Prof. de Grauwe's one-sided view of Target2

Prof. Paul de Grauwe argues in the article, among others, that:

* If a breakup of the EZ were to materialize, this will lead to losses for Germany, independently of the existence of Target2.
* Germany could have avoided this by reducing its current account surpluses; it refused to do so and thus the responsibility for this risk is Germany’s, and not some obscure system like Target2.
 * German banks were willing to lend vast amounts of money to peripheral countries without doing a proper credit risk analysis. No one other than Germany itself is responsible for taking on these risks.
 * With or without TARGET2, the risk that arises from reckless lending by German banks will have to be borne by Germany.

I agree with Prof. de Grauwe’s partial diagnosis but emphasize that is indeed only a partial one. It does not speak for Prof. de Grauwe that he only paints one (convincing) side of the picture while ignoring the other (equally convincing) side. 

Prof. de Grauwe admirably discovers that a country’s Balance of Payments must balance. For mathematical and not for economic reasons, that is. Thus, a surplus in the current account must be offset by a deficit in the capital account. The price which Germany had to pay for its horrendous surpluses in the current account with the rest of the world in the last decade or so was having to make loans to the rest of the world. The same goes for China.

The question is only: what does one do when that problem erupts like it erupted with Greece in late 2009? Does one try to cure it by prolonging it or would it have been better to cure it at the source? Target2 massively contributed to prolonging the problem and, thus, turning it into a potential powder keg.

From the beginning of this blog, I have argued that one should have cured the problem at the source. In the case of Germany, that would have meant: stop Target2-funding for Greece; have the German banks write down their Greek claims to low market values; have them ‘beg’ for a government bail-out; have the government save those banks which justified saving and close the others.

The cost to German tax payers would initially have been similar to the cost which they have not recognized to date. However, the tax payers would have gotten something in exchange for that. They would have gotten temporary ownership of those banks and the hope that upon re-privatization, they could recover some of those losses. The banks' shareholders would have been wiped out (and possibly some bondholders, too). Prof. de Grauwe suggests that 'Germany' is 'Germany'. In actual fact, there are Germans as tax payers and there are others (not only Germans) who own German banks. Prof. de Grauwe seems to support a method where tax payers are called upon to not only save their banks but also their shareholders and speculative investors.

Target2 (and the rescue loans) made it possible that this decision could be avoided. Thus, the deficit countries never really experienced the type of financial crisis which a country normally experiences when it hits external payment problems: as the funds flow from abroad stops, the current account must be brought into balance virtually overnight. Instead, the deficit countries could continue with their current account deficits, this time not financed by reckless banks but, instead, by tax payers.

Prof. de Grauwe exclusively focuses on imbalances in current accounts. He completely ignores imbalances within the capital account. The massive deposit flight in deficit countries, which exceed the deficits in current accounts since the crisis erupted, was only possible because of Target2. Tax payers’ money was de facto automatically transferred to, say, Greece so that wealthy Greeks could take their money out of Greek banks.

Prof. de Grauwe might argue that this, again, is a circular mechanism: whatever German tax payers transferred to Greece was returned by those wealthy Greeks to German banks. Is he not aware that there are places like London, Switzerland, Singapore & Co. (none part of Target2) which also attracted a lot of Greek money?

Prof. de Grauwe completely ignores that a huge part of commercial/financial transactions in the Eurozone took place with counterparties outside the Eurozone. Since the Euro, Greece’s current account deficit with Germany accounted for only 15% of its total deficit. How about the other 85%? For example, Greece’s current account deficit with Germany was in the same magnitude as its deficit with China. Have Chinese tax payers been called upon to contribute their fair share? They would have, had there not been the Target2-system. Instead, the Duchy of Luxembourg became the most overexposed country (with Target2-claims of almost 3-times its GDP). Did Luxembourg have current account surpluses in that magnitude? Or how about Finland? How about Holland?

The relationship between current account surpluses, deficits and cross-border lending is a bit like a chicken-and-egg process. What comes first? If Germany had not lent to Greece, then Greece could not have imported so much from Germany; Germany’s current account surplus would have been smaller and, thus, its banks could not have lent so much to Greece… Target2 did not cause the process but it certainly accelerated the problem once the crisis erupted.

Prof. de Grauwe completely ignores one of the pillars of finance: lending/borrowing is a joint responsibility of lenders/borrowers. The lenders (among them the German banks) messed it up real good and they and their shareholders (and, in consequence, the German tax payers) should have been made accountable for that.

The argument is made in some places (I hasten to add that Prof. de Grauwe does not make it!) that fast-talking foreign bankers literally forced those loans down the throats of financially illiterate Greeks. Similar to those fast-talking mortgage salesmen who bullied unemployed Americans into taking up loans to buy a house. To even put such suspicions in writing  is a giant act of irresponsibility.

The decision to take up Greece’s foreign debt was taken by a very small group of people: executives at the government’s debt management agency, at the Greek banks and at the Bank of Greece. Direct foreign loans to Greek borrowers are virtually not in existence. Certainly the executives at the government’s debt management agency and at the Bank of Greece were professionals of very high international regard. I cannot judge the competence of the bank executives’ competence but I have to assume that they knew more about banking than the above-mentioned unemployed Americans. 

Conclusion 
Prof. de Grauwe is correct when arguing that Germany, actually since WWII but specifically since the Euro, pursued an economic model of current account surpluses (the expression “export champion” is something which Germans are proud of). Enormous current account surpluses carry the same risks as enormous deficits. Germany has ignored that and will, thus, inevitably pay the price for it.

However, Prof. de Grauwe is intellectually less than honest when he argues that this is exclusively a responsibility of Germany (and not of Target2). Someone who robs a bank is responsible for that. If the bank left its doors open, it, too, is responsible for that. Target2 left the doors wide open to extend enormous current account deficits on the part of Greece & Co. after the crisis erupted and, above all, to facilitate enormous deposit flight. Deposit flight is natural in any financial crisis. It takes the existence of something like Target2 to turn it into a fuse cord towards possible future economic wars.