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TARGET2: The flaw in the euro’s design

One of the good outcomes of the eurozone crisis is that it has given the opportunity to millions of European citizens to understand what a pile of financial jargon really means, like CDS, haircut etc. But people are still unaware of what TARGET2 is, because mainstream media have hardly any idea about it. This post is dedicated to it.

TARGET2 (short for Trans-European Automated Real-time Gross settlement Express Transfer system 2) is the international payment system for euro transactions operated by the European System of Central Banks (ESCB). It is the orifice through which all international intra-eurozone payments go through. And it is also the mechanism that the eurozone possesses to balance the balance of payments of the eurozone countries.

You read correctly. The balance of payments of each eurozone country is perfectly balanced. But doesn’t this contradict everything that I have explained so far? No. You will need to know just a little bit of accounting to understand why.

Let’s take two Eurozone countries again as an example, Greece and Germany, and let’s see what happens when a Greek bank receives an order from one of its clients to make an international payment of 100 EUR to a German bank. This payment would go through either the current account of the two countries (e.g. for the purchase of German goods by a Greek importer) or through the capital account (e.g. for the sale of securities from a German mutual fund to a Greek mutual fund). We will not record the movement of the good or the asset exchanged, just the money flows. We will track them down on the banks’ balance sheets:

The numbers in the brackets will guide you to read the diagram. The payment order of the Greek resident moves cash from a Greek bank account to a German bank account, from [1] to [2]. The payment goes through TARGET2 which notices that the net payments from Greece to Germany amount to 100 EUR. In order for the payment to be settled, an opposite flow of 100 EUR has to occur within TARGET2. This will be done with the Bundesbank recording a capital outflow towards the Bank of Greece.

The German bank faces a number of options but let’s assume for simplicity that it deposits the 100 EUR it receives at its account at the Bundesbank ([3] to [4]). The Bundesbank then records a claim to the Eurosystem (ES in short) of 100 EUR [5] which goes through TARGET2. The ECB stands in between the Bundesbank and the Bank of Greece receiving and sending a claim of 100 EUR ([6] to [7]). The Bank of Greece receives the claim [8] and provides the necessary credit to the Greek bank covering its funding shortfall ([9] to [10]).

In the way that TARGET2 operates, the balance of payments between Greece and Germany is balanced. The payment to the German bank went through either the current account or the capital account. It was balanced with a capital outflow from the Bundesbank to the Bank of Greece through the capital account, with the ECB intermediating between the two central banks.

The important “details” are highlighted with blue and red color. Among all balance sheet items shown, only the deposits of clients are part of the money supply of a country, marked blue. After the transaction is processed, the money supply in Greece has decreased (and so Greek residents have less money to transact with) and the money supply of Germany has increased (German residents have more money). Consequently, in money terms, the balance of payments between the two countries is not balanced.

Oxymoronically, the capital outflow from Bundesbank to the Bank of Greece is called a cashless payment while the loan to the Greek bank constitutes a liquidity provision of the Eurosystem to the Greek bank commonly called central bank money. There is a good reason to add the modifier “central bank” in front of “money”: it is not money! Money is what individuals, companies and governments use as a means of payment for the exchange of goods, services and assets; money is what employees receive as salaries and what investors receive as dividends or interest; money is what a government receives from taxes and what a pension fund pays a pensioner. Central bank money is not used by anyone: It is just an accounting trick, hot air filling the vacuum that international payments create on the banks’ balance sheets and on the balance of payments.

The only thing that connects and confuses central bank money with bank money (that’s how real money is called) is that they are mutually convertible on a one-on-one basis. This however means absolutely nothing about the value of central bank money. A euro of bank money can be converted into an infinite number of things. If you can buy a kilogram of potatoes with one euro, that does not turn potatoes into money.

The other important detail about TARGET2 is the loan from the Bank of Greece to the Greek bank, marked red. This is a unique form of capital: It represents a claim of the Eurosystem against the Greek banking system which was however not accompanied by a money outflow. It won’t be settled in bank money but it bears interest in bank money, equal to the ECB’s refinancing rate (currently 1%). This interest will ultimately be paid by Greek residents to German residents (because Greek residents will receive less interest on their deposits and German residents more interest, unless of course the German bank account belongs to a Greek resident).

Maybe it will help you understand why interest is charged if you consider the example from the point of view of the banks. The deposits of clients are liabilities from the banks’ perspective. When the German resident makes a deposit at his bank account, the liabilities of the German banking system increase. The Bundesbank then has the right to send a claim to the Bank of Greece seeking “compensation”.

But this view neglects to identify the value of bank money as a liability. In a previous post I put a brief note that the credit that the banking system provides in an economy can theoretically be repaid in full at all times by the amount of money that the banking system creates, simply because they are both created in the same accounting entry. When the money supply of a eurozone country is reduced through the balance of payments, full repayment of the provided credit in the country becomes mathematically impossible. Conversely, if the money supply increases then total credit can be fully repaid and also leave a surplus of money in the country.

Back to our example, the total credit of the Greek banking system to Greek residents has remained constant but the total money supply has decreased by 100 euros. This makes the repayment of 100 euros worth of credit immediately impossible. The loan of the 100 euros is thus a severely toxic liability for the consolidated balance sheet of the Greek banks because it erodes the value of their assets. Since not all credit can be repaid, some of the bank loans, more than the banks would expect, will turn sour. The longer that the imbalance between credit and money supply lasts, the bigger the credit losses within Greece will be. If the Greek bank recognizes that it should not accept this loan and it should also not accept another Greek bank to receive this type of loan. But if it does not accept it then it cannot execute the payment that the client has ordered and will be forced to declare bankruptcy immediately. Hence, the way that the Eurosystem currently works puts inevitably the Greek bank between a rock and a hard place. At the same time, even if the liabilities of the German banks have increased, the probability that all of their assets will be timely repaid increases, and therefore the value of their assets increases.

Imagine now a situation where the current account and the capital account of Greece remain in deficit (in money terms) for a very long time. Money will keep leaving Greece till at some point there will be no money left in the country. People will be totally unable to transact and the economy will come to a complete halt. By that time, the Greek banks will have plenty of central bank money in their liabilities. But what will the value of their assets be? Zero. If the Greek economy does not have money, then the financial assets of the Greek bank cannot be repaid and their monetary value (not the fundamental value) will be nil. The balance sheet of the Greek bank will be a giant balloon, with worthless euro assets on the left side and plenty of funny money on the right side.

This is only a hypothetical scenario of course. People in Greece will very soon find themselves in need of money also to execute transactions among themselves. They will only be able to get it from abroad by selling goods or assets. If the prices of Greek goods and assets drop, then they will be able to receive the money they need and be able to repay the central bank money through the channels of TARGET2.

But on the other side, German residents can notice that the money supply in Greece is decreasing. They don’t have any reason to buy or hold  now an asset that derives its value from money received from the pool of the Greek money supply. And since Greeks will need the money more and more as the time goes by they have no incentive at all to buy before the price of any good or asset drops to a ridiculously low level, way below its fundamentals. The best strategy then for them is to wait and keep hold of their cash.

Think now how vicious the Eurosystem environment is for the banks and the government of Greece in this example. If the country finds itself unable at some point to fund its current account deficit with private funding (and so its balance of payments turns into a monetary deficit) only the government can step in and save its economy from falling into a deflationary tailspin. How? By borrowing from abroad and running a budget deficit. This is the reason that the Greek government had no other option but to accelerate its borrowings and spend it in a (vain as it turned out) attempt to save the Greek economy in 2007-8; and also the reason that the Irish government had to provide unlimited guarantees to all deposits of the Irish banks during the same period. The government in this case is forced by the system to borrow to ensure the country’s solvency.

If the government eventually fails to rejuvenate the economy, then the Eurosystem can only provide toxic loans to the country’s banks, with the expectation that the residents of the country will at some point sell goods or assets abroad, bring money in the country and allow the banks to repay the central bank loans. But this will happen once the prices of Greek products or assets decrease and/or the German prices increase. Price divergence in different countries is then necessary for the system to keep rolling.

In short, if a eurozone country finds itself with a structural monetary deficit in the balance of payments, the Eurosystem itself requires that the country either resort to public borrowing or to deflation to avert catastrophe. Both are options that the Eurosystem does not allow the countries to use. Go figure.

And the lunacy does not stop there: in order for the Eurosystem to mitigate its credit risk (potential losses are born by the entire ES, not just BoG), the loan that the Bank of Greece gives to the Greek bank needs to be collateralized. The only eligible securities that the Greek bank can pledge as collateral and has plenty of or can easily acquire are Greek Government bonds. Yes, this loan is eventually collateralized with a security that loses its value upon the issuance of the loan. And as these loans increase, the value of the collateral decreases!

In subsequent posts I will revisit TARGET2 but before closing this one I will present you with the following table. It shows the TARGET2 claims of a few selected countries of the eurozone and will give you a very good idea why the peripheral countries have found themselves in the current condition. Data are from 2010 year-end so you can expect that the imbalances have since then increased sharply.

The first column shows the net claim against or towards the Eurosystem (numbers [8] and [5] in the previous diagram). The next columns give an indication of the magnitude of each claim for each country. The claims are compared to the total assets of each central bank and the country’s GDP. The last column shows the per capita TARGET2 asset or liability.

In case you need some help to understand the numbers, just look at the outliers. Ireland has a cash shortfall of no less than 145bn euros which will be covered with equally worth sales of assets or goods abroad; Greece has a shortfall of 87bn euros; Germany has a surplus of 325bn euros, that’s the bailout it received; and Luxembourg has a surplus of 68bn euros, mostly thanks to “tax shy” deposits of foreign residents.

In relation to the countries’ fundamental data, the amounts are enormous and display clearly the mess that the Eurosystem has caused. At some point, some people in Frankfurt have to understand that it is not the European governments that failed, but the Eurosystem itself. Fixing the eurozone crisis is and should be solely their responsibility.


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