They’ve done it again. Italy’s Target2 balances hit -€489.5bn in October. That’s a new record low. Of any country, ever. Including during the European sovereign debt crisis.
But very few of us know what it means.
In fact, nobody knows quite what it means. Even the experts. And if the creators of the system had realised what it means, they wouldn’t have set the system up this way.
My book explains Target2 in detail. But in an easy to understand way. Because you need to know what Target2 is. Or, at least, what it means for you.
It’s like a pressure gage on the boiler of the eurozone system. It tells you how bad the coming financial crisis will be. Given the imbalances are at a record level for Italy, it’s going to be bad. I’m talking about the biggest financial crisis in history.
But what is Target2?
Some people will tell you it’s a debt. Italy owes its eurozone colleagues almost half a trillion euros via Target2. The eurozone members owe Germany almost a trillion euros.
But none of this is on any nation’s balance sheet. It doesn’t show up as debt on the debt-to-GDP ratios. And the money owed doesn’t earn any interest. Nor does it ever have to be repaid. In fact, it’s not even money that is owed…
Germany can’t sell or spend its Target2 positive balance. The so-called credit there is effectively worthless. It’s more of an accounting entry than a debt.
The easiest way to understand Target2 balances is to discover how they come about. You’ll realise just how odd the whole thing is.
There are two ways. The first is to do with trade.
When a Greek buys a German car, he sends money to Germany and gets a car in return.
The eurozone monetary system now has a problem. The amount of euros in Greece has fallen and the amount of euros in Germany has risen. This couldn’t happen if each country had its own currency, as that currency would only be valid in their home country.
If Greece continues with a trade deficit over time, it’ll eventually run out of euros. Which is a terrifying prospect for economists. So they send the money from Germany back to Greece via the Target2 system.
To record the transaction of euros flowing back south, Germany gets a Target2 asset and Greece a Target2 liability. In a way, Greece gives Germany a very abstract “IOU” for the money sent to Greece.
Over time, as the trade deficit continues, Germany’s Target2 assets build up and Greece’s Target2 liability builds up.
In theory, the trade balance is supposed to reverse… eventually. Olive oil exports sold to Germany become bigger than German car exports sold to Greece. The Target2 balance trends back towards 0. No problems arise.
The trouble is, the Target2 system has abolished all the natural forces which make trade rebalance over time. The exchange rate between Germany and Greece cannot adjust to encourage Greek exports and make German cars more expensive in Greece. They’re both on the euro.
Because Target2 is nothing but an accounting entry, it effectively costs Greece as a country nothing to buy German cars. The money they paid Germans flows straight back into Greece via Target2. So the Greeks can go on buying more German cars.
The Germans are being robbed, and they’re financing Greece’s trade deficit at the same time. Without any hope of that trade deficit reversing. Which means the Greek economy is kept in the doldrums, unable to rebalance and return to economic growth.
As I say in the book, it’s a lose/lose situation.
The second way in which Target2 balances can grow is similar. It involves capital flight instead of trade. If the Greeks expect a banking crisis, they can send their money to the supposed safety of Germany. This shows up in Target2 because it also means there’s a currency shortage in Greece, unless Target2 sends the money back. Which it does.
Either way, Target2 is your best measure of crisis potential in the eurozone. How much of a trade and economic imbalance there is. And how much capital flight. Usually it plays out in that order.
In 2012, the balances spiked as the sovereign debt crisis peaked. Trade imbalances became outright capital flight. The Bank of International Settlements confirmed this in a research report, despite years of denials at the European Central Bank (ECB).
But Target2 isn’t just an indicator of pressure. It’s also one part of the boiler that could explode – the weak point.
Some say that the Target2 balance will only matter if Italy tries to leave the euro. Then it’ll have to pay up on its Target2 debts. It’ll have to settle the bill for having been part of the eurozone. The ECB President Mario Draghi himself argued this is the case.
But the chances of a country leaving the eurozone and paying up on its debts to the eurozone financial system are slim. After all, it was the bizarre nature of that financial system which kept places like Italy in the doldrums in the first place.
The whole point of leaving the eurozone is to be free of your euro-denominated debt, not to add to it. If Italy acknowledged and tried to repay its Target2 balances, debt to GDP would go well north of 150%.
Unlike on bonds, Italy couldn’t just declare that it will repay its Target2 debt in Italian lira instead of euro. It doesn’t hold the power to redenominate Target2 balances.
Given all this, the bill for Italeave would be left with the ECB and the rest of the eurozone. Half a trillion euros’ worth.
The budget battle is a sideshow
Italy’s fiscal mess is bad enough before you consider Target2.
With economic growth at 0%, and a recession likely based on forward-looking indicators, GDP is going nowhere fast. Except perhaps down. Interest on Italian debt is rising and above 3% on key bonds. Debt to GDP is well over 100%. And the deficit is about to blow out.
Put the four together and debt to GDP has only one way to go. The interest bill alone, even without a deficit, would gobble up any economic growth. There is no way out. Except out of the euro.
For now, financial markets are relying on bailouts. My book explains why those bailouts will fail, making the coming crisis worse than 2008 and 2012.
Tomorrow, the EU is poised to impose fines on Italy instead of bailouts. Because fines help you out of financial trouble…
The Italians claim they’re going to ignore tomorrow’s budget deadline. They won’t reduce their spending as the EU demands.
But the EU’s fines are not the heart of the issue. Nor the New Hanseatic League’s attempts to formalise Europe’s bailout powers. We looked into that last week.
Target2 is the real issue. The indicator, cause and weak point of the eurozone system’s demise.
You won’t read about it anywhere else. Not in a way that you can understand, and then discover how to protect yourself.
Once you discover what Target2 is all about, you’ll realise something. The budget battle is a sideshow.
The only real constraint and counterpunch that fiscally responsible nations can make against Italy’s budget belligerence is to cap Target2 balances. They could activate the secret German plan to squeeze Italy out of the eurozone on the sly, without copping the blame. It’s a carbon copy of how the Soviet Union’s currency system failed.
In my book, I reveal the specific sentence you need to listen for. If you hear those words in the European or German parliament, it’s time to panic.
Until next time,
Nick Hubble
Capital & Conflict
Category: The End of Europe