On October 17th, the European Central Bank announced another cut to its policy-setting interest rates:
The Governing Council today decided to lower the three key ECB interest rates by 25 basis points. In particular, the decision to lower the deposit facility rate—the rate through which the Governing Council steers the monetary policy stance—is based on its updated assessment of the inflation outlook
This was the third rate cut this year: in June, the ECB cut the deposit facility rate from 4% to 3.75%; in September the rate was cut again by 0.25 percentage points; after this most recent cut, the deposit facility rate is now down to 3.25%.
It is unlikely that the ECB is done cutting rates; euro zone residents can in all likelihood look forward to 2025 as the year when their central bank returns interest rates to the 2.5% neighborhood. The main reason for this is the perennially stagnant euro zone economy (a detailed analysis coming next week), which leads to higher unemployment and worsening public finances.
When the ECB decides to cut interest rates, its hope is a two-fold strike to solve both these problems. Lower rates stimulate credit-driven consumer spending and, some economists still believe, business investments. The lower rates also make it cheaper for governments with budget deficits to borrow money, thus alleviating the burden of public debt. Furthermore, if the ECB achieves the former, there will be an uptick in overall economic activity, which in turn generates more tax revenue.
This is the scenario that the ECB is hoping for. It is also the scenario that investors in euro-denominated government debt seem to prefer. Figure 1 reports the ECB’s deposit facility policy rate (blue) and the market yields on euro-denominated ten-year treasury notes (red). For most of the past ten years, the market has preferred higher rates than what the ECB has offered but last year, the two shifted. For 2024, the market yield has been significantly lower than the ECB’s policy rate—and this is important:
Figure 1
Investors in euro-denominated debt do not see the ECB’s comparatively high rate as sustainable in the long term. The general view is that those high rates were necessary to curb high inflation, which means that now that inflation is back to near-stabile levels, interest rates also need to come down.
More importantly, there is a widespread worry in Europe, among both business leaders and politicians, that there will be serious consequences of the continent’s perennial economic stagnation. The political battle in France over higher taxes on ‘the rich’ is one example; another one is the slow-moving economic panic among German politicians.
I have previously argued against lower interest rates, in both America and Europe. I stand by these arguments, even as both the Federal Reserve and the ECB make their rate cuts. For three reasons, I am particularly worried about the consequences of lower rates in Europe.
First of all, there is the interaction between low interest rates and political expediency. When government has to pay high interest rates to borrow money, legislators are forced to make hard spending priorities, which leads to very tough political battles. By contrast, with low interest rates, government can borrow ‘affordably’ and politicians can come across to voters as ‘preserving’ social benefits rather than cutting them.
Since it is always nicer—and better for your re-election campaign—to be viewed as good-hearted by your voters, low interest rates create strong incentives toward deficit spending. If the macroeconomic context is bad, i.e., economic growth is slow, or even negative, and unemployment is high, there is no independent force at work to slow down borrowing. Put simply: tax revenue has no chance of keeping up with government spending.
In this situation, the risk of a fiscal crisis will grow rapidly; once again, it is pertinent to remind all elected officials about what happened in Greece 10-15 years ago.
Second, these low rates will not at all have the strong positive macroeconomic effect that conventional-wisdom economists will have us believe. When economists try to predict the effects of policy measures such as a lower interest rate, they do so based on a series of premises that are either dubious or outright false. One of those premises is that an economic stimulus of a certain size—in nominal terms or percentage-wise—will have the same effect as an economic contraction of the same magnitude.
It is also assumed that both the positive and the negative effects take the same amount of time to materialize.
This is wrong. An economic stimulus like a rate cut almost always takes longer to proliferate through the economy than an economic contraction. The reason for this is simple: people are risk-averse and will hesitate before spending more money—in particular if they live in, or have recently encountered, genuine uncertainty in their personal finances.
That type of uncertainty is prevalent in much of Europe today, which contributes to the continent’s economic standstill. Therefore, those who hope for a significant positive consumption multiplier from lower interest rates are hoping in vain.
The last reason why I am opposed to lower interest rates in the euro zone is the risk of a return of inflation. I am particularly worried that a very weak macroeconomic stimulus from the lower rates, combined with more deficit spending, will eventually open the faucet where the central bank provides direct financing to indebted governments. Deficit monetization is without competition the fastest and most uncontrollable way to cause inflation.
With all that said, the ECB is on a rate-cutting spree that will probably not end until early next year, and everyone in the euro zone will have to prepare for its consequences.
