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Professor Sinn Misses the Target

07 Jun 2011

Hans-Werner Sinn is a leading German economist and president of the influential Ifo Institute. Sinn has recently written some columns (here and here) that are extremely critical of the operation of the Eurosystem. Sinn’s analysis has been cited approvingly by many high-profile commentators, such as Martin Wolf and Paul Krugman.  Unfortunately, Professor Sinn’s analysis is incorrect and his policy prescriptions extremely dangerous.

Sinn’s latest column discusses something he calls “the ECB’s stealth bailout”.  Since it is well known that the ECB is lending large amounts to banks in peripheral countries, one might question how stealthy the ECB’s activities are.  Sinn, however, has an alternative interpretation of recent events based on information on balances from the Eurosystem’s Target 2 payments system.

Professor Sinn argues that the Bundesbank has been lending large amounts of money to the central banks of peripheral countries, that lending to peripheral countries is causing the stock of credit in non-peripheral countries to shrink, and that the solution to this problem is to place limits on the functioning of the Target 2 payments system.

Here I provide some brief background on Target 2 balances and then address some of the points raised by Professor Sinn. (Since I wrote this over the weekend, I have also come across this excellent post by Olaf Storbeck of Handelsblatt, which makes some of the same points.)

ECB Lending and Target 2 Balances

Recent years have seen a sharp reduction in borrowing by peripheral banks from German banks through interbank money markets and bond markets (see pages 34-35 of this Bundesbank report).  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.

Target 2 is the plumbing system that enables these transfers. This works as follows. Euro area banks maintain accounts with their country’s central bank.  When an Irish bank writes a cheque to a German bank, the Target 2 system transfers money by deducting the Irish bank’s account at the Central Bank of Ireland and crediting 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 Target 2 claims against the ECB while other countries have accumulated negative Target 2 balances. The picture below shows Target 2 balances at the end of 2010.

Is the Bundesbank Lending to Peripheral Central Banks?

Professor Sinn’s latest article correctly states that Target 2 balances represent claims against or to the ECB. However, he also (incorrectly) interprets these balances as representing 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.”  It’s not.  If I loan you money, that means that I lose money if you don’t pay back. The Bundesbank is not owed money by the Central Bank of Ireland. It is owed money by the ECB and it can only lose money if the ECB refuses to pay it back.

The statute governing the ECB requires that the Bank must be solvent, so the Bundesbank’s Target 2 claim does not represent a risk to its balance sheet. The 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 member states to contribute to this recapitalisation exercise in proportion to their ECB capital.  In Germany’s case, this would require covering 27% of credit losses.

So the credit risk to the Bundesbank stems from the Eurosystem’s refinancing operations, not the Target 2 payments system.  If it was France that had built up a large positive Target 2 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 Target 2 balances is a red herring.

Crowding Out Credit In Germany?

Professor Sinn also argues that the ECB’s lending to peripheral economies (GIPS in his terminology) is “crowding out” credit in Germany. He says 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, the Professor worries that ECB policy “shifts too much economic vigour to the GIPS.”

These are highly misleading claims.  The ECB are 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. So 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 the approach of providing as much liquidity as requested will be changed “when appropriate.”  The obvious concern about this policy is that the extension of unlimited loans from the ECB to peripheral banks will lead to inflation.

However, peripheral countries such as Ireland and Greece that are receiving large amounts of funding from the ECB are experiencing falling amounts of credit to the private sector because the Eurosystem loans are viewed as no more than a temporary replacement for the private sector funding that was previously available. So no need to worry about too much economic vigour in these countries!  And Euro area 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 Target 2 Proposals

To avert the nightmare scenarios he believes are about to occur, Professor Sinn’s articles have proposed various reforms to the Target 2 system. In his April article, Sinn proposed setting a cap on Target accounts. He appears to believe that individual country central banks have control over their Target 2 balances, praising Mario Draghi for keeping the Banca d’Italia’s lending under control even though Draghi may have been “sorely tempted” to accumulate a Target 2 deficit.  The truth is that the Banca d’Italia has simply implemented Eurosystem lending operations and Target 2 transfers according to the same rules as other participants: Mister Draghi’s ability to resist temptation had little to do with it.

Understand what a limit on Target 2 balances would imply. 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 Target 2 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.  This kind of suspension of transfers would mean the end of the Euro as a single currency.

Professor Sinn’s latest proposal is that Target 2 balances should be settled each year: Central banks that have a Target 2 deficit pay up so the funds can be distributed to central banks that have a positive Target 2 position. (Unstated, but 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 its financial resources.  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 immediately handing over a full year of their incomes.  This is nonsense.

Sinn justifies his proposal for annual settlement of balances on the grounds that this is the approach taken by Federal Reserve Districts in relation to 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, so that the Bank 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 come up with the money to settle this balance? If such a scenario ever arose (and this is unlikely because, unlike the Euro area, deposit insurance and banking supervision are centralised at the Federal level) Mr. Williams would place a quick call to 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 and specious claims about how the system works.


This content forms part of the E View project, which is part-funded by DG Communication of the European Parliament. 


As an independent forum, the Institute does not express any opinions of its own. The views expressed in the article are the sole responsibility of the author.


Posted in: E View Project | 11 comments

Comments 1-10 of 11

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Grey says: 11 Jul 2011 16:42

To buy on credit and pay the bills -> nonsense! I learn something new every day! :-)

Philip Pilkington says: 11 Jun 2011 4:25

Haha! Whelan has just strayed well into post-Keynesian land without realising it at all. No offense, intended. I think this was an excellent piece. But I think you've just cast an argument in the terms of Modern Monetary Theory.

Scofflaw says: 10 Jun 2011 18:48

The Target 2 figures reflect the fact that the German banks are lending to the ECB, while the Irish banks are borrowing - but they do not in any sense imply that there was any previous lending that this replaces, and Whelan does not offer any evidence to prove that part of his contention. The available figures from the irish Central Bank show that lending by eurozone banks to the Irish covered institutions was never large - at their high point in 2007, eurozone banks owned €16.75bn in securities in the covered banks, which was 13.5% of the total securities at that time. Holdings of securities in Irish banks by eurozone creditors have fallen, but only to €9.6bn, so clearly the German banks have hardly "replaced hugely risky loans to Irish banks", because that money is still *in* the Irish banks. The Central Bank figures are publicly available here: http://www.centralbank.ie/data/site/cmbs/ie_table_a.4.2_covered_institutions_-_aggregate_balance_sheet.xls One would think that economic commentators would consult them before making such large statements.

Georg R. Baumann says: 09 Jun 2011 11:39

It is my understanding that Prof. Sinn's Target2 Interpretation: http://dl.dropbox.com/u/4914840/target2positions.tiff is based to a degree on this paper: http://www.lancs.ac.uk/staff/whittaj1/eurosystem.pdf

David Blake says: 09 Jun 2011 6:02

I think the truth is somewhere between the two extremes of Professor Sinn's piece and this rebuttal. It is clear that Buba has not been lending directly to the Central Bank of Ireland and does not have claims on it which are at risk. But through the intermediation of the ECB it does have exposure and that exposure in practice is more than the 28% of the formal Buba share in the ECB capital structure. Consider what would happen in the event of a default by one or more of the periphery countries. Even if one default did not provoke others, it's not plausible to assume that every country would be able to contribute to covering ECB losses. If Greece defaults, is it really plausible to suggest that Portugal and Ireland will pay more money into the ECB? The reality is that the situation would be like that within the EFSF, where countries in trouble are automatically excluded from contributing towards bailouts for other. The cost then is shared out among those not in trouble. Buba would certainly end up paying significantly more than its current capital subscription in the event of a crisis. The real issue however is not what all this does to Buba or to lending in Germany (it is certainly wrong to say German borrowers are being crowded out,) but what it tells us about the position of the ECB. The ECB was obsessed with denying that the European banks faced a solvency rather than liquidity crisis. This was convenient because it allowed it to avoid the dramatic measures taken in the US and UK. But it meant it became complicit in concealing the truth as national governments and central banks felt the results of the crisis. It is not clear what role if any the ECB played in the original Irish decision to give a guarantee to Irish banks, surely the most foolish individual action of any government in this whole period. But the ECB and the Central Bank of Ireland facilitated what was in fact a massive cover-up of the scale and nature of the Irish problem. Complicity turned into active encouragement as the ECB found itself dragged deeper into the more with Ireland's banks being allowed to make more and more calls on the CBI against bonds whose worth was in compromised by the crisis. So now the ECB finds that the Irish have drawn massively on Target 2 and the ECB owes Buba around EUR300bn. It is irrelevant to criticise Professor Sinn by saying that Ireland has a current account surplus. What matters is, as he says clearly, is the total of current account AND private sector capital outflows, which have been massive. Had Ireland's banks defaulted early on, the German banks would not have been able to withdraw the money and would have carried the losses., In that sense it is the German banks rather than Ireland which have been bailed out by the ECB action. Some might therefore see a kind of rough justice in forcing Buba to pick up much of the bill for recapitalising the ECB if a default forces it to recognise losses. But no one should ignore the fact that the ECB acted irresponsibly in trying to use liquidity to cover a genuine solvency crisis. Having done that, it now tries to prevent rational discussion of how to handle the problem which the countries in trouble face. It cannot admit that it faces losses on the actions it took. Instead it tries to force them onto the burdens of the countries in trouble. One final point on which Professor Sinn is surely wrong. He argues that allowing the ballooning out of Target 2 balances was right when it happened but should be unwound now because the PIGS are not being made to suffer enough. They are being made to suffer too much. And it's in large measure the ECB's fault.

Julio C. Saavedra says: 08 Jun 2011 16:04

It is a bit puzzling why Prof. Whelan should come to voice such acerbic disapproval of the points raised by Hans-Werner Sinn. It is abundantly clear, however, that he misrepresents him in important respects. 1. He claims Prof. Sinn argued that the Bundesbank’s lending to Ireland via the ECB constitutes a direct risk for the Bundesbank. Sinn didn’t. He rather argued that what matters is the ECB’s lending to Ireland. The Bundesbank shares the risk inasmuch as it participates through its capital share in the volume of that lending. His first numerical assessment of the Bundesbank’s risk was published in the German daily Süddeutsche Zeitung on April 2nd of this year. His figures show that he calculated the risk exactly in the way Whelan argued it should be done. 2. He cites Sinn with the statement “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,” and then argues that the ECB does not control the money stock. This is incorrect. The Vox article in fact says: “The crowding out will not necessarily occur, but it is normally the case as, given Germany’s GDP and given Germany’s payment habits, the commercial central banks only need a certain amount of euros for circulation in Germany. Moreover, strict crowding out is inevitable if the ECB controls the overall stock of central bank money in the Eurozone by way of sterilizing interventions or auctioning off limited tenders.” Whelan left out the first sentence. This is a severe misrepresentation, because that sentence argues that crowding out will occur if money demand is determined by other economic factors. As only a certain amount of base money is needed in Germany, the money coming in, say, by way of Irish payments for purchases of goods or assets in Germany, unavoidably crowds out the money that otherwise would have come into the German economy by way of the Bundesbank’s refinancing operations. This has nothing to do with a supply constraint. Even if money supply is perfectly elastic and unlimited at a given rate of interest as it currently is, there is a perfect crowding out as long as the money demand is given, say because it is determined by GDP and the rate of interest charged by the ECB. This is a simple and undeniable fact that should be clear to any economist. Sinn made it explicit that he did not at all assume that the ECB controls the money supply. He just said his statement would a fortiori be true if it did.

Fabian Lindner says: 08 Jun 2011 7:46

Thank you very, very much. We tried to debunk Sinn's scare mongering - as you rightly call it - two weeks ago. (sorry, only in German): http://www.ftd.de/politik/europa/:rettung-griechenlands-die-maer-vom-deutschen-kapitalabfluss/60056034.html and here a longer policy brief: www.boeckler.de/pdf/p_imk_pb_4_2011.pdf

lostgen says: 07 Jun 2011 20:17

I fully agree. There is no reason why the Target-2 account level is important for single nations. It is, however, useful to show that the European interbank market is, at least partially, still dysfunctional.

Joseph Ryan says: 07 Jun 2011 20:05

This is an excellent rebuttal. I had (completely by chance) come across and spent some time studying the very complicated explanations in the Prof Sinn article. Even to a non-economics person like myself, his proposal for settling the balance annually seemed non-sensical and would entail the immediate reversion to seperate currencies. Well done. An excellent explanation and rebuttal.

Oran says: 07 Jun 2011 19:46

It's sinnful!

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