Felix Salmon

Don’t fear Target2. Fear its opponents.

By Felix Salmon
June 15, 2012

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.

11 comments so far | RSS Comments RSS

Wouldn’t the Bundesbank be a hub, rather than a spoke?

Posted by guanix | Report as abusive

@Felix: With each iteration, you seem to be coming closer to the notion that Target2 may actually be a serious health hazard. In this post, you appear to hang your hat on the potential for opponents of the Eurosystem to force a constitutional crisis in Germany as the reason for Target2 toxicity, while you simultaneously deny the impact from the wealth drain that I and others have pointed out. Ironically, you fail to make the link between the two; the driver for the potential of a German constitutional challenge is an economic one. That is, the Maastricht Treaty, in Article 103-(1), to which all member states are bound, renders illegal an obligation to underwrite losses from other member states. Target2, one of the flawed features of the non-fiscally aligned monetary “union,” creates the potential for massive losses for participants in the Eurosystem. If the Target2 issues were merely “internal accounting conventions,” as you referred to them in your prior post, they would not give rise to the potential for a German Constitutional Court to determine that the Target2 system violated the Maastricht Treaty as codified in German Law.

On the wealth drain point, you seem to dismiss this as a cause of Target2-induced economic pain, in part because the base national wealth itself is “literally incalculable,” and therefore the impact of Target2 losses relative to national wealth can’t be calculated. I would offer that just because one can’t accurately calculate the number of healthy cells in the human body, that doesn’t permit the conclusion that the ingestion of a quantity of poison is not dangerous to the body.

Further on this wealth effect notion, you state “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.” Let’s not forget that a country’s ability to generate money (or new wealth) in the future is dependent on its ability to cover all of its costs, including debt service to external creditors. If you want to make the argument, as Professor Karl Whelan has made, that German Target2 write-offs could easily be offset by the printing of sufficient currency by the Bundesbank, I would raise a yellow card. This would be the equivalent of monetizing a country’s debt. If the US Fed bought back every piece of external debt that the US Treasury issued by printing $14 trillion new dollars, has the wealth of America increased by the present value of the interest payments that no longer need to be made to former external debt holders? I think not! This is the same for the case of central bank Target2 receivables that vaporize under the hypothetical collapse of the Eurosystem. The physical goods and real services that were expected to ultimately pay down those receivables would never arrive. Importantly, the printing of new currency to balance the books of the central bank would not make those goods and services magically re-appear unencumbered, and the central banks reduced (or negative) equity would not be improved. Therefore, the *future* ability of the country to generate new wealth is impaired.

I conclude that Target2 losses represent a real cost, and not just by virtue of a legal technicality.

Posted by IvantheK | Report as abusive

@FS – Felix, there are at least a couple dozen of us here who could tear this post of yours to shreds in just a couple paragraphs, but I for one don’t want to do your debate-opponent’s work for him.

Better look again at your cards (objectively, this time) before you call the hand.

Posted by MrRFox | Report as abusive

Flows not stocks, is it? Well the reason that Germany is not as wealthy as it thinks it is is precisely that net historical flows are not as great as it thought, when properly accounted for. The complacent Germans have based their sense of superiority on accumulating financial claims against the very economies they disparage. And once the Euro unravels and Germany’s true terms of trade are revealed, what do you suppose will happen to German income? She depends on Europe for 70% of her exports.

So sure, Target2 “doesn’t matter” in the sense that it is just the specific detail of how an underlying reality is become manifest. But still, the detail is real. The endgame is that Germany with 27% of Europe’s economy ends up with 100% of her money. The problem is not that “the Bundesbank will have to write off lots of paper assets” – as alea pointed out, the Bundesbank can replace these assets at the stroke of a keyboard. The trouble is that these assets have no market value and cannot be used to extinguish Bundesbank *liabilities*.

Posted by Greycap | Report as abusive

“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.”


That’s equivalent to saying that if the United States were to default on bonds it owes to China … just a few hundred billion, it doesn’t matter!

I don’t understand German so difficult to find German data but here’s Australian Bureau of Statistics doing it for Australia every year!

http://www.abs.gov.au/AUSSTATS/abs@.nsf/ DetailsPage/5204.02010-11?OpenDocument

In particular Table 11.

At least now you accept its a loss for Germany in an accounting sense!

Even from an Income viewpoint, the Gross National Income calculation uses/adds interest earned on central bank assets held abroad in calculating it. It doesn’t matter according to you?

Posted by Ramanan_V | Report as abusive

Central bank profits and losses are fiscal items.

A loss is a loss. It affects the fiscal position.

The fact that governments can issue lots of debt doesn’t change this.

And the fact that central banks can print money doesn’t change this.

Central banks print asset swaps.

They don’t print equity or profits.

Profits take time, depending on central bank interest margins.

Anyway, the deficit will be larger by the amount of the loss.

Drive on from there.

But that’s hardly an argument that losses don’t matter.

Might as well say deficits don’t matter.

Oops… I think MMT did say that, sort of, at least according to Krugman.

Never mind.

Posted by JKH | Report as abusive

The complete target2-debate: http://www.robertmwuner.de/materialien_e uro_literatur_target2.html

Posted by RobertMWuner | Report as abusive

Does any party to this debate recognise that any constraint on the ability of the ECB to facilitate TARGET2 balances would (if it was motivated simply by the German Constitutional Court’s views on German fiscal exposure) be a constraint on the ECB’s independence? Karlsruhe have passed the ECB treaty. The opportunity to revisit operational matters with respect to the ECB’s decisions is gone, by the plain wording of the ECB Statute. If the Euro fails, it wont be this way.

Posted by dsquared | Report as abusive

Quite right, this is settled as long as the ECB sticks to its knitting which doesn’t include lender of last resort functions, another matter if there are attempts to extend the ECB mandate by the backdoor.

Posted by alea | Report as abusive

The ECB’s mandate includes anything that it deems to be relevant to its goal of price stability in the Eurozone, apart from the very small category of direct lending to sovereigns forbidden by Article 21.

Posted by dsquared | Report as abusive

Armed with all this good info, IMO Felix is gonna do OK.

Posted by MrRFox | Report as abusive

Post Your Comment

We welcome comments that advance the story through relevant opinion, anecdotes, links and data. If you see a comment that you believe is irrelevant or inappropriate, you can flag it to our editors by using the report abuse links. Views expressed in the comments do not represent those of Reuters. For more information on our comment policy, see http://blogs.reuters.com/fulldisclosure/2010/09/27/toward-a-more-thoughtful-conversation-on-stories/