Europe Tries Hat Trick

March 27, 2014 Updated: April 24, 2016

Many people complain about the lackluster recovery in the United States. Guess what, it’s even worse in Europe and the European Central Bank (ECB) is partly to blame.

This is why Finland central bank Gov. Erkki Liikanen pulled out the bazooka option Tuesday. He said the ECB might impose negative rates on deposits that banks have with the central bank. The objective: To force banks to lend out money so the economy can grow.

“The question of negative deposit rates, in my mind, isn’t any longer a controversial issue,” he told the Wall Street Journal.

The only problem is that this gimmick will not work. Deposit rates have been zero for almost two years and lending in the eurozone is not happening. In fact, it has very little to do with the rate the ECB charges for parking money there, and more with the way the ECB chose to inject liquidity into the banking system.

Long Term Loans

When the crisis in Europe reached its climax at the end of 2011, the ECB injected $1.38 trillion (1 trillion euros) into the banking system through three-year loans at a low rate.

This alleviated the stress in the banking system as weak banks could get liquidity directly from the ECB and repay lenders who would not lend them money because of the risk. So the money moved from the ECB to the weakest lenders to the strongest lenders. But where did it go next?

Since these loans represent balance sheet entries in a double-entry accounting system, they can’t just disappear, like a box of euro bills buried in the yard. Instead, the loans move higher up the lending chain until they reach the strongest borrower, the ECB itself.

In order to balance its books, the ECB has to provide a deposit facility—similar to the Fed’s excess reserve entry—where the strongest banks that don’t need any funding and are risk averse can park their cash.

By definition, they have to do this, no matter how low the rate is and even if it is negative. So deposits with the ECB won’t decline. It is uncertain whether penalizing the banks that ultimately end up having to give their excess liquidity to the ECB is conducive to boosting lending growth.

In fact, the deposit facility won’t decline until the loans get repaid. But that’s not good for lending either because liquidity will decline.

Like the Fed, the ECB can inject money into the system, but it can’t force banks to lend.