How Europe's deficit obsession turned bankers into stimulus fans
Generally speaking, bankers are not fans of government deficit spending.
Mainstream economic thinking worries that deficit spending will create inflation, and inflation eats away at bank profits. Increased deficit spending also often means the government is directing more of the economy's overall resources, leaving less activity for the private banks to direct.
But flatly refusing to deficit spend leaves limited options for responding to a sluggish economy — options that carry their own significant drawbacks. After a point, even private bankers will start begging governments to cut taxes and up spending. The Eurozone seems to have pushed its bankers past that limit.
At issue is the easy monetary policy of the European Central Bank (ECB), particularly its ongoing experiment with negative interest rates — a wild and unprecedented gambit that nevertheless has some basis in economic theory. And it's necessary because the EU member states have basically abandoned deficit spending for purposes of stimulus — partially because Eurozone rules officially limit deficits, but mainly because the ECB won't allow them.
The purpose of the negative interest rates is to revive the Eurozone's perpetually moribund economy, but they're also terrible for banks' business models, where profits are made by charging higher interest rates. So Europe's bankers took the World Economic Forum at Davos last week as an opportunity to press ECB officials for a different strategy. "They pointed to data showing the impact of ultra-loose monetary policy is petering out and urged politicians to cut taxes and increase spending to boost economic growth," the Financial Times reported late last week.
"Bank executives have also been lobbying politicians in countries with budget surpluses — most notably Germany — to loosen fiscal policy in the hope that more public spending and tax cuts will boost growth and inflation, paving the way for the ECB to start raising rates. One chief executive involved in the effort said it was a 'long game' designed to push policymakers to 'reflate' the eurozone economy, noting that the ECB had 'stopped listening' to complaints about bank profitability." [Financial Times]
Adjusting interest rates up is how a central bank tries to cool off the economy, by making credit more expensive. Adjusting interest rates down attempts to boost growth, by making credit cheaper. But what happens if you push interest rates all the way down to zero and your economy remains sluggish? That's the challenge the Eurozone has faced for a while now. And the ECB eventually responded by just punching through zero and taking its interest rate target into negative territory.
If interest rates are negative, then lenders are literally paying people to borrow from them, and savers are being charged money to park their deposits at banks. This upside-down state of affairs is supposed to drive more spending (more lending, less saving) to drive economic recovery. At the same time, as mentioned, negative interest rates also wreak havoc on banks' profits. Europe's bankers have made all manner of complaints, but Eurozone monetary officials aren't having it: "One of Mario Draghi's parting acts before standing down as ECB president last autumn was to tell banks to stop 'being angry' about negative rates and instead focus on fixing their flawed business models," the Financial Times wryly noted.
A lot of the complaints against negative interest rates are questionable. High interest rates are an incredibly blunt and destructive instrument for preventing bubbles and risky investment, for instance — that job is much better left to regulation. It's also not clear why savers' passive incomes should be a higher moral concern than jobs and wages for workers. I myself wrote a while ago that negative interest rates are something the U.S. Federal Reserve should've considered in the aftermath of the 2008 collapse. But there's also the issue of whether negative interest rates work in practice as well as in theory as a way to stimulate the economy. That Europe's experiment in negative interest rates is now several years old, and with little to show for it, suggests this is a real problem.
For instance, negative interest rates could spook people into saving even more and spending less, which would defeat the whole purpose. People might also just liquefy their assets in exchange for cold hard cash, which interest rates don't apply to. How effective negative interest rates can be largely boils down to how easily different assets can be liquefied into cash, which in turn involves a lot of guesswork about the extent of things like the shadow banking system.
Lastly, the way we talk about central banks' interest rates targets often treats them as a god-like dial for cranking economic growth up or down. But it's not like that at all: Negative interest rates do not transfer in a straight line from banks' reserves to the loans they create and the deposits they hold. The specific way the ECB imposes a negative interest rate target is by charging the private banks for holding their excess reserves at the ECB. But private banks don't actually "lend out" their reserves — they create the money for loans out of thin air. Charging banks a penalty for holding excess reserves doesn't force those reserves "out into the economy" in any mechanical sense; it simply encourages private banks to charge each other lower interest rates to borrow reserves, which in turn encourages them to charge lower interest rates for the loans they create for consumers and businesses.
This gets us back to deficit spending — on welfare programs, on public investment, and so forth — and why it's a much more dependable way to stimulate economies back to health. Government deficits add spending to the economy, the additional spending revitalizes business opportunities, and that increases both businesses' desire for credit and the incentive for banks to provide that credit.
A lot of the time, it's safe to assume that policymakers' devotion to austerity and tight money is just craven deference to financial elites: the latter group demands them, and the former provides. But Eurozone officials really have taken "fiscal discipline" to heart as a first-order principle — one they've adhered to even as it's driven Europe's economy into the ditch. Private bankers may not want the government competing with them over who gets to direct economic activity, but if government backs off too much, there won't be any economic activity to direct. Be careful what you wish for and all that.
Of course, that sort of economic immiseration eventually becomes politically intolerable. Something had to give. Which is why Europe's horrified bankers are suddenly changing their tune, and begging European governments to throw off the shackles of "fiscal responsibility."
Whether the European Central Bank will care is another matter entirely.
Want more essential commentary and analysis like this delivered straight to your inbox? Sign up for The Week's "Today's best articles" newsletter here.