In a number of recent columns that have been widely cited, Hans-Werner Sinn (2011a, 2011b) critiques something he calls “the ECB’s stealth bailout” on the basis of figures from the Eurosystem’s intra-Central Bank payments system known as Target2. Professor Sinn argues that:
- The Bundesbank has been lending large amounts of money to the central banks of peripheral countries – Greece, Ireland, Portugal, and Spain;
- This lending to peripheral countries is causing the stock of credit in non-peripheral countries to shrink; and
- The solution to this problem is to place limits on the functioning of the Target2 payments system.
Here, I argue that Professor Sinn’s analysis is incorrect and that his policy prescriptions are extremely dangerous.1
ECB lending and Target2 balances
Recent years have seen a sharp reduction in borrowing by peripheral banks from German banks through interbank money markets and bond markets. The peripheral banks have replaced much of this interbank borrowing with borrowing from the ECB via its lending (refinancing) programmes. The result has been a large net transfer of funds from, for example, Irish banks to German banks.
Target2 is the Eurozones’s “plumbing system” that enables these transfers. This works as follows. Eurozone banks maintain accounts with their country’s central bank. When an Irish bank writes a cheque to a German bank, the Target2 system deducts the Irish bank’s account at the Central Bank of Ireland and credits the German bank’s account at the Bundesbank. Technically, the Bundesbank incurs a new liability in the form of an increase in the value of the Bundesbank account of the bank cashing the cheque but this is offset by a claim against the ECB which appears as an asset on the Bundesbank’s balance sheet.
Recent years have seen the Bundesbank accumulate large Target2 claims against the ECB while other countries have accumulated negative Target2 balances. The picture below shows Target2 balances at the end of 2010 (Deutsche Bundesbank 2011).
Is the Bundesbank lending to peripheral central banks?
Professor Sinn’s “stealth bailout” article correctly states that Target2 balances represent claims owed either against or towards the ECB. His mistake, however, is how he interprets these balances. He states that they represent bilateral claims of the Bundesbank on other central banks. He says “it is as if the Bundesbank had lent money to the Irish Central bank for the purposes of extending a loan to an Irish bank.” But it is not. If I loan you money, I lose money if you don’t pay back. In this sense, the Bundesbank is not owed money by the Central Bank of Ireland. It is owed money by the ECB. If the Irish Central Bank refused to pay, it would be the ECB on the hook, not the Bundesbank. The Bundesbank can only lose money if the ECB refuses to pay it back.
The statute governing the ECB requires that it must be solvent, so it is as close as one can come to a completely safe borrower. Because of this, the Bundesbank’s Target2 claim does not represent a risk to the Bundesbank’s balance sheet. The current risk to the Bundesbank stems from the requirement that national county central banks recapitalise the ECB should it became insolvent due to losses on its lending operations or its portfolio of government bonds. The statute requires national country central banks to contribute to this recapitalisation exercise in proportion to their ECB capital. In Germany’s case, this would require covering 27% of credit losses. If the Bundesbank does not have sufficient funds to cover these losses, it would need to be recapitalised by the German taxpayer.
So the credit risk to the German taxpayer stems from the Eurosystem’s refinancing operations, not the Target2 payments system. If it was France and not Germany that had built up a large positive Target2 balance, the risk to Germany stemming from the ECB’s lending operations would be identical to what it is now. Professor Sinn’s focus on Target2 balances is a red herring.
Crowding out German credit creation?
Professor Sinn also argues that the ECB’s lending to peripheral economies (GIPS in his terminology) is “crowding out” credit in Germany. He writes that “If every year a further €100 billion is granted to the GIPS as Target loans, the stock of credit given by non-GIPS central banks to their commercial banks via refinancing operations will shrink by the same amount”. This is because “strict crowding out is inevitable if the ECB controls the overall stock of central bank money in the Eurozone by way of sterilising interventions or auctioning off limited tenders.” Indeed, Professor Sinn worries that current ECB policy “shifts too much economic vigour to the GIPS” and will trigger a serious inflationary problem.
These are highly misleading claims. The ECB is not currently auctioning off credit via limited tenders. Instead, they are providing the full amount of liquidity requested by banks provided they have sufficient eligible collateral. No German bank is being denied funds from the ECB because of the lending operations to Ireland or other countries.
Is Sinn’s vision of German banks starved of credit likely to come true at some point in the future? The ECB has indicated that its approach of providing as much liquidity as requested will be changed “when appropriate”. The obvious concern about this policy is that the absence of a limit on loans to peripheral banks will lead to a credit-fuelled upturn in inflation, which would then lead the ECB to end the policy.
At present, however, we are seeing the opposite pattern. Peripheral countries (e.g. Ireland and Greece) receive large amounts of funding from the ECB. Yet they are experiencing falling private-sector credit. The reason is that the Eurosystem loans are viewed by banks as no more than a temporary replacement for the private-sector funding that was previously available.
So there’s no need to worry about too much economic vigour in these countries! More broadly, Eurozone M3 is growing at a slower pace than seen in any of the euro’s pre-crisis years when inflation was well under control.
Sinn’s vision of lending to peripheral countries leading to falling credit in Germany and a collapse of the euro due to inflation is scare mongering without any basis in fact.
Sinn’s Target2 proposals
To avert the nightmare scenarios he believes are about to occur, Professor Sinn’s articles have proposed various reforms to the Target2 payments system. In his Project Syndicate article, he proposes setting a cap on Target2 accounts. He believes that individual country central banks have control over their Target2 balances. He praises Mario Draghi for keeping the Banca d’Italia’s lending under control even though Draghi may have been “sorely tempted” to accumulate a Target2 deficit. The truth is that the Banca d’Italia has simply implemented Eurosystem lending operations and Target2 transfers according to the same rules as other participants. Mr Draghi’s ability to resist temptation had little to do with it.
Consider what a limit on Target2 balances would imply. Imagine it’s September 2012 and I’m writing a cheque to a German economics journal to pay my submission fee. However, the cheque bounces. Even though I have sufficient money in my account, I’m told that Ireland has reached its limit on its Target2 balance, so the ECB is refusing to transfer my money. In other words, the euros in my bank account can’t do the same things that a euro in a German bank account can do. In other words, this kind of suspension of transfers would mean the end of the euro as a single currency.
Professor Sinn’s latest Vox column proposes that Target2 balances should be settled each year. Central banks that have a Target2 deficit would pay up and these funds redistributed to central banks that have a positive Target2 position. (Presumably understood is that this would require fiscal support from national governments if the country’s central bank did not have the funds).
Again, let’s be clear about what this means. If this system was implemented this year, the Central Bank of Ireland would have to pay over €150 billion, equivalent to a full year of Irish GDP and way beyond the slim financial resources of the Central Bank. Debts run up by privately-owned banks to the ECB, funds borrowed to pay off German and French banks (with the explicit encouragement of the European authorities on the grounds that to do otherwise would endanger European financial stability) would end up being paid off immediately and in full by Irish citizens handing over a full year of their incomes. This is nonsense.
Sinn justifies his proposal for annual settlement of Target balances on the grounds that this is the approach adopted by Federal Reserve Districts for their Fedwire payments system. However, this is a very poor analogy. Federal Reserve districts have no fiscal connection with the states that they serve.
Suppose there was a regional bank-run in, for example, the district overseen by the Federal Reserve Bank of San Francisco and this meant that the San Francisco Fed did not have sufficient gold or securities to settle its Fedwire balance. Who does Professor Sinn imagine San Francisco Fed President John Williams is going to ask to provide the money to settle this balance? If such a scenario ever arose, Mr. Williams would most likely call Ben Bernanke to explain that the annual settling of balances would not be taking place this year. He wouldn’t find any disagreement on the other end of the line.
The Eurosystem has serious problems and the citizens of its member states have many reasons to question the wisdom of the decision to adopt a single currency. However, this situation isn’t helped by respected public figures making incendiary claims about how the system works and putting forward policy proposals that would cause chaos if implemented.
Deutsche Bundesbank (2011), “The German Balance of payments in 2010”, Monthly Report, 34-25.
Sinn, Hans Werner (2011a), “The ECB’s Secret Bailout Strategy”, Project Syndicate, 29 April.
Sinn, Hans Werner (2011b), “The ECB’s stealth bailout”, VoxEU.org, 1 June.
Sinn, Hans-Werner and Timo Wollmershäuser (2011a), "Target Loans, Current Account Balances and Capital Flows: The ECB’s Rescue Facility" CESifo Working Paper Nr. 3500, 24 June.
Storbeck, Olaf (2011), “The stealth bailout that doesn’t exist: debunking Hans-Werner Sinn”, 6 June.
Whelan, Karl (2011). “Professor Sinn Misses the Target”, The Institute of International and European Affairs, iiea.com
1 Since I wrote the original version of this article (Whelan 2011), I have come across this excellent blog post by Olaf Storbeck of Handelsblatt, which makes some of the same points.