Economy
1:34 pm
Thu June 5, 2014

Is Pushing Interest Rates To Less Than Zero A Crazy Idea?

Originally published on Thu June 5, 2014 2:17 pm

By now, you may have heard that on Thursday, the European Central Bank shifted to a negative interest-rate policy for deposits.

That news may have prompted two thoughts: 1) Isn't that crazy? 2) Who cares what happens in Europe?

These questions have answers. But first, some background:

The European Central Bank's mission is to promote price stability and steady growth. So the ECB policymakers adjust interest rates in ways that can help keep wages and prices moving along on a very gentle upward slope.

Since the Great Recession slammed into Europe more than five years ago, that goal has been hard to achieve. With unemployment still so high in so many countries, European employers have not seen any need to raise wages to keep or attract workers.

And at the same time, consumers haven't had much money to spend, so prices have been depressed. When prices start falling, consumers hold back even more on their spending, waiting for goods to keep getting cheaper. This deflationary pattern can create a downward spiral for the whole economy.

Right now, inflation is running at around 0.5 percent in the euro area, approaching stall speed. So the ECB is determined to get the economy moving fast enough to get wages and prices to perk up too.

That brings us to Thursday's announcement. The ECB said that from now on, if a bank wants to deposit surplus cash with the central bank, it won't earn any interest. In fact, the bank will actually have to pay the ECB for the privilege of parking its cash.

That seems to turn the whole lending process on its head. Traditionally, when you deposit money, you earn interest, which seems to rank up there with the sun-rises-in-the-East rule.

By moving to negative interest rates on deposits, the ECB is pushing banks to stop hoarding surplus cash. It wants banks to lend that money to businesses to fund plant expansions, or to consumers for a new cars or homes.

In other words, the ECB is insisting that banks get money circulating in the real economy, not piling up in vaults.

But there's another reason for this negative-rate strategy. The ECB wants to push down eurozone interest rates in general to make it a less attractive place for global investors to put their cash.

As those investors move their money over to the United States in search of higher interest rate returns, the euro will get weaker and the dollar stronger. In fact, that's exactly what happened after the ECB announcement: The value of the euro slid against the dollar, down to a four-month low of about $1.35. That is well below the 2 1/2-year high of about $1.40.

A weaker euro would help European manufacturers sell their goods for less in the global marketplace.

And that was exactly the point. The ECB's action was intended "to be a signal that the euro's value has been way too high," said Alexander Privitera, director of the economics program at the American Institute for Contemporary German Studies.

While a weaker euro could make life a bit tougher for U.S. exporters in the short term, it could help revive the European economy — and that ultimately would create a healthier European market for U.S. goods and services.

"On balance, it would be good for the United States if Europe's economy strengthens," Privitera said.

Robert Kahn, a fellow at the Council on Foreign Relations, was more skeptical about the likelihood of reviving the European economy. "These moves will be largely ineffective," he said.

Kahn says the ECB needs to take much more aggressive actions, similar to those taken by the U.S. Federal Reserve. That would involve massive asset purchases to create more liquidity in financial markets, he said.

But most economists cheered the ECB action.

"This is a long overdue step and signals that the ECB may finally be taking seriously the dangerous consequences of deflation," Cornell University economics professor Steven Kyle said in a statement. "It certainly shows a clear break with past attitudes and should be applauded."

So, to answer those two questions originally posed:

1) Pushing interest rates to less than zero is a little crazy, but for Europe, it just might work.

2) A lot of U.S. businesses care about what happens in Europe because it is a huge market for U.S. exports. And in a world where financial markets are closely linked, Americans don't want to see a deflationary cycle take hold in Europe and start pulling down financial markets again.

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