Debate Over Target2 Continues: Twilight of the Euro

I previously commented on Target2 in Eurointelligence Displays Stunning Ignorance Regarding Target2.

Eurointelligence blasts Faz for inaccuracies while spreading a pile of its own through the mouth of Mark Schieritz who says (translated) Do not be afraid of the trillions bomb.

Schieritz says: “The claims and the liabilities are fictional quantities. They exist virtually, in the balance sheets of central banks, not in the real world.”

One can stop there knowing full knowledge that Schieritz’s article is complete nonsense.

In the real world, Target2 imbalances are a measure of capital flight and loans that cannot be paid back. Even if there once was adequate capital for loans made by Italian banks, that capital vanished long ago.

Now, Italian depositors are very fearful of bail-ins and have pulled there money out of Italian banks.

That is the “real world”. Real people have real fears, and they should. Anyone holding money in Italian banks is a fool. I gave the same warning about Greece well ahead of capital controls. I make the same case again now, regarding Italy.

New Eurointelligence Nonsense

Here are a couple of new clips from Eurointelligence to discuss.

Against Target2 Hysteria

Martin Hellwig joins the debate on Frankfurter Allgemeine’s Sunday edition with a rejoinder to earlier columns by Hans Werner Sinn (which we covered) and Thomas Mayer (which we didn’t) on the danger to the Bundesbank from its near-trillion-euro claims on the eurosystem, and on the danger to the eurosystem from its near-half-trillion claims on the Bank of Italy. Hellwig argues that Sinn confuses deliberately with the smoke and mirrors of double-entry book-keeping, and is whipping up an unjustified panic over Target2.

What would happen to the Target2 claims if Italy were to default on its payments? Nothing, says Hellwig. If the Italian state defaulted, it would affect Italian bonds but not liabilities between central banks or the payment traffic in the monetary union. The eurosystem would be affected mostly through the effect the defaulted bonds would have on the balance of the Bank of Italy. But the intra-eurosystem claims would not be affected. And the Bundesbank has contributed to causing the widening of the Target2 balances since 2015 by insisting that most of each country’s bonds are bought by the respective central bank.

Nothing Would Happen?

That is ridiculous. The ECB would likely paper over the losses and that is against the treaty. The Euro would take a big hit. Third, everyone would be wondering what country would be next.

Norbert Häring, for Handelsblatt, asks When is a Trillion Euro Not a Trillion Euro?

Germany’s surplus with the European Central Bank hit a new record in April. Germany is currently owed around €950 billion ($1.12 trillion) under the ECB’s Target2 clearing system, which balances out cross-border financial movements within the euro zone.

Hans-Werner Sinn, the former head of Ifo Institute for Economic Research, a leading economic think tank, told Handelsblatt the figure was basically worthless — an “unsecured credit against the euro system, which cannot be called in and which debtor countries pay no interest on.” A private company would simply write off the amount, he added.

No one quite knows would happen to the Target2 system in the event of a high-deficit country leaving the euro system. Last year, ECB president Mario Draghi told the European parliament that any deficits would have to be repaid. But it appears that countries have no binding legal obligation to do so; it is simply “guidance” from the ECB.

If Italy were to withdraw from the euro zone, its banks’ assets and liabilities would be redenominated in its new currency, which would probably see a steep fall in value. The question then would not only be whether Italy should pay its Target2 deficit, but how it possibly could. The Bank of Italy would almost certainly default on a bill for half a trillion euros.

Eurointelligence Counters

Häring starts with the question of how much the German Target2 claims are actually worth. One argument – which he attributes to Hans Werner Sinn and Karl Whelan – is that because Target2 claims are uncallable and pay no interest they are actually worthless.

Häring sees three ways in which Germany could reduce its Target2 surplus. First, the Bundesbank could buy a trillion euros’ worth of real or financial assets in other eurozone member states. Not only is that kind of investment spree by a central bank unusual, but the Bundesbank insisted on not sharing the purchases of other member states’ debt as part of the ECB’s QE programme. But the point stands. If Germany were to constitute a dedicated sovereign wealth fund to invest only in non-German eurozone assets, it could eliminate its Target2 balance. The Swiss central bank for example has engaged in such massive purchases of foreign assets in the past.

The second way is for the German government to engage in a trillion-euro public investment drive to modernise and repair Germany’s infrastructure. For this to reduce Germany’s Target2 surplus the country would have to resort largely to expertise, labour and materials from other eurozone countries.

The third way to reduce the German Target2 balance is for German wages and prices to increase significantly. This would allow and encourage German consumers to buy goods and services elsewhere in the eurozone. But export competitiveness and wage suppression have been central to the German economic model since the time of Gerhard Schröder.

Only if Germany fails to adopt some combination of these strategies and the eurozone ultimately breaks apart would Germany realise a loss on its Target2 claims.

Key to the Debate

That last paragraph above is key to the debate. Yes, Germany could go on a buying spree, up and until the point of default. Say Italy defaults, what then?

Meanwhile the balances keep rising and rising.

Twilight of the Euro

Hans Werner Sinn discusses Target2 in Are we seeing the twilight of the euro?

In May 1998, irrevocable conversion rates for the currencies that would be merged into the euro were implemented. In a sense, this makes the single currency just over 20 years old. The first decade of its life had the feeling of a party, particularly in Southern Europe; but the second decade brought the inevitable hangover. Now, as we enter the third decade, the prevailing mood seems to be one of increasing political radicalization.

The original party was a cornucopia of cheap credit, which capital markets happily issued to the countries of Southern Europe under the protection of the euro. For a while, these countries finally had enough money to increase public-sector salaries and pensions, as well as spur private consumption and investment.

But the credit flooding into these countries created inflationary bubbles, which burst when the 2008 financial crisis in the United States spread to Europe. As capital markets refused to extend further credit, Southern Europe’s previously halfway-competitive but now overpriced economies soon ran into serious trouble.

By mid-2018, the net amount of payment orders to Germany through the Target system had risen to €976 billion. As a perpetual overdraft drawn from the Bundesbank, this money was not unlike the International Monetary Fund’s Special Drawing Rights, except that there is much more of it — a sum greater than all of the funds IMF countries are willing to loan to one another. Spain and Italy alone drew down about €400 and €500 billion, respectively.

Despite — or because of — this windfall, Southern European countries’ manufacturing sectors are still a long way from regaining competitiveness. In Portugal, for example, the output of the manufacturing sector is still 14 percent below what it was in the third quarter of 2007, after the first breakdown of the European interbank market. And for Italy, Greece, and Spain, that figure is 17, 19, and 21 percent, respectively. Meanwhile, youth unemployment is above 20 percent in Portugal, more than 30 percent in Spain and Italy, and almost 45 percent in Greece.

Now that we are entering the euro’s third decade, it is worth noting that Portugal, Spain, and Greece are all governed by radical socialists who have abandoned the concept of fiscal responsibility, which they call “austerity policy.” Worse still, Italy’s establishment parties have all been swept away. The country’s new populist government – comprising the Five Star Movement and Lega Nord – intends to increase the country’s debt substantially to pay for its proposed tax cuts and guaranteed-income scheme; and it might threaten to abandon the euro altogether if the EU refuses to play along.

In view of these facts, even the most committed euro enthusiast cannot honestly say that the single currency has been a success. Europe has quite plainly overextended itself. Unfortunately, the great sociologist Ralf Dahrendorf was right to conclude that, “The currency union is a grave error, a quixotic, reckless, and misguided goal, that will not unite but break up Europe.”

Acting man

Acting Man referred to me and he gets the last word in TARGET-2 Revisited

Acting Man discusses Capital Flight vs. The Effect of QE. He also noted the growing Target2 liability of the ECB itself.

The ECB is a supranational entity and in terms of the payment system it is treated as if it were a country of its own. Most of the debt purchases under the QE program are conducted by NCBs – in particular, every NCB is tasked with buying sovereign bonds issued by its own country of domicile.

However, the ECB is also engaged in direct bond purchases, and these create TARGET-2 liabilities as they necessarily involve the flow of central bank money from the ECB to various NCBs in whose jurisdictions it buys bonds. If the NCBs concerned have a positive TARGET balance, total TARGET balances will increase*.

As Draghi notes in his press conferences, roughly 40% to 50% of the purchases under the APP are from non-resident institutions (which may in turn act on behalf of their customers). Most of the trading with such institutions takes place in the largest financial centers in Europe, with Frankfurt in Germany a particularly active one.

One could also say: as long as the APP is underway, it is actually difficult to tell to what extent a rising TARGET-2 balance is driven by QE or by capital flight. For instance, it inter alia seems likely that recent political upheaval in Italy has given fresh impetus to capital flight from there. In fact, the political situation in Italy was fraught with uncertainty ever since the resignation of the Renzi government, and the growth of Italy’s TARGET-2 liabilities has accelerated since then.

However, there is another important point which Mr. Draghi neglects to mention when he insists that growing TARGET-2 imbalances are merely an APP-related technicality.

It is certainly true that when the Bank of Italy purchases Italian government bonds in Frankfurt from international banks which access TARGET-2 through the BuBa, the above mentioned effects on claims and liabilities in the payment system will arise – but why do they just continue to grow?

Why are the sellers of these bonds not using the proceeds to purchase other investment assets in Italy? Or putting it differently: What does this represent, if not capital flight?

It seems to us it doesn’t really matter that the purchases are conducted under the APP – if no offsetting capital flows into Italy take place subsequently, it still means that someone got out of Dodge and decided not to return.

Bottom Line

Claims that none of this matters and that there would be no consequences if Italy left the Eurozone and defaulted are as ridiculous as ever.

The harder people attempt to come up with reasons that none of this matters, the sillier they look.

Mike “Mish” Shedlock