The wages of Sinn
What are the wages of sin? Death, according to Paul's Epistle to the Romans. And that's what awaits the euro-zone if it does not achieve re-alignment of competitiveness, according to the Ifo Institute's Hans-Werner Sinn.
Professor Hans-Werner Sinn, president of the Ifo Institute and a director at the Centre of Economic Studies at the University of Munich, has been causing quite a stir with his recent academic papers, as well as statements on the airwaves and in the press.
He is very clear that the fundamental problem at the heart of the euro-zone is the misalignment of competitiveness between the periphery and the core, and that the project must collapse if a re-alignment is not achieved. More controversially, he has long noted the growing imbalances in the Target-2 cross-border payment system since the onset of the financial crisis, and has developed a theory that these imbalances indicate that this system is being used to finance current account deficits in the periphery - a transfer of wealth that removes the incentives to pursue that crucial re-alignment of competitiveness. Even more contentiously, Sinn has argued that this use of Target-2 is leading to a large flow of newly created peripheral central bank money into the core of the euro-zone, which is "crowding-out" central bank credit in the core.
A number of economists, such as Citi's Willem Buiter and Karl Whelan at University College Dublin, have made technical criticisms. Whelan has also come out swinging a few times in his blogs. Olaf Storbeck, international economics correspondent with Handelsblatt, seems to have made it his personal project to demolish Sinn's claims at every opportunity in his own blog. "Hans-Werner Sinn fritters away his reputation as a serious academic and has entered the domain of populists that make biased and flawed arguments," he wrote in one example back in October last year. The chief economist at a major European bank's asset management arm recently told me: "Professor Sinn is wrong - and he knows he's wrong."
Following his recent appearance at the Annual Portfolio Management Conference organised by Uhlenbruch in Frankfurt, which Sinn used to present his Target-2 theory again, I spoke to him to get to the bottom of the ideas that are causing such heated debate - and to ask how he thinks the euro-zone can get out of its current mess.
Martin Steward, IPE: The ECB appears to have encouraged this peripheral money creation that you identify with its lower collateral quality requirements for refinancing operations with national central banks. How much of the responsibility for this innovative use of the Target-2 system would you assign to the ECB's lax collateral requirements?
Professor Hans-Werner Sinn, Ifo Institute: The entire responsibility lies with the ECB. Without the lax collateral requirements, by which the ECB has offered refinancing credit cheaper than the market, no one would have taken that extra credit from the ECB. So then the question becomes, 'Is that defensible?' I would say that it was defensible in 2008 when we had an imminent crisis, but, now that we are more than four years on, I doubt that it remains defensible. You can't do this permanently because that would imply that we no longer have a market economy. In a market economy, investors decide for themselves where to place their wealth, and their investment caution is what underpins the success of the capitalist system. If the ECB or other political bodies distort that decision, growth losses are all but inevitable.
IPE: One criticism that I have seen of your theory is that, while it establishes a correlation between the build-up of Target-2 balances and a build-up of current account deficits in the periphery, it cannot establish causality. Other critics - such as Ulrich Bindseil and Philipp Koenig - have pointed out that Target-2 balances and peripheral current account deficits only match-up in aggregate, and that the positions of individual economies complicate the picture. Are these valid criticisms?
H-WS: This shows a deep misunderstanding of the argument, which is very simple: a current account deficit has to be financed either with private capital imports or with the printing press, and, as private capital imports ceased to be available, the printing press replaced them. Why should that imply any sort of correlation with the printing press and the current account? The point isn't that the printing press gives rise to the current account deficit, the point is that the printing press now finances it, while before the crisis it was the capital markets that did so. Had the printing press not been available, the current account would have had to shrink. The current account didn't shrink despite the dearth of capital flows because the printing press was there as a replacement.
IPE: The claim that peripheral central banks' credit is crowding-out local, core central bank credit has proven controversial.
H-WS: It's not controversial at all because it is a trivial and indisputable fact, as Timo Wollmershäuser and I showed in our June 2011 working paper. The false allegation was that I had argued that the crowding out occurred via a reduction of money supply in the core. In truth, however, I argued that the crowding out resulted from the fact that money demand is given - that is, it has a ceiling - in the core. As liquidity flowed into the northern countries via the Target accounts because the South solved its financing needs with the printing press, banks in the core deliberately took less refinancing credit from their National Central Banks or invested the excess liquidity with them. Thus, the money created locally was crowded out by the money flowing in from abroad, just like the credit-backed deutschmarks were crowded out by the dollar inflows during the Bretton Woods period. The confusion stemmed from the fact that some people misunderstood the term 'crowding-out'. But I used it in the same way as Friedman did when he developed the concept of crowding-out, alluding to the reduction in mothers' meals provided to children when schools began to offer free meals. In Friedman's example, public meals crowd out private meals because the size of the demand for food is given.
IPE: What is the danger associated with that liquidity coming from peripheral central banks rather than local central banks? Surely a Greek euro is the same as a German euro?
H-WS: It's the same liquidity, no difference. But the process means that a public credit is flowing from the North to the South at below-market conditions, currently at a rate of 1% for three years, which is way below the private rates for similarly risky lending. If the collateral were safe, this would not imply that market rates are being undercut, but that is not the case. In fact, the collateral requirements have been reduced to ridiculously low levels in recent years. As soon as the southern banks started to run out of sufficiently good collateral, the ECB reduced the standards further. A good metaphor for this process is that the core central banks lent their electronic printing presses under overly favourable conditions to the South. It is no longer the capital market that determines the allocation of capital across space, but the ECB's governing council. Once again, such political influence is defensible in an acute crisis, but the emergence of an acute crisis once the ECB changes its policy cannot be used to defend such a policy forever. We are now in the ECB's fifth year of providing excessive Target credit and will have to face the long-term structural imbalances that such a policy causes.
IPE: Have you not argued that there is particular risk for the Bundesbank?
H-WS: Yes. The policy imposes a risk on the solid central banks of the euro-zone, above all the Bundesbank, which would bear 43% of the losses should the GIIPS countries default together. Basically, the ECB provides CDS insurance for free to creditors and debtors of the Target flows, at the expense of the central banks and hence of the taxpayers of the still economically sound euro-zone countries. Should the euro break up, the Bundesbank's risk will be even bigger because it would then have a claim against a system that no longer exists. The German Target claims of €700bn against the ECB mean that, relative to a normal situation where each country has created only the money circulating in its jurisdiction, €700bn of German savings have been converted from marketable claims into claims against the Bundesbank. The savers have a claim on their banks, their banks have a claim on the Bundesbank, and the Bundesbank has a claim on the ECB system, which it can never call due, since it will vanish should the euro-zone break up.
IPE: Does this present a danger of monetary inflation in the core?
H-WS: Technically speaking, not really, because the extra money that is printed in the South is shredded in the North - it is sterilised automatically by the German banks by taking less refinancing credit. That is the crowding-out process. While by now nearly all the base money circulating in the euro-zone stems from the South, there is no more money in circulation either in the North or in the South. Real goods come, and debt is being redeemed, but rather than handing over marketable assets in exchange, as is normally the case, the buyers pay with a Target claim given to the Bundesbank against the ECB system.
IPE: You appear to be describing a vicious circle here: Germany has an incentive to keep its Target-2 balance growing to avoid euro-zone break-up because a break-up would crystallise the country's liabilities in the form of these apparent long-term loans created via Target-2.
H-WS: Yes, it's a trap. Germany cannot escape the euro without losing the claims it has accumulated already, and has to accept one rescue programme after the other. In the end, this will lead to a political revolt in Germany.
IPE: The threats posed by this innovative use of Target-2 lead you to suggest that it should be taken back to basics - rather as in the US Interdistrict Settlement Account, balances should be kept as close to neutral as possible.
H-WS: There is a variety of possibilities. One is to impose higher interest on the Target credit drawn by a national central bank than is currently the case. Currently, the rate of interest is only 1%. Another is to go the American way, which is asking the debtor central banks to hand over once a year marketable assets to the central banks that have positive balances. Both would provide an incentive to reduce the refinancing credit and limit money-printing to the size of a country's economy.
IPE: I can see that this might be a good starting point, but now that the balances have accrued, wouldn't settling them rapidly be financially devastating for the peripheral countries? They simply can't afford to do it.
H-WS: That is debatable. We might need a grandfathering rule that distinguishes the old debt that has built up from any new debt. On the other hand, countries are always able to create covered bonds backed with real estate, gold or seniority claims on future tax revenue that they can hand over to their creditors.
IPE: Doesn't your prescription imply limits on Target-2 balances? And if so, might that lead to the cross-border payments system simply seizing up? A business in Greece could try to settle a payment to a business in Germany and find its cheque bouncing simply because Greece has reached its Target-2 balance limit. That seems to go against the grain of what a currency union is all about.
H-WS: The need to redeem the Target debt implies no limit in a direct sense. Of course, each individual transaction can always be carried out. But it does make it unattractive to draw Target-2 credit out of the local ATM. If a Southern country wants to import more than it exports, it has to borrow in the markets to finance the difference. Thus the redemption simply means pushing borrowers back to the market and away from the printing press - ultimately, that's what we have to do. But of course we can't impose hard limits on Target balances, since that would cause cross-border transactions to collapse - that would, indeed, be stupid.
IPE: Your criticism of this innovative use of the Target-2 system often sounds like the same criticism that one could make of the idea of Eurobonds with joint liability. Does this mean that you reject the idea of Eurobonds? If so, what is your blueprint for preserving the single currency, if you have one?
H-WS: I do reject the idea of Eurobonds, with their proportional liability and, in particular, joint liability. Given that the government bonds and bank bonds of some southern states have become toxic, Eurobonds mean that the investors can shift the burden of their assets to the taxpayers of the still solid euro-zone countries. This is unfair and creates wrong incentives for the future. Eurobonds will lead the euro-zone back to the period of equal nominal interest rates that do not reflect risk premiums, and will therefore continue to result in excessive capital flows and current account imbalances across Europe. We would simply be repeating the same mistake we made leading up to the crisis. The main problem in Europe today is the re-alignment problem. The cheap credit that the euro brought to southern Europe led to inflationary bubbles that deprived the Southern economies of their competitiveness. Those bubbles have to deflate back to normal via reduced price levels, or, alternatively, we have to inflate Germany. However, Germany does not want to inflate and the Southern countries don't want to deflate. Thus the realignment within the euro-zone will take very long and involve much hardship for the uncompetitive countries. The only possibility for countries whose path back to equilibrium is too long within the euro-zone is a euro exit and a return to their original currencies, which can then be devalued. This would be my recommendation, a sort of 'rehab clinic' stage for some of the Southern economies: they can exit the euro, depreciate, become more competitive, reform, and then return to the single currency at a different exchange rate. We urgently need that. We need to form something between a common currency union and a fixed exchange rate mechanism. The idea of never having a re-alignment is clearly not workable. All other problems are subordinate to this re-alignment problem: either the euro-zone succeeds in re-aligning its price vector, or it will die.