For some time economists have been engaged in an arcane controversy about the significance of the imbalances in the joint settlement system used by eurozone central banks, called Target 2. In a series of contributions, Hans-Werner Sinn of the CESifo research group in Munich has drawn attention to the fact that central banks in the northern part of the eurozone were accumulating claims on central banks in the southern part via Target 2. From about zero in 2007, these claims have risen to €400bn in 2010 and €800bn lately.
The notion of a balance of payment crisis within the eurozone was alien to the concept of a monetary union. It was routinely assumed that for countries within it, balance of payments would become as irrelevant as they are between regions within a country. This assumption was wrong. Countries are not regions, largely because much their banking systems are primarily exposed to their sovereign and to domestic borrowers. So when the sovereign is in distress or private borrowers partially insolvent, the banking system is contaminated and there is a stigma attached to being a bank from country X or Y. Foreign lenders become wary and stay put. Target 2 balances largely reflect this counterparty risk.
But a symptom is not a disease. It is the diseases that must be cured. This certainly requires more than letting the fever subside through a huge injection of central bank liquidity. Public finances must be made convincingly sustainable, bad loans on banks’ balance sheets must be provisioned and recapitalisation must take place wherever needed. Continue reading »