Why Germany's TARGET2-Based Eurozone Preservation Mechanism Is Merely A Ticking Inflationary Timebomb

Tyler Durden's picture

We have covered the topic of the German TARGET2 imbalances previously, both from the perspective of what catalysts can lead the Bundesbank to suffering massive losses (the one most widely agreed upon being a collapse of the Eurozone, which explains why even discussions of that contingency are prohibited in Europe), from the perspective of its being an indirect current account deficit funding mechanism, and from the perspective of what is the maximum size TARGET2 imbalances, funded primarily by the Bundesbank, can grow to before eventually causing irreperable damage to the Bundesbank. Still, there appears to be ongoing mass confusion about the topic, with numerous economists proposing contradictory theories, all of which supposedly rely on traditional economic models. Today, to provide some additional and much needed color, we once again revisit the topic of TARGET2, and this time we look at arguably the most critical question: what happens when the TARGET2 imbalance bubble ultimately pops. And here is where the true cost to Germans becomes apparent, because there is no such thing as a "borrowing from the future" free lunch. Which is precisely what TARGET2 does, only instead of a direct cost, the post-TARGET2 world will result in the now traditional indirect cost of all monetary experiments gone awry: runaway inflation.

As Goldman summarizes:

Who ultimately pays for TARGET2 losses? Higher inflation part of the bill


[T]he important point in the context of the financial risk for Germany from the growing TARGET2 imbalances is that, in the event of a break-up of the Euro area, the price paid would not necessarily be in the form of a massive recapitalisation of the Bundesbank, which could endanger the solvency of the German government itself. Rather, it would come in the form of higher inflation, as Germany faced the financial costs of the Bundesbank’s rising net claims vis-à- vis the other Euro area central banks.

In other words, if Goldman sought to appease Germans' fears about the aftermath of providing what effectively equates to "costless" bailouts, in the form current account deficit funding for the PIIGS, by telling them the final cost may well be a tide of runaway inflation, one which may come far sooner than most expect, we are skeptical they have succeeded.

Full report from Goldman:

Assessing the financial risks of TARGET 2 for Germany

As Germany recorded current account surpluses from the early 2000s, its financial exposure to the rest of the world rose. While Germany’s net international investment position (NIIP) was close to zero at the turn of the century, it had risen sharply to close to €1trn by 2011. This significant rise in German net foreign asset ownership also necessarily implied an accumulation of the financial risks associated with these assets. However, both the ownership and composition of these net claims against the rest of the world have changed significantly over time: banks and other financial institutions have reduced their net holdings of foreign assets substantially since the start of the crisis in 2007, while there has been a sharp increase in the public sector’s foreign exposure.

The rise in the net foreign asset position of the public sector has taken place through two channels:

  • The financial help provided to the Euro area periphery through the EFSF and—in the case of the first Greek programme—other government-owned institutions has led to a direct increase in financial exposure for the German government.
  • The other, and more relevant channel in terms of the volumes involved, has been the Bundesbank’s TARGET2 claims against the Eurosystem.

It is thereby no coincidence that the increase in net foreign assets on the Bundesbank’s balance sheet roughly matches the decline seen on banks’ balance sheets. Thus, the TARGET2 imbalances, at least so far, have mainly replaced financial risk that was previously sitting on private-sector balance sheets.

Further movement of capital from the periphery to Germany—for example, as peripheral households transfer deposits to Germany—would imply additional, genuinely new external financial risk for Germany, reflected in a further rise in TARGET2 claims.

But it is important to bear in mind when assessing Germany’s external financial risk that, as a central bank, the Bundesbank’s ability to deal with financial losses incurred as a result of these exposures is of a different character to the ability of the private sector or government. In particular, the operational capacity of the Bundesbank would not necessarily be significantly impaired even if it were forced to run temporarily with significant negative equity.

A current account surplus implies more foreign assets

Throughout the 1980s, Germany recorded a rising current account surplus (see Chart 1). This surplus quickly turned into a deficit as the reunification boom led to a sharp increase in imports. It took until 2001 before this current account deficit was turned back into a surplus. The combination of weak domestic demand, a recovery in competitiveness and strong external demand then pushed the current account surplus to a record high of around 7.5% of GDP in 2007.

As a consequence of the growing current account surpluses recorded over the past ten years, Germany net international investment position (the difference between all foreign assets owned by the German private and government sector and German assets owned by foreigners) has increased sharply (see Chart 2). At the end of 2011 Germany’s NIIP stood at close to €1trn.

The assets that make up Germany’s NIIP include bonds (whether issued by governments or corporates), loans, stocks and foreign direct investment. But regardless of the specific characteristic of the underlying asset, they all also represent a financial risk to some degree, in the  sense that the return on these assets is not certain—and could even be zero.

Changes in sectoral risk exposure to the periphery

The aggregate figures for the NIIP blur the significant differences that exist at the sectoral level. Chart 3 shows the NIIP broken down into different sectors, such as Monetary Financial Institutions (MFIs) (which are mostly commercial banks), non-financial corporates and private households, the government and the Bundesbank.

The chart illustrates three noteworthy points:

  • Banks/MFIs have reduced their NIIP sharply. German banks’ NIIP rose from a negative -€300bn in the middle of 2000 to +€520bn by the end of 2008. Since then, their NIIP has declined to €170bn at the end of last year. Meanwhile, German banks’ gross credit claims against the periphery have declined from almost €600bn to around €300bn (Chart 4).
  • Corporates and private households have seen their NIIP increase further during the crisis. Companies and private households represent the bulk of Germany’s NIIP. Roughly 60% of these assets (€700bn) are portfolio investments, 30% are direct investments, and 10% are lending and deposits held at foreign banks (Chart 5).
  • Foreigners hold a significant share of Germany’s public debt. The German government sector (all levels, excluding Bundesbank) was indebted on a net basis vis-à-vis the rest of the world by more than €1trn at the end of last year.

Exposure to the periphery

Looking at Germany’s country-specific exposure, German net investment in peripheral economies stood at around €1trn at the beginning of 2012, the bulk of which is concentrated in Italy, Spain and Ireland (Chart 6 shows the net investment of all sectors vis-à-vis the countries in the  periphery). Note, however, that these figures do not reflect the net claims of the Bundesbank vis-à-vis the Eurosystem due to TARGET2 imbalances. As a claim on the ECB rather than a specific country, these claims are not against a specific country and are therefore recordedas net investment into the Euro area.

Most German investment in the peripheral countries reflects ownership of companies or production facilities located there. Roughly a third of the net investment in the periphery is lending (Chart 7). Lastly, we take a look at bank lending to peripheral countries (Chart 4). While Germany’s  overall financial exposure to the periphery has been broadly stable, banks have reduced it significantly since the beginning of the crisis.

Pulling all these data together, we can see a clear shift in the composition of Germany’s net foreign asset position: financial institutions have sharply reduced their exposure to the periphery , while the public sector has increased its claims significantly. The main channel through which this transfer of risk has taken place has been the TARGET2 system.

TARGET2 imbalances are on the rise

Commercial banks use the so-called TARGET2 system to facilitate money transfers across the Euro area. One crucial feature of TARGET2 is that claims between national central banks resulting from cross-border money flows between commercial banks are not settled. If, for example, a commercial bank in Greece wants to transfer money to a German bank, the Bank of Greece simply asks the Bundesbank to credit the account of the German commercial bank with that amount and at the same time debit the account of the Bank of Greece with the same amount. As a central bank, there is no funding required for the Bundesbank in this operation. The Bundesbank simply ‘prints’ the money it credits to the account of the German commercial bank.

Before the crisis, flows between the periphery and Germany were broadly balanced. Banks and nonfinancial corporates borrowed from German banks and companies in order to finance, in large part, the trade deficit the periphery held with Germany. This implied that money flowed from the periphery to Germany (to pay the bill for imports) and from Germany to the periphery (to provide a credit such that the bill could be paid). But as German banks reduced their lending to the periphery on account of concerns about counterparty risk (Chart 4), capital flows have become a one-way street. Consequently, the net claims of the Bundesbank against the Eurosystem have risen sharply (Chart 8).

What are the financial risks from TARGET2?

In assessing the financial risk stemming from the increase in the net claims of the Bundesbank against the Eurosystem—the TARGET2  imbalances—it is important to bear in mind that, at least so far, they mostly replace debt held by German banks. Put differently, the financial risk for the country as a whole has not changed significantly on the back of the rising net claims of the Bundesbank.

This may no longer be the case, however, once rising net claims reflect not only normal commercial and investment activities, but rather deposit flight from the periphery to Germany. So far, there is no real evidence that private households or companies are shifting their deposits to Germany in a significant way. But a genuine deposit flight from the periphery to Germany would lead to a significant increase in the  Bundesbank’s net claims.

After all, peripheral private households alone hold more than €1.5trn of deposits. To be sure, the Bundesbank’s rising net claims vis-à-vis the Eurosystem would only represent a financial risk if a country were to leave the Euro area. Moreover, the losses of the Eurosystem are shared among all remaining countries. Thus, the financial risk for Germany has actually been reduced, as potential private losses have been replaced by  losses that will be shared by the Eurosystem. However, in the event of a break-up of the Euro area, the losses from the Bundesbank’s net claims would materialise on the Bundesbank’s balance sheet alone.

Bundesbank operational effectiveness not endangered by potential losses

At this point, it is not possible to calculate the exact size of the Bundesbank’s potential losses in the event of a complete break-up of the Euro area. First, the amount would depend on how much further net claims rise. Second, it is not clear how much of these claims would need to be written down. Arguably, other national central banks/governments would have little incentive, or the economic means, to honour any of these liabilities. But depending on the circumstances of the break-up some mutual agreement about a haircut could be found.

That said, even though we do not know ex ante the size of the losses the Bundesbank faces, we can say that, in principle, these losses would not impair its ability to operate monetary policy. Put differently, it is not the case that the Bundesbank would first need to be recapitalised before it could once again conduct monetary policy at the national level. Indeed, there are several examples of central banks that have operated with negative equity and have been able to maintain price stability. The Bundesbank could, for example, simply insert a claim against the German government on the asset side of its balance sheet in order to maintain its balance sheet in balance in an accounting sense.

Who ultimately pays for TARGET2 losses? Higher inflation part of the bill

This does not mean that potential TARGET2 losses would not imply a significant challenge to the Bundesbank. Its first challenge would be to stabilise inflation expectations. Expectations about future price developments play a crucial role in the inflation process: if economic agents were to expect, for whatever reason, an increase in prices and adjust their economic decisions accordingly, expectations would become self-fulfilling. This is why central banks in general monitor inflation expectations carefully.

How would inflation expectations react if the Bundesbank were to incur significant losses and had to operate with negative equity? Again, there is no easy answer to this but, according to the so-called fiscal theory of the price level, the credibility of a central bank also depends on its solvency. The Bundesbank’s solvency would be questioned if the losses exceeded the net present value of its future income (seignorage). A backof-the-envelope calculation of this net present value suggests the Bundesbank has economic capital of around €2trn. Thus, the Bundesbank has significant capacity to absorb losses before endangering its ability to guarantee price stability.

There is also a more mechanical way of assessing the potential inflation risk stemming from Bundesbank losses on the back of the TARGET2 imbalances. These imbalances are the result of rising deposits on the balance sheets of German commercial banks. These deposits ultimately represent a claim on German GDP, as the holders of the deposits could spend the money sitting in their accounts. Another way to look at this is that rising deposits at German banks imply that monetary aggregates are rising in relation to the underlying German economy.

Whether these deposits would be inflationary or not would depend on several factors—not least how quickly these deposits are spent. But it is clear that the greater the amount of deposits held by non-residents after the breakup, the greater the potential inflationary risk. A high degree of uncertainty surrounds all of this and it is not possible to be more precise about the potential inflationary implications. But the important point in the context of the financial risk for Germany from the growing TARGET2 imbalances is that, in the event of a break-up of the Euro area, the price paid would not necessarily be in the form of a massive recapitalisation of the Bundesbank, which could endanger the solvency of the  German government itself. Rather, it would come in the form of higher inflation, as Germany faced the financial costs of the Bundesbank’s rising  net claims vis-à-vis the other Euro area central banks.

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bank guy in Brussels's picture

The whole pop premise that Germany is a 'rich, finally sound country' might be totally false ...

As ZH articles have been pointing out, scenarios of EU break-up, GIIPS leaving the euro, etc., are all a recipe for catastrophe for the German banks, insurers, and pension funds, loaded up (sometimes 60-to-1) with GIIPS bad debt - still hundreds of billions, as noted above, even after 'reduction since the start of the crisis'. Not to mention most of a trillion in TARGET2, etc. in the public sector as above.

And that is perhaps why Merkel and Germany are, in the end, going along with 'save the euro-zone' strategies'. Even Spain and Italy agree it helps the whole EU to keep up the fiction of 'rich Germany' ... but in the end the whole euro-zone are all as vulnerable as their banks, and the banks are ultimately sh*t in Germany as much as everywhere.

What makes more sense is what Jim Sinclair has been saying for a few years ... it's game and farce for as long as possible ... but in the end it's QE to infinity across the Western world.

Kitler's picture


Mutually Assured Destruction

And let's not forget, as long as Germany makes stuff (25% of employment is in manufacturing) they need the common currency or risk eventual mass unemployment from 'Switzerland' disease.

John_Coltrane's picture

An excellent analysis in this article and your comment.  I agree with your comment regarding how the EU (and all the central planners) intend to deal with it-money printing and inflation to slowly degrade the unpayable debt liabilities as long as possible.  But, not to infinity as is often prosaically stated.  Instead, QE until a critical point is reached, the so-called Minsky moment of fiat monetary collaspse as all trust is the system is lost, at which point the entire financial system undergoes a phase transition to massive deflation and credit/debt default and reset.  This should have been allowed to happen in 2008 but by putting it off using QE the debt balloon has that much more air (debt and leverage) in it so in the future the blow up will be that much greater.  The reset will allow the amount of finite resources in the world to come to equilibrium with the finite (not infinite) supply of fiat.  A possible alternative approach to avoid the explosive blow up is to let air of the balloon slowly via credit contraction a al Japan.  Central planners obviously don't like this approach but its better for savers and the productive members of society who unfortunately are now in the minoriity.  This critical point scenario is guaranteed to happen as surely as entropy will continue increasing with time or water turns to ice at 0 centrigrade. 

Marco's picture

The paper with the German banks, insurers and pension funds is just paper ... the reason Germany has a sound economy is because it's able to sustain a trade balance/surplus. They can obviously pay for their standard of living in goods, more than pay for it in fact.

Which is not to say they don't have problems, the same problem everyone else has ... TPTB will only allow the 99.9% to sustain a comfortable lifestyle by going into debt, either personally or through government proxy. No one but them is allowed to life comfortably without debt.

Because at some point they intend to collect on paper debt ... and bring the 99.9% real poverty. They don't need the 99.9% to sustain their lifestyle, they just need us not to cut off their heads (they're still working on that last bit, in come the drones).

El Viejo's picture

Doesn't the lessening aggregate demand of retiring Boomers worldwide mitigate this inflation time bomb to a degree???

falak pema's picture

great financial jargon; the will to survive goes beyond it. THe trouble is that current German leadership is sitting between two stools and balancing like a fool. As its unstable equilibrium in a western world which is a financial cesspool, the outcome can only be : very bad and worse! 

So Merkel and her German/ Euro fellow men can die of cholera or the pest. We are all in that existential choice. Lets play strip poker. It'll avoid us from ending up like RR and Maggie with brains infested with forgotten memory! Legacy of Pax Americana heydays gone virally sick! 

The supreme irony of this age is : Pax Americana thinks it invented freedom. Play on Agamemnon, Clytemnestra awaits you at home; with her vengeful knife! The spirit of american people!

ouchtouch's picture

There is a simple solution:  Convert to DM, but non-residents/citizens get freshly printed Euro deposits back, not DM.

cossack55's picture

Even simpler. Have all correspondence to Germany signed by Arthur "Bomber" Harris and Curtis Lemay.

andrewp111's picture

Germany needs to convert to DM before the amount of deposit flight is too much.  And a side benefit is that all Germany's external debt will still be denominated in Euros, and if Germany leaves the EZ, the Euro will become a Drachma.

Nussi34's picture

"depending on the circumstances of the break-up some mutual agreement about a haircut could be"

In case of a break up the deposits of foreigners from EZ countries will just be held as a collateral against the these EZ countries balances.


Bunga Bunga's picture

Much simpler. Everyone gets 40 DM like in 1948 and we will see a second wirtschaftswunder.

Non Passaran's picture

You're SO smart... 

How can they print new Euro if they exit the euro (which is what they have to do in order to issue the new DEM)? Idiot.

Or, if they issue the new DEM and don't leave the euro, then anyone who gets the "freshly printed euros" can simply exchange them for the new Mark. As long as they remain in the eurosystem they can't randomly print euros, at least not to the extent that it would matter. If they did, then it'd hurt the new DEM more than it'd hurt the euro.

Hedgetard55's picture

So, it's all good then? No real problem unless the whole Eurozone goes tits up, is the message I got from this hard to follow post.

andrewp111's picture

I think that has bee obvious all along.  As long as the EZ is fully intact, the TARGET2 balances are meaningless. If one State - any State -  leaves, then the Eurosystem has a big problem.

debtor of last resort's picture

Keeping the system afloat and let the taxpayers pay the bill. What's the contribution of multinationals to the ESM? Huh? Tell me.... Let everybody work and pay till he/she drops, just to keep the 'system' alive. Nothing more, nothing less. Lower wages in Germany/Netherlands for example is good for exports. Multinationals earn the money, shortages are for Joe Twopack. A sixpack is not affordable anymore. Well, maybe with less booze there will be some sense into Joe's mind. 

timbo_em's picture

My suggestion: Germany nationalises its banks, the Bundesbank then prints €700 B, channels the money to the banks and they buy hard assets in southern Europe. You're welcome!

allocater's picture

The Bundesbank already printed the €700 B, the German banks already have the €700 B.

The only thing that keeps the conscience of the Bundesbank clean, the only way the Bundesbank can continue to say with a straight face "We do not print money" is the fact that it put the little accounting note in it's books that says "collect €700 B from South Europe in the future"

Now the funny thing is, that there is no mechanism with which it can collect these €700 B. It was never indented to be collected. The system does not know how to collect it, is has no language, no transaction to collect it. So the little accounting line just sits there.

Atomizer's picture



ESM = Erectile Dysfunction Meds. At the end of day, EU is conducting a short term bridge loan.  

Let’s just keep going on by kicking the can ahead. Our cost benefit analysis shows that most Muppets will comply until we drain their resources.

Thelma & Louise: Ending Scene

John_Coltrane's picture

Bridge loans are very popular with banksters who always say, "a rolling loan carries no loss" (I think this expression was from the original depression of the 1930s)

Zero Debt's picture

"If the can doesn't roll, kick it"
-ECB proverb

wandstrasse's picture

We Germans tend to be the hardest players... but the biggest losers eventually.

Tuffmug's picture

More inflation and catastrophy boogie men trotted out by Goldman to scare the world into maintaining the status quo.

RockyRacoon's picture

How would inflation expectations react if the Bundesbank were to incur significant losses and had to operate with negative equity? Again, there is no easy answer to this but, according to the so-called fiscal theory of the price level, the credibility of a central bank also depends on its solvency.

Hey, Ben, you reading this?

No Euros please we're British's picture

Meh, the Germans are used to a little inflation, and they make some excellent wheelbarrows.

spekulatn's picture

"Merkel is already defending the deal, which she claims is a good compromis. According to a BBC report, the funds will not only be able to lend directly to banks, "they will also be used to buy bonds of countries like Italy and Spain whose borrowing costs have soared - with the intention that those countries will not have to apply for a formal Greek-style bailout."

She called the agreement "a good compromise" and indicated that Germans ought not to be worried that they will end up funding the profligacy of Europe's Southern PIGS. 

But as Rogers points out, there have been numerous false starts within the EU. The chances of this latest summit offering a final resolution to the ongoing crisis is doubtful. In fact, the numbers are enormous. Here are some facts courtesy of ZeroHedge in an article posted in early June entitled "Systemic Risk: Why This Time IS Different and the Central Banks Won't Be Able to Stop the Crisis" by Graham Summers."




slewie the pi-rat's picture

i stayed home from my ride for a while smoking great weed and eating crackers and peanut butter just hoping to see a piece which began:  WHY GERMANY...

schuable, my main finiMini returned my call, BiCheZ! so there!

he sez this stuff is fine b/c it is completely sterilized

i told him he was fill of shit and he hung up

see ya!

RobotTrader's picture

I'm sure the Fed and TPTB is going to allow the CRB to run for a little while.

But once it gets back near last year's highs, the "jawboning" will start and we'll see more of the same as what we saw in 2010, 2011, and 2012.

1) Crash in commodity prices

2) Investors will be "fleeing" to the USDX and Treasuries

3) Stocks will suffer a mild correction, but retail will hold up the best since oil prices will be crashing

4) Another intermediate buying opportunity in stocks will emerge, and the "Wash, Rinse, Repeat" cycle will begin anew.

misterbear's picture

Anyone else find it odd there has been little to no mention of Greece before, during, or since the summit?


Follow the yellow brick road...

RobotTrader's picture

Speaking of Greece, the S & P 500 has rallied from a low of 900 in August 2010 to 1350 today on "Greece Fears".

ZeroSpread's picture

Sorry, dear, you got that worng too. SNP rose via HFT. Greece helped the Germans to keep the EUR low to increase their sales though. 

Come to think about it, where's your mom.. didn't she tell you to take care of the weeds in the yard?

tom's picture

Another long piece on Target2 imbalances that doesn't really explain where they come from.

In a nutshell:

1) Saver/investors are pulling out of peripheral Europe, by disposing of (including not refinancing) assets there, and withdrawing deposits

2) A big part of what they're pulling out is being sent to core Europe by wire transfer through the Target2 system

3) Since periphery banking systems generally have only bare-minimum reserves, there are only two ways in theory that those Target2 payments can be satisfied a) periphery banks must sell assets to foreigners in order to bring in reserves from elsewhere, or b) periphery national central banks must create new euros by increasing lending to their banking systems. In practice there's been only the latter way, mainly via LTROs and in Greece emergency liquidity assistance.

4) Those newly created euros are then transferred and appear as deposit assets of core European banks, as deposit liabilities of the Bundesbank, and as Target2 assets of the Bundesbank (claims on the ECB).


In other words, the growing Target2 claims of the core on the ECB are a direct result of euro issuance in the periphery being used to facilitate capital flight from the periphery.


AUD's picture

as Target2 assets of the Bundesbank


allocater's picture

Why does LTRO and emergency liquidity assistance. not show up in target-2 and lower the imbalances? If it is money flowing into Greece it should. Then it flows right back out again, so the sum of these programs on target-2 should be zero?

jimmyjames's picture

So far, there is no real evidence that private households or companies are shifting their deposits to Germany in a significant way. But a genuine deposit flight from the periphery to Germany would lead to a significant increase in the  Bundesbank’s net claims.


Here's some evidence that shows the capital flight from the periphery to Germany and a few other so called safe countries-




andrewp111's picture

There has been a slow but steady leak of capital from the PIGS to Germany for years now.  So far, there hasn't been any bank runs, probably because it is difficult for small depositors to open accounts in Germany without proof of residency.


Does anyone know how hard it is for a Greek or Spaniard to buy Bunds over the internet without going through a domestic financial institution? Is there a German equivalent of our Treasury Direct?

jimmyjames's picture

There has been a slow but steady leak of capital from the PIGS to Germany for years now.  So far, there hasn't been any bank runs


Those two charts show that there have been bank runs and not so slow and steady


Bankia customers have withdrawn deposits worth over 1,000 million euros since the government announced its intervention last week, according to data presented suggest the board meeting yesterday.

On Wednesday, Bankia not respond to Reuters requests asking whether there were bank runs Thursday and no one has commented on the information published by the newspaper El Mundo in its paper edition.


localpacific's picture

well the eurozone could bounce back this week ...

European Summit Lifts Markets And Slams Dollar

devo's picture

Global inflation for 5 years, then global collapse. I don't think they can extend this beyond 5 years. So bullish for commodities. If people just convert their dollar savings into coins (pennies/nickles) they're going to preserve wealth and likely gain.