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Home / S. Sumner: Money Illusion / The ECB cut its IOR to minus 0.5%; it should have been minus 50%

The ECB cut its IOR to minus 0.5%; it should have been minus 50%

Summary:
The ECB should stop playing around with negative interest rates and simply put a prohibitive tax on excess reserves (something I proposed in 2009). If a small amount of excess reserves are needed to clear interbank balances, then exempt a modest amount of bank reserves from the negative 50% interest rate (aka 50% tax rate.)   It’s time to abandon interest rate targeting and move to a monetarist approach to policy. In the short run, this heavy tax would lead banks to convert deposits at the ECB to currency. To some extent, they’ve already been doing so under the minus 0.4% deposit rate: The interest rate on the ECB deposit facility was lowered to 0% on 11 July 2012. It was then lowered by a further 0.10 percentage point on 11 June 2014, on 10 September 2014 and again on 9

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The ECB should stop playing around with negative interest rates and simply put a prohibitive tax on excess reserves (something I proposed in 2009). If a small amount of excess reserves are needed to clear interbank balances, then exempt a modest amount of bank reserves from the negative 50% interest rate (aka 50% tax rate.)  

It’s time to abandon interest rate targeting and move to a monetarist approach to policy. In the short run, this heavy tax would lead banks to convert deposits at the ECB to currency. To some extent, they’ve already been doing so under the minus 0.4% deposit rate:

The interest rate on the ECB deposit facility was lowered to 0% on 11 July 2012. It was then lowered by a further 0.10 percentage point on 11 June 2014, on 10 September 2014 and again on 9 December 2015. These decisions did not have a noticeable impact on the amount of cash held by MFIs (i.e. in their vaults and in cash dispensers, referred to as vault cash) until 16 March 2016, when the Governing Council decided to lower the interest rate on the ECB deposit facility to ‑0.40%. This decision represented a pivotal point for some MFIs, after which they decided to convert part of their liquidity into cash, as illustrated in Chart A. For these MFIs, the costs of cash (i.e. costs associated with cash storage and handling) were obviously less than the losses resulting from the negative yields from the ECB deposit facility and current accounts held at NCBs. An average of €50.1 billion was held as vault cash by MFIs between January 2008 and March 2016. Between March 2016 and December 2017 the amount of vault cash held by MFIs increased by €21.1 billion and reached €76.8 billion, i.e. 6.6% of the total value in circulation. The increase in vault cash was mostly driven by German MFIs (69.4% of the increase) and, to a lesser extent, by Italian, French, Austrian and Spanish MFIs.. .

This increase in vault cash has, however, remained limited. Logistical constraints such as storage capacities or maximum amounts covered by insurance are the most likely limitations on MFIs holding larger amounts of cash.

This 21 billion euro increase in vault cash is trivial. Less than 2% of bank reserves have been converted, despite the strong incentive to do so. If banks are forced to hold almost all of their vast reserves in cash, then interest rates may fall further. But why stop there? Apply the 50% tax to excessive bank cash holdings as well as reserve deposits at the ECB. This will force the currency out into circulation. Large institutions will now hold more currency, but they also have their limits:

Big institutions and individuals are finding creative places to put their cash and avoid negative rates. Banks including UBS Group AG received some requests, even recently, from big institutional and wealthy private clients to withdraw cash from their accounts and hold it in physical notes in their vaults as a way around negative interest rates. For very big amounts, this has generally not been possible, while for smaller amounts it has been done. Money kept in cash limits the effectiveness of negative rates.

The cash will become a hot potato, and increasingly end up in the hands of many individuals and small businesses. Because interest rates on their bank accounts will be substantially negative (more than 100 basis points negative), European savers will search for alternative investments:

In Switzerland, some individuals are putting cash into real estate, prompting fears of overbuilding. “Holding cash,” said Swiss Bankers Association chief economist Martin Hess, “is simply more expensive than building an empty house.”

The hot potato effect will continue until NGDP starts rising rapidly. At that point, nominal interest rates will rise above zero and the ECB’s main problem will be holding down inflation. In the long run, my plan will give savers higher nominal returns than the current policy regime. Actually, if the ECB were truly serious about this then interest rates would rise even in the short run.

Ultimately, the ECB needs to make a decision on the “socialism or inflation” question. Which do they dislike more, higher inflation of a bloated balance sheet? I can’t answer this question for them—it’s a political decision for the Europeans to make.

PS. Completely off topic, here’s a brain teaser:

At precisely 3pm today, Monday, September 16, 2019, I will be in the second largest city in the third largest country (by area) in the world. This country also has the world’s largest GDP. Where will I be?

The hard part of this question is that there are two correct answers.

You can be in two places at the same time.


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Scott Sumner
Scott B. Sumner is Research Fellow at the Independent Institute, the Director of the Program on Monetary Policy at the Mercatus Center at George Mason University and an economist who teaches at Bentley University in Waltham, Massachusetts. His economics blog, The Money Illusion, popularized the idea of nominal GDP targeting, which says that the Fed should target nominal GDP—i.e., real GDP growth plus the rate of inflation—to better "induce the correct level of business investment".

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