The European Central Bank (ECB) will be meeting on June 5 and is widely expected to take action in the form of cutting interest rates or starting a bond-buying program.
In other words, the ECB is going to follow in the footsteps of the Federal Reserve and start its own version of quantitative easing — or, in simpler terms, create money out of thin air.
Mario Draghi, President of the ECB, has continued to add confirmation that some kind of move is coming. He is preaching the need to keep price inflation from running too low.
In classic Keynesian fashion, Draghi and the ECB members want to make sure inflation stays in an acceptable range. They believe there must be some price inflation, despite the fact that workers’ incomes are not keeping pace with inflation.
One of the more interesting speculations to come out of the buildup to the ECB meeting is that they may somehow impose negative interest rates. Only in a world of massive government intervention would we be discussing the possibility of something so peculiar as a negative interest rate.
In the real world of economics, the borrower pays an interest rate to a lender, who makes money (interest) by taking on the risk of lending and deferring gratification. The lender is willing to not spend his money now.
In a free market economy, interest rates are essentially a price put on money, and they reflect the time preference of people. Higher interest rates reflect a high demand for borrowing and lower savings.
But the higher rates automatically correct this situation by encouraging savings and discouraging borrowing. Lower interest rates will work the opposite way.
When the government/central bank tampers with interest rates, savings and lending are distorted, and resources are misallocated.
This is evident in looking back on the housing bubble. The artificially low interest rates signaled that there was a high amount of savings. But it was a false signal.
There was also a signal for people to borrow more. Again, it was a false signal.
As these false signals were revealed, the housing boom turned into a bust.
Bank Lending
When we hear of the possibility of the ECB imposing a negative interest rate, we can assume this would apply to the banks.
Taking inflation out of the equation, a negative interest rate would not occur in a free market. Why would anyone lend money only to be paid back less? The person or entity would simply just hold on to the currency. At most, they would pay someone a fee to store the money.
In the case of the ECB, there would likely be rules placed against banks that are under its jurisdiction. Banks would be charged a fee to hold excess reserves, which would compel them to make more loans.
This would likely do the trick in increasing inflation. As banks lend out money through the fractional reserve process, this is essentially creating money out of thin air.
If someone deposits money in a bank and the bank loans that out, then it becomes “available” to more than one person. Of course, if everyone showed up for their money all at once, the banks would not be able to make everyone happy and make good on its promises. There wouldn’t be enough money there.
Today’s world of deposit insurance keeps bank runs from occurring often. It also encourages reckless lending. But given the system we have today, forcing banks to lend will increase inflation as more money flows through the system.
Would the Fed Follow?
With all of this talk about the ECB imposing negative rates, there is a question of whether the Fed would bring a similar policy to the U.S.
Since the fall of 2008, the Fed has approximately quintupled its monetary base, but we have not seen massive price inflation.
One of the reasons for this is because much of the new money that was created out of thin air went into banks as excess reserves. Banks have not been lending out most of this new money as the law allows. They are content in keeping it on reserve at the Fed and “earning” a small interest rate of 0.25%
The lack of fractional reserve lending has kept most of this new money from multiplying through the system, and it has kept prices from being bid up.
The Fed will say it wants banks to lend. We heard this from Bernanke when he was head of the Fed. It will also say it wants moderate price inflation, which to the Fed is slightly higher than it is now.
Yet the Fed is paying banks one-quarter of a percent on excess reserves. If it really wanted banks to lend, it would stop paying them not to.
If the Fed really wanted to get banks to lend, it could charge them a fee to hold excess reserves. This would essentially be a negative interest rate. If the rate were high enough, it would certainly induce most banks to lend out all of their reserves.
But at this point, I see no motivation for the Fed to change its policies. It has been able to buy government debt, bail out banks by buying mortgage-backed securities, and still keep a relatively low price inflation indicator.
Sometimes I question the intelligence of the people at the Fed. But really, they are political; they are probably not completely stupid. I don’t see why they would compel banks to lend at the risk of triggering massive price inflation.
For this reason, I don’t think it is likely that the Fed will impose a negative interest rate on banks anytime in the near future. The Fed is under more scrutiny now than it has ever been before. Imagine the comments and stories all over the internet if the Fed were to enact a negative interest rate.
If anything, the Fed would first just stop paying the 0.25% on reserves. On the margin, this might make a difference. But at this point, I see little motivation for Fed officials to encourage more bank lending.
What If?
If for some reason I am overestimating the intelligence of central bankers and the Fed does decide to try the idea of a negative interest rate, you should quickly prepare for drastic changes in the economy.
If banks start lending out massive amounts of U.S. dollars, I believe it would quickly lead to high price inflation. Depending on how things played out, we could see price inflation rates go higher than they were in the 1970s.
If you ever hear serious talk about the Fed using negative interest rates, then it is time to quickly get out of anything denominated in U.S. dollars. You will want to move into hard assets. This might be one of the few times I would actually encourage people to take on debt, particularly if it is used to buy hard assets.
The adjusted monetary base went from around $800 billion in 2008 to about $4 trillion today. If this new money is multiplied through bank lending, it will make for interesting and chaotic times.
Let’s hope that doesn’t happen. If the ECB decides to experiment with negative rates, hopefully Americans can learn from the disaster that would occur there.
Such a move by the ECB would be a signal to exit the euro for anyone who owns any. It may also signal the beginning of the end of the European Union.
Until next time,
Geoffrey Pike for Wealth Daily
