ECB Goes Negative

Spontaneous Finance has a good post on why negative interest rates on bank deposits at the European Central bank will not encourage bank lending to businesses, especially lending to small businesses that represent greater risks. As Julien shows, the move by the ECB does little more than squeeze bank profits at a time when low interest rates have already reduced profits. The analysis covers Europe, but the same principles apply to the US because the European Basel accords regulate banking on both banks of the pond.

At the same time, regulators are still stinging from media a political criticism that they were AWOL before the 2008 crisis and therefore caused it through negligence.  So regulators are cracking down on what they perceive as risky loans, which means any loan to any business other than a government protected large corporation. Central banks are pyromaniacs while regulators are fire fighters who put out the fires the banks try to ignite faster than the banks can start them.

Also, keep in mind that most large corporation in the US are sitting on mountains of cash which they could invest without taking out loans. The Fed and ECB should ask why corporations aren’t investing their cash instead of trying to get banks to lend by reducing their profit margins. The obvious reason that corporations won’t invest their own money is that high taxes and the costs of regulation (about $10,000 per employee in the US) make investment prospects in the West ugly as a fence post.

The ECB and Fed need to revisit the US recovery after 1982 and ask themselves how was it possible for the US to recover so rapidly from such a deep recession (not much better than the latest one) with historically high interest rates? As Julien shows, higher rates expand profit margins and make banks more likely to loan to small businesses. In addition, higher rates help consumers save and recover the losses they suffered in the recession because of the better risk/reward ratios. Increased savings means that real funds are available to loan so that banks don’t have to counterfeit money to increase lending, which leads to the artificial, unsustainable boom followed by the bust cycle.

Central bank policy merely follows the dogma of mainstream economics and the ECB’s recent policy move underlines the poverty of mainstream economics. It has no tools but counterfeiting and deficit spending, even though both hurt the economy more than they help. Certainly, in the early days of a recession central bank counterfeiting can help in the short run, but the medium term consequences are disastrous. 

But the real problems with the US and European and Japanese economies are micro, not macro. Corporate cartels have captured the regulatory agencies. In Europe that is a feature they’re proud of; in the US they try to hide it from the public the way people do certain body parts that they’re proud of but don’t want to advertise. The cartels get regulations passed that protect them from competition while often having governments create artificial demand for their products through subsidies. 

So what does this all mean for investors? Again, don’t expect much more than 2% inflation for the medium term at least. The micro effects of regulation are strangling the macro policies of counterfeiting money. Also, as I mentioned in a previous post low rates do not prevent recessions. The Ricardo Effect will work even if central banks keep interest rates near zero. The -1% decline in GDP in the first quarter was a warning shot.