_ Prof. Dr. Philipp Bagus, Universidad Rey Juan Carlos. Madrid, 24. July 2021.
Target-2: Fundamentals and Understanding
There are very different opinions about the Target-2 system (hereinafter referred to as T2). In the extensive and controversial debate, two main camps face each other. Both sides of the debate make valid arguments from their point of view. However, I think that they do not yet fully grasp the core problem, so that some introductory explanations are in order.
T2 a payment system for transfers within the euro zone. The target balances measure the net money inflows and outflows of a country in the system. If more transfers are made from the euro zone to a country than are sent from it to the euro zone, the result is a positive target balance; in the opposite case a negative one.
In the following three examples of the creation of a target balance are presented, which will also be addressed in the policy note further down.
First: capital flight
If citizens of a country no longer trust their banks or their government, as happened in the case of Greece in 2015 in particular, and doubt whether their country will remain in the euro zone, they can make a transfer to a country they consider safe. There they can find assets such as real estate, which then tend to rise in price. Such a transaction is recorded in T2 and, like a “fever thermometer” (FDP 2019), reflects the flight of capital and thus confidence in the preservation of the euro zone.
The flight of capital is therefore “registered” in T2. However, the registration of processes that have already been completed and cannot be reversed. The flight of capital has taken place. The purchased property has already risen in price. The owner has changed.
Second: the bond purchase program of the ESCB
The Public Sector Purchase Program (PSPP) is mentioned in the debate as a further reason for the increase in target balances. The ESCB has been buying securities, especially government bonds, since 2015. Each central bank buys the bonds of its own government. The Bundesbank buys German government bonds and the Banca d´Italia buys Italian government bonds. If the Banca d´Italia now buys an Italian bond in Luxembourg or Germany, where many fund companies are based, a target liability arises for the Banca d´Italia and a target claim for the Luxembourg central bank or the Bundesbank.
When the ESCB creates new money and buys government bonds with it, there is a redistribution. The first to get the new money, the bond sellers, benefit. If prices rise (or fall less than they would otherwise have), other market participants lose. The redistribution effects of money creation are also called cantillion effects. In this case, the prices of bonds rise, interest rates fall and, above all, the debtors benefit, above all the governments. The latter no longer have to work as hard as they did before on structural reforms. In fact, reform projects in the euro zone have stalled since 2015.
If the bond purchases now take place abroad, this redistribution is also reflected in the Target2 balances, and indeed to a relevant extent because of the extent of the ESCB purchases. In this second example, too, the T2 balances reflect part of the real economic (redistribution) processes that have already taken effect and are irreversible.
Third, redistributive money creation. As a final example, T2 balances are mentioned here, which represent a redistribution within the euro zone. In the euro zone, several central banks have the opportunity to create the same currency and thus to use up a common resource, namely the purchasing power of the euro. Governments can indirectly use this opportunity. Since this mechanism is a tragedy of the commons, this connection has been referred to as the “tragedy of the euro”.
Every euro zone government has the opportunity to run deficits in order to buy votes and finance them with the issue of government bonds. The (national) banks can buy these government bonds and deposit them with their central bank as collateral for refinancing loans. This gives them new central bank money on the basis of which they in turn can create new book money. As a result, prices tend to rise; the purchasing power of the euro (the commons resource) tends to fall, not just in the deficit country but in the entire euro zone, externalizing part of the cost of the national deficit to foreigners.
We are dealing with monetary redistribution in this mechanism. The countries in which relatively more base and book money is created, and in which the price level rises first, will begin to import from the still cheap foreign euro area and pay with the newly created money. There are permanent current account imbalances financed by the printing press.
Let us assume that a Greek company receives a new loan from its house bank, which in turn refinances itself with the Greek central bank with Greek government bonds as security. With the new loan, new money is created. If the company now buys a tractor in Germany with the new money, there will be a transfer from Greece to Germany. Greece’s T2 liabilities are increasing and the Bundesbank’s target claims increase in line with the amount of the tractor purchase.
Until 2007, German investors (especially banks) invested in countries with relatively higher levels of money creation such as Greece, Italy or Spain, so that the T2 balances offset each other because a private transfer from Germany to the south took place.
From 2008, however, the target balances rose because private investments in the south collapsed. So, if a Greek company imports goods from Germany today and finances itself with newly created money without compensating Greek goods exports to Germany or German investment payments to Greece, the T2 balances rise.
In this case, the T2 balances reflect the monetary redistribution that flows from Germany to Greece. In other words, in this third example, the T2 balances can be interpreted as a measure of monetary redistribution in the euro area. However, here too, the redistribution has already taken place when the balances appear.
The tractor is in Greece without any Greek goods or services flowing to Germany in return. A T2 claim appears in the Bundesbank’s balance sheet, but it is not due and cannot be collected.
In fact, it is worthless. From a real economic point of view, it is already too late when the tractor is exported and an unrecoverable claim has arisen.
From an economic point of view, the target balances are not loans. Loans always have a term and can be called due, while this is not the case with the T2 balances. Loans are also the result of a conscious decision by a lender to transfer control of a thing to the borrower for a certain period of time. However, the Bundesbank does not consciously decide to grant a loan, but only processes the payment transactions.
Since it is not a question of credit, the T2 claims must be viewed as grant from an economic point of view. A “loan” with no term is a grant. The T2 claims also do not represent German savings because they cannot be collected. From an economic point of view, the tractor is being given away.
Assuming that there are no imports from or investments to Greece to compensate for the T2 receivable, the German economy only receives an uncollectible receivable from Greece as “consideration”, which bears fictitious interest but does not result in any payment. Therefore Hellwig (2018, p. 360) writes correctly: “If you look closely, the current value of the Target claims is zero.”
Target 2 risks
According to the above, the economic effect has already happened when the T2 balances appear. However, there is a risk in a steady increase in T2 balances.
So are the existing T2 balances a risk that would have to be capped, as Fuest and Sinn (2018, p. 22) suggest?
Hellwig (2018b, p. 348) argues correctly that a central bank that liabilities in foreign denominated currencies can never become insolvent. Bank notes and bank deposits with it are liabilities that it creates itself and can therefore be set to zero. Because there is no (no longer) an obligation to redeem.
So are central bank book losses irrelevant? Is the only danger in a reduction in the central bank’s profit distribution? Hellwig (2018b, p. 379) argues that book losses from T2 claims are “ultimately irrelevant”. It is correct that in an uncovered paper money system the liabilities in its own currency do not oblige a central bank to do anything and that the central bank cannot become insolvent through this. Today’s central bank has no real liabilities. But it does not follow from this that their assets (in relation to the base money spent) are irrelevant.
The quality of a central bank’s assets is important to the quality of the currency it issues.
The truth of this claim is illustrated by a simple example. Suppose a central bank sold its gold reserves and bought Venezuelan bolivares with the proceeds. This asset swap would reduce the quality of the currency issued by the central bank. This is because the average quality of the assets that can be used to defend the currency decreases.
A central bank can sell high quality assets in the markets against their currency to support them. The quality of central bank assets is also relevant in the event of a currency reform, for example as a result of the euro leaving or collapsing.
If the average quality of the central bank’s assets that match the liabilities (base money) falls, then the quality of a currency also decreases. If the assets suffer losses and, for example, the market value of the Venezuelan bolivares falls to zero due to hyperinflation, then this development is not irrelevant; even if it is correct that today a central bank cannot default in its own currency.
The same applies to losses on T2 claims. T2 receivables are poor quality assets because they are irrecoverable, illiquid and at high risk of loss if the euro collapses / exits. It is therefore problematic if a large proportion of the Bundesbank’s assets are T2 claims.
If the euro collapses and central bank assets lose value, a loss of confidence in the currency cannot be ruled out. Unredeemable paper money currencies are based on the trust of users and this trust could get a decisive blow from the dissolution of the T2 claims, even if the real economic loss has already occurred.
Reduction of the T2 balances
Various events can reduce the T2 balances.
- The flight of capital could be reversed. One possibility to achieve a reversal of capital flight is centralization, debt pooling and transfer union in the euro zone. This option implies some cost. The redistributive effects would be enormous and at the expense of German citizens. Furthermore, there would be a great moral risk to have citizens of other countries pay for their own debts. A very inflationary euro would result in the long term.
- Private investments could flow from the T2 creditor countries to the T2 debtor countries. This possibility requires the deficit countries to become more attractive, and above all cheaper. That would require painful structural reforms in these countries. However, the ECB’s policy and monetary redistribution, which is reflected in the T2 balances, oppose this.
- The monetary redistribution is reversed. More new money is created in the T2 receivable countries than in the deficit countries, which makes the competitiveness of the receivable countries so bad that payment flows are reversed. In that case, Germany would have costs in the form of higher credit creation and the associated distortions, as well as in the form of a deterioration in international competitiveness.
It follows that the T2 balances of Germany alone can only be reduced at high cost without the help of other countries. With insight and appropriate reforms in the deficit countries, the T2 balances could of course be reduced. But this option is not in German hands. This is countered by the self-interest of these countries and the incentives created by the ECB for monetary redistribution, which are reflected in the T2 balances.
There are various measures to remedy the causes behind the T2 imbalances, which are suitable to varying degrees.
First, one can call for a deepening of the Capital Markets Union. The Treaty of Rome ensured the free movement of capital in the EU. Free movement of capital can therefore hardly be meant by a capital markets union.
A different risk assessment is to be welcomed from a market economy point of view. With different risks of loss resulting from different fiscal responsibility of the member states, their deficits, debt levels and solvency of banks and companies, different interest rates result. This “fragmentation” arises from the expectation that banks will be bailed out by their own states.
Communicating risks and debts would reduce capital flight (see above) and fragmentation and reduce T2 balances. But it also means high costs in the form of moral risk and a redistribution at the expense of the more solvent states and banks. In addition, a “capital market union” does not mean a fundamental limitation of monetary redistribution (tragedy of the euro), but rather the incentive to pursue it more intensively, since risks are communitized.
Another proposal to limit the T2 balances aims at depriving states of their privilege as debtors and is therefore a step in the right direction. Today government bonds are considered risk-free by banking regulation. The deprivation of privilege would require banks to hold more equity. This would reduce the banks’ credit creation potential. The interest on government bonds would rise because they would be less attractive. Limiting credit creation could reduce the T2 balances; at least their rise would be slowed down.
The higher interest rates on government bonds would also increase the incentives for structural reforms in the deficit countries and could thus reduce the T2 balances.
It should not be forgotten that the haircuts for government bonds in the ECB financing business are lower than for other bonds. This privilege in haircuts must also be questioned if the aim is to deprive states of their privilege.
The requirement for equity coverage for government bonds in an amount commensurate with the risk is in itself a good idea in order to prevent excessive debt. However, calculation is difficult. The risk of default on government bonds depends on the solvency of the state and is expected to bail out its banks. The default risk of government bonds is therefore dependent on the solvency of the banking system that is supported by this state. If a low default risk is assumed, more government bonds can be bought by the banks and the default risk is reduced. If a higher risk is assumed, only fewer government bonds can be bought by the banks, which actually increases the risk. Only a complete unbundling of states and banks would allow risk-adequate (and non-privileged) pricing. Such an unbundling would require a radical restructuring of the system.
Another requirement is to rule out bailouts. This is to be welcomed if one wishes to encourage responsible behavior. However, it is not clear why this measure should reduce T2 balances. Rather, if it is implemented, capital flight should increase and thus increase the T2 balances.
The political incentives are geared towards a bailout, so that politicians are unlikely to adhere to any rescue bans in an acute crisis. In the case of Monte dei Paschi, the Italian government defied the spirit of the law and saved the bank with taxpayers’ money. Instead of issuing bans that nobody will adhere to in a crisis, it would be more productive to eliminate the basis of bailouts; namely the partially covered banking system and its interdependence with the states. A change to a precious metal-backed sovereign money, such as a pure gold standard, would also have the advantage that the T2 balances would automatically be deposited with precious metal.
Furthermore, one can demand that in the event of a euro exit, the T2 liabilities are converted into euro bonds. If adhered to, this measure would limit losses from T2 claims. However, it is not clear why this measure would reduce T2 balances today. A regulated exit procedure could even make the possibility of an exit appear more likely and encourage capital flight.
From the point of view of the remaining euro members, however, the implicit deposit of the T2 balances would be a hedge and currency quality improvement.
Nevertheless, political negotiations about this measure will take place in the event of an exit and the exiting state may not want to and be unable to pay due to an expected devaluation. Backing the claims with gold today would eliminate this political risk.
Another demand, which changes the majority rules to a qualified majority when it comes to taking unconventional monetary policy measures, points in the right direction if one wants to limit the redistributive money creation (and the tragedy of the euro) and thus the T2 balances. The requirement for a qualified majority makes unconventional monetary policy measures less likely.
Liberal economic views on the Target-2 problem
As mentioned earlier, the underlying problem lies in the tragedy of the euro and not in the fragmentation of the banking sector. The fragmentation is due to the differing solvency of the states that became indebted as a result of the tragedy of the euro.
A further socialization of private investment risks is explicitly rejected in the application, at the same time a “capital market union” is sought, which leads to the question of what exactly this “capital market union” should consist of.
Closing the loophole in the Bank Recovery and Resolution Directive is a worthwhile goal, although from a political and economic point of view this loophole is no accident and is difficult to close.
If one rejects a limitation of the T2 balances because this could jeopardize the “free movement of payments”. However, a reform of the BRRD such an upper limit on T2 balances would indirectly limit the tragedy of the euro. A Greek bank can no longer create new money to finance the famous German tractor.
A change of perspective is needed in the T2 discussion. As made clear in the introduction, the T2 balances are only a symptom of the underlying problem of monetary redistribution.
There are economists who claim “purely market-related TARGET2 balances would be unproblematic”. Since we are dealing with a state monetary and central bank system with a monopoly on the creation of base money, T2 balances can never be market-related. In the realm of money and money creation, we are dealing with a state monopoly and not a market.
There is no standard for a moderate or optimal amount of money. It is a planned economy arrogance to believe that one has knowledge of an optimal amount of money.
In addition, it is not clear why a “Capital Markets Union” should lead to a more efficient allocation of capital and “cheaper financing of European companies”. For one thing, interest rates are artificially low. A normalization of the interest rate level upwards is desirable and no further interest rate cut; this is the only way to correct distortions.
On the other hand, a socialization of risks (if that’s what the Capital Markets Union means) does not mean a more efficient allocation of capital.
For an efficient capital allocation in a market economy only the entrepreneurs are responsible, who are not hindered with given free movement of capital. When opportunities for profit arise from fragmentation, entrepreneurs are able to track them down.
One should limit the risk of loss from monetary redistribution and T2 balances. Further steps need need to be taken.
Liberal-conservative approach for solving the Target-2 problem
The demands of the party “Alternative for Germany” (AfD) are going in the right direction.
The main problem is correctly articulated. There is no protection “against a sell-off of German goods through asymmetrical money production.” That is indeed the crucial point.
There is only an indirect limitation of asymmetrical money production via the Stability and Growth Pact (or the Fiscal Pact) and the inflation target of the ECB (as well as its refinancing conditions). However, both limits can be changed or not respected
It could be added that in addition to money creation and capital flight, the bond purchase program is also a reason for the rising T2 balances, whereby these balances can also be interpreted as capital flight (see above).
The T2 balances were not created by “regulatory obstacles”. A capital markets union ignores the underlying problems. If by the Capital Markets Union it is meant that small and medium-sized companies get better access to the capital markets through whatever measures, then the T2 balances could even increase as a result, because probably more Greeks want to invest in small German companies than vice versa. Even all measures that increase the intergovernmental flow of money, such as defragmenting the banking sector, do not automatically mean a decrease in T2 balances.
The AfD correctly warns of the costs and risks of a banking union. It is also correct that if the euro persists due to the interest pooling, there is a risk from the T2 claims for the Bundesbank. A negative equity capital does indeed endanger the “independence” of a central bank.
A very interesting and elegant proposal is that of buying gold from the Bundesbank in other euro countries to reduce the T2 claims. It should be added that the Bundesbank could also exchange its T2 claims for gold directly with the ECB. However, the Bundesbank is formally “independent” of direct instructions from parliament and the government. The initiative here would have to come from the Bundesbank itself.
Securing target claims upon exit involves the risk (see above) that with direct coverage, as proposed by the AfD, it would disappear. Going even deeper, the asymmetrical money creation itself should be limited by full coverage and, for example, a pure gold euro.
The most important requirement is the deposit of target liabilities with valuable, marketable collateral, taking haircuts into account. These are to be transferred to the ECB and from there to the central banks with T2 claims. Security should be used starting with gold and then with decreasing creditworthiness. If the central banks’ assets are insufficient, the collateral from refinancing transactions should be used. In this case, I cannot assess whether the use of collateral from refinancing transactions does not cause legal problems.
In any case, one must ensure that a central bank should refrain from bringing in government bonds of its own state as collateral for the T2 liabilities, as these can become worthless if the euro is left or the bank collapses. Only gold and gold claims should be allowed as security and ideally a gold euro should be introduced immediately.
Conclusion: The AfD demands are a step in the right direction if one wants to avert risk and harm from German citizens and money users, but they also fall short of the mark. Because the T2 balances are only a reflection of the underlying problem of asymmetrical money creation, which with a view to the T2 balances can only ever be limited indirectly, either through upper limits or through the requirement of collateral. If the interests of German citizens, especially savers and money users, are secondary and who are primarily interested in the realization of a transfer union, monetary redistribution and the T2 balances are unproblematic anyway.
AfD (2019), Targetforderungen unabhängig vom Fortbestand des Euros besichern, Bundestagsdrucksache 19/9232.
Bagus, P. (2009), The Quality of Money, Quarterly Journal of Austrian Economics, 12, no. 4, 41-64.
Bagus, P. (2011), The Tragedy of the Euro, The Independent Review, 15 (4), 563-576.
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Bofinger, P. (2018), Sind Target-Salden eine „Druckerpresse“ für Kredite?, Handelsblatt vom 19. August 2018.
Eisenschmidt, J., D. Kedan, M. Schmitz, R. Adalid und P. Papsdorf (2017), The Eurosystem’s Asset Purchase Programme and Target balances, ECB Occasional Paper Nr. 196, European Central Bank, Frankfurt.
FDP (2019), Kapitalmarktunion vertiefen, Staatsschulden entprivilegieren, TARGET2-Salden verringern, Bundestagsdrucksache 19/6416.
Fratzscher, M. (2018), Das Target-System ist für Deutschland und Europa ein Anker der Stabilität, Handelsblatt vom 2. August 2018.
Fuest, C. und H.-W. Sinn (2018), Target-Risiken ohne Euro-Austritte, ifo Schnelldienst, 24, 20. Dezember 2018, 15-25.
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Hellwig, M. F. (2018a), Wider die deutsche Target-Hysterie, Frankfurter Allgemeine Sonntagszeitung vom 29. Juli 2018.
Hellwig, M. F. (2018b), Target-Falle oder Empörungsfalle?, Perspektiven der Wirtschaftspolitik, 19 (4), 345-382.
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Mayer, T. (2018), Ein Wahnsinn namens Target 2, Frankfurter Allgemeine Sonntagszeitung vom 10. Juli 2018.
Sinn, H.-W. und T. Wollmershäuser (2012), Target Loans, Current Account Balances and Capital Flows: The ECB’s Rescue Facility, International Tax and Public Finance 19(4), 468–508.
Sinn, H.-W. (2015), Der Euro. Vom Friedensprojekt zum Zankapfel, Hanser, München 2015, Übersetzung von The Euro Trap. On Bursting Bubbles, Budgets and Beliefs, Oxford University Press, Oxford, 2014.
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Winkler, A. (2018b), Große Summe – großes Problem? Warum die Debatte um die Target-Salden so hitzig ist, Wirtschaftsdienst 98 (10), S. 744–51.
 The problem of the T2 balances was first raised by Sinn and Wollmershäuser (2012). Homburg (2012) and Sinn (2015), Westermann (2018), and Mayer (2018) aim in the same direction.
Whelan (2017), Bofinger (2018), Fratzscher (2018), Hellwig (2018a) and Krahnen (2018) consider T2 to be largely unproblematic. An overview of the arguments can be found in Winkler (2018). The opposite sides are currently represented by Fuest and Sinn (2018) and Hellwig (2018b).
 See for example Hellwig (2018b, pp. 365-366).
 Hellwig (2018b) suspects that the target balances have been significantly influenced by the PSPP since 2015 and refers to Eisenschmidt et al. (2017). He rightly asks why the Luxembourg seller is not reinvesting the sales proceeds in Italy. The answer lies in the inattractiveness of investing in Italy.
 See Siehe Thornton (2018).
 Bagus (2011).
 Hellwig (2018b, S. 363).
 It is true that not only the Greek tractor buyer benefits, but of course also the German exporter, who is at the fore in the chain of cantillon redistribution. If, however, the newly created money remains in Germany (otherwise the T2 balances would also equalize), then it drives up prices there to the detriment of potential buyers. All in all, Germany “loses” a tractor without “winning” anything. In Germany, however, there are definitely winners due to the cantillion effects. For cantillion effects, see Thornton (2018, Chapter 5).
 Incidentally, a capital obligation can also be financed by creating money. The Greek does not buy a tractor with the new money, but a property in Germany.
 See Hellwig (2018b, p. 361, p. 363) or Fuest and Sinn (2018, p. 20). For the central bank’s profit calculation and the transfer to the common pool, which is later distributed to the central banks of the ESCB, Greece treats the T2 liability as a deposit at the main refinancing rate. The loan to the tractor buyer’s bank also bears interest notionally at the main financing rate, so that the items for the profit calculation are balanced out. If the central bank loans in Germany decrease because the tractor buyer reduces his borrowing, then interest income for the Bundesbank ceases to exist. However, this omission is compensated for by the fact that the Bundesbank’s T2 claim pays interest at the main refinancing rate. If the Greek bank does not pay its loan because, for example, the Greek banking system collapses, then there is a real loss for the Greek central bank, which continues to pay interest on the T2 liability in the common pool. The payout to the Bundesbank from the pool could therefore decrease. The AfD understands this T2 risk and is also recorded as a risk by Fuest and Sinn (2018).
 Nevertheless, Hellwig would probably come across the term “grant”, since he sees the balances as unproblematic.
 The AfD (2019) also mentions this possibility, although it is rejected because of better alternatives.
 See Hellwig (2018, p. 350).
 For the quality theory of money see Bagus (2009), as well as for the central bank balance sheet analysis Bagus and Schiml (2009). On the importance of the quality of central bank balance sheets, see Bagus and Howden (2016).
 The currency quality would also deteriorate if the central bank, without selling gold, purchases additional bolivares by issuing its currency in a balance sheet extension. It makes a difference whether a central bank creates new money and buys bolivares or gold from it.
 If the US Federal Reserve announced that its gold reserves were gone, it would not be insolvent. Still, this announcement would be relevant to the quality of the dollar.
 If the euro collapses / leaves, its collectability becomes a political issue. It is correct that the T2 balances naturally offset each other within the euro zone. However, if the euro exits or falls apart, the T2 claims are immediately relevant as they no longer cancel each other out. If the federal government wants a German exit from the euro as a credible means of pressure to discipline other states in their fiscal policy, it needs high-quality assets that could be used to build a new currency. Otherwise, the German threat to exit is not very credible. High, unsecured T2 balances therefore result in costs for Germany in the form of a deterioration in its negotiating position.
 Fuest und Sinn (2018, S. 23).
 Siehe Huerta de Soto (2011), oder Marquart und Bagus (2014).
 Siehe Huerta de Soto (2011, Kapitel 7) oder Hayek (1988).
 See Fuest und Sinn (2018) and above.