It doesn't work like that - TARGET2 edition

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.


  1. Nice article, thanks for the information.

  2. Excellent debunking of the myth perpetrated that Germany is the victim here. As you say, it is just circular trade. ISTR a page on the BBC website showing the flows of money between nations.

    In fact Germany 'lurves' the Euro and all the almost insolvent Club Med countries. As long as they don't actually go bump, it doesn't matter how much the people are suffering. Becaue all these countries keep the Euro low and German factories pumping out their excellent produce - so good in fact that are seriously undervalued in the single currency. So Germany wants to keep the whole ship afloat.

    [Now of course with the prospect of a Socialist president in France and the Dutch government throwing in the towel, things promise to become very interesting....]

    The parallel with China is compelling. China is only loosening the bounds on the Rembibi/Xuan under serious pressure (mainly domestic inflation, not a US gunboat) because again it is linked with a rather more stable but still indebted currency aka USD.

    In the former case, unless all the Club Med countries bail out, Germany is sitting very pretty indeed. In China's case as they control the exchange rate, it is difficult to see how they will fall foul either.

    But consider this - if Club Med detaches itself from the Euro, the Euro-North will soar in value while Euro-Med will sink. And if China loosens its grip on exchange rates, the Xuan will soar and the USD will sink. So in both cases the USD/Euro-Med assets held by Germaany or China will become worth less. Which is why they want to carry on, even if the German taxpayer misunderstands it and whinges on about Greece.

    "Nobody ever imagined that such trade imbalances would build up" Eh? Given the amount of money spent on the expensive education of the politicians who dreamt it up, perhaps their returns on investments should be scrutinised rather more!

    They clearly could not run a corner shop, let alone a currency zone with different national banks, private banks and a central bank that is floundering around not doing the obvious QE because their major creditor in Berlin wouldn't like it!

  3. John,

    Haha. An excellent description of everything that is wrong with the Eurozone! And I agree, there are significant parallels between Germany's relationship with the Eurozone and China's relationship with the rest of the world.

    You're being slightly unfair to the ECB, though. The two LTROs were in effect enormous rounds of QE, as I explained in this post:
    And the ECB has also from time to time bought sovereign bonds under its SMP programme, which is also a form of QE.

    But I don't like the way the ECB dances to the Bundesbank's beat. The latest is that the ECB is talking of raising interest rates because of inflationary pressures in Germany. If they do, Spain is toast because so much of its private debt consists of variable-rate mortgages: its banking system would collapse and take down the sovereign. Raising rates at the moment would be utter madness.

  4. Frances -

    I was being slightly naughty about the ECB as they have been doing the occasional large chunk of pseudo-QE but hoping no-one would notice! But the rigid approach that the Bundesbank would have applied pre-Euro was the blueprint for the ECB.

    In fact even the BoE's QE is of course not directly funding HMG but buying on the market but it is much more open about it.

    The big problem is now that the Euro-zone is being run from Berlin but the people of PIIGS don't vote there and have no say over what the German government will do.

    This is likely to lead to serious unrest in many of these countries which could bring the whole deck of cards down. The knock-on affects in the UK will be disastrous even though we are not (thank heaven) part of this charade.

    Maybe they may follow other suggestions such as the bank collar of a New Money Tax and Excess Interest Tax. (I posted this on Positive Money a little while ago.) After all, despite Cameron's bleating, it was the banks that caused the major damage yet it is the people who are having to pay for it.

    If Hollande is elected in France, which is quite possible now they have a choice of two idiots, at least the French, who have the habit of cutting off other peoples' noses, may buck the slash and burn trend, having devised the EEC in the first place as a WW2 war reparations system! If the Euro fails it will be disaster for Paris in particular as French banks are very exposed.

    The stupidity - or is it vanity - of the politicians knows no bounds! The Bundesbank's reputation was based on pre-unification so why it was used as model escapes me. Mitterand's price for supporting German unification in 1991 was 2 Ostmarks for 1 DM (black market was 10:1 if you remember) from which Geramny had not fully recovered from absorbing 16 million unproductive but very well educated workers with a shot infrastructure before the Euro was formed.

    Pigeons, roost, home - in some order! But schadenfreude is not the word - we will be in the dark and smelly if everything blows up!

  5. I thought that the Bundesbank control of the ECB was the prize Germany received for abandoning the mark? Or is that just my cynicism showing...

  6. Frances, You’ve obviously got a good grasp of how the EZ works. I was in contact with some academic at Lancaster University a year or so ago who agreed with me that there is a dire shortage of basic explanations as to how the EZ works. The ECB “explanatory material” is a clear as mud.

    I suggest you would be doing a great public service and/or possibly make a name for yourself if you set out such a basic explanation.

  7. Hi Ralph,

    I'm not very up on the constitutional stuff but I understand the economic and financial issues. But TARGET2 is a real-time gross settlement system, and after 17 years working in banking & IT I think I have a fair understanding of how those work!

  8. This comment has been removed by a blog administrator.

  9. I often do not comment on blogs but your blog has such a method and writing model that I have no choices but to remark here. Nice submit, keep it up.


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