Monetary Solidarity in Financial Integration: Payment Systems As Insurance Mechanisms for Stabilizing Expectations in Conditions of Uncertainty
My contribution is twofold. In line with the second strand of research, I provide evidence that stabilization of financial markets must deal with expectations that evolve endogenously, ie with the stabilization effort itself. And I base my argument on a conventional, widely used methodology, namely comparative institutional analysis of functional equivalence in very different settings. Specifically, my paper analyzes the payments systems of two monetary unions, the euro and the dollar areas, to show how they anchored a variety of potentially destabilizing expectations during the North-Atlantic crisis since 2007-08. TARGET in the euro area and ISA in the U.S. ensured the smooth processing of cross-border payments inside two monetary unions when banks, traders and savers had lost trust in the financial system. [1]
A payments system is a crucial institution that distinguishes a currency union from a fixed exchange rate system. It ensures that a euro is a euro irrespective of whether it was issued in Portugal or the Netherlands; and a dollar is a dollar throughout the United States even if the district of New York experiences for several years a high inflow of bank deposits from virtually every other district. The historical experience of the U.S. during the Great Depression can show how catastrophic the consequences can be if the integrity of a payments system is questioned during a banking crisis (Eichengreen et al 2014). The experience of the EU can show how effective and politically robust this institutional anchoring of endogenous expectations provided by a payments system is, even without the support of a political union and when all other policy options are severely constrained.
The first section of this paper outlines the heated arguments against the payments system of the euro area. It peaked in 2011-12, after Hans-Werner Sinn, a renowned German economist and notorious critic of the euro, was apparently tipped off by former Bundesbank President Schlesinger about the strong rise of claims and liabilities between national central banks. It had been independently noted by Whittaker (2011), an academic and MEP of the UK Independence Party, and even earlier by Peter Garber (2010), a research economist at Deutsche Bank. The insinuation was that the Bundesbank and ultimately German taxpayers were forced to amass billions of doubtful claims through TARGET2. Such was the outrage that the Bavarian section of the German taxpayers association, supported by its European representation, brought a criminal court case against the Bundesbank management (Bund der Steuerzahler 2012a).
The second section explains why the payments systems in both the euro area and in the U.S. began to show huge imbalances after 2007. The fact that the U.S. also registered this phenomenon should have given those who raised the alarm in Europe reason to pause, since nobody suggested that the U.S. experienced an internal balance of payments crisis or was about to fall apart. In both monetary unions, extraordinary monetary policy interventions substituted for disrupted interbank markets, and the payments systems were the vehicles for this market-making of last resort. It should be noted that mere anchoring of expectations may not be enough in a severe crisis. There must also be instruments that can replace markets for some time until expectations have settled on a majority belief in a particular state of the world.
The third section shows how TARGET provided effective insurance against at least three risks: a sudden stop of trade finance, the disruption from capital flight, and the eventuality of a euro area break-up. In line with Cecchetti et al (2012) and Whelan (2014), the section provides evidence that the various diagnoses of what was driving the payments imbalances all played a role at some stage; it was not a matter primarily of either trade deficits or of capital account reversals. This entails the important lesson that different actors may have categorically different expectations and so specifically targeted institutional mechanisms will not achieve stabilization. By contrast, a functioning payments system in a monetary union is analogous to universal social insurance. It covers all risks (‘known unknowns’) and even uncertainty (‘unknown unknowns’), and the entitlement to insurance is based on membership analogous to residency rather than on contributions.
The fourth section sums up what this study of a monetary safety net for financial markets tells us about “uncertain futures in economic decision-making”. It considers the promise that different research programmes hold: one that tries to improve the microfoundations of economic decision-making through research in behavioural finance; and another that emphasizes the destructive macro-interactions that would occur in conditions of uncertainty even if rational expectations prevailed. My case study makes a positive case for the latter research programme.
[1] TARGET stands for Trans-European Automated Real-time Gross settlement Express Transfer
System for cross-border payments in the euro area. ISA stands for the Inter-district Settlement Account in the U.S. which fulfils the same role between Federal Reserve Districts in the U.S.