How target balances actually signal the strength of ECB system and not weakness…

The topic of Target imbalances which was in rage in 2011-12 has subsided big time. It hardly makes news now as EZ crisis has eased significantly as well..

Most then had suggested that TARGET imbalances showed the weakness of EZ system as it allowed weak countries to be bailed out by stronger ones. Thus creating imbalances. However, you now how economics is. There is always an alternative story to be tol.

Michael Bordo, eminent econ historian in this voxeu article defends the TARGET system. He says it shows historical lessons have been learnt!:

Since 2007, there has been a buildup of TARGET imbalances within the Eurosystem – growing liabilities of national central banks in the periphery matched by growing claims of central banks in the core. This column argues that, rather than signalling the collapse of the monetary system – as was the case for Bretton Woods between 1968 and 1971 – these TARGET imbalances represent a successful institutional innovation that prevented a repeat of the US payments crisis of 1933.

So Bordo takes you to the times of Bretton Woods collapse:

There has been a build-up of TARGET liabilities since 2007 by some central banks (notably Greece, Ireland, Portugal, and Spain, or the ‘GIPS’), and of TARGET assets by Germany and others. This is compared to the historical accumulation of big US current-account deficits under Bretton Woods’s gold-dollar standard that were matched by the large surpluses of Germany and others (see Sinn and Wollmershaeuser 2011 and Kohler 2012).

The events of 1968–1971 did not end well. Back then, the US did not have to adjust its payments deficit – other countries accepted US dollars as international reserves. In the face of rising US inflation after 1965, growing payments imbalances, and inflationary pressure on the surplus European countries, the whole Bretton Woods system collapsed between 1971 and 1973.

Another Bretton Woods analogy relevant to today’s Eurozone problems is that of the UK, which ran persistent current-account deficits and faced deflationary pressure that eventually led it to devalue in 1967. Germany, by contrast, ran persistent surpluses and faced ongoing inflationary pressure. On two occasions, it was forced to revalue.

Which analogy is more apt? And are there other analogies which may be even more relevant?

He says second analogy is more important. The breakdown of Eurozone was indeed avoided because of Target system unlike thr BW system which did not have any such system:

The Bretton Woods system was an adjustable-peg international monetary system with member countries having independent monetary and fiscal policies. It also had restrictions on capital flows. By contrast, the Eurozone is a monetary union with perfectly fixed exchange rates with no option for adjustment. Members do not have access to monetary policy as a palliative, and capital is freely mobile.

Under Bretton Woods, the adjustable peg allowed some adjustment between deficit and surplus countries; and independent monetary and fiscal policies, the IMF, and capital controls gave members with imbalances some temporary respite. For the US as reserve centre country, devaluation would require raising the price of gold (as advocated by France). This was strongly resisted by the US on the grounds that it would be time-inconsistent and would benefit the pariah states – the USSR and South Africa. As it turned out, ending the system was the only way out.

The Eurozone is not a pegged exchange-rate system, nor is one member’s currency used as a reserve currency. The Maastricht Treaty abolished members’ currencies and created a new currency, the euro, and a new common central bank, the ECB. The escape valve of the Bretton Woods adjustable peg is not present. Moreover, unlike national monetary unions like the US, the Eurozone does not have a fiscal union or a Eurobond to facilitate adjustment.

But a more important difference between the Bretton Woods breakdown analogy and the crisis in the Eurozone is the existence of a payments clearing mechanism – the TARGET system and the Eurosystem of national central banks and the ECB. In the Eurosystem, a key mandate is a uniform currency across the Eurozone – that a euro always be worth the same in every member country (Cour-Thimann 2012). Thus under TARGET, country imbalances are financed by access to the liquidity facilities of the Eurosystem of national central banks using the ECB as a clearing platform.

What happened in the Eurozone after 2007 is that the TARGET liabilities in the periphery (and the TARGET claims in the core) built up because the ECB acted to prevent the breakdown of the payments system after the interbank market collapsed and private capital flows disappeared (Cour-Thimann 2012). Indeed, before 2008, most flows between countries in the Eurozone were intermediated by banks. After that the interbank market dried up, and national regulators started treating banks as legally separate entities even when they were part of a euro-wide banking group. So what was previously a euro-wide banking system became fragmented. TARGET substituted for the euro banking system. The Federal Reserve performed the same function in the 2007–2008 crisis in the US, but unlike Europe the big banks still transferred money across the country.

Bretton Woods did not have an international central bank to act as a clearing mechanism as Keynes wanted with his International Clearing Union. If it did, perhaps the outcome would have been different. Clearly the ‘Bretton Woods breakdown’ analogy (1) is less relevant than the ‘persistent imbalances between countries’ analogy (2).

Always interesting to compare to historic events. One thought Target balances to be a unique thing but it has historical parallels too. And not too far in history. Just that this time the lessons seem to have been learnt.

Though, I doubt whether TARGET system was developed keeping this BW history in mind…Will be interesting to look at this aspect of history..

Other than this, the author explains the BW system really well. Just sit with a pencil and paper to figure the flows..


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