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.)


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.