In many ways, Hans-Werner Sinn, who leads Germany's IFO Institute, is actually more or less what is considered a mainstream economist. Nevertheless, he is a quite outspoken one and not beholden to the political class. As a result he managed to fall from favor with Germany's ruling elite when he became the first economist to make noises about the TARGET 2 payment system in euro-land and its woeful lack of a settlement mechanism.
Had he discussed this somewhere in the echo-chambers of academe, nobody would have noticed or cared. However, he went public with it. He certainly exaggerated the potential losses the Bundesbank might face in a worst case scenario. However, he was quite correct in denouncing the system as a hidden subsidy and bailout mechanism. It is one of the several ways in which the absence of currency depreciation is reflected -- and in this case also buffered -- in the euro system.
If one follows the trail of assets and liabilities across the euro-system, it is clear that ultimately, the TARGET 2 claims that the BuBa holds indirectly against Spain are backed by securities Spanish commercial banks have transferred to the Bank of Spain. No problem as long as the euro survives and with it the hope that the imbalances might be reduced again, but the potential for this to become a problem can hardly be denied.
Moreover, by venturing into the arcana of the euro area's payments system, Sinn has provided the population with a reminder, respectively pointer regarding the absurdities of the fractionally reserved banking system, modern-day central banking and the unholy three card Monte in which commercial banks, central banks and governments are engaged in. Since the whole system is based on a mixture between confidence and an elaborate extend and pretend scheme -- a thin reed, indeed -- such pointers are usually not provided to the public very often.
Not surprisingly, other economists soon began to attack Sinn. Newspapers wrote things like "He looks like Captain Ahab, what can you expect?" and he was accused of fomenting the crisis (as though it was his fault that governments and most big banks in the euro area are de facto, if not yet de iure, insolvent).
That is not surprising, since most macro-economists are employed by the State, and in many cases receive research grants from central banks. An unhampered free market economy would hardly have a use for most of them. Obviously their intellectual output, to paraphrase Hans-Hermann Hoppe, can be expected to be "viciously statist." Naturally some of them tend to spring unbidden to the aid of their benefactors, probably in the hope of ingratiating themselves.
Sinn seems to worry more about the plight of the German taxpayer than about pleasing central bankers or politicians, which has earned him the charge of being a "populist." The people raising this non-sequitur charge have evidently not considered that he is not a politician, so whose votes is he supposed to be angling for?
So much for Mr. Sinn -- he may not be an Austrian, but he nevertheless has our sympathies. With that out of the way, here is what he recently had to say about the banking union.
Sinn on the Banking Union -- the "Fire Channel"
Sinn and one Harald Hau (with whom we are not familiar) have published an op-ed in the FT, in which they make a number of critical remarks regarding the banking union. The entire article ("Eurozone banking union is deeply flawed") is well worth reading, but we will excerpt only a few passages further below that strike us as especially interesting.
At its core, Sinn's critique is very similar to remarks we have made on the topic in these pages in the past. The main problem of the banking union and its planned overarching deposit insurance scheme is that it opens the European core to enormous potential liabilities. The financial reserves of the existing EU bailout vehicles are laughably small compared to this.
As Sinn points out, this could ultimately lead to even more instability rather than the hoped for stability -- if the core ends up overloaded, the whole house of cards might collapse, and the risks are indeed large. Moreover, the body of rules pondered in this context has ended up postponing the often talked about "bail-in" for bank bondholders and shareholders into the far future and Sinn rightly notes that this amounts to a potential redistribution from poor to rich. Not only that, but banks are able to get financing below market rates as a result of all this coddling, which encourages risky behavior and furthers capital misallocation. As to why the banks have no business taking on more risk, consider the ratios of tangible equity to assets of major euro-land banks in this list (compiled by former Kansas Fed chief Thomas Hoenig, who is currently arguing for tougher Basel III rules, which the banks are naturally fighting tooth and nail).
Sinn also puts a few numbers on the potential risks, which are truly staggering. A few excerpts:
[But] do the European Stability Mechanism (the eurozone's rescue fund) and the banking union plan not ask for more from private creditors? If so, they do not go anywhere near far enough. Plans to protect investors from the consequences of their wrong decisions are being pushed forward. Take the 'bail-in' proposals suggested by the European Commission as part of a common bank resolution framework.
These plans 'should maximise the value of the creditors' claims, improve market certainty and reassure counterparties.' Senior creditor bail-ins are explicitly ruled out until 1 January 2018, 'in order to reassure investors.' But if bank creditors are to be protected against the risk of a bail-in, somebody else has to bear the excess loss. This will be the European taxpayer, standing behind the ESM.
The losses to be covered could be huge. The total debt of banks located in the six countries most damaged by the crisis amounts to €9.4tn. The combined government debt of these countries stands at €3.5tn. Even a relatively small fraction of this bank debt would be huge compared to the ESM's loss-bearing capacity.
[…] First, the write-off losses imposed on taxpayers would destabilise the sound countries. The proposal for bank resolution is not a firewall but a 'fire channel' that will enable the flames of the debt crisis to burn through to the rest of European government budgets.
Second, imposing further burdens on taxpayers will stoke existing resentments. Strife between creditors and debtors is usually resolved by civil law. The EU is now proposing to elevate private problems between creditors and debtors to a state level, making them part of a public debate between countries. This will undermine the European consensus and replicate the negative experiences the US had with its early debt mutualization schemes.
Third, asset ownership in bank equity and bank debt tends to be extremely concentrated among the richest households in every country. Not bailing-in these households amounts to a gigantic negative wealth tax to the benefit of wealthy individuals worldwide, at the expense of Europe's taxpayers, social transfer recipients and pensioners.
Fourth, the public guarantees will artificially reduce the financing costs for banks. This not only maintains a bloated banking sector but also perpetuates the overly risky activities of these banks. Such a misallocation of capital will slow the recovery and long-run growth. (emphasis added)
Again, we certainly don't agree with everything HW Sinn has said over recent years, but he has correctly identified the major problems with the banking union. And consider those numbers for a moment: the banks in the six crisis-stricken euro-land nations (which are Portugal, Greece, Ireland, Spain, Italy and Cyprus) have total debts of € 9.4 trillion, and their governments have another € 3.5 trillion in debt (the bulk of this has been incurred by Italy). These numbers are beyond good and evil.
The Blow-Up in Waiting
Now to a few additional comments along similar lines. There are now €5.1 trillion in money substitutes in the euro area banking system, of which € 758bn. are covered (by bank reserves and vault cash). The cover is however shrinking fast due to the LTRO repayment, as that reduces the cash assets of banks deposited with the ECB. To this sum about € 4.7 trillion in credit claims that are included in M3 must be added (i.e. time deposits and the like, money that is not promised to be available in the form of standard money on demand; the data are courtesy of Michael Pollaro).
The covered portion of money substitutes in both the U.S. and the euro-zone is money that would indeed be available to depositors should they demand to be paid. Most of it is the result of debt monetization since 2008 and as such it has massively diluted the money supply (or harbors the potential to dilute it, depending on the extent to which only bank reserves have been created and the extent to which deposit money has been created concurrently as well. For an overview of the mechanics involved, see here). Obviously, the uncovered portion of these money substitutes has no standard money backing at all -- it is the deposit liability that is created ex nihilo by fractional reserve banking activities. On the other side of the ledger are the assets held by banks, most of which have a maturity profile that is far from congruent with the allegedly available on demand portion of the money supply sitting in demand deposits. Any other company but a bank would have to declare itself instantly insolvent if its books were similarly configured (banks can however rely on the central bank backstopping them).
Of course these assets do have value. Depositors would get something back if push came to shove, but how much they would get back would depend on how these assets perform. One could engage in a few thought experiments in this context; how big a portion of the assets held by Spanish or Greek banks must be considered dubious? What is the portion of bank capital held in the form of sovereign bonds (officially regarded as risk-free) really worth? We're not necessarily referring to the current market value of these bonds here, but the likelihood that the sovereigns will actually be able to pay. On the whole most of their balance sheets -- if one properly considers all the future liabilities they have contracted for -- make the treasuries of Philip II of Spain (nicknamed "the Prudent" of all things) or of Charles II of England look like shining examples of fiscal probity.
In the U.S., in Japan and lately also in the euro-zone central banks have performed truly astonishing extend and pretend miracles, but that doesn't alter the underlying reality (in fact it makes it even worse in many respects). They are the last bastion of the aforementioned confidence (faith in their omnipotence is probably at an all-time high right now). But just like much of the money the system has created, it rests on little more than thin air.