Target2 Imbalances and German Democracy: Surmountable Contradictions?

Prof. Peter Lindseth

Some readers of EUtopia Law may recall that prior posts have made a couple of references here and there to the ECB’s payment system, known as Target2.  No doubt these references were puzzling: Target2 is not a topic well known to lawyers, nor is it easy to understand, even for economists.  Lately, however, this seemingly technical feature of the European monetary union has become a major topic of debate in Germany (see, e.g., here).  Thus, it is perhaps time for lawyers throughout Europe to start paying more attention to it.  Apologies in advance for the long post, but the topic is indeed complicated.

The central political and economic issue in the debate has been whether, by operation of Target2, Germany and other countries in the Eurozone core (notably the Netherlands, Luxembourg, and Finland) have engaged in something approaching a “stealth bailout” of the Eurozone periphery, perhaps exceeding their contributions to the EFSF or the future ESM.  The protagonist in the German debate over Target2 has been Hans-Werner Sinn, one of Germany’s leading economists and the director of Munich’s Ifo Institute (Sinn’s concerns regarding Target2 are collected here—scroll down for his contributions in English).  In the UK, John Whittaker of the University of Lancaster first raised many of the same concerns (for more detail, see here.)  Sinn’s more well known version of the argument has been heavily criticized in Germany, notably by Olaf Storbeck, the international economics correspondent for the business daily Handelsblatt (in English, see, e.g., here, here, here, and here).  A collection of links to the literature available online in this debate is now available here, with contributions in both German and English.

I am obviously on dangerous ground with this topic, being neither an economist nor an expert in German constitutional law (and frankly my handle on the German language isn’t so great either).  But it strikes me that, even as an outsider in more senses than one, the economic and political focus of the debate so far has missed something.  There is, I would suggest, a legal and constitutional dimension that relates specifically to the uncomfortable relationship between democracy and technocracy in modern governance, something to which my prior posts alluded but did not develop.  So my purpose here is to explore the controversy surrounding Target2 imbalances from the perspective of representative democracy on the national level, using Germany as the case in point.

Let me first provide a bit of substantive background on the workings of Target2 and why it has emerged as an important topic in the Eurozone crisis in Germany.  One main effect of the crisis has been a collapse in confidence in the continued solvency of banks, particularly in the Eurozone periphery.  This collapse has in turn led to a dramatic shrinkage in interbank lending, which is the normal source of bank liquidity for routine business operations.  In the context of the crisis, the Target2 payment system has taken up the slack.  That is, it has developed into a de facto means of moving liquidity among national banking systems in the EMU, to the benefit of both central and commercial banks in the periphery (for a succinct explanation of how this works, see, e.g., here).

The result, however, has been major imbalances in the Target2 payments system, with excess liquidity flowing away from the Eurozone core (Germany, Netherlands, Luxembourg, and Finland) toward the periphery, where it is sorely lacking.  The German imbalances are by far the largest of all, reportedly reaching 547 billion euros at the end of February 2012.  In economic terms, the official view is that these imbalances are unproblematic; they are, in some sense, merely an accounting entry, reflecting the movement of liquidity within the EMU (for more detail, see the Annual Report of the Bundesbank, pp.48-50).  When confidence returns and interbank lending is restored, these imbalances will dissipate.  Or so the theory goes.

A problem would arise, however, if the EMU itself breaks down—through a default and exit of a member-state, for example.  In this case, the central banks in the core, most importantly the Bundesbank, could be left holding the bag, so to speak.  That is, these “imbalances” could convert into “liabilities” that the core’s national taxpayers might eventually have to make good in order to shore up the balance sheets of their domestic central banks.

From the official perspective, this is seen as a remote possibility. Jens Weidmann, President of the Bundesbank, for example, recently declared that he is not worried about Target2 imbalances per se “because I believe the idea that monetary union may fall apart is quite absurd” (original German here).  Additionally, in principle, there is collateral backing up these imbalances in the event of a break-up—but it should be added that Weidmann has expressed concern about the declining collateral standards of the ECB with regard to the Eurozone periphery.  In any case, any liabilities resulting from such a break-up would have to be distributed among the remaining Eurozone members according to their share of capital in the European Central Bank, thus mitigating the losses to Germany. This may be cold comfort to German taxpayers, however, given that Germany’s share would be the largest and its exposure would grow in absolute terms as the imbalances themselves continue to grow as a consequence of the Eurozone crisis.

For purposes of this discussion, however, I want to take the official position regarding the risks associated with Target2 imbalances and Eurozone collapse as true.  Let’s assume the ultimate risks are remote, even “absurd”, as Jens Weidmann has maintained.  But this assessment, which experts within the German government apparently share, still suggests something of a circularity, if not a contradiction, at the heart of the EMU, at least as it has evolved in the Eurozone crisis.  The imbalances in the Target2 system may themselves be integral to an incentive structure that helps to make an EMU collapse politically “absurd” even if the economic fundamentals might otherwise warrant it. To put it another way, these imbalances stand as a kind of “sword of Damocles” over the heads of politicians and taxpayers in the core member-states.  In order to avoid converting what are now mere Target2 “imbalances” into potentially massive Target2 “liabilities”, the Eurozone’s stronger economies obviously have a clear incentive to take whatever steps are needed to shore up the weaker ones and thus make collapse politically “absurd”.  Exit is effectively out of the question for any member state, strong or weak, thus reinforcing the irreversibility of the Euro (something obvious to Barry Eichengreen even before the crisis).

This is precisely as it should be, one might say, given the sort of economic interdependence that the currency union was designed to promote.  But it also suggests that the incentive structure at the heart of Target2 (in effect raising the possibility of severe penalties for failing to keep the EMU intact) already contains elements within it of something like a political union. Or at least it contains a strong measure financial-political solidarity, albeit through the technocratic backdoor of the payment system and its provision of liquidity in the absence of interbank lending.  (In this regard, Chancellor Merkel’s telling comment in her BBC Newsnight interview—that “we have taken the decision to be in a currency union. This is not only a monetary decision, it is a political one”—may be of some relevance here.)

This already developed political dimension of EMU, however, raises some potentially uncomfortable issues with regard to the jurisprudence of the German Federal Constitutional Court (GFCC).  As the court made clear in its 1998 decision on the constitutionality of the currency union (para.86 in the official English translation, but para.80 in the original German – go figure), a political union was clearly beyond the scope of the original democratic legitimation given to the EMU in Germany:  “the Maastricht Treaty … establishes a Monetary Union without simultaneous or immediately ensuing political union. Should it emerge that the Monetary Union cannot in reality be achieved without a political union, then a new political decision will be required … For this decision [a] treaty amendment is necessary, and can come about only through assent by the national State organs, on their political responsibility”.

There may also be other, more specific constitutional problems with the Target2 incentive structure.  Most importantly, it may run afoul of the no-bailout clause in Article 125 TFEU, which is itself an expression of the political limits of the existing currency union. Article 125 provides: “A Member State shall not be liable for or assume the commitments of central governments, regional, local or other public authorities, other bodies governed by public law, or public undertakings of another Member State, without prejudice to mutual financial guarantees for the joint execution of a specific project.”  Germany successfully worked around this obstacle in earlier Eurozone bailouts by casting its contributions as bilateral assistance not governed by the clause.  But it will be difficult to treat Target2 liabilities in the same way.  Perhaps someone might argue they constitute “mutual financial guarantees for the joint execution of a specific project”—that project being the currency union writ large.  I see that as a real stretch, to put it mildly, but then one should never underestimate the interpretive creativity of lawyers when it comes to the Eurozone crisis (recall the early recourse to Article 122 TFEU as a legal basis for bailouts).

According to the decision of the GFCC on the Greek bailout last September (para.129), the no-bailout clause exists as part of a range of provisions in the treaty to prevent “the assumption of liability for decisions of financial effect of other member states—through direct or indirect pooling of state debts—in a manner that exceeds the bases of legitimation in an association of sovereign states”.  The court could find that the provision of liquidity via Target2, which is ultimately backed up by the Bundesbank and the German taxpayer, fits comfortably within this prohibition.  Even though, in the event of member state default or exit, the necessary payouts will in fact go to the Bundesbank to shore up its balance sheet, their underlying cause will have been debts incurred by a “public authority or other body governed by public law” within the meaning of Article 125 (i.e., the central bank of the exited member state).  In this way, Target2 could be seen as a mechanism for “pooling debts” within the meaning of the GFCC’s case law, and any subsequent payout by the Bundestag could constitute a prohibited “liability or assumption” of those debts under Article 125 TFEU.

Finally, the Target2 incentive structure itself raises potential concerns regarding the Demokratieprinzip that the judges on the GFCC have articulated in their series of judgments on the Eurozone crisis.  The most recent was last month on the scope of Bundestag oversight of Germany’s participation in the EFSF (my earlier post on this decision is here).  In that case, the court insisted (para.109) “that the German Bundestag is the place in which, on its own responsibility, decisions are to be made about revenues and expenditures, including with regard to international and European obligations”.  Moreover, in its decision last September (para.124), the court more specifically concluded that, “if supranational legal obligations were created without a corresponding decision by the free will of the Bundestag, then the parliament would find itself in the roll of a mere rubber-stamp [a Nachvollzug – literally a ‘re-enacting’] and could no-longer exercise overall responsibility for spending policy within the framework of its budgetary rights”.  Finally, again last September (para.125), the court ruled that, “in particular [the Bundestag] is not permitted, even by statute, to subject itself [sich ausliefern – literally to ‘deliver itself up’] to any mechanism of financial effect, which—whether on the basis of its overall conception or an overall assessment of its individual measures—could lead to unclear burdens of budgetary significance, be they expenditures or revenue losses, without prior constitutive consent” of the Bundestag.

As an outsider, I obviously defer to the superior knowledge of German constitutional law experts on the meaning and import of these passages.  They could, in the end, simply amount to a sort of surenchère verbale from which the court will inevitably have to retreat in the face of the fait accompli of monetary union as well as the functional demands of resolving the Eurozone crisis. Nevertheless, on their face, they do seem to raise several questions with regard to Target2:  Might the constitutional problem with the payment system be that—“whether on the basis of its overall conception or an overall assessment of its individual measures”—what were initially mere “imbalances” could be transformed into real “liabilities” without any vote of the Bundestag, by virtue of another member-state’s default or exit from the Eurozone and the technical operation of the Target2 system?  Could this risk, which is built into the technocratic structure of the currency union, in turn “lead to unclear burdens of budgetary significance … without prior constitutive consent”?  Does Target2 thus run the risk of turning the Bundestag into a “mere rubber-stamp [Nachvollzug]” within the meaning of the GFCC’s jurisprudence?

Indeed, one might argue that even the fear of any future Target2 liabilities could have a major impact on the Bundestag’s budgetary autonomy, by effectively compelling further bailouts to keep the Eurozone intact; hence the “sword of Damocles” over German politicians and taxpayers, trapping them in a web of unforeseen legal and political obligation to rescue other Eurozone members, lest Germany face, in the extreme, potentially massive Target2 liabilities.  This all points to the political-legal logic at the heart of Target2:  on the one hand, it may make the collapse of the currency union politically “absurd”, per Jens Weidmann, the Bundesbank president; on the other hand, it may make the payment system itself constitutionally problematic, per the Demokratieprinzip of the GFCC.  Or at least this is the potential contradiction I am trying to highlight with this post.

To Weidmann’s credit, he seems to be alive to elements of this problem.  For example, in his critique of the ECB’s loose-money policies and declining collateral standards, which he related to the Target2 imbalances, Weidmann argued recently: “Decisions relating to the redistribution of major solvency risks of banks or governments among taxpayers across the euro area is the sole responsibility of elected governments and parliaments” (original German here). This statement echoed many of the concerns raised by Andreas Voßkuhle, President of the GFCC, in a speech in Dortmund last month, exploring the impact of the Eurozone crisis more generally on representative democracy on the national level.  “It would be fatal”, Voßkuhle reportedly said, “that, in rescuing the Euro, democracy were left by the wayside”.

The Target2 controversy, in all its technocratic complexity, may well provide the trigger for a deeper process of reflection over the meaning of the Demokratieprinzip in Germany in relation to the Eurozone crisis.  What this all suggests, however, is that perhaps the currency union was built on much shakier, indeed even internally contradictory, legal ground than is normally supposed.  Of course, it seems deeply unlikely that the GFCC would ever prevent Germany from meeting its Target2 liabilities, particularly when they would have to ultimately be paid to the Bundesbank in any event.  But any substantial loss via Target2 might also make the court much less likely to grant the usual Einschätzungsspielraum, or “margin of appreciation”, to policymakers in their efforts to address the Eurozone crisis going forward.

In the hearing last summer on the Greek bailouts, one of the complainants, Karl Albrecht Schachtschneider (long regarded as among the most extreme opponents of the currency union in Germany), stood before the judges in Karlsruhe and argued “Was ökonomisch falsch ist, kann rechtlich nicht richtig sein” – “what is economically wrong cannot be legally right”.  This statement reportedly provoked laughter in the courtroom. The idea that the court would or could substitute its judgment for that of policy-makers on matters of substance was apparently taken, for lack of a better word, as “absurd”.  As President Voßkuhle stressed at the hearing:  “We are not deciding here on the correct Euro-stabilization strategy.  That is the job for politics and not jurisprudence”. Certainly the movement of liquidity through the central banking system via Target2 is a feature of the current Euro-stabilization strategy.

But given the incentive structure at the heart of Target2—the unforeseen “sword of Damocles”, so to speak, now all too well perceived—perhaps the final question should be “who will get the last laugh?”  It could just well be Professor Schachtschneider—but only if there is a major deterioration in the Eurozone crisis, leading to a member-state exit, thus giving rise to Target2 liabilities.  We should all hope that does not happen, because the consequences could well be horrendous.  But if it does, then perhaps the judges on GFCC might realize that the usual “margin of appreciation” given to technocrats and policy-makers in the construction of the common currency was, in this instance at least, misplaced.  Perhaps then the court might see that Professor Schachtschneider, despite the seemingly laughable nature of his outlandish claim last summer, might have had a point after all.  Only time will tell.

4 thoughts on “Target2 Imbalances and German Democracy: Surmountable Contradictions?

  1. Pingback: Verfassungsblog › Target2 Imbalances and the “Demokratieprinzip”: Some Questions

  2. Update: The analysis by Irish economist Karl Whelan here ( suggests that the incentive structure described in this post may not be as problematic as I thought. Per Whelan:

    “In a post-euro world, the Bundesbank would be one of a select number of central banks that could be counted on to print a currency likely to retain its value. Weidmann could write himself a cheque, stick it in the vaults and declare the Bundesbank to be solvent without any need to call on the German taxpayer.”

    “That isn’t to say a euro break-up would cause no problems for Germany. The likely appreciation of the new DM would see Germany lose competitiveness which would hit its exports. It would also require recapitalisation of its private banks as their DM-denominated liabilities would rise in value relative to their balance sheets that may be left with significant non-DM assets. But the solvency of the Bundesbank will be very low down the list of potential problems.”

    If this is true, then Target2 imbalances may not be the “sword of Damocles” that I described, and thus I would need to reconsider the concerns I expressed in this post. -PLL

  3. Update2: I’m still trying to sort out the Target2 incentive structure from a public law/constitutional perspective and hope to be blogging on that soon. In the interim, I wanted to alert readers to this comment from Frances Coppola here (, which contains the following interesting passage:

    “The prevalent belief is that if Greece were to leave the Eurozone, the value of the Bundesbank’s assets would be reduced, leaving it technically insolvent since its liabilities (base money in circulation, in this case) would exceed its assets. The effect of this would be a significant fiscal tightening caused by reducing base money in circulation (deflation) and/or increasing German taxes to recapitalise the Bundesbank. So Germans are understandably angry that they would end up picking the tab for Greece’s exit.”

    “Except that the Bundesbank’s claim isn’t against the central banks of other countries. It’s against the ECB. It is the ECB that has a claim against Greece, not the Bundesbank. So in the event of Greece leaving the Eurozone, it would actually be the ECB that would be technically insolvent, not the Bundesbank.”


    “Any decision to recapitalise the ECB would hit Germany hardest because of its dominance in the Eurozone. German taxpayers would be footing a large part of the bill for partial breakup of the Eurozone. Personally I don’t think this is anything like as big a problem as the LTRO unwind in three years’ time will be, or the problem that the ECB already has with valuation of junk sovereign and other bonds it has accepted as collateral. But it is the prospect of having to recapitalise the ECB that German taxpayers should be worrying about, not whether the Bundesbank’s claims will be met.”

    She then goes on to make a proposal about “sterilizing” the balance sheets of national central banks, by forcing them back on to commercial banks’ balance sheets. I still need to reflect on that proposal from the standpoint of the constitutionality of the Eurozone incentive structure. But she concludes with this key point:

    “It really isn’t helpful to regard the TARGET2 imbalances as a ‘debt’ problem or as Germany doing some kind of bailout. The problem arises from the inadequate setup of the single currency. Nobody ever imagined that such trade imbalances would build up, and so nobody put in place any formal mechanism to sterilise central bank operations and keep the trade imbalances in the private sector where they belong. By allowing the imbalances to reside on central bank balance sheets, the Eurozone has been able to pretend for too long that trade imbalances are not an issue. If they were forcibly transferred to the private sector, the Eurozone leadership would have to admit that trade imbalances are not only an issue, they are the major cause of the insolvency of the Eurozone banking system and the instability of the currency union. And then we can perhaps stop blaming countries for their debt problems and point the finger at the real culprits – the banks that have lent so recklessly, the governments that have protected them, and the politicians who have created the deformed and dysfunctional single currency.”

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