Europe’s unbalancing act

In: Uncategorized

22 May 2013

This is my Perspective column from this week’s Fund Strategy magazine.

Sometimes important questions can be buried in nerdy technical discussions. This is certainly the case with the arcane debate about the eurozone’s Target2 imbalances. If those who proclaim their importance are right they reveal a new dimension to the financial challenges facing the currency bloc.

Critics of these imbalances are essentially suggesting that bailouts of weaker member states have gone on for longer and are more extensive than widely assumed. In practice they represents a covert system of fiscal transfers between member states. This is essentially the view of the German authorities although they are reluctant to express it officially.

Those who reject this argument, including the European Central Bank itself, do not deny the existence of substantial imbalances. However, they vociferously reject the interpretation made by the critics.

Reasons for their rebuttals vary. Among the counter-arguments are the claim that they are just a technical matter and a rejection of the view that Germany will lose out in the event of a eurozone collapse.

To understand what is at stake it is necessary to delve into the technicalities more deeply. Target2 is the settlement system owned and operated by the Eurosystem (the monetary authority of the eurozone central banks). That is it facilitates the transfer of funds between eurozone central banks. Target in this context stands for Trans-European Automated Real-time Gross settlement Express Transfer system.

An examination of the flows reveals some striking patterns. For a start net flows from the advent of the eurozone in 1999 until 2006 were negligible. However, they exploded from early 2007 until the summer of 2012 before narrowing slightly. From this perspective a covert bailout of weaker states had already started six years ago.

Second, the stronger northern eurozone economies have a positive net balance in the system while the weaker ones have a negative one. Germany easily has the largest positive balance in absolute terms but Finland, Luxembourg and the Netherlands are also in positive territory. Spain and Italy have the largest negative balances in absolute terms.

Hans-Werner Sinn, the president of Germany’s Ifo Institute for Economic Research in Munich, is the leading critic of these imbalances. He had an article published on the subject in Wirtchaftswoche (Economics Week) in February 2011 although since then he has covered the subject extensively in English too.

He has also had a book published on the topic in October 2012 with a revealing title: Die Target Falle: Gefahren für unser Geld und unsere Kinder (The Target Trap: Dangers for our money and our children). It clearly reflects German fears about playing the role of Europe’s paymaster.

Sinn has done more than anyone else to popularise the idea that the Target2 system had become the vehicle for a hidden bailout of the eurozone by the Bundesbank, Germany’s central bank. For example, he put forward this argument, among many other places, in an article on the VoxEU website in June 2011 (“The ECB’s stealth bailout”).

To explain how the system worked he gave the hypothetical example of an Irish farmer who asks his bank for a loan to buy a tractor in Germany. After having trouble borrowing from other European banks his bank turns to the Central Bank of Ireland for help. The CBI then “prints” fresh euros and lends them to the farmer.

Then the farmer transfers these euros through the Target2 system to the German tractor maker. As a result of these transactions the CBI’s monetary base (its liabilities) shrink back to normal but the Bundesbank’s liabilities initially increase by the same amount.

However, given that only a certain amount of money is allowed to circulate in the German economy he argues that a “crowding out” will occur. In other words, the Irish farmer’s loan will have come about at the expense of Germany borrowers.

Although the stock of euros will not have changed the Bundesbank has in effect financed the loan to the Irish farmer.This would not have happened if the farmer had borrowed the money privately in Germany.

Given the stakes involved it is not surprising that Sinn’s arguments, and those of others who support him, have provoked a vociferous response. For instance, an article in the May issue of the ECB’s Monthly Bulletin says: “Given the integrity of the monetary union, TARGET balances do not represent financial risk beyond that inherent in the Eurosystem operations underlying the balances”. It clearly did not want to attack Sinn overtly in such a forum.

Among several other lines of attack one of the most interesting came from Paul de Grauwe, a prominent Belgian economist and former liberal MP, and a colleague argued that Germany was ultimately responsible for the large current account surplus it built up with other eurozone nations during the good years. German banks should have done a proper credit analysis when they lent to such countries.

Target2 transfers will not in themselves bring about a collapse of the eurozone. However, they are an important indicator of the level of risk and the degree of imbalances within the region.