When the good drives out the bad

There's a fairly regular monetary phenomenon that needs a name. It's similar in nature to Gresham's law, yet the inverse version.

Gresham's law is commonly stated as the phenomena by which "bad money drives out the good". But as any economist will tell you, that's not quite it. Bad money chases out the good, but only if authorities have chosen to enforce a fixed exchange rate between the two moneys. When the market ratio diverges from the fixed ratio, the undervalued money—the "good" one—will disappear from circulation while the overvalued money —the bad one—will become the exchange medium of choice. Bad money drives out good money because they pass by law at the same fixed price.

That's the classic Gresham's law. However, it's possible to show how an authority can set a fixed price between two moneys yet rather than the bad coin chasing out the good, the opposite happens: the good coin chases out the bad.

Before I show how, let's first give an example of Gresham's law. Say that new full-bodied silver coins and debased silver coins with the same face value circulate concurrently. If authorities set a law requiring that all coins must be accepted by the populace at face value, buyers and debtors will only settle their bills in debased silver coin (the "bad" money). Full-bodied coins (the "good" money) will be held back as hoarders clip off a bit of each coin's silver content, converting the entire full-bodied coinage into debased coinage. After all, why spend x ounces of silver on goods when a smaller amount will suffice? Thus the bad chases out the good.

Now let's vary our example to have good money chase out the bad. Say authorities promise two-way conversion between all silver coins at face value. Everyone will bring debased silver coins, the "bad" money, to the authorities for conversion into full bodied coins, the "good" money. In essence, they are bringing in x ounces of silver and leaving with x + y silver. This will continue until every bad coin has been deposited into the authority's vaults so that only the good money circulates.

So why in the first case does bad silver coin chase out good yet in the second good chases out bad?

When coins circulate at face value while their true market price differs, a mispricing is created. Any mispricing provides an arbitrage opportunity. In our first example, the arbitrage is such that all those holding full-bodied coin can take a full-bodied coin, file off some silver, and purchase the same amount of goods as before with the now debased coin, all the while keeping the silver clippings to themselves. A different sort of arbitrage opportunity arises in our second example. Because the authorities offer a two-way conversion feature, everyone holding debased coins gets to enjoy a risk-free return by bringing those coins in for conversion into full-bodied coins. They get more silver with less.

So the way that the arbitrage opportunity is structured will either incentivize the population to switch to bad money or to good. We get Gresham's law if people switch en masse to bad coins, and we get an inverse-Gresham effect if they take advantage of conversion and switch en masse to good coins. Since I'm not feeling especially creative, I'll call this effect Mahserg's law (Gresham spelt backwards).

My favorite modern example of Gresham's law is the proliferation of credit cards. In the same way that an owner of a full bodied coin could clip a bit of "bonus" silver off the coin while still being guaranteed the same purchasing power, payment with a credit card allows its owner to maintain their purchasing power while getting rewards to boot.

There are a few modern examples of Masherg's law. In 1978 U.S. authorities created a situation in which two different exchange media with the same denomination circulated concurrently, the Susan B. Anthony dollar and the good old $1 US bill. Because it was novel and untrusted, the Susan B. Anthony was considered to be "bad" money. The dollar bill, which enjoyed network externalities that had been established over a century of use, was the "good" money. The Federal Reserve offered two-way conversion between coin and paper. The inevitable result was that whatever Susan B. Anthony dollars were emitted into the economy were quickly brought back to the Fed to be converted into paper dollars. The good money drove out the bad. To this day Susan B. Anthony dollars are nowhere to be seen.

Another example of Masherg's law is a good old bank run. Take the intra-Eurosystem bank run that began after the credit crisis. There exist many different brands of euros, some issued by Germany, some by Greece. As a condition of membership in the Eurosystem, all nations are required to accept each other's euros at par. With the spectre of euro breakup growing in 2010 and 2011, Greek euros came to be viewed as inferior to German euros. Since it was possible to convert the bad into the good at par, everyone leaped at the opportunity. The quantity of bad Greek euros rapidly contracted while the quantity of good German euros grew, a process that would have eventually resulted in the complete extinction of Greek euros if Mario Draghi hadn't stepped in to short-circuit the run.

My favorite modern example of Masherg's law is the zero-lower bound. A central bank issues two media, dollar bills and dollar deposits. It allows free conversion between the two at par. Say that the central bank reduces the interest rate it pays on reserves to a negative rate so that reserves are inferior, or "bad", relative to 0%-yielding bills, which are now good. Anxious to avoid the negative rate penalty, everyone will race to convert their reserves into cash at the central bank until reserves no longer exist. The good has chased out the bad.

The zero-lower bound can be thought of as the lowest rate that a central bank can institute before setting off Masherg's law. Modern central banks are petrified of encountering this particular law—that's one reason that they aim for a positive inflation target

And what about Gresham? Say our central bank reduces rates below zero. If the central bank ceases allowing convertibility between dollar notes and deposits but continues to require merchants to accept the two media at par, then the incentives change such that the good no longer chases out the bad. With no conversion outlet for bad currency, people will hoard notes while only deposits will circulate. After all, why use good cash to pay for groceries when a negative yielding deposit will suffice? We're back at Gresham's law, or the chasing out of the good by the bad.

Financial Plumbing: Europe and the Fed's Interdistrict Settlement Account

One of this blog's most recurrently popular posts is a 2012 ditty entitled the Idiot's Guide to the Federal Reserve Interdistrict Settlement Account. The Interdistrict Settlement Account, or ISA, is a highly esoteric "plumbing" mechanism that lies at the centre of the Federal Reserve System. After a century of being ignored, it suddenly became a popular topic for discussion in late 2011 and 2012 as the breakup of the euro became a real possibility. Groping for a fix, European analysts turned to the world's other large monetary union, the U.S. Federal Reserve System, to see how it coped with the sorts of monetary problems that Europe was then experiencing.

Here's a short explanation of the ISA. Consider that there is no such thing as a unified Federal Reserve dollar. Rather, both the paper dollars that you hold in your wallet and the electronic reserves that a private bank holds in its vaults are the liability of one of twelve distinct Federal Reserve district banks. Thanks to the convention among these Reserve banks of accepting each others dollars at par, a 1:1 exchange rate between each of these twelve U.S. dollar brands prevails. This gives rise to the useful mental short cut of assuming that there is one homogeneous dollar brand. But to do so ignores the heterogeneity at the core of the system —we can imagine worlds, for instance, in which one district's dollars, say those of the St Louis Fed, are considered to be so inferior to the rest that the other Reserve banks will only accept "St. Louis's bucks" at a discount.

All inter-district flows between Reserve banks must be settled, which is where the ISA comes into the picture. The ISA is a ledger that tracks the various imbalances that accrue between Federal Reserve banks. Each April that imbalance is settled by a transfer of assets from debtor to creditor Reserve banks, so that if St. Louis is owing and San Francisco is owed, then bonds will flow from the former to the latter, reducing each district's respective ISA balance (or increasing it) to a sufficient level.

I'm happy to say that my ISA post was useful to a number of researchers, including Karl Whelan (pdf), Kevin H. O’Rourke and Alan M. Taylor, and most recently, Alexander Wolman (pdf), who all made reference to it in recent papers. I like to think that this demonstrates the second purpose of the econblogosphere. The first purpose, of course, is to swarm over polished work by those like Piketty and Reinhart/Rogoff searching for chinks in the armour. The second is to act as an advance scout of sorts. When a completely new problem crops up, a blogger can quickly pump out a few posts, establishing a beachhead from which the main army—academics with time, money, and resource—can begin to launch a larger-scale attack.

While scouts can provide useful hints on where to launch initial sorties, they will always make a few errors, and I want to draw attention to one error I made in my ISA post. I speculated that the Federal Reserve banks may not have bothered to settle the ISA in 2011. Given a visual inspection of the various imbalances that had arisen between several of the Reserve banks, it appeared that the Richmond Fed in particular had been allowed to carryover a large deficit while the New York Fed (FRBNY) was stuck with an outstanding credit. Luckily for the small group of folks interested in the ISA, Federal Reserve researcher Alexander Wolman has recently provided some clarity on this issue.

Wolman has written the definite explanation of how the ISA functions and it is well worth your time if you want to discover how this fascinating mechanism works. (In defense of my old Idiot's Guide, note that I did manage to incorporate the destruction of the Death Star scene into it — I doubt Alex's editors would let him get away with that). He also goes through the data to show how the ISA settled in April 2011. I had originally focused on the New York Fed's ISA balance as the basis for my suspicion that settlement may not have occurred—the FRBNY's ISA balance had not fallen by the proper amount over the settlement month. But if you look at the FRBNY's securities balance on its balance sheet, you'll see that it rose by $100-$150 billion, an amount sufficient to settle the debts that other Reserve banks owed it. If you care to explore more deeply, Alex deals with this on page 135 of his article. I'm tickled pink that he managed to "settle" this bit of trivia since it has been a recurring topics on this blog. (See here and here).

I should point out that the 2011 episode interested me because if non-settlement had occurred, then the ISA would impose very weak constraints on payments imbalances arising between the various district Reserve Banks. European analysts, who were looking to the U.S. for inspiration, needed to know whether the ISA imposed stern limits on imbalances or lenient ones.

Like the Fed, the ECB is composed of a number of member banks, or national central banks (NCBs). Each issues their own brand of Euro while accepting all other Euros at par, thereby ensuring a smooth 1:1 exchange between the various Euros. Unlike the Fed, the ECB has no settlement mechanism. Imbalances that arise between member banks can continue growing perpetually. This is what appeared to be happening between 2008 and 2012 as European depositors, wary of a break up the Eurozone, fled the GIIPS banking systems for safe havens like German and Dutch banks, resulting in the emergence of massive deficits and credits between the various member NCBs. The chart below illustrates the size of these imbalances, which have since shrunk.

Source: Euro Crisis Monitor, Osnabrück University

A number of analysts, led by Hans Werner Sinn, felt that a U.S.-style ISA settlement mechanism should be grafted on to the European payments system. In theory, this would impose strict discipline on NCBs and prevent imbalances from emerging. Many, including myself, felt that this sort of discipline might be a bad idea.

But a better rebuttal of the proposed European ISA is that the Federal Reserve ISA was never the stern mechanism that folks like Sinn made it out to be. Though my point about 2011 non-settlement is false, other features of the ISA provide for long settlement delays, including the "rediscounting mechanism" that I mentioned in my Idiot's Guide. However, the best person to learn from on this topic is economic historian Barry Eichengreen who, in the video that I've linked to below, provides a definitive historical overview of the ISA.

While the whole video is worth watching, I'm going to draw attention to a chart that Eichengreen shows at around minute 14-15 which I reproduce below.

Source: Federal Reserve Bulletin, 1922

During 1920 and 1921, large and persistent imbalances between Federal Reserve banks emerged, much like the imbalances that have plagued the Eurosystem since the credit crisis. It would seem that the Fed, just a young pup at the time, faced the very same problem that the ECB began to face just nine years after its debut and, much like the ECB, it chose to handle it by allowing for non-settlement. Eichengreen (and Mehl, Chitu & Richardson) has an upcoming paper that explores the long history of Reserve bank "mutual assistance", although for now you'll have to be content with the video.

The European payment imbalances debate (or Target2 debate) has long since died out. Germany's ever-growing creditor position halted in 2012 and has been shrinking ever since while debtors like Italy, Spain, and Greece have seen their negative positions return towards zero. No one talks about intra-Eurosystem imbalances or Euro breakup anymore, at least not on the blogosphere. But I have no doubt that somewhere in the ECB's deepest catacombs a group of European monetary architects are debating if, how, and when to import an ISA-style settlement mechanism into Europe. Let's hope that they are very careful in their approach and consider the softest possible solution.

Don't shackle Target2

Like Guntram Wolff over at the Bruegel blog, I hope that the much-rumoured capital controls on Cypriot deposits don't get enacted. So far the Euro authorities seem to have done everything right, albeit in a slow and circuitous manner. Insolvent banks are being closed, uninsured depositors, unsecured creditors, and shareholders are being bailed in, and solvent banks are slated to reopen.

Wolff's main concern is that capital controls threaten the very meaning of a monetary union:

With capital restrictions, the value of a euro in Cyprus is no longer worth the same as a euro held by any other bank in the eurozone. A euro in Nicosia cannot be used to buy goods in Frankfurt without limits. Effectively, it means that a Cypriot euro is not a euro any more.

Enact capital controls and we'd see the emergence of an entirely new currency trading pair CYP€:onshore€, with Cypriot euros trading at a discount. The discount would emerge since the ability of CYP€ to buy things outside of the island of Cyprus is limited. It would be a less liquid euro than "mainland" euro, and therefore would get penalized with a liquidity discount.

A Eurosystem in which euros are heterogeneous would technically be workable. For an analogy, look at China. The Chinese yuan has several different prices. Mainland yuan (CNY) typically trades at a discount to yuan in Hong Kong(CNH) and yuan in Taiwan (CNT). I've cribbed a chart below that shows the spread. Chinese capital restrictions prevent arbitrage forces from reducing the gap. Foreigners would prefer to buy cheaper CNY than more expensive CNH and CNT, but they can't because restrictions on capital inflows into China prevent them from doing so. Chinese companies would like to borrow in Hong Kong rather than China since they'd be borrowing high-value CNH and repatriating it, thereby lowering their cost of funding. But capital outflows are also limited.*

Source: HSBC Global Research

Just like capital controls prevent the closing of the CNY-CNH spread, the introduction of European capital controls would lead to the emergence of the CYP€-€ spread. What are the dangers of Europe adopting a Chinese model of multiple prices for the same currency?

As Wolff points out, the Eurosystem already has a tool to deal with flight from banks: the ECB's incredibly powerful Target2 clearing system. When Cypriot banks reopen and depositors start to transfer deposits to Germany, Target2 will accommodate these flows by stepping between the two banking systems, simultaneously acting as a creditor to Cyprus and a debtor to Germany. Like any lender of last resort, Target2 will be vigorous in lending, providing whatever assistance is required to Cypriot banks facing liquidity shortfalls.**

The great thing about Target2 is that its mere presence has the ability to prevent a bank run from ever being kick-started. If Cypriot depositors know at the outset that the incredibly powerful Target2 will accommodate their fears, why should they be fearful? Target2 is like Chuck Norris, as Nick Rowe and Lars Christensen would say. Its mere presence is enough to create powerful self-fulfilling counter-effects.

Cyprus wants to soften potential deposit flight with capital controls rather than leaving Target2 to do all the work. One wonders if these controls would help at all. Controls are porous, and investors will find cunning ways to get around them.

Worse is the precedent this sets. If capital controls are used as a substitute for Target2, the Euro risks losing a major stabilizing force come the next crisis. Say that it is 2016 and doubts spring up concerning Finland's banking system. If Finnish depositors know that Target2 will accommodate all deposit outflows from solvent Finnish banks, then they realize that they have nothing to fear, and the panic will subside on its own accord. But if Finnish depositors think that Cyprus-style capital controls will be put in place to prevent deposit outflows, the panic will only be exacerbated as people try to withdraw money from Finland before capital controls cause FIN€ to trade at a discount. Anyone who gets through the gate before it closes can't lose, so everyone tries to get through the gate. This effect is perverse, since the very rumour of capital controls leads to their actual adoption. With capital controls, a European bank panic is self-fulfilling—with Target2, that same panic is self-correcting.

Leave Target2 free to be the regulator of European liquidity flows—don't use capital controls. Haven't we already learnt this lesson? It was Draghi's speech about Euro convertibility from last summer that helped reduce yield spreads and stop the intra-European bank run. Gavyn Davies read that speech as a reaffirmation of unlimited Target2 power, and so did I.*** Never shackle Target2.
_______________________

* The Chinese are moving to less capital controls. Spreads are already declining, and at some point the CNY-CNH/CNT differential will be no more. 

** The provision of these LOLR services is subject to Cypriot banks providing collateral. But the winding up of insolvent Cypriot banks and the haircutting of depositors *should* have insured that the remaining quantity of Cypriot banking liabilities have been pruned so that they equal the quantity of remaining collateral.

*** See this comment as well as my first Never Shackle Target2 post.

Bitcoin fork and Euro breakup

Well this is interesting. A bitcoin "fork" has emerged. I'm watching right now as the price of bitcoin on the Mt-Gox exchange plunges from $48 down to $37 or so, and now back up to $45. My guess is that the fork will be pretty much resolved before I wake up tomorrow—if not the mechanics, at least the optics.

What's a fork? I like to think of bitcoin as a publicly distributed ledger. Anyone who owns a bitcoin has a spot in that ledger. The ledger is in turn updated every ten or so minutes to account for new transactions. Updating occurs in a decentralized manner. Competing "miners" work to add batches of recent transactions to the ledger by solving a complex problem. The winning miner earns some bitcoins while all the the other miners double check to verify that the block of transactions submitted by the winner are real and sync with the existing ledger.

This all works fine as long as there are enough competing miners working to verify the process. If one miner, or group of miners, gets too large, they might collude to fork the ledger, adding false transactions to the original. Other participants may stay loyal to the original, resulting in two different ledgers.

The bitcoin ledger was forked tonight because of a technical error, not collusion. Incompatibilities arising from a changeover in Bitcoin versions was at fault, according to this source, with some users using the older version and others using the newer. Nevertheless, the price of bitcoin fell 24% in two hours (it took the Dow eight hours to fall 23% in 1987).

But doesn't this tale of impending bitcoin breakup sound familiar? Remember the Euro crisis?

One of the deep problems facing the euro over the last three years was fear of euro break up. If Greece decided to leave the euro (or was kicked out), a Greek euro would no longer be equal a German one. In the mind of the markets, euros had ceased to be homogeneous. In anticipation of potential break up, a tremendous bank run began in which massive amounts of Italian, Greek, Irish, Spanish, and Portuguese euro deposits were converted into German and Dutch euro deposits. This all occurred on the books of the ECB's intra-eurosystem clearing mechanism—Target2. While no limits had ever been placed on Target2 balances (or imbalances), fears that Germans might revolt and try to close the Target2 window led to ever faster withdrawals from the GIIPS.

Much like heterogeneous euros, tonight's fork means that bitcoin transactors can't be sure if their bitcoin belong to the older or the newer version of the ledger. Are they guaranteed that the two will be fungible? Given this uncertainty, a bank run quickly developed. Except rather than a euro-style intra-bitcoin migration, everyone headed off to Mt-Gox and tried to buy USD as quick as possible.

Mario Draghi pretty much stopped the intra-euro bank run by pledging to ensure that euros would always be convertible at par. (See Gavyn Davies here & here). Likewise, the bitcoin developers are quickly moving to resolve the bitcoin run by ensuring that the fork is folded back into the original ledger. Both incidents serve as reminders that there is no such homogeneous entity as "money". The sudden realization of this on the part of the public leads to panics. Those maintaining payments networks need to immediately patch any threat of heterogeneity lest those panics become crises.

Disclaimer: Long bitcoin still.

Without proper balancing forces, Hans-Werner Sinn's "European ISA" will be destabilizing

(Disclaimer: this article is geeky. If you want to follow it, you should already know a bit about the European Target2 imbalances debate (here is a good intro) and have read my description of the US Interdistrict Settlement Account)

There is a tension involved in being a lender of last resort. Central banks are supposed to provide liquidity to solvent but temporarily illiquid institutions during a liquidity crisis. But they're not supposed to go as far as keeping bankrupt banks or governments alive. Hans-Werner Sinn’s proposal to import the Federal Reserve's Interdistrict Settlement Account (ISA) into the Eurosystem seems to me to be an attempt to impose on National Central Banks (NCBs) the discipline necessary to prevent them from crossing this almost transparent line.

But an ISA-type settlement mechanism in a European setting threatens to not only prevent NCBs from crossing the line; it could prevent them from fulfilling even their basic duty as lender of last resort. This would be dangerous. The very fear that an NCB is limited in acting as lender of last resort could lead to self-fulfilling runs on NCBs during crisis. Faced with the requirement of fulfilling its role of lender of last resort or meeting an ISA-type settlement requirement, it is likely that settlement will be sacrificed, resulting in an embarrassing loss of face and credibility to the Eurosystem as a whole.

Is the Federal Reserve’s ISA binding?

A large part of Sinn’s yearning for an ISA-style mechanism comes from the idea that “there is quite a penalty for District Feds that create and lend out more than their fair share of the monetary base. This is the reason why a TARGET-like problem has never arisen in the US to this day.” [source]

I disagree with him on his views on the ISA. While ISA settlement certainly imposes a constraint on district Reserve banks, it is a distant constraint. I call it distant because other “balancing” mechanisms (which I'll outline below) come prior to final settlement. As a result of these balancing mechanisms, district Reserve banks are unlikely to ever come close to settlement failure and therefore the ISA does not genuinely discipline them.

A hypothetical ISA settlement failure would happen if a district Reserve bank, in fulfilling its duty as lender-of-last resort, perpetually lent reserves to regional member banks facing crisis. If these newly-created reserves were to be moved to neighbouring districts, the district Reserve bank would be required to settle these capital outflows with ISA-permitted settlement media. In times past, gold was the settlement media, but nowadays it its System Open Market Account (SOMA) assets. All assets purchased by the Federal Reserve system in the open market are assigned to this account. Each district Reserve bank in turn receives an allocation of SOMA. Should the crisis be protracted and outflows continue, the district Reserve bank will eventually run out of SOMA assets and fail to settle its ISA debts.

But there is an important mechanism at work that prevents prolonged district Reserve bank loans to failing member institutions. In the US, insolvent banks are quickly shuttered and sold off by the Federal Deposit Insurance Corporation (FDIC). This is called bank resolution. Secondly, there are few regulatory barriers and certainly no cultural or linguistic boundaries to overcome when it comes to US bank mergers. A private bank in the Cleveland district can easily buy a weakened bank in the San Francisco district and vice versa.

Due to quick resolution and a relatively painless merger process, district Reserve banks need not lend to weak private member banks for extended periods of time. As a result, district Reserve banks don’t create the huge amounts of reserves that, when transferred to another district, might lead to an ISA settlement failure. Contrary to Sinn’s belief, the necessity of ISA settlement is only a distant constraint on district Reserve banks.

Potentially lethal problems with a European ISA

Sinn wants to graft an ISA-style mechanism onto the Eurosystem. The idea seems to be that if NCBs were to face a periodic day-of-reckoning that required the settlement of outstanding Target2 debts with real assets, then they would be dissuaded from incurring irresponsible debts in the first place.

I agree with Sinn on the idea of implementing some sort of Target2 settlement mechanism. Even Keynes, in devising his International Clearing Union, wrote:

Measures would be necessary to prevent the piling up of credit and debit balances without limit, and the system would have failed in the long run if it did not possess sufficient capacity for self-equilibrium to prevent this. Proposals for an International Currency (or clearing) Union, February 11, 1942

But there is a certain danger in implementing an ISA-style settlement mechanism without the same balancing mechanisms we see in the US. This danger arises because the settlement mechanism interferes with the lender of last resort role of NCBs. Acting as lender of last resort is a duty that all central banks must be left free to exercise. The famous line from Bank of England Director Harman on the quelling of the 1825 crisis comes to mind:

We lent it [pounds] by every possible means and in modes we had never adopted before; we took in stock on security, we purchased Exchequer bills, we made advances on Exchequer bills, we not only discounted outright, but we made advances on the deposit of bills of exchange to an immense amount in short, by every possible means consistent with the safety of the Bank, and we were not on some occasions over-nice. Seeing the dreadful state in which the public were, we rendered every assistance in our power.

As long as US-style balancing mechanisms exist —  both a quick resolution mechanism and the ability to freely merge banks  —  it is unlikely that an NCB, in discounting freely, will create the incredible volume of reserves that might lead to a European ISA settlement failure. But my understanding of European banking is that bank mergers are not easy (see pdf). Nor has a proper European wide resolution protocol been established. Perhaps readers can elaborate on this.

So let's imagine that Sinn’s plan to implement an ISA-style settlement mechanism is adopted without the balancing mechanisms I've previously mentioned. The next time a crisis hits, the NCBs will discount freely, as they should. They'll have to do a lot of it, since problem banks aren't being resolved, nor are they being merged. There will probably be capital flight from one country to another. This will bring the intra-Eurosystem settlement mechanism into play, requiring the transfer of settlement asset from debtor NCBs to creditor NCBs.

The problem is that as an NCB gets closer to settlement failure, depositors will flee ever faster to other European NCBs. Depositors will do this because they anticipate that settlement failure will lead to temporary inconvertibility of that NCB’s euroliabilities — better to get out while it's still possible, goes the thinking. This effect is perverse, since the very threat of settlement failure leads to the self-realization of settlement failure.

What does an NCB do when it hits Sinn’s settlement constraint? Does an NCB cease acting as the lender of last resort and settle? Or does it continue to lend and let settlement fail?

Relaxing the law is embarrassing

One of the lessons of monetary economics is that there are grave consequences to stepping aside as lender of last resort. Because of this, the most likely answer to the above question is that the law concerning Eurosystem settlement will be temporarily put aside to allow for continued lending.

There is a long tradition of setting law aside to allow for lender of last resort purposes. Peel’s Act of 1840 attempted to constrain credit creation by dividing the Bank of England into an Issue Department and a Banking Department. The Issue Department issued banknotes 100% backed by gold. The Banking Department issued deposits which were convertible into these notes. During a crisis, the Banking Department would be swamped with requests for notes. But Peel’s Act prevented the Issue Department from providing the Banking Department with bank notes. As a result, people grew even more anxious to withdraw existing notes from the Banking department, igniting a run. In order to save the Banking department from insolvency, during each crisis the government would issue a rather embarrassing public letter saying that the legal separation between the two departments was temporarily null. As a result, the Issue department could lend notes to the Banking department, and the crisis ended.

Much like the Bank of England of the 1800s, it would be embarrassing for the Eurosystem to adopt Sinn's ISA-style settlement mechanism only to have to publicly annul settlement each time a crisis hits and lender of last resort action is necessary. Far better to promote the emergence of strong balancing mechanisms like bank resolution and mergers, and only after that implement some sort of settlement mechanism. The former will dull the bite (and potential embarrassment caused by failure) of the latter.

PS. Karl Whelan is circulating a draft paper on Target2 and is looking for constructive criticism. I haven't commented on his paper in this post as I'm waiting for his final version. But drop by here to read & comment.

PPS. As a free banker, I don't support monopoly banking. I took off my free-banking hat to write this.

Let the ECB capital key float

Bankers clear and settle with each other at a clearing house

Perry Mehrling had in interesting comment about how to settle the Eurosystem's Target2 imbalance problem.

If there were Eurobills, balances could be settled periodically by transfer of assets, just as is done in the Federal Reserve System. More precisely, if there were a System Open Market Account at the ECB, in which all of the national central banks held shares, settlement could be made by transfer of shares.

Perry is talking about adapting the structure of the Fed's Interdistrict Settlement Account to Europe. To understand the ISA, check out my Idiot's Guide to the Federal Reserve Interdistrict Settlement Account. In short, the 12 regional Reserve banks run up debts and credits to each other over the course of the year due to changes in payments flows. These debts and credits are settled each year by transferring securities that have been bought in open market operations from debtor Reserves banks to creditor Reserve banks.

The Eurosystem, on the other hand, doesn't require that the clearing debts wracked up by the various National Central Banks (NCBs) be settled. Which is odd. Not even Keynes's ICU would have allowed infinite debts, and Keynes was a forgiving sort of guy.

Perry's idea is that with the Eurosystem embarking on a program of Outright Monetary Transactions (OMTs), maybe the securities amassed will allow for a mechanism to settle intra-Eurosystem imbalances. Debtor NCBs like the Bank of Greece will have to transfer OMT securities to creditor banks like the Bundesbank. Perry specifically discusses the idea of having each NCB own shares in the OMT portfolio and have these shares transferable so as to facilitate settlement.

I like this idea and think it can be twinned with the already existing ECB capital key. What is the capital key?

All NCBs have an ownership stake in the overlying ECB. The relative amounts held by each are determined by the capital key. The key's weights are based on relative population and GDP. Germany for instance, has been given an 18.9% weighting in the capital key. Greece has been given a 1.96% weighting.

The ECB holds a unique set of assets on its balance sheet (see year-end 2011 statements). These have been transferred to it from the NCBs. First, it holds 16 million ounces of gold, worth around €21b. It also holds around €41 in forex reserves denominated in yen, dollars, and more. Lastly, it holds a few assets purchased during previous open market campaigns. Also worth considering is that the Eurosystem's total profits are paid out according to the capital key. This means that the profits yielded by assets held by the Bank of Greece don't necessarily get paid out to the BoG... they get amalgamated with all NCB profits and then allocated to each individual NCB according to the capital key. So having a big weighting in the capital key is definitely worth something.

Say that going forward all OMT purchases are conducted through the ECB and not the NCBs. That means that in addition to its gold and forex position, the ECB gets even bigger, and shares in the capital key are rendered more meaningful.

You can then institute a Fed-style settlement program by letting each NCB's weighting in the capital key float. Each year debtors get their share in the capital key lowered. Creditors get their's increased. That adds some quid pro quo to intra-Eurosystem balances. What happens if a central bank's representation in the capital key were to fall below zero because of persistent capital flight? Then the national government would have to recapitalize their respective NCB's contribution to the ECB so that it's portion of the key rises back to 0%. Or you could soft-pedal the whole thing and institute some sort of broad system of reforms a country has to initiate once it falls below 0%. Either way, the system is redesigned to have a tendency to equilibrate.

Is such a tendency necessary? I leave you with some words from Keynes's Proposals for an International Currency (or clearing) Union, February 11, 1942:

Measures would be necessary to prevent the piling up of credit and debit balances without limit, and the system would have failed in the long run if it did not possess sufficient capacity for self-equilibrium to prevent this.

The Interdistrict Settlement Account finally settles

Last year and earlier this year, debate concerning the Target2 mechanism in Europe and its growing imbalances shed some light on the equivalent institution in the US, the Interdistrict Settlement Account (ISA). The argument has been made to import the ISA structure into Europe, in particular, the yearly settling of accounts between district Reserve banks. If the ECB were to operate this way, the idea goes, then there would be some sort of quid pro quo on Target2 imbalances - European national central banks (NCBs) would not be able to accumulate debts to each other ad infinitum.

The observation was made that contrary to what one might expect, the ISA at the time did not seem to be balancing. Thus the idea that adoption of the Fed model would impose "firm limits" on intra-Eurosystem credit is invalid, since the Fed doesn't seem to always impose settlement on district Reserve banks. This April, though, the ISA seems to have been settled, as the charts below will illustrate. Nevertheless, the point still stands that the Federal Reserve System may choose to constrain itself by requiring interdistrict settlement or it may choose to forego that restraint.

Buoyant Ireland

Nick Rowe is pessimistic, and points to one of the dreariest articles I've read to date on the Europe situation.

I noticed that Ireland seems to be doing much better than the other peripherals. See the chart below. Its stock market is relatively strong, having outperformed markets in Greece, Italy, and Spain while keeping up to the German DAX. At the same time, Ireland isn't seeing capital outflows anymore. While Greece, Spain and Italy's TARGET2 balance is deteriorating, Ireland's has been improving for over a year. (Note that data is to end of April).

(click here for expanded version)

What are the Irish doing differently? Is Ireland presaging how the other peripherals might be stabilized, or are they just lagging behind?

Note: For one explanation of the difference, see this Allied Irish Bank report (pdf).

More on the comparison of the Federal Reserve and ECB settlement mechanisms

Michiel Bijlsma and Jasper Lukkezen have a very good article on the Bruegel blog that deals with the question: why is there no Target2 debate in the US?

Bruegel on the Target2 vs Interdistrict Settlement Account debate

The Belgium-based think take Bruegel recently linked to my guide to the Federal Reserve Interdistrict Settlement Account. In my ongoing attempt to ensure the Target2 debate doesn't founder on faulty comparisons to the Interdistrict Settlement Account, here's another post.

Although they have a better grasp on how the ISA works than most, the authors Michiel Bijlsma and Jasper Lukkezen do make an important error:

The important difference between Target 2 and ISA, however, is that in the US all Reserve Banks are owned by the federal government. This means that in the US it is possible to safeguard the integrity of the system by changing the settlement rules. This is as exciting as a game of monopoly among friends. As all Federal Reserve banks are owned by the federal government, a loss in Richmond is irrelevant when there is an equal gain in New York. In the Eurozone, however, the ECB is owned by the national governments via the national central banks, not by the European Union as a whole. When one would change the settlement rules here – for example by discounting claims – this means a transfer across countries.

In actuality, all twelve Federal Reserve district banks are owned by their member private banks. What allows the Fed to change settlement rules is not any ownership position in the Fed (they have none) but the system's constituting articles, or Federal Reserve Act, which put the preservation of the par value of US dollar-denominated banking liabilities above the necessity of the system settling.

As I pointed out in response to commenter John Wittaker here, if the Federal Reserve system was to be dissolved and there existed significant imbalances between districts, final settlement might not be guaranteed. That's because a district Fed's credit is only as good as the credit of its member private banks. If these member were asked to re-capitalize the district bank to enable it to achieve settlement, but they were unable to do so, it would cause problems.

So in that respect, Bijlsma and Lukkezen  are wrong to say that a loss in Richmond and a gain in New York is ultimately irrelevant. When all the chips are down, these imbalances represent transfers between shareholders of district Reserve banks. For instance, if the Richmond Fed failed to settle and its shareholders, including Bank of America, could not support a recapitalization of that district, then the New York Fed would have a massive loss on its hands. This would require member banks like JP Morgan to re-capitalize it. Thus, in comparing the ECB settlement mechanism to the Federal Reserve mechanism, it's not fair to say transfers do not occur - all that can be said is that these transfers are distributed across a different spectrum of actors.

Bijlsma and Lukkezen also have a similiar article here though they don't attribute to the Money View credit for the initial observation nor myself for the underlying research. They note:

Every year in April the average ISA balance over the past 12 months is calculated and netted via transfer of gold certificates between reserve banks.

This also is not entirely correct. Settlement via SOMA transfers, not gold certificates, has been the standard operating procedure since the 1970s.

The Idiot's Guide to the Federal Reserve Interdistrict Settlement Account

The argument about ECB Target2 imbalances, an argument which began in mid 2011 with this article, continues to be reignited in various arenas. One component of the argument is the comparison of Target2 to the Federal Reserve’s mechanism for settling inter-Fed settlement imbalances; the Interdistrict Settlement Account.

Because the various debaters often have such diverging views on how the Interdistrict accounts are settled, I’m donating this post to the blogosphere with the goal of ensuring that the debate doesn't founder on faulty comparisons of Target2 to the Interdistrict Settlement Account. As such, I'm going to talk a bit about the history of Interdistrict settlement, how the process has changed over time, and how it works now. Once that's done I'll bring the discussion back to Target2 in order to pin down the comparison in a more robust way. I don't claim to know everything about these mechanisms; I've just spent a few weeks educating myself, so if I am wrong on any aspect leave me a comment.

In first learning about these two mechanisms I had a very meta reaction. By meta, I mean the same sort of reaction faced by anyone asking who watches the watchers?  In this particular case, the more appropriate question is “who clears for the clearers?” 

Another thing that makes the Target2 and Interdistrict settlement mechanisms so fascinating is that, within the monetary architecture, they are “core”.  Take out the core and the whole structure disintegrates.

Yet despite their centrality to the superstructure, nobody (except for a few cloistered central bankers) really knows much these mechanisms. It is only now that imbalances are cropping up that we the public find the inclination to catch up on how these arcane but vital systems function.

All sorts of commentators have already explained how Target2 works and the imbalances that have arisen. I won’t touch on these; just search Google for Target2. What follows is a discussion of the Federal Reserve Interdistrict Settlement Account.

Target2 and the Federal Reserve Interdistrict Settlement Account

Perry Mehrling wrote an interesting post called Why did the ECB LTROs help?

He visits the comparison of the Federal Reserve Interdistrict Settlement Account and the ECB Target2 settlement mechanism. I have also found this comparison in a number of other publications, see the list at bottom. Here is the comment I left at the Money View blog.

My reading of the Euro-system rules is that deficit national central banks (NCBs) never have to settle with surplus NCBs. These intra-system balances can grow ad infinitum. Thus, deficit NCBs don't have to worry about owning acceptable assets for settlement, since there is no ultimate day of reckoning. The result is that survival constraints for Eurosystem NCBs are far looser than the survival constraints faced by regional Federal Reserve banks, which must settle each year. In the old days this settlement was conducted by transfers of gold certificates amongst regional Federal Reserve banks. After 1975 the settlement medium was switched to securities held in SOMA. But in the case of the Eurosystem, there is no ultimate settlement mechanism or medium that I am aware of, neither gold nor securities. 

Merhling's co-blogger Daniel Neilson had an interesting reply in which he pointed out that it would appear that the Fed's April settlement seems to no longer be occurring:

Indeed the Federal Reserve System seems to have decided to let FRBNY accumulate a large claim on the other Reserve Banks. One can see why the various Reserve Banks might not feel the need to imagine a breakup of the United States in deciding on the makeup of their balance sheets.

The appearance of non-settlement is noticeable in Mehrling's chart. The reversion to mean that should be occurring each April settlement did not happen in 2011. Debts to the New York Fed from other regional Federal Reserve banks are, seemingly, being allowed to accumulate.

Whether in fact settlement rules are being ignored is a mystery to me. Here is my comment:

Odd that this is not mentioned in the Fed's financial notes. What is the resolution of the data in that chart? End of week? It might not give sufficient granularity for us to assess whether claims were allowed to accumulate, or were settled for a day or two before returning to trend.

Buiter explains why the constraint can be escaped:

"The Interdistrict Settlement Account must be settled once a year with gold-backed securities or Federal treasury bills. This would represent a constraint on inter-district credit flows only if the stock of Federal Treasury bills allocated to the individual Federal Reserve banks was exogenous. However, individual regional reserve banks can always buy Federal treasury bills from banks or other holders of the stuff in their own districts, financing this with an increase in base money. The Federal Reserve Board could then decide to undo this transaction or ‘sterilise’, it. However, an interest-rate-setting Fed will only undo this, if the regional Fed’s Treasury bill purchase and the associated increase in base money were to lead to an excessive divergence between the actual Federal Funds rate and the Federal Funds target. This is highly unlikely. Even when the Fed’s official policy rate is at the effective lower bound for the official policy rate and the Fed is engaged in QE, there is no effective constraint on the ability of regional Reserve Banks to settle the Interdistrict Settlement Account imbalances with Treasury Bills funded with base money issuance. The yearly settlement requirement in the Interdistrict Settlement Account procedure would thus not appear to be a constraint on persistent credit imbalances between individual Federal Reserve banks’ districts."

I am hoping to investigate this mystery a bit further.

There are a number of conflicting resources explaining how the interdistrict account is settled, and how binding this is.

1. The key source is pg 136 - 138 of the Financial Account Manual for the Federal Reserve.
2. The Buiter quote I mention above comes from a Citi report called Original Sinn.
3. Peter Garber's Deutsche Bank article The Mechanics of Intra Euro Capital Flight also touches on the comparison.
4. Citi prints Hans-Werner Sinn reply to Buiter here, giving his views on interdistrict settlement.
5. Here is Sinn's initial paper.
6. I got the reference to the 1975 settlement changes from Meltzer, A History of the Fed, Vol 1. "The diminished stock of gold and gold certificates and rising levels of reserves and deposits required a change in interbank settlement... In 1975 the operations staff recommended that monthly gold transfers cease. Reserve banks other than New York would change once a year. New York would pay for withdrawals and receive deposits from the Treasury. Once a year, the Interdistrict Settlement Fund would reallocate securities in the System Open Market Account to balance accounts. Gold remain as collateral for the note issue, but securities would be the principal collateral (memo, Maurice McWhirter and Alan Holmes to FOMC, Board Records, April 11, 1975). Step by step, gold lost its monetary role and main provisions of the 1913 Federal Reserve Act disappeared."

There are no other good sources that I've been able to locate on the Target2/interdistrict comparison.

Note: I have blogged more extensively on the Interdistrict account here.

The Euro isn't a glove, it's a Chinese finger trap

Tyler Cowen posts on Is there an easy way out of the eurozone? He notes it would be harder than Robert Barro thinks.

I agree. My comment:

Barro’s is the Euro-as-glove argument. You can slip it on, and slip it off just as easily.

I like the Euro-as-Chinese-finger-trap argument. Once you’re in, you aren’t going to get out of it.*

*Germany can’t leave it easily, because it is owed some E500b by the ECB via the Target2 settlement system. Leave it and lose it. The PIIGS can’t leave, because as Tyler points out, a bank run will immediately result. And if they dodge the run, they surely won’t be able to dodge euroization: citizens will spontaneously disengorge any newly-created liras/drachmas/etc in favour of the already-circulating and vastly superior Euro.

ECB, NCBs, and arbitrage yet again

Tyler Cowen posts again on the theory that banks are using the ECB's new and broader facilities for arbitrage by buying risky sovereign debt, thereby driving interest rates down.

There is another explanation for the fall in rates, see my comment below:

The new ECB collateral rules dramatically increase the quantity of assets that banks can submit to the ECB in order to get ECB clearing balances. Bank loans are now allowed, so are lower quality ABS. This means that it is less likely that the national governments will have to guarantee local bank debt. This was a real problem in Greece and Ireland, for instance, for the local banks had run out of assets to submit to the ECB. Instead, banks were creating debts amongst each other and having the government guarantee these debts, before submitting them to the ECB as collateral.

Since private non-marketable debt can now be submitted to the ECB, governments will no longer be required to covertly bail out their banks by guaranteeing intra-bank debts. That means that euro government debt is now a lot safer, and explains why yields are falling. So you can use an ECB arbitrage theory to explain the data, but there are alternatives.

Interfluidity also chimes in on The Eurozone’s policy breakthrough? My comment below:

I think the ECB’s policy change is designed to stop the intra-European bank run currently in effect, and not to support various governments. The arbitrage bit that Cowen is writing about is either a red herring or simply incidental.

Because of the Eoro area clearing & settlement mechanism, banks subject to capital flight need to submit collateral to their NCB on a continuing basis to deal with a bank run.

By lending settlement balances for three years and, more importantly, accepting lower quality ABS and bank loans as collateral, the ECB is committing NCBs to averting all degrees of bank runs from member banks. Hopefully this flexing of its muscles is enough to stop the run.


See this older blog post too.

ECB, NCBs, collateral, capital key, Target2, and intra-eurosystem credit

Two comments on The Money View. One on Perry Mehrling's The IMF and the Collateral Crunch and the other on Daniel H. Neilson's Is there an ECB?

Neilson links to the erroneous Tornell/Westerman piece. My comments on this are in a previous post. In short, Karl Whelan's Worse than Sinn clarifies the issue. Sterilization by the Bundesbank is not happening. 

Merhling and me discuss the nature of the transactions conducted between borrowing NCBs and the lending ECB.

Perry, I can't find any explicit reference to whether intra-Eurosystem credits are collateralized or not.

But I still think not. Collateral is posted by a borrower to a lender to protect the lender should the borrower default. Then the lender can collect the collateral instead.

But ECB losses are dealt with in a specific way. See bottom of http://www.ecb.int/ecb/orga/capital/html/index.en.html

In short, if the ECB suffers a loss on a loan to an NCB then that loss is allocated to all NCBs according to the ECB's capital key.

The March 2011 Bundesbank report describes this:

"An actual loss will be incurred only if and when a Eurosystem counterparty defaults and the collateral it posted does not realise the full value of the collateralised refinancing operations despite the risk control measures applied by the Eurosystem. Any actual loss would always be borne by the Eurosystem as a whole, regardless of which national bank records it. The cost of such a loss would be shared among the national banks in line with the capital key."
So it would be redundant or unecessary for an NCB to post collateral to the ECB for ECB credit, since in the case of non-payment the ECB has a claim on all NCBs to make up the loss.

That being said, I don't think this necessarily changes the thrust of your post.