My work on TARGET2 is part of a collaboration with Steffen Murau; I am responsible for what is expressed here.
As the European Central Bank begins its pivot toward interest-rate liftoff, there is once again talk of the eurozone’s integrity. These days, such discussion takes the form of opinions about rising bond spreads—the increasing premium paid by Greece and Italy on their sovereign debt, relative to rates on German bunds. If the ECB stops buying Greek and Italian bonds, those spreads may have to widen further to entice new buyers to step in.
The ECB has indicated that it will take some action to contain these spreads, but did not announce a specific plan at last week’s policy meeting. Any such plan will involve the ECB buying Greek and Italian sovereign debt, or lending money to someone else to do so. The details will have to do with the political-economic nuances of European integration.
The integrity of the eurozone is not, I think, in particular jeopardy at the moment. But it is a good opportunity to take a look at TARGET2, the European interbank payment mechanism, a key component of the eurozone monetary plumbing. In today’s post: a nice graph of TARGET2 balances, an analogous graph for the US Fed’s interdistrict settlement account, the big theoretical difference between them, and a caution against overreaction.
This graph shows eurozone member states’ balances in the TARGET2 payment system. I show the seven largest balances, lumping the rest into “Other” (with apologies to my friends in Other). The outer extent of the graph, about 1.75 trillion euros at present, measures total gross balances. It is a closed system, so total positive balances equal total negative balances—the graph is symmetrical:
Some important features of TARGET2 come through nicely in the picture. For example, Germany’s large and persistent positive balance shows that it is a net provider of funds into the payment system, along with Luxembourg and the Netherlands. Spain, Greece and Italy have persistent negative balances. In words, this says that, as a consequence of history to date, Germany holds a claim of over a trillion euros, and other surplus countries smaller amounts; these claims are in theory payable by the deficit countries.
TARGET2 balances are recorded on the balance sheets of the various national central banks, as assets for the surplus countries and as liabilities for the deficit countries. This is the right thing to do, because it correctly expresses the cumulative payment flows among the eurozone members. This leaves one wondering, however, how these claims could be collected.
Interdistrict settlement account balances
TARGET2 balances are essential to monetary union—they are the balance-sheet quantities that adjust so as to ensure that one euro in Germany is always equal to one euro in Spain. The United States is also a monetary union, and the comparison is instructive. The graph below is the comparable graph for the Federal Reserve’s interdistrict settlement account. Its participants are the twelve Fed branches, named for the cities where they are located. The graph selects the branches that typically have the largest and most variable balances, lumping the rest as “Other”:
The financial structure of the two payment systems is similar—in both cases, branch banks transact among themselves to allow par clearing across the entire monetary union. Each system has a dominant participant—New York in the US, Germany in the eurozone. But note that over the two decades shown here, New York, unlike Germany, has been as likely to have a negative balance as a positive one. Which way it goes depends on the patterns of money flow among the parts of the US banking system. Even during the pandemic, New York has played different roles, providing funds in 2020 and absorbing funds in 2021. This is in sharp contrast to the role of Germany, which has only ever been a creditor to TARGET2.
The difference matters: in Europe, TARGET2 participants are member states, and though they are part of European institutions, they retain a strong sense of national politics. In the US, participant Fed branches are organized into economic-geographic regions. Importantly, these do not correspond to any other major political division, and they even cross state lines. So New York’s dominance of the US financial system is sometimes a political issue, but it is hard to imagine the Fed’s Second District somehow seceding from the dollar. It is much easier to imagine a euro member state exiting the monetary union.
Another feature of the system that is quite visible in the graph is that balances in the interdistrict settlement account sometimes get quite big, during times of financial stress, but then every once in a while (e.g. in 2012 and 2014) they are sharply brought down to zero. This is an illustration of settlement: the balances among the reserve banks are resolved by the transfer of another asset—government or mortgage-backed securities. Settlement has not been a part of the operation of TARGET2—total balances, and individual balances, have tended to grow, and there is not a mechanism in place to ensure settlement.
Against incautious interpretation
Conversations about TARGET2 tend to devolve quickly, with everyone interpreting what they see according to their prior political inclinations about the eurozone. Let me urge against any extreme interpretation. It is true that TARGET2 is not routinely settled up, but it is up to the participants to decide whether and when settlement is necessary. For now, no one is insisting. If that ceases to be true, we will hear about it from politicians long before it shows up in TARGET2 balances.
The TARGET2 debate is indeed a recurring "hot topic", by now mainly relegated to commentaries in newspapers in Germany (FAZ), where mainly Eurozone critics and pro-Austerity fanatics predict time and again that once these imbalances have to be settled creditor Central Banks are on the hook. But there is also the view that all of this is just an "accounting phenomenon" (this paper has a good explanation of the issue, going into some detail http://www.ebr.edu.pl/pub/2019_2_48.pdf ).
Minor thing: " The outer extent of the graph, about 1.75 billion euros at present" - I think it should be trillions