Tag Archives: banking

Understanding Eurozone Imbalances II: Talking TARGET

More time is only good if it’s used for something. The success of the Greek debt swap this week staved off chaos but is not a solution to Europe’s problems or a signal that an end to the crisis is in sight.  Recent weeks have seen a growing awareness of the accumulation of imbalances in Europe’s central payment system, TARGET. These imbalances are yet another reflection of the fundamental asymmetries at heart of Eurozone crisis and are analogous to build ups that destroyed the Bretton Woods system.

The commentary and debate on TARGET is currently overly technical. This post explains and analyses the nature and origin of these imbalances, and asks what they mean for the Eurozone (for some background on the link between budget and current account deficits see here and the crisis in general here, here and here!).

What are TARGET imbalances?

TARGET is an acronym standing for Trans-European Automated Real-Time Gross Settlement Express Transfer. Fog lifted?! It’s basically a system through which commercial (‘normal’) banks in one Eurozone country make payments to commercial banks in other Eurozone countries. Importantly, TARGET balances can be interpreted as a measure of the accumulated deficits and surpluses in each Eurozone country’s balance of payments with other Eurozone countries, reflecting the amount of ‘extra’ money circulating in a country over that created inside the country by it’s own national central bank.

Until mid 2007, TARGET balances netted out at zero; there were no deep asymmetries in financial flows within the Eurozone. This is no longer the case.  Prompted by the financial crisis, imbalances in the TARGET system have ballooned. This is shown in the graph below, taken from Sinn and Wollmershaeuser (2011) (GIPS refers to Greece, Ireland, Portugal and Spain).

TARGET imbalances have gone under the radar because they do not show up on the ECB’s balance sheet. However, this is not to say they are inconsequential.  Researchers have commented on the similarities in the imbalances captured by the TARGET balances and those that destroyed the Bretton Woods system. Therefore, understanding what these balances reflect, how they have arisen and how to fix them is of crucial importance.

Something for Nothing

Let’s build up how these imbalances have arisen in stages.  To understand the full story, we need to look at how payments are made between banks. When customers make transfers between commercial banks, in effect, it is actually central bank money, or ‘base money’, that actually flows between them.

Consider a Greek factory owner wanting to buy a new machine. If she buys from a vendor within Greece, funds need to be transferred between bank accounts within the same country. To affect the transfer, base money is taken out of the central bank account of the purchaser’s bank and put on the central bank account of the vendor’s bank. The purchaser’s bank then charges the checking account of our factory owner, and the vendor’s bank credits the vendor’s account with the payment amount.

If our factory owner instead buys from a machine vendor in another country, say Germany, a similar procedure occurs but payments now flow via the Target system of the European Central Bank (ECB). When the Greek National Central Bank (NCB) debits the account of the commercial bank of our Greek factory owner, it takes money out of the Greek economy and sends a payment order to the Bundesbank. In so doing, it acquires a liability to the ECB. On the other side, the Bundesbank creates new money and transfers it to the German producer’s commercial bank, acquiring a claim on the ECB.

Target balances reflect these liabilities and claims on the ECB. Until 2007, payments between countries cancelled out as they flowed in both directions. This is despite the huge asymmetries in intra-Eurozone trade because importing countries paid for their imports with foreign money received from asset sales to exporting countries. Thus, private capital flows financed trade flows. Target imbalances have arisen because trade and asset flows no longer net out at zero, causing a build up in claims and liabilities. A Target deficit represents a net outflow of money to pay for an inflow of goods, and a Target surplus can be thought of as an accumulation in a stock of ‘outside money’ within a country.

Look like loans….

Target balances are best thought of as loans given that they reflect the fact that economic goods are moving between countries without movements of goods or other assets in return. They represent real claims and liabilities on the ECB. To affect our machine payment transfer, the Greek NCB destroyed money without its assets becoming any smaller and in so doing acquired a liability to the ECB. This Greek Target liability can thus be thought of as a public debt provided to the country by the Eurozone. On the other hand, the Bundesbank created money without actually receiving any tangible assets from commercial banks. The Target claim it acquires compensates for that and thus can be thought of as a public credit given to the Eurozone, allowing recipients to buy foreign goods.

The Rescue facility before THE Rescue facility

To get at the full picture, we need to add another level of complexity. As described above, Target balances shift money from Greece to Germany. The Greek NCB destroys money when a payment request to buy the German machine comes in, and the Bundesbank creates money to wire to the vendor’s commercial bank in return. If this was the end of the story, there should be no money left at all in Greece. Their coffers should have been emptied long ago. Yet, the monetary base of periphery countries has actually grown slightly since the start of the crisis. What is going on?!

The money flowing out of the periphery countries via international transactions has been fully offset by the creation of new money by their NCBs. In effect, these NCBs have been issuing new money as a form of credit to finance the purchase of foreign goods, taking the place of the private credit that was free flowing before the financial crisis.

Likewise, in Germany, we should have seen an explosion in the monetary base given that the payment process demands the Bundesbank creates new money and this new money has not been used to purchase foreign assets. No such explosion has occurred. German commercial banks have not needed all the additional money flowing into them and thus have either reduced the amount they tend to borrow from the Bundesbank or have placed the unneeded liquidity at the ECB to earn interest.

Therefore, we have witnessed a huge shift in refinancing credit from Germany to Greece without any change occurring in the monetary base of these countries. This credit reallocation represents a capital export from Germany to Greece, a loan given by the Bundesbank to periphery countries, enabling them to buy more German goods than would otherwise be the case.

This public credit provision can be thought of as a hidden rescue facility, propping up the economies of the periphery countries long before the creation of official rescue provision. Sinn and Wollmershaeuser (2011) argue these flows are analogous to Eurobonds, the only difference being that Eurobonds imply transfers of existing money, while the Target credits imply a reallocation of money creation activity. Target credits thus also involve liabilities. If the periphery states go bankrupt, all Euro countries are liable for losses in proportion to their capital shares in the ECB. No wonder the Bundesbank has started to worry about Target imbalances…

We’ll take the Parthenon (and everything else)

In theory, given sufficient appetite, peripheral and core countries could go on swapping Target claims for real goods indefinitely, with imbalances becoming more entrenched over time. However, this is unsustainable. These imbalances reduce the ability of the ECB to influence the Eurozone economy and preserve and perpetuate the structural asymmetries at the heart of the crisis.

Given that Eurozone countries, by definition, operate within a single currency union, there are no automatic mechanisms to force the system back into balance. If we want adjustment, explicit policy action to tackle the heart of the problem is called for, i.e. credible steps to harmonise structural policy and reduce the asymmetries in productivity and demand across the Eurozone. We are yet to see believable policies to this effect, especially those that would challenge German dominance.

Rather, what we have seen in the last few weeks are moves by the Bundesbank to insure the €500bn Target claims it has built up against the Euro system. Given that these claims represent public loans to the periphery, they stand to loose a lot if the Euro was to suddenly collapse, some 20% of GDP in fact. The head of the Bundesbank has proposed that these claims be securitized, or in other words, he demands access to the Periphery property and asset markets to cover losses in the event of a Euro collapse. Wow. Shame we’ve already snatched the Elgin Marbles. Finally, the fact that this proposal has even been raised signals that the Bundesbank is deeply worried about the death of the Euro. For them to seek this kind of insurance, demise is still most definitely on the cards.

Something for Nothing? Understanding Executive Pay

Critiques of executive compensation don’t have to center on fairness, although, clearly, this is an important concern. Current remuneration levels are a product of market failure and executive capture of the pay setting process and can be attacked on efficiency, not just equity, grounds. However, direct regulation of wages via maximum rates or restrictions on the ratio of highest to lowest are not the way forward. Radical restructuring of the structure of executive pay and how it’s reported are achievable goals, with potentially far reaching consequences. The government must act to reduce the salience of phony “performance pay” deals and increase the bite of the ‘outrage constraint’.

To infinity and beyond

The staggering level of executive pay hit the headlines last week. Commentators were ablaze at the news that the boss of RBS, a nationalised bank, was awarded a bonus (which he declined yesterday) of just under £1million. Actually, a focus on this bonus somewhat misses the point as it misrepresents the true scale of his salary. The Independent report that Hester’s total remuneration could reach a phenomenal £50million in the next few years conditional on RBS’s share price so, in the grand scheme of things, a £1million bonus isn’t the big issue here.

However, singling out individuals or just focusing on “the bankers” underplays the extent of the issue. Executive and CEO compensation has been hurtling to heaven since the late 1980s. Average CEO compensation for the top 500 firms in the US more than quadrupled over the 1990s. Some UK bosses earn over 1000 times the national median wage. In the last year alone, a time of stagnant growth, executive pay in the FTSE 100 rose on average by 49%, compared with just 2.7% for the average worker.

Yet, such comparisons and figures may be misleading. Firms have got much bigger over the period, many (until recently) performing much better. The structure of our economy has also been transformed.  One needs to correct for these changes to ensure we are comparing ‘like with like’ across time.  However, controlling for factors such as firm size, industry classification and firm performance relative to industry average, still leaves us with staggering rises in average CEO remuneration to account for. For example, Bebchuk and Grinstein (2005) calculate that had the relationship between such factors and CEO compensation stayed constant in the US over the 90s, compensation would have only risen by half as much as what was actually witnessed.

Something for nothing?

How can these rises be explained? Justified? The orthodox view sees pay setting boards operating at “arms length” from executives, setting their pay to maximize shareholder value. Pay is set to attract and retain the best people for the job and provide the right incentives. Under this view, we’d have to look for things like big changes in the added-value of executives, the ‘cost’ they face in doing their job and the size of their ‘outside option’. However, extensive research indicates that none of these factors can account for the scale of growth witnessed. Efficient market mechanisms are not the main engines driving the growth of high pay.

The incorporation of large performance related payments has been a big contributor to the executive pay flood. In 2010, the median bonus for maximum performance of a FTSE 100 executive commanded a bonus worth 150% of basic salary. Stock options have become a central feature of remuneration packages without any offsetting adjustment of cash based compensation.

Linking pay to performance is motivated by what economists call the “principal agent problem” and provides a way of aligning the interests of agents, i.e. executives, to the owners of the company, i.e. the shareholders. However, strong incentive pay is only justified when, among many other factors, executive effort has a strong link to profitability, when high pay actually incentivises high effort and does not crowd out other “intrinsic” motivations or inefficiently distort executive attention. These requirements are not met in reality.

Experimental studies in behavioural economics and psychology highlight that high pay as an incentive mechanism is often counter productive. The link between explicit financial incentives and performance is tenuous at best, and negative at worse. As soon as tasks become complex, or even just marginally more taxing than ‘mindless’, financial rewards are consistently found to have a negative impact on overall performance. And this is the conclusion of studies coming out of Chicago and LSE, the ‘establishment of the establishment’, as Daniel Pink puts it.  Bonus culture has also been cited as a cause of dangerous short termism and unsustainable strategising. Furthermore, qualitative evidence suggests that those at the top are often motivated by things other than money. As the former CEO of Shell puts it:

You have to realize: If I had been paid 50% more, I would not have done it better. If I had been paid 50% less, then I would not have done it worse.

Even if there was a strong case for performance related pay, this wouldn’t justify the size and structure of current pay packages. “Performance” elements in current packages are actually largely independent of individual action. No attempt is made to discriminate between general rises in company value and those arising from the good governance of executives. Executive influence is likely to have played a large part in this. The extreme complexity of schemes and wide freedoms to unload share based incentives have enabled executives to obtain much larger amounts of compensation than more cost-effective plans would have ever provided. Incentive payments have largely been a smoke screen, making it easier for CEOs to justify excessive pay levels even though these performance schemes are fundamentally flawed.

Bloated pay is thus a product of market failure, not the consequence of efficient procedures designed to maximize shareholder vale. Executives have substantial influence over their own pay levels and board members have insufficient incentives to engage in unpleasant haggling over remuneration packages. Complicated compensation packages have been dressed up as well designed incentive schemes to make huge payments more palatable. In general, these schemes are not cost-efficient and overstate the true value of executives to their firms.

Slimming these cats down

Government action is required to get top pay under control. However, direct wage controls, such as specifying some maximum salary, are not the way forward. This instrument is too blunt, so would be grossly inefficient, and would damage the competitiveness of the UK economy given that other countries are not about to follow suit. Further, a maximum salary rate is politically infeasible and so energy is better spent exploring viable options.

The calls to raise shareholder control of the pay setting process are valid, although, unlikely to do enough. Data complied by a leading advisory body, Pirc, demonstrates that shareholders don’t currently exercise the rights they already have to curtail executive pay. Shareholders are increasingly hedge funds and overseas investors who hold shares for such a short time that they have no interest in the inner workings of companies. Their gains are likely to come via speculation.

Raising the diversity of remuneration committees will help to guard against ‘crony capitalism’ and compensate for weak shareholder discipline. The High Pay Commission recommends that employees from lower down the firm structure have an input into the structure of remuneration. I also feel that effort should also be made for other industry professionals, and potentially academics, to play a role in the committee.

In my opinion, radical restructuring of the structure of executive pay and how it is reported are achievable and potentially very effective ways of reigning in top pay. Compensation packages must be made simpler and be presented in a standardized format. Taking first the structure of pay packages, the illusion that bonus payments and complicated incentive plans actually live up to their names must be shattered and salaries restructured accordingly. Studies highlighting the bogus nature of most performance plans should be bought to public attention. Pay packages should be restricted to contain only a single performance related element and that chosen performance measure should be in someway linked to the medium or long term health of the company to try to break the chronic short termism infecting many head offices. Enforcing a simplification of salary structure will also limit the role of compensation consultants, whose advice has been cited as a cause of the increased complexity of modern remuneration packages.

Public outrage and pressure from workers lower down the company structure can only be effectively generated with adequate information. This “outrage constraint” is an important curb on top pay but it has been weak over the last few decades, muted by the smoke screen created by complicated, ineffectual incentive plans and the rising stock market. The stock market boom has provided a convenient justification for pay inflation even though a firm’s stock market value is only weakly (if at all) linked to its earnings and performance and the actions of its executives. Steven Hester’s bonus refusal is evidence that transparency and public pressure can initiate change. The High Pay Commission found attempts to actively “camoflauge” salary packages, with ever more complicated pay arrangements often buried in the depths of impenetrable reports. It has not been easy to find out how much executives actually bring home. Simplifying pay packages as I’ve argued above, combined with a requirement of standardized reporting will make it easier for public outrage to be created and directed at excessive, unjustifiable pay deals. Further, publishing the ratio of median to top incomes should be a legal requirement for publically listed companies. The new economics foundation report covers this consideration in great detail. Making executive pay and its divergence from that of the average company worker will raise the salience of top pay in public discourse, helping to curtail capture at the top.

In conclusion, executive pay is not the product of an efficient market. Performance payments are red herrings, not structured to optimally solve ‘principle agent’ problems but to line individual war chests. The level of pay should not be regulated, but its structure should. Packages must be simplified and their reporting made more transparent. These reforms are achievable and should be swiftly enacted.