The Money View

OMT: Slouching toward Eurobills?

The Eurocrisis has many dimensions—bank solvency crisis, sovereign debt crisis, political unity crisis, and economic/unemployment crisis—but time after time it has been the liquidity crisis dimension driving events, and ECB response to the liquidity crisis driving institutional evolution.  The reason is simple.  Liquidity kills you quick.

Most people, probably, think that the real point of Outright Monetary Transactions is to support the price of sovereign debt, notwithstanding Draghi’s claim that it is about fixing a broken monetary transmission mechanism, since low policy rates seem not to be transmitted to low sovereign debt rates.  But maybe Draghi has more of a point than most people realize.  From a money view perspective, let’s consider the possible connection between proposed Outright Monetary Transactions and the ongoing problem of burgeoning Target 2 balances between surplus and deficit national central banks of Europe.
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.
From this perspective, OMT can be seen as the first step toward a kind of system open market account, and the shares in that account would be a kind of first step toward a Eurobill.   
We know that the Bundesbank is not happy that it has accumulated such large Target 2 balances, which are essentially unsecured claims against the Eurosystem as a whole.  We know also that the Bundesbank would be quite happy receiving German bonds as settlement for those claims, but that is not going to happen and everyone knows it.  So the question is whether Spanish sovereign bills would be acceptable, and it seems that maybe the answer is positive, especially if the sovereign commits to some kind of conditionality before hand.  
Even better however if the Bundesbank could receive shares in a system open market account, representing a portfolio of the various assets held by the Eurosystem.  The point is not so much diversification as it is security.  In effect, these shares would be a kind of proto-Eurobill, maybe not yet traded in private money markets, but traded nonetheless in settlement between national central banks.  So maybe we should  be pushing for a package deal, not just Spanish OMT but also others (Italy and maybe also France), in order to begin creating a system open market account at the ECB. (See here for such a proposal).
If it works, OMT holds out the prospect to finally settle the Target 2 overhang.  Start with Spain.  Suppose that Rajoy asks for OMT.  Spanish banks sell Spanish bills to the ECB, use the proceeds to repay loans from their national central bank, which then uses the proceeds to repay Target 2 loans from the Eurosystem.  Hey presto, settlement.  
But now the ECB has new Spanish bills as an asset, and new deposits as a liability, and both have to be booked at one of the national central banks.  Book them at the Bundesbank and the deposit liability cancels against the Target 2 repayment, leaving Spanish bills as an asset.  In effect, Target 2 balances are replaced by Spanish bills.  That's why the crux of the matter is whether the Bundesbank commits to accept Spanish bills.
The larger point of this post is the simple observation that the Bundesbank will more readily accept Spanish bills if in some sense these bills are the joint and several liability of all the European sovereignties.   If Spain, Italy, and France all went in for OMT together, and the resulting assets were segregated in a system open market account in which all national central banks held shares, we would be halfway there.
The unsecured liabilities of the Eurosystem, such as Target 2 balances, are already the joint and several liability of the national central banks which capitalize the ECB.  A system open market account in which national central banks hold shares is just a secured version of the same thing.  This is the sense in which Draghi’s OMT offers the prospect of a kind of backdoor Eurobill, essentially a secured clearinghouse certificate now, but possibly something more in the future.



That's a fine idea. I like it.

Since we're brainstorming, here's another.

The system already has an allocation mechanism, the capital key. It's fixed, but why not let the capital key float? Have the ECB do all the open market purchases, not the NCBs. Payment imbalances between NCBs can be settled by adjusting the capital key so that debtor NCB's share in ECB capital falls while that of creditor NCBs increases. As a result, debtor NCBs have a smaller claim on the ECB, and thereby a smaller claim on overall system profits and a smaller share of e-SOMA. (No, not a pill. e-SOMA = European system market account)


Interesting article. Does that mean that ECB created reserve entries for the purpose of clearing are higher in ther hierarchy of money than NCB created euro reserves?


The blog entry suffers from several misunderstandings regarding the way in which Target and the ECB's modentary policy works.
1) The entry states: "Suppose that Rajoy asks for OMT. Spanish banks sell Spanish bills to the ECB, use the proceeds to repay loans from their national central bank, which then uses the proceeds to repay Target 2 loans from the Eurosystem. Hey presto, settlement." If Spanish banks sell Spanish bills to the ECB, then the T2-position is automatically reduced. The purchase price is transferred via T2 and thereby decreases the T2-liability of Banco d'Espana. If, however, Banco d'Espana purchases the bills (since it is part of the Eurosystem), then the T2-liabilities are not decreased. Yet, how should Banco pay its "T2-debts" to the Bundesbank? If Banco makes a payment to Bundesbank, its T2-position increases immediately. In fact, T2-loans do not exist. The T2-position is an accounting position. The only problem occurs whenever a country whose central bank has T2-liabilities leaves the euro area. In this case the T2-positions transform into foreign-denominated debt.
2) To establish a general settlement mechanism (as in the US) works only if the ECB decides to switch to asset purchases in its normal monetary policy operations (instead of using credit operations). This would create a sufficiently large pool of assets that could be reshuffled between national central banks.
3) The US settlement system is a relict from gold standard times. It has no consequences and no bearing on the handling of banks by the district feds. No consequences are specified as to what would happen if a district fed does not have sufficient settlement assets. Moreover, the district feds have no access to the SOMA since this is managed by a portfolio manager appointed by the Fed NY. Hence, the only consequence of the settlement is a re-distribution of seignorage which has hardly any consequences in the US because the largest part of seignorage is transferred to the US treasury.
4) Introducing newly created bills as settlement assets in the euro area would re-enforce the link between banks and sovereigns. Every unit of liquidity that is moved cross-border within the euro area immediately leads to higher government debt. Even if the T2-positions were settled by a transfer of assets, once the interest payments on the assets are made or the debt is repaid, a T2-position of similar magnitude re-emerges.
5) There is no need to settle the T2-positions as long as no country leaves the euro area. The easiest way to deal with the exit risk implied by T2-positions is to centralize monetary policy and let the centralized power (say, the ECB) enter the credit contracts and give it access to the collateral. This would, at least to some extent, limit the exit risk exposure.
6) Another way to eliminate exit risk is to transfer the wealth of all national central banks to a single entity, say the ECB. While 5) and 6) would in no way limit the capital flows within the euro area, they would help to eliminate (part of) the exit risk. In case of a full wealth transfer, if a nation withdraws from EMU, the ECB could keep the national central bank's wealth to make good any losses and then re-transfer the remainder. However, this proposal is politically not feasible.


"That's why the crux of the matter is whether the Bundesbank commits to accept Spanish bills"
It seems to me like we are at the European version of Bretton Woods. I do not think that Germany will agree to that, at least not officialy.

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