The strange world of negative interest rates

There has been considerable discussion recently about central bank interest rate policy, and in particular, what further monetary easing they can provide when interest rates are at or close to zero. Central banks have been using a range of unconventional tools, of which quantitative easing is the best known, to depress market interest rates. I have serious reservations about the effectiveness of these for the real economy, and in a recent post suggested that QE is not only ineffective but actually toxic for the real economy. But there is evidence that central banks are starting to consider negative rates as a policy instrument, so in this post I shall consider what would be likely to happen if central banks reduced rates to below zero.

There are two types of rate that central banks could reduce to below zero. One is the policy rate itself, which is the rate at which the central bank will lend to banks against collateral. The other is the interest rate that the central bank pays on excess reserves. I shall return to the policy rate later, but first I wish to discuss the effect of reducing interest rates on excess reserves to below zero.

Banks currently have rather a lot of excess reserves, since the unconventional tools themselves have caused reserves to build up, so reducing interest rates on excess reserves looks like an attractive policy. After all, if maintaining higher balances in their central bank reserve accounts than they need to becomes expensive, banks won't do it, will they?

Let's consider what negative interest rates on excess reserves actually are. There are two ways of looking at them:

- Negative interest rates on reserves are a charge to banks for placing money on deposit in a fully guaranteed deposit account. They are equivalent to a safe deposit charge.

- Negative interest rates on reserves can also be regarded as a tax on deposits. As with all taxation, the burden of that payment does not fall on the bank itself. I shall discuss shortly where the burden actually falls.

The thinking behind charging banks for safe deposits at the central bank is that banks will choose to lend that money out for a positive return instead of suffering erosion of principal in return for safety. This unfortunately demonstrates the misunderstanding of lending that underlies the failure of modern macroeconomics to explain or prevent financial crises. Banks lend if they choose to - if the balance of risk versus return works in their favour. If it doesn't, no amount of reserves will make them lend. They will hoard money instead. And the fact is that the balance of risk versus return at the moment is so horrible that banks do not wish to lend except to the most creditworthy borrowers. Banks are seriously damaged and very, very scared of losses: they are already carrying high levels of risky loans against which they have insufficient loss-absorbing capital, and governments are withdrawing the implicit guarantee that enables them to maintain risky lending against insufficient capital. And the world is a risky place for banks at the moment: there is a severe credit crunch in the European periphery due to the ever-growing sovereign debt crisis there, and creditworthy borrowers are thin on the ground everywhere due to damaged household and corporate balance sheets.

Not only that, but there is evidence that creditworthy households and corporates don't want to borrow, either. Borrowing and spending is out of fashion, saving and thrift is in.  The Bank of England's "Trends in Lending" report says risky borrowers such as SMEs can't get the finance they want at the rates they want to pay, but it also notes that lenders complain about low demand and lack of creditworthy borrowers.

There is general risk aversion among investors, too. Yields on highly-rated government debt are at historic lows: in some countries this is partly due to QE, but German bunds have had no QE and yet were recently trading at yields at or below zero. Traditional safe haven currencies such as the Swiss franc are under such exchange rate pressure that the Swiss National Bank has intervened to prevent the franc's appreciation damaging the Swiss economy. Deposit account interest rates are on the floor, and some banks in the US are imposing negative interest rates on large sums of money in FDIC-insured deposit accounts.

It's worth remembering, too, that reserves are created by the central bank, not by commercial banks, and that commercial banks have no power to reduce the total amount of reserves in the system. That can only be done by the central bank. So if commercial banks were discouraged by negative interest rates from holding excess reserves, but there were still excess reserves in the system, banks would look for ways of passing on those excess reserves to other banks. Excess reserves would become something of a hot potato, with no bank wanting to be caught with excess reserves at the end of the day. I suppose that might improve the velocity of money, but I could see it leading to all manner of stupid investments.

So, if - say - the ECB imposed negative interest rates on excess reserves in a world which is both risky and risk-averse, how would banks behave? I can't see any reason at all why they would increase lending. They would be more likely to look for other "safe" investments as an alternative to parking deposits at the central bank. And they wouldn't have far to look. The debt of countries like Germany, the US and the UK is explicitly  backed by government guarantee just as central bank reserve accounts are. If the yield on these bonds were higher than the negative interest rate charged by the ECB, banks would purchase these with their surplus deposits. There might also be round-tripping from banks seeking to arbitrage the difference between sovereign debt yields and central bank negative interest rates. The inevitable effect would be downwards pressure on the yields on "safe" government debt in much the same manner as QE.

But negative interest rates on reserves could have an even more toxic effect too. For this we need to look at the experience of Denmark, which introduced negative rates on excess reserves in response to the ECB's cutting of rates to zero. Denmark was forced to do this because it is maintaining a currency peg to the Euro, and interest rate parity with the Eurozone would place that peg under pressure due to capital flight from the stressed areas of the Eurozone. Denmark's banks complained that their margins were being squeezed. The Danish central bank's rather unsympathetic response was to suggest that Danish banks could simply raise their rates to borrowers. Which the Danish banks duly did.

Now, Denmark is experiencing some inflationary pressure due to capital inflows from the Eurozone, and its currency is under pressure, so raising interest rates to borrowers helps to dampen this down - which is why the Danish central bank was unimpressed by the banks' complaint. But consider what would happen if an economy experiencing deflationary pressure introduced negative interest rates. The squeeze on the margins of already-damaged banks would inevitably lead to higher rates to borrowers and reduced lending volumes. This is monetary tightening, not easing, and the effect would be contractionary. It would make the recession worse.

This is also consistent with my description of negative rates on excess reserves as a tax on deposits. I've described it as monetary tightening, but it could also be seen as a fiscal tightening since central banks are part of government: one of the strange effects of very low interest rates is that the distinction between monetary and fiscal policy is becoming ever more blurred. And the Danish experience shows where the incidence of that tax would fall. It would not fall on banks, which would find a way of passing on that cost to people: nor would it fall on savers. It would fall initially on borrowers, as lending rates were raised: then, as lending volumes fell in response to higher rates, it would fall on shareholders in the form of lower returns, and employees in the form of lower wages. And the overall effect on the economy would be deflationary, due to reductions in both credit and income for businesses and households.

So negative interest rates on excess reserves would be counter-productive. Fortunately the Fed seems to be wise to this and has ruled them out, at least at present: but unfortunately the classical macroeconomic bias of the Eurosystem leadership appears to have rendered them incapable of understanding the contractionary effect of negative interest rates on reserves, even though they have an example on their doorstep. At a press conference the other day the head of the ECB, Mario Draghi, appeared to suggest that negative interest rates might come soon. Heaven help the Eurozone if that goes ahead.

But what about cutting the policy rate itself to below zero? This would in effect mean central banks would pay commercial banks to borrow from them.

A negative policy rate would be a direct subsidy to banks. And if it actually worked to improve lending volumes and bring down rates for riskier borrowers, it might be a worthwhile subsidy, too. But in a world that is both risky and risk-averse, I don't think it would have that effect. Remember that banks only lend if the risk versus return profile works for them. And people and corporates only borrow if they wish to spend - which at the moment they don't, much. The failure of QE as an economic stimulus to the real economy demonstrates that throwing money at banks doesn't make them lend. Why would paying banks to borrow be any more effective?

A negative policy rate could be effective as a bank recapitalisation. The central bank lends against collateral - typically its own sovereign debt and sometimes other sovereign debt too. Suppose the central bank pays banks to borrow against collateral of the sovereign bonds they already hold, on which they are receiving interest. They then use that money to purchase more sovereign bonds to repo back at the central bank for more funds. And they receive interest both on the borrowing and the purchases, all of it effectively paid by taxpayers (since central bank payments are guaranteed by government). That is state-funded bank recapitalisation by the back door. Nice.

There is no doubt that banks need recapitalising. But why on earth do it by such a roundabout route? And what is to stop them paying out their earnings from this sovereign round-trip in the form of shareholder dividends and employee bonuses?

Like negative rates on reserves, negative policy rates could actually have a toxic effect on the real economy. Across Europe, including the UK, many loan rates - especially mortgages and business loans - are tied to the policy rate. So if the policy rate were cut to below zero, lenders would find their margins squeezed on existing lending: they could even find themselves receiving negative returns on these loans. Realistically they cannot cut their deposit rates to savers to below zero (savers would stuff mattresses instead), so their only option is to RAISE lending rates to new borrowers, widening credit spreads. Exactly the same effect as negative interest rates on reserves, in fact - and the same effect as QE. Existing floating-rate borrowers would of course find their borrowing costs eased: but would they spend this money? Many of them are highly indebted, and many more of them are suffering erosion of their savings due to very low real interest rates. I suspect they would use the windfall from lower borrowing costs to pay off debt, or to top up their savings, rather than spend. In which case the overall effect on the real economy of a negative policy rate would be contractionary, not expansionary.

So cutting policy rates to below zero would be as counter-productive as cutting interest rates on reserves. And it would be unpopular. I can't imagine any electorate, wounded as they are by the behaviour of banks, tamely accepting bank funding being subsidised while interest rates to new borrowers soared and the economy crashed.

But suppose, in a world gone mad, central banks decided to cut both interest rates on reserves and the policy rate to below zero. This is where things become very, very strange. Government (via the central bank) would pay banks to use state funds to settle lending while taxing them if they attempted to self-fund. The effects would be extraordinary.

Firstly, banks would be actively discouraged from holding excess reserves at the central bank. But they would have an increased need for government securities. So initially they would try to reinvest excess reserves in government securities, driving down yields. Thereafter, any further need for collateral could be met by using central bank funding to buy securities.

Both the unsecured interbank market and the repo market would die, because it would be far cheaper for banks to borrow from the central bank than from funding institutions - even with the cost of holding increasingly expensive safe assets for collateral. Banks would become completely dependent on central bank funding.

Rates to commercial depositors would crash, as banks would no longer have any incentive whatsoever to seek deposits. In fact as they would be charged to hold them, either directly through the tax on excess reserves or indirectly through negative yields on assets purchased with those deposits, they would actively discourage them by cutting interest rates. As commercial deposit rates approached zero, savers would start hoarding cash instead, or investing in physical assets such as gold.  There might also be a flood of money into National Savings if the interest rate were favourable. And as returns on various kinds of wealth fund including pensions, already low, turned negative due to crashing yields on safe assets, they would close their doors and savers would be forced to turn to cash or physical assets.

Banks' aversion to holding deposits could have very weird consequences for the real economy, as the Fed notes. For example, if they imposed negative interest rates on ordinary deposits including current accounts, people would stop using banks and we would return to a cash-based economy: or they might even turn to alternative currencies such as e-credits on mobile phones. I have no doubt that e-credit suppliers would be only too happy to see their currencies take the place of sovereign currencies for day-to-day transactions.

Theoretically, recapitalisation of banks coupled with low-cost funding should encourage banks to lend. But their balance sheets are still stuffed full of risky loans. Even if they had more capital and cheap funding, they wouldn't want to take on more risk lending. No, they would go for safe assets and cash. Nowhere in this bizarre scenario is there ANY incentive for banks to increase risk lending.

Theoretically, too, deposit rates crashing to zero or below and falling rates on floating-rate loans to existing borrowers should encourage households and businesses to spend instead of saving. But not when they are highly indebted and suffering erosion of principal on existing savings. No, they would pay off debt and increase their savings. Nowhere is there any real incentive for households and businesses to spend instead of saving.

And it gets worse. As safe collateral became scarce, central banks would inevitably extend the range of acceptable collateral to other bank assets, such as mortgages.....eventually all forms of lending would be pledged to the central bank in return for funding. Banks would no longer carry the risk of that lending: in the event of default, the loss would rebound to the central bank to whom the asset was pledged, and the state - not the bank - would take the loss. The ECB is already a long way down this path even without negative rates.

So the final outcome of a complete negative-rate policy would be a state-recapitalised banking system, funded entirely by the state and with lending risk borne by the state. Effectively, that is nationalisation of the banking system - but without the control that would force banks to use state funding productively to benefit the real economy. It would be the worst of all possible worlds.....except one in which the sovereign currency was rejected in favour of private-sector alternatives because of the cost of holding it. If the sovereign currency is rejected because people have to pay to use it, how long will government and the rule of law last?


  1. Sovereign currencies - whether backed by gold or not - are becoming obsolete because the public sector cannot compete with the private sphere.

    1. The only reason our existing “privately produced money” system (i.e. fractional reserve system) survives is that it is backed by and subsidised by the state. No doubt you’ll have heard about the recent billion pound and trillion dollar bail outs. Thus it’s a bit unrealistic to say that the private sector here “competes” with the public sector.

    2. Like love, communication and other spontaneous forms of human expression, money existed before any particular State did. Revolving doors clearly demonstrate a grey zone, but it's becoming increasingly too costly (i.e. not profitable enough) to even bother going into government.

      Proper defaults on government debt would also teach bond investors a lesson, namely that they should not engage in the socially destructive practice of channelling scarce savings through the government bond market into the hands of politicians and bureaucrats with the aim of obtaining a ‘safe’ income stream’ out of the state’s future tax receipts (i.e. stolen goods) but to instead invest savings in capitalist enterprise and thus fund the creation and maintenance of a productive, wealth-enhancing capital stock. Losing their money in allegedly ‘safe’ government bonds is, quite frankly, what they deserve.

    3. I should add that:

      Next to Japan, Britain is the most highly geared society on the planet (private and public debt combined), and when the markets pull the plug on this island nation, the fallout might make Greece look like a walk in the park.

  2. Governments, or more precisely Governors will always exist, but competition in the 21st century will be allowed to filter the good from the bad, so that natural elites rise rather than random choices emanating out of mob rule based on who could convey the most outlandish promise with a serious face, like happened in the 20th century, which by no means was particularly rule-bound, considering the 2 world wars and the littering of Earth with nuclear weapons. No, far from dispensing with the rule of law, the inversion of the governance structure will start to slowly impose rule of law overtime as the currency system folds.

    A sound introduction to the new reality, dealing directly with your last question, can be found here:

  3. One, of course, could also seriously ask...what evidence is there, anyway, that law & order currently prevails in the UK? As Azizonomics has recently suggested, if anything the appointment of a Canadian to the most powerful "public office" signals the arrival of a kind of lawless anarchy that now has seemed to dominate the UK for probably a few years....Perhaps, then, it's not so much a matter of changing anything, compared to just realising the truth, alal New York Times

  4. And as returns on various kinds of wealth fund including pensions, already low, turned negative due to crashing yields on safe assets, they would close their doors and savers would be forced to turn to cash or physical assets.

    Houses. It would reinflate the housing bubble and recap the banks. I presume, therefore, that this will soon be UK government policy. (Mind you, if you agree with Dan Davies this has already happened.)

    1. It's already Fed policy.....

      However, the essence of a pension scheme is it is GRADUAL savings from income over a lifetime. A mortgage could be seen as a similar arrangement, but not if banks are charging astronomical interest rates to anyone except people who could really afford to buy the property outright anyway. It's a very expensive way of saving for your future - assuming you can even get a mortgage, that is. Which brings me to something I didn't say in the post.

      I don't think banks would want to lend at all in a negative-rate world. Risk-averse banks only want to lend to creditworthy borrowers, who could arbitrage the difference between the interest rates on loans and deposits. Loan and deposit rates would therefore end up the same - which means zero income for banks. Their only way of making money would be from the charge on deposits, unless they lent to much riskier prospects. And as savers wouldn't want to be charged for deposits, so would stop using them, the negative rate world really means the end of banking as we know it.

  5. Interesting post thanks.

    The paradox of thrift...

  6. "Realistically they cannot cut their deposit rates to savers to below zero (savers would stuff mattresses instead)"

    Really? In a world that is risky and risk-averse, and people are thinking about the return of money rather than the return on money, stuffing mattresses isn't too great a solution. Too much risk of burglary. It may very well be that the least risky option is to leave your money in the bank and accept that's where it will erode the least.

    We've been here before, but a long time ago. Remember, banks used to be places where you could put your gold safely, for a charge. We may be returning to those times. This idea that savers should get paid for saving is relatively new.

    1. We do of course already have current accounts at negative interest rates - but these are presented as fees.

  7. Another nonsensical element of negative interest rates is that they are an attempt to boost the economy via just ONE FORM of economic activity: investment. You might as well boost an economy by trying to encourage the consumption of baked beans, swim suits, restaurant meals and cars, and then wait for the trickle down effect to benefit the rest of the economy – which it certainly would eventually.

    1. Hi Ralph,

      yes, I agree. But I'm more worried about the fact that negative rates would actually have the OPPOSITE effect. They would be contractionary, not expansionary. There is serious risk of a deflationary spiral if rates are cut to below zero in a depressed economy.

  8. Now I always thought that negative interest rates also have less conventional interpretation. I (or big banks) would be paid to borrow money. (Lose money with deposits, Make money by borrowing more money !!!) Why not, it's no dafter that taxing deposits and would be stimulative. I'd sign up for a billion or two and give it back later and pocket the interest !

    1. Indeed, there would be the prospect of creditworthy individuals borrowing money they don't need. That was where I was going with my comment above about creditworthy individuals arbitraging the difference between deposit and lending rates. They would have to spend the money, though, otherwise it wouldn't be stimulatory at all.

      Another bizarre prospect might be large companies providing deposit and payment facilities for their employees - internal banks - rather than expecting employees to have bank accounts.

  9. As the FT reports this morning:

    The NIC, the agency that sits atop the US intelligence community identifies a second shift – from the state to the individual. The report calls this individual empowerment a “megatrend”, a development that will change fundamentally the way societies are organised.

    To place your head in the sand and simply ignore the most primary of all changes to the world in the 21st century - mentioned above and manifested from politics to personalised medicine - is to just do a huge disservice to your own self, insofar as it means that you remain in an imaginary world of an unusual extreme.

    1. This post is about an unprecedented financial policy which I consider would have disastrous economic effects if it were attempted. I really don't see what your remark has to do with that. I'm also puzzled by your second paragraph, which reads like a personal attack on me. I hope you don't mean it as such and it is simply your unfortunate use of English.

      I accept comments on this site only if they relate to the subject being discussed: it is not the place to grandstand your general political opinions. Please confine your comments to the subject of the post.

  10. It's very noteworthy that you ask people to not comment upon certain things. It highlights your fraught, guilty conscience.

  11. You cannot separate politics from finance, why is that hard to understand? This yearning for "impartiality" is a hopeless ambition, but you follow your (partial) thinking, as is quite natural! To even the most casual observe, it is outright clear that finance has been highly, highly politicised. Central bankers ARE politicians. Any assertion to the contrary only grasps for a higher ground that actually does not exist.

  12. Why don't you consider what this central banker from Belgium says? What forces you to ignore his thinking? "Your" system is already over! Bye for now

  13. Watch from lecture 1 - through to 5: it is not physically possible for a debt based money system to recover from this situation. You are harping on constantly about the crisis that has passed while blissfully ignoring the question of, what will come instead? It is an absolute waste of your mind, no doubt misdirected thanks to these artificial interest rates!

    Watch. Learn. Listen.

    1. I expect visitors to my site to abide my rules. Which are:

      1) please confine your comments to the subject of the post

      2) please be polite and refrain from personal attacks on me or on other visitors to this site.

      You are breaking both of these rules. You are no longer welcome and I will not accept any further comments from you.

  14. This graphic pretty much explains negative real rates

  15. Great post! It appears we are in agreement on this issue (I suppose that's why I think it's great :) ). I left out much of the money market discussion, but saw a lot of this coming back in summer 2009, fwiw.

    Scott Fullwiler

  16. The idea of negative deposit rates in eurozone might have its advantages if ECB wants to roll down LTROs. Basically German banks will be "incentivized" to lend to Spanish banks which will pay back their LTROs to ECB. In the end the result might be positive for Spanish banks since they will pay less on interbank (like 20-25 bps) than to ECB (75 bps) and positive to German banks since they will make 20-25 bps instead of 0 at ECB. Sounds like a win-win-win situation to me.

    1. JP Morgan's Stocks & Flows team have made the same point - see FTAlphaville:

      I think this is a bit of a special case, though. Pretty much all the other indicators are negative, so the question is whether this positive result outweighs all the negatives.

    2. Aha, thanks for the link. Yes, I also think that it is a very special case. In no way can the banking system shoulder the whole accumulated current account deficit of PIIGS. Target2 is not the problem but a symptom. And 25bps are very unlikely to make a big dent into the risk appetite of German and co banks. But it might be of help to improve short-term sentiment which might have some other nice spill-over effects. However, if German and co. banks refuse to play along, the consequences can be much more tangible than just sentiment. ECB, if keeps on with negative rates, might play with serious fire.

  17. Why wouldn't the banking system be able to accommodate the whole accumulated current account deficit of the PIIGS?

    It's been able to withstand hundreds of billions of euros of capital flight from Spain and Italy to Germany. The clearing and settlement system has not and will not collapse from said massive transfers of funds inside the eurozone. It's been designed with the intent of dealing with such situations and making sure the eurozone will always guarantee that a euro is a euro independently of whether its origin lies in Germany, Italy or any of the other member countries.

    I think the capacity of TARGET2 to absorb the imbalances inherent in the eurozone has been seriously underestimated. And the periphery governments should be much more aggressive in defending their interests and evading austerity by using TARGET2 and their domestic banking sectors to finance the rollover of the portion of their public debts held abroad - in non peripheral countries of the eurozone.

    1. Why? Nothing more simple than that. Risk.

      But then you seem to be confusing target2 balances where the risk is taken by the eurosystem and commercial banks should take over that risk from eurosystem. Two opposite cases. Even ECB is unhappy with the risk though they could handle it as long as they wanted.

  18. No, I'm not confusing anything.

    The periphery government sells newly-issued bonds to domestic, public sector commercial banks and then uses the deposits to pay off maturing bonds held by foreign creditors in other eurozone countries.

    The TARGET2 balances will increase as a result of this process (higher positive balances for the Foreign NCB, higher negative balances for the periphery NCB).

    But the periphery government is now financing the rollover of maturing bonds via its own, government-owned commercial bank.

    It has escaped the dictatorship of the financial markets and won't need to ask for troika help to finance said rollover.

    So you're right in the sense that risk is being transferred to the eurosystem. But that is, precisely, the purpose of the whole exercise. The periphery governments would be recapturing part of their lost monetary soveriegnty and using it to implement the rollover of their old debts.

    1. Right, but something that cannot go on indefinitely, will not. While the eurosystem can be abused in the way you describe its purpose is clearly not what you describe. Therefore such arbitrage can be, and rightfully will be stopped before it even starts.

      btw, the same can be done with US Treasury and US Treasury even owns a couple of banks but still it does not happen. For good reasons.

    2. Sorry to butt in. Jose, I think what you describe is explicitly forbidden in the ECB's mandate and by the Lisbon treaty, since it is effectively monetary financing of peripheral governments' debt. It also reinforces the toxic feedback loop between domestic banks and their sovereigns - which given the awful state of peripheral banking systems is not really wise.

  19. Hi, Frances.

    I'm sorry but I just can't agree with you.

    There is nothing in the Treaties or the ECB mandate that prevents NCB´s from making advances to commercial banks against collateral provided by said banks. Quite the contrary, it just happens everyday.

    In a periphery country where the government owns a commercial bank (publicly-owned banks also exist in non periphery countries, including Germany, btw) there can be no rule against that bank buying government debt. All commercial banks buy government debt as a matter of course; and state-owned banks are simply normal banks that happen to have the government as shareholder.

    When the government sells debt to its own commercial bank and uses the corresponding deposits to pay off maturing bonds held abroad it is not creating any new "money". The deposits are used to settle an old debt, not to pay for new government expenditures. In this sense, they are similar to currency held in banks' vaults - they are not "in the hands of the public". They end up as a liability in a foreign commercial bank's books - the bank that holds the maturing bond. This new liability is then cancelled alongside the maturing bond in the banks books.

    In the process, the foreign NCB will acquire a new liability (the new deposit - reserves - of the foreign commercial bank) and create a new asset in the form of an advance of funds to the periphery NCB.

    And the periphery NCB will have to create a new asset: an advance of funds to the government-owned bank. This advance will provide that bank with the necessary reserves to make payments abroad. The collateral will be the newly-issued government bond.

    This is same the process - backed by TARGET2 - that has guaranteed the financing of the periphery countries' net imports since the collapse of the normal interbank lending market in 2008-2010. The same process that has "financed" the massive flight of deposits from Spain and Italy to Germany in the last year or so. It can also "finance" the rollover of periphery public debt held abroad - if the periphery governments are smart enough to use their own commercial banks for this purpose.

    And yes, this will help said governments to eschew the "aids" of the troikas that carry a terrible cost: the destruction of entire economies and countries via irrational austerity.

    What could be wrong with that?

    1. What is wrong with that is that in order to buy the newly-issued debt the state-owned commercial bank would have to borrow from the Eurosystem. So the Eurosystem would be financing the government's debt rollover via the state-owned bank. If it were done via privately-owned commercial banks or foreign banks it would be acceptable, even though it is a fudge (indeed the LTROs were used in exactly this way). But to use a wholly state-owned bank as a conduit for Eurosystem money to reach government is a breach of both the ECB mandate and the Lisbon treaty.

    2. Eurosystem can finance only current account deficit. It does not and cannot finance government debt as such because within the same country it is a wash. Whether government owned banks use this option or not is irrelevant. Banks in general hold lots of government debt and nothing can stop them from holding even more. However the "wash" becomes a ponzi as soon as there are leakages to other countries within eurozone.

    3. Ok, I'll try to reply to your points step by step.

      " order to buy the newly-issued debt the state-owned commercial bank would have to borrow from the Eurosystem".

      Not exactly; the state-owned bank will only have to borrow from the eurosystem if it uses the deposit created by the bond sale to make a payment abroad.

      "...the Eurosystem would be financing the government's debt rollover via the state-owned bank".

      There's nothing wrong with that. The eurosystem has been financing net imports of the periphery and massive capital flight from the PIIGS. And this at the tune of hundreds of billions of euros a year. It could accommodate with no problem a few extra billion euros of government debt rollover.

      "If it were done via privately-owned commercial banks or foreign banks it would be acceptable...".

      The European Treaties don't discriminate between publicly-owned, private sector owned, domestic-owned or foreign-owned banks. And rightly so - a bank is a bank, independently of who is its owner(s).

      "...even though it is a fudge (indeed the LTROs were used in exactly this way)"

      Well, I don't think there was a fudge. But if it were so, why should a fudge by the ECB itself (the gatekeeepers of the euro!) be acceptable yet those by mere governments of poor countries subject to condemnation? It would be the height of juridical and logical inconsistency. No court could subscribe to such an interpretation.

      " use a wholly state-owned bank as a conduit for Eurosystem money to reach government is a breach of both the ECB mandate and the Lisbon treaty."

      That's a personal interpretation, again - IMO -inconsistent with the letter of the Treaties. The treaties forbid ECB or NCB buying of government debt in the primary markets only - not in the secondary markets. And in the primary markets commercial banks are free to but any type of debt, including that issued by governments of eurozone countries.

      It´s true that the ECB's publications have deemed open market transactions in secondary markets to be "irregular and exceptional" (see their February, 2011 paper on the implementation of monetary policy in the euro area) - but this hasn't stopped them from implementing SMPs and now announcing OMTs when such policies are needed to prevent the deterioration of the euro crisis.

      Summing up: there is one and only one prohibition in the Treaties - direct financing of governments from central (not commercial) banks. That's all.

      So, my point is the following: it's about time the periphery countries start using the features and mechanisms of the eurosystem to defend their interests and prevent the destruction of their economies via troika-imposed austerity.

      This can be done - while staying firmly inside the eurozone and abiding by its rules.

    4. No, Jose, you are missing the point. No bank can fund a bond purchase from thin air. They would have to borrow from the Eurosystem - probably via their NCB - in order to buy the newly-issued debt. You have missed out the first step in the process - and it is that first step that makes this effectively monetary financing of government. The real issue has nothing to do with Target2 and everything to do with how commercial banks fund themselves.

    5. Well, Frances, I'll have to use your own words to defend my point :)

      A bond purchase is a loan to the government - and loans create deposits, right?

      So the first step doesn't require borrowing from the eurosystem. The bank simply books an asset (loan to the government, represented by a Treasury bond) and a liability (a deposit of the government). All created out of nothing.

      The second step - payment of the bond held abroad - does require that the eurosystem lend reserves to the government-owned bank.

      Anyway, I think you'd like to know that this idea of government financing via a state-owned bank is not mine. I took it from a recent (October, 2011) paper by the well-known PK economist Marc Lavoie where he says this:

      "...a (eurozone) government that is under pressure from international financial markets, having trouble in getting foreign financial institutions to rollover their securities, could direct its domestic publicly-owned commercial banks to acquire new bond issues at the price of its choice (...) The proceeds of these sales, initially held as deposits at the domestic bank, could be used to redeem the securities that foreign banks decline to roll over".

      So I do think that this is a proposal that merits much more detailed study. IMO, it's a scandal that periphery governments have simply ignored this possible way out of the terrible crisis that has been imposed on their countries, with no end yet in sight.

    6. No, Jose. The bank is not lending to the government, it is buying an asset. Yes, the asset it is buying is effectively a term loan, but that is not how the accounting works. It is a purchase, not a loan. No new deposit is created: instead, the bank must either have or obtain sufficient funds to be able to pay government for the piece of paper it is buying. A periphery bank would almost certainly have to do that by means of a repo transaction with the NCB or the ECB.

      I should remind you also that even a direct loan to government would still have to be settled. The bank would have to obtain the funds to physically pay its government the money it has borrowed - or, if it is bounced directly to the foreign bondholder, to pay that bondholder the settlement amount. You really should read ALL of what I wrote about how loan accounting works. Yes, a deposit is created "ex nihilo", but when the loan is settled real funds have to be found, and that is done by borrowing. As I said, this has nothing to do with Target2 and everything to do with how commercial banks fund themselves. The funding requirement applies as much for transactions within a country as it does for cross-border transactions.

    7. "Yes, the asset it is buying is effectively a term loan, but that is not how the accounting works".

      How does the accounting work, then?

      Either loans create deposits, or they don't. It's not possible to have it boths ways.

      Since in my model loans do create deposits, I cannot agree with you when you say that "...No new deposit is created: instead, the bank must either have or obtain sufficient funds to be able to pay government for the piece of paper it is buying".

      This would be the "deposits fund loans" model that you have rightly rejected in dozens of previous postings in your blog.

      IMO, the accounting for the government-owned bank proceeds in the following way, along the process:

      Step one (buying the government bond):
      Assets: + government bond ; Liabilities: + government deposit

      Step two (sending payment abroad, 2 simultaneous accounting entries):
      Assets: minus reserves at NCB; Liabilities: minus government deposit.
      Asset: + reserves advanced from NCB; Liabilities. + advance of funds from NCB.

      At the end of this process the bank's books will be like this:
      Assets: + government bond; Liabilities: + advance of funds from NCB.

      So the funds to send the payment abroad come from the NCB - it sends the needed reserves to the commercial bank and assures the payment will proceed smoothly and reach another eurozone country.

      Just what it takes to guarantee that the eurozone is - and will always remain - a single currency area.

    8. Sorry, I forgot to add the following comment on your reply:

      "...this has nothing to do with Target2".

      It does involve TARGET2 the moment the payment to the foreign bondholder is made (using the newly-created government deposit).

      The foreign bondholder - let's say it's Deutsche Bank - will have a new asset on its books (reserves at the Bundesbank) and a new liability (the periphery government's deposit). And the Bundesbank will have a new liability: the deposit of the Deutsche Bank.

      The Bundesbank will thus have to create an asset to balance its books: an advance of funds to the periphery NCB.

      At the end of the day, this advance will become a credit on the ECB - and the periphery NCB will also have a debit position towards the ECB.

      And these entries on the accounts of the eurosystem (NCBs and ECBs) constitute TARGET2 balances.

    9. Jose,

      What is it about "it is an asset purchase, not a loan" that you don't understand? The asset is bought. To buy something, the bank has to have funds - it can't invent them. "Fractional reserve" - loans creating deposits - applies to lending, not asset purchase. A commercial bank can no more create money to fund purchases than you can. It has to have funding or it can't make those purchases. Why do you think LTRO money was used to purchase new Spanish debt? According to your accounting Spanish banks could have purchased that debt without the LTROs - they could simply have created the money. It doesn't work like that. You must account for it in exactly the same way as any commercial institution making an asset purchase would:

      DR Cash
      CR (Financial) assets

      funded by:

      DR Loan account
      CR Cash

      The effect is that money is borrowed to finance the purchase of an asset. However, as banks don't have loan accounts (credit facilities), the funding entries would arise from a real interbank loan or NCB repo transaction. You can't simply assume this away.

      Because the government has an account at the bank, you then treat the payment to the government as a customer deposit, just as if a government official had come into a branch and deposited the money at the cashier's desk:

      CR Government deposit account (liability)
      CR Cash (asset)

      The end result is that the government has a new deposit which is effectively fully backed with cash (like full reserve banking), and the bank has purchased a new financial asset funded by borrowing from the NCB. The NCB has therefore indirectly funded the government's new debt issue. If the commercial bank were a private or partly state-owned organisation it could be argued that the NCB's funding was for the bank, not the government. But a wholly state-owned bank is an arm of the government, so NCB providing funding to such an institution specifically for the purchase of government debt cannot be seen as anything other than monetary financing of government - which is illegal under the Lisbon Treaty.

      Your settlement accounting with the foreign bondholder using Target2 is correct. But as I keep saying, that is not the point. The real issue is the fact that bank asset purchases have to be funded.

      If the commercial bank lent directly to the government, rather than purchasing assets, your accounting would be correct because the loan would be self-funding. But the NCB would still have to advance funds to the commercial bank, just later in the process. It could therefore still be argued that this is monetary financing of government - and I have no doubt that the Bundesbank would argue exactly that. The legality of such an arrangement involving a wholly-owned state bank could be challenged in the courts.

      Please don't misunderstand me. I think the rules preventing central bank financing of governments are totally bonkers and causing serious tensions in the Eurozone. But as far as I can see your solution would require treaty change.

    10. Well, I suppose we have to define precisely what's the difference between an asset purchase and a loan - and then decide whether banks can or cannot make loans to governments and create deposits for governments in the process.

      I´d really like to know what are, in your opinion, the rules or regulations that prevent a government-owned bank (or any bank, for that matter) from making a loan to the government and simultaneously create a deposit owed to the same government?

      Why is it that, in your view, any bank can lend to entities such as households or firms thereby creating deposits "out of nothing" - but cannot proceed in the same way with an entity called "government"?

      Anyway, if we can agree that it's at least conceivable to assume a situation where a bank is lending "created out of nothing" funds to a government there remains the question of deciding whether this could be seen as an instance of the monetary financing of governments forbidden by the euro treaties.

      I'd answer that it's impossible to tell in advance what would happen, because systematic rollover of government debt held abroad by using a government-owned bank has never been tried before.

      But I very much doubt the Bundesbank would complain, because while it's true that the German NCB would be accumulating credits over the eurosystem it's also a fact that this would happen for a good cause - that of guaranteeing that a German commercial bank will have its bonds being paid off at maturity.

      It would simply be another post-2008 instance of the banking sector of Germany transferring risks to the public sector - life as usual, considering the precedents :)

      Summing up:

      1. Can a commercial bank lend directly to a government, just like it does for a household or firm?

      2. Could such lending be seen as a violation of articles 123 and 124 of the Lisbon Treaty


      3. Would this be a violation only when the lending bank is government-owned (at this point we'd also have to decide on the threshold - whether it's, say 51%, 90% or wholly government-owned) or would it also apply to lending by private sector commercial banks?

      These would be the questions to consider for a periphery government willing to analyse all possible strategies to escape from austerity.

      I hope you and I can at least agree on this summary.

    11. Commercial banks can in theory lend directly to governments. I'm just pointing out that the accounting for asset purchase does not create money in the way that lending does, so the bank must be funded in advance of the purchase. I would also like to point out that a loan to government would also have to be funded at time of settlement if the government wished to use it buy back debt held by domestic creditors and those creditors' deposit accounts were not held at the same bank as the one making the loan. The need for NCB funding is not limited to cross-border transfers.

      I think your three points are a reasonable summary. However, I disagree with you that the Bundesbank would not object: the Bundesbank has a horror of monetary financing of governments and would rather let banks go bust and sovereigns default than allow anything that smacked of "printing money" - which is how they would inevitably see state-owned banks lending newly-created money directly to government.

    12. Well, I'm glad we can agree that commercial banks may lend to governments in the primary market - creating new deposits for the government in the process.

      And of course it's true than an asset purchase - say, the bank buying a Treasury bond in the secondary market - has different accounting entries since in this case the bank is not lending funds. It's buying a pre-existing asset from a third party (likely an institutional investor such as a pension fund) and it does have to possess in advance the necessary funds to buy said asset. In this case, it was the third party - not the bank - who lent funds to the government in the first place.

      As for what happens at the time of settlement - or more generally at the time the government uses its deposit in the commercial bank to make payments, either at home or abroad - the bank will credit reserves and debit a deposit. It will have to compensate for this negative position in reserves by borrowing from the central bank. And in the absence of a normally functioning interbank market (Europe post-2008) the NCB will simply have to lend said reserves back to the bank if it wants to keep the payments system working smoothly.

      Finally, we have the question of the putative negative reaction from the Bundesbank.

      I'd advise the periphery government to not pay any attention to the usual whining of the German NCB.

      Let it complain if it so wishes. After all, the Bundesbank has been protesting for years against every monetary measure designed to rescue the eurozone - against SMPs, OMTs, you name it - and yet said measures have gone ahead as needed, the German central bank's objections notwithstanding.

      The key point is the following: the Lisbon Treaty only forbids direct financing of governments by central banks, not commercial banks. Any complaint against using a commercial bank (even if fully or partially owned by a government) to fund the rollover of debt held abroad by transferring it to TARGET2 balances would have to be argued in court. It would be a true juridical battle. And I think it's fair to say that there would be a non trivial probabibility that the government might win said battle.

      So, considering what is at stake - overcoming destructive austerity policies in the periphery - it's reasonble to conclude that the government should go ahead with the process.

      In other words: just do it!

    13. I´d really like to know what are, in your opinion, the rules or regulations that prevent a government-owned bank (or any bank, for that matter) from making a loan to the government and simultaneously create a deposit owed to the same government?

  20. (Second set of answers)

    "Eurosystem can finance only current account deficit. It does not and cannot finance government debt as such because within the same country it is a wash."

    Right. Debt payments inside a country do not call for financing from the eurosystem. This financing only takes place if payments are made outside the borders of a country.

    "However the "wash" becomes a ponzi as soon as there are leakages to other countries within eurozone."

    Why Ponzi? If the government of a country pays off maturing debts held abroad the balances of TARGET2 will automatically increase. But said balances are limitless and have no maturity. This has to be so in order for the eurozone to survive. It's an indispensable feature, not a bug of the system.

    If there were limits on the balances - say, a trillion euros - then an agent trying to transfer the trillioneth and first euro out of a eurozone country and into another would not be able to do so.

    This situation simply cannot and will not arise - because the day a euro in a member country cannot be freely transferred to another member country the eurozone will have ceased its existence.

    Just like a dollar in Tennessee will always be transferrable to California or New York - otherwise, goodbye dollar area (the U.S.).

    The presence of the well designed TARGET2 system guarantees that settlement and clearing of payments can proceed smoothly and with no limit inside the eurozone.

    1. Jose, You need to make contact with Neil Wilson, who I think explained this in exactly the way you have a year or more ago on Warren Molser's website. I think you have been very clear, thanks.

  21. Surely eurozone and eurosystem is not the same as the US states and US government. There is no point in comparing them or discussing this topic.

    1. The U.S. and the eurozone are alike as far as the following feature is concerned: a territory where a single currency is accepted as legal tender for the payment of taxes.

      Of course, apart from this common point they are very different from each other.

  22. I'm obviously a bit late to this discussion, but found this post very enlightening nonetheless. Although I've tried to present a similar position before, this is far more comprehensive and deserved linking for a hopefully broader audience

  23. I have difficulty with this. Let's start from the premise that loan margins are set in order to maximise absolute bank profits. Ceteris paribus, any increase in margins will reduce profits by reducing demand for credit and with it loan volumes. Likewise any reduction in margins offsets any increase in volumes. If Danish banks raised margins in response to the imposition of a negative rates, this implies the market is far from competitive, according to the following logic.

    A negative rate is, as you point out, a fixed absolute cost for the banking system to bear because the volume of reserves is set by fiat. Now, for variable costs, ones that increase with lending activity (eg bank funding costs), the return on lending earned by the banking sector must, overall, also increase so as to preserve system-wide profitability. While (ceteris paribus) this will reduce borrowing, this is the necessary outcome in a competitive market because lending carries a higher cost. Lending has to fall.

    But as a matter of definition, costs that do not vary with lending do not fall if lending is reduced. So raising margins would have to offset at least in full the depressive effect on revenues of reduced lending, else system-wide profits will fall. And if this offset is achieved, then there would be no reason to wait until fixed costs have risen in order to achieve this efficiency. So the negative rate on reserves cannot account for the increase in margins observed in Denmark following this event - which is more likely to reflect banks colluding to blackmail policymakers.

    Imposing a negative reserve interest rate increases the costs on the banking system. But unlike a simple tax on bank profits, it falls most heavily on banks with the highest reserve ratios. Therefore individual banks will seek to reduce this ratio, trading any gains made against reductions in their liquidity/funding position. Plus ca change...if this increases overall bank lending, as it should, then this might be a useful outcome

    1. Margin rises don't necessarily reduce profits, if the demand for loans is greater than the banking system's willingness to provide them - which is the case in Denmark, which is experiencing inflows of money from the Eurozone. The relationship between lending volumes (demand) and margin is rather more complex than you suppose, not least because the banking system is not a free market - it is possibly the most rigged and regulated market in the world.

      There is little chance that banks would seek to replace risk-free reserves with risky lending. They are much more likely to look for equivalent risk-free assets, as I said in the post. Therefore I do not see any prospect of negative rates increasing bank lending.

  24. I don't think I suggested the banking system was perfectly competitive. I don't suppose you would disagree with me that banks are highly motivated by profits - and owing to public loss subsidy and underpriced liquidity probably much more so than a 'fair' market would tolerate?

    Can you explain why it took negative rates for Danish banks to 'wake up' to the opportunity of raising loan margins profitably - exploiting excess demand for credit - that you contend?

    Your prediction that banks will turn to Treasuries or proxies is reasonable. But holding Treasuries is not a one-way bet for individual banks, not now and not in a negative rate environment. As bonds are steadily bid up in price, holders would be assuming ever-greater interest rate risk (except on short-dated bonds). More pointedly, since bond supply is not limitless, turning to safe assets would also become principal-destroying, and banks would be no more inclined to hold negative yielding bonds than negative yielding base money.

    The response of individual banks to negative rates would probably be to push bond prices up. As you note, while making loans is self-funded by the resultant deposit (at least at inception), purchasing say bonds is quite different in that it needs to be prefunded (unless the bond seller is a customer of the same bank). For an individual bank, as reserves are removed from its balance sheet, this avoids the corresponding cost.

    For the banking system, however, there is no escape. The bond sale proceeds are reabsorbed into the system (if they ever left it), so while reserves may be juggled from bank to bank (your "hot potato"), there is no lightening of the overall tax imposed on the banking system. Unlike other taxes (eg on profits, transactions, etc) taxing reserves leaves the banking system with one method of reducing its overall impact: to expand.

    Therefore buying bonds offers banks collectively no reprieve because this activity does not expand broad money. It leaves systemic reserve ratios unchanged. Your prediction of bond buying may be valid, but it will quickly hit limits, individually (from negative yields/interest rate risk) and collectively (system-wide profitability). So I fail to see any reason to discount an uptick in bank lending following on the heels of such a policy in fairly short order.

    For what it is worth I also don't see much scope for banks to pass the "tax" onto non-banks. Banking expansion spells greater bank lending, all of which will need funding - much of it from depositors. Banks will have to be no less competitive with savers as they are now (however perfect) - and arguably there will be more competition for deposits. By the same token increasing lending requires banks to compete for borrowers too - so lending margins will (eventually) fall. The dead weight loss within banking, a symptom of its monopolistic character, would actually finally be squeezed.

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  26. Like the new background image Frances. Seems like just what the NWO ordered! We'll see.....

  27. get cash
    Lenders always like being able to contact people and the more numbers you offer, the more comfortable they are.

  28. Interesting post thanks.

    The paradox of thrift...

  29. Very good article and research on the neu bubble in the housing market. Continues government interference has gone from being unwise to immoral.

  30. I'm obviously a bit late to this discussion, but found this post very enlightening nonetheless. Although I've tried to present a similar position before, this is far more comprehensive and deserved linking for a hopefully broader audience..!!

  31. Britain is the most highly geared society on the planet (private and public debt combined), and when the markets pull the plug on this island nation, the fallout might make Greece look like a walk in the park.

  32. Thanks Nice and very nice for Article.

  33. Very informative and amazing work, can't imagine the amount of brainwork to sift through all the cause and effect in the economy. :) Are there any other alternative scenarios apart from the doom & gloom scenario?

  34. Hi, I'm re-reading this post in 2020. I'm just curious whether your opinion on how negative policy rate + tax on extra reserves should play out has changed. Maybe better said: now that this is all real, how is reality different than you expected? Or is the final paragraph of this post ... imminent?


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