One Currency Zone - Two Circuits

(New Gold Supra-Theory Salon des Refusés – Post 4)

We are delving into the workings of the Eurosystem’s TARGET2 system (T2) using circuit theory to separate it into discrete circuits in order to try to identify whether gold could improve this system. The Euro gets the job done in the household consumption circuit (discussed here).

Earlier we referred to the other components of T2 as the 'non-consumption circuit' to differentiate it from the circuit we were exploring. Now we are trying to determine if gold has any potential role in correcting TARGET2 imbalances through some other circuit involving goods that aren't consumed.

Monetary circuit theory is a way of looking at endogenous money creation by a banking system. Individual banks generally borrow first and then lend. So it’s difficult to detect this endogenous money circuit by looking at the books of a single bank. Banking systems lend money into existence in the form of deposits. The money created by one bank’s lending surfaces as a deposit on the books of another bank.

A key point to remember as we look at this T2 system is that by trying to separate it into two circuits we are creating a simplified conceptual model in order to try to understand a few specific issues. The reasons for the current TARGET2 imbalances and to determine if gold could have helped to prevent them or correct the imbalances if it played a different role in the system today aside from being the primary ECB reserve asset.

Before we press on here’s a recap on the household consumption circuit theory. The fathers of the Euro used a modified version of the price>specie>flow mechanism in the design of the Eurosystem. I’ll style this here as prices+>Euro>flow. The phrase ‘prices+’ is used to indicate that there are more factors involved than prices alone. Under a free trade regime the money flows in this mechanism automatically correct imbalances in the availability and diversity of the most-demanded consumption goods and services across the Eurozone.
 

In this post I’m going to draw on one of the BIS Working Papers (No. 393) titled “Interpreting TARGET2 balances”. (Hat tip to Piripi Peterson for the original link to it.) Even if you don’t have time to read the whole paper take a look at the graph on Page 1 titled “The TARGET2 claims of the Deutsche Bundesbank”. The range of fluctuations in the DB's T2 balance was reasonably consistent from 2000 to 2007. Then it took off between 2007 and 2012. I think we can summarise the conclusions of the authors of this BIS paper as follows:

1. The German banks were pulling loans and repatriating funds from the Club Med countries.

2. Money from international banks was positioning itself in Germany for a breakup of the Euro single currency zone. Hedging “redenomination risk” (or speculating on it) with the aim of being redenominated into a new Deutsche Mark if the breakup happened.

3. The Eurozone inter-bank credit market seized up.

Issues 1 and 2 offer the best explanation for the bulk of the T2 imbalance but I think item three is the one that we should focus on. Under normal circumstances the existence of the Eurozone inter-bank lending market can’t be detected by looking at T2 because clearing occurs between banks before any net balances flow through the TARGET2 payments system. (In that BIS paper the authors explain this using simplified balance sheet entries.)

I think we can also see an inter-bank credit circuit exposed by the T2 imbalances that complements our household consumption circuit. A circuit that mainly funds transactions involving assets as opposed to household consumption goods and services. Exploring the Eurozone monetary system with this perspective could be an interesting exercise but our focus here is on the question of whether gold has a role to play in this circuit and in correcting T2 imbalances.

When the Eurozone inter-bank market froze this circuit became visible on the central bank balance sheets because a central bank is the lender of last resort. It’s only in times of crisis that the lending which normally occurs in the inter-bank market moves onto the balance sheets of central banks. If the cause of a banking system crisis is merely a lack of liquidity the solution is to supply Euro - not gold. If the problem is insolvency the solutions are an orderly bankruptcy, merger with a stronger bank or recapitalisation of the insolvent Eurozone bank with Euro.

One of the major challenges for a central bank is that a liquidity crisis and a solvency crisis are identical in appearance. (Being able to view these net inter-bank flows via T2 doesn’t tell the ECB Eurosystem what is on a commercial bank’s books.) In a crisis the CB must act and carry out a forensic investigation later. In my opinion the right solution to this problem is the banking union and making the ECB the chief regulator of Eurozone banks (with a mandate to deal with the underlying causes of crises pre-emptively).

Highly-rated sovereign debt forms part of this inter-bank credit circuit because it is classified as a risk-free asset for banks under BIS rules. That BIS paper identifes sovereign debt as one of the underlying factors in the current T2 imbalances. Normally the sovereign debt held by banks is imbedded in the inter-bank credit circuit. In an ongoing crisis like the present one it erupts onto central bank balance sheets as collateral for emergency funding.

It doesn't seem likely that gold could address any of the problems in this inter-bank credit circuit of the Eurozone monetary system. To identify gold’s role in this new international monetary and financial system I think we need to turn our attention to currencies and the concept of a risk-free asset. Then we can restart the discussion about gold and international trade settlement (after we deal with a couple of the issues that hindered the first attempt).