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The Other Euro Flaw
We have not been shy to point out the potential (and now proven) flaws in the Euro experiment (here, here, and here for example) over the past year or so but UBS reminds us that while most people remain fixated on the absence of a fiscal transfer union in so large a monetary union (to offset incidents of inappropriate monetary policy) as Eurobonds and Federalism come back to the fore; it is the second flaw - the absence of an integrated banking system (backed implicitly by a credible lender of last resort) - that should be getting front-page headlines. As Niall Ferguson noted at Zeitgeist this morning, "Structural reforms will work but will not work this week" and in the meantime, TARGET2 balances grow out of control and the longer the 'problem' remains, the worse it becomes leaving an implicit infinitely supported firewall as the only interim solution. While most who foresaw the Euro as implicitly leading to federalism were right, it seems the link to a German dominance (of ECB rulings and general fiscal and monetary decisions) has been the ultimate outcome. While an integrated banking system would do nothing to change the relative competitiveness or growth issues that plague Europe, the 'essential' internal capital flows would be sustained. Is this sort of integration a realistic prospect? The politics is not especially propitious.
UBS - The other flaw with the Euro
Before the ink had dried on the Treaty of Maastricht, economists gathered to point out the two fundamental problems that existed. The first was the absence of a fiscal transfer union in so large a monetary union to offset incidents of inappropriate monetary policy. Fiscal policy transfers cannot create equality of economic performance, of course, but they can smooth the rough edges of a monetary union.
Much of the current crisis of the Euro has focused on the fiscal failings of the union. This is, perhaps, an inevitable consequence the current circumstances. A partial transfer mechanism is in place which is fuelling national resentments. Governments have focused, occasionally with a certain amount of hypocrisy, on the need for fiscal rules to be rigidly enforced on others (few governments have followed the rules to date). Fiscal transfers are a visible cost to taxpayers in parts of the union, and so inevitably this is a topic that encourages emotional headlines in the populist media.
The need for a Euro banking system
The second flaw or the Euro as a monetary union, which has received less media attention, is the absence of an integrated banking system backed by a credible lender of last resort (with the power of seignorage). This plays a critical role in a monetary union by ensuring that internal imbalances in trade are readily offset by capital flows.
If we consider a monetary union like the United Kingdom, the regional imbalances in trade that exist between the component parts of the monetary union are not something that is economically important. Partly this is because of the existence of a functioning fiscal union, of course. Those regions with a “trade deficit” towards the rest of the country may be net recipients of fiscal transfers, and that is a capital flow finances the current account imbalance. Partly, however, it is the result of an integrated banking system.
In the case of the United Kingdom, capital flows are hidden within individual financial institutions. If Yorkshire (for instance) runs a trade deficit with the rest of the United Kingdom, that can be financed by bank lending into Yorkshire from UK banks. The bank lending itself is financed by deposits (collected from Kent, perhaps). The bank is internally transferring capital between geographies, from south to north.
The Euro area’s lack of a pan-monetary union banking system (internalising the capital transfers that are necessary to offset the imbalances) has seen an evolution of capital transfer mechanisms. Initially this was through bank lending from banks in one economy to customers in another economy; a German bank lends to clients in Spain, or a French bank lends to clients in Greece. This creates a country risk to the bank, to be sure, but in reality it is not that different from a UK bank using deposits in Kent to lend to Yorkshire.
With the advent of the global financial crisis, this mechanism has shifted. Banks are retrenching in the Euro area, and the capital flow of cross border lending that balanced the internal balance of payments has been lost. Instead, as is well known, an imbalance has occurred in the Target II transfer system with central bank money. Simplistically this is two stage process (a Greek importer is effectively creating a securitised liability with the Greek central bank, and the Greek central bank incurs a liability with the Bundesbank and receives money from the Bundesbank to pay for the import). As long as the Euro is intact, this is not a problem. Any loses incurred (because of collateral default, for instance) are incurred in common by the European System of Central Banks. It could be considered akin to foreign exchange intervention in a fixed exchange rate system.
The risk is if Target II ceases to function. This, it should be noted, would have to be a deliberate action by central banks. However, there is a (distant) precedent in the United States. The implosion of the US monetary union in 1932/33 had many facets. Banks refused to lend across state boundaries, inter-state transfer payments were limited or prevented, and so forth. One of the key markers in the fragmentation of that monetary union was the refusal of the Federal Reserve Bank of Chicago to discount the bills of the Federal Reserve Banks of New York (i.e. a refusal to lend dollar cash to the New York Fed), in January 1933. The consequences are pretty much the same as if central banks in the European system of central banks refused to participate in Target II, or discriminated against specific economies in some way. In all probability, such discrimination would lead to a general fragmentation of the Euro area – as of course it did in the United States.
So what would help?
Creating an integrated Euro area banking system would further internalise the imbalances that persist in the Euro area. Moving to a single bank regulator, a single source of capital for bank bail outs, and a single lender of last resort for the banking system would create a more integrated banking system across the Euro area. To be sure this would do nothing to change the relative competitiveness or growth issues that plague the Euro area monetary union. However, the risks that surround the essential capital flows would be lessened. Moreover, individual governments would be lifted of the burden of contingent liabilities associated with their banking systems, which would help to clarify their fiscal positions.
Is this sort of integration a realistic prospect? The politics is not especially propitious. One can imagine the populist media asking “Why should German taxpayers pay for Spanish banks?”, even though this is not what is happening (at least not in the long term). On the other hand, the benefits of a more integrated financial system are clear, and the ECB has been a strong proponent of such a move.
Politically, presenting integration as being a means of strengthening regulatory control of the banking system may be acceptable. The current crisis may help to propel the idea of integration up the political agenda as being a necessary condition for a functioning monetary union – or at least, a monetary union that functions more effectively than does the Euro.
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Euro was meant to implode and wipe out wealth.
i expect germany exiting euro faster than greece. the euro was devised to bring germany down. the only curious thing is that most don't suspect who will actually blow up on the euro grenade. germany ain't taking it for "the team"
Practicing to do belly-flops and cannon-balls, they may have a point -- lots of fun and creates big splashes, but results in low competitive scores.
lagarde is perfect to instruct that to Eurozone, as she was synchro swim champion.
the IMF will revel in its role of saving the purchasing power of deposits of the Greek, Spanish, Portugese & Italian common citizen.
that will make it easy for the Japanese, American & Chinese common citizen depositors to accept the same.
After officially relapsing into recession how is it that the UK is still AAA rated?
They have their own printing press and most of their debt is denominated in their own currency.
Still say, "Never!" regarding Euro Bonds, Gene?
You are going to absolutely love sharing a bank account with the French, Spanish, and especially the Italians!
Co-signers, bitchezz!!!
It would require a change in the German Constitution as well as several other nations(mostly AAA) signing off on the whole thing.
We're still much closer to mass nationalizations on this continent than to Eurobonds, so I suppose that won't change anytime soon. While the technocrats need to keep pushing this meme and catering to the Germans, all it would take for my prediction is one large nationalization like Credit Agricole or someone similar to start a huge wave.
We shall see.
As for your comment regarding the UK I suggest you meditate on it for a moment. You might come across just how twisted that logic truly is.
Hitler didn't bother changing the constitution, he just ignored it.
All the best tricks are old tricks.
Not applicable for utterly too many reasons not least of being that it goes against German interests to do so.
The most ignored Constitution today is geographically elsewhere.
We shall see.
"German interests" are unfortunately completely schizophrenic. On the one hand, attempting to preserve vestiges of sound money and fiscal discipline. On the other, a perennial guilt complex - amounting at times almost to paranoia - for the 3rd Reich, and resulting compensatory warm fuzzy feelings of socialistic brotherhood towards the PIIGS especially in the current opposition parties. If I had to bet, the second will prevail and Germany will end up like France or Italy.
"Hitler didn't bother changing the constitution, he just ignored it. "
Sounds familiar.
1. They have their own currency and can "print"
2. They are talking a good austerity game (though budget deficit levels, declining rates of public sector redundancies etc show it is at least partially BS)
3. The debt maturity averages 14 years, by far the longest in the world, so rollovers are not a big issue. Contrast this with 5 years in USA (was as low as 4 - Greenspan's fault!).
Still, I wouldn't lend them money for 10 years at less than 2%, but then again I wouldn't ever lend them money.
First reason sort of out-weighs the other two yet the logic is backwards completely. The US can 'print' and still we all saw how that changed last summer. My question remains unanswered.
The Euro has little to do with money. It is a political control construct.
http://silvervigilante.com
good article, bullish :)
seriously, the flaw it points in turn has implications for greater ECB role, which everyone is calling for.
ZH reported here that Buba has indicated monetization/inflation as a way out, and they have their eye firmly fixed on Target 2.
So this is back door stuff going on, good of UBS to provide a single note for the context of the many things going on bu not hitting the headlines atm
Doesn't matter...Germans will extend their 0% 2 year bond auction tomorrow to offset the TARGET2 losses - I am certain that it will be oversubscribed as every EU bank has tons of excess reserves to buy these bonds, pledge them at the ECB & get a negative real & nominal return....I mean does it really matter at this point - GREXIT stage left....
when you go for inflation, best do it with zero coupon bonds.... that was my thought.
Article is talking about risk to Target 2; as documented on ZH, Losses from GREXIT = 400bn FIRST ROND only...
SERIOUSLY????? The european central banks are going to let this happen????
And to prevent this all that is needed is CTRL + P???
Come on, lets scare the momo money into selling their wealth then gobble it up at dirt cheap prices
Problem. Reaction. Solution.
Does this mean that when USEurope is materialized, a binary reserve currency status will come to the fore?
Oceania has always had two reserve currencies.
I only remember the dollar being mentioned a few times.
Now I really wish I wasn't stoned back then.
Thilo Sarrazin's new book "Europa braucht den Euro nicht" (Europe doesn't need the Euro) dissects all the above points and more. Sarrazin is a former member of the board of the German Bundesbank.
The book is getting ripped apart by the government-grovelling mass media but has a substantial following in the comments sections of the online major newspapers and in the blogosphere.
Basically, German politicians, who like all others worldwide know f**k all about economics, consented to the EUR in the naive hope that political union would automatically follow the currency union. Now they are attempting to force political union with W. Screwbli as the high priest (the term "4th Reich" has been occasionally provoked by this process) in order to "rescue" the EUR. A grotesque farce.
I think currency union was deemed necessary for achieving a political union and they knew very well what could/would happen. The euro was regarded as a weapon to bring about a union, like the German tanks of old. Only the useful idiots ever believed that the euro could work. Some of them still do, including shitload of economists - who are the most brainwashed group of idiots on the planet (with a few exceptions fortunately). When the shit hit the fan the big question was always what would come out on top: Fear (political union) or anger (nationalism and breakup of the EU). Which remains to be seen.
There is a war going on in Europe now between collectivists who use the ECB, IMF and the Fed as weapons and nationalists. Trust me, the Brussels collectivists will do anything, and I mean anything, to keep the euro alive until political union is a reality. If they have to pour a trillion euros into the euro bank system in the next 12 months, they will. They are likely to succeed. The only real threat is a black swan event like a military coup in Greece or something like that. The nationalists are weak and will lose this war unless something like that happens.
The only question now is HOW they will pour all this money into the system. Not if, or when. It will happen, and soon.
"Creating an integrated Euro area banking system"
bigger, bigger, bigger, boom
bigger, bigger, bigger...FED!
your saying its a problem to put the german's in charge?
Bomb the PIFGIS!
You can't put wine back into a grape. The European bureaucracy and it's politicians will try to keep the Euro alive but it's going to be another Frankenstein if they try for too long.
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