Believing in Europe’s financial tooth fairy

Published in Business Spectator (Melbourne), 12 June 2012

Saying something genuinely new on the euro crisis is getting more difficult as time passes. The problems never change, only the sums involved. However, a jump in Germany’s implicit exposure to Europe’s problems by a few hundred billion euros in less than a year still deserves a mention.

When I last wrote about the Bundesbank’s unenviable position within the Eurosystem (Europe’s hidden doomsday machine, 8 November 2011), Germany’s central bank had built up a claims against other European central banks for a total of €462bn (based on Bundesbank figures for September 2011). Last week, the Bundesbank announced that by the end of May 2012 this figure had risen to a new record level of €699bn – that’s a €237bn increase over just eight months.

As European politicians are haggling over a comparatively measly €100bn bailout package for Spain, the Bundesbank, by allowing these claims to mount up, effectively provides similar assistance to the euro periphery on an ongoing basis. Unfortunately, this has turned the German central bank into a financial tinder box. An uncontrolled breakup of the eurozone now has the potential to wreck Germany’s public finances and its banking sector.

The system which caused the Bundesbank’s exposure is complicated but the basic problem is simple. The countries at the heart of the euro crisis can no longer access capital to finance their trade deficits. At the same time, capital is fleeing their economies in search of a safe haven.

While such developments would usually result in an adjustment brought about by the exchange rate, in the eurozone something else happens. The central banks of the crisis countries virtually print money to provide their financial institutions with liquidity. Through the European Central Bank’s ‘Target 2’ clearing system this liquidity is channelled through to the banks in the healthier euro countries.

In this process, the euro core’s central banks build up claims against the Eurosystem, ie other European central banks. And thus the central banks of Germany, Finland, the Netherlands and Luxembourg (GFNL) are gradually amassing larger and larger positions against the remaining central banks of the eurozone. Together their claims are worth roughly €1 trillion, at least at face value, and rising every month. How much they are really worth depends on the ability to keep the eurozone alive. If the euro breaks up, at least a proportion of the GFNL claims would have to be written off.

If the prospect of the Bundesbank losing a share of its €699 billion Target 2 position does not sound too pleasant for Germany, it is just the beginning of Germany’s problems in the event of uncontrolled euro breakup.

Not only that the write-downs would wreck the assets side of the Bundesbank’s balance sheet, of which close to two thirds consist of dubious Target 2 claims. Any Bundesbank troubles endanger the stability of Germany’s banking sector.

As Germany’s banks are awash with liquidity through the constant flow of recently created central bank money in the euro periphery, they don’t know how to help themselves but to park the money with the Bundesbank. In this way, the Bundesbank has become a net debtor to Germany’s financial institutions – not quite the position a central bank would typically find itself in. And certainly not a desirable position at a time when the health of the Bundesbank’s balance sheet looks dubious.

If the euro breaks up and Germany’s Target 2 claims can only be partially recovered, the Bundesbank could technically be bankrupted overnight. But what then? Would Germany’s commercial banks also have to write down their deposits with the Bundesbank? Would the German government be able to recapitalise the Bundesbank? Or would central bankers manage to inflate their way out of this calamity by providing liquidity to themselves for a change? Nobody knows.

The only certainty is that any correction of Germany’s (and the other GNFL countries’) Target 2 claims would be extremely painful – not for the euro periphery, but to the euro core. Whereas in the euro crisis so far it is the periphery countries that have suffered the most, in the euro end game the core countries will be most badly affected. They will suddenly realise how exposed they have become to the rest of Europe through their central banks – not only through explicit bailout packages, EFSF or ESM that used to dominate public debates.

It is obvious for anyone able to read a balance sheet that the GFNL central banks have been manoeuvred into a vulnerable and risky position. And yet the response to this development is not to change course. Quite the opposite: In their desperate attempts to keep the euro alive, Europeans are letting the Target 2 balances balloon month by month, thus exacerbating the problem and increasing the final bill.

The official line on this mess is that it won’t be allowed to come to the boil. In the ECB’s wishful thinking there is no option for a breakup of monetary union or a write-down of Target 2 claims. Europe’s central bankers insist that there is no technical limit to these claims and that, over time, they should recede naturally. It’s the monetary equivalent of believing in the tooth fairy.

Europe has allowed this crisis to fester for too long. There are no easy solutions any more. Ending Target 2 now would be a disaster as it would kill the euro periphery’s banking sector. Keeping Target 2 alive will create an even bigger catastrophe in the future as it will ruin the GFNL central banks. But hoping for the Target 2 issue to disappear by itself is the most irresponsible option of all.

Continuing the Target 2 madness prevents the long overdue adjustment of intra-European trade and payment balances. It locks both PIIGS and GNFL countries into a monetary system that works for neither.

If Europeans only understood half the severity of this problem, there would be a revolution tomorrow morning. For the time being, however, the European soccer cup provides a most welcome distraction.