Much has changed since the beginning of “quantitative easing” (QE), the large-scale asset purchase programs conducted by all major central banks. The ECB is one of them. Ever since the start of these programs, central bank balance sheets were massively expanded. One of the problems with QE is that bank reserves are no longer scarce. Before the crisis, central banks used to adjust the supply of bank reserves to manipulate (both upward and downward) the interest rate on these reserves (which is, for instance, the effective Fed funds rate in the case of the Fed). Since this has become impossible after QE, central banks began opting for an alternative method: that is, paying interest on reserves (IOR). Besides all technical discussions about the effectiveness of this method (and we already had extensive discussions of this nature), there is something else going on. The technocrats of the ECB are overlooking something of great importance: their “new method” is politically unfeasible.
Central banks completely lost control during the crisis of 2008. Interest rates were lowered to practically zero, but even under these circumstances the economy went into freefall and banks were collapsing like dominoes. Central banks around the world pulled out all the stops to turn the tide. That these very same central bankers do not understand that they, far from being the metaphorical firefighter, are rather the pyromaniac, is something we have discussed in earlier articles in greater detail.
Anyhow, the economy recovered (partially, since economic growth has been by historical comparison weak, very weak) and central banks began discussing the idea of “normalizing” monetary policy. The premise is that economic growth is picking up again, but that as soon as economic growth begins to pick up pace, inflation will rise, too. Therefore, the central bank must raise interest rates in a proactive manner, to make sure that inflation will not get out of control as the result of increasingly rapid growth in credit.
There you have the story as you would read it in the paper.
Banks are legally obliged to hold a minimum level of bank reserves. In the past, banks were all but happy to hold these reserves. Investments made by banks must earn money, yield enough interest, to maintain a healthy and positive net interest margin. And when a government forces you, by law, to invest in assets that earn nothing, there is little reason for joy. Bank reserves were akin to deadweight – completely worthless assets – for banks.
Until the crisis of 2008. Because precisely at that moment, central banks out of a sudden began to pay interest on bank reserves.
The Fed was, after all, scared to death that QE would lead to high inflation. By paying interest on bank reserves, they tried to prevent banks from using these reserves to expand their credit portfolios by manifold. The idea was to persuade banks to do the exact opposite, while the Fed would add billions worth of assets (US Treasuries and mortgage-backed securities) to their balance sheet.
In the Eurozone, another chapter was written and added to this already remarkable era in monetary history. The ECB began, instead of paying interest, charging a negative rate on bank reserves (deposits at the central bank). The interest rate on a deposit at the ECB (in other words: on bank reserves!) is currently -0.4%, which simply means that banks must pay 0.4% to the ECB to hold balance at the central bank. Moreover, Draghi announced that we should not expect and changes in interest rates in the near future. The negative ECB interest rate currently works as a tax on commercial banks, because banks have no choice but to pay the negative rate.
Draghi, with his large-scale asset purchases, buys up €60 billion worth of assets every month, which means that the amount of outstanding bank reserves which are liable to the negative rate also increases by €60 billion a month. Only in the case banks would lend substantially more, they would be able to avoid what effectively amounts to a bank tax. However, this is an impossibility by definition due to:
- Bank regulations (Basel III) impose additional restrictions on commercial banks regarding liquidity and capital
- There are simply not enough creditworthy and solvent households and corporations that want to borrow money
The total M3 money supply in the Eurozone equals €11,600 billion euro. The ECB balance sheet equals €4,200 billion euro and Draghi buys an additional €720 billion euro in a year’s time. Banks are required to hold 1% in required reserves to which the negative interest rate does not apply. That implies that, under current conditions, banks would roughly have to hold €420,000 billion euro in assets to avoid the ECB tax on “excess reserves”, or 42 times the current amount of credit outstanding.
To illustrate my point: ING Bank currently holds about €1,000 billion in assets, which grosso modo consists of loans to businesses, households and governments. The ING, therefore, has to lend out 42 times more to comply with what we have outlined above and thus avoid the ECB tax: by definition an impossible task.
Given the current political climate, this negative interest rate is an easy sell. A tax on banks? Those very same banks that were (ab)using taxpayers´ money to take excessive risk only a few years back? “Sure, why not?”, a majority would say. Yet there exists another side of the coin.
The ECB will have to “normalize” their monetary policy at a certain point. In other words, at some point in time the ECB will have to raise interest rates. And because the old method does no longer work since 2008 (manipulating the supply of bank reserves), the new method has to be applied (raising interest on reserves).
“Piece of cake”, the ECB technocrat says.
Without realizing that his proposal, and his current method, implies that the ECB must pay a billion-dollar subsidy to persuade banks, ironically, not to lend any money.
Imagine this: the ECB raises interest rates because they expect that inflation, after economic growth is picking up pace, will rise. The ECB raises the interest rate on bank reserves to prevent banks from lending. But the interest that the ECB pays to commercial banks will be shouldered one way or another by the taxpayer. Ergo, the ECB´s monetary policy is akin to an enormous subsidy to commercial banks.
How much exactly? We can estimate the size of this ECB subsidy with a few assumptions:
- European banks currently hold €542 billion in bank reserves (this amount excludes required reserves over which no interest is paid or charged). Of course, this amount grows to the extent that the ECB continues its monthly asset purchases.
- A “normal” interest rate by historical standards would be, let´s say, 4%. In 2007 and 2008, the ECB rate stood at this level and at the start of the millennium the ECB rate was kept at even higher levels.
In this scenario, the ECB would pay out €21.8 billion euro a year in interest to commercial banks. And, moreover, just to keep them from lending to others.
What if inflation really begins picking up? Just as was the case in the 70s for example? What if the ECB has to pay 10% instead of 4% to really restrain the debasement of the currency? In that case, the ECB would have to pay out an astonishing €54.2 billion euro in disguised bank subsidies.
How morally OK is it that a (semi)public institution such as the central bank pays commercial banks to prevent them from lending out money? And perhaps even more relevant: how pleased would an average law-abiding citizen with democratic voting rights be when he or she finds out that the ECB is paying a billion-dollar subsidy to commercial for-profit banks?
Who does honestly think that the ECB can pay out billions whilst avoiding that a majority of European voters begins opposing the ECB and its, according to the technocrats completely viable, exit strategy?