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Eurozone Debt Imbalances Aren't Sustainable Yet They're Unfixable Due to Germany's Constitution

What cannot go on forever, won't. But what's the resolution?
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Target 2 Balances 2021-05

What is TARGET2?

TARGET2 is the real-time  gross settlement (RTGS) system owned and operated by the Eurosystem. 

The use of TARGET2 is mandatory for the settlement of any euro operations involving the Eurosystem. The Eurosystem consists of the European Central Bank (ECB) and the national central banks of the 19 European Union member states that are part of the Eurozone.[2] Participation in TARGET2 is mandatory for new member states joining the Eurozone.

Under the TARGET2 system all debt is treated alike even though it is a measure of capital flight. The ECB disputes my last statement but it is what it is. 

A Table of County Codes shows Spain (ES), Italy (IT), the ECB itself, and Greece (GR) have payment imbalances with Germany (DE), Luxembourg (LU), Finland (FI), and Ireland (IE).  

Fundamentally Flawed

Target2 is one of the fundamental flaws of the Eurozone. The ECB treats all of this country-to-country debt equally, as if it can be paid back.

Germany is a creditor to the tune of over €1 trillion. How is Italy supposed to pay creditors €493 billion, Spain €502 billion, or Greece  €91 billion, primarily to Germany? 

Cascade Risk

Due to guarantees, should Italy leave and default, the remaining countries would be legally required to share Italy's debt responsibilities.

For example Spain, already a massive debtor, would be responsible for a huge share of Italy's liabilities given Spain's weight in the EMU.

Cascade default risk is high. Alternatively the ECB would violate its rules and paper over the mess.  

Euro Itself is Fatally Flawed

These TARGET2 imbalances keep growing because the Euro itself is fally flawed. 

Due to productivity issues, cultural issues, and pension promises, there is no single interest rate that makes any sense for the 19 EMU states: Austria, Belgium, Cyprus, Estonia, Finland, France, Germany, Greece, Ireland, Italy, Latvia, Lithuania, Luxembourg, Malta, the Netherlands, Portugal, Slovakia, Slovenia, and Spain.

ECB Micromanagement Mess

Despite the impossibility of it all, the ECB attempts to micromanage interest rates while insisting on a target rate of 2% inflation with no way to properly measure inflation.

Not only is there no single interest rate that makes any sense, there is no way to average inflation rates that makes any sense. 

Core Inflation Rates

In an effort to keep all the balls in the air, the ECB has purchased 40% of all the bonds available. 

Of course, Germany is howling all the way. 

Understanding the History

Political Vanity Project

In response to Brooks, Jake Pugh responded 

The Eurozone economy and the single currency is totally incompatible. It's a political vanity project which delivers low growth and economic poverty to the most disadvantaged in society.

I agree with Pugh, especially as implemented. But what do we do about it?

Wrong Solution

S. Boezio Tweeted to Robin Brooks 

What periphery needs is the old, very effective, currency devaluation. Their own currency..as simple as that... till then, there will be a continuous divergence among economies.

How many times have Greece and Italy had currency devaluations? Did it ever fix anything?

Not Only Wrong, Impossible

Devaluation never has and never will fix fundamental flaws. If devaluations and credit writedowns fixed anything, why does Argentina repeatedly devalue? 

Within the Eurozone, devaluation is not even possible. 

Greece, Italy, Spain, and Germany are all on the Euro. It is impossible for any country in the Eurozone to stay in the Eurozone and simultaneously have a currency devaluation. 

Correct Solution

Greece, Spain, Italy, (peripheral Europe in general) need pension reform, work rule reform, and debt writeoffs.

All three countries resist the necessary reforms.

Even with the correct solution, without significant debt forgiveness, it would take decades and lots of patience to restore balance.

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Capital Flight

Fear of debt writeoffs is one of the drivers of capital flight. 

It's crazy to have money in Italian banks now just as it was crazy in 2005 to have money in Greek banks.

Again, the ECB denies the above, but the ECB cannot come out and say Italian banks are at risk anymore than it could say prior to the Greek crisis that Greek banks were at risk.

This is as clear now as it was then (or should be). Yet ordinary people do not see it. Businesses and the wealthy do see it, which is why these imbalances (and capital flight) keep growing. 

Eurobonds

Peripheral Europe embraces eurobonds as the solution. Curiously, French President Emmanuel Macron is also on board with the "more Europe" idea and he is now fighting for his political life.

Eurobonds are a form of debt commingling. 

Germany's constitution prohibits debt commingling and that is the source of endless disputes. But it is not just Germany who resists. 

Q: Who else resists Eurobonds? 
A: Look at my lead chart for the general answer: Creditors.  

Can This Go On?

No. It's unsustainable. 

But the title of this post (read it again) it reminds me of the trap question: What happens when an irresistible force meets an unmovable object? 

If you do not know the answer, think about it for a second.

Here goes: The question is illogical. If there is an irresistible force then by definition there is no such thing as an unmovable object, and vice versa. 

What's the Resolution?

  1. Debt Commingling and Forgiveness With Reform
  2. Debt Commingling and Forgiveness Without Reform
  3. Cooperative Breakup With Reform
  4. Cooperative Breakup Without Reform
  5. Uncooperative Breakup With Reform
  6. Uncooperative Breakup Without Reform

We do not know the resolution, nor the time frame, but one of the above is going to happen because there are no other reasonable choices. 

Voluntary reform alone would take too long and is currently fought tooth and nail.  

Creditors will have to insist on reform, but coupled with forgiveness or a cooperative breakup reform might then be politically feasible.

Creditor's Choice

Germany and the creditors will forgive debt or countries like Italy and Greece will eventually decide they have had enough and leave the Eurozone.

Under options 1 and 2 there is no Eurozone breakup. 

Options 1 and 3 address the issue albeit with hugely different short-term consequences. 

Options 2 and 4 are kick-the-can efforts that will buy some time but ultimately fail again. 

Option 5 would eventually fix the problem but would result in high inflation, perhaps hyperinflation in the interim. With immediate strong reforms and a lot of short-term pain, such inflation might conceivably not last long. 

Option 6 is the path to chronic and lasting or repeated hyperinflation.

Creditors Guaranteed to Pay a Price

It's important for creditors to understand that under any option, the creditors are guaranteed to pay a price

The creditors either forgive debt willingly or there is a default by the debtor nations. 

The creditors' primary choice is forgiveness or default, not avoidance of pain

Creditors get to choose. Unfortunately, they do not seem to understand it's impossible for them to avoid pain.

Explaining the Lack of Progress

Place Your Bets

Greece almost left the Eurozone but Italy leaving is a better bet now. Euroskepticism in Italy is on the rise.

The sad thing, and as we have seen time and time again, default or restructuring in without lasting reform fixes nothing. 

Two options, #1 and #3 fix most of the problem.

However, the problem with resolution #1 is that countries remain under control of flawed ECB and TARGET2 mechanisms. 

The Euro, ECB, and TARGET2 all remain poorly formed constructs. In addition to any resolution above, TARGET2 must be addressed as part of the necessary reforms.

Mish

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