29 April 2012

Karl Whelan: TARGET2 - Not why Germans should fear a euro breakup

The Bundesbank has built up large credits with other central banks in Europe – via the TARGET2 system. Does this represent a risk to Germany in the event of a breakup of the euro? This column argues that Germany will have far bigger things to worry about.

The past few years have seen significant transfers from banks in the rest of the Eurosystem to banks in Germany. This has led to a significant change in the composition of the Bundesbank’s balance sheet, so that TARGET2 credits now account for the majority of its assets, while loans to German banks have declined because they have ample supplies of deposits. In recent months, with loans to German banks already at very low levels, the continuing transfers to German banks have led to a dramatic increase in the assets of the Bundesbank.

What happens if there is a euro breakup?

As long as the Eurosystem continues to exist, the Bundesbank’s TARGET2 assets will continue to generate income and play the same role as its other assets. However, recent developments raise the question of what would happen to the TARGET2 credit if there was a complete breakup of the Eurosystem.

The answer depends in part on how orderly such a breakup would be. An orderly negotiated breakup would likely see TARGET2 debtors hand over assets of equivalent value to their liabilities to be pooled together and redistributed to TARGET2 creditors. Because the ECB Governing Council has agreed that the credit risk associated with assets obtained from Eurosystem monetary operations should be shared among its members, such a ‘TARGET2 Treaty’ could also include an agreement to compensate TARGET2 creditors for any subsequent credit losses on their newly acquired assets.

That scenario may sound a bit rosy. What happens if there is a disorderly breakup and TARGET2 debtors refuse to continue paying interest or hand over assets as compensation, so the Bundesbank’s TARGET2 credit becomes worthless? For many, the answer is: “Germany will have to provide the Bundesbank with a fiscal transfer of 20 per cent of GDP to ensure its solvency”.

If this answer was correct, then the TARGET2 credit would indeed represent a large risk for German taxpayers. However, there is no reason whatsoever why a post-EMU German government would need to adopt such a policy. The new Deutschmark would, like the euro, be a fiat currency and there would be no need for all D-marks to be fully backed by hard assets held by the Bundesbank.

If German officials were concerned about the need for the Bundesbank’s balance sheet to show assets greater than liabilities, then they could agree for the Bundesbank to write itself a cheque equal to the value of the TARGET2 credit and to top it up each year with interest. There would be no need to also top up its liabilities, so the Bundesbank’s technical solvency will have been restored without raising any taxes on German citizens.

I suspect some may suggest that a failure fiscally to recapitalise the Bundesbank would produce a currency that people will have no faith in and/or that this will result in inflation. However, this approach would do nothing to change the amount of money circulating in a post-EMU Germany. And a cheque tossed in an empty vault can’t trigger hyperinflation. More likely, because the value of a fiat currency depends largely on the faith of citizens that the quantity of the currency will be kept in limited supply, is that the new Deutschmark will appreciate significantly, with the result being deflation rather than inflation.

Indeed, it is likely that Germany would face serious problems after a euro breakup because of the appreciation of its currency. Its export-orientated economy would suffer badly and its commercial banks would find that their assets – much of which would now be denominated in weaker foreign currencies – no longer cover their liabilities. The German taxpayers would likely have to pay a serious price to maintain a hard currency and a solvent private banking system.

So a euro breakup could be very damaging to Germany but these dangers are not related to the Bundesbank’s TARGET2 credit. To avoid the dangers associated with a euro breakup, it is imperative that payments system continue to function smoothly. Proposals, such as those of Sinn and Wollmershäuser (2011), to restrict the functioning of the TARGET2 system would, if implemented, lead to the end of the euro and cast Germany into severe economic difficulties.

It is time for those German economists who understand the meaning of the TARGET2 balances to respond to the scaremongers before it is too late.

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