Project Syndicate, October 25th, 2011.
In August, the European balance-of-payments crisis moved beyond the Eurozone’s periphery and began buffeting Italy. Interest spreads for Italian government bonds began to rise, Prime Minister Silvio Berlusconi’s administration was alarmed enough to implement an austerity program, and the European Central Bank helped with extra liquidity.
The ECB directed the central banks of all Eurozone members to buy huge quantities of Italian government bonds during the crisis. While the national central banks have not revealed how much they bought, the aggregate stock of all government bonds purchased rose from €74 billion ($102 billion) on August 4, to €165 billion this month. Most of this increase was probably used to purchase Italian government bonds.
The German Bundesbank, which was forced to buy most of the bonds, strongly opposed the program, but was unable to stop it. In response, ECB Chief Economist Jürgen Stark resigned. He followed Bundesbank President Axel Weber, who had resigned in February because of the earlier bond repurchases. Meanwhile, the new Bundesbank president, Jens Weidmann, openly objects to the program, while German President Christian Wulff has publicly accused the ECB of circumventing the Maastricht Treaty.
But the bond purchases are just the tip of the iceberg. Equally important, but largely unknown, is the fact that the Banca d’Italia has resorted to the printing press to cover Italy’s gigantic balance of payments deficit. The extra money printing and lending, as measured by the so-called Target deficit, effectively means drawing a credit from the ECB. This credit replaces the private capital imports that had hitherto financed the country’s net purchases of foreign goods, but which dried up because of the crisis, and it finances a capital flight, i.e. the purchase of foreign assets. The ECB in turn draws the Target credit from the respective national central bank to which the money is flowing and which therefore has to accept a reduction in its scope for issuing refinancing credit.
Until July, only Greece, Ireland, Portugal, and Spain had drawn Target credit, for a combined total of €330 billion. Italy was stable and did not seem to need the printing press to solve its financial problems. No longer.
In August alone, Italy’s central bank drew €40 billion in Target credit, and it probably drew roughly another €50 billion in September, when the Bundesbank’s Target loans to the ECB system increased by €59 billion (after a €47-billion hike in August). This is the highest Target loan ever drawn from the Bundesbank in a single month, and in all likelihood it went primarily to Italy.
This is an explosion in slow motion. The stock of overall Target credit that the ECB system has drawn from the Bundesbank was around zero until mid-2007. By the end of September, it had climbed to €450 billion – in addition to the purchases of government bonds that the Bundesbank has been forced to make.
As Italy’s monthly current-account deficit approximates only €3-4 billion, the Target credit must have compensated primarily for capital flight. Italian investors sold their assets to the banking system, which paid with newly printed money. The investors then invested the proceeds in Germany, buying shares, bonds, and other assets. In essence, Germany and Italy traded Target claims against marketable assets. Greece, Ireland, Portugal, and Spain’s collective draw on Target credits forced the Bundesbank to reduce the refinancing credit that it issued by about €30 billion per year from 2008 to the end of 2010, when it stood at barely €90 billion. At that rate, it was predicted that the level could fall to zero within the next three years. The Italian Target credit, however, has now exceeded that estimate. In September 2011, the Bundesbank’s stock of refinancing loans, net of its deposit facilities vis-à-vis German banks, turned negative for the first time in history. The ECB’s shifting of refinancing credit via the Target system has therefore already hit the limit, three years
earlier than the trend of the past three years would have suggested.
This is not the end of the world, not even for the ECB. However, the Bundesbank has entered a new regime in which it will have to borrow extensively from the private banking sector to absorb the flight money from the crisis countries. They, in turn, will continue to compensate for capital flight by cranking up the money-printing press.
With this, the Eurozone has entered dangerous territory. Deposit facilities count as central bank money and have inflationary potential, given that the German banks could withdraw those funds at any time. If they do, more than the Target balances could be exploding in Europe.
Hans-Werner Sinn is Professor of Economics and Public Finance, University of
Munich, and President of the ifo Institute
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