For the first 6-7 years of European monetary union, ie through 2006, the Bundesbank’s Target2 receivables stood at an average of 1.5 billion Euros. The world was still in order. Teutonic export surpluses with mostly the European periphery were countered by their capital imports from Germany. Accounts naturally balanced as they must, and there was no need for the Italian Lira or the Spanish Peso, had they still been existing, depreciating to induce such balancing.
The common currency was during that time celebrated as a massive success and perceived as a key stepping stone in the direction of further Continental integration. How things can change, though. This August’s Target2 reading was 1.245 trillion Euros, almost 1,000 times the previous value, in record territory, only exceeded once earlier in the year, but relentlessly trending up. Think about it…! The Bundesbank has blown up its balance sheet by far over a trillion, with ECB receivables.
What happened? Current and capital accounts were obviously no longer in equilibrium. Ever since the eurocrisis hit, capital transfers into the periphery ebbed and no longer balanced current accounts. Worse, the eurozone’s free movement of capital allowed principally the Italians to move their private and corporate liquidity up north, causing a substantial capital flight to the perceived safety of bank accounts in the German jurisdiction.
In pre-Euro times, such a scenario would have been absorbed by Lira depreciation. Well, that’s history. To keep the Euro afloat, twin deficits have to be balanced by a different kind of capital channelling, namely by way of the ECB and the Target2 mechanism. The more funds Italians and other peripherals transfer to Germany, the more the Bundesbank has to re-direct those surpluses back into the likes of Banca d’Italia etc, else the common currency would cease to exist.
The quantities are being measured by Target2 balances, the German one obviously presenting this humongous surplus, after all a huge chunk of German national wealth, and periphery countries being deep in the red. Italy alone reported Target2 liabilities in August of just shy of 660 billion, having doubled across the past 5 years and now making up for more than half of Germany’s ECB receivables. The divergence is simply mind-boggling and seemingly irreversible.
In addition, as I have pointed out in this space numerous times, those receivables aren’t exactly backed by anything. The counterpart is solely the in itself hollow construct of the ECB, and claims aren’t fungible with any peripheral collateral such as Italian or Spanish government bonds. Technically, the Bundesbank has no handle whatsoever. Only a reversal of capital flows can monetise the receivables again and save Germany’s national wealth, but that doesn’t seem likely.
Not a problem, the eurocrats would have touted all along. As long as the eurozone remained one, it would be a mere accounting phenomenon and not matter. Well, as long as… because if Italy were to exit, not only the Azzurris would be flushed down the toilet but even rich Germany be bankrupt. However, there is no need for a government in Rome, and we will have an interestingly new one shortly, to exit and blow things up on the Old Continent.
Just threatening to do it will do the job. We have reached a magnitude of imbalance that allows for a lot of room to blackmail the rest of the eurozone and Europe as such. Italy isn’t Greece, a country that should have been made an example of in 2012 in order to at least try to safeguard monetary union. Italy is too big, and the eurosystem has gradually been manoeuvred into a state where pillars such as the principles of the Maastricht Treaty and the sacred ECB capital key have been destroyed.
Mario Draghi demonstrated ultimate loyalty to his fatherland. When throwing a so-called lifeline to the periphery during the eurocrisis, the rest of Europe and particularly Berlin didn’t grasp that they would forever be at the mercy of Rome’s rulers. As ludicrous as it sounds, and whether one wants to accept it or not, Italy is firmly in the driver’s seat of the eurozone’s monetary and probably also fiscal policy going forward.
The incoming new government is likely to bring such views further to the fore. The mutualisation of government debt is already progressing, but it is still merely a matter of time before a debt restructuring will be inevitable. Italy’s debt-to-GDP ratio has been propelled beyond 150%, close to the level when the first haircut on Greece’s debt was performed. Greece’s debt, by the way, has long swelled back up beyond pre-haircut levels, to roughly 200%.
I am not sure the northern European population would accept a Greek restructuring scenario again, this time in the context of Italian proportions – at least not in a very transparent form and for everyone to see. In other words, a reset of Italy’s liabilities will probably only be imaginable by way of a still much less understood Target2 mechanism, ie a sizeable discount on the imbalances there. Effectively, it’s the same result… resetting Italy’s gross debt by haircutting Germans’ national wealth.
