Suppose a Greek shipping magnate decides he’s not comfortable keeping his wealth in Greece, and decides to buy some nice real estate in Berlin. (As if most of the Greek wealthy hadn’t removed as much as possible to Germany, the US and UK long ago.) He writes a check for €1m on his Greek bank to the buyer, who deposits it at Deutsche Bank. To settle the check, the Greek bank wires the funds from its reserve account at the Greek central bank, the Bank of Greece. The Bank of Greece instructs the Bundesbank to credit Deutsche Bank’s reserve account at the Bundesbank. Then the Bundesbank is owed €1m by the ECB, and the Bank of Greece owes €1m under the Target2 system (corrected).

There has been a lot of controversy about this process, and the notion that Germany will get stuck with massive losses if, following massive capital flight now in progress to Germany, the peripheral countries leave the euro.

A thought experiment:

Suppose that on the day after the euro’s establishment, there had been a massive bank run in Greece. On day 1, the euro is established, and all drachma accounts are redenominated in euros. On day 2, everyone in Greece realizes this will never work, and rushes to put all their euros in Germany. After €500b flood German banks, Greece somehow departs the euro and re-introduces the drachma.

Does Greece owe Germany €500b under that scenario, for the privilege of reintroducing its own currency? Nothing happened in the real economy to justify that. No goods or assets flowed to Greece. What effectively happened is the same as if the ECB did €500b of quantitative easing in Germany, buying assets there, and draining a similar quantity of assets from Greece. Greece didn’t receive anything in the bargain. They are even. The ECB is even1. They just issued more euros in a smaller currency zone than they expected. Why would Greece have to buy back every euro that was issued in Greece? They weren’t a loan from the ECB.

If the euro zone remains intact, the Target2 balances are meaningless and can accumulate forever. The national central banks are like branches of the ECB and what impacts the real economy is its transactions with the ECB system, the accounting within the system doesn’t really matter.

If the euro zone breaks up, all bets are off. If Greece leaves, any business that owes euros, and only generates drachma cash, is not going to pay back the euros. It will be bankrupt, or there will have to be a managed default where everyone agrees that Greeks can pay back euro debts in drachmas at some exchange rate. Everything will have be renegotiated, and the people owed money, ie Germany, will take a hit.

How big a hit is an issue for geopolitics. At one extreme, the Europeans could backstop the Greek banks 100% and help bail out the Greek economy with a quasi-Marshall Plan. At the other extreme, they could send in tanks and seize Greek property. The question becomes what cost they are willing to pay for some level of stability, and to prevent Russians and Chinese interests from gaining a foothold. Or whether they would rather punish the Greeks and set an example for other countries under pressure to exit the euro, and preserve German wealth and the electoral prospects of the government. And again Target2 balances are irrelevant.

I just can’t see any scenario under which Target2 balances would matter, or how either side could use them as a binding constraint or bargaining chip. It’s just an accounting plug, and a bogus number bandied about to inflate the costs of a Greek euro exit. Of course, fallacies and illusions can be a rich vein for political fear-mongering.

Edit 9/4/2012: Thought some more and discussed with intelligent people. The next question is, what happens on Day 3? The newly reduced euro area will want to drain now-excessive euro reserves. So they sell bonds or other assets to drain euros. In Greece, when they want to re-introduce drachmas, they do it by buying assets, such as bonds. So, effectively a transfer to Greece took place, Greece gains some assets by virtue of reintroducing the currency, and Europe loses some assets. If instead Greece bought euros, effectively extinguishing the excess euro reserves, which in this scenario equal the Target 2 balances, that would make everyone even again. I still feel that this is ultimately a political question. Insisting on full repayment of the cumulative balance of payments by an impoverished departing country would be a bit unseemly, a modern-day Merchant of Venice.

1Everyone is even at the day 1 exchange rate, anyway. If the original drachma exchange rate was too strong, leading to the bank run, the assets bought in Germany are more valuable than they should have been, and Greece came out ahead by the amount of the overvaluation.