Target II, the cross-border payment system owned and operated by the Eurosystem, was established to facilitate international transactions. But the Target system has effectively become a credit channel in favour of southern European countries, given that it allows for balance-of-payment imbalances without a true settlement mechanism. Huge imbalances emerged, as northern central banks carried out more payment orders for southern national central banks than the other way round. Currently the gross Target balances total about €1 trillion ($1.3 trillion), or 10.8% of the eurozone’s GDP, with the central banks of Germany, the Netherlands, Luxembourg and Finland holding nearly all of the claims and the central banks of the GIIPSC countries (Greece, Ireland, Italy, Portugal, Spain and Cyprus) holding the lion’s share of the liabilities. To put these figures into context, the gross US ISA balances are currently only at about $100 billion, or 0.8% of US GDP, as they require an annual settlement of most of the deficits by reallocating ownership shares in a joint clearing portfolio of marketable interest-bearing assets.
The European Central Bank (ECB) allowed these Target liabilities to accumulate by giving southern European banks and their clients the opportunity to replace the money withdrawn in the form of net payment orders, by borrowing rising sums of fresh money from their central banks, secured by increasingly weak collateral. Thus, the southern banks’ clients effectively used the electronic printing presses of their national central banks to purchase goods in other countries, to repay foreign debts and make foreign investments. Northern central banks were forced by the mechanics of the payment system to credit the payment orders and create the corresponding liquidity. They absorbed this liquidity as northern commercial banks redeemed their refinancing credits and lent the extra liquidity stemming from the payment orders to their respective central banks. All of the base money circulating in the eurozone has originated from the refinancing or open market operations of the GIIPSC countries and none of this money originated from similar operations in the northern countries.
There are two interpretations of how this process came about. The ECB’s interpretation is that the printing press simply compensated for an exogenous capital flight, financing the current account deficits and the stocks of credit that the northern countries called back home. The other interpretation is that the printing press undercut market conditions in terms of rates and collateral requirements, thus causing the capital flight that the ECB claims to merely have compensated for.
Whatever the truth, German commercial banks alone brought around €700 billion to the Deutsche Bundesbank to redeem their refinancing credit and fill their deposits. Thus, instead of marketable securities bearing risk-adequate rates of return, nearly all that Germany has received in return for its €711 billion current account surpluses since the beginning of 2008 have been Target claims (€624 billion). Should the euro break up, these claims will be largely worthless; and if there is no crash and everything just muddles along, their value will largely evaporate with inflation, given that the ECB seems satisfied with charging southern central banks interest rates that are below inflation. The ECB’s main refinancing rate is currently 0.75%, while the eurozone’s average inflation rate is 2.6%.
The Target balances are not only symptoms of the crisis; they also constitute a concrete measure of the public credit that has flowed to the southern countries via the ECB system. Combined with the ECB’s government bond purchases, this credit is four times as large as all of the combined bailout funds granted to date by parliaments, the European Commission and the International Monetary Fund.
If Europe had the US system, Target debtors would be obliged to repay most of their debts to the central bank by handing over high-yielding securities once a year. If it still had the Bretton-Woods system – the fixed exchange rate system that bound together Western countries up until 1973 – Germany’s balance-of-payment surpluses would have been settled with gold as they were back then.
The option of printing the money that private capital markets are no longer willing to provide has created a trap for surplus countries such as Germany and the Netherlands, luring them into endless rounds of rescue operations. Why did Mario Draghi, president of the ECB, succeed in convincing the German government to tolerate government bond purchases by member central banks of the Eurosystem, especially in spite of opposition from the Bundesbank president, Jens Weidmann? He probably argued that Germany should actually be happy if the Bundesbank were put in a position to accept government bond purchases, instead of accumulating further claims via the Target system.
Such purchases would enable the government bonds of southern countries to flow back into the northern countries while shifting money into the south. This should bring Target balances back down again. Target credit would be replaced by open central bank credit and the Bundesbank’s unsecured credit claims would be exchanged for equivalent assets, which, unlike the Target claims, would remain legally valid claims if the Eurosystem were to fall apart.
Taking the Target trap logic a step further, from a German viewpoint, government bond purchases by the European Stability Mechanism (ESM), which became operational at the beginning of October after Germany’s constitutional court pronounced on its sound legal basis, are even better than government bond purchases by the ECB. Unlike in the ECB Governing Council, Germany is represented with a voting weight in the ESM’s board of governors that corresponds to its share in the ECB’s capital (27%), and decisions are taken by a qualified majority. In other words, Germany cannot be outvoted on the ESM’s board of governors, as the Bundesbank president and the German ECB chief economist have repeatedly been since May 2010 at the ECB. This consideration decisively influenced the German Bundestag’s decision to approve the ESM treaty during last winter’s consultations on the issue.
So how does the future look? In view of the present situation, it is safe to assume that the bailout logic will not stop with the ESM. The ESM’s capacity will be exhausted at some point, despite leveraging: since Germany’s constitutional court left out a banking licence for the ESM in its September judgement and is more than sceptical about secondary market purchases of government bonds by the ECB, the German government will have to take bailout decisions to parliament again and again. To avoid the painful debates this would entail, the German government is likely to try to sidestep any trouble by introducing eurobonds. Peace will then reign for a while, until it becomes clear that low interest rates are once again being abused by debtor countries, crippling reforms and sustaining the south’s overdrawn goods and asset prices.
Target credit has triggered an avalanche of public credit towards southern Europe that can no longer be checked politically unless the root of the problem is tackled, namely the ECB’s missing settlement mechanism.
Hans-Werner Sinn is a professor of economics and public finance at the University of Munich and president of the Ifo Institute in Germany.