Why negative interest rates won't jumpstart Europe's economy

What would you do if your bank announced that instead of paying you interest on your savings, you were going to start paying the bank for the pleasure of holding your money?

There is a good chance you'd look for somewhere else to put your money. Perhaps you'd withdraw your money and stuff it inside your mattress, although that would earn zero interest and leave your money uninsured against theft. Perhaps you'd invest it in bonds and stocks, or in your own or a friend's company. Perhaps you'd just spend it. Or perhaps a mixture of the above.

This is what the European Central Bank wants banks to achieve: more investing, less parking their cash at the ECB. The ECB has slashed its deposit rate to -0.1 percent, and reduced the interbank interest rate to a record low of just 0.15 percent. The goal is to encourage banks to lend — to each other, and, hopefully, to consumers and businesses. The hope is that this will boost the broader European economy, which at present looks rather bleak.

Subscribe to The Week

Escape your echo chamber. Get the facts behind the news, plus analysis from multiple perspectives.

SUBSCRIBE & SAVE

Sign up for The Week's Free Newsletters

From our morning news briefing to a weekly Good News Newsletter, get the best of The Week delivered directly to your inbox.

From our morning news briefing to a weekly Good News Newsletter, get the best of The Week delivered directly to your inbox.

Sign up

There's only one problem: it's not going to work.

Europe's big problem is its falling inflation rate, which has now been below the ECB's 2 percent target for the last eight months. A low but moderate rate of inflation is important for a modern debt-driven economy, because of the nature of debt.

Inflation raises the nominal price of goods and services throughout the economy. This devalues the nominal worth of past debts, which helps debtors. For example, if you took a $10 loan in 2010, and $10 is worth much less in 2014, then a portion of that debt has been wiped out.

This in turn often helps creditors, since a debt repaid, even if it is partially devalued by inflation, is a much better return than a debt default.

Indeed, if inflation falls to zero or below into deflation, the default rate tends to soar, as debtors struggle to service their debts. Yes, individuals and businesses sitting on cash will see their purchasing power rise — but creditors looking forward to future streams of income may see their purchasing power fall as debtors' defaults mount. These defaults may cause yet more defaults, as businesses who are owed money by failed businesses and bankrupt individuals end up unable to pay their own debts.

This spiraling phenomenon was called debt deflation by early 20th-century economist Irving Fisher. The Federal Reserve has fought against deflation since the 2008 bust with both ultra-low interest rates and quantitative easing — in effect, buying assets with newly printed money. And with unemployment falling steadily, stock markets hitting all-time highs, and real GDP far above its pre-recession peak, it appears that the Fed's policies are working.

Yet quantitative easing has remained off the table in Europe, with many European policymakers expressing concerns that such money-printing would be excessively inflationary. And the ECB has thus far managed to keep inflation positive without any quantitative easing. However, inflation is now falling closer to zero. Indeed, in some countries, such as Greece, it is already deeply negative.

Today's move represents a last throw of the dice to avoid quantitative easing. But I doubt this will have much economic benefit. There are serious impediments to European lending, including anxiety about the wider economic malaise, fear of deflation, a lack of economic growth, and massive unemployment caused by the enforcement of vicious fiscal austerity in the peripheral euro zone nations of Greece, Spain, Portugal, Italy, and Ireland.

(Another factor may be concerns about the ability of the euro zone to manage crises, although some of these fears have been allayed since ECB chief Mario Draghi announced the OMT program, which aims to keep interest rates in the periphery low.)

If banks don't want to lend because of real fears over the European economic situation, discouraging them from parking their cash at the ECB with negative interest rates will hardly prevent them putting it away in a vault.

But there are two policy changes that could get credit flowing. First, quantitative easing, which has succeeded at reversing deflationary trends in the U.S., the U.K., and Japan. And second, reversing fiscal austerity measures in the periphery. The latter is not within the ECB's power, so sooner or later the first will have to be tried if the euro zone is to avoid a full-blown deflationary spiral.