The European Central Bank (ECB) cut its deposit rate to -0.4% from -0.3% on Thursday, March 10, 2016, and its target refinancing rate also dropped five basis points to 0%. As part of its continued ultra-low rate measures, the ECB boosted its quantitative easing (QE) program up to monthly bond purchases of €80 billion.
Most central banks are operated by Keynesian or New Keynesian theorists, so the move towards negative rates follows the standard script: Reduce interest rates if economic growth is slow and deflation is on the horizon. The resulting cheap money should, according to theory, spur borrowing and investment. More spending means more jobs, more wages and, eventually, economic growth.
The world's central banks don't have strong track records when instituting easy money policies, however. Experiments in negative interest rates have been relatively few and far between, and many experts worry about harmful side effects. Here are a few of the negative drawbacks of Europe's monetary experiment.
Economic Distortions Grow Even Worse
Interest rates matter. Lower interest rates affect homebuyers, savers, investors, businesses and governments. Important and scarce resources are shifted into capital goods sectors, unsupported by underlying fundamentals, at the expense of consumer goods sectors. Businesses lever up too much. Households save too little. Too many long-term projects are undertaken. Historically, such distortions eventually unwind in very painful fashion, such as happened in the Japan during the 1990s or the United States after 2007.
Prudent Europeans Hurt by Low Interest Rates
The ECB's actions make it tougher on Europeans who save money and live on budgets. Pro-inflation policies increase costs of living, even if only by preventing prices from falling. Negative interest rates disincentivize savings in safe retirement accounts, forcing people to consider riskier investments.
The longer-term prospects are even worse for Europeans relying on government-funded assistance in retirement — and a number of Europeans do rely overwhelmingly on such social programs. As public debt burdens grow, future politicians will have very difficult choices to make about long-term payments to those receiving government assistance.
Europe's Banks Can't Handle the Stress
Banks in Europe and Japan have struggled with low profitability for years, and QE programs deserve much of the blame. The ECB's negative interest rates put huge pressure on banks to lend money, but they don't suddenly make borrowers more reliable or debtor businesses more profitable. The result is more loans gone bad. This is most striking in Italy, where a disturbing percentage of bank loans are nonperforming.
Historically, banks lean on two backstops when loans portfolios prove unprofitable: They invest depositor money in relatively safe assets, or they park money at their central banks to earn a pittance. However, the ECB's policies mean central bank deposits actually lose money, and bond yields in Europe collapsed in the face of negative interest rate policies (NIRP).
QE Probably Increases Income Inequality
Income inequality is a natural byproduct of industrial capitalism — some families escape poverty faster than others, making it mathematically impossible to avoid unequal wealth and income distributions. This is normally harmless, but it can become a cultural problem when the rich seem to get richer while the less fortunate see stagnant wages (or worse).
Evidence from the Federal Reserve's QE programs suggests ultra-low interest rate programs accelerate income inequality in an economy. The wealthy benefit because they are disproportionately connected to capital markets and corporate profits. Less-fortunate families have smaller investments and appreciable assets, see low wage growth and higher costs of living.
Consumers May Decide to Hoard Cash
Money usually goes wherever it's most welcome. In circumstances with no good destinations, however, money stays put. Retail banking customers could decide they don't want to risk their money in equities and don't want to pay banks to store their money. The response is to sit on money at home, which could lead to even less investment and defeat the entire purpose of QE. It could also lead to a government-led war on cash, should the problem persist.
Governments Keep Piling On Debt
The largest borrowers in the world are national governments. In a low-interest rate environment, those are the borrowers realizing the greatest reduction in debt servicing costs. Recent history suggests a reduction in government interest payments leads to greater total borrowing levels. In other words, national governments take those savings and use them to borrow even more money.
Government borrowing crowds out private capital market activity, results in higher future taxation or inflation, and can threaten national solvency when taken too far. Low interest rates may delay the day of financial reckoning for EU governments, but it likely makes the problem worse along the way.
The Inflation Bomb Gets More Dry Powder
QE is carried out through large asset purchases by a central bank. Central banks aren't sitting on large piles of savings from which to purchase assets, so they have to create new money. If the supply of money grows too quickly, inflation follows.
Fortunately for most consumers, much of the trillions of dollars created by the Fed, the ECB and the Bank of Japan since 2008 have yet to bid up prices very far. Some assets, especially stocks and real estate, have grown significantly, but the costs of bread and electricity aren't skyrocketing. Surprisingly low oil prices have also helped.
The ECB's NIRP dissuades banks from parking money at the central bank. This forces additional currency into circulation, which strips purchasing power from existing denominations. If too much money begins moving around European economies too quickly (a problem economists call the "velocity of money"), consumers might face accelerating inflation.
The EU Alliance Fractures Even Further
The EU suffers from infighting. Many in the United Kingdom want to leave the union entirely, and some countries are struggling with waves of Syrian and other Middle Eastern refugees. Greece perpetually teeters on economic collapse, which could drag the rest of the continent with it. It is clear from European news outlets and press releases that Germans are tired of bailing out Portugal, Ireland, Italy, Greece and Spain — a group of countries sometimes derisively labeled "PIIGS" by other EU members.
If monetary policy continues to fail, expect major calls for reform from competing countries, each looking to exert more control over the ECB. Since 2013, German voters have been the most vocal about keeping financially irresponsible governments from making monetary decisions.