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Chart of the day: Net Target2 Balances in Eurosystem show capital flight

I like Karl Whelan’s take on what this Target2 chart means (underlining added):

My assessment, as argued in this article is that the Bundesbank losing its Target2 credit would be no more than a minor inconvenience to Germany. We now live in a world of fiat currencies. The man that accepted that euro for your cup of coffee this morning didn’t do so because he believes the central bank has “positive equity”.  He did so because it’s the legal tender of the land.

The post-EMU Bundesbank (it wouldn’t be a new central bank) won’t have to worry about its equity position because it won’t have the same kind of solvency concerns that you and I have because it has the power to print money. (See this recent Bill Mitchell blog post “The ECB cannot go broke – get over it”).

Another disappointing aspect of Burda’s article is that while there is a single mention of “capital flight”, the use of language in the article predominantly links Target2 balances with the traditional trade balances associated with David Hume specie-flow theory. I’m sure Burda knows this but it is worth reminding people again that the ever-growing Bundesbank Target2 balance relates far more to capital flight from the periphery than current account balances

The Target2 problem is really a manifestation of an accelerating bank run. I have said many times, this is my major concern, the bank runs and the resulting shrinking credit and likely deadweight loss that accompanies them.

In terms of insolvency, I should note that when I first wrote about this I said "central banks can go broke". But now I think that’s a very misleading headline. Companies can operate with negative equity and be considered solvent as long as they are self-funding. Individuals with negative home equity (and negative net worth) are not necessarily insolvent either. Insolvency means that one cannot repay one’s debt. Negative equity is a different condition. I should help you separate the two mentally if I want to be honest and unbiased in presenting the issues. I apologise for not doing this before.

I would put the central bank solvency issue somewhat differently than Whelan though. The truth is that central banks can have negative equity, yes. This doesn’t matter operationally. As Whelan writes, a central bank "has the power to print money". The CB can have negative equity for a very long time. That said, I don’t think it’s politically tenable to have a major central bank operating with negative equity. When the Fed was buying up dodgy assets earlier in the crisis it came under attack for these same reasons.

Former Atlanta Fed President William Ford says, technically, yes, the Fed can go bankrupt. He argues that the Fed’s balance sheet is highly leveraged as a result of quantitative easing expanding its balance sheet. The result is that the Federal Reserve is thinly capitalized despite its having just transferred a record $80 billion in profit to the US Treasury. Ford says that this creates a situation in which the Fed would be technically insolvent on a mark-to-market basis if interest rates were to go up 1%.

My take: there is certainly a ‘political’ element to this analysis, namely a desire to rein in the Federal Reserve…

You can spin it however you like but the politics of a central bank’s operating with negative equity go to trust in the currency. In my view, a central bank’s operating with negative equity would severely undermine the trust in the currency’s value. From a political standpoint Willem Buiter is right to argue:

it may be desirable for the Treasury to recapitalise the central bank should the central bank suffer a major capital loss as a result of its lender of last resort and market maker of last resort activities.

This is why the Germans should be worried about Target2. The question, of course, is what should be done then.

Source: Universität Osnabrück

(Thanks to Mark for pointing me to the chart.)

About 

Edward Harrison is the founder of Credit Writedowns and a former career diplomat, investment banker and technology executive with over twenty years of business experience. He is also a regular economic and financial commentator on BBC World News, CNBC Television, Business News Network, CBC, Fox Television and RT Television. He speaks six languages and reads another five, skills he uses to provide a more global perspective. Edward holds an MBA in Finance from Columbia University and a BA in Economics from Dartmouth College. Edward also writes a premium financial newsletter. Sign up here for a free trial.

6 Comments

  1. Dave Holden says:

    Yes, the elephant in the room, that place where what’s operationally possible meets what’s politically credible.

    • David_Lazarus says:

      The problem for the US is that nothing is politically possible, and what is credible will not be done. Overall the US banking system is still insolvent. Adding several trillion of QE does not hide that fact. House price indexes are lower, but they are still a long way from being affordable compared to median wage rates. Everyones expectation of valuations are still way too high. The high cost of property is imposing a huge burden on households and its ability to repay normal debts. If the Fed is insolvent with interest rates of 1% then what prospects are there for many households who are in the same position? While muddling through might be working for now it has stopped households paying down debt and saving. That can only mean trouble at some point. 

  2. Christian Kurzer says:

    The graphic is down.

  3. The Dork of Cork says:

    Surely a Treasuary Prints Fiat as acknowledged by Buiter – as a Central Bank Needs Collateral.

    Look back to 1914 , the BoE was a private central bank back then , there was a run on the BoE by the various clearing banks as they feared (quite rightly) that their customers were hoarding sovergins.

    To facliatate the medium of exchange the Treasuary issued unbacked Notes(under the classical gold standard ) (although I believe they did pay the going  interest rate  of the day). which covered 20% of the Banks liabilities.

  4. Blissex says:

    «suffer a major capital loss as a result of its lender of last resort and market maker of last resor»

    Ahhhh the usual weasel euphemisms!, this times used by Buiter. A central bank can hardly suffer capital losses, never mind ones major ones if it acts as “lender of last resort and market marker of last resort”; it may suffer illiquidity, but not capital losses.

    But obviously the Fed Board has been acting as patsy of first resort, by buying at grossly inflated prices toxic securities from the various banks that needed recapitalizing after distributing a large chunk of their risk-adjusted capital as bonuses and other compensation to their management.

    • David_Lazarus says:

      Yes but for the European eurozone central banks they cannot print money so can go bankrupt as well as insolvent, they too are currency users not issuers. So really the role of lender of last resort is death sentence for the central bank that bails out its insolvent national banks. You only have to look at what it has done to Ireland to see the outcome. It forces austerity on a nation to re-capitalise its central banks who in turn have been sucked dry by its insolvent national banks.

      The US and UK central banks can always print money to save themselves. The issue of trust in the central bank becomes another matter. So for eurozone central banks the end result of each banking crisis is eventual bankruptcy of each state as losses are made good by a sovereign central bank that is a currency user. The concept of lender of last resort is valid, but not in a world where the banks are allowed to lend well beyond the ability of central banks to act as lender of last resort. The ECB needs to take on the role of lender of last resort and reimburse sovereign banks for any banks already bailed out. This would drastically reduce the debt burden for Ireland and could set an example of how to resolve this crisis.