Today, Liam Halligan in the Sunday Telegraph wrote an excellent article castigating the Eurozone leadership for running cap in hand to emerging markets for help when they haven't reformed their banking system or resolved the structural problems with the single currency. Halligan's articles are always well worth reading and this one is no exception. But there is something wrong. About three quarters of the way down the article he says this:
"Obscure data shows that under so-called Target 2 operations, the ECB’s intra-eurozone payments system, the Bundesbank is owed a mighty €620bn by other member states. This stealth bail-out dwarfs German’s covert contributions to previous eurozone rescues, which themselves provoked bitter public criticism."
The TARGET2 system has been the subject of much debate recently. There have been repeated claims, of which Halligan's is just the latest, that the Bundesbank's deficit in TARGET2 represents a "stealth bailout" of indebted Eurozone countries. My friend Beate Reszat has written an excellent post explaining why this view is wrong and how TARGET2 really works. Others - including FTAlphaville, which produced several rather technical blogs about this - have also had a go at sorting out fact from fiction. But to no avail, it seems. The Bundesbank itself even describes the imbalance as money "owing" to Germany. This is a serious misrepresentation of the truth.
The Bundesbank's TARGET2 claim is an accounting representation of the trade imbalance between Germany and the rest of the Eurozone. Germany has a considerable current account surplus (excess of exports over imports), a large part of which is balanced by current account deficits in other Eurozone countries, as I have explained elsewhere. There are therefore REAL inflows to the German private sector as money is received in payment for exports. These payments are made via the national central banks and the ECB using the TARGET2 system. Beate's article (link above) is an excellent explanation of how the transfer mechanism works, but for those who want something more succinct, this article summarises it neatly and has a useful picture.
But the story doesn't end there. Once the money has reached the exporters, these payments eventually find their way back into commercial banks in the form of deposits. Banks that have excess deposits may lend them to other banks, or they may use them to reduce their need for funding either through the interbank market or from the central bank. A proportion of the deposits arising from payments to German exporters through the TARGET2 system therefore end up back in the Bundesbank as commercial bank reserves, reducing the commercial banks' need for borrowing from the Bundesbank. As a loan from a central bank to a commercial bank is represented in accounting terms as a commercial bank liability and a central bank asset, if commercial banks reduce their central bank borrowings the central bank's asset base is reduced. I hope this is clear.
The intra-Eurozone payments mechanism relies on base money creation and destruction (seigniorage) by central banks. When an importer in Greece buys a consignment of BMWs from Germany, no physical funds are transferred between the central banks: the Greek central bank reduces base money in Greece by the value of the import, and the Bundesbank increases base money in Germany by the same amount. In each central bank, that takes place as a double-entry accounting entry: the increase in base money in the Bundesbank is balanced by an increase in its assets (its TARGET2 claim). Conversely, the decrease in base money in the Greek central bank (liability) is balanced by a decrease in its assets. The end result is that the Bundesbank appears to have lent money to the Greek national bank. But this is simply a representation of the trade flow between the two countries and a consequence of double-entry accounting. It is not, in any sense, a "debt". And when you take into account the REDUCTION in the Bundesbank's asset base arising from export payments through TARGET2 eventually finding their way back into the Bundesbank in the form of commercial bank deposits, it is clear that the Bundesbank's assertion that its TARGET2 claim is money "owing" to Germany is incorrect. The increase in its asset base arising from its TARGET2 claim is at least partly offset by the reduction in its asset base arising from commercial bank deposits.
However, the Bundesbank's TARGET2 claim does mean that it has on its balance sheet assets that look like loans to other central banks. And it is indeed correct to note, as many people have, that in the event of a country leaving the Eurozone, the Bundesbank's TARGET2 claim against that country would be likely to become worthless. There has been considerable discussion in other places about whether or not central bank insolvency is a problem, mostly in relation to the unwinding of QE. It might be worth having a similar discussion in relation to the possible insolvency of Eurozone central banks if the Eurozone breaks up.
The prevalent belief is that if Greece were to leave the Eurozone, the value of the Bundesbank's assets would be reduced, leaving it technically insolvent since its liabilities (base money in circulation, in this case) would exceed its assets. The effect of this would be a significant fiscal tightening caused by reducing base money in circulation (deflation) and/or increasing German taxes to recapitalise the Bundesbank. So Germans are understandably angry that they would end up picking the tab for Greece's exit.
Except that the Bundesbank's claim isn't against the central banks of other countries. It's against the ECB. It is the ECB that has a claim against Greece, not the Bundesbank. So in the event of Greece leaving the Eurozone, it would actually be the ECB that would be technically insolvent, not the Bundesbank.
The discussion we need to have regarding central bank insolvency in the event of Eurozone breakup therefore concerns the ECB, not the national central banks. There are two possibilities:
- the Eurozone breaks up completely and the ECB is dissolved
- some countries leave the Eurozone, leaving the ECB insolvent, and the remaining countries recapitalise the ECB
The first of these I think is a pretty remote possibility, but if that were to happen then the central bank imbalances would become peer-to-peer with currency translation risk. The Bundesbank would have direct cross-border balances with the central banks of its trading partners, and those balances would have to be revalued from time to time to represent movements in the exchange rate. Exactly what it currently does with its non-Eurozone trading partners, in fact. And I repeat - these balances are accounting representations of trade imbalances, not actual money that has to be paid. The exports have ALREADY BEEN PAID FOR. Controls on cross-border movements of capital therefore would make absolutely no difference.
The second is rather more complex - and much more likely. Any decision to recapitalise the ECB would hit Germany hardest because of its dominance in the Eurozone. German taxpayers would be footing a large part of the bill for partial breakup of the Eurozone. Personally I don't think this is anything like as big a problem as the LTRO unwind in three years' time will be, or the problem that the ECB already has with valuation of junk sovereign and other bonds it has accepted as collateral. But it is the prospect of having to recapitalise the ECB that German taxpayers should be worrying about, not whether the Bundesbank's claims will be met. There is ZERO chance of the Bundesbank being left insolvent. The ECB can if necessary meet the Bundesbank's claim through seigniorage - though this would seriously upset the Bundesbank, with its inflation phobia and horror of money creation. Sometimes I think Bundesbank officials think the Bundesbank and the ECB are the same thing.....
The long-term solution to the TARGET2 imbalances, obviously, is to eradicate trade imbalances between Eurozone countries. I have to say that current economic policy in the EU seems to be heading in the wrong direction at the moment, and in particular, Germany's determination to hang on to its current account surplus is making it virtually impossible to undertake the necessary rebalancing. But in the meantime, the Eurozone should create a sterilisation mechanism for central bank TARGET2 balances, to get them off central bank balance sheets and onto commercial bank balance sheets where they should be. An example of a sterilisation mechanism might be the following:
- The German government would instruct the Bundesbank to issue bonds to the value of its TARGET2 claim and force commercial banks to buy those bonds.
- on the other side, countries with trade deficits would instruct their central banks to transfer TARGET2 liabilities to commercial banks by lending them money at very cheap rates or even (shock, horror) by directly crediting commercial bank reserve accounts.
This would amount to the Club Med national banks doing QE to counter the deflationary effect of the reduction in the money supply arising from their net import payments via TARGET2, and the Bundesbank doing reverse QE (selling assets) to counteract the inflationary effect of the expansion of the German money supply arising from its net export receipts. (Note that both figures must be net of offsetting export receipts in Club Med and import payments in Germany.) This might be a bit of a problem - I don't think there's any doubt that the Club Med economies could desperately use some QE, given the appalling economic contraction they are experiencing, but are the inflationary pressures in Germany sufficient to justify monetary tightening at the moment?
In practice Eurozone central banks do informally sterilise part of their TARGET2 balances, the Bundesbank by encouraging commercial banks to reduce their borrowings and the Greek national bank by lending to cash-strapped Greek banks. But no formal sterilisation mechanism exists, and I imagine significant enhancement of the TARGET2 system would be required to create it. The trouble is, such a mechanism would bring to light the full horror of German banks' reckless lending to fund Germany's trade surplus. I suspect the German government would have to bail them out, something it has been systematically avoiding by claiming that other countries "owe it money" in various ways.
It really isn't helpful to regard the TARGET2 imbalances as a "debt" problem or as Germany doing some kind of bailout. The problem arises from the inadequate setup of the single currency. Nobody ever imagined that such trade imbalances would build up, and so nobody put in place any formal mechanism to sterilise central bank operations and keep the trade imbalances in the private sector where they belong. By allowing the imbalances to reside on central bank balance sheets, the Eurozone has been able to pretend for too long that trade imbalances are not an issue. If they were forcibly transferred to the private sector, the Eurozone leadership would have to admit that trade imbalances are not only an issue, they are the major cause of the insolvency of the Eurozone banking system and the instability of the currency union. And then we can perhaps stop blaming countries for their debt problems and point the finger at the real culprits - the banks that have lent so recklessly, the governments that have protected them, and the politicians who have created the deformed and dysfunctional single currency.