The (asymmetrical) negative side of negative rates

Commenting on the last Japanese move, Lisa Abramowicz (The Negative Side of Negative Rates) rightly argues that the only positive effect on spending that one can expect from negative rates is through a depreciation of the yen (at least, as long as it lasts). She writes that negative rates is an idea that “sounds good in theory”, but she clearly acknowledges that the effect on bank lending is likely to be dampening, not stimulative. That negative rates do not have an expansionary, and have probably a deflationary effect has been maintained by some economists, including this blog here and here and also the Q&A here. It should be clear by now to an increasingly number of people that what we call a negative interest rate (on banks’ excess reserves) is actually a positive tax rate!

I suspect that those who believe that negative rates stimulate lending have a view of central bank interest rates that does not fit the reality of a monetary system. They seem to think there is a symmetry between positive and negative rates. They seem to think that because lower interest rates mean lower cost of borrowing, an interest that gets so low to turn negative is an even more powerful borrowing (and spending) stimulus. Equivalently, at negative rates lenders will get encouraged to lend less (and spend) more.


This would be applicable to a real-exchange economy, where people save corn. Not to a monetary economy where saving is the other side of debt. Savers are not people holding corn. They are people holding financial assets (corresponding to someone else’s liabilities) that they can either continue to hold or trade at a price that reflects market conditions.

Central bank negative rates are a tax on those financial assets to which they apply, to wit, excess bank reserves. Banks are not properly “lenders” of excess reserves to the central bank. They are forced holders of central bank money as a consequence of “Quantitative Easing” operations that have filled U.S., Euro area, British, Japanese, etc, banks’ balance sheets with excess reserves. And banks simply cannot avoid the tax. And their net worth falls.

When the interest rate charged by the central bank for lending to banks is positive and falls, banks pass on to clients their falling cost of borrowing. But this is precisely where symmetry ends.

When the interest rate charged by the central bank on banks’ excess reserves is negative, banks will pass on to clients their rising cost of operations. Notice that if a bank lends to clients at negative rates so to get rid of excess reserves and lessen its loss from the “tax”, it incurs in a sure loss plus it will soon discover that if all banks do the same, its excess reserves will quickly restore to the initial level.

The moral of the story is this: When an idea doesn’t work the way it is expected, people say that the idea may sound good in theory, but it is not applicable in practice. I see it differently (as my students know…). If the theory is good, it should help explain practical questions. If it doesn’t, it’s just a bad theory.


More Target2 divergence: This time is different

In the midst of the Eurozone “sovereign debt” crisis and increasing spreads in 2010-11, interbank lending came to a halt. At the same time, bank clients were moving funds from the banks of the countries “in trouble” to the banks based in “safe countries”. Because “core” banks were not willing to lend liquidity back to them, “periphery” banks borrowed from the Eurosystem to settle their payments, and Target2 balances diverged. This ended with Draghi’s “whatever it takes” announcement in the Summer of 2012 and the introduction of OMT in the ECB’s toolbox.

What is happening today (SEE CHART) is very different, and does not reflect a “flight to safety” as it did back then. Today’s divergence is a consequence of the ECB asset purchase program (QE), as well as of the current levels of policy interest rates set by the ECB.


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Mario Monti defends the austerity fortress

I have known Mario Monti since the time he was my professor of Monetary Economics in the late 70s. An excellent teacher, he opened his course by teaching financial accounting and balance sheets, explaining that every financial asset has a corresponding liability and demonstrating the importance of net sectors’ financial positions.

Today, Mario Monti chairs the EU “high-level group on own resources”, working on a reform of the EU budget. In an interview by Federico Fubini (Corriere della Sera, 18 October 2015), he discusses the current state of public finances in the EU and shares his concerns that the tight fiscal policy enforced in highly indebted EU countries is now being relaxed prematurely.

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Eurozone desperately needs a “FISCAL WHATEVER-IT-TAKES”. But EU leaders ain’t bold enough to act.

Even under the rosiest scenario that a deal is reached on Greece’s new three-year bail-out program, the economic conditions of Greece, and of the Eurozone as a whole, will remain serious. Europe seems unable to find the political path to move out of such deadly gridlock. Yet, the logic is simple.

Eurozone like Monopoly

Consider the Eurozone like the game of Monopoly. Continue reading