Europe wakes up and smells the depression

The ECB’s discussion of negative interest rates, intended to stimulate bank lending, is a long overdue acknowledgement of the depths of Europe’s pain.

The European Central Bank did it. It cut interest rates from 0.75 per cent to 0.5 per cent in a move that was generally anticipated by the market, even though the run of economic news for the past year made such action long overdue.

What was not anticipated were comments from ECB President Mario Draghi that, if circumstances presented themselves, he had an “open mind” to the idea of negative interest rates for bank deposits held at the central bank. In reference to negative interest rates, Draghi said quite simply that the ECB was “ready to act if needed” and that “all the options are still very open here, our thinking is very much in the preliminary stage given the complexity of the issue”.

While the market reaction to the prospect of negative interest rates was concentrated in a sharp 1 per cent fall in the euro, the rate cut and talk of negative interest rates are another step along the way of the ECB slowly coming to terms with the worst economic conditions since the 1930s Great Depression. Indeed, in some countries in the eurozone such as Greece and Spain, conditions are probably worse now than in the 1930s.

The ECB appears to be extending its ‘whatever it takes’ approach to maintain financial stability and restore economic growth, even if it is a little slow in delivering on that message.

Negative interest rates would impose a financial penalty on the banks when they deposited their funds with the ECB. By way of illustration, a deposit of €100 with a yield of minus 0.5 per cent would mean that the depositing bank would only get back €99.5 when the deposit matured. In other words, the incentive of the banks to hold large and ever increasing deposits with the ECB would be constrained. The alternative is that the banks lend their reserves to the private sector and get a positive return.

Draghi said that he was frustrated that the banks were not lending more to businesses and households and thereby providing much needed liquidity that is required to see a pick up in investment and spending. This is where the notion of negative interest rates entered the discussion. The theory, at least, is that negative interest rates would go some way to reversing the caution in lending from the banks. Many economists and those in financial markets who have watched the run of dismal news flowing from the eurozone are hoping that the ECB acts sooner rather than later.

Draghi also noted that GDP in the eurozone has declined for five consecutive quarters, and he painted a gloomy outlook suggesting that “weak economic sentiment has extended into the [Northern] spring this year”. This is perhaps an understatement given the fragile economic news in recent months, including the record high 12.1 per cent unemployment rate.

The interest rate cut also followed news earlier this week of a sharp and potentially worrisome fall in the annual inflation rate, to just 1.2 per cent in March. It is just a few tenths of a per cent from reaching a record low.

It was only sensible that Draghi said that “our monetary policy stance will remain accommodative for as long as needed”.

It was a belated acknowledgment from what remains one of the most unrealistic and hawkish central banks globally that economic conditions were dire and have been for some time.

The ECB’s counterparts in the US, Japan, and the UK, for instance, long ago cut interest rates to near zero and in addition have embarked on mass quantitative easing. Yet the ECB remains lethargic and this is showing up in the fact that the unemployment rates in the US and the UK are below 8 per cent compared with the horrendous level in the eurozone.

This just goes to show that monetary policy can and does work in meeting objectives for the real economy. Easy policy can and does underpin economic activity.

It is a pity that is has taken over 25 million unemployed people in the euro area as a whole for the ECB to realise it.

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