Negtive Interest Rate in Europe.

As many have noted, the European Central Bank, or ECB, just announced negative interest rates on money held with it. The ECB announced this because the inflation rate in Europe has come dangerously close to deflation. The ECB is concerned with a deflationary spiral taking hold in Europe and damaging the world's economy. A deflationary spiral is when prices drop encouraging people to save more and spend less. This would further depress the economy and accelerate deflation. As no one buys anything unnecessary, anticipating their cash to gain value, the economy shrinks, people lose their jobs and output recedes.

Much of the current commentary focuses on how the negative interest rate is supposed to stimulate lending. Basically, since the negative rate penalizes banks saving excess funds with the ECB, they will need to do something else with that money. This something else, the ECB hopes, will be investments that grow the economy. The problem here is that there are a ton of things banks can do with the money that have no impact on global growth. Because of banking regulations, a large portion of bank holdings have to be in government debt. So the most likely effect will be that short term excess funds will be used to buy short term government bonds, which still yield a small return on investment. Unfortunately, this is not the lending the ECB wants. The ECB wants these banks to lend to private businesses to fund hiring and wage increases. Unfortunately, lending to private companies is risky and current banking law discourages it in favor of government debt. So the likely effect of this rate change is, at best, psychological.

The real problems in the European economy do not stem from banks not lending, and as a result, this policy change is not going to be a panacea for the worlds economy. The problem most of Europe faces is that the cost of doing business on the continent is much, much higher than it is in the developing world, or the third world. As a result, there has been little growth in employment or wages over the years. More over, Europe has one of the most protected labor economies in the world. It is very expensive to hire workers there, and very difficult to downsize operations once they are opened. This acts as another regulatory impediment to growth. Without loosening the labor economies on the continent, lowering regulatory barriers to entry and exit and generally lowering the cost of doing business in Europe, companies are going to have a strong incentive to move their operations out of Europe. While this pressure remains, European recoveries, if they exist at all, will be tepid, regardless of what the ECB interest rate policy is.