Passing the Bailout Buck
Recently, there has been an intense debate in Europe on the TARGET2 system (Trans-European Automated Real-time Gross Settlement Express Transfer System 2), which is the joint gross clearing system of the eurozone.1 The interpretation of this system and its balances has provoked divergent opinions. Some economists, most prominently Hans-Werner Sinn, have argued that TARGET2 amounts to a bailout system. Others have vehemently denied that. Jürgen Stark of the European Central Bank (ECB) even said that some commentators could lose their reputation as serious academics by claiming that TARGET2 functions as a bailout system.
Indeed, TARGET2 debits and credits have been built up since the beginning of the financial crisis. While peripheral countries accumulated TARGET2 debits, in April 2012 TARGET2 claims of the Bundesbank amounted to almost €644 billion. That is almost €8,000 per German.
But does TARGET2 really amount to an undercover bailout system for unsustainable living standards in the periphery? Let us start our analysis with a simple example of two individuals using a bank to clear their payments.
Person A sells a good or service to person B for €100. In international trade terms, A has a current account surplus while B has a current account deficit. A receives a claim or credit against the bank of €100 when the payment is made (the broken line in figure 1). B has a debt and owes the bank €100. The debt relationships are shown by solid arrows pointing in the direction of the debtor.
A now has some money saved in his bank that he may plan to use, for instance, for retirement. B has to produce something of value to be able to pay back his debt. A will finally be paid by B's production of real goods (that may maintain him at retirement).
For A it is important that the bank's loan to B is secured by a good guarantee or collateral such as a high-quality security or real estate. In the absence of collateral for B's loan, problems arise if B does not pay his debt because he dies or for other reasons. If the bank does not hold other property to make up for the bad loan, A will be left with a claim against a bankrupt bank.
Of course, if the bank has the privilege of printing (legal-tender) bank notes, the bank will not go bankrupt but can pay back A. But A will then be paid back merely in paper, a worthless claim in our scenario, because B has not produced anything and has died. So what should A buy with the newly printed paper? A's standard of living will fall at retirement as his wealth is based just on paper.
Let us now assume that A lives in Germany and B lives in Spain. Furthermore, we introduce Commerzbank as A's German bank, and Banco Santander as B's Spanish bank. In addition, we add the two national central banks and the ECB.
We again assume that A exports goods worth €100 to B. When the payment is made, A receives a claim against Commerzbank. A's bank account increases €100. B gets a €100 loan from Banco Santander (alternatively he could run down his deposit account at Banco Santander). Commerzbank gets a claim against the Bundesbank (or reduces its refinancing from it), while Banco Santander increases its refinancing with the Bank of Spain (or reduces its excess reserves).
On the level of central banks, the Bundesbank receives a credit against the ECB while the Bank of Spain gets a debit. Underlying this procedure is an import of goods to Spain that has been financed by Banco Santander creating new money in form of a loan to B. The money creation results in TARGET2 debits for the Bank of Spain and TARGET2 credits for the Bundesbank.
Let us compare the TARGET2 method with the financing of imports in a gold standard. In both systems, import surpluses may be financed by capital imports, i.e., A or Commerzbank buys a bond from B. If there is no private capital financing in a gold standard, the import must be paid by transferring gold. In contrast, in the Eurosystem, import surpluses can simply be financed by producing claims against the ECB. Instead of gold, the Bundesbank receives TARGET2 credits. While in a gold standard, the payment of imports (if not financed by private loans) is limited to the outflow of gold, there is no limit for TARGET2 credits, i.e., the import surpluses may be financed without any limit by the creation of Euro claims.
How do TARGET2 debits and credits disappear? The balances disappear if A imports from B or if B sells a bond to A or borrows from him on the private market. There is nothing to assert against financing the import surplus through private loans or bonds. TARGET2 debits, however, are not private loans but amount to public central-bank loans. Without TARGET2, someone in the Spanish economy would have had to find private investors to finance the trade deficit paying potentially high interest rates, especially if no high-quality collateral for such loans can be provided.
In this sense, the TARGET2 system indeed amounts to a bailout of an uncompetitive economy with too high prices. Thanks to this bailout mechanism, the country does not have to deregulate labor markets, and reduce government spending to adjust prices relatively but can continue its spending spree and maintain its uncompetitive internal structure.
But are the TARGET2 debits and credits really never settled? Surprisingly, there is indeed neither a limit for the TARGET2 bailouts, nor are the accounts ever settled. In contrast, in the Federal Reserve System debits are backed by gold certificates and each year balances are settled. If the Federal Reserve Bank of Richmond has a debit with the Federal Reserve Bank of New York, the former settles its account sending gold certificates to the latter.2
The Eurosystem not only allows the financing of import surpluses via money creation; it also enables "capital flights." In the current situation, a default of the Greek government would bankrupt its banking system. In order to prevent losses, Greek depositors have sent and are sending their money from accounts at Greek banks to accounts of banks in Germany and other countries. Through this transfer, the Greek bank loses reserves while the German one increases its reserves. The Greek bank increases refinancing from its national central bank (i.e., receives newly created money) while the German bank can decrease it loans from the Bundesbank. The Bundesbank earns a TARGET2 credit, the Bank of Greece a TARGET2 debit. If the Greek government defaults, and the Bank of Greece default on its debits, losses mount for the ECB. Thus, the risk of a Greek default is now shared by German savers through the TARGET2 credit.
What Is the Essence of TARGET2 Balances?
TARGET2 credits ultimately represent claims of savers, while TARGET2 debits represent debts of companies, governments, and individuals. TARGET2 accounts are just a consequence of an ongoing redistribution and of bailouts. For instance, TARGET2 accounts may mirror the tragedy of the euro, i.e., the monetization of government deficits. Take the following example. A Spanish bank creates new money to buy a Spanish government bond. This allows the Spanish government to maintain its government spending and to delay reforms of the labor market. It may increase public-sector wages and unemployment benefits. The competitiveness of the Spanish economy is hampered due to too high wages resulting in a trade deficit: a Spanish minister buys a German car. In the beginning, the trade deficit may be financed by private entities, for instance, by loans from German banks to Spanish banks. Yet after some time the Spanish banks will run out of good collateral. The increasing government debts and the overindebtedness of the private sector reduce the quality of Spanish debt as collateral. At some point, private investors do not want to continue to finance Spanish banks and the Spanish trade deficit because they do not have good collateral (we are already beyond this point). Yet thanks to TARGET2 the party can continue. Spanish banks can use bad collateral (Spanish government bonds) and refinance with the Bank of Spain, which accepts Spanish government bonds as collateral for new loans. As a result of this indirect monetization of government bonds, TARGET2 debits to the ECB increase. Bad risks (collateral) are shifted to the Eurosystem and socialized. TARGET2 thereby allows to finance the trade deficit through public central bank loans.
Not only public debts may be monetized through the Eurosystem and their risk socialized through TARGET2 but also private debts. This possibility augmented importantly in February 2012, when the ECB allowed national central bank on their own risk to determine eligible collateral for central-bank loans.3 Depending on the exact collateral rules, a Spanish bank may now loan to a Spanish company to import from Germany. The Spanish bank may take the loan to the importer as collateral for a new loan from the Bank of Spain (of course, applying a haircut). In this way, the private loan (in this case used for consumption), has been monetized. As an effect there will be also TARGET2 debits for the Bank of Spain and TARGET2 credits for the Bundesbank.
What Are the Risks Exactly for a TARGET2 Credit Country Such as Germany?
If Greece leaves the euro, it most probably will not pay its debits to ECB with gold or hard assets. The ECB will suffer a loss, and through its capital contribution 27 percent of such a loss falls on the Bundesbank. If more countries leave the euro, the loss is correspondingly higher. In the opposite case of a German exit of the euro, the Bundesbank will suffer important losses if the new German currency appreciates as the Bundesbank's main assets are now TARGET2 credits denominated in euros. Moreover, the remaining eurozone countries might resist paying for the TARGET2 credits.
But is the liquidation of TARGET2 credits a real loss? If we take our initial example of the two individuals with a clearing bank, the conclusion is straightforward. If B defaults, the bank goes bankrupt and A loses his savings. The same happens in the case of the Eurosystem. If the peripheral governments default, their banks default, their national central banks default and the ECB goes bankrupt. The Bundesbank then has a TARGET2 claim on the bankrupt ECB and goes bust too. Commerzbank loses its claims on the Bundesbank (or is not refinanced anymore) and defaults as well. Then the German saver is left with nothing but empty hands. The purpose of the visible bailouts of peripheral countries such as Greece is to maintain the illusion that no losses are to be suffered for savers in Germany and other countries.
But can the ECB or the Bundesbank really go bankrupt? Can they not always pay, just by printing more money? It is true that the ECB can always pay its bills by producing money. However, creating money does not take away the fact that the wealth is gone when the periphery defaults. It is like B not paying with real goods because he dies. A may receive new paper money from his bank, but this will not feed him through retirement. Unfortunately, as long as the European periphery remains uncompetitive relative to Germany, nothing will be produced to settle the German TARGET2 credits. Most likely, their real value is gone forever. To think that they will represent real wealth is an illusion that will be ended in one of three possible ways. The first is the already-mentioned inflation when the ECB just prints money to keep the system afloat.
Second, in the case of a peripheral default, the quality of the assets of the ECB is impaired, its capital consumed. The ECB loses options to reduce the quantity of money in circulation and defend the value of the euro. The ECB simply has no good assets to sell; they have evaporated. There is the danger that the confidence in the currency evaporates also, first on international currency markets and later internally. The value of the currency may collapse and the wealth illusion of currency holders and savers ends.
Third, another alternative is to recapitalize the ECB by transferring high-quality assets to it. The ECB can then use these assets to maintain confidence in the currency and defend its value. The recapitalization, of course, requires also an expropriation of wealth holders in Germany and other countries. After default and inflation, fiscal expropriation means an alternative end to the wealth illusion.
TARGET2, Eurobonds, European Stability Mechanism: What Is the Difference?
Eurobonds are jointly issued and guaranteed by all 17 eurozone members but have been very controversial. For instance, Eurobonds have been vehemently resisted by the German government until today. However, TARGET2 has not been resisted by the German government. TARGET2 is just the reflection of a substitute bailout. When governments issue bonds bought by their banks leading to a trade deficit, the result is a TARGET2 debit. The TARGET2 imbalances are just a sign of euros created in the periphery used to pay for goods from abroad.
The European Stability Mechanism (ESM) is another substitute for Eurobonds, as the ESM may grant loans to struggling governments issuing bonds guaranteed collectively. The difference between the three is merely of degree. There is more parliamentary control for Eurobonds or the ESM. In the ESM, creditor countries have more control over bailouts than with Eurobonds. Interest rates differences are also more pronounced with the ESM than with Eurobonds. The ECB wants to shift the bailout burden from TARGET2 to the ESM. Governments prefer to hide the losses on taxpayers as long as possible and prefer the ECB to aliment deficits. However, all three devices serve as bailout systems and form a transfer union.
- 1. The best short introduction and analysis of TARGET2 may be found in Stefan Homburg, "Anmerkungen zum Target-2-Streit," Wirtschaftsdienst, volume 91, numer 3 (2011): pp. 536–530. Our analysis and graphs follow Homburg's line of argumentation closely.
- 2. At least these rules appear in the Federal Reserve accounting manual. It seems, though, as if the Fed has suspended settlements ultimately. See Michiel Bijlsma and Jasper Lukkezen "Target-2 of the ECB vs. Interdistrict Settlement Account of the Federal Reserve" (2012).
- 3. Jens Weidmann criticized the change in collateral rules and demanded collateral for TARGET2 debits in March 2012. However, only central banks and governments could provide good collateral such as gold for TARGET2 debits. Most banks have no good collateral left. Otherwise they would have used it to refinance themselves on the private markets and not through the Eurosystem with its low collateral standards.