Tangled and off target

And that's not the end of the European Central Bank's liabilities. There's also something called the Target2 Balance. (Target stands for Trans-European Automated Real-Time Gross Settlement Express Transfer System. Apparently the "s" in "settlement" is silent.) Target2 handles payments among banks in the eurozone and imbalances among eurozone members.

Membership in Target2 is mandatory for countries in the eurozone. Membership is open to European Union members that don't use the euro. Six non-eurozone central banks use Target2.

On one level, Target2 is a settlement system. On this level, the system works like this: European banks maintain accounts with their national central banks. When, say, a Spanish importer places an order with a German exporter and asks its bank to pay that exporter, the importer's Spanish bank transfers money to the German bank account of the exporter. The Target2 system debits the Spanish bank's account at the Spanish central bank, the Banco de España, and credits the receiving German bank at Germany's central bank, the Bundesbank. The Spanish and German companies settle their credits and debits with their respective banks, which then settle with their respective national central banks. The two central banks settle their accounts, not by transferring actual assets (cash, for instance) but through liabilities and credits in the Target2 system. The Banco de España winds up with a liability and the Bundesbank with a credit.

But on another level, Target2 is an automatic funding system designed to cover trade imbalances among eurozone members. If a country -- let's say Spain again -- imports more than it exports, it winds up with a big, and growing, liability in the Target2 system. But doesn't have to transfer cash or other assets to the Bundesbank to settle those liabilities. It, in essence, winds up owing the Target2 system, which has, in turn, created a liability that is ultimately due to the Bundesbank, but that in the short term is actually funded by the Target2 system.

I think you can guess what has happened in recent years to Target2 liabilities and credits as the eurozone's weaker economies lost competitiveness and imported much more than they exported to Europe's stronger economies. The Target2 liabilities for the eurozone's peripheral economies, including Greece, Italy, Spain, Portugal and Ireland, climbed by 150 billion euros in April to 770 billion euros. I don't have exactly comparable figures for the credits run up in the Target2 system by the eurozone's stronger exporters, but in February the Bundesbank showed a positive credit balance of 576 billion euros.

Trust is the tipping point

There's nothing magical about any of these numbers. There's no reason that a 1.9 trillion euro balance sheet -- the size of the European Central Bank balance sheet a year ago -- should be economically viable and a 3 trillion euro balance sheet shouldn't be, or that a 620 billion euro Target2 liability should be supportable and a 770 billion euro liability shouldn't be. So why panic now?

In the end, it comes down to trust.

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If those Byzantine mercenaries had been willing to accept the debased solidus in 1050 as good money, the fact that it was only 10% gold wouldn't have mattered. Likewise, if the national central banks of Europe are willing to backstop the European Central Bank and, more importantly, if everybody in the financial markets is willing to trust that willingness, the fact that the European Central Bank has just 6.5 billion euros in capital becomes irrelevant. If banks and everybody in the financial markets believe that the Bundesbank and other Target2 creditors are willing to keep letting other central banks run up their liabilities, then the Target2 system is as good as gold. And the euro is solid.

But it works only if the trust in the system is there.

And it's here that the leaders of the eurozone have done real damage to their "money" in the way that they've handled this crisis.

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