The Case for Keeping Europe’s Negative Rates Where They Are

The European Central Bank’s negative interest rates remain divisive. But there’s a stronger case to be made for allowing euro zone borrowing costs to fall lower, especially at this stage of the pandemic, than there is for backing away from them now.

Negative rates have long been seen as a tax on the aging savers and lenders of Europe’s creditor nations of Germany, Austria and the Netherlands. The main concern is reaching the so-called “lower effective bound” — the rate at which the transfer of negative rates onto bank clients triggers a depositors’ “run” on banks, erodes banks’ profitability and capacity to lend, and undermines the effectiveness of ECB stimulus.

Although these fears are legitimate, the experience of 2020 has defied the critics.

There’s little evidence that the ECB’s current overnight rate of -0.5% is anywhere near the euro zone’s lower effective bound rate. The European Systemic Risk Board’s credit risk data as of September shows that bank lending margins don’t present an existential threat. For German, Belgian and Dutch lenders to the corporate sector, margins have actually improved in the past year.

What’s more, the problems of low profitability in Europe’s banking sector and cash hoarding by aging populations predate the ECB’s negative rates, which arrived in 2014. Like much of the developed world, Europe has seen slower population and productivity growth — trends that were accelerated by the financial crisis, the euro sovereign debt crises and the pandemic. This “secular stagnation” has forced the ECB’s rate ever lower to stimulate demand. 

In a union of countries experiencing chronic demand shortages, excess savings and a pandemic, the policy remedy isn’t higher rates. This would drive recessionary government austerity and borrower defaults. What we need are measures to end cash hoarding, raise return on capital and support massive government stimulus.

The more pressing risk is that euro zone borrowing costs still aren’t low enough. Persistent expectations that inflation won’t meet the ECB’s target of below but close to 2% signal that growth has been below potential for too long, and that policy rates are too high.

Overcoming the bank’s legacy of “excessive hawkishness” will require more than getting the present rate-setting right; it will require a promise to overcompensate in the future — for example, by shifting to average inflation targeting, as the Fed did this year. In practice, this means lower rates, for longer.

The euro’s appreciation against faster-recovering regions this year also hints that domestic rates have been too high. As the ECB’s chief economist Philip Lane recently explained, a stronger euro negates almost all of the reflationary benefits from the fiscal response to the pandemic. This is a problem for the bloc’s most vulnerable government borrowers. The European Commission estimates that emergency government transfers have lifted Italy’s public debt to GDP by a whopping 25 percentage points to 160% this year, while Greece’s public debt has broken above 200% of GDP.

After this year’s record fall in nominal GDP, it will likely take at least a couple of years for economies to return to 2019 levels of activity. That means this debt hangover will remain with us for the foreseeable future and ECB rates will have to stay at current or lower levels long enough to stimulate growth and bring government debt back to sustainable levels. 

In light of this, the ECB has taken important steps to make negative rates effective. Perhaps the biggest innovation has been delineating its negative rates system into a two-tier lending rate and deposit rate. The deposit rate on reserves at the central bank has served as a floor for money-market interest rates, providing an anchor for government yield curves. This, together with the effects of the bank’s loans and asset purchases on closing credit spreads, has allowed euro zone governments, including Italy and Greece, to fund their Covid programs at a record-low cost of debt.

Perhaps even more important, the bank introduced a more negative lending rate on its long-term bank loan facilities at the onset of the pandemic in March. Banks are being paid between a half and a full percentage point to borrow 3-year funds from the ECB. This dual deposit-and-loan negative rates system affords the ECB policy space to lower rates deeper into negative territory.

It also alleviates a political constraint on monetary policy. The negative ECB bank deposit rate is seen as a deeply unpopular tax on the excess savings of the union’s wealthy but frugal creditor nations of the North. But a second negative rate on ECB bank loans this year — which directly benefits lenders and incentivizes them to pass on stimulus — gives the central bank the political freedom to stimulate demand. The ECB’s Bank Lending Survey shows that European lenders see negative rates as having led to cheaper borrowing costs for customers and higher loan volumes, in effect driving monetary expansion in Europe.

Of course, negative rates are no panacea for the euro zone’s inflation and debt-productivity gaps. But combined with the ECB’s asset purchases and long-term bank loans, they’ve kept markets functioning and borrowing costs low, enabling governments to use record amounts of stimulus. Europe’s weakest borrowers have benefited most.

In a union of different macroeconomic structures, finance systems and fiscal capacities, the ECB’s negative rates have been the great equalizer, acting faster than political consensus to address an economic crisis. With the recovery faltering amid the pandemic’s second wave, the risk now isn’t doing too much, it’s not doing enough.

This column does not necessarily reflect the opinion of the editorial board or Bloomberg LP and its owners.

Lena Komileva is managing partner and chief economist at G+ Economics, an international market research and economic intelligence consultancy based in London.

©2020 Bloomberg L.P.

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