VOX, www.voxeu.org, 1. Juni 2011.
The Eurozone crisis lingers on. This column argues that the Eurozone payments system has been operating as a hidden bailout whereby the Bundesbank has been lending money to the crisis-stricken Eurozone members via the Target system on the order of €300 billion. Urgent corrective action is needed, the author argues, as the scope for this sort of transfer is limited. If markets sense the end of the line, the Eurozone may face a crisis like the one Britain faced in 1992.
The parliaments of the Eurozone struggle to find an agreement about the future European Stability Mechanism (the €700 billion bailout system for the Eurozone’s stricken economies) hoping that their rescue package will solve the problems of Europe’s periphery once for all. They should know, however, that they are not the first to set up such a package. Theirs will just be a replacement for another rescue package worth more than €300 billion that the ECB has been operating for the past three years.
The ECB’s bailout system is buried in the so-called Target claims and liabilities in the national central banks’ balance sheets. Target is an acronym Trans-European Automated Real-time Gross Settlement Express Transfer System. At first glance, Target seems to be an irrelevant technicality, part of the mechanics of daily transfers of money among Eurozone banks – nothing more than a settlement system for inter-bank transactions. This impression is wrong.
- The Target balances are interest-bearing public loans that are being used to finance current-account deficits. In fact, the balances come close to short-term eurobonds.
- Moreover, their size dwarfs the parliament-approved bailouts extended to Greece, Ireland and Portugal.
The operation of Target balances is a bit involved. Consider an example. The Central Bank of Ireland, like every bank in the world, has to have matching assets and liabilities. Roughly speaking (see Hawkins 2010):
- Its loans to the Irish banking sector are its main assets along with its gold and foreign currency reserves.
- Its liabilities consist of the euros it issues, namely the euro reserves held by Irish commercial banks and euro currency issued in Ireland.
If Irish banks transfer more euros out of the country than they receive, the liabilities side of the Irish Central Bank’s balance sheet will be too small. The money doesn’t disappear however; it shows up on the liability side of some other Eurozone central bank’s balance sheet. Thus one central bank, say the Bundesbank for example, will have liabilities that are too large and one will have liabilities that are too small. Target balances ‘clear’ these discrepancies.
The accumulated net flow of euros leaving Ireland is thus the Irish Target deficit. This appears as a liability to the ECB in the Irish Central Bank’s balance sheet. The central bank whose liabilities are now too large is given an interest-bearing Target claim against the ECB and this goes on the asset-side of its balance sheet. Interest is paid to the receiving central bank because it must now provide euros to its commercial banks for the purpose of carrying out the transaction without acquiring an interest-bearing claim against these banks (as the case usually is if the money is created via the commercial banks’ refinancing operations).
This is why the foreign trade statistics of Eurostat rightly count the creation of Target claims against other countries’ central banks via the ECB as a capital flow between the national central banks. That is to say, it is as if the Bundesbank had lent money to the Irish Central bank for the purposes of extending a loan to an Irish bank.
The Target balances are thus a measure of cumulated payments imbalances made by the Irish banking system. Another way to say this is that they reflect Ireland’s past current account deficits with other Eurozone nations that have not been financed by inflows of private or public capital, but rather by the Irish Central Bank’s money creation (typically by way of extending credit to its commercial banks).
How a normal payment mechanism became a bailout mechanism
In normal times, these Target imbalances are minor because the surplus of Irish payments to rest of the Eurozone is financed by inflows of private or public capital from these countries.
In today’s situation, by contrast, a lack of confidence on the part of investors may mean that the euros are not flowing back to the Irish banking system. The result is a rising Target balance that, in essence, allows Ireland to borrow euros via the Irish banking system and its national central bank from other Eurozone central banks.
A more detailed example
In order to better understand the economic meaning and formal booking of Target claims and liabilities in the euro system, let’s take an Irish farmer who asks his bank for a loan to buy a tractor in Germany. Unable to borrow from other European banks, or only at high premiums, his bank turns to the Irish Central Bank, which “prints” and lends out fresh euros for the purpose. This raises the Irish Central Bank’s assets and liabilities. The farmer then transfers these euros through the central bank system to the German producer. This means that the Irish central bank’s money base (its liabilities) shrink back to normal but the Bundesbank’s money base (liabilities), in the first instance, increase by this same amount.
However, the new money coming into the German economy as a result of the payment for the tractor is likely to crowd out normal German money creation by way of the Bundesbank’s lending to German banks. The crowding out will not necessarily occur, but it is the normal case to be expected as, given Germany’s GDP and given Germany’s payment habits, the commercial banks only need a certain amount of euros for circulation in Germany. Moreover, strict crowding out is inevitable if the ECB controls the overall stock of central bank money in the Eurozone by way of sterilising interventions or auctioning off limited tenders.
As explained above, in compensation for “printing” the money needed for the transaction without acquiring a claim against its commercial banks, the Bundesbank is given an interest-bearing target claim against the ECB, and the ECB acquires a similar interest-bearing claim against the Irish Central Bank. And of course, the CBI holds a claim against the Irish commercial bank, which in turn holds a claim against the Irish farmer. Thus, ultimately, the credit to the Irish farmer comes from the Bundesbank at the expense of a similar credit provided to the German economy.
The stock of euros has changed neither in Ireland nor in Germany, and yet the tractor is delivered to the Irish farmer through a loan from the Bundesbank at the expense of loans to the German economy. This is a forced capital export from Germany to Ireland.
If the Irish farmer had borrowed the money privately in Germany, no Target balances would have arisen, as the euros from the private German load would have flowed into the Irish Central Bank to offset the outflows linked to the tractor’s purchase. They would be zero, as was practically the case from 1999 through 2006, before the financial crisis erupted. But they are not zero today.
The size of the problem
The Bundesbank’s Target claims have lately been growing by nearly €100 billion per year due to the reluctance of private investors to continue financing the current account deficits of the GIPS, i.e. Greece, Ireland, Portugal, Spain. The GIPS’ Target liabilities grow apace. They rocketed from minus €30 billion in mid-2007 (when the interbank market first broke down) to €344 billion by the end of 2010. This was roughly the size of their accumulated current-account deficits (on the order of €365 billion in 2008, 2009, and 2010). During the same period, the Bundesbank’s Target claims rose to €326 billion.
Although Spain took less and Ireland more than their respective current-account deficits, the ECB, and indeed effectively the Bundesbank, has replaced private capital flows that would otherwise have been needed to finance the GIPS’s current-account deficits. This was, in effect, a bailout long before the corresponding parliaments took any notice. This bailout made it possible for the GIPS to continue living beyond their means, and it saved them from a drastic reduction in credit flows.
Crisis management versus long-term bailout
The tolerance of the ECB with regard to money creation by a national central bank for the purpose of paying the import bill or accommodating capital flight was justifiable during the most acute stage of the crisis. It was imperative to avoid a collapse of the GIPS in 2009. However, the problem is that the ECB still hasn’t applied the brakes, even though the world economy has recovered. This distorts capital flows in Europe, shifts too much economic vigour to the GIPS, and defers their adaptation to the new reality.
The shifting of money creation is limited to the stock of money needed
In any case, the ECB’s “surrogate lending” cannot be extended arbitrarily. If every year a further €100 billion is granted to the GIPS as Target loans, the stock of credit given by non-GIPS central banks to their commercial banks via refinancing operations will shrink by the same amount. Year by year, the money flowing from the GIPS countries to the other Eurozone countries is crowding out central bank money issued there as well as ECB loans given to those countries’ commercial banks.
By the end of 2010, the stock of the ECB loans to the non-GIPS euro countries had shrunk to barely €184 billion euros, just 32% of the total, while €383 billion, or 68% of the total, had accumulated in the GIPS. This is lopsided as the GIPS’s economies account for a mere 18% of the Eurozone’s GDP. Obviously, if the net money flow out of the GIPS countries continues at a rate of €100 billion annually, this policy can be continued for at most two further years.
Understanding the ECB’s tough stance
The situation is as dangerous as the one in 1992. That was when the British pound collapsed because the Bank of England had fewer deutschmarks and francs to sell than Gorges Soros was buying. True, the central banks could sell their gold and currency stocks to sterilise the money flows, but this would lead to a public outcry. Even with this, the ECB would only gain at most six more years (given the stocks of gold and foreign currency in the system); in 2018 it would be over for good. After that, the ECB system could no longer compensate for the fresh money issued by the GIPS with withdrawals of money from the rest of the Eurozone. That would make inflation inevitable.
The impossibility of continuing this policy is the reason why the ECB is now taking such an aggressive stance when it comes to providing more liquidity to Greece and the other GIPS countries. And it explains why Germany acquiesced to channelling new public loans through the European Stability Mechanism.
Time to move on
As the Great Recession is now over, it is time to stop the surrogate lending by the ECB system. This could be done by applying the US rules, for example.
In the US, the Interdistrict Settlement Account (the US equivalent to the Target system) must be settled once a year with gold-backed securities or Federal treasury bills. Thus, no money creation for the purpose of helping the citizens of one Fed district (there are 12 in the US) to finance a net inflow of goods or assets from other districts is possible. If a district wants to import from other districts more that it exports to them, it has to find private lenders who are willing to finance that. And if it wants to invest in other districts in net terms it has to earn the money for that purpose by delivering more goods and services. Given that the US is a nation while the Eurozone is still far from qualifying for that status, it makes little sense for the ECB to deviate from the US solution by providing more generous access to its teller machine for such purposes.
Adopting the US system could mean, for example, that Target liabilities have to be paid annually with gold, currency reserves, or other marketable assets that cannot be produced by the paying country itself. This rule would force the GIPS banks to seek financing in the private market where interest rates are high, and the GIPS economies would then react by borrowing less and reducing their current-account deficits.
Some European countries, however, seek an extension of the ECB policy via the European Stability Mechanism’s formal issuing of eurobonds (regular credit flows guaranteed by the Eurozone countries in proportion to their ECB capital shares). Since what the ECB has done with its Target credits, whose risk is also born by the euro-using countries in proportion to their capital shares, comes close to issuing short term eurobonds, such a move many seem logical. It would halt the rise in Target loans and salvage the ECB from an unbearable situation. However, it would also perpetuate the GIPS countries’ trade deficits and prevent the necessary real depreciation that they have to undergo to become competitive again. It would thus increase the GIPS foreign debt year by year and would inevitably lead either to a collapse of the Euro-System or to a European transfer union. The longer the cheap money drug is indulged in, the more painful the withdrawal. Wait too long and no cure will be possible.
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