Why Draghi’s negative interest rates will not reverse Europe’s economic torpor

A rather glum looking “Super” Mario Draghi

The latest inflation reading in the Eurozone last week revealed a rise of 0.5% on the HICP (Harmonised Index of Consumer Prices) year-on-year in May, marking a fall from April’s 0.7% reading and raising concerns about deflation once more. Whilst it is difficult to understand exactly why a trip to the supermarket should not cost you the same (or, heaven forbid, less) than it did a year earlier, monetary authorities invariably urge action at the first sniff of falling prices.

In fact, the deflation problem is deemed so dangerous that it recently gave rise to one of the boldest monetary expansions ever conducted, and which has come to be known as “Abenomics”. But it is not only in Japan that the problem is felt with alarming concern. Last week the ECB decided to take action to stave off deflation, by cutting its refinancing rate from 0.25% to 0.15% while also turning its deposit rate negative (-0.10%). At the same time, ECB President Mario Draghi restated his will to push for quantitative easing, if deemed necessary, in the near future. 

These historic decisions taken by the ECB are intended to boost prices and avoid deflation, as alluded to in Draghi’s most recent comments. But, given that the principle contributing factor to low inflation in Europe is low energy prices (due to the strong Euro), one has to question Draghi’s motives. After all, low energy prices are good for the economy!

The problem here of course is that the exchange rate is what really interests the ECB. The Bank wants to devalue the currency and enter the global currency war against the US, China, Japan, and the UK. But in spite of all the tough rhetoric, the Draghi “Bazooka” is still nowhere to be seen. In fact, last week’s announcements actually contributed to a rise in the value of the Euro – exactly the opposite to what was intended. The ECB is caught in the middle of a conflict of interests with many pushing it to act with bold measures while Germany, with one eye on the hyperinflation generated during the Weimar Republic in the early part of the twentieth century, still keen to avoid any measures that may create inflationary pressures. Because of this, Draghi does not have much scope to act, hence the focus on making verbal threats. Of course, words may suffice, but only for a limited time frame. Last week it wasn’t enough to entertain investors who were waiting for the big party, only to hear that the punch bowl was yet to arrive.

When assessing the actions of the ECB, in particular the introduction of the negative facility, we can take a look at what happened in Denmark when they undertook similar measures. The main intuition behind a negative deposit rate is to bolster investment. With institutions being charged to park money at the central bank, they should look for better alternative uses for it, in particular lending to clients. But judging by the economic conditions currently prevailing in Europe, such a scenario seems unlikely.

The massive deleveraging imposed by the crisis and subsequent austerity measures taken by national governments have hit the European consumer hard. With an unhealthy consumer, businesses are unlikely to invest to create additional capacity, as it would surely be a waste of money. To some extent this is a global problem. In the US for example, companies have been using cheap money to repurchase their own shares instead of investing in production. Therefore, setting negative deposit rates will most likely have a negligible impact on the economy and possibly even contribute to a deterioration of the banking system if institutions cannot pass the higher costs on to their customers through higher lending rates.

The Danish experience shows that negative rates alone are a poor means of boosting bank lending, as Denmark continued to face a decline in lending even after setting negative rates. However, the Danish experience does support the efficacy of negative rates as a currency devaluation tool. Prior to the introduction of negative rates, Denmark was experiencing an appreciation of the Krone, which put its peg to the Euro at stake. But after setting a negative rate, the central bank was able to put an end to the hot money flows and achieve a devaluation of the Krone. With this in mind, it seems that the ECB is attempting to make its move into the global currency wars. But, this is a game that usually ends badly, particularly for the late entrants.

Europe needs to rethink its current fiscal policy and create conditions for investment to grow. With interest rates near zero, it is obvious that it wouldn’t make much difference whether the base rate were set at either 0.15% or 0.25%. But it would make a lot of sense to reduce taxes for the consumer. Just to put this into perspective, last Friday Portugal “celebrated” its Tax Freedom Day – it in effect being the day until which an average worker needs to work just to pay his annual taxes. On average, the real tax rate for a worker in the EU is currently 45.27%, which is simply too high. Perhaps this is the point that policymakers should address if they want growth and prosperity, instead of tinkering with monetary policy.

Failing that, it is time for central banks to cut the rhetoric. To maximise the potential benefits of monetary policy, “shock and awe” is necessary.