How the Target2 payment system keeps the Euro Project alive – for now

The Euro is kept afloat by the Target2 settlement system and is destined to fail if the Eurozone continues to fall short of satisfying the conditions for being an Optimal Currency Area. That is the assessment of David Blake, finance professor at Cass Business School, who believes the Eurozone can only be saved by achieving the EU founding father’s dream of full fiscal and political union. A dream that will prove difficult to accomplish in the face of strong opposition from the populist parties springing up all over Europe.

Target2 is the Eurozone’s cross-border payment system. Very few people have heard of it yet it is mandatory for the settlement of any Euro transaction involving the Eurosystem. Ever since the Eurozone sovereign debt crisis in 2011, Target2 has been acting as a bailout system for the Euro. Although this was strongly refuted by the European Central Bank, the paper “Target2: The silent bailout system that keeps the Euro afloat” argues that Target2 is indeed being used to stop the Eurozone from imploding, but the manner in which it is being used may itself lead to huge economic problems for a number of the Eurozone’s member states, in particular Italy and Spain.

The establishment of the Euro was one of the most important stepping stones, economically and symbolically, towards a fully federal Europe. However, for a single currency union to survive in a specific geographical area, there needs to be sufficient wage flexibility and labour mobility, sufficient price flexibility and capital mobility, a fiscal mechanism for redistributing resources from regions with trade surpluses to those with deficits, and for the different areas within the union to have broadly similar business cycles. All these conditions were identified by Nobel prize-winning economist Robert Mundell as being essential for the creation of an Optimal Currency Area (OCA), a geographical area over which a single currency and monetary policy can operate sustainably on a long-term basis. The US arguably fulfils these conditions, but this paper argues that the Eurozone does not and therefore cannot be classed as an OCA.

The reality is that different business cycles and inadequate labour and capital market flexibility within the Eurozone mean that systematic trade surpluses and deficits develop. To deal with these trade imbalances, the more efficient economies in the Eurozone, such as Germany, need to recycle their trade surpluses back to deficit regions using fiscal transfers in order to keep the Eurozone economies in balance. As the Eurozone has no official system of regional redistribution, it is Target2 – a simple inter-central bank payments and book-keeping system - that is critical in facilitating these payment flows, maintaining this balance, and keeping the Euro afloat. However, as the Target2 debts being built up by deficit countries such as Italy and Spain can never be repaid – their economies are too weak to do so – the author argues that the whole process is unsustainable, with Italy, in particular, identified as the country which may tip the system into disaster.

The solution may very well be full political union, together with common fiscal and monetary policies, and an official mechanism for recycling trade surpluses back to deficit economies. It could also be that ever closer union between European states is forged by crises, such as that which Target2 threatens. That is certainly what Jean Monnet, one of the progenitors of the EU, predicted. However, there is significant resistance amongst the peoples of Europe to such close union and considering the size of the Target2 imbalances this paper argues that the Eurozone’s problems may overwhelm it before it can realise Monnet’s dream.

Target2: The silent bailout system that keeps the Euro afloat is available for download at the link below.


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