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"It Is High Time That Central Banking Is Recognized For The Disease It Is"
11-14-2013, 11:34 AM,
"It Is High Time That Central Banking Is Recognized For The Disease It Is"
"It Is High Time That Central Banking Is Recognized For The Disease It Is"

Winners and

In a recent
editorial at German newspaper Frankfurter Allgemeine Zeitung (FAZ),
Hans-Werner Sinn, president of Germany's IFO Institute and a prominent
critic of the ECB and the euro area bailouts, revisits the topic of the
euro-systems payment imbalances that are expressed in TARGET-2 claims and
liabilities. The reason why Sinn felt compelled to write this editorial
is that another economist, Marcel Fratzscher of the DIW in Berlin (another
economic research institute), recently asserted that 'Germany
is the big winner' in the events surrounding the TARGET

The main reason why there is
even a debate over the euro-system's payment procedures is in fact that Sinn
pointed out two years ago that the system was abused as a 'stealth
bailout' mechanism for the euro area periphery and that Germany was exposed to
huge risks because of it.

This provoked angry reactions
from courtier economists and even the Bundesbank, who tried in vain to put the
genie back into the bottle by arguing that it all didn't matter. It was merely
an accounting artifact, and no further implications were to be inferred.
Naturally, even people who don't understand how exactly the system works
were compelled to ask: if it 'doesn't matter', then why does the chart look like

In view of this chart, which
had begun to depict vast and growing imbalances precisely since the beginning of
the crisis period, the argument that it 'didn't means anything' and
entailed no risks for anyone just didn't sound very credible. People
also wondered why a prominent economist like Sinn would risk his reputation by
opposing this consensus view dispensed from on high.

 What Was

To begin with, Sinn was
perfectly correct. He has not once misrepresented the risks posed by the system.
Curiously, even Fratzscher admits in his editorial that yes, it is indeed a
stealth bailout. He argues however that the potential costs are outweighed by
the benefits, since in his opinion, the imbalances mostly reflect 'capital
flight by German investors from the periphery', which the TARGET system enabled.
Moreover, he argues that it is a good thing that credit that was previously
extended by private investors is now de facto extended by the central
bank, as it keeps all sorts of companies in the periphery in business. These
would have been cut off from credit otherwise.

Sinn counters that
first of all, it cannot be determined with certainty just whose capital flight
was financed. The TARGET balances themselves cannot tell us anything
about that. Sinn points out, that 'in effect, the North's printing press was
lent to the South' and notes that this fact – and the attendant risks for the
holders of TARGET claims – is obviously no longer in contention. The only bone
of contention is 'just what was financed with it'.

Sinn concedes that German
capital flight was in part financed by the TARGET system, but notes
that the DIW calculations (which are actually based on IFO's numbers) are wrong.
For one thing, DIW confuses gross with net amounts, as there were flows in the
opposite direction as well. In fact, from 2008 to 2012, Germany has altogether
exported a net €170 billion in capital! Instead of €400 billion as assumed by
DIW, Sinn contends that at most €200 billion were recalled by German
investors from the periphery. And even so, argues Sinn, it was not the business
of the central bank to protect German banks: 

“[Capital flight] does not
explain the build-up of Germany's TARGET claims, and even if it did, it wouldn't
have been the ECB's job to protect German banks and financial institutions from
losses. Such fiscal aid measures are the responsibility of finance ministers,
and not the ECB board.” 

Sinn then explains that
TARGET was for the most part used as a kind of vendor financing system –
Germany's export surplus was partly financed by the TARGET system, partly by
Germany's private sector capital exports and partly by aid packages granted in
the course of the bailout. 

In short, it is mainly Germany's trade
surplus that is reflected in the BuBa's TARGET claims. He argues furthermore
that there are a number of complex business structures at work, and the TARGET
liabilities of the crisis countries cannot be fully explained by the balance of
payment deficits of these countries. He notes that in some countries like
Portugal and Greece, TARGET liabilities and current account deficits are very
closely linked, while in others like Spain and Italy, capital flight is the main
factor. However, it is not necessarily capital flight to Germany. Other foreign
investors such as British investors were enabled to recall their investments due
to the TARGET mechanism as well (for instance, there may be a circular flow such
as this one: UK investors remove capital from the EU periphery, then lend money
to US buyers of cars, who in turn use the funds to import cars from

Perpetuating Imbalances
and Robbing Savers

Sinn then points out that the
ECB, via its lowering of credit rating standards for  central bank refinancing,
enabled the national central banks in the periphery to undercut capital markets.
Much higher interest rates were demanded in the capital markets, reflecting the
higher risks in the crisis countries.

The conditions offered
by the ECB in terms of refinancing were such that banks in the still healthy
countries could no longer compete with it. In short, the ECB has driven away
private sector competition in the capital markets of the periphery.
This has contributed to the further fragmentation of European capital
markets, since without the lure of higher interest rates, private investors have
no good reason to take the risk of investing in the crisis countries. Higher
interest rates would however have forced these countries to save more and enact
sweeping structural reforms of their labor markets and government finances,
which would ultimately have made them more competitive and lowered their
ingrained balance of payment deficits. Sinn points out that most of the crisis
countries are still far from having regained competitiveness, which can be
largely deemed an unintended consequence of the ECB's

Since private capital markets
have been undercut via the printing press, Germany's banks and insurers are no
longer able to earn interest rates that adequately reflect risk. Insurers have
been forced to recall the return guarantees that have traditionally extended to
their policyholders.

Sinn stresses that the
advantages accruing to German debtors via low interest rates must be seen in the
context of the fact that Germany is actually a net creditor to the world, not a
debtor. Creditors are losing out when interest rates are artificially lowered.
It is as though “the ECB were acting as a purchasing agent of German
savings, which it then services and distributes to the crisis countries at
whatever conditions it deems appropriate”. Sinn estimates that the crisis
countries have enjoyed €205 billion in interest savings due to the ECB's
interventions, interest that exporters of capital such as Germany would
otherwise have earned.

Sinn concludes that “it is
not entirely wrong in this context to talk about the expropriation of German
savers by means of low interest competition via the printing

Indeed, central banks are
ultimately robbing savers everywhere these days. The prudent are forced to pay
for the mistakes of those who have been irresponsible and have squandered their

Are Lower TAREGT
Imbalances A Sign of Improvement?

Over the past few years,
investors have rearranged their portfolios, causing among other things a
construction boom in Germany. Meanwhile, the EU and the ECB have organized a
giant flow of public funds into the crisis countries to replace private capital
flows. All of this will only perpetuate the misallocation of saved capital.
Capital will continue to be consumed.

Sinn then points out
that Germany and other Northern countries have been regularly outvoted at the
ECB board since May of 2010. In his opinion, the ECB board's actions
are in conflict with article 125 of the EU treaty, as they have created a giant
volume of public credit and public guarantees in favor of the Southern
countries, which could eventually get the ECB itself into trouble. In a worst
case scenario, the write-offs may well exceed the ECB's capital of €500

Even though the central
bank could continue to function even if its capital base were  wiped out, it
would be a devastating signal to the capital markets if part or all of its
capital were lost. We agree with this assessment, for one thing because
write-offs of a part of a central bank's assets mean that its flexibility with
regard to lowering the extant money supply is curtailed. Secondly, in the minds
of investors and users of the euro, it would look as though some of the
'backing' of the central bank's liabilities was gone. Although fiat money is
irredeemable anyway, this would likely have a psychological impact that could
severely damage the euro.

The most interesting part of
Sinn's editorial however concerns the recent decline in the TAREGT-2 imbalances
(see the chart above). This will probably be regarded as controversial and we
expect it will ignite further debate. Sinn writes: 

“If one adds up the purchases
of government bonds by the central banks of the still healthy countries in the
euro area and the TARGET credits in favor of the six crisis countries (Greece,
Ireland, Portugal, Spain, Italy and Cyprus) for which the ECB board is
responsible and deducts the claims of the crisis countries arising from a
slightly under-proportional issuance of banknotes, then one gets a total of €
747 billion in ECB financed rescue loans. That is about two times the sum of the
already granted fiscal rescue measures of the community of € 385 billion, for
which the national parliaments are responsible.

The loans of the
community are economically indistinguishable from ECB credit, but they arrived
on the scene much later and are basically follow-on loans designed to relieve
the ECB. In view of the advance payments made by the ECB, parliaments
are essentially forced to push through a fiscal rescue architecture in the form
of the European Stability Mechanism ESM and other measures, since if they were
to deny the ECB such follow-up financing, the entire euro-system may well
collapse. The strong insistence on a recapitalization of banks with ESM funds,
which ECB president Draghi has recently expressed in a letter to the EU
commission, is also explained by his panic-like fear of the ECB's own

Since the TARGET
liabilities of the crisis countries have been a great deal higher at one point
than the € 681 billion remaining today, some observers feel that there is no
longer cause for alarm. They have perhaps not yet understood that the fiscal
rescue loans extended by the community replace the TARGET liabilities of the
crisis countries directly and fully. This is an automatic process
resulting from the TARGET system's very nature. Without the fiscal rescue
measures on the part of the community, the TARGET liabilities of the crisis
countries would ceteris paribus not be at € 681 billion today, but at €
1,066 billion.

In the construction of the
rescue architecture, Europe's parliaments are confronted with decisions without
alternatives, which have been prepared years ago already by the ECB board. They
have been degraded to rubber-stamping agents. To me it is questionable whether
the fiscal regional policy that has been decided behind closed doors by the ECB
and for which there are no parallels in the US Federal Reserve system, is still
compatible with the rules of parliamentary democracy and the German

Obviously, Sinn isn't prepared
to shut up and let them get away with this


The notion that the euro area
crisis is over has recently been heavily propagated  by EU politicians and the
mainstream media. However, it is way too early for such victory laps. The fat
lady is still waiting in the wings.

Hans-Werner Sinn is
perfectly correct in pointing out that the ECB's attempts to restore the
'monetary policy transmission mechanism' by suppressing interest rates in the
periphery is going to perpetuate capital malinvestment and delay the necessary
reforms. He is also correct when he states that these interventions
have actually scared private capital away, as investors require adequate
compensation for the risks they are taking. Meanwhile, savers are ultimately
paying for this ongoing waste of scarce capital.

It is high time that
central banking is recognized for the disease it is. Without central banks
aiding and abetting credit expansion, this situation would never have
arisen. Even a free banking system practicing fractional reserve
banking could not possibly have created such a gigantic boom-bust scenario.
Money needs to be fully privatized – the State cannot be trusted with


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