The Bundesbank currently has a claim of 1.3 trillion euros vis-à-vis the rest of the national central banks of the Eurosystem – a situation that continues to cause concern among economic policy-makers in Germany, though not so much elsewhere. A new study by Robert Perotti concludes that the German criticism of the Target system is not unfounded, but that proposed solutions would trigger the very outcome that is feared: a breakup of the Eurozone.

The research notes that both critics and defenders of the system have proposed that Target balances be ‘settled’ periodically, with debtor countries paying the balance with ‘breakup-proof’ assets – those on which there cannot be a default in the event of a breakup, such as gold or US government bonds. But Target debtors’ central banks do not have enough breakup-proof assets even to come close to being able to settle their Target balances. Insisting on settlement with truly breakup-proof assets would almost certainly trigger a breakup of the currency union.

More

Target is a seemingly arcane system that records the claims and liabilities of each national central bank of the Eurosystem whenever customer deposits and central bank reserves ‘cross the boundaries’ of two countries of the Eurozone. When a country has a current account surplus or a capital inflow, its central bank accumulates a corresponding Target claim. The effects can be large: currently the Bundesbank has a claim of 1.3 trillion euros vis-à-vis the rest of the Eurosystem.

Many German policy-makers and economists have expressed serious concerns: what would happen if the other countries reneged on these claims, for example, if there were to be a breakup of the Eurozone?

Most European policy-makers and academics have been dismissive of the German preoccupations: the Target claims are paper claims, they say, Germany would not suffer any real loss. Not so easy, argues Roberto Perotti: the German criticism of the Target system is not so unfounded after all, and should be taken seriously.

Perotti shows that a Target claim is like a token that can be used only in the Eurozone: it is irredeemable, carries zero or even negative remuneration, and cannot be used as a medium of exchange. It can be used within the Eurozone to finance the import of goods or a capital outflow. If the Eurozone breaks up and debtor countries renege on the Target claims, this is indeed a real loss from the perspective of the creditor countries as a whole: other assets will have to be used to fund the import of goods.

Perotti shows that the main criticism of the German position carries little water. Target claims appear as assets on the balance sheet of the Bundesbank; even if they disappeared, say the critics of the German position, this would simply cause a loss of capital of the Bundesbank, but in a world of paper money, central bank capital is irrelevant.

Moreover, the critics add, the Treasury can always recapitalise the central bank and this would just be a transfer of resources between two branches of the public sector: the citizens would be unaffected.

This is debatable: a large negative central bank capital would simply be unexplored territory, both for central bankers and for the public, where psychology could play a bigger role than economics. But more importantly, as argued above, the default itself is a real loss of purchasing power to the German citizens: a token is lost that could be used to finance the import of goods.

What are the solutions? Like it or not, there are no solutions, Professor Perotti concludes. Both critics and defenders of the Target system have proposed that Target balances be ‘settled’ periodically: debtor countries pay the balance with ‘breakup-proof’ assets – those on which there cannot be a default in case of a Eurozone breakup, such as gold or US government bonds.

At first sight, this mimics the arrangement of the US Federal Reserve System, where the regional Federal Reserve banks settle their balances annually essentially using risk-free government bonds. But the settlement amount becomes part of the profits that each regional Fed rebates to the Treasury, and hence settlement is effectively irrelevant in that system.

In addition, with ‘quantitative easing’ (QE), by far the largest component of assets of each Eurozone central bank is its own government’s bonds, which clearly a debtor country can default on in the case of a breakup.

Quite simply, Target debtors’ national central banks do not have enough breakup-proof assets even to come close to being able to settle their Target balances. Insisting on the settlement of Target balances with truly breakup-proof assets would almost certainly trigger a breakup of the Eurozone as we know it.

---

‘Understanding the German criticism of Target’

Author:

Roberto Perotti (Bocconi University)