Don’t fear Target2. Fear its opponents.
Yanis Varoufakis is hosting what he calls “a debate between Felix Salmond and Marshall Auerback”, by asking Auerback to respond to my post on Target2. But here’s the thing: it’s not really a debate if the two sides agree on nearly everything. There’s very little to take issue with in Auerback’s post, and he doesn’t seem to disagree with me on the substance of Target2. Instead, he takes a step back and gives a bit of big-picture context for Target2, asks why the Target2 imbalances have grown so big, and speculates that it could be German attempts to kill Target2, rather than Target2 itself, which would cause chaos in the Eurozone.
Basically, the EU treaty allows for complete capital mobility within the Eurozone, something which caused no real problems until we hit the financial crisis. When money left one country and arrived in another — moved from Spain to Germany, say — the Spanish bank would cover the resulting hole in its balance sheet by turning to the interbank market, where there were no shortage of German banks willing to lend to their Spanish brethren. With the interbank market providing an efficient and effective mechanism for keeping money flowing around the Eurozone, the ECB just needed to work at the margins, running a daily auction for banks in need of a bit extra overnight liquidity.
But then in the summer of 2007 the European interbank market started seizing up; once Lehman Brothers collapsed, it was to all intents and purposes nonexistent. And so the ECB, faced with an imminent liquidity crisis, changed the rules: for the past few years, any solvent European bank has been able to borrow unlimited sums directly from its national central bank, at low ECB-set rates. And it’s those borrowings which ultimately resulted in today’s large Target2 imbalances.
Once Europe’s interbank market died, it stayed dead, and we’ve had a liquidity crisis ever since. As Daniel Davies put it in a report I blogged in November, “if we think of wholesale funding as commodity input, it is much more like the supply of limestone to a kiln than the supply of flour to a bakery – not only can the banking sector not produce loans without new financing, it cannot shut down for a short period of time either, it needs constant supply.”
Basically, if there hadn’t been a serious liquidity problem in the European banking system since 2007, the Target2 problem wouldn’t exist. The reason that there’s any worry at all about Target2 is entirely a function of the fact that the European interbank market still doesn’t exist, and the Eurozone’s banks seem to be no more willing to lend to each other today than they were in the worst days of the crisis in 2009. At least that’s certainly the case when it comes to cross-border loans to PIIGS.
So while Target2 isn’t a huge problem in and of itself, it bespeaks the lack of a Eurozone interbank market, and that is a problem. Worse, the Germans are unhappy. Germans are the people complaining the loudest about Target2 — and those complaints, if they’re based on German constitutional law, can be dangerous. As Auerback said on Wednesday, and as notorious Target2 alarmist Hans-Werner Sinn has been saying repeatedly, it’s arguable that the Target2 system, because it saddles the Bundesbank with potentially unlimited liabilities, violates recent German Constitutional Court rulings which say that aid from Germany to the rest of the EU must be limited and ratified by the German parliament.
If Target2 were to be found unconstitutional in Germany, that really would be devastating for the Eurozone: the ECB’s liquidity operations are the only place, pretty much, that European banks can fund themselves on a day-to-day basis. Rather than having an efficient web of interbank relationships, Europe has been reduced to a hub-and-spoke system where everybody just faces the central bank instead. If the biggest and most important of those spokes — the German one — is found unconstitutional, then that’s the end of the euro right there.
People like Sober Look, in response to my post, have been saying that the big problem with Target2 is that if the Eurozone falls apart, then Germany would be forced to write off a large chunk of its national wealth — a number which is literally incalculable. As with companies, the important wealth of a country lies in its ability to generate money going forwards, rather than in its ability to hold on to money it has generated in the past. I don’t think that arguments about hypothetical wealth figures are particularly compelling, and the amount of money that the Bundesbank earns each year is so small — less than a billion euros, last year, which is less than one tenth of one percent of German GDP — that if the Bundesbank stops remitting profits to the German fisc, no one will really notice.
The real thing to worry about Target2 in Germany, then, is not that the euro will fall apart and the Bundesbank will have to write off lots of paper assets. Rather, it’s the fear that someone will challenge the whole system in Germany’s Constitutional Court, that it will be found unconstitutional, and that the entire financial sector of Europe might fall apart as a result.