The European System of Central Banks (ESCB) led by the European Central Bank (ECB) will become operational when Stage III of Emu begins on January 1 1999. Member countries will irrevocably lock exchange rates, and interbank payments in euros will begin. There will be respite from Stage II instabilities: bilateral currency markets will no longer exist to batter policy goals.
Is this respite permanent or only the eye of the storm? Could Stage III itself be subject to an attack that forced a realignment of the “irrevocably fixed” exchange rates and a break-up of the system? The received wisdom is: no. The Maastricht Treaty, stability pact, and legal changes surrounding the organization of the ECB all set the fixed rates in concrete. A collapse in Stage III is equivalent to the withdrawal of an Emu member from its treaty commitments.
However, a realistic view of the centrifugal forces pulling against monetary union produces a less definitive answer. Sovereign regions at loggerheads over monetary policy could threaten monetary union. They would be affected differently by the economic shocks of business cycles and would thus have different preferences for secular inflation. Such divergences could be sufficiently strong to impel a country to choose to bear even the costs of unilateral withdrawal from the group.
For example, finance ministers and central bank officials might be unable to reconcile excessive unemployment in one region with the system as a whole – particularly in the absence of major new intra-Emu redistributive mechanisms – or might face nationalistic political platforms. Financial markets would start moving funds from more inflation-tolerant regions to less inflation-tolerant ones. The question then is how the infrastructural arrangements designed to underpin the union would emerge to determine capital flow dynamics in a crisis and, indeed, to accentuate potential cross-border flows.
Under the ESCB, each national central bank will retain its identity, continue to operate its own national large-value payment system and have its own balance sheet and capital. The profits and losses on ESCB monetary operations will be distributed to the national central banks in proportion to their ECB shareholdings.
When it goes on-line at the start of Stage III, the Target payment system will provide the interface between national payment systems. Euro payments from one country will be delivered nearly instantly as euros in another.
Suppose a French bank makes a euro payment to a German one. Software controlling the French national payment system will automatically deduct euros from the bank’s account in the Banque de France and pass the payment order through Target to the Bundesbank, which adds the euros to the German bank’s account. In settling this payment, the Bundesbank automatically gives credit to the Banque de France, which is booked by incrementing the Bundesbank’s correspondent account at the Banque de France and subtracting from the Banque de France’s correspondent account at the Bundesbank.
If the individual national central banks freely provide credit to other national central banks, Target will function as planned and serve as the heartbeat of the unified currency. In this optimistic scenario, speculators will have no chance to profit by attacking the exchange rates of the system in the face of unlimited inter-central bank credit. This differs from the current exchange rate mechanism (ERM) in which unlimited inter-central bank credit is not available.
A precondition of attack on Stage III must therefore be scepticism that a national central bank will provide unlimited credit in euros to the weak national central banks in the system when it is preparing to leave the union. In a Stage III attack, the credit mechanism that determines the amounts in play will depend closely on how Target operates and on the financial operating policy of the ESCB.
Suppose that ECB policy generates a euro that is sufficiently weak to encourage some countries in the monetary union to consider an exodus. In this example, Germany will stand for the strong euro proponents and France for the weak, which are in ascendancy at the ECB. Positioning itself for a break-up, the financial system will move euro-denominated funds from France to Germany, at first slowly and then in a deluge, as in a currency crisis.
How will the euro payment mechanism facilitate the movement? When the crisis breaks out, the global financial community will sell French euros – euro bank deposits payable in France – and order payments through Target to German institutions, which provide German euros – bank deposits payable in Germany that can still be Deutschmarks in Stage III.
Because final settlement is made simultaneously with the transmission of a payment message, the bank sending the payment must have central bank money available on initiating the payment order. To avoid payment gridlock, Target provides for daytime overdrafts, so the French banking system can make outgoing payments larger than its euro deposits in the Banque de France, provided that it has the proper paper for collateral. In a crisis, the overdrafts will have to be rolled over as overnight loans at the rate set by the ECB, uniformly across national central banks. In this way, French securities will be financed by the Banque de France, which in turn funds them by borrowing from the Bundesbank.
Outgoing payments to Germany can potentially be as large as all liquid French euro securities that can be settled quickly and that are deemed acceptable by the ECB as collateral at the Banque de France plus initial bank deposits at the Banque de France. German banks, in turn, will expand their German euro (Deutschmark) liabilities, which are balanced by their euro (Deutschmark) claims against the Bundesbank.
Atop its original dismay with the weak euro monetary policy, in a crisis Germany must also absorb the growing Bundesbank euro claims against the Banque de France. If there is a break-up, these claims will have to be settled, but in the weak euro as defined by the ECB. Presumably the corresponding Bundesbank euro (Deutschmark) liabilities will be redeemed in the stronger successor currency, German euro or resurgent Deutschmark, a source of catastrophic loss for the Bundesbank.
If the Bundesbank limits its lending to the Banque de France to avoid losses it must eventually cut off further credit by disconnecting the national payment system from Target . This severance of the German euro from the French euro eliminates the par exchange between them. We then have a return to different currencies, where French euros have become distinct from German euros. Ending the par exchange rate ratifies the expectations of speculators and allows them to profit from their short French euro positions.
The attraction of the attack is the large short position against the weak euro region made possible through payment system credit and the inevitable overnight rollovers through ESCB standing facilities. The stakes can become much higher than in previous currency crises, and the potential profits from a successful attack even greater. The policymakers will not have the luxury of a leisurely separation decision at an undetermined time. Their hands will be forced by speculative attack.
The essence of this Stage III attack possibility is a well-worn story. A currency area breaks up with a flood of currency from the region where it will have less value. The cross-border surge is a means of satisfying the suddenly increased currency demand in the strong currency region and the reduced demand in the weak currency region at the moment of monetary disintegration. To prevent excessive inflow, the receiving region closes the border until equilibrium can be restored and a new currency launched. In the Stage III environment, turning off Target will have the same motivation as an old-fashioned border closure.
As long as some doubt remains about the permanence of Stage III exchange rates, the existence of the currently proposed structure of the ECB and Target does not create additional security. Quite the contrary – it creates a perfect mechanism for an explosive attack on the system. To imagine that speculators will have leaner pickings in 1999 compared with the ERM crises of 1992 and 1993 because of institutional changes may be a costly illusion.
Peter Garber is professor of economics at Brown University, Rhode Island
