Intra-EMU Payments: The Target System
So, a euro is not always a euro because banks have different characteristics depending on, where their headquarter is located, the financial strength of the home-country’s government and regulatory principles that apply within the different countries. In any case, until the financial crisis emerged, the European inter-bank market worked almost completely without friction. Until 2008, balance-of-payments imbalances were seemingly recycled without difficulties via the European and the Transatlantic inter-bank markets. Short-term lending between banks was considered safe; that is, until the default of Lehman Brothers in September 2008. All at once, inter-bank lending became restricted and much more costly. Suddenly, it was considered a risky business, especially when crossing borders. Private banks in countries with a balance-of- payments surplus found it much safer to deposit their surpluses in the national branch of the ECB, even if the rate of interest was low and became negative in 2015.
Within the ECB system, each member state operates its inter-bank market via the national branch of the ECB, which administrates the liquidity according to principles decided by the board of directors in Frankfurt. Hence, the German liquidity surplus is showing up as deposits in the German branch of the ECB system (the former German Bundesbank). The emergence of the Eurozone inter-bank distrust can be read from the ECB statistics.3 Within a few years, the German branch accumulated a creditor position of more than € 700 bill. The main counterparts were the Spanish and Italian branches of the ECB system, because Euro deposits were literarily leaking out of the Italian, Spanish and other southern European banks towards German banks, which deposited the excess liquidity in the German branch.
The main subject of criticism of this cross-border ECB recycling was the unlimited credit facilities made available to solvent private banks. The idea was to facilitate daily cross-border payments between indisputable safe banks. This ‘inter-European Central Bank market’, called Target2 system, was established in early 2008, which has an unlimited short-term debit clearing facility and provides solvent private banks with necessary foreign liquidity. When the private inter-bank market stopped functioning frictionless, it was heavily supported by a clearing facility established via the ECB system. Before this moment, it had been the German, Dutch and French private banks which ran the major creditor risk. After 2008, fresh liquidity was provided by the central bank system. In the following figure, one can see how the accumulating balance-of-payments surpluses and deficits appeared in the ECB branch statistics.
However, a hang-over of debt from the ‘old’ balance-of-payments deficits derived before 2008 due to current account deficits in Greece, Spain and Portugal were still on the books of the private banks in the surplus countries. This existing foreign debt was partly guaranteed and partly taken over by the national governments from banks going bust.
From 2008, the public finance of the weaker Eurozone members experienced a double liquidity squeeze. The public sector current deficit had enlarged and governments had taken over a huge amount of private banks’ liabilities with bad assets, creating an immense financial need. This mess over the public sector budget caused credit rating bureaus to downgrade government debt, which caused the interest rate to rise rapidly and made it nearly impossible for these governments to sell bonds on the conventional markets. As we have explained before, the EU stepped in first at an inter-governmental level because the EU Treaty did not allow EU institutions to finance broken governments. The situation changed after 2012 when ECB started to buy private and later government bonds in the secondary markets, while the EU Treaty was amended to allow loans directly to distressed member countries from an EU institution.
Amongst other critics, Sinn (2012) has been very critical towards the semi-automatic recycling of liquidity from surplus countries to deficit countries within the ECB system. He views this recycling as leading to a kind of moral hazard, where running a balance-of-payments deficit could go unquestioned for much too long and thereby cause a threat to Germany’s financial stability, if the process of breaking up the Eurozone gained momentum. His fear in 2012-2013 was that a sudden collapse of the common currency and the ECB system would leave the German Bundesbank with a huge amount of nearly valueless claims on the southern European banks. His main arguments are directed towards the much too easy recycling of liquidity back to countries with a balance-of-pay- ments deficit. This recycling took away any immediate incentive to reduce these deficits, that is, according to his monetarist theory, to improve competitiveness by wage reduction and reduce public sector deficit.
But Sinn’s arguments are somewhat flawed. First, one could argue that if the balance-of-payments surplus makes the Germany financial sector more fragile, then an obvious policy would be to reduce this surplus to the benefit of the German citizens and the unemployed people in southern Europe. Second, liquidity provided by the ECB system might not in the future be limitless. So, the Euro member states have to remove their balance-of-payments deficits to stop borrowing abroad. Or thirdly, see Fig. 7.4 if the surplus countries are unwilling to reduce their surpluses, the Eurozone as a whole had to create a substantial external surplus, which would be large enough to give all the Eurozone countries a balance-of-payments surplus. A combination of
Fig. 7.4 Balance of Payments, current account, 2014 Source: OECD, Economic Outlook, 2016
austerity policy, wage reduction and euro depreciation paved the way for such a huge Eurozone surplus, but at the expense of economic stagnation, falling wage shares and increased social misery, see Chap. 6.
Some Concluding Remarks on Eurozone