NBER WORKING PAPER SERIESTARGET LOANS, CURRENT ACCOUNT BALANCES AND CAPITAL FLOWS:THE ECB’S RESCUE FACILITYHans-Werner SinnTimo WollmershaeuserWorking Paper 17626 BUREAU OF ECONOMIC RESEARCH1050 Massachusetts AvenueCambridge, MA 02138November 2011We thank Jürgen Gaulke, Marga Jennewein, Michael Kleemann, Paul Kremmel, Wolfgang Meister,Beatrice Scheubel, Heidi Sherman and Christoph Zeiner for technical support, and in particular JulioSaavedra. We also thank Mario Draghi, Otmar Issing, Georg Milbradt, Helmut Schlesinger, ChristianThimann, Gertrude Tumpel-Gugerell, Jean-Claude Trichet and Martin Wolf for in-depth conversations,without implying in any manner whatsoever that they adhere to our arguments. The train of argumentsand the most essential charts have already been presented by H.-W. Sinn at the following events: internalseminar, Banca d’Italia, 22 April 2011; public lecture, Humboldt University Berlin, 9 May 2011; Introduction,Munich Economic Summit, 19 Mai 2011. We thank Michael Burda for serving as the formal discussantfor the Berlin lecture. This is an updated version of the one presented and discussed at a press briefingon 22 June 2011 in Frankfurt. We thank the participants for their valuable comments. The views expressedherein are those of the authors and do not necessarily reflect the views of the National Bureau of EconomicResearch. An online video of the Berlin presentation is available at: working papers are circulated for discussion and comment purposes. They have not been peerreviewed or been subject to the review by the NBER Board of Directors that accompanies officialNBER publications. 2011 by Hans-Werner Sinn and Timo Wollmershaeuser. All rights reserved. Short sections of text,not to exceed two paragraphs, may be quoted without explicit permission provided that full credit,including notice, is given to the source.

Target Loans, Current Account Balances and Capital Flows: The ECB’s Rescue FacilityHans-Werner Sinn and Timo WollmershaeuserNBER Working Paper No. 17626November 2011JEL No. E50,E58,E63,F32,F34ABSTRACTThe European Monetary Union is stuck in a severe balance-of-payments imbalance of a nature similarto the one that destroyed the Bretton Woods System. Greece, Ireland, Portugal, Spain and Italy havesuffered from balance-of-payments deficits whose accumulated value, as measured by the Target balancesin the national central banks’ balance sheets, was 404 billion euros in August 2011. The national centralbanks of these countries covered the deficits by creating and lending out additional central bank moneythat flowed to the euro core countries, Germany in particular, and crowded out the central bank moneyresulting from local refinancing operations. Thus the ECB forced a public capital export from the corecountries that partly compensated for the now reluctant private capital flows to, and the capital flightfrom, the periphery countries.Hans-Werner SinnIfo Institute Leibniz Institute for Economic Researchat University of MunichPoschingerstr. 581679 MunichGERMANYand [email protected] WollmershaeuserIfo Institute -- Leibniz Institutefor Economic Researchat University of MunichPoschingerstrasse 581679 [email protected]

1.Introduction1This paper investigates the Target balances, an accounting system hidden in remote corners ofthe balance sheets of the Eurozone’s National Central Banks (NCBs), to analyze theEurozone’s internal imbalance. It shows that the Target surpluses and deficits basically haveto be understood as classical balance-of-payments surpluses and deficits as known from fixedexchange-rate systems. To finance the balance-of-payments deficits, the European CentralBank (ECB) tolerated and actively supported voluminous money creation and lending by theNCBs of the periphery at the expense of money creation and lending in the core. This hasshifted the Eurozone’s stock of net refinancing credit from the core to the periphery and hasconverted the NCBs of the core into institutions that mainly borrow and destroy euro currencyrather than print and lend it. The reallocation of refinancing credit was a public capital flowthrough the ECB system that helped the crisis countries in the same sense as the officialcapital flows through the formal euro rescue facilities (EFSF, EFSM and the like) did, but itactually came much earlier, bypassing the European parliaments. It was a rescue program thatpredated the rescue programs.As we will show, in the three years 2008-2010, Target credits financed almost theentire current account deficits of Portugal and Greece and a quarter of the Spanish one. In thecase of Ireland, they financed a huge capital flight in addition to the country’s current accountdeficit. And, beginning with the summer of 2011, they have financed an even more vigorouscapital flight from Italy. With the Italian capital flight, the Target credits have reached a newdimension and the ECB has entered a new regime, whose implications for the survival of theEurozone should be discussed by economists. We can only touch upon the upcoming issues inthis introductory piece.2.Target Loans through the EurosystemThe Target claims and liabilities that had accumulated in the NCBs’ balance sheets untilsummer 2011 are shown in Figure 1. Germany, by that time, had claims on the Eurosystemamounting to 390 billion euros, and the GIIPS (Greece, Ireland, Italy, Portugal and Spain) inturn had accumulated a liability of 404 billion euros. The Target liabilities of Ireland andGreece alone were 119 and 96 billion euros, respectively.1This is an updated and abbreviated version of an earlier discussion paper of June 2011 (Sinn andWollmershäuser, 2011) presented as a plenary lecture to the August 2011 IIPF congress in Ann Arbor, Michigan.It takes the Italian capital flight beginning in August 2011 into account. The train of arguments and the mostessential charts of this paper have already been presented by H.-W. Sinn at the following events: internalseminar, Banca d’Italia, 22 April 2011; public lecture, Humboldt University Berlin, 9 May 2011; Introduction,Munich Economic Summit, 19 Mai 2011. An online video of the Berlin presentation is available foHome/c-event/c3individualevents/ event 20110509. By nowthe topic has been also discussed in a scholarly way by a number of German authors in a special issue of IfoSchnelldienst. See ifo Institut (2011) with contributions of H. Schlesinger; W. Kohler; C. B. Blankart; M. J. M.Neumann; P. Bernholz; T. Mayer, J. Möbert and C. Weistroffer; G. Milbradt; S. Homburg; F. L. Sell and B.Sauer; I. Sauer; J. Ulbrich and A. Lipponer; C. Fahrholz and A. Freytag; U. Bindseil, P. Cour-Thimann and P.König; F.-C. Zeitler; K. Reeh; and H.-W. Sinn). Furthermore, the ECB published information on the economicsof the Target balances for the first time in October 2011 (European Central Bank, 2011b).1

Figure 1: Target balances in the Eurozone (end of August 2011)Note: The data are directly drawn from the balance sheets of the NCBs or calculated as proxy from theInternational Financial Statistics of the IMF, as explained in detail in the Appendix. Our method for calculatingIMF proxies is identical to that adopted by the ECB. While Target balances in general should add up to zero, theresidual of the data presented here is explained by the ECB’s own Target liabilities stemming from assettransfers from NCBs, by Target claims of some non-Eurozone NCBs that are connected to the Target paymentsystem and which have converted euros into national currency, and by measurement errors resulting fromdifferences between the true balance sheet data and the imperfect IMF proxies. See the Appendix for furtherdetails.Source: Own calculationsThe Target claims and liabilities are interest-bearing.2 Their interest rate equals theECB’s main refinancing rate. However, interest revenues and expenses are socialized withinthe Eurosystem. Since the NCBs belong to their respective sovereigns, the Target liabilitiesconstitute gross government debt, even though they are not officially counted as such. ForGreece this debt is 44% of GDP, for Ireland 76%, for Italy 3%, for Portugal 35%, and forSpain 6%.The Target imbalances went unnoticed for a long time, because they are not shown onthe ECB’s balance sheet, given that they net out to zero within the Eurosystem.3 They can befound, however, if somewhat laboriously, in the NCBs’ balance sheets under the “IntraEurosystem Claims and Liabilities” position. Furthermore, they can be found in the balanceof-payments statistics, where they are shown as a flow in the financial account under the“Other Financial Transactions with Non-residents” position of the respective NCBs and as astock in the external position of the respective NCBs as “Assets/Liabilities within theEurosystem”. Interestingly enough, the ECB revealed in October 2011, in its first publication2Deutsche Bundesbank (2011b, p. 170).Precisely speaking, they net out in the euro countries, the ECB and those EU member countries that also usethe Target payment system. The latter cannot have a negative Target balance as they are not allowed to printeuros.32

on the issue, that it does not possess a reporting system of its own, but constructs the datafrom the IMF statistics (thus following the method we had introduced in the June 2011version of this paper; see also the Appendix to this paper).4Many think that the Target imbalances are a normal side-effect of the Eurozonepayment system, as they are wont to occur in a currency system. This assessment iscontradicted, however, by the dramatic evolution shown in Figure 2, which, as we will showbelow, in all likelihood would not have been possible in the US system. The Targetimbalances evidently started to grow by mid-2007, when the interbank market in Europe firstseized up. Before that they were close to zero. German claims, for instance, amounted tobarely 5 billion euros at the end of 2006.It is striking that a strong, albeit not perfect, correlation exists between the rise of theGerman Target claims and the rise in the Target liabilities of the GIPS (without Italy). Othercountries were involved, but with relatively negligible amounts, as shown in Figure 1. Thecreditor countries included Luxembourg and the Netherlands, while the debtors includedAustria, France, Belgium and Slovakia, and, in particular, Italy. But the key players are,evidently, the GIPS, Italy and Germany.During the first three years of the crisis Italy was not involved. Figure 2 shows Italyamong the countries having a Target claim until June 2011. However, from July 2011 on,when markets turned jittery about Italy, forcing the Berlusconi government to enact austeritymeasures, the country also became a Target debtor. The Target balance of the Bank of Italyfell by 110 billion euros in only three months, from 6 billion euros in June to –104 billioneuros in September, of which –87 billion euros were accumulated in August and Septemberalone. Thus, Italy is the main reason behind the Bundesbank’s Target claims rising by 113billion euros over the same three months, to 450 billion euros in September 2011.By September 2011, the volume of Target credit drawn by the GIIPs countries fromthe Bundesbank through the ECB system far exceeded the official loans given to them by theEurozone countries combined. Until July 2011 Greece had received 65 billion euros from theeuro countries and the IMF; Ireland and Portugal had received 25.9 billion euros and 30.3billion euros respectively within the framework of the European Financial StabilisationMechanism and the European Financial Stability Facility (EFSF). In total, the officialEurozone aid amounted to 172 billion euros. In comparison, the Target loans provided by theBundesbank totaled 450 billion euros, as mentioned.4European Central Bank (2011b, footnote 5). Cf. Sinn and Wollmershäuser (2011).3

Figure 2: Net claims of the NCBs resulting from transactions within the Eurosystem(TARGET)Sources: Own calculations; see Appendix.3.The Official Bundesbank and ECB StatementsThe Target debate began in Germany. After H.-W. Sinn brought the Target imbalances topublic attention with articles in the German papers Wirtschaftswoche, Süddeutsche Zeitungand Frankfurter Allgemeine Zeitung, pointing out the risks they involved,5 the Bundesbank5See Sinn (2011a, 2011b). A number of columns were published subsequently. See Handschuch (2011),Krumrey (2011), Fischer (2011) and Whittaker (2011). In Sinn (2011e, 2011g) the Target issue was firstinterpreted in a balance-of-payment context. See also Sinn (2011f, 2011d). Two earlier articles by a DeutscheBank official dealing with the Target issue were made available to us by Thomas Mayer, Chief Economist at theDeutsche Bank, on 9 May 2011: Garber (1989) analysed the protecting function of the Target system againstpossible speculative attacks during the transition from the virtual to the physical introduction of the euro in 2002.Furthermore, there is another text by the Deutsche Bank, to the best of our knowledge an internal paper that hadnot been published, Garber (2010), in which some of the problems associated with the Target system wereaddressed, but devoid of any interpretation in terms of balance-of-payments or current account imbalances. Anearly warning of internal imbalances in the Eurozone payment system was expressed by Reeh (1999, 2001). In4

reacted with various, nearly identical statements. One day after the first publication by H.-W.Sinn on 21 February 2011, while confirming the figure calculated by the Ifo Institute of 326billion euros in net claims of the Bundesbank to the end of 2010,6 it tried to play down theimportance of the issue in a press release. Other statements by the Bundesbank and, inOctober 2011, by the ECB followed. In essence, the banks said: Target balances are a statistical item of no consequence, since they net each otherout within the Eurozone (Bundesbank).Germany’s risk does not reside in the Bundesbank’s claims, but in the liabilities of thedeficit countries. Germany is liable only in proportion to its share in the ECB, and if ithad been other countries instead of Germany that had accumulated Target claims,Germany would be liable for exactly the same amount (Bundesbank and ECB).The balances do not represent any risks in addition to those arising from therefinancing operations (Bundesbank and ECB).A positive Target balance does not imply constraints in the supply of credit to therespective economy, but is a sign of the availability of ample bank liquidity (ECB).All points are basically correct (and do not contradict what we said in previouswritings), but they hide the problems rather than clarify them and deny the fundamentaldistortions in the euro countries’ balances of payments which, as we will argue, are preciselymeasured by the Target balances. Reacting to the first version of this discussion paper, formerBundesbank President Schlesinger criticized the Bundesbank for playing down the Targetproblem. He argued that the Target claim is the most important item in the Bundesbank’sbalance sheet and an important part of Germany’s foreign wealth, by no means only a“statistical item”, as the Bundesbank argued.8Point 1 is true, but irrelevant. Between a debtor and its creditor the balances net out tozero, but that does not make the creditor feel at ease if he doubts the debtor’s ability to repay.Point 2 is true if a country defaults, destroying the banks’ collateral and causing adefault of its NCB, while the Eurosystem as such survives. In this case the loss of the ECB’sclaims against the country is shared by all non-defaulting NCBs according to their capitalshares. Should the disaster hit all GIIPS countries, Germany, for example, would be liable inproportion to its capital share in the ECB, namely about 43% of the 404 billion euros in GIIPSliabilities, i.e. around 170 billion euros. This was basically the calculation one of us publishedon 2 April (though assuming a 33% loss, as the possibility of an Italian default was not yetconsidered).9 No speculation regarding the likelihood of such a scenario was made. The issueis the value-at-risk. However, if Italy and Spain default, this could mean the end of theEurosystem, something that has been considered by Anglo-Saxon economists as possible ifSinn (2011c) a figure was named for the risk for Germany represented by the Target imbalances and by otherrescue systems of the euro countries and the IMF. An editorial comment on it was written by Beise (2011). Muchattention attracted an Article in VOX (Sinn, 2011h) as well as an article by Martin Wolf in the Financial Timescommenting on a lecture given by H.-W. Sinn on 19 May 2011 at the Munich Economic Summit (Wolf, 2011).An extended version of the VOX article in German was published as Sinn (2011i). In Sinn (2011j, 2011k) anattempt was made to clear some misperceptions and wrong interpretations on the issue that had been widelypublicised on the Internet. Finally, the June 2011 CESifo Working Paper preceding this publication (Sinn andWollmershäuser, 2011) contains a detailed reply to some critics of Sinn’s early writings, pointing out that thedifferences of opinion arose mainly from misunderstandings.6Sinn (2011a); Deutsche Bundesbank (2011a). (On its website, the Bundesbank press office had misdated thispress release until the first version of this working paper came out, to 21 January 2011, i.e. one month beforeSinn’s article was published in Wirtschaftswoche).7Deutsche Bundesbank (2011a, 2011c). Deutsche Bundesbank, letter to the Ifo Institute of 18 March 2011.European Central Bank (2011b, p. 37). Similarly, Ruhkamp (2011).8Schlesinger (2011).9See Sinn (2011d). If the GIPS (not including Italy) default, Germany’s share in the losses is 33%.5

not probable.10 In this case, it cannot be taken for granted that the former members of the eurocommunity would choose to honor their Target debts. Legally, this is a grey area, and here theBundesbank and the ECB may not be fully correct. It cannot be ruled out that Germany in thisscenario would have to write off its currently more than 450-billion-euro claims. This may bethe largest threat keeping Germany within the Eurozone and prompting it to accept generousrescue operations such as those agreed on in October 2011.While again true, the statement made in point 3 hides the unusual size of the liabilityrisk implied by the Target credit. To be sure, this credit materializes through the Eurosystem’snormal refinancing operations (as well as emergency loans, so-called Emergency LiquidityAssistance, ELA, guaranteed by the respective sovereign that some NCBs granted on theirown against no or only insufficient collateral). But it does measure, as we will show below,the additional refinancing credit an NCB issues to finance the country’s balance-of-paymentdeficit with other Eurozone countries. As such it does imply additional risk. It would notimply such additional risk if it were redeemed within a fiscal year through a transfer ofinterest-bearing assets as is the case in the US monetary system. This will be clarified insection 10.Point 4, finally, is true, insofar as a positive Target balance signals generous liquidityprovision in a country. But, as we will show in section 7, it is precisely this abundance ofliquidity that implies a crowding out of refinancing credit in Germany. The Target imbalancesdo measure an international capital export through the Eurosystem, and hence a public credit,mainly from Germany, to the GIIPS countries. This is not a net outflow of credit, privateinflows and public outflows taken together, but in itself it is an outflow in the same sense as apublic rescue credit from one country to another is such an outflow.4.What are the Target Balances?The term Target balances has created much confusion