Germany’s Constitutional Conundrum

By Marshall Auerback

Hans-Werner Sinn, President of Germany’s Ifo Institute and the Director of the Center for Economic Studies at the University of Munich, has taken to the pages of the NY Times to explain why Berlin is balking on a further bailout for Europe. Amongst the points that Sinn makes against German sharing in the debt of the euro zone’s southern nations is a legal one: “For one thing, such a bailout is illegal under the Maastricht Treaty, which governs the euro zone. Because the treaty is law in each member state, a bailout would be rejected by Germany’s Constitutional Court.”

Sinn also argues that Germany’s counterparty credit exposure already exposes the country to immense credit risk: “Should Greece, Ireland, Italy, Portugal and Spain go bankrupt and repay nothing, while the euro survives, Germany would lose $899 billion. Should the euro fail, Germany would lose over $1.35 trillion, more than 40 percent of its G.D.P.”

Let’s leave aside Sinn’s broader rhetorical points (“Has the United States ever incurred a similar risk for helping other countries?” Umm, yes, it did – there was that little matter of World War II). Levity aside, professor Sinn does raise a huge potential conundrum as far as Germany and its broader relationship to the Eurozone’s institutions go. In fact, recent German Constitutional Court rulings on bailouts could well blow apart the European Monetary Union. This is because the potential unlimited liabilities to which Germany is exposed under Target 2, the ELA, and various other lender of last resort facilities adopted by the European Central Bank do on the face of it run afoul of the court’s ruling, which argued that any future bailouts had to be limited and subject to the democratic consent of Germany’s Parliament. What happens, for example, if someone in Germany were to challenge the very legality of Target 2 on those grounds?

This is not the first time in which Sinn has expressed concerns in regard to Germany’s exposure via “Target 2”; indeed, he was to our knowledge one of the first to raise this issue in a number of scholarly papers ( see here).

So what exactly is “Target 2”? Target 2 refers to Trans-European Automated Real-time Gross Settlement Express Transfer. It is the euro system’s operational tool through which the national central banks of member states provide payment and settlement services for intra/euro area transactions. Target 2 claims can arise from trade and current account transactions as well as from purely financial transactions.

Recently financial transactions have become dominant. Funds have been taken out of banks on Europe’s periphery and have been deposited in banks in the north of Europe, principally in Germany. The bank receiving the deposit places those funds with the Bundesbank (or other recipient national central banks); in doing so it has its funds delivered through the Bundesbank (or other recipient national central banks), which in turn deposits with the ECB. Via the ECB the funds then go to the bank on the periphery that has lost deposit funds. That is a Target 2 transaction. The so-called Target 2 outstanding balance is the net position of such claims between two European countries. The ECB in effect acts as the hub through which these transactions are mediated.

Target 2 has taken on heightened relevance in the past year as a consequence of the Eurozone’s silent bank run. As deposits have fled the periphery banks – Greece, Portugal, Ireland and Spain – these banks have become increasingly reliant on Target 2 to overcome funding problems.

As an aside, it is also worth noting that banks can also borrow under the emergency liquidity assistance (ELA) program. Such assistance is extended by single national central banks to their banking systems. The risk is borne at the national level. The collateral requirements imposed upon a commercial bank for obtaining ELA funds is less than the collateral requirements needed for obtaining Target 2 funds. The national central bank in a country like Greece with commercial bank deposit runs ultimately funds its ELA financial assistance to its commercial banks from the ECB. That ECB funding for ELA is above and beyond Target 2 funding.

The ECB also conducts repo operations with banks in the system. Recently these repo operations (e.g., LTRO’s) have also been funding banks in the periphery that have been experiencing deposit runs. It has been widely believed that LTRO funds received by Italian and Spanish banks went entirely into purchases of their government’s bonds. Some of these funds did go into purchases of national government bonds, but only in part; some of those LTRO funds financed deposit losses.

So where is the money ultimately coming from? To some extent there is a circular quality attendant with the banking crisis. Money leaves, say, a Greek bank. A wealthy Greek ship-owner is worried about the solvency of his country (or a concern that he might actually have to pay taxes), so he quickly withdraws the sums from a Greek bank and redeposits the money with a German bank. The German bank now might find itself flush with billions of dollars which it can’t use, so it re-deposits the money with the Bundesbank, which in turn places it with the ECB. The ECB then might turn around and extends funding (via Target 2, or the ELA) back to the Greek banks and in effect closes the financial circuit created in the Eurozone when a citizen of one country chooses to move his deposit from a domestic bank to a bank domiciled in another euro area nation.

Of course, some of this money goes outside the euro zone (Swiss banks, US banks, London property, gold, etc) and it is almost certainly the case (even though the ECB would never admit it) that some of this funding (perhaps most of it) comes from the ECB actually creating new net financial assets. To get a sense of how big the ECB’s exposure is, it is worthwhile looking at its “loans to other monetary financial institutions”, which is one of the line items buried in its balance sheet. That the ECB creates new euros is not itself problematic from an operational standpoint: as the sole issuer of the euro, the ECB is free to provide as many euros as is needed to keep the funding system in place. It cannot go broke.

To reiterate, a private bank needs capital – clearly because there are prudential regulations requiring that – but because it can become insolvent. It has no currency-issuing capacity in its own right. While the ECB has an elaborate formula for determining how capital is allocated from the national member banks, at an intrinsic level, it has no need for capital. The ECB could operate forever with a balance sheet that if held by a private bank would signal insolvency.

The point is that a currency issuer (ECB) and a currency user (private bank) are not comparable in terms of solvency. The latter is always at risk of insolvency, the former never, so there is no OPERATIONAL risk or limit per se implied in the ECB’s actions.

Although it might well assert to the contrary, the ECB has massively expanded its lender of last resort facilities, in many cases in violation of the Maastricht Treaty. As Professor Wilhem Buiter has argued in a recent paper:

[T]he European Central Bank (ECB) has been acting as lender of last resort (LoLR) for the sovereigns of the Eurosystem since it first started its outright purchases of euro area (EA) periphery sovereign debt under the Securities Markets Programme (SMP) in May 2010 (see de Grauwe (2011b), Wyplosz
(2011, 2012) and Buiter and Rahbari (2012a)). The scale of its interventions as LoLR for sovereigns has grown steadily since then and its range of instruments has expanded. We interpret the longer-term refinancing operations (LTROs) of December 2011 and February 2012 as being as much about acting, indirectly, as LoLR for the Spanish and Italian sovereigns by facilitating the purchase of their debt by domestic banks in the primary issue markets, as about dealing with a liquidity crunch for EA banks. A future third LoLR instrument will be indirect lending by the Eurosystem to periphery sovereigns. This will be achieved through national Central Banks lending to the International Monetary Fund (IMF) and the IMF lending to the Spanish and Italian sovereigns, once these sovereigns have come under suitable troika (IMF, European Commission and ECB) programmes. If and when the European Stability Mechanism (ESM) gets a banking licence (becomes an eligible counterparty of the Eurosystem for the purpose of repos or other forms of collateralized borrowing), the ECB will have a fourth mechanism through which it can act as LoLR for sovereigns.

Which gets us back to the issues raised by Sinn: Reflecting mounting German concerns about the country’s growing counterparty exposure risks to the periphery, Sinn has proposed limiting Germany’s Target 2 exposures. From a German legal perspective, Sinn is on very solid ground. In May 2010, when Germany’s Parliament voted to provide financial aid to Greece to prevent it from insolvency and to approve the €440 billion ($620 billion) European Financial Stability Facility (EFSF), with €147 billion in loan guarantees, this was challenged in Germany’s Constitutional Court. At the time, Germany’s highest court ruled that the parliamentary criteria had been adhered to when the government agreed to those specific bailout measures.

At the same time, the court said the Bundestag had not ceded any of its authority in budget decision-making with its approval of the legislation. Furthermore, the judges ruled that future aid package resolutions could not be automatic and should not infringe on the future decision-making rights of Germany’s parliament. Aid packages, they argued, would have to be clearly defined, and members of parliament would have to be given the opportunity to review the aid and also stop it if needed.

Under the terms of the German court’s ruling, then, Target 2 itself would appear to be unconstitutional, even though Target 2 itself was one of the features incorporated in the Treaty of Maastricht. But the problem with Target 2 is that it involves an open ended indeterminate exposure of the German people to losses involved in the bailout of the periphery. The German parliament has no say in the disbursements. That this is unconstitutional would appear to be very clear on the basis of Germany’s Constitutional Court rulings. Logically, it should extend to the other Lender of Last Resort financings that have been undertaken by the ECB, cited in the Buiter article above.

So consider the following: imagine that there is a Constitutional Court challenge of the Target 2 and other ECB lender of last resort financings. The day this occurs and becomes public the bank run will accelerate greatly. To be sure, the court might well rule that ECB agreements amongst the member states take precedence over the earlier ruling expressed in the wake of the 2010 bailout for Greece. But it would be hard to square that argument with the clear meaning expressed by the German court at that time. And if the Constitutional Court rules that ECB lender of last resort bailouts are unconstitutional the banks on the periphery will have to close and suspend payment on requests for withdrawals. So Germany’s court could well become the instrument of the euro’s destruction by frustrating the ECB’s capacity to operate as lender of last resort.

22 Responses to Germany’s Constitutional Conundrum

  1. IMO, one has to be careful about Sinn’s writings. Some of it is OK but his whole analysis is mixed with a lot of incorrect conclusions – such as Bundesbank running out of control of monetary policy etc. (For example, in the first step German banks would decrease their indebtedness to Buba when they have more settlement balances and after that while there are more and more inflows, the excess settlement balances can be removed by deposit facilities at Buba etc). His language is also highly neoclassical.

    Of course those who have written strongly against Sinn also err :-)

    Also according to this http://www.ecb.int/ecb/legal/pdf/l_01820060123en00010017.pdf, NCBs and the ECB have no choice but to provide each other unlimited and uncollateralized credit facility. So Germany or its courts cannot limit the amount of inflows into Germany via TARGET2. (Unless they resort to capital controls on incoming flows).

    “The ECB and each of the NCBs shall open an inter-NCB account on their books for each of the other NCBs and for the ECB. In support of entries made on any inter-NCB account, each NCB and the ECB shall grant one another an unlimited and uncollateralised credit facility”

    So if they want to restrict inflows, they have to do it at the point of entry. That is the reason one sees so much politics around ELA. Because if banks are prevented from accessing ELA, they will soon prevent customers from transferring funds within the EA and funds transferrors will be trapped.

    Also, the LTROs were done with the aim of not financing the NCBs/nations but to actually increase the overall liquidity and improve the stressed interbank situation so that the markets gain confidence and in fact had it worked as planned (which it did partially), it would have reversed the outflows and reduced the TARGET2 imbalances (of course specifically target imbalances not imbalances generally defined).

  2. “Via the ECB the funds then go to the bank on the periphery that has lost deposit funds. That is a Target 2 transaction …. As deposits have fled the periphery banks – Greece, Portugal, Ireland and Spain – these banks have become increasingly reliant on Target 2 to overcome funding problems … The ECB then might turn around and extends funding (via Target 2, or the ELA) back to the Greek banks and in effect closes the financial circuit created in the Eurozone… ”

    The right idea, roughly, but technically not correct

    TARGET 2 does nothing to fund the commercial banking system that originally lost deposits. TARGET 2 funds go no further than to fund the balance sheet gap left by the reserve (liabilities) that were originally cleared (for example) from the Greek Central Bank to the Bundesbank, in making payment for the outflow of commercial bank deposits from Greece to Germany.

    From there, it takes an entirely separate and independent central bank operation to fund up the system reserve balance of the commercial bank that lost its deposits (Greece in this example).

    Thus, TARGET 2 is a clearing system for central bank reserves in a multi-central bank operating system.

    TARGET 2 balances are one money hierarchy level higher than the reserves that the national central banks issue to their respective commercial bank users.

    TARGET 2 balances are effectively at the level of “super central bank money”, due to the nature of the multi-central bank operating system.

    TARGET balances are distinguished from reserve balances in the same way that reserve balances are distinguished from commercial bank deposit balances. Each element in that chain represents a distinct level of money hierarchy. Each higher level is the clearing system for the one below it.

    Thus, a TARGET surplus balance is no more a loan of central bank reserves than a central bank loan to a commercial bank is a loan of commercial bank deposit liabilities.

    TARGET entries (surplus and deficit; positive and negative), represent lending and borrowing of TARGET balances – not the lending and borrowing of central bank reserves.

    The sum of all TARGET balances is zero, comparable to a zero reserve system for a single central bank and its commercial bank users.

    The transaction or transfer that is represented by TARGET 2 entries from one national central bank through the ECB to another national central bank has no direct association with any other central bank balance sheet activity.

    In particular, TARGET 2 transfers from the Bundesbank to the Greek Central Bank (via the ECB) do nothing to restore the original level of reserve balances issued by the Greek Central Bank – reserves that it lost to pay for the outflow of commercial bank deposits. Conversely, TARGET 2 transfers don’t reduce the higher level of reserve balances now issued by the Bundesbank.

    Thus, immediately following the TARGET 2 transfer of TARGET balances, the Bundesbank still has a higher level of system reserves outstanding and the Greek Central Bank has a lower level of system reserves outstanding, than was the case before the original commercial bank deposit transfer from Greece to Germany. Those reserve systems are still “out of balance” with respect to their earlier positions.

    Other things equal, the Greek Central Bank can now restore system reserve levels through entirely separate refinancing operations of some sort, and the German bank can restore its system position by reverse refinancing operations. THOSE are the transactions that operate to restore national central bank reserve levels to their original positions – NOT the TARGET transfers.

    And to the degree that regular refinancing, LTRO, and ELA are all central bank reserve creating transactions, any of those types of operations could be used by the Greek Central Bank in this case to restore earlier system reserve positions.

    MMT might want to consider modifying/adding to its existing description of “money hierarchy”, to allow for “super central” bank money where a super central bank like the ECB actually clears the reserves of its constituent operating central banks via TARGET clearing.

    Solvency and credit risk issues are quite separate from funding issues per se.

    For example, the Bundesbank has the following 3 types of credit risk exposure:

    a) Direct credit risk exposure through ELA (IF it were to use ELA)

    b) Shared credit risk exposure through other ECB lending programs such as LTRO

    c) Contingent credit risk exposure through TARGET 2, in the event of Euro zone break up

    Sims took quite a beating in the blogosphere when he first started talking about Germany’s TARGET 2 exposure. But he was fundamentally right about the nature of the contingent credit risk.

    • “Sims took quite a beating in the blogosphere when he first started talking about Germany’s TARGET 2 exposure. But he was fundamentally right about the nature of the contingent credit risk.”

      Yeah agree as you know from Whelan’s blog – although it took me a while to realize that his beaters although more accurate in smaller (but important matters), had a messed up conclusion.

      George Soros asks Willem Buiter in the following link (@45:55) about Target2 and Sinn:

      http://www.youtube.com/watch?feature=player_detailpage&v=881o4lg_84o#t=2754s

      Buiter says: “Seldom has one economist done a greater disservice to one discipline than Prof Sinn”

      My god!

  3. In an op-ed in today’s Wall Street Journal (“How the Euro Will End”), Gerald P. O’Driscoll Jr.—a former vice president at the Federal Reserve Bank of Dallas—makes the following remarkable statement: “Fiscal and banking crisis are often linked because in modern economics the state and banking are joined together. Banks purchase government debt, supporting the state, and governments guarantee the liabilities of banks.” This statement, more clearly than anything I’ve recently read, reveals the convoluted illogic of mainstream economic thought. If you actually follow his logic, what Mr. O’Driscoll appears to be saying is this:

    The government doesn’t have enough money to cover its expenses, so it issues bonds, which the private banks purchase, thus providing the government with the currency it needs to conduct its business. The government, in turn, guarantees to bail out the private banks should it, the government, not have enough money to redeem the bonds—in which case, presumably, it would sell more bonds to the banks to get the money it needs to redeem the first set of bonds.

    This seems like a very sensible system, and I’m pleased to think that our “modern economics” (and our Federal Reserve Banking system) are founded on such logical principles. As a novelist-architect, I have difficulty following what Mr. Aurerback, Ramanan and JKH are saying here, but it sounds very much like they are describing exactly what Mr. O’Driscoll appears to be saying in his statement.

  4. Ramanan,

    Right.

    Sinn got the contingent, strategic credit risk issue right, and that’s really what he was basing his particular language use on – language that others seemed to be objecting to due to the automatic nature of the clearing function in normal course.

    Looks to me from past perusals that Buiter makes central banking solvency issues way too complicated.

    There’s a straightforward interpretation based on prevailing institutional arrangements, and one based on “contingent” arrangements. But in all cases, you must assume some institutional structure with accountability in the form of double entry book keeping (or quadruple entry if you will :)) for things like capital (or not), reserves, etc. – in order to remain grounded on planet earth.

  5. R.,

    As I recall now, one of Sinn’s original sins (:)) was to attribute TARGET 2 imbalances (exclusively) to current account origin, or at least it seemed to read that way, when shortage of offsetting private gross capital flows (like one way migration of bank deposits alone) does the trick. But he corrected that later, I think. Nevertheless, his critics went ballistic, while overlooking the more important correctness of his view in the context of longer term Euro zone structural risk.

    • JKH,

      Yes makes sense. I think Sinn was probably using the idea/experience of the pre-1999 arrangement where European central banks ultimately refused to when another CB needed zillions of resources to defend the peg. The Euro area arrangement just makes this automatic and irrevocably fixes the exchange rate – in some sense simple and in some sense profound. So in the pre-1999 arrangement this would mean the central bank giving loans to each other but in this present case these entries are automatic. His critics saw this (the latter) and started saying “this is not lending” and things like that (i.e. they shouldn’t be classified as loans).

      I also think that the participation of the NCBs/ECB in the debate was counterproductive in some sense. They were just downplaying the whole thing and the critics of Sinn used these articles to show that they had been right etc.

      I initially couldn’t follow the discussions because critics seemed generally right and thought that their own muddles in the issue was more or less as happens in economics. Only when I saw the Irish Economy blog did I realize … Had to work out some of the story/debate backward after exchanging comments with you at Heteconomist.

      I hadn’t followed Sinn’s story of current account deficits but remember his opponents making some questionable claims. Even in the Buiter video Buiter says its a loss to Buba but not to “Germany Inc” which is the same as Whelan. His story about taxpayer versus irresponsible lenders probably has some element of truth although his argument is too simplified but is not a valid argument against Sinn. As in he argues as if it is a subsidy to the German lenders to the periphery, but that is right only if Germany is giving it as a fresh policy.

      I think more proper argument about why it is a loss to Germany in a real sense is that a strong external position leaves Germany with deciding how to distribute the benefits of its wealth amassed but if it suffers a loss, then the nice thing is gone and the question of how it is distributed to Germans doesn’t arise to the same extent – which is bad. From a financial sense it is more easy to argue.

      But Sinn has listeners in the official circles and according to Soros this thing is driving the German government to move toward an integration.

    • “in order to remain grounded on planet earth.”

      :-)

  6. So there is a plot to destroy the Euro, right? Which country would be most likely to want that? Not China, right? hmmm …

  7. First of all, I don’t think I was joining in the blogosphere attack on Sinn. His legal points do raise some very interesting issues which I wanted to discuss here. As far as the other aspects go, I think his characterisation of Target 2 is somewhat incorrect. Take a look at the numbers for Ireland. According to IMF figures (Table A11) im 2010 Ireland only had a very small current account deficit (0,7% of GDP) . In 2011 Irland probably will even have a small current account surplus (0,2% of GDP). However, the Irish national bank at the same time is by far the biggest Target2 borrower (see here). At the end of 2010 the Irish Target2 liabilities equaled 146 bn euros. (Greece came second with Target2 liabilities of 87bn euros).

    However, according Bindseil und König even the accumulated Irish current account deficit over the last 10 years only equals 41bn euros.

    Hence, both economists come to the conclusion that the huge Target2 liablities are by no means an indication that Ireland lives at the expense of Europe. Those figures just show that a bank run on Ireland is happening and customers withdraw their money from Irish banks:

    Bindseil and König write with regard to the Irish central bank:

    “The large increase in TARGET2 liabilities of around EUR 91.7 bn between the end of 2009 and the end of 2010 can be almost exclusively attributed to the ongoing difficult situation of the Irish banking system and the loss of access to private sector funding. Funding out flows of this order of magnitude could enforce massive asset fi re sales of banks, if the central bank was not stepping in to close these gaps.”

    Willem Buiter et. al. make excactly the same point in their ”TARGETing the wrong villain: Target2 and intra-Eurosystem imbalances in credit flows”. With regards to Greece and Portugal – two countries with significant current account deficits and huge Target2 liabilities -they assert:

    “for Greece and Portugal, the largest increases in Target2 net liabilities were, again, in 2010, when the increase in Target2 net debt was much larger than the overall current account deficit. The data on current account deficits and changes in Target2 balances therefore do not provide support for the hypothesis that the current account has been the main driver of change in national net Target2 balances for the EAP countries.”

    Buiter et al also come to the conclusion that:

    “the driver is what could be termed ‘deposit flight’ – a movement of financial balances from Ireland to Germany which is, at least directly, unrelated to the demand for goods – it is a financial portfolio rebalancing that does not require any change in the national saving-investment balance”
    What is actually happening with the bank run in Europe? Deposits are leaving the banks on the periphery and going to banks in the core. The banks in the core lend to the System of European Central Banks (with basically the ECB “on the hook”) which then provide lender of last resort financing to the banks on the periphery. It may be that by April the banks in Greece, Ireland and Portugal had lost half their deposits and the banks in Italy and Spain had lost a quarter of their deposits. To understand the eventual significance of this process, let us assume the bank run continues and the banks on the periphery overall lose the majority of their deposits, the banks in the core have corresponding huge claims on the ECB, and the lender of last resort position of the ECB is now equal to a majority of what was the outstanding deposits in the banks on the periphery.
    What kind of a banking system is this? A dysfunctional and a highly unstable one. One would have a set of banks on the periphery that are massively dependent on ECB lender of last resort financing. That would probably be dysfunctional, as they would be disinclined to lend to their normal client base. That is negative for these economies on the periphery.
    The banks in the core would not be so impaired. With a larger deposit base they might be more inclined to lend to their usual client base. However, most of the deposit funds received from the periphery will probably flow into the System of Central Banks with, ultimately, the ECB “on the hook”.
    Add to that the proposed additional fiscal austerity which Germany is proposing as a reason for additional help to the periphery and you have a major problem on your hands. So what is the nature of the problem?
    What is wrong is the distorted role of the ECB and the unstable nature of the euro banking system overall. If we simply trend the recent deposit run forward, within perhaps six months the majority of the original deposits in the peripheral countries will have departed. That would basically leave the ECB with a lender of last resort exposure to the periphery on the order of three trillion euros or more. That would represent a loss exposure equal to almost 40 times ECB capital (before revaluation of gold reserves). I do not believe central banks, as basically government entities, need to have a positive capital. But I think a loss exposure from possible euro exits by these peripheral countries of this magnitude is highly problematic.

  8. JKH
    One other point: Under Article 66 of the EU treaty there is complete capital mobility within the Eurozone. A citizen in any country can hold deposits in the common euro currency in banks domiciled in other countries. To meet this opportunity the banks in Europe’s northern core improved the banking facilities they offer to prospective deposit and loan clients on Europe’s periphery. Guaranteed freedom of capital movements and the introduction of the common currency opened the door for citizens in the periphery countries to move their deposits to banks domiciled in the northern core, and those northern core banks facilitated that transfer in every way. As a result it is virtually costless for a Spanish citizen to conduct all of his euro business with a German bank.
    Given this ease of capital movements there had to be in the Euro area a quiet automatic payment system that would deal with transfers from banks in one country to banks in another. Initially the architects of the European monetary system thought that the private “markets” would accomplish all the needed financial transfers. If a Spanish bank lost deposits and a German bank received deposits, the interbank market would allow the German bank to immediately and profitably put the money to work and in doing so allow the Spanish bank to fund its deposit loss.
    And apparently this is how things went in the early years of the euro. In 2007 German banks had direct claims on banks on the periphery of over 800 billion euros. However, when the Great Crisis occurred in 2008-2009 market confidence ebbed and private sector interbank lending dried up, especially to the European periphery. As a result German bank claims on banks in the periphery have since fallen in half.
    What made up the difference? First, the payments transfer system through the system of European Central banks called Target 2. Target 2 refers to Trans-European Automated Real-time Gross Settlement Express Transfer. It is the euro system’s operational tool through which the national central banks of member states provide payment and settlement services for intra/euro area transactions. Target 2 claims can arise from trade and current account transactions as well as from purely financial transactions.
    Recently financial transactions have become dominant. Funds have been taken out of banks on Europe’s periphery and have been deposited in banks in the north of Europe, principally in Germany. The bank receiving the deposit places those funds with the Bundesbank (or other recipient national central banks); in doing so it has its funds delivered through the Bundesbank (or other recipient national central banks) to the bank on the periphery that has lost deposit funds. That is a Target 2 transaction. The so-called Target 2 outstanding balance is the net position of such claims between two European countries.
    There are specific collateral requirements that must be met for Target 2 funding of banks to occur. Sometimes banks with deposit losses cannot meet those collateral requirements. However, there are other lender of last resort channels that can come into play.
    When banks in some Eurozone countries – in this case the periphery – have funding problems and don’t meet Target 2 collateral requirements, they can borrow under the emergency liquidity assistance (ELA) program. Such assistance is extended by single national central banks to their banking systems. The risk is borne at the national level. The collateral requirements imposed upon a commercial bank for obtaining ELA funds is less than the collateral requirements needed for obtaining Target 2 funds. The national central bank in a country like Greece with commercial bank deposit runs ultimately funds its ELA financial assistance to its commercial banks from the ECB. That ECB funding for ELA is above and beyond Target 2 funding.
    Lastly, the ECB conducts repo operations with banks in the system. Recently these repo operations (e.g., LTRO’s) have also been funding banks in the periphery that have been experiencing deposit runs. It has been widely believed that LTRO funds received by Italian and Spanish banks went entirely into purchases of their government’s bonds. Some of these funds did go into purchases of national government bonds, but only in part; some of those LTRO funds financed deposit losses.
    Through these many channels the European System of Central Banks closes the financial circuit created in the Eurozone when a citizen of one country chooses to move his deposit from a domestic bank to a bank domiciled in another euro area nation.
    So far,so good. Unless there emerges a perceived risk that one country in the European monetary system may someday exit the euro. The consequences are obscured by a now extensive existing body of legal contracts written in euros. But euro exit by any nation opens the possibility that it may go back to its original currency. And that currency may somehow be worth less than the euro. There arises a risk of a currency devaluation loss for those holding euro deposits in a bank domiciled in an economy that could exit the euro. This poses problems – very severe problems.
    In 1998 Professor Peter Garber recognized that the above created a fatal flaw in the euro system. As long as there was no perceived probability of euro exit by any euro nation, the established transfer system coupling private markets with European system of Central Bank support (Target 2, ELA, ECB repos) would function like any other monetary system in a single nation state. However, Garber recognized that if there arose the prospect of a euro exit and, therefore, a devaluation risk for holders of deposits in the banks domiciled in the country slated for exit (e.g. Greece or Spain), the European monetary system would be exposed to a bank run. Under the EU treaty capital mobility was guaranteed. Under the common currency deposit transfers from domestically domiciled banks in countries at risk of euro exit (e.g. Greece, Spain) to banks domiciled in other euro nation states (e.g. Germany, Netherlands) was costless. Faced with any non-negligible perceived risk of a euro exit and thereby a devaluation loss, rational market participants should move all their deposit funds from the banks domiciled in the country at risk of euro exit to banks domiciled in nations at the Eurozone’s unassailable core.
    In the United States we have 50 states and one central bank. There are fund transfers across states. But there cannot be any prospect of a secession of a state that will bring with it its own devalued currency. Hence, there is no incentive for deposit flights from banks in one state or region to another. Therefore, private markets, with a little help from the Fed, will close the financial circuit to the extent there are such fund transfers. The European Monetary System was supposed to work that way. And as long as no one worried about any country leaving the euro, it did. But once the risk of euro exit on Europe’s periphery raised its ugly head, the euro system became completely different. Peter Garber argued that, given such a perceived prospect, the euro system was a perfect mechanism for a deposit run. And once doubts arose in 2009 about a possible euro exit by Greece and Ireland, a deposit run began – and in earnest.

  9. “At the end of 2010 the Irish Target2 liabilities equaled 146 bn euros. (Greece came second with Target2 liabilities of 87bn euros).

    However, according Bindseil und König even the accumulated Irish current account deficit over the last 10 years only equals 41bn euros.”

    Marshall: The NIIP is a better thing than accumulated current account deficits. At the end of 2011, it was €156bn – closer to €146bn.

    Of course this is also not the full picture because in its full generality one has to consider gross assets and liabilities instead of net.

    I like this chart by Martin Wolf which however does not have Ireland

    http://im.media.ft.com/content/images/03755100-8334-11e1-9f9a-00144feab49a.img?width=842&height=226&title=&desc=Martin%20Wolf%20chart

  10. Marshall,

    – Thanks for the additional color

    – Wasn’t suggesting you were joining the attack on Sinn; quick the contrary

    – I also noted his somewhat incorrect characterization of the current account connection in my comment above (June 13, 2012 at 6:14 pm) and agree; substantial private capital flows ex current account are involved

    – My main point was that the illustrative TARGET clearing transaction moves bank reserves from the periphery to the core, but the consequent TARGET entry of core central bank surplus and peripheral central bank deficit has no operational effect on bank reserves and in particular does not transfer reserves from the core back to the periphery

    – The rebalancing of the reserve mismatch between the two central banks that is created by a net TARGET reserve flow requires separate and additional ECB transactions such as repo, LTRO and ELA

    – I characterized these two different categories of transactions (TARGET and non-TARGET) as operating at different money hierarchy levels

    – In particular, TARGET and the other types are not alternative facilities; TARGET is automatic in its net trans-central bank reserve effect; the others are elective in their exclusive central bank reserve effect; the second type is required to offset any sustained reserve effect of the first type

    – Apart from that point, which is just a particular technical one in the context of how you seemed to describe the system, I agree generally agree with what you’ve written

  11. JKH,
    Yes, my main point is in fact that Sinn makes a lot of good points, particularly the fact that Germany now does have in fact an unquantifiable counterparty risk which does impact on the budget-making capacity of the German parliament. And in that regard, it creates a real potential dilemma for the Eurozone, because you appear to have normal central bank lender of last resort functions potentially impeded in a legal sense by Germany’s court. I don’t see how one can interpret the German ruling in any other way. It will be very interesting (in the sense of the Chinese curse of living in “interesting” times) to see what happens if the ECB’s broader lender of last resort powers were ultimately subject to a court challenge in Berlin.

    • It is important to keep a few things apart: the German Verfassungsgericht is (more or less) only talking about fiscal policy. Here indeed there is little room to maneuver left as the Bundestag will have to explicitly assent to any sizeable commitment. There is however no comparable restriction on monetary policy by the ECB and I cannot see how lender of last resort functions would be seriously impeded by any ruling so far. Most importantly the ECB is free to print all the money it wants to.

      TARGET is a completely different animal, and for all practical purposes of no discernable relevance in the real world. It is simply a mechanism of keeping money supply constant when trans-border transfers are being made. No liability (as in obligation to repay) is incurred. The whole language involving debtors and creditors is badly mistaken.

      To convinve yourself of that try a little thought experiment: a TARGET “debtor” exits the Euro and repudiates its TARGET “liabilities”. The ECB decides to simply suspend the account and DO NOTHING. Consequence: none whatsoever. TARGET is a way of keeping track of flows, not a mechanism for transferring wealth.

  12. Georg R. Baumann

    Marshall, JKH

    Thanks for the enlightening article and exchange here.

    I believe what you point out Marshall concerning exclusive constitutional German issues, already is a thing of the past. I believe that Merkel is about to transfer this aspect of sovereign to the European Overlords and in doing so circumvents constitutional issues. One has to consider her overall history in doing exactly that, in my opinion the German constitution in it’s original form was one of the very best ever created, Merkel however diluted and literally destroyed the essence on purpose to allow for Lisbon treaties.

    The transfer of more sovereignty to a Central European Government is the explicit goal of the overwhelming political force in Europe, the European Peoples Party, EPP, that dominates all three major institutions top down, EU Parliament, Council and Commission.

    You can not force a political or fiscal Union under pressure and against the will of the people, well, I mean of course you can, but it will not be a healthy foundation for a future societal structure.

    Best
    Georg

  13. Georg,

    I think even if Mrs Merkel is about to transfer some aspects of German sovereignty over to the European Overlords, as you suggest, I’m sure this would require a change in Germany’s own constitution would it not? So I don’t think she can evade the legal issues as easily as you suggest, unless of course, you think that the Constitutional Court is simply a banana republic court which will affirm anything that the political powers that be want.

    And the other point is that even if the court does rule in a manner according to what the political elites in Brussels and Berlin desire, the mere fact of a constitutional challenge could well exacerbate the bank run. If you, as an individual depositor think there is even a remote possibility that Germany’s courts could rule all of the ECB’s lender of last resort facilities unconstitutional, wouldn’t you race to move your money as a precautionary measure?

  14. Pingback: Greece and the Rest of the Eurozone Remain on the Road to Hell | | New Economic PerspectivesNew Economic Perspectives

  15. Georg R. Baumann

    Hi Marshall,

    thanks for your reply, coincidentally, today was the day where the constitutional court in Germany ruled on matters concerning the ESM, and this gives ma an opportunity to add some meat to the point I made earlier.

    The ruling states that the German government violated the constitution, here in particular 23.2 of the German Constitution and did not inform the Parliament at the earliest about the plans concerning the ESM, and in particular refrained from forwarding the ESM contract drafts since April 6th 2001. The ruling also confirmed that the German government acted against the constitution concerning the so called EURO PLUS Pact.

    This ruling emphasizes what I tried to highlight in my original post when I said that Merkel simply will circumvent constitutional issues, and I think this ruling is pretty much evidence of what I boldly claimed.

    Cheques and balances no longer work adequately in this system Marshall. No Germany, not yet, on a Banana Republic level as Ireland Ltd. had been turned into, but deliberately circumventing the peoples representation, the essence of democracy in Germany, the Parliament, clearly indicates what methods and tactics are at play here.

    Another examples in this context was Merkel’s attempt to swiftly and completely transfer decision powers concerning ESM and EFSF to her chosen insider circle of nine, granting them exclusive powers, thankfully this was stopped just in time by a constitutional court ruling. The attempt in itself speaks volumes, really.

    Taking both and the Lisbon history into account, I say Yes Marshal, she easily circumvented constitutional law, and never hesitated doing so.

    Probably superfluous to say, the above mentioned ruling from today has no impact on the governments decision concerning ESM and / or Euro Plus Pact, none whatsoever.

    Best
    Georg

  16. Georg R. Baumann

    P.S. Sorry for typos, no way to edit a post.

    The english translation of that ruling is not up yet, but you can find it at a later stage here:

    http://www.bundesverfassungsgericht.de/en/decisions.html

  17. Hello all, (if anyone is still paying attention to these comments)

    Hugely interesting debate here…slightly above my head I’ll admit. I was wondering:

    1. If TARGET2 is replacing deposits, is this actually a good thing for the banks’ profitability, as I’m sure T2 interest rates must be below prevailing consumer deposit rates?
    2. If, as Firionel mentions above, the ECB is free to print all the money it wants to, then if German deposits have been passed to the Greeks and the Greeks default, then when the Germans want their deposits back, can’t the ECB just print and give them back? If so, then the counterparty risk argument is moot.

    Thanks,

    Thomas