June 14th, 2014
in Op Ed
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.
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.
Alan Shipman does not work for, consult to, own shares in or receive funding from any company or organisation that would benefit from this article, and has no relevant affiliations.