you want the common currency to exist. As a central bank you can't deny liquidity, or you lose your interest rate (at best) and you endanger the whole payments system (at worst).

    1. From the start, Target2 (the ECB) should have adhered to the rules, i. e. first class securities as collateral for debit balances. If no more collateral, no more debit balances. If collateral is downgraded to junk, reduce debit balances. That is how Central Banks have worked ever since they were formed.

      That would have required governments to address the issue from the start. For example, if Greece sees that the ECB is going to cut all its banks off ECB liquidity, then Greece would have to bail out its banks. Since Greece would not have had the resourecs for that, Greece would have had to go to the EU/IMF for bail-out's. Either way, politicians could not have unloaded their responsibility to the ECB.

      In the final analysis, there would have been, from the start, much more pressure to reduce current account deficits and, above all, to reign in deposit flight.

      Every bank, even the huge Deutsche, has to manage its liquidity reserve. Typically, they do that by holding eligible securities against which they could obtain last-resort financing from the ECB in case of need. Even if the huge Deutsche, one day, ran out of its liquidity reserve, it would have to close for business. Tt wouldn't close; instead, it would be bailed out by the German government. If the German government couldn't handle that, it would have to be bailed out itself. One of the reasons why bank are cautious about their liquidity reserve is because they now they could go out of business if they didn't.

      In short, Target2 should not have been diesabled. It should have been run they way it was designed under the very controls that had originally been stipulated for it.

      A Central Bank cannot deny liquidity? Well, how do you think most banks fail? They fail because they run out of liquidity. Very few fail because of non-compliance with minimum capital. In fact, if you look at bank failures, very many of them showed very solid balance sheet figures the day before their failure. Think of Lehman!

  5. Target2 does adhere to the rules. Liquidity to Greek banks is given through the Emergency Liquidity Assistance provision, which is the liablity of the Greek Central Bank and not the Eurosystem's.

    You're telling me that the ECB should let the *entire* Greek banking system fail. You're describing an improbability, for obvious reasons.

    Furthermore, even if - theoretically - that happened, what's the difference? As you say, Greece would be bailed out in order to recapitalize it's banks. Which is pretty much what's going to happen now.

    You're also telling me that the ECB should lose it's interest-rate target.

    That's not how a common currency and monetary policy works.

    You also correctly imply that the rise in Target2 imbalances is primarily due to deposit flight rather than current account deficits. How exactly are you going to stop deposit flight in the single market and common currency? You can't.

    It seems to me that - reforms in Greek society aside - your blog mostly supports solutions that can only take place under a sovereign currency.

    1. When a country runs into such an extreme external payments crisis as Greece did beginning in late 2009 (essentially, a run on the entire country had started), the two traditional instruments are: (a) curtailing imports (either through special taxation or outright controls) and (b) capital controls (not excluding the possibility of an overall deposit freeze).

      You will say that this would violate EU-treaties. Correct! But as we have seen for over two years now, EU-treaties were not designed to deal with the type of crises we have seen and thus they have to be violated all the time. There is such a thing as emergency situations and emergency situations require emergency laws. By the time EU-courts would have settled any law suits, the crisis would have been over.

      With import and capital controls, the awareness that there is a crisis hits almost ALL people immediately. In Greece, a reasonably large section of society is not affected by the crisis even today (and some even benefit from it!). The sooner you have awareness that there is a huge crisis, the sooner you will get preparedness to solve it.

      Just so you don't mistake this as a 'downgrading' of Greece on my part: after Lehman, a massive confidence crisis spread throughout Germany approaching panic (as I remember, in Greece there was nothing like that at the time). Chancellor and Finance Minister had to publicly guarantee all deposits. That worked, and no run started. If it had not worked, even the 'honorable' Germany would have had to implement a deposit freeze (temporarily). In retrospect, politicians are admitting that today.

      I was not arguing that the entire Greek banking system should have been allowed to fail. Instead, I was arguing how it could have been saved properly.

      The difference between what I am suggesting and what happened is that the problems would have remained where they belonged: foreign creditors would have had to reschedule their Greek debt (instead of being able to pass it on to tax payers); Greece would have required substantially less Fresh Money from abroad because of lower imports and no capital flight; and Greece would have started from day 1 with real problem solving instead of dancing around for 2 years.

      That’s not how ‘a common currency’ works? We could debate this forever. Let me say this: it seems pretty clear by now that the inventors of the Euro never wanted it to work like the ‘common currency’ which you have in mind and they made all kinds of restrictions which are uncommon in a ‘common currency’.

      You are correct in observing that my mindset starts with the question “what would happen if there were sovereign currencies”. I start with that premise and then I ask myself what kind of measures should be taken with the Euro to simulate as much as possible what would have happened with a sovereign currency. This no to kill the Euro but, instead, to maintain it. I do think the Euro is, on balance, good for everyone. It’s ‘first round’ was kind of blown because the Euro’s users didn’t act properly (and I definitely include EU-authorities among the ‘users’!). So, my pragmatic approach is: forget the ‘first round’ because it is spilled milk; divide the damage evenly and start with the ‘second round’ as quickly as possible BUT do it right then. But for God’s sake --- don’t procrastinate!

      PS: the ECB did NOT adhere to T2-rules! Once the Periphery banks ran out of government bonds as collateral, they started accepting all sorts of other collateral (in fact, they should have stopped lending when the government bonds were downgraded to junk). The ELA came only much later when they saw that they had to find a ‘more official by-passing of rules’.

  6. "Let me say this: it seems pretty clear by now that the inventors of the Euro never wanted it to work like the ‘common currency’ which you have in mind and they made all kinds of restrictions which are uncommon in a ‘common currency’."

    I agree, and it's a serious problem, as the recent downgrade of France shows.

    It really is quite entertaining watching Europe self immolating just because they realized - halfway through - what a common currency really means.

    Fools, fools.

    Own up, and either complete this incomplete common currency, or abolish it.

    1. I just saw this very interesting article. It sort of proves my point: even though the Euro may not have been designed as a real 'common currency', it could have worked if the 'users' had not blown the 'first round'. The problem is that closing the 'first round' once and for all will cost a LOT of money (actually, it has already cost that money; the cost just hasn't been recognized yet). But if one would close the 'first round' and get it over with, there is no reason why a 'second round' shouldn't have a fair chance.