TARGET2 Balances Mask Reduced Financial Fragmentation in the Euro Area

As we write, the claims of the Bundesbank on the other euro-area national central banks (NCB) through the TARGET2 system are approaching €1 trillion. What do these claims represent? Are they subsidized German loans to other euro-area countries―primarily Italy, Portugal and Spain? Do they signal further financial disintegration in Europe? Or, as large as these numbers are, are they simply a consequence of the complex mechanics related to the construction of the Eurosystem and how it implements monetary operations?

The answer is two-fold: for the first few years of the euro-area crisis―when German claims peaked at €750 billion―imbalances reflected subsidized loans to counter rising financial fragmentation. From 2008 to 2012, funds shifted from banking systems in the periphery of Europe perceived to be under stress, to banks in the core seen as being relatively stable, creating a web of liabilities and claims among NCBs. After 2012, the risk of breakup receded, so the interpretation of renewed increases in TARGET2 balances has changed. Indeed, the doubling since early 2015 is a natural (and almost inevitable) consequence of the manner in which the Eurosystem implements its various asset purchase programs (APPs)―their version of quantitative easing and large-scale asset purchases. Moreover, the impact of the APP expansion on TARGET2 balances has concealed a further, if still incomplete, reversal of the financial fragmentation triggered by the euro-area crisis several years ago.

To be sure, the increase of TARGET2 balances in both periods reflects a credit expansion, but in the latter, the NCBs collectively earn a return that is far more market sensitive. Put differently, the increase of TARGET2 liabilities associated with the Eurosystem’s APPs is backed by marketable assets that could, and probably should, be transferred to the national central banks (NCB) that currently have claims on the system….

Inflation Policy

Inflation in the United States remains at levels that most people don’t really notice. Overall, the consumer price index rose 2.8 percent from May 2017 to May 2018. And, when you look at core measures, the trend is still below 2 percent.

With inflation and inflation expectations still so benign, it is no wonder that despite solid economic growth and the lowest unemployment rate in 50 years the Federal Open Market Committee continues to act quite gradually (see their June 2018 statement). Inflation could well turn up in the near term—perhaps by more than the policymakers expect. But, for reasons that we will explain, if we were on the FOMC, we would stay the planned course: remain vigilant, but certainly not panic.

We start with a look at the data. What we see is that trend inflation has stayed reasonably close to the Fed’s medium-term target of 2 percent for the past two decades. There have been occasional deviations, like the temporary rise in 2008 and again in 2011, but overall, the path is remarkably stable….

Banks and Money, Or Watch out What You Wish For

On 10 June 2008, a large majority of voters in Switzerland rejected a proposal that all commercial bank demand deposits be held at the central bank. This Vollgeld referendum was another incarnation of the justifiable public revulsion to financial crises and the bailouts that inevitably accompany them. Vollgeld proponents claimed that a system in which the central bank is the sole issuer of “money” will be more stable.

Serious people debated the wisdom of this proposal. One of Switzerland’s premier monetary economists, Philippe Bacchetta, wrote passionately in opposition. Martin Wolf, chief economics commentator at the Financial Times, argued in favor. And Swiss National Bank Chairman Thomas Jordan discussed the many dangers in detail.

It should come as no surprise that, had we had been among the Swiss voters, we would have voted “no.” In our view, the Vollgeld (sovereign money) initiative combined aspects of narrow banking with those of retail central bank digital currency. We see these as misguided, distorting the credit allocation mechanism and more likely to reduce than improve financial stability (see here and here). In the remainder of this post, we explain why….

Italeave: Mother of all financial crises

After years of calm, fears of a currency redenomination—prompted by the attitudes toward monetary union of Italy’s now-governing parties and the potential for another round of early elections—revived turbulence in Italian markets last week. We have warned in the past that an Italian exit from the euro would be disastrous not only for Italy, but for many others as well (see our earlier post).

And, given Italy’s high public debt, a significant easing of its fiscal stance within monetary union could revive financial instability, rather than boost economic growth. Depositors fearing the introduction of a parallel currency (to finance the fiscal stimulus) would have incentive to shift out of Italian banks into “safer” jurisdictions. Argentina’s experience in 2001, when the introduction of quasi-moneys by the fiscal authorities undermined monetary control, is instructive….

To Form a More Perfect Union

On 31 May 2018, Vítor Constâncio completes 18 years on the Governing Council of the European Central Bank (ECB)—8 as Vice President and 10 as Governor of the Bank of Portugal before that. Ahead of his departure, Vice President Constâncio delivered a valedictory address setting out his views on what needs to be done to make European Monetary Union (EMU) (and what people on the continent refer to as the “European Project”) robust.

Before we get to his proposals, we should emphasize that we continue to view political shifts as the biggest challenge facing EMU (see our earlier posts here and here). The rise of populism in recent euro-area member elections is not conducive to the risk-sharing needed to sustain EMU over the long run. Without democratic support, investor fears of redenomination risk—associated with widening bond yield spreads and, possibly, runs on the banking systems of some national jurisdictions—will continue to resurface whenever political risks spike or local economic fortunes ebb. This latent vulnerability—resembling that of a fixed-exchange rate regime with free movement of capital—diminishes the prospect for strong and stable economic growth in the region as a whole.

Turning to the need for change, the current framework has three significant shortcomings…

Making Unelected Power Legitimate

Through what administrative means should a democratic society in an advanced economy implement regulation? In practice, democratic governments opt for a variety of solutions to this challenge. Historically, these approaches earned their legitimacy by allocating power to elected officials who make the laws or directly oversee their agents.

Increasingly, however, governments have chosen to implement policy through agencies with varying degrees of independence from both the legislature and the executive. Under what circumstances does it make sense in a democracy to delegate powers to the unelected officials of independent agencies (IA) who are shielded from political influence? How should those powers be allocated to ensure both legitimacy and sustainability?

These are the critical issues that Paul Tucker addresses in his ambitious and broad-ranging book, Unelected Power. In addition to suggesting areas where delegation has gone too far, Tucker highlights others—such as the maintenance of financial resilience (FR)—where agencies may be insufficiently shielded from political influence to ensure effective governance. His analysis raises important questions about the regulatory framework in the United States.

In this post, we discuss Tucker’s principles for delegating authority to an IA. A key premise—that we share with Tucker—is that better governance can help substitute where simple policy rules are insufficient for optimal decisions….

Banking the Masses: 2018 Edition

The two leading financial trends of our time are the integration of digital technology and the advance of financial inclusion. The latter involves both provision of access to those who have no account (the “unbanked”) and increased usage of financial services by those with a tenuous link to the formal system (the “underbanked”). A combination of swift technological change and government promotion is speeding the rise of inclusion.

Six years ago, the World Bank estimated that roughly 2.5 billion adults (15 or older) had no bank deposit, no formal credit, and no means of payment other than cash or barter. Stunningly, in its Global Findex Database 2017 published last month, the Bank now estimates that the number of unbanked adults has plummeted to 1.7 billion. Over the past six years, more than 1.2 billion adults have gained at least basic financial access through a financial institution or their mobile phone.

In addition to a range of technological progress, India’s government-led financial inclusion program has been the second key factor in the recent advance of inclusion. By our estimate, the gains in India account for more than one-half of the 515 million persons who acquired access globally between 2014 and 2017!

In the remainder of this post, we briefly describe the benefits of financial inclusion, and highlight key trends regarding access since 2011 as well as prospects for achieving the World Bank’s goal of universal financial access. We conclude with a short discussion of Africa, where the largest gains still lie ahead. Reflecting long-term demographic prospects, we emphasize that the advance of financial inclusion in Africa will matter for the global economy, not just for Africa.

Universal Central Bank Digital Currency?

Digital currency is all the rage. Bitcoin has more than one thousand crypto cousins. There is even a token called dentacoin, whose issuers claim it will transform dentistry! In the past, we have been clear in our views. We agree with BIS General Manager Agustín Carstens: these are exactly like past attempts of people to issue their own private money. As Carstens said on another occasion, these tokens are “a combination of a bubble, a Ponzi scheme and an environmental disaster.”

Regardless of whether the blockchain will revolutionize dental health, the appearance of cryptocurrencies has driven central banks to think about one particular aspect of their business: paper currency issuance.

In this post, we expand on some aspects of our earlier discussion of central bank digital currency (CBDC). What is it and what would its wider introduction mean for the financial system? Our conclusion is unambiguous: Watch out what you wish for! ….

On the Distribution of Wealth

In an effort to understand the dynamics of the distribution of consumption, income and wealth, over the past decade, there has been an explosion of research. While important debates about measurement and data interpretation continue, a range of evidence points to two important conclusions. First, over the past two centuries, the global income distribution has become far more equal. But, while the gap between countries is now much smaller, in recent decades, inequality within some advanced countries, especially in the United States, has risen.

Rather than income or consumption, in this post we focus on the distribution of wealth. Wealth affects welfare in at least two key ways. First, in the presence of borrowing constraints, it provides a buffer against fluctuations of income, allowing households to smooth consumption in the face of temporary bouts of illness or unemployment. Second, it provides the basis for household spending in retirement. .

As we will see, the distribution of wealth is far less equal than that of income. Moreover, recent research shows that, following the Great Financial Crisis of 2007-2009, the U.S. wealth distribution has become decidedly more unequal. As a result, a large portion of U.S. households appears to have little scope for meeting retirement needs out of their current net worth, making federal insurance programs key to their future well-being.

Alternative Reference Rates: Meeting the Challenges

Guest post by Richard Berner, Executive-in-Residence (Center for Global Economy and Business) and Adjunct Professor, NYU Stern School of Business

In response to the fragility of LIBOR and other interest-rate benchmarks, regulators globally are working with industry to identify sturdy alternatives. Despite significant progress, concerns persist that the transition to these new reference rates will be disruptive.

While these concerns are legitimate (see Eclipsing LIBOR), both U.S. and global authorities and market participants have begun to address them in ways that should go a long way to managing the risks. In this post, we review why LIBOR’s persistent fragility makes reform critical, and examine progress on some of the ongoing reforms....

Commentary

Money, Banking, and Financial Markets