Europe's negative interest rates are no way to boost long-term growth.
Now that Federal Reserve Chair Janet Yellen has announced an increase in U.S. interest rates, what will happen in Europe, where rates are negative? Europe is resorting to negative rates to stimulate its economy, rather than reforming taxes and regulations. Europeans have just committed to higher energy prices in Paris, further slowing growth.
Negative rates in Europe started in September 2014. Now, the European Central Bank charges 0.3 percent to hold deposits. Sweden's rate is negative 0.35 percent, and Switzerland's is negative 0.75 percent.
“Negative interest rates cannot lead to permanent growth without resource misallocation...”
Negative rates discourage people from saving and encourage them to spend. They discourage banks from holding money and encourage them to make loans. In the short-term, this should raise consumption, investment and GDP.
American Enterprise Institute scholar Desmond Lachman tells me, "Although the ECB would not publicly own up to it, the main way in which the ECB's unorthodox monetary policy works is by cheapening the value of the Euro. Europe has a record current account surplus, but this is seen as helpful in providing a boost to exports and as causing Europeans to buy domestic rather than foreign goods."
Since the European Central Bank began quantitative easing, the Euro has depreciated by more than 20 percent against the U.S. dollar. Lachman notes that we complain if China manipulates its currency by 2 percent, but we do not say a word when Europe manipulates its currency by 20 percent.
The track record of GDP growth in European countries since the start of negative interest rates has been positive. European GDP grew at an annualized rate of 0.8 percent before rates became negative, and 2 percent afterwards. In Sweden, GDP grew at 1.6 percent before and 3.2 percent afterwards. Only in Switzerland, GDP grew at 2 percent before and declined to negative 1.2 percent afterwards.
Total household loans in the Eurozone were up 1.2 percent in the year ending October 2015, compared to no growth in the prior year, just after negative interest rates took effect.
Nevertheless, negative interest rates cannot lead to permanent growth without resource misallocation for at least four reasons:
No country has ever devalued its way to prosperity. If it were possible to achieve economic growth by printing money, buying bonds or setting interest rates at negative rates, then many countries would be rich. The reverse is true: Weak currencies lead to slower growth, as we have observed from recent experiences in the Western world and Latin America.
Negative rates disadvantage particular groups within the economy. Savers, retirees, pension funds and insurance companies are all harmed by negative and zero interest rates. Thrift, which means putting aside money today in case of a rainy day tomorrow, makes no sense with negative rates. There is no reason to delay current spending to save for tomorrow's capital stock.
Negative rates drive people on fixed incomes into risky assets. Some, including senior citizens, need income from their savings. They are driven into risky assets such as equities and junk bonds in order to get the 5 percent return that they would normally receive from savings accounts. They are forced to take on more risk than they prefer.
Negative rates could cause inflation. Germany had its own experience with hyperinflation between World War I and World War II, and the West had problems with stagflation in the 1970s. Inflation cannot easily be contained, despite European Central Bank President Mario Draghi's optimism.
Negative rates mask fundamental problems in Europe that need to be remedied to attain growth. By reforming its red tape and taxes, Europe could be productive without currency manipulation. But that would call for tough policy choices that countries are not yet ready to make.
This piece originally appeared in U.S. News and World Report
This piece originally appeared in U.S. News and World Report