We have long worried about the Eurozone, particularly the Banks in the southern member countries; the constant flow of funds especially into Greece and Italy from the Bundesbank and the Bank of France has already caused concern in those countries. In Germany a number of court cases have already been held in this regard. It was ex Fed Chair Greenspan that brought this situation to the fore a few years ago, at that time saying it could easily result in the collapse of the Euro.
At the core of the problem, of course, is trying to have one currency and one interest rate policy for so many countries with divergent economic cycles. Currently Germany needs a tightening of monetary policy whilst Italy requires a continued loose policy. That is obvious.
However the system used to balance the differing central banks’ needs within the zone, Target 2 (T2), appears not to have a safety valve. In fact the system is similar to a credit card without an interest rate payable and without a repayment schedule. Indeed the Bundesbank has a huge T2 credit balance whilst the central banks of Italy and Spain have equal and opposite T2 debit balances: as they are net importers and Germany is a huge exporter within the zone.
There have been many papers written on the subject with differing views of the merits of T2 but is hard to understand how the continued running up of debt can be good for the future outlook of a country. As most will know we utilise the Net Foreign Asset (NFA) position of a country to decide on their creditworthiness and that analysis clearly shows Italy in particular as a deteriorating credit while Germany continues to improve. Under our system we take the NFA and divide that into GDP with a minimum requirement of -50% of GDP for investment. After a country falls below that level it is clear that there is usually an acceleration in the deterioration of the balance sheet, quite often resulting in the need for a bailout. Italy is heading that way with the help of T2.
Another problem as we see it with the system is the lack of differentiation between a good credit and a bad credit within T2, as all are treated equal. Now surely that encourages continued borrowing as there is no additional cost involved for those less able to pay back.
T2 is rather like my three sons system of financing, which is to try and use me as Wonga, of course without repayment and naturally no charges, penalties or interest.