A few years from now, when the euro crisis will be long over and when enough books will have been written about it, the topic that will have been most extensively analyzed is going to be TARGET2. It is going to be TARGET2 because this system is the most hideous financial construction ever created as well as one of the most profoundly misunderstood. As the TARGET2 imbalances have continued to grow, an equally growing coverage of the issue by the press and academia has failed to provide any new insight because each incremental piece of information is just an echo of a previous incomplete and erroneous analysis. So far, the entire coverage of TARGET2 has been narrowed down to the very basics: how central bank claims arise, how much they have risen in the last month and what is the risk associated with them should the euro fell apart. But while the description is usually correct, the interpretation of the facts surrounding TARGET2 is disturbingly flawed.
It is flawed because there can be no meaningful interpretation of TARGET2 without a simultaneous analysis of the intra-eurozone shifts in money supply and aggregate demand, capital formation and capital employment, the stability of the banking system and at the very end the euro’s chances of survival in its current form. In my next few posts I will try to set the facts about TARGET2 straight, starting by debunking the claim we see repeated all too often that it constitutes a back-door bailout mechanism of the eurozone’s periphery. A concise introduction to TARGET2 I have already included in a previous post (here).
As it is very well known, flows of TARGET2 claims reflect money flows to the opposite direction through the balance of payments of each country in the eurozone. What is also known is that aggregate demand is the product of money supply and money velocity. With the money velocity following a random walk, an expected decrease of a country’s money supply should also lead to lower expectations of aggregate demand and total output. The opposite should be expected when the money supply increases, although in that case price adjustments can be faster and real output growth slower.
Due to a number of reasons, the countries of the eurozone have developed structural current account deficits and surpluses, which at any given moment signal an expected shift of the money supply within the eurozone over the subsequent period, unless counterbalanced by an investment flow. But investment flow is in turn driven by expectations of aggregate demand. It is therefore natural that cross-border capital flows within the eurozone will tend to flow to the same direction as current account flows, whereas from a macro risk perspective it would be desirable that the flows would offset each other. The consequence of this is that as capital account surpluses are becoming increasingly necessary to offset current account deficits, the incentives for capital flight are rising at the fastest pace, thereby accelerating money outflow and dampening aggregate demand in the deficit countries. This behavior is simple and rational from an individual investor’s point of view, regardless of the investor’s domiciliation and regardless of the devastating effect it has to the economy.
The prescribed solution of internal devaluation as “the only way” to deal with the current account imbalances does very little to address this fundamental problem. Without any doubt wage cuts can contribute to the reduction of the production costs and boost competitiveness over time, but in order for these cuts to have any material impact on the current account they would have to be large enough to offset: a) an increase in funding costs caused by the decrease in the supply of loanable funds and increase in risk premia, b) a lack of private and public investment which by itself increases competitiveness and reduces production costs, c) losses of economies of scale, d) brain drain, e) rising operational risks by the disruption of public services, suppliers’ bankruptcies, striking employees etc. And this list does not take into account any measures that the surplus countries are going to take to retain their own competitive position once recession reaches their door through their own current account. In all, internal devaluation only manages to hurt aggregate demand before having any significant, permanent effect on the competitiveness of the economy.
Concurrently, the effects of the shift in money supply at the level of the real economy have a very direct impact on the solvency position of the deficit countries’ banking system and on their ability to extend credit and “create” new money. As I have explained before, in order for these banks to remain at the minimum probability solvent, their economies need to eventually run a balance of payments surplus and at some point reduce their TARGET2 liabilities to zero. However, the deficit countries are still struggling to balance their current accounts and they are not anywhere close to achieving a balance of payments surplus. And even if at some point they do, their economies will be already so damaged that this surplus will not matter anymore. The banks’ debtors will have already ran out of business defaulting on their obligations and the banks will have already gone bankrupt. In this toxic environment banks are unable to stimulate demand by extending credit to the economy and in contrary they are being forced to withhold credit so as to limit their exposure and contain potential losses.
The effect of the money shortage is even more clearly reflected in the fiscal balance of the deficit countries. A government has a very unique business model which allows it to raise revenue from any economic activity that takes place within its tax jurisdiction. With the reduction of the money supply and the slowdown in economic activity, wherever this occurs in the national economy, the government takes immediately a hit on its tax revenues and since it ultimately redistributes all its revenue, the hit is inevitably borne by the ones who are in greater need of its services and its support. Even though the government has some leeway to maintain a basic welfare system and provide support for the weakest social groups and its most important functions, as the economy deteriorates the need for support that the government has to provide rises as fast as its means to provide it are reduced. Needless perhaps to mention here again, but this is exactly the cause of the large and persistent budget deficits and of the inability of the deficit governments to refinance their debts.
And whilst everything is going from bad to worse in the deficit countries, the exact opposite scenario occurs in the surplus countries. The shift in the money supply leads to a boom in domestic demand. Capital flight from the deficit countries reduces borrowing costs encouraging investment. Government revenue rises and spending on welfare and public investment increases. Unemployment decreases and with wages becoming increasingly more competitive, skilled professionals are more enticed to flee deficit countries in search of better prospects in the surplus countries. The banks enjoy the boom too because asset prices increase and loan defaults diminish.
However none of this would be possible if each country had maintained its own currency, or even if the euro countries shared a fixed exchange rate system, because in both cases the countries’ money supply would be unaffected by international transactions. The case of a fixed exchange rate system in particular illuminates in the best way the fundamental flaw of the euro and is therefore very useful to consider how it would work when analyzing TARGET2.
In a eurozone with the euro as an accounting currency issued by the ECB, the 17 countries would maintain their own currencies making them convertible into euros on a 1-on-1 basis. This would imply a fixed exchange rate among the individual currencies too. In such a system interest rates would remain at very similar levels across the eurozone, possibly creating the same structural current account imbalances across the currency block. If the market did not finance these current account deficits, then the central banks of the deficit countries would have to use their foreign exchange reserves to prop up the domestic currency. At some point however, if the balance of payments deficits persisted, the deficit central banks would run out of foreign exchange reserves and would need to abandon the peg (like the Bank of England did in 1992 or the Central Bank of Argentina in 2002). In order for this fixed exchange rate system to be “irreversible” like the euro (sic) the ECB would need to step in to support the currency that is under pressure. How? By buying local currency denominated government securities. And it would have to do so in unlimited amounts, just like it does now with TARGET2. The crucial difference is though that in this case the money supply in the deficit country would not decrease and the country would not have to face a capital squeeze, which also means that the intervention of the ECB would be much smaller in size. The deficit government would borrow and raise money, money that it could use within some kind of strict conditionality of implementing measures necessary to restore the competitiveness of the economy.
A fixed exchange rate system would produce the same results with the current, common currency system if the ECB instead of government securities was buying the weak currency leaving it idle in bank deposits without permitting the deficit country to print any new money and stimulate demand. But this behavior would be irrational from the ECB’s side since it would most certainly bankrupt the very banks in which it keeps its deposits. The ECB and the eurozone countries would never participate in such a fixed exchange rate system. Yet, this is precisely what they got!
Analyzing TARGET2 within this context is critical in understanding why the euro crisis gets deeper as time goes by. Evidently the economic reality is exactly the opposite than the one that the media present or the one that the political and monetary authorities dare to address. On the basis of what I have described above, it should be crystal clear that the assertion that TARGET2 is the back-door bailout mechanism of the periphery is beyond ridiculous. TARGET2 is nothing else than the balancing accounting entry of the real, front-door stimulus the periphery provides to the core. The days of this mechanism are certainly numbered, since any alternative to the euro would create an economic environment in which the deficit countries would have any capital created with their money reinvested within their economy, just as it happens in any other country in the world.
I am patiently expecting that very soon the people in the deficit countries will become fully aware of the euro’s vicious self. Mass media propaganda and ignorance has done a good job so far keeping them misinformed and scared of the prospect of being “ousted” from the euro. When it will eventually be proven that their economic situation is just the result of this perverse monetary system, fear and despair will give their place to fury and the will for self-determination. At that moment, the ECB is going to approach their governments and ask them, even beg them to buy their bonds in whatever currency they are denominated. What should the governments respond then? Should they agree to “make good” on the TARGET2 liabilities they accumulated in order to bail out the core?
The debate will very soon begin.