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03 October 2012


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Very interesting. For years I have been trying to understand words/phrases like "liquidity squeeze", "create/destroy money", "cant afford to", "money supply". However I think this says the following (in simple terms).

- The Spanish central bank owes the ECB 434B
- the ECB owes German central bank 750B.
- The reason the Spanish central bank has not paid the ECB is that it does not have the 434B.

Have I understood correctly?

Doesnt this 434B amount to a loan from the ECB to the Spanish central bank and therefore effectively increase Spanish debt by 434B (since the Spanish govt backs the Spanish CB)? So this is a way of Spain borrowing money from the ECB while bypassing the debt markets and various ECB rules, and inter-govt bail out funds.

Seems extra-ordinary to me.

If any of the debtor countries defaults and leaves the euro, they will probably default on these target2 obligations as well and the northern countries CBs will lose their money anyway.

Terry Smith

ChrisR: That’s my understanding-these are in effect loans by the ECB to amongst others Spain funded by Germany, Finland and the Netherlands. It seems extraordinary to me too.


Thanks Terry

So in summary:

- all the borrowing rules the EZ have invented are equivalent to the Maginot line, and
- Target2 is equivalent to the Ardennes.

Terry Smith

ChrisR: Good historical analogy. Thank you.


Yeah, T2 is a bit of an arcane and complicated subject.
Morgan's article is interesting but it has some flaws which are possibly a result of relying on Sinn's analysis.

There two key points to remember:
1. Target2 is a mechanism for payment settlement *not* credit generation.
2. T2 Liabilities occur when a country's citizens/corporations *pay* more than they receive.

The second point is important because phrases like "Spain hasn't 'paid' for imports" or "using a virtual cash dispenser" or "withdrawing savings from those countries with more solid economies" are incorrect. The problem exists precisely because funds are flowing *to* (predominantly) Germany. Those funds may be (inter alia) payment for imports, repayment of loans to German banks that aren't renewed or actual capital flight (moving your EUR deposits from BBVA to Deutsche).

So Morgan's analogy of the Bookseller is a little bit awkward because it sort of reinforces that misconception. However, in his defence, I can't think of a good analogy (!) and the core of what he's trying to get at is correct: Banco de Espana itself hasn't settled physically with the Bundesbank for the transfers that have been effected in the system.

The analogy notwithstanding, the second half of Morgan's article is a bit more interesting. He's right that the ECB's redundant statement ignores the inherent risks in an individual NCB's balance sheet...but those risks would be the same even if there were no T2 liabilities.

Why? Because the BdE's T2 liabilities are part of an accounting identity: there are assets on the other side of BdE's balance sheet to match them. (So ChrisR's 3rd bullet point above isn't quite right). So even if BdE physically transferred these assets to Buba, the risks for Buba and for the Eurosystem as a whole would be the same.

What are those risks and who's on the hook in the case of default? The NCB's assets are mostly either the result of normal Eurosystem Credit Operations (i.e. collateral that meets ECB eligibility rules) or Emergency Liquidity Assistance (ELA) (i.e. collateral that meets the NCB's eligibility rules). In the event of counterparty default, the ECB is on the hook for the former and the NCB for the latter.

What's the worse case scenario? A country pulls out of the Eurozone? Even in this case, it's not a given that the country would automatically choose to renege on its T2 Liabilities...but if it did choose to do that then the ECB would take the loss. If the loss required some recapitalisation of the ECB itself, each NCB would have to inject capital in accordance with the capital key. That's important because it means Buba's exposure is the same *regardless* of which NCBs actually have the T2 credits.

The final point on "liquidity squeeze" is perhaps the most pertinent to the topic (IMO, more so than the imbalances themselves). As the domestic interbank market ceases to function, the BdE has basically stepped in to become the market maker. Incidentally, what's often overlooked is what happens on the credit side: the German banks are awash with cash and the Bundesbank doesn't hold that much in the way of Bunds so it's losing its ability to keep interest rates in Germany *up* using standard monetary tools! You can't affect lending rates if no-one's borrowing!

For me, what I find amazing is that Univ. Osnabrick thinks Europe "is heading for a balance of payments crisis": we are already in a balance of payments crisis! That's the whole essence of the problem!

To its credit, the T2 system provides a buffer because the effect of a BoP crisis is often sudden and devastating whereas the steps required to remediate it are not! So the sooner we start tackling the cause of the problem the better.

That's more than I intended to write and probably more than you wanted to read. Generally, however, I think Sinn overplays the risks of the T2 imbalances themselves. If you want more on the flaws in Sinn's analysis I can recommend Whelan (although he's quite outspoken and clearly dislikes Sinn!) or, for a more balanced view, Bindseil.

Terry Smith

Andrew: I asked Tim Morgan to respond to your comments re Target 2. Here is Tim’s response.

"You make some very good points here – I’ll try to answer them, whilst agreeing with you that it’s difficult to tackle T2 with brevity!

My discussion did draw significantly from Prof. Sinn’s work, though I looked at Whelan, and at a lot of other sources as well. (I found Anders Aslund particularly helpful). I certainly don’t agree with Sinn when he advocates taking a hard line on the T2 'deficit' countries. As you might know from my recent eurozone report, I believe that the euro problem is much more nuanced than a simple stand-off between ‘responsible’ and ‘feckless’ countries.

I do think that a country leaving the eurosystem would be highly likely to walk away from its T2 obligations as well. A default would indeed require a capital injection by the other partners – in fact, the rules seem to imply that a defaulting country would itself have an obligation to contribute, which shows just how bizarre this system is! The bottom line, perhaps, is that the entire eurosystem contains no provisions for failure.

Anyway, the aim with my article was to explain the T2 issue to those not familiar with this arcane but important subject, and I like to think that I did get to the core issues (particularly regarding liquidity) without miring readers in far more information than they really need."


In my view (I wrote one of the earlier explanations of the TARGET2 controversy: http://reservedplace.blogspot.de/2011/07/right-on-target.html ) Hans-Werner Sinn is right that Germany is exposed to major real loss through its TARGET2 credit position. In principle, there are two lines of defence to support the value of a TARGET2 credit, and neither is reassuringly strong. The first line of defence is that all TARGET2 credit corresponds to reserves somewhere in the eurosystem, and these reserves are always backed by assets – typically ECB refinancing loans. The trouble is that, because the ECB has repeatedly backed down when its collateral rules threatened to bind PIIGS banks, these loan assets are now of dubious quality. Moreover, although acquired in the course of open market operations centrally directed by the ECB, these loan assets are actually owned by the national central banks of the TARGET2 deficit countries. The second line of defence is that, as Tim Morgan notes, the risks are supposed to be shared with other eurozone members, according to the ECB capital key. So, in the event of an exit of a country from the eurozone which then repudiates its TARGET2 deficit, the other member states are supposed to share the loss. Since Germany holds the bulk of the TARGET2 surplus, in theory this could mean France taxing its people to transfer resources to Germany to cover the Bundesbank's TARGET2 loss. Bonne chance avec cette!



Thanks for posting Tim's response and in particular for pointing me towards Aslund whose views on this topic I hadn't read.

Apologies also for the late response. (I find it difficult to keep track of when new comments are added to old posts!)

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