The paper “Target2 and Central Bank Balance Sheets” by Karl Whelan has been presented at the Economic Policy Panel in Dublin in April 2013. It contains a summary – and critical review - of a debate that has been started by Hans-Werner Sinn, who interpreted large imbalances in the TARGET2 system as sign of balance of payments crisis within the Euro-Area.

The paper “Target2 and Central Bank Balance Sheets” by Karl Whelan has been presented at the Economic Policy Panel in Dublin in April 2013. It contains a summary – and critical review - of a debate that has been started by Hans-Werner Sinn, who interpreted large imbalances in the TARGET2 system as sign of balance of payments crisis within the Euro-Area. Sinn had raised the issue, in a column on VOXEU.ORG (2011a), where it currently ranks as the second most read article of all times and in a longer research article, jointly with Timo Wollmershäuser (2011 and 2012 a, b). Clearly, the topic is one of most controversially debated issues in contemporary economic policy research. Prof. Whelan has been among the first commentators who have rejected concerns about large imbalances in the TARGET2 system. He argues that these concerns are overrated and suggests that policy makers should not focus on “balance sheet items relating to TARGET2” (p.38). The present working paper is an extended version of my comments in Dublin, where I illustrated that Whelan errs on the other side. In my response, I focused on the following four critical points: First, the author chooses the example of deposit flight to illustrate TARGET2 mechanics. This is not representative for most countries and misses the welfare implications. Deposits that have been moved across borders are typically not the household deposits of “Mr. A”, who wire transfers his savings to Germany. To a large extend, TARGET2 balances have rather been driven by a flight from low quality assets that was facilitated by lower collateral standards. Secondly, the author argues that TARGET2 liabilities have “not reflected discretionary actions by peripheral central banks or governments” (p.38). He rejects the tragedy-of-the-commons argument in Tornell (2012) and Dinger et al (2012), by referring to the joint decisions at the ECB council. However, it is not (only) the decision making, but rather the implementation of policies that creates the common pool problem. The paper neglects several channels through which countries can indirectly affect their TARGET2 balances. Third, the policy proposal in the paper – the redemption of TARGET2 liabilities with collateral from monetary policy operations – provides no workable solution to the problem of large imbalances. A substantial part of this collateral is government bonds. Using this collateral to redeem TARGET2 liabilities would indirectly facilitate government financing in times of crisis. It would undermine the conditionality typically attached to other rescue funds, such as the IMF or the ESM. Finally, the paper does not give fair credit to earlier academic contributions on the topic. Capital flight via the target system has been analyzed by Garber (1998). Sinn and Wollmershäuser (2012 a,b) provided the first analysis of Europe’s balance of payments crisis. They also constructed the first TARGET2 data set. Their analysis of break-up scenarios is similar to the one presented in this paper. I do not see that the present paper uncovers mistakes in these articles. Moreover, it adopts part of the discussion. The close link between TARGET2 balances and central bank credit is an original finding of Sinn and Wollmershäuser (2011, 2012a). Also the notion that capital flight leads to Target2 imbalances is not contrary to their paper, but rather an integral part of their analysis. The paper seems to reduce the article by Sinn and Wollmershäuser to emphasize the current account only (p. 17). This is not a correct citation of their work. The strong conclusions reached in the present paper (“flawed”, “inaccurate”, etc.) follow from this misinterpretation – and are thus unfounded.

http://eurocrisismonitor.com/Downloads/WP_99.pdf