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Explainer: why does the eurozone need a negative interest rate?

It’s not unusual for central banks with economies to revive to let their interest rates go negative in “real” terms by keeping them below the rate of inflation. The eurozone, the US and the UK have done…

Positive interest rates meant Euros were stuck in the bank. Mario's Planet, CC BY-NC-SA

It’s not unusual for central banks with economies to revive to let their interest rates go negative in “real” terms by keeping them below the rate of inflation. The eurozone, the US and the UK have done so for long periods since 2008 to combat financial crisis and recession.

However the European Central Bank (ECB) has become the first in a major currency zone to set a negative “nominal” interest rate. It is charging commercial banks for the funds they deposit overnight instead of paying them. This move shows the seriousness of the risk that the eurozone will fall back into recession and the limited options it allows (by design) for any other means of promoting recovery.

The negative borrowing rate (now a 0.1% charge) on money deposited by banks is designed to make them lend the money instead of keeping it in reserve. This is intended to restore eurozone economic growth by encouraging more lending for “real” investment.

More growth certainly is needed. Germany and Spain are now the only big Euro countries sustaining an upturn. GDP growth for the zone as a whole was a fragile 0.9% year-on-year in the first quarter of 2014 and the IMF forecasts the eurozone’s full-year growth at 1.2%, compared with 2.8% for the US and 2.9% for the UK.

If charging banks for not lending can’t revive the eurozone’s “real” investment and credit growth, the ECB’s new 0.15% benchmark rate (below the 0.25% of the US Federal Reserve and the Bank of England) may at least weaken the Euro against other currencies, as funds flow out to find higher returns elsewhere. The demand boost from a lower exchange rate, promoting Eurozone exports and import-substitution, might give businesses the necessary kick-start.

Deflation danger

The ECB has been prompted to take this action by the danger of deflation – falling prices – and its negative implications for the already faltering recovery. Four of eighteen member states saw consumer prices fall in April, dropping the eurozone’s average price rise for the past 12 months to just 1%.

Prolonged price falls can undermine firms' capital investment by raising the real interest rate – the gap between nominal interest and inflation. If capital can earn more while sat in a bank than invested in machines or fields, why invest? If prices are going to fall, why buy now? Because employees don’t rush to accept wage cuts when the cost of living falls, deflation can also hit businesses by raising their labour costs in real terms.

Impending deflation is a symptom of the eurozone’s intractable malaise. Firms are cutting prices in a desperate attempt to generate more sales when investment is low, household spending squeezed by ongoing austerity measures, and major trade partners still slow-growing. But the symptom will become an additional cause of “Eurosclerosis” unless mild inflation can be rekindled. That’s not an easy task for central banks whose usual struggle is to bring inflation down.

Reductions of last resort

While the UK and US can keep interest rates just above zero, the ECB has resorted to negative rates because of its unusually severe recession risk. That risk reflects the eurozone’s dangerous lack of other options for stimulus, compared to other large single-market, single-currency areas.

All high income economies encountered crisis in 2008, but the US and UK were able to attack their recessions with major fiscal stimulus packages, deliberately raising public spending while holding down tax rates and letting revenues fall with national income. On some measures, the US stimulus plan was far bigger than Roosevelt’s first New Deal during the 1930s Great Depression. And while George Osborne claims to have restored UK growth through fiscal austerity, he’s actually done so by running bigger and longer deficits than any of his predecessors.

In contrast, the eurozone has no big central budget. The only member big enough and solvent enough to run an effective fiscal stimulus is Germany, which has instead moved its budget into surplus. Other members, whose budgets were pushed into deficit by the downturn, have undergone “excessive deficit procedures” which force them back to balance with painful spending cuts and tax increases. So while others fought recession with expansionary fiscal policy, the eurozone has risked a relapse, further subduing households’ ability to spend and businesses’ incentives to invest.

Fiscal stimulus was made possible in the US and UK by central banks adopting quantitative easing (QE) – buying previous and new bond issues so that their yields stayed down (enabling those near-zero interest rates), and so that productive investments gave a better relative return. At the ECB, governor Mario Draghi pledged similar QE when he announced a commitment to “outright monetary transactions” (OMT) in September 2012.

That “whatever it takes” announcement ended the perilous rise in peripheral member states’ borrowing costs that was then threatening to plunge them back into recession. But the ECB’s scope for QE is limited because it can only buy the bonds of individual member governments. There are still no “Euro eurobonds”, issued and backed by the whole zone. Germany’s reluctance to underwrite other countries’ debt means such bonds are unlikely ever to materialise; indeed, OMT could still unravel when a German challenge to its legality reaches Europe’s highest court.

More Dunkirk than Normandy

One of the earliest advocates of collective eurozone debt issues, former Luxembourg premier Jean-Claude Juncker, is poised to be the EU Commission’s next president. But even with those powers, he’s very unlikely to be able to bolster Draghi’s monetary arsenal to match that of other central banks.

There is no guarantee that the ECB’s negative interest rates will deliver the boost needed to avoid renewed depression and deflation. Monetary policy is still appropriately likened to a string, which can pull an overheated economy down to earth but cannot push a depressed one back into motion. Even if the latest initiative weakens the Euro, the zone’s story so far is that a weaker currency further widens Germany’s export surplus, while doing little to help other members sell more abroad.

With fiscal policy still neutral or contractionary across much of the zone, penalising savers and subsidising borrowers is unlikely to spark recovery on its own. It could even worsen the situation, by setting back the banks’ return to financial health and giving investors the impression of panic in Frankfurt.

With the US and UK now debating when to raise their benchmark rates, as final confirmation of their escape from financial crisis, the eurozone’s bold move is more likely to be viewed as a Dunkirk-like distress flare than a “big bazooka” deployment worthy of the D-Day anniversary.

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7 Comments sorted by

  1. John Kampert

    aged pensioner

    As the article says:
    "Firms are cutting prices in a desperate attempt to generate more sales when investment is low, household spending squeezed by ongoing austerity measures"

    If I get it right that the economic profession's view is that negative interest rates should be seen as a proper approach to the western world's depression problem, then how could that improve household spending? Once the banks have collected all household savings by means of real or nominal negative interest then the game will be over!

    Does not this whole ridiculous economic theory-game with interest rates just throw a stark light on the fact that money in the twenty first century is just a government created fiction? And the government tool for goods and services' exchange is used by those manipulating the political controllers to transfer more end more real assets into fewer and fewer pockets?

  2. R. Ambrose Raven


    Observe how what passes for the politico-economic debate on Europe totally avoids any discussion of 21st Century issues that might actually draw Europe out of its mess by the unusual expedient of actually designing a socio-economic system that is intended to serve ordinary people – or even in providing a good range of social services of acceptable quality for Europe’s ordinary people.

    Europe’s ruling class – through governments and the media - serve the filthy rich. They are fixated far more with…

    Read more
    1. James Hill

      Industrial Designer

      In reply to R. Ambrose Raven

      Adam Smith indicated the present problem of the Idle Rich and their not being personally employed to keep themselves alive, when he described the Dutch of his time, the wealthiest people in Europe.
      Paradoxically, within their own community, everyone being a "moneybags" meant that no-one could feed themselves by lending money to anyone else. Their solution was to turn their homes into factories and "value add" to raw materials and increase their wealth accordingly by their own efforts.
      Rich but not Idle.
      This fate could befall the present Rich of Europe, whereby they actually earn their wealth, as the former Dutch did, by being self employed.
      And this would be instead of being parasites upon the poor, by depriving them of finance and forcing them to pay higher interest than they can afford, in order that the these same rich be "Idle".
      Put them to honest work, surviving by the sweat of their brows!

  3. paul canosa

    husband, businessman, human

    A friend pointed me to this conversation from a discussion we are having about interest rates. Thanks for writing and posting it.

    The article concludes with the position that the US is considering a raise in their benchmarks. I find this to be a dubious statement as Fed forward guidance has already locked in rates going forward and is now talking about moving it out to mid 2015. (Link to FT article hopefully works)

    Further from the working man's perspective I can see the logic of wanting to have deflation as it simultaneously lowers prices, consumption tax and thus keeps more cash in their pocket at the end of the week. Yet it is admonished by those who make policy.

    Finally I believe the Japanese will be closely watching the EU petri dish for signs of economic "stimulus" as they have been mired in a multi decade long battle themselves.

    Once again thanks Alan for posting your article

  4. Matthew Smith

    logged in via Facebook

    All our western economies have one simple problem in common, we try to keep them going with a tiny fraction of the available cash. To boost the economy we need more money flowing through the system, but most of the money is with the gilded bankers who just try to lock it away from any risk.
    Negative interest rates are certainly not in the textbook of the conservatives - it just proves how desperate things have gotten. Matthew from