It’s not everyday that purely academic economic theory gets put into actual practice by a mainstream institution, but that’s just what happened this week when the European Central Bank (ECB) lowered its interest rate for commercial bank deposits to -0.10%. This was in conjunction with expanded efforts by the ECB to inject extra monetary stimulus into an extremely depressed European economy. Now I admit, at first glance, news like this doesn’t seem all that strange. Our own Federal Reserve has been undertaking multiple rounds of monetary stimulus ever since the 2008 financial crash (think Quantitative Easing). To explain why this could be a potential earthquake, I want you to take a look at the exact interest rate number; it’s negative. That’s. Not. Normal.
Most economic majors would characterize Central Banks like this (at least I hope they would): in addition to being a bank for the commercial banks, it’s their job to execute monetary policy through various tools, a common one being interest rates that, when adjusted, can expand or contract the flow of credit in an economy. It’s fairly simple. When interest rates decrease, mainstream thought tells us that this incentivizes additional borrowing thereby increasing economic activity. The opposite occurs when interest rates rise. Mainstream thought goes on to say that proper adjustments in interest rates, the most famous of which is the discount rate, by a Central Bank can lead to prudent economic management without the need for governments to get overzealous with fiscal policy. But what if interest rates don’t work?
Imagine a situation where interest rates are already fairly low (within a couple percentage points of zero) and the economy is doing great. Then, without warning, some major catastrophe happens and the economy plunges headlong into recession. The expected response for Central Banks is to lower interest rates and stimulate economic growth. But what happens as the rate approaches zero and the Central Bank can’t lower it anymore? You become stuck in a situation called a liquidity trap; the financial system can borrow cheaply, almost freely, and yet banks, corporations, and consumers are neither borrowing nor spending. They just save money and use the savings to pay off old debts. Meanwhile, the economy moves along at a snail’s pace while sparking deflationary fears.
If this situation sounds familiar, it should. This is precisely what happened following the financial crash in the United States and Europe, the effects of which we are still stuck with. Banks have no choice but to store away the trillions in monetary stimulus rather than lend it into the real economy. The Central Bank is powerless to fight this situation with interest rates because they’ve begun to run up against what’s called the zero lower bound, the idea that interest rates on bank deposits can’t go below zero. When interest rates are positive, even if they’re as small as 0.15% for example, banks make some money by keeping the money in the Central Bank’s vaults. We’re all familiar with this because our savings accounts generally receive some annual interest income; ergo, we get paid for keeping our money in a commercial bank.
In a weak economy like ours, banks don’t see many lending opportunities because consumers are either ineligible for loans or too cautious to borrow and spend. So the rational step is to just keep the money and earn, however small, interest income on it. The problem is that this does nothing to advance an economic recovery. This is where the idea of a negative interest rate was born. Think about it for a second. If interest rates are negative, the bank has to pay the Central Bank for its deposits rather than the other way around. Many economists have theorized that this would incentivize a commercial bank to make more loans rather than keeping trillions parked. To them, negative interest rates have the added benefit of monetary stimulus without the need for governments to run deficits and run up public debt (you can see why Europe seemed like such a good place to try this out right?).
Sounds fairly promising. I should clarify that the ECB’s experiment isn’t technically the first time a negative interest rate has been used. Both Sweden and Denmark tried it with their respective currencies. Suffice it to say, their results weren’t really much to look at. Denmark in particular instituted the rate to lower the value of its currency which had been driven too high at the time. Other than that however, its not exactly clear that the negative interest rates did much for either of their economies. Granted, the Eurozone is a much larger economy; however, there are other reasons to doubt the policy.
First and foremost, it’s not at all clear that the incentive structure will work as it’s supposed to. Now, more than any time in recent history, is an ideal time to borrow; interest rates are near zero and no one will ever get such cheap loans once the economy picks up and interest rates rise. But people still aren’t borrowing and the negative interest rates, being placed only on commercial bank deposits at the Central Bank, will not change any systemic incentives for consumer borrowing. Even if banks are more willing to lend, which it isn’t clear that they will be, consumers have to be willing to borrow.
Why do I say that banks might not be willing to lend? If you think about it, negative interest rates are kind of like a tax imposed by the Central Bank on deposits. However, making more loans isn’t the only way to avoid such a tax; remember, loans come with huge risks for banks, particularly when consumers don’t have as many assets as they used to. Instead, banks might very well return to pre-crash behavior and avoid the negative interest rates by making risky bets and investments using shoddy financial products. This is particularly dangerous considering that European Banks are in far worse financial health than U.S. Banks. It’s even possible that the banks, based on their risky position, might look at the -0.10% figure and assume that such a rate is not worth avoiding in the short-term and end up doing nothing. The ECB doesn’t really have the option of going lower with the negative interest rate because, if the rate gets too low, that would undermine trust in the entire banking system. Remember that the basic purpose of a financial system is to provide a safe place for your money. What on earth is safe about a system that periodically takes away chunks of your money?
There’s an even worse problem I have with this negative interest rate debate. No matter what some economists may say, negative interest rates are at best a short term substitution for actual fiscal policy. Central Banks can’t credibly sustain such rates for longer than a couple of years max. On top of that, there’s no guarantee about the quality or quantity of lending that the rates MIGHT encourage. Only fiscal policy, channeled into productive economic sectors can guarantee long-term, sustainable returns to the economy. But wait, you might say. The whole reason this debate got started was because Western countries have run up large levels of public debt! I’ll stop you right there and remind you that Europe is a special case compared to the United States, Britain, Australia, Canada, and other countries with their own currencies. European countries can’t print the Euro and are therefore very vulnerable to public debt crises. But that doesn’t mean that European politicians and the ECB are out of options completely. This isn’t the article to discuss them, but Europe does have policy options for increasing government spending. It should be pursuing those options and establishing a long-term growth strategy rather than blindly pursuing dubious attempts to stimulate untargeted, questionable lending by banks
For let us not forget, that this was how we got into this mess in the first place.