What Germany should fear most is its own fear

Paul De Grauwe, Yuemei Ji, 18 September 2012



The large expansion of TARGET2 claims and liabilities since the start of the sovereign debt crisis has led to fears that countries like Germany would lose vast amounts if the Eurozone broke up (Sinn and Wollmershäuser 2012)1.

This fear created strong negative emotions vis-à-vis the Eurozone in Germany and thus became an important political factor. But is an EZ breakup a serious risk for Germany? We argue that the answer is no.

Our analysis proceeds in two steps.

  • We distinguish between the risks emerging from holding net foreign claims and the gross claims that TARGET2 balances comprise; and
  • We show how German wealth losses can be avoided in the case of a Eurozone breakup.

Total foreign claims and TARGET2 claims

It is important to start from rock solid truths. If a country has net financial claims against the rest of the world, that nation must have had current account balances that were in surplus in the past. This means that Germany has accumulated current account surpluses against other Eurozone nations in the past. There is no other way Germany can accumulate financial claims on the rest of the Eurozone.

This leads to the following insights.

  • The size of possible losses depends upon the size of the net foreign claims;
  • Such losses are realised only if foreign debtors to default on their debt.

The next point is the critical one in the currently heated debate.

  • TARGET2 claims of Germany are not a good indicator of this risk since they are not a good indicator of Germany’s net foreign claims.

TARGET2 liabilities have increased mainly as a result of speculative flows (De Grauwe and Ji 2012) and thus do not change the net claims of Germany on the rest of the Eurozone. What TARGET2 has done is shift the composition of these claims between the German Central Bank and German banks. Consider an example.

A Spaniard with euro deposits in a Spanish bank shifts his deposit to a German bank – driven by fear that Spain will exit and convert his euros to devalued pesetas. While prudent, this is really just foreign exchange speculation by the Spaniard – the transfer is a speculative flow.

The crux is that this Spain-to-Germany deposit transfer creates a new German liability and a new German asset:

  • The new bank deposit in Germany is a new German liability vis-à-vis the Spaniard, and
  • The change in the Bundesbank’s TARGET2 balance is a new German claim on the Eurosystem.

Specifically, the Spain-to-Germany deposits transfer leads to an increase in Banco de España’s TARGET2 liabilities to the Eurosystem and a corresponding increase in the Bundesbank’s TARGET2 claims on the Eurosystem. In other words, the liability shows up in the Germany commercial bank and the claim in the German central bank.

One way to think of this is to imagine that the Spaniard’s new German bank deposit could – if such transfers were possible legally and politically – pay off the new Bundesbank claim on the Eurosystem. Of course, this is highly unlikely, but it brings home the fact that TARGET2 balances created by speculative capital flows are not net German claims – they are gross claims that are exactly offset by other assets in the German financial system. Using the balance of TARGET2 claims to the risk facing Germany is therefore erroneous.

How much of the TARGET2 imbalances are net versus gross flows?

After 2010, German TARGET2 claims increased dramatically and much more than the current account surpluses during this period, and the same was true for other northern EZ members such as Finland and the Netherlands.

This is made clear by Figures 1 and 2. The net claims, which equal the current account surpluses, are shown in Figure 2. Figure 3 shows the gross claims channelled through TARGET2. Plainly, the increases in the gross claims and liabilities after 2010 were many times larger than the net claims.
This is why the explosion of the TARGET claims of Germany since 2010 cannot be interpreted as an explosion of the risk of foreign exposure for Germany.

This risk increased moderately because since 2010 Germany continued to accumulate current account surpluses. It could have decided to reduce its current account surpluses by pursuing more expansionary fiscal policies, but did not to do so. The increase in the net foreign exposure – while not enormous – was entirely Germany’s own decision. It cannot be blamed on the TARGET2 system. (See Figure 3 in the addendum for TARGET2 claims as shares of GDP.)

One could argue, however, that because of the higher Bundesbank TARGET2 claims it is the German taxpayer who now bears a higher risk. But this is also erroneous. This leads us to the second part of our answer.

Figure 1. Current account surplus/deficit GDP

Source: Data stream and authors' own calculations.

Figure 2. TARGET2 change GDP ratio

Source: Data stream and authors’ own calculations. Note for figures 2 and 3: The current accounts and TARGET2 changes are quarterly data; they are therefore divided by the corresponding GDP of that quarter.

How the Bundesbank could avoid losing if the Eurozone breaks up

To explain the plan for avoiding losses, it is again necessary to return to rock solid fundamentals – the role of central banks in today’s fiat money system. There are three key facts to keep in mind:

  • When the Bundesbank acquires claims (assets) it issues liabilities – which are, by definition, the money base.
  • The value of the money base is not automatically determined by the value of the assets held by the Bundesbank; its value is independent of the value of the assets held by the central bank.

In the fiat money system we live in, the Bundesbank could destroy all its assets without any effect on the value of the money base – as long as people continued to trust the Bundesbank to maintain price stability. Economists who are confused on this point are usually thinking about central banks in gold-standard terms. Back then the central bank’s assets (gold) had a very direct impact on the value of the monetary base – after all, the central bank promised to back paper money with gold. The ECB (and most central banks of large developed countries), however, has made no such promise. The value of its liabilities, therefore, is not dependent of the value of the assets it holds.2

  • The value of the money base is exclusively determined by its purchasing power in terms of goods and services.

Putting these together we see that the only way for Germany as a whole to lose wealth from the Eurozone breakup is for the Bundesbank to lose control of supply of the money base which in turn undermines its purchasing power value.

To avoid wealth loses in the event of a Eurozone breakup, the Bundesbank needs to stabilise the value of the money base. That is all what is needed. The key point is that this condition is independent from the value of the assets held by the central bank (see also Whelan 2012 on this). 

The practicalities: Refuse euro conversion for non-residents

Let us apply these principles to a scenario where the Eurozone breaks up. When the Eurozone ends, central banks will have to convert the outstanding euros into the new national currency. The Bundesbank will have to issue new DMs for old euro – just like it did when the Eastern Länder joined.

We start by showing how mistakes by the Bundesbank could result in large wealth loses. Then we show how this could be avoided by restricting conversions to German residents – in essence forcing the speculating Spaniard from our earlier example to convert his euros at the Banco de España.

Suppose the Bundesbank announces a conversion rate of one euro to two marks. Since it can create as many marks as it likes, the Bundesbank’s ability to convert has nothing to do with the asset side of its balance sheet (including the TARGET2 claims). The wealth destruction only comes if price rises undermine that value of the money base. This is indeed a worry – if the Bundesbank mishandled the conversion.

  • Many non-residents may try to convert their euros into marks – creating a situation where too many marks are in circulation to be consistent with price stability.

If that happens, inflation would set in and German residents would experience wealth losses related to the Eurozone’s demise.

  • The Bundesbank, however, can avoid this risk by restricting the conversion of euros into marks to German residents.

In doing so, it can be sure that the amount of marks created as a result of the conversion is such as to keep prices in Germany stable. Under those conditions the German taxpayers will not lose a single pfennig.

  • A similar restriction will also have to be applied to bank deposits held by non-residents in the German banking system.

There is no doubt that prior to the collapse of the Eurozone large speculative movements into German banks will be triggered. A conversion of these euro deposits into new German mark deposits would lead to an excessive increase of the German mark money stock and would risk creating inflation in Germany. A restricted conversion, however, can ensure that this does not happen, thereby shielding the German taxpayers from losses induced by the conversion.

Justice will prevail: Losers with limited Bundesbank conversion

This tactic cannot avoid all wealth loss. Our Spaniard, for example, will have found that his supposedly one-way bet has turned into a trap. The citizens of countries in the periphery that shifted their deposits to Germany etc would have to take their euros back home to get them converted. Central banks of these countries are likely to apply a devalued conversion rate, i.e. they are likely to give back a lower amount of national currencies for one euro than the one applied at the start of the Eurozone. And even if the central banks were to use the same conversion rate as the one at the start of the Eurozone, it is likely that the new national currencies of these countries would depreciate sharply in the foreign exchange markets, leading to large losses for its holders.

Thus, at conversion time, 'justice will prevail'.

  • The peripheral countries that have issued too much government debt in the past will be punished, i.e. their citizens will bear a loss of wealth resulting from a depreciated currency.
  • The virtuous German taxpayer, however, does not have to share in this loss.

Provided, the Bundesbank controls the conversion from euros to German marks and restricts this to German residents, the latter will inherit a stable new currency that will take the place of the old euro, which incidentally was also very stable in terms of purchasing power.

By restricting the conversion of euros to German residents in this way the Bundesbank can ensure that the losses that will occur as a result of excessive issue of debt in peripheral countries will also be borne by the residents of these countries, and not by the German taxpayer. Put differently, this restricted conversion is equivalent to pushing the devalued claims from the Bundesbank balance sheet back unto the balance sheets of the central banks of the debtor countries.


The accumulation of large imbalances in the Eurozone payment system (TARGET2) is a dramatic indicator of the loss of confidence in the Eurozone’s integrity. It has led to the view that Germany has been forced to provide credit to the deficit countries, and as a result has been pushed into a situation in which it had to take on unacceptably large risks that will lead to large losses for the German population if the Eurozone were to disintegrate.

This claim has received much attention in the German media and has contributed to creating fears for imminent disasters. The claim, however, is unfounded.

  • First, the accumulation of a net foreign asset position of Germany is indeed a source of risk, but it exists since Germany accumulated current account surpluses.

Since these surpluses are the result of policy choices of that country, it can be said that Germany has chosen to take these risks. Germans should stop complaining about these risks.

  • Second, the net foreign asset position of Germany and its ensuing risk has little to do with the increase in gross claims such as the TARGET2 imbalances.

These have increased significantly without increasing the net foreign asset position of that country. As a result, these TARGET claims are a bad indicator of the risks of Germany.

  • Third Germany could avoid wealth losses from a Eurozone breakup by limiting euro-to-mark conversion to residents.

We argued that the only risk faced by Germany is that if the Eurozone were to collapse, the Bundesbank may at the moment of conversion of euros into new German marks be led to issue too many marks, thereby creating inflation. This risk, however, can be eliminated by restricting the conversion of euros into marks to German residents. In so doing the Bundesbank will force the peripheral countries that have issued too much debt to pay the price of this policy by accepting devalued national currencies.

Although the fear of large potential losses of Germany as a result of the accumulation of TARGET2 claims is unfounded, this fear has become a reality in Germany. It has led to the view that any financial assistance will lead to losses for Germany, and to a great resistance towards providing financial assistance to peripheral countries. As a result, this fear also influences political attitudes and makes it difficult for the German government to take a more lenient attitude vis-à-vis peripheral countries. Ultimately, this fear increases the risk of a breakdown of the Eurozone. Or to paraphrase Franklin Roosevelt, what Germany should fear most is its own fear.


Bindseil, U, and König, Ph, (2011), “The economics of TARGET2 balances”, SFB 649 Discussion Paper 2011-035, Humboldt University Berlin

Buiter, W, (2008), "Can Central Banks Go Broke", CEPR Policy Insight No. 24, Centre for Economic Policy Research, London, May.

Buiter, W, Rahbari, E., and Michels, J. (2011), “The implications of intra Eurozone imbalances in credit flows”, VoxEU.org, 6 September.

De Grauwe, P, and Ji, Y, (2012), "What Germany should fear most is its own fear. An Analysis of TARGET2 and Current Account Imbalances", CEPS, 12 September.

Dullien, S, and Shieritz, M (2012), "German savers should applaud the growing TARGET balances", VoxEU.org, 7 May.

Sinn, H-W, and Wollmershäuser, T, (2012), "TARGET loans, current account balances and capital flows: the ECB’s rescue facility", International Tax and Public Finance, May, online.

Whelan, K, (2012), "TARGET2: Not why Germans should fear a euro breakup", VoxEU.org, April 29.


Before analysing the nature of the risks underlying TARGET claims it is important to relate these claims (and the liabilities) to each country’s GDP. This is done in Figure 1. It now appears that of the four countries with TARGET claims (Luxembourg, Finland, Netherlands and Germany) Germany has the lowest level as% of GDP (24%). Luxembourg’s claim represents a whopping 278% of GDP (Finland: 40%, the Netherlands 25%). Thus, if there are any risks, they are larger for the other creditor countries than for Germany.

Figure 3. Target claims and liabilities as% of GDP

Source: data stream and authors’ own calculations. The values of Luxumbourg after 2009 Q2 exceed 100% so that they are not included in the graphs.

1 For descriptions of the mechanics of the TARGET2 system see Bindseil and König (2011), Dullien and Shieritz(2012) and Sinn and Wollmershäuser(2012).

2 Another way to put this is as follows. When the central bank acquires assets, mainly government bonds, it issues new liabilities. The latter take the place of the government bonds in the portfolios of private agents. It is as if the government debt has disappeared. It has been replaced by central bank debt. The central bank could literally put the government bonds in the shredding machine. This would not affect the value of the central bank debt as the central bank has made no promise to redeem its debt (money base) into government bonds. And as long as the central bank maintains price stability agents will willingly hold the new debt (money base) issued by the central bank.

Topics: Europe's nations and regions, Monetary policy
Tags: Eurozone crisis, Germany, TARGET2

Professor of international economics, London School of Economics, and former member of the Belgian parliament.

Yuemei Ji

Economist, LICOS, University of Leuven