Target-2 balances, the intra-euro area settlement accounts, are heading for €1tn of Bundesbank claims on the rest of the single currency bloc. Mirroring the euro area’s internal balance of payments, the Target-2 balances have been rising since the onset of the financial crisis in 2007. After a respite following the European Central Bank’s emerging measures in 2012, a further substantial boost has come from the ECB’s quantitative easing programme, under the large-scale government bond purchases that started in Mach 2015.
The balances result from national central banks’ ability to issue euros, which are freely transferable to buy goods and assets across countries – enabling Italian investors, for example, to transfer funds risk-free to other centres where they may be more secure than in Italy in the event that the euro area breaks up. It is worthwhile looking at the parallels and contrasts with the US – and to ponder what the US reaction would be if a similar system were enacted there.
The US indeed has a roughly similar set-up, called Fedwire, which records claims and liabilities among the 12 regional banks of the Federal Reserve System. But there are some crucial institutional differences. Most importantly, the balances are periodically settled. While the Federal Reserve Bank in New York had a large surplus between 2008-12, the balances have been much closer to zero since then.
Furthermore, euro area central banks have far greater leeway than the regional US Feds in the liquidity they provide. Imagine the US had introduced the following reform package in 2008: bonds of the US states, including the state of California, which was facing financial trouble at time, would be allowed to be used as collateral by banks when borrowing from the regional Feds. This would have indirectly opened the door for the state to keep financing itself through the local banking system, instead of implementing painful spending cuts.
Second, suppose the San Francisco Fed, for example, had an emerging liquidity assistance instrument. Instead of closing troubled banks, the regional Fed could provide the money to rescue them, without collateral. Also, the governor of California would have had the power to create further collateral by giving a ‘California state guarantee’ on performing credit claims of private California banks, which would make them eligible as collateral at the San Francisco Fed.
Finally, imagine the US quantitative easing programme no longer bought US Treasury bills or mortgage-backed securities, but instead purchased Californian bonds. More precisely, the Fed in San Francisco would be buying, while the Fed in New York had to pay for them, because the previous bond owner happens to have their bank account in New York. Under these circumstances, the imbalances would be more comparable.
The impact of Europe’s QE on Target-2 was predicted by observers and analysis, including myself. While the national central banks create liquidity according to the ECB capital key (under which bonds are bought in proportion to the share of the ECB capital provided by each country), this liquidity does not need to stay in the country where it was created. In principle, it all could be wire-transferred to Germany and end up as a liability on the Bundesbank balance sheet. The Bundesbank, in return, would only get a Target-2 claim on the euro system.
Moreover, the national central banks may purchase bonds directly in Frankfurt, or in London, from a trading partner that maintains its euro accounts in Frankfurt as well. In these cases, the Bundesbank is responsible for crediting the money directly in the bond-sellers’ reserve account with the Bundesbank, and gets an offsetting Target-2 claim on the euro system. For this reason, the pattern of Target-2 balances has become foreseeable and closely follows the expansion of QE.
Returning to the US comparison, would taxpayers in New York be worried if California elected a governor who wanted the state to exit the US and issue its own currency, as some politicians close to the ruling parties in Italy have recently indicated they wish to do? Perhaps it would be a matter of magnitude. Target-2 claims crossing €1tn in the US would mean that there had been enough net transfers between the regional Feds to buy a 51% stake in 16 of the 30 stock companies listed on the Dow Jones Index at current prices. After a potential breakup, the former holders of Californian state debt would remain the share-owners of these companies, while the New York Fed would merely have a dollar claim on the San Francisco Fed, which might declare insolvency after California exited the union. Even for US standards, this could result in a significant loss.
Implementing key elements of the US system in Europe, including periodic settlement, would make Target-2 system much more sustainable. Clearly, this would not constitute a limitation on the free movement of capital, as dollars are free to move in the US.
The sheer scale of present imbalances may keep the euro area together in the shorter term, because of the panic that would ensue in creditor countries from the large-scale losses they would suffer if a debtor country departed and redenominated its debts in much lower-valued new currency.
Italian politicians have long been aware that the higher the Target-2 balances, the lower the likelihood that Germany – in the shorter term – would risk redenomination disruption. However, in the same way as the North Atlantic Treaty Organisation and the Warsaw Pact did not wish to depend on ever-growing nuclear stockpiles to keep the world safe during the cold war, it would be unwise to rely on escalating Target-2 balances as preventing an explosive crisis in the longer term.
Frank Westermann is Professor of Economics at Osnabrück University.