More Target2 divergence: This time is different

In the midst of the Eurozone “sovereign debt” crisis and increasing spreads in 2010-11, interbank lending came to a halt. At the same time, bank clients were moving funds from the banks of the countries “in trouble” to the banks based in “safe countries”. Because “core” banks were not willing to lend liquidity back to them, “periphery” banks borrowed from the Eurosystem to settle their payments, and Target2 balances diverged. This ended with Draghi’s “whatever it takes” announcement in the Summer of 2012 and the introduction of OMT in the ECB’s toolbox.

What is happening today (SEE CHART) is very different, and does not reflect a “flight to safety” as it did back then. Today’s divergence is a consequence of the ECB asset purchase program (QE), as well as of the current levels of policy interest rates set by the ECB.


The ECB is currently offering overnight credit to banks at 0.30%, is charging a 0.20% on overnight deposits in excess of any required amount, and offers liquidity in its weekly refinancing operations at 0.05%.

It seems that the bulk of the sellers of bonds to the ECB are clients of German banks (or banks in non-euro countries that are using German banks as correspondent banks). So banks settle the bonds for their clients, credit the account of their clients, and their liquidity balance goes up.

Because liquidity is more than banks need, most banks have no borrowing needs, and any excess liquidity is hardly loaned to other banks. Under conditions of ample liquidity, those few banks that need liquidity have two options: Borrow in the interbank overnight market for liquidity, where the interest rate is currently around -0.1%, or borrow at weekly ECB auctions at 0.05%.

What happens is that banks in the “periphery” would only be willing to borrow from German banks with ample liquidity at a cost that is less than 0.05%. Banks in the “core”, however, still perceive a counterparty risk on banks in the periphery, although much less dramatic than in 2011-12. And as long as their lending premium is high enough to make borrowing from the Eurosystem a more convenient option, banks in the “periphery” borrow directly from the Eurosystem. The result is that T2 balances in “core” countries go up, while T2 balances in the “periphery” go down.

In conclusion, the QE liquidity largely goes to banks in the “core” and sits there. This also means that “core” banks are the ones most penalized by negative rates.

Mario Monti defends the austerity fortress

I have known Mario Monti since the time he was my professor of Monetary Economics in the late 70s. An excellent teacher, he opened his course by teaching financial accounting and balance sheets, explaining that every financial asset has a corresponding liability and demonstrating the importance of net sectors’ financial positions.

Today, Mario Monti chairs the EU “high-level group on own resources”, working on a reform of the EU budget. In an interview by Federico Fubini (Corriere della Sera, 18 October 2015), he discusses the current state of public finances in the EU and shares his concerns that the tight fiscal policy enforced in highly indebted EU countries is now being relaxed prematurely.

I do believe Monti has a point when he claims that the recent EU concessions on budget rules have initiated a tendency toward flexibility, risking a possible loss of credibility for EU rules. He may also have a point when he argues that the Italian government’s tight fiscal policy in 2011-13 (under Monti’s premiership) may have contributed, politically, to convincing Germany to accept Draghi’s “whatever it takes” move that saved (so far) the euro.

But Mario’s view of public debt is, I’m afraid, outdated.

In the cited interview, Monti criticizes Italian Prime Minister Renzi for being too relaxed on fiscal rules. I won’t discuss here if Renzi’s projected budget indeed deviates,  and, if so, how much, from EU rules. This is not the point here. My point is Monti’s approach to public debt and his concerns about fiscal flexibility.

I too am concerned about flexibility, but, I suspect, for a different reason. I fear that easing fiscal rules through a non-transparent process may raise more political discontent among EU partners. A sounder political approach would be fiscal expansion coming from a shared EU governance decision. And yet, as long as the latter is not yet happening, what’s wrong, economically, with the EU permitting larger deficits than the rules allow?

On the contrary, Monti is alarmed with flexibility for precisely an economic reason. He views public debt as a gift to today’s voters, funded by future voters’ money. And I suspect he would use this same argument if a larger fiscal deficit were the result of a shared EU decision. Monti’s concern is not only about single euro members attempting to get away from rules; it is about making any exception to those rules, at any level of government.

This is where I believe Monti is wrong, and I will show why by building on the concepts that he taught me long ago.

An accounting rule that Mario taught in the first two weeks of his course says that every financial asset must have a liability and that each sector’s position is measured by its net balance. The logical consequence is this: Because the private sector, notably households, develops a demand for financial savings (consisting of a variety of financial assets), households can accumulate their desired stock of financial assets (aka savings) only if other sectors are willing to accept an equivalent stock of liabilities.

This means that in the midst of European stagnation, where households are unhappy about their stock of financial assets (and thus keeping their demand for goods low), the solution lies in finding ways to increase other sectors’ liabilities.

The key to the argument is this: Europeans can count on only three possible sources to fund their desired savings. First, they can count on the private sector, notably, non-financial firms, increasing their borrowing to invest. Second, they can count on foreigners buying more goods from Europe than Europe imports, so that Europeans receive back euros or hold increasing positions of foreign currency, notably dollars. Third, they can count on governments allowing the deficit to grow.

There are today strong reasons to believe that the first two channels may be viable in the short run and yet are unsustainable in the long run. Monti’s view, however, is the opposite, and he argues that the problem is public debt and that large deficits today mean more taxes in the future.

Monti does not explain how realistic it may be, at this time, to fund private saving by an increase in private debt or by an increase in net exports, nor how long that could continue before it all becomes, again, unsustainable. Also, Monti should clarify what he means when he states that public debt today means more taxes in the future.

Large deficits today could indeed mean more taxes in the future if the economy appropriately responds to fiscal expansion to the point that growth becomes so strong that a tax hike might become reasonable to slow down growth. This, however, would only reflect the  full success of fiscal expansion!

It is equally true that large deficits today could provoke an EU reaction of forcing a tax hike, but this would be the result of the application of EU rules.

The concept that large deficits today inevitably mean more taxes weighing on future generations is just not true. Money is not like a reserve of food that the current generation consumes leaving none to its children. Government debt is no different from banknotes in circulation, or banks’ accounts at the central bank, and they can all be considered the “monopoly money” that functions as the “wheel of commerce” (in Adam Smith’s words). Having long abandoned the gold standard, there is nothing else the government owes us in exchange for its money except to honor its obligation to accept its currency when we make payments back to the government!

Future generations have been highly penalized by the EU’s austerity approach to macro policy that has blocked the possibility of governments funding private savings and has forced households and firms to deleverage. This leaves no other relief except for exports, thus reinforcing the misconception that the only way to end the crisis is through the trade balance, ignoring the fundamental truth that our net exports are dependent on foreigners funding their own spending with more debt.

Dear Professor Monti, balanced-budget rules only mean either compelling the domestic private sector to increase its own indebtedness or taking advantage of foreigners’ own indebtedness. Neither of these results would seem to be in the best interest of future generations!

Eurozone desperately needs a “FISCAL WHATEVER-IT-TAKES”. But EU leaders ain’t bold enough to act.

Even under the rosiest scenario that a deal is reached on Greece’s new three-year bail-out program, the economic conditions of Greece, and of the Eurozone as a whole, will remain serious. Europe seems unable to find the political path to move out of such deadly gridlock. Yet, the logic is simple.

Eurozone like Monopoly

Consider the Eurozone like the game of Monopoly. Continue reading