The sentence that dooms the euro

Acting Man’s blogger Pater Tenebrarum summarised the eurozone’s Target2 system with words that doom the euro: “TARGET-2 is a settlement system without a settlement mechanism.”

Understand this sentence is the key that unlocks the death of the euro. And the financial crisis that kills it off.

Now the internal workings of the euro system don’t make for riveting reading. But over the last week, I’ve discovered something that puts a whole new light on the eurozone’s plight.

The plumbing behind the Soviet Union’s monetary union was extraordinarily similar to the euro system’s today. And the rouble zone’s flaws played a large part in the collapse of the Soviet Union – a contributory and causal part.

The interesting part is, the same flaws apply in the eurozone…

Especially the one Tenebrarum mentions. The lack of a settlement mechanism. There is no need to “pay up”.

Historians and economists argue that it is unfair to compare the rouble zone and the eurozone. But their reasoning gives everything away: the eurozone is bigger, more integrated and far more indebted, they say. Therefore, it won’t collapse like the rouble zone did.

But these are not reasons why the eurozone won’t collapse. They don’t address the reasons why the rouble zone collapsed, nor the obvious similarities to the eurozone. Instead, they’re just reasons the eurozone collapse will be worse when it happens.

Arguing that a eurozone collapse won’t happen because it will be too terrible is shoddy. Perhaps it’s a requirement to get your work published in the euro-loving world of academia and the media.

Anyway, lets escape today’s media hysteria about Donald Trump, Brexit, Turkey and burkas. I want to take you back to the early 1990s to discover what Tenebrarum’s comment about Target2 means, and what it predicts for the euro.

The rouble zone is a roadmap for the eurozone’s failure

The Soviet Union and its satellite nations like Cuba and Vietnam were subject to Russian monetary rule in the rouble zone.

International transfers for trade and capital movements inside the rouble zone were conducted in an incredibly similar way to the eurozone’s Target2.

To be clear, the “cash rouble” economy was vastly different in the Soviet Union thanks to communism. But the financial transfers between the nations of the rouble zone were very similar to how the eurozone works today. And they suffered from exactly the same problems.

Hans-Werner Sinn summarised it in his book The Euro Trap, with my emphasis added:

Every state had an account with the International Bank for Economic Co-operation (IBEC) in Moscow that it could use for payment orders to other states, the unit of account being the so-called transfer rouble.

Since the system imposed no limits to balance-of-payments imbalances, member states took advantage and built up growing debt positions that basically were credited by the Central Bank of Russia.

This led to inflation and growing political tensions within the system, as Russia was unable to cope with the export of real economic resources that it had to credit to the member countries.

These tensions ultimately contributed to the fall of the Soviet system.

I ended up deleting the emphasis because the last three paragraphs were all in bold…

It’s extraordinary how closely Sinn’s statement could apply to the eurozone and its Target2 system:

  • No limits to the build-up of balance-of-payments imbalances.
  • Member states who use the system to borrow vast sums of money without limit or cost.
  • Inflation and political tension.
  • An imbalanced flow of real resources.
  • And the fall of the Soviet’s monetary union.

It’s practically a list of the points and predictions we made about the Target2 system in past Capital & Conflicts.

Let’s unpack all this a little more so you can realise the predictive power the collapse of the rouble zone has for the coming collapse of the eurozone.

The rouble zone and Target2’s systematic theft

The rouble zone featured something called transfer roubles (TRs). They’re the Soviet version of the eurozone’s Target2 balances.

In fact, the think tank Bruegel’s explanation of the Soviet TR reads like an explanation of Eurozone’s T2:

According to the CMEA’s Complex Program of Socialist Economic Integration approved in 1971, the TR was to be also used for multilateral settlement purposes, i.e. trade surplus of country A against country B could be used for imports from country C.

In short, the TR was only used as an accounting unit to determine net balances in bilateral barter transactions registered on special accounts in the International Bank of Economic Cooperation in Moscow (a CMEA institution). A deficit in one year was to be repaid by surpluses in subsequent years, and took the form of a technical credit in the meantime.”

The transfer rouble “was not a real currency” in the sense that you couldn’t spend it or exchange it for spendable money.

The problem here is the same one we delved into when we examined Target2 in the past. The rouble zone makes the criticism of Target2 come alive by presenting a real example where these issues have played out already. Leading to the demise of the rouble zone.

Trade involves the exchange of things of real value. If all you get in return for your exports is an accounting entry, this robs you of something of value. You’ve sent real resources abroad, and got a theoretical something or other in return.

The other inherent problem, in both the eurozone and rouble zone, is that both the systems prevent(ed) the natural self-correction of trade imbalances. In fact, they preserve(ed) those imbalances by stopping the price and exchange rate moves that correct them when you’re not in a monetary union.

Put these two features together and you have a build-up of trade flows that do not rebalance with an endless exchange of real things for accounting entries. It’s a systematic theft of one nation by another.

The only way you can get value out of your Target2 balances and transfer roubles is if trade balances reverse. Then the accounting balances revert to 0 as you get real value back in the form of present imports in exchange for your past exports.

But that won’t happen because there is no self-correction mechanism for the trade balances to reverse. The fluctuating exchange rate doesn’t smoothen the trade cycle like it usually would. Instead, a fixed exchange rate perpetuates trade balance divergence. Eventually leading to an economic crisis.

To escape this vicious circle, the only option is to leave the monetary union. Then an exporting nation will begin to receive something of real value in exchange for its exports, and an import nation will see its currency adjust to rebalance trade and start growing the economy. A win/win proposition.

The trouble is, if a nation leaves the monetary union, what happens to all those transfer roubles and Target2 balances that nations have accumulated or owe? To answer that, you need to know more about what they really are.

Target2 and the transfer rouble as a limitless and free borrowing mechanism

Just like Target2 balances, transfer roubles were in effect debt. They were even accounted for as such in the Soviet Union according to Bruegel, just as Target2 “claims” are today (emphasis added):

A deficit in one year was to be repaid by surpluses in subsequent years, and took the form of a technical credit in the meantime.

The reason for this is simple. When an export nation gets transfer roubles or Target2 claims from an importing nation in exchange for its exports, those are in effect a promise to send back some goods at a later date. A promise is a debt. A promise to repay with something of real value.

The transfer rouble and the Target2 claims walk, talk and act like debt. But in the last few weeks, there has been a vicious debate in the German media about whether Target2 claims really are debt.

Regardless of how you classify transfer roubles or Target2 claims, their effect is the same. They represent a promise to repay in goods at a later date.

Only that won’t happen. The imbalance will simply grow.

Not only is there no tendency to self-correct trade flows, there is no limit on the level of Target2 claims. Which is precisely the problem the rouble zone was plagued with according to three prominent American economists, who published their views in 1994:

However, no effective mechanism was implemented to address overdrawn balances. Accordingly, the non-Russian republics used this system as a line of credit, without extreme concerns about repayment of these credit extensions. This led to free-rider problems and excessive inflation.

Target2 allows deficit nations to borrow the money they need to pay for their deficit from the nation they are importing from. It happens automatically. It’s a self-perpetuating trade deficit paid for with nothing of value.

Here’s what it all boils down to: the rouble zone and Target2 system are settlement systems without settlement mechanisms or limits, that can be used as a borrowing mechanism to fund trade deficits, while preventing them from rebalancing.

In other words, they’re like bank overdraft facilities with no limit, no cost and no need to ever repay, both encouraging and financing more spending than a nation produces. Meanwhile, the exporting nations are forced to finance other nations’ consumption of their goods at 0% interest rates, without hope of ever being repaid.

That’s what Pater Tenebrarum’s quote really means. Target2 is a settlement system for the settlement of trade balances, but it features no actual method of settlement – of paying up for debts or imbalances.

Capping Target2 didn’t work in the rouble zone

Hans-Werner Sinn explains the rouble zone’s backers tried to fix the system’s flaw by imposing limits on the level of transfer roubles, which some (Germans) have suggested doing for Target2 balances:

In 1992, after the Wall had come down, Russia changed the system by introducing bilateral overdraft limits. This, however, reduced its attractiveness for the member states and induced them to exit it, which led to the collapse of the Rouble Zone in September 1993.

The experience of the rouble zone suggests that it is precisely the opportunities for abuse which a monetary union creates which motivates some nations to stay in it. If that opportunism is countered, nations leave, wrote the three economists in 1994:

The desire of a country to secure a (disproportionately) large share of benefits and political influence in a currency union provides the compelling logic behind a country’s decision to forego an independent currency and submit itself to centralised monetary discipline.

Anyone in eastern Europe watching the Italian budget negotiations with the EU will be enjoying themselves as much as Gideon Gono, Zimbabwe’s former central bank governor, did when Ben Bernanke and Mario Draghi announced quantitative easing…

Until next time,

Nick Hubble
Capital & Conflict

Category: The End of Europe

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