A Treatise on the TARGET2 Imbalances & Stagnation in Europe

Abstract

Since the Global Financial Crisis, there have been two parallel issues faced by the Eurozone, Stagnation and TARGET2 imbalances. This study analyses the aspect of settling TARGET2 in an equitable and fair manner that could also resolve the issues of sluggish growth, deflation and high unemployment in Europe. It is proposed that the TARGET2 balances are settled by an adjustment to the monetary base in the EMU. Specifically, it implies that the Eurozone members are granted a right to settle their imbalances against Euro-system in proportion to their capital key weights. The proposed approach will have four order/tier effects which include, a) adjustment of monetary base at the EMU level, b) creation of additional liquidity in the Euros -system member states, c) creation of much needed fiscal space and d) cross-border spillovers among the EMU members. While keeping the bleak economic outlook of Eurozone in context, we analysed the implication of proposed mechanism at first tier using a Factor-Augmented VAR model on data from 2000Q1 to 2017Q1. Our key results suggest that such an approach would lead to a considerable increase in the real output growth, investment, consumption, gross fixed capital formation, stock markets as well as exports and imports of Germany, Greece, Ireland, Italy, Portugal and Spain. The magnitude of the proposed mechanism is comparable to the stimulative stance taken by authorities since the GFC and qualitative easing of “whatever it takes”. Comparatively, there are substantial gains for the TARGET2 surplus countries like Germany than the deficit countries as the former can address its public expenditure needs as well as settle large external surplus without breaching balanced budget act (Schuldenbremse). Given that, the adjustment will be based on the capital key weights and existing arrangements, the proposed approach is equitable, fair, and can be used as an unconventional tool by the ECB.