_ Prof. Dr. Stefan Kooths. Research Director, Business Cycles and Growth, Kiel Institute for the World Economy (IfW Kiel). 10. June 2021.*
Persistent and pronounced Target-2 balances are an expression of massive balance of payments financing by the Eurosystem. As a result, private cross-border financing flows are replaced by those of the central bank system, whereby the mechanisms of the capital market are suspended. This distorts the allocation of new capital in the European currency area (current service transactions) and allows capital flight. As a result, with the help of the Eurosystem, investors can swap assets from the crisis countries for assets from the core countries at prices for which they could not find an exchange partner on the market. This also includes the repatriation of previous capital exports, for example from Germany (reversing previous capital flows). In this way the principle of liability is damaged and the risk pricing is distorted. Without monetary balance of payments financing, on the other hand, the capital that previously flowed into the crisis countries would be “locked up” there and could only flow back into the countries of origin with the acceptance of corresponding price reductions.
Losers and winners of the Target-2 problem cannot be tied to national borders. The distortion of market mechanisms associated with monetary balance of payments financing is a regulatory problem for the entire currency area. To the extent that the Eurosystem primarily refinances assets from the crisis countries, it takes additional risks on the central banks’ balance sheets. These risks are essentially shared between the national central banks in accordance with the ECB capital key. In addition, the purchase of assets does not say anything about the origin of the previous owner and thus about the ultimate beneficiary. If, for example, the Italian central bank buys Italian government bonds from a German life insurance company, which transfers the proceeds to Germany, this would be reflected in the Target-2 balances of Germany (surplus) and Italy (deficit). As a result, however, German investors were relieved of a risk by the Eurosystem. The line of conflict in the Target-2 problem thus runs primarily between EMU taxpayers (and money users), who are burdened with additional risks, on the one hand, and investors who are relieved of risk positions, on the other. A purely market-based solution to the European debt crisis would have led to clearer write-downs, which, in accordance with the liability principle, would have had to be largely borne by investors from the euro area and the rest of the world.
The swelling of the Target-2 balances could only occur to this extent because monetary policy was drastically loosened and this resulted in asymmetrical money creation in the euro area. A mere flight of liquidity (relocation of credit positions) from banks in the crisis countries to banks in the core of the euro area would be reflected in a one-off increase in Target-2 balances, but would not be classified as a problematic balance of payments financing (on the contrary, it could even be considered an expression of the Europeanization of the banking system ). The liquidity outflows from the crisis countries (in which liquidity flight, capital flight and – initially – current account financing were reflected), was, however, repeatedly offset by the creation of new central bank money in the crisis countries. Again, this was only possible because, in the course of the full allotment policy, collateral requirements were also reduced. In addition, there were additional liquidity injections, which were also mainly used by banks in the crisis countries. As a result, money creation has shifted asymmetrically to the crisis countries of the euro area, which only made it possible for the Target-2 balances to swell on the scale observed. Because a euro that is not created in a country cannot flow away from there.
In order to solve the Target-2 problem, monetary policy must be able to operate in a robust banking system. The turning to the monetary policy course that ultimately caused the emergence of the Target-2 problem was primarily due to concerns about the stability of the banking system. Without the intervention of the Eurosystem, the outflow of liquidity from the crisis countries would have led to bank failures in the crisis countries, which would also have massively affected the core countries due to the financial interdependence. In order to effectively counter the Target-2 problem, the resilience of commercial banks in the euro area and, in particular, the national segmentation of the banking markets must be overcome. This primarily includes overcoming the nexus between commercial banks and the solvency of the states in their respective home countries. There is an urgent need to relieve monetary policy of the responsibility for the stability of the financial system, otherwise the mechanisms on the capital markets (especially the liability principle) will remain permanently diluted, while at the same time the boundaries between monetary and fiscal policy will be blurred. Important proposals in this regard would be, in particular: 1. that the Capital Markets Union be systematically deepened in order to reduce national fragmentation in the European commercial banking market and to increase private cross-border risk sharing; 2. That the euro member states are deprived of their role as debtors, so that banks have to hold equity in a risk-adequate amount to hold their government bonds, and large exposure ceilings limit the links between individual banks and states. An automatic extension of the term of the bonds in the event of a default will also be stipulated in the investment conditions for government bonds.
Unwinding the Target-2 balances deals with symptom but does not solve the underlying problem. The transfer of assets to replace Target-2 deficits does not improve the risk exposure of the surplus countries, on the contrary, it would completely expose them to the default risk of an individual deficit country. A transfer of assets to which this risk does not apply, on the other hand, is likely to be subject to narrow limits. The suggestion that the Bundesbank, for its part, should act as a buyer of assets in other euro countries would also not be expedient. The euro liquidity newly created in the course of such operations would probably flow back to Germany immediately, as long as the reasons that previously existed for the creation of Target-2 positions have not been resolved. As a result, the Target-2 balance would remain largely unchanged.
The Target-2 problem cannot be solved overnight and requires a monetary consensus in the euro area. A return of the Eurosystem to first-class collateral standards and a reduction in the excessive supply of liquidity so that the liquidity distribution in the euro area takes place again via market mechanisms is decisive for a reduction in the Target-2 positions (or their risk-related mitigation). This presupposes an overall robust European banking system. To the extent that this is successful, Target-2 positions will be reduced by themselves in the course of market transactions. However, this will only be done gradually. The prerequisite for this is a common monetary policy understanding of the conditions of a hard currency regime, which in particular includes the question of the strict ban on monetary state financing. If such a consensus cannot be reached between the EMU member states, the future of the euro area would be seriously endangered. Because institutions can only ever be as stable as the consensus that supports them.
Kooths, S., und B. van Roye (2012): Nationale Geldschöpfung im Euroraum: Mechanismen, Defekte, Therapie. Kieler Diskussionsbeiträge 508/509, Kiel.
Fiedler, S., S. Kooths und U. Stolzenburg (2017): Target (im-) balances at record level: Should we worry? In-depth analysis for the European Parliament, Committee on Economic and Monetary Affairs, Brussels.
Gern, K.-J., S. Kooths und U. Stolzenburg (2019): Euro at 20: The Monetary Union from a Bird’seye View – A concise critical assessment. In-depth analysis for the European Parliament, Committee on Economic and Monetary Affairs, Brussels.
The views expressed in this publication are exclusively those of the author and do not necessarily reflect the position of the MIWI Institute or other mentioned or affiliated organizations and persons.