Oh For A Big Fat Slice Of 1970's Stagflation In Europe

by: The Motley Monetarist


The ECB has proclaimed in its latest bulletin that its policy of negative interest rates and deflation is working because of private consumption.

However, a closer look at trends since 2014, when negative interest rates commenced in Europe show dismal lending patterns by banks, and an even more depressed household sector.

Although initially negative interest rates seem to have lifted bank lending, deflation seems to have taken a toll amongst households, depressing savings and increasing the value of debt.

"If there's a bustle in your hedgerow, don't be alarmed now" - Led Zeppelin.

The news that the Bank of Japan is the latest bank envisaging a negative interest rate policy was one of a series of depressing announcements that sent markets into a swoon. The BOJ has assured the public that the negative interest rates charged to banks won't penalize banks, since these negative interest rates will be charged only to the policy-rate balance, a margin of the total deposits the bank has with the central bank. This will also not have any effect on any asset purchase operation the BOJ or any other bank engages in, since prices on these future asset swaps will also have to increase as a consequence of any negative interest rates charged, even on the margin.

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Source: oecd.org

Europe has experienced this all too painfully now since March of last year when QE commenced and June 2014, when the first negative interest rate was charged. The idea is to incentivize banks to loan to consumers and businesses. However, the perverse effect might be to increase cash holdings by the public, since cash is not charged a negative rate. This situation, combined with deflation, pushes households into tighter and tighter margins with respect to their consumption decisions.

The question is whether, given this toxic combination, the Eurozone has reached the Krugmanian "black hole", where, as he explains it, prices fall in the face of excess capacity, businesses don't borrow, even as interest rates fall. Then as excess supply increases, prices fall even faster. In other words, whatever might be the positive effect, if any, of negative interest rates, they are crossed out by the deflation.

The 1970's stagflation seems like a golden period under the circumstances. At least then, central banks could correct the inflation. In the following, we look at several indicators in the Eurozone since the inception of QE to see how they have fared.

Cash, cash everywhere

One immediate effect of negative interest rates would be to increase the amount of cash in circulation at the expense of deposits, especially if banks pass on the cost of the rates to depositors. Some proposals call for taxing cash, maybe by the central bank monitoring bank's cash withdrawals and then applying a quarterly charge greater than the negative interest rate.

As the graph below shows, there was a notable spike in the amount of banknotes in circulation around the end of October (probably as a reaction to the inception of negative interest rates in the Eurozone). This variable has stabilized since, declining just after the inception of QE last March. But the circulation of banknotes in the Eurozone has since increased. It should be noted that the changes in banknotes in circulation has not come at the expense of electronic money use, increasing by 21% between 2013 and 2014 (the ECB issues only yearly figures for this variable). (All data below from ecb.europa.eu)

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The paradox of low lending with low interest rates

In theory, the idea of negative interest rates is to incentivize banks to increase their loan rate, especially when monetary policy is reaching the dangerous point of no return. However, if, due to the reigning deflation, consumer demand is stagnant, companies would have little demand to borrow, notwithstanding negative interest rates. Thus, one could say that deflation in the Eurozone explains the paradox of low lending with negative interest rates. The ECB, in its February 2016 economic bulletin, is putting a positive spin on the figures below, by claiming that the sluggish growth is due to low export growth, which it claims, is counterbalanced by an increase in private consumption, notwithstanding the deflation (more on that below, including what's happening with household debt).

In the graph below, loan issuance by banks in the Eurozone has shown a slight uptick in the latter half of the year. However, the ECB's sanguine interpretation of events is undermined by the graph that follows. Loan issuance by banks has declined in the latter half of 2015, although it seems that negative interest rates had a momentary, if brief moment of glory in the latter half of 2014.

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It is of course reassuring to note how closely deposits track loans. But the statistics in the latter half of 2015 clearly undermine whatever positive spin the ECB is putting on developments in the Eurozone.

Debt v. savings reflects deflation v. negative interest rates

Ultimately the brunt of the ECB's policies will be borne by households. Again, the ECB's optimistic projections are undermined by the trends indicated in the following graphs. Household savings has plummeted, while increasing a bit in the earlier part of 2015. Of course, negative interest rates are anticipated to have this effect on household savings (although probably very low growth is to blame, for the most part).

But then note the precipitous recent decline in household financial asset/liability ratio in the graph that follows. This combined with the graph above it shows that both household assets have declined and liabilities have increased. In a situation of deflation, this is clearly a dangerous trend, as households find it difficult to unwind their debt positions.

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O Eurozone, we hardly knew ye

It seems to make one head spin-negative interest rates, deflation, sluggish growth, low export growth. According to the ECB, the one bright spot seems to be brisk private demand. However, banks don't seem to want (or be able) to lend.

The 70's sure look very good today.

Disclosure: I/we have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours.

I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.