Target, 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 vice versa. Currently the gross Target balances total about 1 trillion euros or 10.8 per cent 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 GIPSIC countries (Greece, Ireland, Portugal, Spain, Italy, Cyprus) holding the lion's share of the liabilities. To put these figures into context, the gross US ISA balances are currently only about 100 billion dollars or 0.8 per cent 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these Target liabilities to accumulate by giving Southern banks and their clients the opportunity to replace the money withdrawn in the form of net payment orders by borrowing rising sums of fresh money from their central banks against increasingly weak collateral.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 to 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, however, as Northern commercial banks redeemed their refinancing credits and lent the extra liquidity stemming from the payment orders to their respective centrals banks. All of the base money circulating in the Eurozone has originated from the refinancing or open market operations of the GIPSIC countries and none of it 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 have merely compensated for.
Whatever the truth, German commercial banks alone brought around 700 billion euros (900 million dollars) to the Deutsche Bundesbank to redeem their refinancing credit and fill their deposit accounts. Thus, instead of marketable securities bearing risk-commensurate rates of return, nearly all that Germany has received in return for its 711 billion euros in current account surpluses since the beginning of 2008 have been Target claims (624 billion euros). Should the euro break up, these claims will be largely worthless; and if there is no crash, and everything just muddles on, 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 per cent, while the Eurozone's average inflation rate is 2.6 per cent.
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 purchases of government bonds, 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-yield 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 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 to 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 constitutionality, are even better than government bond purchases by the ECB. Unlike in the ECB 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 per cent), 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. 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 capacity will be exhausted at some point, despite leveraging: Since Germany’s Constitutional Court left out a banking license for the ESM in its September judgment 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 that 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.
Published under the title “Fieberthermometer der Krise”, Wirtschaftswoche, No. 43, 22 October 2012, p. 44.
Prof. Dr. Dr. h.c. mult. Hans-Werner Sinn
Präsident a.D. des ifo Instituts