The danger of the eurozone’s hidden divide
Imbalances between nations are growing year-by-year
Back in October, the Telegraph reported that the eurozone was at “risk of financial meltdown”. According to experts, the European Central Bank could soon have “no choice but to follow the Bank of England and step in to prevent market disaster.”
Except that, while the British meltdown was bad enough to topple Liz Truss, there’s been no equivalent upheaval on the continent. And for that, we should all breathe a sigh of relief.
Like what you’re reading? Get the free UnHerd daily email
Already registered? Sign in
The last thing we need right now is another eurozone crisis. The first one was bad enough — and taught us there are no quick fixes when it comes to something as fiendishly complicated as the European single currency. Unlike recent events in the UK, ending the first eurozone crisis required a lot more more than a swift change of prime ministers.
Despite the multiple impacts of Covid, the cost-of-living crisis and Putin’s invasion, the eurozone is currently holding it together. Unlike 10 years ago, we haven’t seen the interest rates on public debt diverge uncontrollably between Germany and the so-called “peripheral” member states like Italy and Spain.
However, there is another indicator worth keeping a wary eye on. It concerns TARGET2 — which can be thought of as a running tab between the central banks of each eurozone member state. If there is a net flow of euros from country A to country B, then that would be recorded by TARGET2 as a negative balance for A and a positive balance for B.
Normally one would expect these balances to shift back and forth with the free movement of goods, services, people and capital. Except that’s not the way things have worked out. The imbalances between eurozone nations have become permanent and they’re growing year-by-year.
You can see the long-term trend in the chart above from Osnabrück University. Countries like Italy are going deeper and deeper into negative territory — while other nations accumulate ever-larger positive balances. Germany alone now has a positive balance of more than a trillion euros.
It is sometimes claimed that this isn’t real debt, just an accounting quirk of the system. But this is wrong. Money is quite literally a promise by a central bank to pay the bearer on demand. Money circulating in a national economy has to be backed up by assets held by a country’s central bank, otherwise the bank would be insolvent.
Therefore there can’t be a net flow of euros from, say, Italy to Germany unless the German central bank acquires a balancing claim on Italian assets. This is what TARGET2 is actually keeping tabs on. It’s a special kind of debt, but still a debt.
The big question for the eurozone is how long can this great divide — between creditor and debtor nations — keep growing? Anyone who says forever is fooling themselves.
A monetary union of budgetary sovereign states is doomed to fail.
I said this in 2000 and I still believe it. I am surprised the Euro has lasted this long. The wealthy countries managed to kick the can down the road in 2010; however fiscal and monesary policy will not tolerate permanent separation.
I have felt that the Euro, monetary union, was brought in to ‘fail’, and this imminent failure would/will eventually be used as the clinching argument that fiscal union, the single treasury or chancellery, alongside the ECB, is necessary.
Once one has monetary and fiscal union introduced then political union isn’t just inevitable it is de facto.
It may be this has to happen before the imbalances within and across do become explicit, and probably uncontrollable.
This would be a shame because ante this de facto the situation may be untangled without violence but after it becomes fact I can’t see how a non violent resolution of the difficulties could come about.
The answer to the question posed in last paragraph is ‘for as long as the Germans are willing to tolerate it’.
When all other arguments fail, EU apologists always fall back on describing the EU as a “Peace Project,” trying to elide this corporatist bureaucratic regime with nebulous concepts like unity and cooperation. As “proof” of their success as an agent for peace they point to 75 years without intra-European warfare – (though the peoples of the former Yugoslavia might have a word or two to say on that)
EU leaders love nothing more than to pretend the EU has brought and maintained peace in Europe, as though NATO was merely a figment of our imagination.
Some years ago people used to go on about the ‘McDonalds Peace theory’. .. Namely that “No country with a McDonald’s outlet has ever gone to war with another.” (McD’s expansion into the Balkans and former Soviet satellites killed off that particular boast). But there was some logic to it, in that countries with middle classes large enough to sustain a McDonald’s have reached a level of prosperity and global integration that makes warmongering risky and unpalatable to its people. Over the last half century most European nations have achieved a level of prosperity and interconnectedness which has reduced the likelihood of armed conflict.
But, far from being the peacekeeper, I fear that the EU, in its current guise, is fostering the climate that could lead to worsening relations between member states. Beggaring thy neighbour is not how to keep peace between countries, yet that is precisely what the North/South split in the eurozone is doing – with potentially dangerous outcomes. Given that EU nations are in no way “equal” players in the project I would go so far as to suggest that what peace we have seen in Europe is increasingly DESPITE the EU not because of it.
Looking ahead, I’d argue that when it comes to threats that might lead to Europe fragmenting into potentially hostile confrontation, it is precisely those economic policies that bankrupt certain member nations while enriching others that is the most dangerous catalyst.
This is exactly correct. Globalism has always held that trading relationships promoted peace by giving both sides mutual shared interest and vested common interests but that was always too simple. The door swings both ways, and every relationship and interaction that could develop into a positive incentive for peaceful relations can also become a point of conflict when one or both sides perceives it to be unfair in some way, or one side sees the other side as having all the power in the relationship and believes it is being exploited or oppressed. Moreover, time has a way of changing relationships great and small. What looked like a good deal in 2000 might not look so good ten or twenty years later. No matter how madly in love with one another two people seem to be, there’s an even chance they’ll get divorced somewhere down the road. One need look no further than the building cold war between China and America to find an example of how globalism accomplished the exact opposite of what its adherents intended. Had Chimerica never occurred, whatever disputes they might have today would look very different, and play out in a very different way. The relationship was exploited by many on both sides without regard for anything other than economics, with the ultimate result being two countries with incompatible cultures and governmental systems whose populations are as hostile toward one another as their respective governments are, and thanks to all the trade that happens and continues to happen, they also have dozens of ways to inflict economic pain on one another, which they will use in a cycle of provocation and retaliation until they run out and are staring hatefully at one another across the table, assuming they don’t blow each other up along the way. The EU, being the ultimate globalist project that some people openly declared to be a prototype for a world government, is likely to be the last political holdout of those idealistic notions and quite likely to cling bitterly to the sinking ship of globalism long after everyone sensible has abandoned it and looked toward keeping their own house in order.
Excellent summation. I agree entirely
I am sorry but I don’t understand it. What does it mean that there is a “debt”, say, from Germany to Italy? Who is supposed to be better off, the borrower or the lender?
Besides, the color coded graph is pretty much unreadable.
That was my thought too. I think the main point is that the EU wants all the Eurozone economies to converge for a stronger union but in fact they are getting further apart so the policy has failed. What I don’t understand is whether the Germans for example would be pleased or not at this situation and why.
“What I don’t understand is whether the Germans for example would be pleased or not at this situation and why.”
Generally not, given that any messy fallout will inevitably involve Germany’s Target2 “asset” evaporating.
However, there’s an interesting view mentioned by Yanis Varoufakis a cople of years back in which he describes the practice of many Eurozone cash holders to transfer their money from the banks of their own Eurozone nation to Germany by opening accounts in German retail banks. They were speculating that Germany might leave the Eurozone to prevent running up even more bad debts under Target2, and if this happened of course, Germany would redenominate all German banks balances as German Marks – which would, inevitably, instantly diverge upwards in value from the Euro, and the Euro would crash. It would be a handy way to make a lot of free money at no obvious risk.
This has not happened (yet) of course, but it is nonetheless an intriguing theory.
Thanks John, I’ve read your other very informative posts on this thread and it’s beginning to become clear.
It’s a standard trade deficit/surplus problem. For example: let’s say France buys a bunch of stuff from Vietnam, so Vietnam has Euros is needs to do something with. The only place to spend Euros is in Europe, so Vietnam has to buy things from Europe. They can buy either current production (imports), past production (real estate / factories), or future production (corporate & govt bonds). Contrary to the magical thinking among many economists, there is no 4th option.
Over time, as the Vietnamese buy the most interesting things (to them) in Europe, they’re less interested in getting more Euros. This results in the Euro falling (losing value) compared to the Vietnamese Dong: 1 EUR used to equal 22,000 dong, but now it takes 25,000 dong to buy a Euro, because Euros are less useful to the Vietnamese. Currency devaluation is a natural feedback effect of trade deficits and tends to balance them out over time.
However, because Germany and Italy use the same currency, that sort of correction can’t happen. There is no exchange rate between Germany and Italy, to Italy keeps losing money to Germany. And since Italy now lacks sovereign control of its monetary policy, it can’t print more money to make up for this. That’s the essence of the problem.
I’m glad this is being discussed again, Target2 is a fiasco in the making and anyone who thinks it’s just an accounting quirk is deluded.
The really interesting thing about Germany’s position in this is that although German banks are technically in receipt of cash from account holders, this represents a liability to the German central bank itself because it is the lender of last resort which guarantees the solvency of the German banking system.
Target 2 exists because there is no fiscal union across the Eurozone. In the UK fiscal union, there are ongoing fiscal transfers between regions which nobody bothers to account for because the UK is one country – that’s what a fiscal union is, in this sense. In the Eurozone, German (and Dutch and Finnish) money flows to the periphery constantly, but because they’re different countries, the transfers constitute a debt owed back to the creditor nations.
Some of the unintended consquences of how Target 2 works are really quite scary. Here’s an excerpt from a PDF I got hold of a couple of years back:
“Consider a German manufacturer (A) who banks with Deutsche Bank and an Italian consumer (B) who banks with Banca Monte dei Paschi di Siena (MPS). Also involved are the German central bank (Bundesbank), the Italian central bank (Banca d’Italia) and the ECB.
A sells €100 worth of goods to B, but B does not have the money to pay for these goods. So B borrows €100 from MPS. MPS, in turn, increases its refinancing with Banca d’Italia by €100 (i.e., borrows €100 from the Italian central bank). The €100 is transferred via Target2 to the Bundesbank. The Bundesbank receives a credit of €100 from the ECB and Banca d’Italia receives a debit. The Bundesbank transfers €100 to Deutsche Bank which, in turn, reduces its refinancing with the Bundesbank (i.e., receives a claim for €100 against the German central bank). Deutsche Bank credits A’s account with €100.
To reiterate, the importation of goods to Italy from Germany – which leads to or increases both a current account surplus in Germany and a current account deficit in Italy – has been financed by MPS creating liquidity in the form of a loan deposited in B’s bank account. The liquidity creation results in a Target2 debit for Banca d’Italia and a Target2 credit for the Bundesbank.
In this example, Target2 turns the private debt of an Italian consumer into the national debt of the Italian government owed to the other national governments in the Eurozone.”
Are we all supposed to believe that this isn’t all going to go wrong at some point?
This is the reality behind the smoke-and-mirrors of the ‘single currency’: Germany has to buy the otherwise unsellable debt of the bankrupt but unreformable deficit countries in the eurozone to try to prevent a collapse. It’s a sort of never-ending atonement for the Nazi era.
I think Germany has no intention of actually standing behind that debt if – when, I should say – it crystallises. The Germans have already said publicly that unless the Target2 system starts operating as originally promised (that fiscal flows become self-correcting) it will claim the unilateral right to print the trillion or so Euros required to pay off what its central bank is owed.
The alternative would be to add this sum to the country’s sovereign debt liability, which it will never do, no matter how many times other EU nations mention the war.
But this would of course fundamentally change the institutional nature of the ECB, as well as diluting the spending power of every nation unable to do the same. It would amount to a monetary solution to a fiscal problem with the added dimension that the benefits of the plan are to be reserved to Germany while the dispersed costs are to be borne by the rest of the Eurozone.
Not a formula for European unity. I’m guessing.
Wait, you mean the balance of trade matters? Who knew?
Orwell was right: “There are some ideas so stupid only an intellectual can believe them.”
Is that why many intellectuals believe a trans woman is a real woman?
That’s exactly the sort of thing Orwell was talking about.
I first flagged up the “T2 scandal” years ago whilst discussing Brexit with friends.
Many were arguing at the time that the “German Economic Miracle was entirely smoke and mirrors, and in reality Germany had actually been (secretly via allowing a T2 imbalance to develop) simply buying its own goods via third party countries.
I am no economist so welcome other more knowledgeable opinions please.
You vastly oversiplify, but there is some truth in your description.
French economist and intellectual Charles Gave shares this view.
I’m not an economist either. I get the idea of what’s happening but what are its consequences? Why would Germans not like it?
Well people generally get fed up with people who owe them money if they can’t pay it back
Thanks and sorry to be dense but I still don’t quite understand. If I’m a Spanish company and I buy some goods from a German company and pay in Euros then my bank sends some Euros to the German bank of my supplier. So that would be a negative amount for the Spanish bank and a positive amount for the German bank. But the debt has been paid so no one owes anyone any money after that transaction so why should Germans be unhappy about that? Doesn’t it just mean that German companies are doing better than Spanish companies which must be good for Germany.
Now consider what happens if Spanish companies keep buying stuff from German companies but German companies don’t buy (as much) stuff from Spanish companies. Eventually, all the Euros in Spain end up in Germany and Spain can’t buy anything from anybody.
The difference is that a substantial proportion of spending in the periphery states is funded via debt issuance that filters back through the system and ends up as balances in Target2. So a German company may well have made a sale in Spain, but the Bundesbank ends up guaranteeing the Euro balance of the German company in question, but has only an IOU from the Spanish central bank as the corresponding asset.
OK. Your bank doesn’t pay the money directly to the German bank. Cross border transactions are handled by central banks through the central euro reconciliation system, which is now called Target 2.
The issue with Target 2 arises because central banks in the PIIG countries have simply ignored at least euro 1.5 trillion (probably much more) of these reconciliations and the Bundesbank hasn’t pursued them although it has reimbursed the creditor banks in Germany.
The PIIG banks can’t pay these debts because, as a consequence partly of the 2008 and 2011 crises, they no longer have the money. The Bundesbank won’t pursue them because that would cause a series of defaults – and as long as there are no defaults they remain on the asset side of its balance sheet.
Basically it’s a massive fraud on the people of Germany. If any private institution rigged its balance sheet in this way its directors would go to jail.
I think we need a revised article to decipher the comments on this thread. My head is spinning…
As I understand it, the German Bundesbank, having expended over a trillion Euros in supporting the Med. countries like Greece, have recorded that transaction on their balance sheet (2017’s balance sheet can be seen here ( https://www.bundesbank.de/resource/blob/766666/99cfcfa6e3be30ad293d1338718d8d7a/mL/2018-02-27-geschaeftsbericht-2017-guv-data.pdf )
On it, under matching Assets, they record:-
“5 Lending to euro-area credit institutions related to denominated in euro” just under 1tn Euros. But…
As I also understand it, not one single Euro of the the balancing Liability is reflected in any of the statements of any other central bank, Greek, or otherwise.
This figure is purportedly owed to the German Bundesbank, but no other entity has accepted that they owe any of this. The money has simply evaporated, and 58% of the Bundesbank assets are non-existent, leaving the bank insolvent. And everyone is just pretending this isn’t happening.
Here’s an old YouTube presentation by a German economist explaining it.
YouTube, July 2018
Bigger than the GFC – Target 2 and the Euro crisis
– Dr Oliver Hartwich
Please would anyone care to explain it to a simple lad like me?
If anyone can explain if this is the same sort of problem the us dollar fx market is having I’d be grateful. As far as I understand this is a kind of off sheet debt too. This was on my news feed, all sounds very bad and dodgy. Especially after reading about the euro on here.
Looking at the graph linked here, I see that Greece is close to neutral. I expected it to be down there with Italy and Spain. Did they actually meaningfully reform after the eurozone crisis?
Yes they did – by shrinking their economy by 25% and by getting German and French banks off the hook. Not that they had a lot of choice. Ireland did something similar.
Unlike Italy, Greece is not too big to fail, and so the EU could strangle it with impunity. It has now returned to a sort of stability and (again unlike Italy) can sell its government debt in the capital markets.
Without even looking at the graph key I knew which country was the light blue, and which was the green.
Join the discussion
To join the discussion in the comments, become a paid subscriber.
Join like minded readers that support our journalism, read unlimited articles and enjoy other subscriber-only benefits.Subscribe