This is part of our special feature on The Crisis of European Integration. 
Albeit an arcane institution, TARGET, the cross-border payments system of the euro area, is a good example for how economics and political economy can be combined to advance our understanding of European integration.  Both missed the significance of this vital piece of infrastructure for a monetary union. Economists tend to ignore what seems not to have an obvious economic function and political economists tend to ignore what seems to have only an economic function. The infrastructure of financial markets is still an area of research (Jones and Underhill 2014).
The significance of TARGET came to light during the financial crises of 2008-12. During the crisis, the euro area’s cross-border payments system could process payments between member states when virtually everybody – banks themselves and their customers – had lost trust in the financial system, as a whole or in particular member states. The members of the network of central banks, the Eurosystem for short, held claims on each other that commercial banks no longer wanted to hold on banks in other jurisdictions.
More generally, TARGET removes the constraint of foreign exchange reserves for members of a currency union (Bindseil and König 2011: 4). This is the crucial difference that a shared currency makes to merely fixing exchange rates “irrevocably,” which is how economic theory conceptualises forming an “optimum currency area” (Mundell 1961). Due to this property of removing the foreign exchange constraint, TARGET could provide several insurance services (Cecchetti et al 2012, Whelan 2014, Schelkle 2017: 284-97).
TARGET acted as insurance for trade in the event of a sudden stop of capital flows. It also acted as a vehicle of deposit and capital flight inside the euro area, i.e. individuals used it to protect their property rights, which was to the detriment of domestic banks but shielded the euro area as a whole against the mayhem that capital flight can create. And finally, TARGET acted as a hedging instrument against the catastrophic risk of euro area dissolution, even for non-euro area banks. It is not an overstatement to claim that TARGET was the single most important institution that ensured the integrity of the euro area when the escalating market panic seemed unstoppable. Draghi’s famous speech could not have done the trick if there had not been TARGET that allowed him to claim that the ECB can “do whatever it takes” to save the euro.
Why did it take a systemic crisis to discover these properties of a cross-border payments system? One answer is: the insurance property had simply never been tested. The cross-border payments system was created as part of the technical infrastructure of a monetary union, facilitating the smooth processing of payments between banks across borders. But once an event revealed its economic significance, economists were able to cut right through institutional detail and distinguish between cause and effect. The cause of the anomaly was the well-known collapse of interbank lending indicated by the symptom of rising imbalances in the Eurosystem.
It was a political campaign in Germany that raised the attention to TARGET, although the ECB had already noted the anomaly. The campaign was orchestrated by Hans-Werner Sinn (2012) and was supported by the Bavarian taxpayers association, which raised a criminal charge against the Bundesbank management (that the German court dismissed) as well as the new right-wing party “Alternative für Deutschland” (AfD). It could have been just a freakish movement, largely ignored by the political establishment. But the campaign reached a world audience when this notorious economics professor managed to impress Martin Wolf (2011) from the Financial Times who came to see TARGET imbalances as indicative of “Intolerable choices for the Eurozone.” This then made Paul Krugman (2011) write a blog in which he predicted the euro area to be in “meltdown territory.”
To the credit of many economists, they got quickly and thoroughly on the case. Legitimate questions regarding these imbalances could be answered by 2012 thanks to the rapid dissemination of research on Internet platforms and in central bank publications.  These economists established that the TARGET imbalances were a safety valve helping the system to survive, rather than a symptom of system breakdown. A cross-border system is necessary whenever a network of regional or national central banks operates the payments system. The Federal Reserve System of the United States is exactly such a network and the Inter-district Settlement Account (ISA) is the US equivalent of TARGET. ISA showed imbalances almost as large as those in TARGET (Schelkle 2017: 280-2). This is not really surprising, given that mistrust in the financial system was as rampant in the US dollar area as it was in the euro area. This forced the Reserve System also to substitute for frozen wholesale markets. Yet, these imbalances caused no public reaction whatsoever.
So, once economists had established the function of TARGET, a few interesting questions were still left. How can we explain the unintentional nature of the insurance that TARGET provided? What does this tell us about cooperation and risk sharing in the euro area more broadly? We must wonder how the insurance that TARGET provided came about since universal risk sharing is not the order of the day in the euro area. TARGET was initiated by the ECB and large banks like Deutsche Bank. They wanted a reliable payments platform, for the uniform transmission of monetary policy and for doing transnational business at low cost, respectively. Economies of scale and technical robustness had made TARGET the payments platform of choice for banks dealing with and in the euro area even though private alternatives existed. We understand since 2009 that these institutional and commercial incentives for TARGET could not be satisfied without providing the public good of insurance.
In this, the case of TARGET resembles the case of the Federal Reserve. Lawrence Broz (1998) has drawn on a forgotten version of Olsen’s logic of collective action to show in great detail how the Fed came about as a by-product of commercial agendas of New York banks. This happened after two failed attempts to establish a central bank permanently in the early nineteenth century, each time sabotaged by states’ rights activists that resented the centralization of monetary power. This cost the US dearly, in the guise of financial instability that regularly ravaged the expanding economy. The New York bankers wanted an internationally tradeable, hard currency to win foreign exchange and trade finance business from the City of London. Again, these selective incentives could not be satisfied without providing the public good of a stable currency and a lender of last resort (although it took the Fed until after the Great Depression to take on this latter responsibility).
Political economists can also explain why the public good function of an institution, which generates many and diverse stakeholders over time, may have to remain latent for it to become first established. The same devolutionist forces in the US states would have resented the creation of the Federal Reserve System if it had concentrated on developing an interbank money market and rather engaged in resolute lending of last resort when financial crises hit the US. In Europe, it would not necessarily have been an attractive proposition for all signatories to TARGET if they had been aware that the platform can ensure payments from and to trading firms of a member state the banks of which are seen by markets as too unsafe for business. Or that it can become a vehicle for capital flight that, on the one hand, gives a country more time to adjust than if it had to fight an immediate currency attack but, on the other, also generates sustained pressure to adjust. Or that it will lock members into the monetary union since losses will materialise – and will only materialise –if a member with large liabilities to the TARGET system leaves the euro area. The nationalist campaign of Sinn et al sensed that Germany cannot easily walk away any more, as it could, figuratively, with exchange rate realignments that typically revalued its claims against the counterparts. All these implications of universal insurance could have tipped the balance against a vital element of a monetary union and undermine its insurance function.
This by-product explanation for the provision of public goods alerts us to the fact that any such provision is contested and vulnerable to political backlash, once the latent function materialises. Sinn’s proposal to cap the maximum TARGET imbalances, included in the AfD party manifesto for the European Parliament elections, aimed at limiting exposure to potential losses if a member state like Greece is forced out. But such caps amount to the dissolution of a monetary union, in other words: collective action failure on a grand scale. The great puzzle is that this nationalist campaign in Germany remained the exception to the rule that TARGET was not contested. There were certainly a few concerns expressed, for instance by the Finnish member of the Governing Board in the ECB and in the Austrian Parliament. Bundesbank President Weidmann once raised the question whether additional collateral should be requested for running up TARGET imbalances so as to prevent free riding, this perennial anxiety of euro area policymakers. But this would have led to a drastic reduction of cross-border payments since collateral had to be pledged already when a bank sought credit and additional reserves from its national central bank; hence acceptable collateral became increasingly scarce. All these understandable concerns were laid to rest by rational argument. Only Hans-Werner Sinn decided that his political campaign was more important than his reputation as an economist.
Now that the insurance role of TARGET is acknowledged, the once unintentional risk sharing can be seen as a form of monetary solidarity. It did not come about because of altruistic behaviour or a pre-existing European identity. It is in the interest of export as well as import nations that a sudden stop of capital flows does not disrupt the financing of trade. When capital becomes fugitive, it is less disruptive if it can be kept within the currency area and is guaranteed an easy return to the member state from which it fled.
The social historian and political economist Peter Baldwin (1990: 299) ended his history of the welfare state with the following statement: “Solidarity – the group’s decision to allocate resources by need – is only misleadingly analogous to altruism. An individual sentiment, altruism, is generally confined to narrow circles of the like-minded. Solidarity, in those few instances where it has been realized, has been the outcome of a generalized and reciprocal self-interest. Not ethics, but politics explain it.” This also applies to monetary solidarity: TARGET allowed to draw very different constituencies on its insurance services and while this public good provision did not go unchallenged, its risk sharing properties benefit both sides of the imbalances and even those being on neither side.
Waltraud Schelkle (insert bio here)
Photo: Macro of euro zone map from the coin, Patryk Kosmider | Shutterstock
Baldwin, P. (1990). The Politics of Social Solidarity. Cambridge: Cambridge University Press.
Bindseil, U., & König, P. (2011). The economics of TARGET2 balances. SFB 649 Discussion Paper, 2011-035.
Bindseil, U., Cour-Thimann, P., & König, P. (2012). Target2 and Cross-border Interbank Payments during the Financial Crisis. CESifo Forum, 13, 83-92.
Broz, J. L. (1998). The origins of central banking: solutions to the free-rider problem. International Organization, 52(2), 231-268.
Cecchetti, S. G., McCauley, R. N., & McGuire, P. M. (2012). Interpreting TARGET2 balances. BIS Working Papers, No 393, Basel: Bank for International Settlement.
Jones, E., & Underhill, G. (2014). Theory of Optimum Financial Areas: Retooling the Debate on the Governance of Global Finance. SWIFT Institute Working Paper, NO. 2013-001.
Krugman, P. (2011). The euro living dangerously. New York Times, 1 June.
Mundell, R. (1961). A Theory of Optimum Currency Areas. American Economic Review, 51(4), 657–665.
Schelkle, W. (2017). The political economy of monetary solidarity: understanding the euro experiment. Oxford: Oxford University Press.
Sinn, H. W. (Ed.) (2012). Special issue: The European balance of payments . CESifo Forum (Vol. 13). CESifo: Munich.
Ulbrich, J., & Lipponer, A. (2012). Balances in the Target2 Payments System – A Problem? CESifoForum, 13(January), 73-76.
Whelan, K. (2014). TARGET2 and central bank balance sheets. Economic Policy, 29(77), 79-137.
Wolf, M. (2011). Intolerable choices for the eurozone. Financial Times, online 31 May.
  This article is based on Schelkle (2017: ch.9).
  For instance, voxEU.org , for data see the eurocrisismonitor.com and the ECB. A special issue of the CESifo Forum that Sinn (2012) edited gives a good insight into the debate, with the articles by Bindseil, Cour-Thimann and König as well as Ulbrich and Lipponer as the only defences of TARGET.
Published on November 2, 2017.