The eurozone has come a long way since the economic crisis. Whilst then the Irish and Greek economies were on the verge of collapse in 2012, now in 2018 the Irish unemployment rate was 6.1 per cent in January, not too far above the 5 per cent rate it averaged as our economy peaked in 2007. While the Greek economy languishes far behind where it was in 2007 and it is no longer the centre of anxious news headlines wondering whether it can remain in the euro system. Across the eurozone, economic growth has been running strongly for the past year or so.
However, there is a key measure of the economic strains that underlie the eurozone called target 2 balances. These balances measure the amount that the constituency central banks of the European Central Bank (ECB) owe each other. They provide a key insight into pressures building up or abating behind the scenes.
As fears grow that a country may leave the eurozone and replace the euro with a weaker currency — such as the drachma or the lira — depositors withdraw monies and move them to the eurozone core, where they should be free of redenomination risk. As money pours out, the commercial banks of the weaker eurozone states face slow motion bank runs that threaten their existence.
To stave this off, the ECB acts as a clearing house to channel central bank money back in the opposite direction. As Italian depositors take their money out of Italian banks and relodge it north of the Alps, the German central bank lends money back to its Italian counterpart, which it can then lend to its country’s commercial banks that might otherwise run out of cash. The resulting positions between the eurozone’s national central banks are referred to as target 2 balances.
Those balances peaked in August 2012 when Germany owed €751 billion, Italy owed €289 billion and Spain owed €434 billion. In 2013 and 2014, those balances reduced after Mario Draghi, the President of the European Central Bank, promised to do “whatever it takes” to save the euro and took action to back that up. What goes unreported however, is that since 2015 those balances have been growing again, driven in the main by pressures in Spain and Italy. As of January, Germany was owed €860 billion while Italy owed €438 billion and Spain owed €385 billion.
That these balances should deteriorate dramatically when the eurozone is experiencing above-trend economic growth suggests that the eurozone crisis wasn’t cured by Mr Draghi; its symptoms were merely temporarily alleviated. What we are starting to see is cracks beneath the surface that have the potential to make the whole thing collapse.
It is possible to say that target 2s are a technical obscurity that only the central banking equivalent of train spotters pay attention to, but this would be incredibly naive. What these numbers begin to indicate is a country’s central bank owes more and more the ECB, which in turn makes that country dependent upon the ECB. As more and more of its money is put at risk defending the that economy, the ECB seeks a correspondingly increased say on its management.
The problem is we are now seeing a fierce rejection of the EU and the eurozone and the Italian’s are just the start. The eurozone was founded for political reasons, not economic and as a result, members simply don’t fulfil the conditions necessary to have an optimal or even adequately functioning single currency zone. What happens as these economies start to reject the European project?
Eurozone members are far less economically integrated with each other. Although the aspire to be like the United States in integration across states, they do much less trade with each other than US states do, with inter-state trade amounting to just 17 per cent of total output compared with 60 per cent in the US. Economic growth rates are far more closely correlated among US states than eurozone members. Americans are much more mobile across state borders, with 42 per cent living outside the state where they were born. In Europe the same proportion is just 14 per cent. Last but not least, 30 per cent of a state-specific budgetary shock is offset by federal transfers in the US; the equivalent for transfers from Brussels on this side of the Atlantic is 0.5 per cent.
The real weakness of the euro project is not that it didn’t go far enough but that it admitted too many members operating at different stages of different economic cycles. Today the ECB base rate is too low for Germany; the result is rampant property price inflation. It’s simultaneously too high for Greece, where consumer spending is a mere 70 per cent of 2007 levels.
What is beginning to show is that there are inconsistencies within the institution that are undermining how it operates, rising target 2 balances are a serious concern and must be addressed by Mr Draghi’s successor to the role after he retired next year. The successor major issue will be that politics, not economics, drives the fundamental European project.