A recent paper in the Journal of Risk and Financial Management by Professor David Blake, “Target2: The Silent Bailout System That Keeps the Euro Afloat”, takes an in depth look at the history and problems of the Eurozone since its inception in 1999. His conclusions raise many concerns about the sustainability of the financial and political status quo within the Eurozone, with worrying implications for its close partners such as the UK.
At a conceptual level, Professor Blake asks whether the Eurozone meets the criteria for an Optimal Currency Area. These criteria were distilled into four conditions by Nobel prize winning economist Robert Mundell. Do the members of a prospective currency union face sufficiently similar economic and financial pressures that a “one size fits all” interest rate and currency regime will be workable? Do they enjoy wage flexibility and labour mobility? Do they have flexible prices and capital mobility? And, are counter-cyclical stabilisation measures in place to redistribute balance of payments surpluses and deficits?
The USA is presented as an example of a reasonably functioning Optimal Currency Area. Compared with this, Professor Blake’s conclusion is that the Eurozone does not. Its member nations face differing economic circumstances, cultural differences restrict labour mobility, socialist policies restrict downward wage and price flexibility, consumer financial services are parochial, and the absence of a fiscal and political union hinders the implementation of policies to redistribute wealth between nations.
The evidence for dysfunctional outcomes from the Eurozone is apparent, not only in a lower growth rate and higher unemployment than the USA, but also in structural financial imbalances. The South of Europe runs up persistent balance of payment deficits, with trade deficits often exacerbated by net capital flight, while the North of Europe runs persistent balance of payment surpluses. The banking system in the South is undercapitalised, while that in the North is obliged through the financial mechanisms run by the European Central Bank and by political pressures to subsidise and/or bail out the losses in the South.
For example, the total cost of rescuing EU banks between October 2008 and December 2012 amounted to EUR 592 bn in state aid. And by 2023, the ECB had loaned an accumulated amount of EUR 3400 bn to public and private entities through various asset purchase programmes.
The more straightforward financial transfers take the form of purchases of government bonds. In theory, the Eurozone governments are limited to a Maastricht debt ceiling of 60% of Gross Domestic Product. However, this limit seems to be more honoured in the breach than in the observance. In 2019 the Eurozone ran a debt to GDP ratio of 86% on average, with Spain at 98%, Portugal at 115%, Italy at 133% and Greece at 180%.
The Basel II capital adequacy rules for banks, as applied by the ECB, treat all Eurozone government debts as risk free, regardless of the opinions of rating agencies and actual interest rate spreads in the financial markets. This artificially encourages lending to less creditworthy governments, thereby increasing the actual risks to the banking system.
A particularly insidious mechanism operated by the ECB is known as Target2. This is not a target, but a clearing mechanism operated by the ECB for the balance of payments deficits (and surpluses) that arise between Eurozone countries. The technical details are described in Blake’s paper, but the net result is that the ECB effectively ends up as lender of last resort to the central banks of Eurozone countries with balance of payments deficits that cannot be financed in the normal capital markets. The ECB funds these loans by taking deposits from those Eurozone central banks with surpluses and by issuing Eurobonds.
Once again, the ECB rules stipulate that Target2 balances at the ECB should be treated as risk-free, even if the funds have been used by the ECB to fund the least creditworthy parts of the Eurozone. This has the effect of upgrading risky loans made by the ECB into “risk free” deposits at the ECB. Between 2005 and 2022, the Bundesbank’s Target2 deposits with the ECB increased from zero to EUR 1269 bn, while Italy’s balance fell from zero to EUR 684bn in debt. As Professor Blake argues, Target2 “has become an unofficial channel for bailing out the euro”.
Various commentators have proposed that the Target2 balances should be added to government debt. Notably, Mario Draghi, the then ECB governor, said that if a country wished to leave the Eurozone, it would first need to settle its Target2 liabilities “in full”.
Taking these balances into account, the debt to GDP ratio of Spain rises to 138% and that of Italy to 167%.
If the Eurozone was a political union and the ECB was a normal central bank, with the ability to draw on fiscal revenues, print money and build reserves to compensate for bad debts, all this would matter much less. However, as Professor Blake points out, “no member state individually controls the ECB, so EZ members are ‘‘sub-sovereign’’, implying that the member states do not (and cannot) stand behind their government debts or currency in the way genuine sovereigns do—by printing more money to repay their debts when their tax base proves to be insufficient”.
So, as matters stand, Target2 is compared by Professor Blake to a Ponzi scheme, where the ECB’s ability to continue dispensing funds to deficit countries depends entirely on the willingness of creditor nations to continue extending further credit. Professor Blake notes the similarities with the sub-prime loan debacle in the US, where loans were artificially repackaged as “low-risk” investments, regardless of the actual risks associated with the underlying loans, a practice which precipitated the Global Financial Crisis of 2007-8.
In Professor Blake’s analysis, the financial imbalances in the Eurozone are likely to continue to grow until either the Eurozone breaks up, or until some financial crisis forces the Eurozone nations into a political and fiscal union. The former option would be economically disastrous not only for the Eurozone but also for its partners. Professor Blake estimates the exposure of the UK to collateral damage from obligations taken on while a part of the EU in the range of Eur 56-196 billion, depending on the extent to which other EU members can meet their share. The latter option of a political and fiscal union run from Brussels, while possibly the preferred option of ruling elites, may not have popular support across the Eurozone.
Professor Blake suggests we keep a close eye (a) on the South of the Eurozone, and Italy in particular, for developments in its ongoing government debt crisis and (b) on the North, and Germany in particular, for signs of a populist uprising. Either might upset the delicate consensus that permits the ECB to continue its juggling act.
Precis of the full article by Dr Rudolph Kalveks - December 8, 2023.
For the full article of 126 pages by Professor David Blake, please click on this link or download the attached pdf file below:
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