Alasdair Macleod: All You Need To Know About Negative Interest Rates

On Thursday, the European Central Bank (ECB) took the historically unprecedented step of lowering certain of its interest rates below 0%. In a report to our premium subscribers immediately following the announcement, Chris likened the move to the policy equivalent of dropping a neutron bomb.

In the days following, despite the ECB attempting to clarify its stance further, many questions still linger; most notably: What exactly will the implications of this negative interest rate (NIRP) policy be?

We've asked our European correspondent, Alasdair Macleod, to lay things out in black as white as much as is possible. In this detailed podcast with Chris, he explains exactly what steps the ECB is undertaking, what the most probable ramifications will be, and where the highest degrees of risk now lie: 

The reason we have got into this silly situation  is you have got a two-way pull. On the one hand, you have got the central banks saying we need to get this economy going; which basically means that banks have got to lend to non-financial corporations in the EU in order to get these economies going. This is the sort of standard central bank mantra.

But the banks on the other hand in Europe are horrendously over-geared. When you look at a large bank like Deutsche Bank, you see its balance sheet is something like 55 times geared. I mean, it is enormous. The European banks have on the whole not managed to repair their balance sheets since the Lehman crisis in the way in which U.S. banks have. This leaves the EU banking system fundamentally weak and vulnerable. The banks know it. They would rather hold sovereign debt guaranteed by the ECB. They would rather put money on deposit with the ECB in order to lessen the systemic risk. Because otherwise they will lend it out to their peers and through the interbank market. They are now being told: Look, we will charge you for the facility.

Again, what the ECB is trying to do is they are trying to encourage banks to lend to the non-financial sector.

Now, there is another aspect of this. That is that they are making money available under something called the Targeted Long-Term Refinancing Operations (TLTRO). Now, under this, a bank can borrow from the ECB the equivalent of a bank's loans to the non-financial sector, excluding mortgage lending, at 10 basis points above the ECB's base rate of 0.15%. In other words, if you are a bank, a Eurozone bank, you can borrow from the ECB at a 0.25% for four years until September, 2018. Now the initial sizes of this facility is 400 billion Euros, but there will be further charges available in September and December.

You can see that here we have the ECB on the one hand and the banks on the other. The banks in the system have got the problem that some of the biggies are horrendously over-geared. But unless the ECB can get the economy going, the whole thing is going to fall over. Don't worry about the gearing lads, we'll make the money available. Just go out and lend it!

You can see that this is a very serious development. Just to give you a sort of a little bit of a flavor for the problem from the ECB's point of view. Inflation in the European monetary union has fallen to roughly 0.5%. This is against the target of 2% (bear in mind that the next set of bank balance sheet stress tests assumes the most extreme adverse scenario is an inflation rate of 1% percent...)

So, we are already at 0.5%. From the ECB's point of view, they are looking at something which is terrifying them: that's deflation. If you get deflation, then sovereign debt ratios are likely to spiral yet higher despite any austerity packages that countries like Spain or Italy might bring in. To illustrate this point, I think I am right in saying that today the Italy, Holland, and the Portuguese economies actually contracted in the first quarter of 2014. France, which was a biggie had zero growth. Now, you can see that if you have got declining and sort of falling prices in this environment. How and if you look at prices relative to the mountain of debt that these countries how, you can see that suddenly all sorts of ratios start looking very nasty. It is that, I think that the ECB is absolutely desperate to stop.

The reason they have announced NIRP the way they have is they want to drive the Euro lower. I think they feel that if they can have a lower Euro, then that will stop prices falling and indeed hopefully perk them up a little bit. But this whole idea is killing savings. I mean, central banks have been trying to do this ever since they have bought into the Keynesian theories. It has got us into a cycle of just worse and worse credit defaults. They are giving the medicine which historically has been proven to kill us. They are just doubling the doses.

This is not going to succeed, I fear. I'm not sure that the very short-term benefits that you sometimes see when they ease a currency are likely to follow through, because the whole point about driving a currency lower is that you persuade people against all reason that things are looking better. Businesses will employ people because they see that their margins are improving. They can start selling things again. That is the sort of basically the Keynesian mean.

At this point, I think this has been tried so many times that industry in the Eurozone and indeed elsewhere is no longer persuaded by this argument. I think everybody is now sitting on their hands and saying well, we actually do not really want to do very much. Because we just see risk, risk, risk. I don't think that the ECB can actually get around that fundamental problem with these latest measures. Everybody still sees risk. It may drive the Euro lower which may rescue the inflation rate from falling below 0.5%, but I really don't see that it is going to be more effective than that.

You see, Mario Draghi (the head of the ECB) is dealing with is a post Keynesian-world where our problem of Too Much Debt cannot be admitted. His objective as an appointed head of a central bank is to keep the show on the road at all costs; that's really what we are talking about. The level of debt and the amount of mal-investment in the whole system is immense. At the same time, they're killing all of the savers.

Here again, instead of doing what is the sensible thing to do -- that is, for us to save rather than spend -- they are doing the reverse. That they are effectively eliminating savings from the system and replacing it with newly-printed fiat money and bank credit. That's the attempt, and I have to say that I think it's bound to fail.

The ECB now finds itself on the cusp of this failure. Remember, there are some very big banks with gearing over 40-50 times. All you need is a fall in prices of 1%, 2%, or 3% for a few companies to go bust, and then those banks are no longer solvent. It is a nightmare scenario. It really is.

Click the play button below to listen to Chris' interview with Alasdair (55m:48s):

This is a companion discussion topic for the original entry at

Interesting how the ECB "loan" estimates are inline with the IMF's SDR powder keg.  So if the IMF SDR get exhausted (these loans go down a drain) what happens after that?

[quote=KugsCheese]Interesting how the ECB "loan" estimates are inline with the IMF's SDR powder keg.  So if the IMF SDR get exhausted (these loans go down a drain) what happens after that?

Anyone know what US bank gearing (leveraging) is?   Bear-Stearns was 37 when it imploded?  Gearing for Everyone saves the system?

McLeod is poorly informed. The ECB's intentions are not what he thinks. 
Commentators in the English-speaking world refuse to see that the ECB is on a radically different to path to the Fed. Mr Martenson and Mr McLeod make the mistake of viewing the ECB through the dollar lens (where nominal performance at all costs means they have no choice but to print money until their curriencies die) ... 
Mr McLeod ; why do you think the US banking system is in better shape the EZ's? Is it all the freshly printed 'capital' they were given? The ECB did not do the same (except some liquidity, as the system was not ready for EZ wide bail-ins). Soon it is ready : Deutsche Bank will be reduced to a speck of dirt. Plus many others ...
The ECB is going to radically shrink the EZ banking system - bail-ins are coming. Only approx. 5 per cent of EZ citizens have more than €100k in a bank (that number is decreasing) so it will not end the world.
Once again : bail-ins are coming to the Eurozone but NOT to the US or UK. This will strengthen the Euro, not weaken it. Also severing the links between sovs and banks.  
While the Fed and Bank of England save their banking systems and destroy the currency, the ECB is shrinking the banking system and protecting the currency. Which track would you prefer to be on? 
Mr.McLeod, I would like to make a bet with you (any stakes you like) : the Euro will never weaken significantly against the USD from here and we will soon see 1.45 ~ 1.55 ... After that gold and oil will no longer be priced in USD. 
Eventually, perhaps when Fed Reverse Repos spiral out of control (US rates MUST be kept positive at all costs, so that the world has a nominal risk-free asset), global capital will try squeeze into the Euro (inflows like the Swiss had 2 years ago, but X times bigger). 
Hold onto your hat Mr McLeod as the ECB will start purchasing gold on the open market as THEIR way to manage liquidity. What? They haven't told you in advance? 
Imagine what the reaction will be!
Imagine the gold price! 
Watch for the new economic system BuBa, ECB and BIS bring in as the dollar dies. Asia and the Oil countries already support it. A system that does not pretend inflation is the same as growth. 

It seems to me all the questions that are asked about a broken toys and then trying to fix the problem with another broken toy only to find out to broken toys  fixing broken toys will not create a fixed toy. 
Great you can talk about all the exchange systems I think you are asking the wrong questions thinking you will get the right answers. The real problem facing humanity is  Perceptions Trickery giving great advice. 

Wake up humans… Information is moving to fast, to deep, to wide, and density getting very heavy. The problem is human not understanding we live in 1 world manipulated by countries, corporation, and banks. Deal with the problem. The speed,depth, width, and density  of misinformation. I like the call and so what? 


Lets think about increases in bacon and beef prices for a moment.
Bacon up 53%, ground beef is up 35%. But what is the farmer getting? Getting barely cost recovery normally and below cost of production if they're forced to buy stock feed in a drought.

Say's Law assumes that there are perfect markets. A few big supermarket chains and meat processors in most national markets, makes the timely transmission of market signals back to the farmer, near impossible. Another example of broken markets. Remember it was the failure of Say's Law in the 20's and early 30's that lead to the dominance of Keynesian thought until the late 60's.

Keynes is taken out of context too often. He was born in 1883 and died in 1946. He dies early at 62, we never got to see what he would have advised in a booming post WWII economy. More importantly, he never lived in a world of (long term) increasing energy prices. His work is important, but often taken out of context, by both his detractor and 'follower'.