Thursday, March 08, 2012

About those Fed currency swaps...

...once again, we need to be aware of the scale and importance of the problem of the Fed entering into what amounts to unsecured dollar loans to the ECB (and indirectly, Euro-area Banks) These are massive bets on Euro area stability without congressional approval or oversight. I do not maintain that this course of action is wrong, but a public understanding of the risks would be a more wise course of action should something "go wrong". This is highlighted by the following snippet which is largely true given the currency issues in the Euro area discussed here years ago.

Last week, the conflict escalated to a new level. Weidmann complained in a letter to ECB President Draghi that the central bank was accepting increasingly lower-grade collateral in exchange for its cash injections. This poses a danger, he warned, as the central banks in the north of the euro zone are owed ever growing amounts of money by their counterparts in the south. If the euro zone broke apart, the Bundesbank would be left holding a good deal of its bad debt from so-called TARGET2 loans, which currently amount to some €500 billion ($660 billion), he warned.

This may sound somewhat technical to most laypeople, but among leading ECB officials the letter was seen as violating a taboo. TARGET2 refers to the central banks' internal payment system, which has accumulated massive imbalances during the course of the euro crisis. These inequalities aren't problematic as long as the monetary union remains intact. So far, the Bundesbank has always played down this risk. But Weidmann's about-face is a "disastrous signal," say ECB executives because, for the first time ever, the Bundesbank "is no longer ruling out a break-up of the euro zone."

On the surface, the wrangling revolves around loan conditions and interest rates, but in reality it has to do with the basic course of European monetary policy: the question being whether a debt crisis can be combated with even more debt, or whether it will spark the next, possibly even greater crisis.

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