I have written a new article on Target2 for Vox-EU titled “TARGET2: Not why Germans should fear a euro breakup.”
It is interesting to see how the debate about Target2 has changed over time. This is the third article I’ve written for Vox on this subject. The first two (here and here) largely dealt with serious inaccuracies that were being aired prominently, such as claims that the Target2 system was crowding out credit in Germany or that the Budesbank was being forced to sell securities to fund loans to the periphery. While new false claims about Target2 have since emerged (e.g. CESIfo’s claim that German commercial banks are having to alter the asset side of their balance sheet because of Target2) these particular stories appear to have been put to rest.
More recently, as the Euro crisis has escalated, the focus of discussions on Target2 has switched to the question of what would happen to the balances if there was a complete Euro breakup and those central banks with Target2 liabilities refused to honour their debts. This is a legitimate question and it is the one I address in today’s article.
My conclusion is that there will be no need to fiscally recapitalise the Bundesbank should its Target2 credit turn out to be worthless because the new-DM will, like the Euro, be a fiat currency and such currencies do not obtain their value from being backed one-for-one by hard assets held by the issuing central bank.
This conclusion will, I’m fairly sure, attract a lot of criticism, particular from the Northern European parts of the internets. However, I think much of the scare-mongering about Target2 reflects a general confusion about the nature of central bank balance sheets within a fiat currency system.
Consider, for instance, the constant stream of business press reports featuring various commentators worrying about the balance sheet of the ECB. As I’ve noted before, much of the commentary on the potential credit losses focuses on the wrong figures by discussing the ECB’s capital when, in fact, loss-sharing on monetary policy operations is shared across the full Eurosystem, which has nearly half a trillion euros in capital and revaluation reserves to absorb losses.
Even when these articles focus on the right figures, they usually greatly exaggerate the potential problems associated with the ECB’s potential “solvency.” Articles like this one, for instance, seem to be premised on the idea that the value of the euro as a currency depends on the Eurosystem having assets that “back” the currency: One euro more in assets than liabilities and the Eurosystem is fine, one euro less and disaster supposedly awaits.
The truth is that the euro is a fiat currency and its value as a medium of exchange does not stem from the public’s faith in the value of the assets held by the central bank. Commentary that hypothesises existential problems for the euro stemming from perceived issues with the Eurosystem’s balance sheet are simply based on false analogies between private sector and central bank balance sheets.
I’d like to be able to point to lots of other useful work on this topic but, unfortuantely, these issues are rarely discussed in mainstream economics textbooks or journals. Here though is a nice recent presentation by Columbia’s Ricardo Reis that touches on some important points in relation to central bank balance sheets. Hopefully Ricardo will produce a full paper on this soon.