Signup for our free newsletter:

Euro Zone In Crisis

Written By Brian Hicks

Posted March 11, 2015

Less Than Zero

Would you deposit money in a bank that pays negative interest? Neither would I. What would there be to gain?

Apparently something… potentially. As crazy as it sounds, several of Europe’s central banks have reduced interest rates to below zero.

Some see it as a last ditch effort to galvanize an economy while others see it as a sure way to lose all foreign investment.

No matter how you look at it, it’s unorthodox and could produce a sharp decline in deposit rates, which would leave Europe’s economy in more dire straits than before. Even low positive deposit rates could interrupt the money markets that help fund financial institutions.

Present Precedent

This isn’t the first time that the European Central Bank (ECB) has decided to experiment with negative rates before settling on a bond-buying program such as those currently being used in the United States and Japan.

It did so last September, resulting in a deposit rate of 0.2%. Rates venturing into negative territory was part of an attempt to punish banks that were hoarding cash at their central banks rather than giving out loans to businesses or weaker lenders.

This will prevent a slide into deflation or anything else that might undo Europe’s ongoing recovery.

Since central banks provide a standard by which all other financial bodies in the region determine their borrowing costs, yields on a range of fixed-income securities, including government bonds, also slipped below zero.

These changes are especially making themselves known in Sweden, Denmark, Switzerland, France, and Germany.

How Low Can You Go?

Negative interest rates have always been indicative of desperation. They reveal that traditional policy options haven’t worked and bolder avenues need to be explored. Negative rates have been induced before, but never in a region as large as the Euro area.

Most have accepted that it’s time for drastic action. The Euro zone is struggling with a shortage of credit and unemployment is near its highest level since 1999.

Rates should reduce lending costs for companies as well as households, increasing demand for loans. But if banks make their customers pay to keep their money in their accounts, funds could migrate to the bottom of people’s mattresses instead.

Banks are open to eating the costs of negative rates themselves to retain their customers, but that will cut their profits between their lending and deposit rates, which is a risk that could undo the progress made in making loans more available.

What’s Next?

So while the ECB’s plan to cause rates to drop below zero in order to save the Euro zone’s economy is well underway, they still haven’t worked out whose going to bear which parts of that load.

When Europe’s policy makers decided to purchase $60 billion worth of debts a month, they didn’t agree on how to share those losses, which threatens to limit the force of their plan.

The ECB is spending more money in the face of a lack of money, which is inflation. Not only could this be a bad plan, but it doesn’t look like they know what they’re going to do with it.