The ECB's secret bailout strategy: but in the end, either the euro will collapse or Europe will establish a transfer union.

• Author: Sinn, Hans-Werner

Why did Greece, Ireland, and Portugal have to seek shelter under the European Union's rescue umbrella, and why is Spain a potential candidate?

For many, the answer is obvious: international markets no longer want to finance the PIGS--Portugal, Italy, Greece, and Spain. But that is only half true. In fact, international markets have not financed any of them to a considerable extent for the past three years; the European Central Bank has. The so-called "Target" accounts, hitherto ignored by the media, show that the ECB has been much more involved in rescue operations than is commonly known.

But now the ECB no longer wants to do it, and is urging eurozone members to step in.

Normally, a country's current account deficit (trade deficit minus transfers from other countries) is financed with foreign private capital. In a currency union, however, central bank credit may play this role if private capital flows are insufficient. This is what happened in the eurozone when the interbank market first broke down in mid-2007.

The PIGS' own central banks started to lend newly printed money to their private banks, and this money was then used to finance the current account deficit. These funds went to the exporting countries, where they circulated as part of normal transactions.

The exporting countries' central banks responded by reducing their emissions of fresh money to be lent to the domestic economy. In effect, central bank money lending in exporting countries, above all in Germany, was diverted to the PIGS.

The ECB's policy was not inflationary, because the aggregate stock of central bank money in the eurozone was unaffected. But, as PIGS' central bank lending came at the expense of central bank lending within the eurozone's exporting countries, the policy amounted to a forced capital export from these countries to the PIGS.

The amount of the ECB's "replacement lending" is shown by the so-called Target2 account, which measures the deficit or surplus of a country's financial transactions with other countries. As the account includes international payments for both trade in goods and financial claims, a deficit in a country's Target account indicates foreign borrowing via the ECB, whereas a surplus denotes foreign lending via the ECB.

The balance is not reported on the ECB's balance sheet, since it is zero in the aggregate, but it does show up on the respective balance sheets of the national central banks as interest-bearing claims against, and...