Economic Problems: Negative Interest Rates and Deflation

Since the 1960’s Europe has feared inflation, rather than its opposite – deflation. Germany in particular has been stringent in its policies to protect the value of savings, pensions and avoid the buildup of personal debt.

Now a new spectre is beginning to haunt the Euro zone, particularly in those countries where the economic recovery is stagnant and unemployment remains high. In Spain, France, Italy, Ireland and Greece the growth rate for 2014 was below .2%. All these countries have failed to reach their forecast rate of growth in 2014.

Basically, deflation is a general decline in prices along a supply chain. The mechanism works as follows: persistent unemployment, coupled with low wages reduces consumption, and prices fall. Individuals and firms postpone purchases in the expectation that prices will fall even further in the future. The cash flow of firms declines, but costs such as wages, rents, interest on loans and mortgages continue at the same level and profits fall.

In the initial stages of deflation, firms may cut or freeze wages and delay payments along their supply chain. Staff are then laid off or put on short-time work, further reducing consumption and creating employment. In the end, general recession and/or negative rates of growth are the result. Japan experienced the onslaught of deflation in the 1990’s and still remains a weak economy.

The strategy of the European Central Bank (ECB) is to lower interest rates to zero and impose “negative rates” on bank deposits, i.e. the ECB  will charge an interest rate on the deposits held by the wholesale banks. Banks will then suffer a double whammy: holding deposits and not lending, plus the loss of savings deposits because savers will not find it worthwhile to deposit their money with the bank. As well as using negative rate charges, the ECB can also attempt to stimulate activity through quantitative easing – printing money for the banking system to increase loans. ECB boss Maro Draghi has also released 400 billion Euro’s (£325 billion) to lend on condition the banks lend it to businesses outside the financial sector.

If these strategies do not work (i.e. if the banks fail to lend money to businesses for innovation and growth), there are very serious political and social consequences, including perpetual high unemployment, increased bankruptcy, anti-migrant riots and the growth of nationalist xenophobia, increasing the threat to the integration of the Euro zone and its currency.