There is a lot more the ECB can do

So far, the debate on negative interest rates completely misses the point. If the private sector could borrow at long maturities at negative interest rates, banks could be profitable, and savers didn’t experience a fall in income, it is highly likely there would be an acceleration in demand. The problem is with negative interest rates as currently implemented – which is primarily as a tax on bank deposits held at the central bank.

Most people, quite understandably, don’t know know what central banks are actually doing when they set interest rates at negative levels. It certainly doesn’t mean that mortgage rates are negative – which would be a stimulus – but it does mean a negative interest rate on many forms of savings, such as government bonds in Europe.

So what are central banks doing? They are setting negative interest rates on deposits which banks hold at the central bank. Many economists seem delighted that central banks have pulled off this trick, forgetting to ask the obvious: will it work? Financial markets have delivered a worrying verdict. Martin Sandbu, has argued that pessimism may be exaggerated, and Miles Kimball thinks CBs just need to go further. Would it be a stimulus to consumers if banks started charging negative interest rates on their deposits? At first glance, the opposite is true – this is analogous to raising taxes.

So what can the central bank do? What no one seems to be discussing at the moment is that setting negative interest rates on deposits held by banks at the central bank is by no means the most effective interest rate for central banks to be changing – for the obvious reasons we have just outlined, and many others. What central banks should be trying to achieve is to reduce the cost of borrowing to the private sector, while leaving bank profitability at worst unchanged, and at best improved. Furthermore, it would be ideal to keep the return on savings reasonably constant.

In fact, this is extremely easy to do. Central banks also charge interest rates on the rate at which banks can borrow from them. This is the interest rate that needs to be cut – not the rate at which deposits are remunerated.

So here is what the ECB should do: TLTROs are targeted long-term loans which the ECB has provided banks in the past. It needs to do the same again – at negative interest rates and for longer-maturities, and targeted at household borrowing, including mortgages, and corporate investment.

To make it very clear that this would boost the economy, consider the following: the ECB announces a €1trn 10-year ‘TLTRO’ at -2% interest rates, which banks have to lend to the private sector for at -1%. At the same time, the ECB raises the deposit rates on bank reserves held at the ECB to zero.

What would happen? There should be a rise in the return on conventional savings invested in government bonds – because the deposit rate has risen. That is a good thing. At the same time the cost of debt to the private sector has fallen sharply – no one in the private sector is currently borrowing for 10yrs at -1%. And banks are profitable: they make a 1% spread on 10yr loans to corporates and a zero (rather than negative) return on their reserves.

Now, I remain of the view that helicopter drops would still be a far preferable policy than directed extensions of credit, with the risks of capital misallocation they entails. But things may not be bad enough for policy makers to do really sensible things.

If policy-making economists are really determined to pursue negative interest rates, they should at least do it competently. Make interest rates negative for borrowers, and raise returns on savings. That may sound like the best of all worlds – it is, and it is well within the powers of the European Central Bank.