June 26, 2014

Horse 1703 - Europe's Mad Money - Minus Interest Rates and Money Which Is Cheaper Than Free

With effect from 11 Jun 2014: −0.10

The European Central Bank which is headquartered in Frankfurt, has decided to take the incredibly unusual step of reducing interest rates from 0 to -0.1%. Let me just re-phrase that - the ECB has decided that its lending rate to banks is less than zero, which means that they will not have to pay back as much as they have borrowed.
To be honest I was shocked when I heard this and my initial reaction was that the bankers had decided to take an extended holiday to Cloud-cuckoo-land; visiting Wicker Basket and Lower Bonkers.

One of the levers which the ECB and indeed any central banking system can pull if it wants to regulate the economy is that of Monetary Policy. By fiddling with interest rates it can either create a drive for people to borrow more or less money, depending on what their future expectations are. By lowering the official interest rate to less than zero, it sends a symbolic message across Europe.

Banks generally like to park their funds in at least some form of ultra secure deposit facility. Europe was hit by the Global Financial Crisis particularly hard and some countries like Portugal, Ireland, Greece and Spain have made some banks reticent about extending credit.

Lowering interest rates to less than zero should have the effect that banks pull their funds out from being parked at the ECB and make them want to lend them out; after all, it its now costing them less than zero to borrow money, they can lend it out, even interest free and still turn a profit.
This in turn should have the effect of increasing aggregate demand for investment funding which is a net injection into the economy and therefore lead to an increase in consumer spending, which in itself has various multiplier effects which are expansionary on aggregate incomes and GDP.

The two most obvious injections into economies are either Government Spending or Investment Spending; since some governments across Europe are already carrying debts of more than 100% of their respective GDPs, then they aren't going to be particularly likely to want to borrow even more money themselves; since those injections of funds have to come from somewhere, the ECB has decided that it should be from private enterprise.
The other major reason why Government Spending isn't particularly likely at the moment, is that European politics has for the moment shifted to the right. Whilst countries like France and the Low Countries aren't particularly likely to privatise more infrastructure, places like Britain has; Britain has even taken tougher steps by trying to cut back on education and welfare spending. Moreover, Europeans are generally distrustful of a very large central European governmental system, and this has been reflected by hard-right and anti-Europe parties being elected as MEPs across Europe.
When you eliminate the impossible, whatever remains however improbable, must be the answer here. Since expecting governments to spend money and create expansionary effects on the economy, then what else is the ECB supposed to do?

The other thing of note is that during periods of decreased consumer confidence, people tend to want to save more of their money to help them weather the storm. Savings by definition are not spent and are a leakage from the circular flow of money. Does increased saving lead to an increase in the available funds for investment and therefore the amount of investment spending? You'd think so but no; or at least not immediately.
To a great extent, economies are run by highly irrational people's brainwaves; the term "animal spirits" has been used from time to time to describe this. Investment spending isn't always driven by the cool drive to turn profits; some of it does require a turn of optimism. A downturn in confidence and optimism can have the effect of slowing economies and causing fiscal stagnation and constipation, and this is obviously what the ECB sees at the moment. It wants general inflation to run at about 2% to keep prices and demand ticking along.

Rather than force banks and governments through regulation which may or may not work, the ECB has basically decided that it is going to encourage the banks to lend money by discouraging them to park their money with them - your money doesn't have to go home but it can't stay here. Time will in fact tell if this mad theory even works at all because it may even have the bizarre effect of simply lining the pockets of Europe's banks. They may cynically take up the offer and not lend out anything but just borrow the funds and then pocket the 0.1% difference in bankers' bonuses.
But in these crazy times of starting sentences with conjunctions and ending them prepositions which is not something with which we shall not put. The European Central Bank must do something. This is something. Therefore it must do this.

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