The European Central Bank took the unprecedented step of lowering interest rates into negative territory last week, essentially charging banks to keep cash on hand. The stated reason: to get European banks, still reeling from the continent’s monetary crisis, to lend more in an effort to jumpstart Europe’s economy.
On Thursday, ECB chief Mario Draghi announced that the bank would change the deposit rate for the Europe’s commercial banks to -0.1 percent from zero. He also announced that the interest rate the bank would charge on borrowed money for traditional borrowers would drop from 0.25 percent to 0.15 percent.
The move serves two purposes. First, it’s aimed at combating low inflation, which are keeping prices down across the euro zone.
Second, it’s a prompt to get European banks to loan more money in the hopes that this money could kick-start a faster European recovery. Across the euro zone, growth has been, at best, fragile. The EU projects just 1.5 percent growth across the continent in 2014, hardly enough to combat widespread unemployment, especially among Europe’s youth.
Draghi made clear that if these steps failed to produce growth, he was prepared to do more.
“We think this is a significant package. Are we finished here? The answer is no,” he said Thursday. “If required, we will act swiftly with further monetary policy easing. The governing council is also unanimous in its commitment to using unconventional instruments within its mandate should it become necessary to further address risks of too prolonged a period of low inflation."
The next step is quantitative easing, a move that would essentially make the ECB the European Federal Reserve. If Draghi decides to go this route, the ECB would begin to buy government bonds and other securities in order to increase the money supply. This strategy helped to get the United States out of recession and back to growth.
Even without quantitative easing, Draghi’s announcement made him the second most powerful person in Europe, according to Edward Goldberg, professor at Baruch College and the New York University Center for Global Affairs. He also said that Draghi’s actions were a direct response to the right wing surge Europe experienced in recent EU parliamentary elections.
“In all practical sense Europe has two leaders now: Draghi and Merkel,” he said, referring to German Chancellor Angela Merkel. “It is obvious that the right wing vote … for the European parliament was partly due to the very unsettling economic conditions in much of Europe and the absolutely huge amount of youth unemployment.”
Goldberg added that the failure of European leaders to acknowledge the need for the kind of action Draghi initiated compounded the EU’s search for economic growth.
“Unfortunately because of the structure of the Eurozone and because of the charter of the ECB, Draghi could not have initiated these policies sooner,” he said. “It makes one appreciate very much the US's Fed ability early on in the great recession to be able to act based on its dual mandate and political independence.”
Tied Up in Regulation
Steve Hanke, professor of applied economics at Johns Hopkins University, offered a different take on Draghi’s actions. He said that the decision to charge European banks to hold money in reserve showed how over-regulation has strangled the EU.
According to Hanke, the Basel III requirements, which were born from the 2008 financial crisis, make banks keep cash on hand to make sure they can withstand a market shock. Draghi’s demand that these banks lend could be at odds with the need to have cash in reserve.
“They’ve increased the level of bank supervision, they’ve increased all kinds of bank regulations,” Hanke said. “If you put all of this together you have a schitzo monetary policy and a very distorted one.”
Hanke said that the ECB’s new policy highlights one of the problems at the heart of the EU’s fractured response to its sovereign debt crisis. The EU has taken a piecemeal approach, plodding along with policies that work in the moment but not the long-term. Draghi’s decision to charge banks for keeping money in reserve shows that these policies can sometime be contradictory.
“Policy one is squeeze the devil out of banks and force a credit squeeze,” he said. “The affect of that is falling credit and a near recession in Europe. Then you have to have some extraordinary ‘policy two’ to try to neutralize the stupid policy one.”
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