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Finance

The ECB's risky low interest rate policy

European Central Bank President Mario Draghi is always up for surprises. One year ago, he said he would save the euro, whatever the cost. Now, he's shaking up another ECB tradition.

"We'll never commit ourselves from the outset" - that was the standard comment made by former European Central Bank President Jean-Claude Trichet when he wanted the bank to give itself leeway and preserve its independence from politics. But on Thursday (04.07.2013), Trichet's successor Mario Draghi turned the tables. He announced that the prime interest rate would remain low "for a longer period of time," or even continue to drop. Currently, the prime rate stands at 0.5 percent for the eurozone.

Draghi's long-term commitment may break with ECB tradition, but it's by no means a revolution. "It was admitting powerlessness," Andreas Freytag, economics professor at the University of Jena, Germany, told DW. "The ECB understands that countries do not want to implement reforms. To prevent the collapse of the euro system, the bank must now establish this long-term low prime rate policy."

Japanese model

Andreas Freytag

Freytag thinks structural adjustments are needed

This is how circumstances have developed in Japan, Freytag argued. In other words, "several decades of no structural reforms, low interest rates that allow the government to indebt itself ever more, and pushing problems into the future," he said.

Governments, especially those in southern Europe, should be pleased that a side effect of Draghi's announcement is extra pressure on the euro. "When the ECB establishes a more expansive financial policy, and the US considers the opposite in its own country, that will of course have an effect on the exchange rate," said Tobias Basse, currency expert at the German NordLB bank.

Eurozone exports benefit from a weakened euro, but there's a flipside to that. "The weaker euro makes imported raw materials, primarily oil, more expensive," Basse told DW. "And that's not necessarily positive for all the industrial branches."

Risks and side effects

Another risk is that the ECB becomes a prisoner of its own politics. Like a drug dealer, the ECB continues offering low interest rates to the financial markets - and ends up becoming addicted itself.

"There's no motivation to stimulate the financial markets and trigger a dramatic price slump that could in turn negatively affect national economies," Basse said. In this way, they become even more dependent on the financial markets.

Tobias Basse. (Photo: NORD/LB)

Basse describes low interest rates as a vicious cycle

But what makes investors happy is poison for savings, as this money earns less interest than the rate of inflation. Banks have the same problem with low interest rate policies, Freytag said. "They don't have a profit margin anymore. How would this be possible with three percent interest rates?" he pointed out.

Zombie banks financing zombie companies

And it could get even worse. "It could be possible that banks will no longer provide loans that would be in default. And in this context, they could be constantly providing new loans to bad, defaulting companies," Freytag said. It's a vicious cycle: the poorly performing companies would receive all the loan resources, while good companies wouldn't get any more funding.

The ECB is in fact seeking, through its unconventional measures, to force the banks to forgive business loans and push companies toward more investment. But as the saying goes, you can lead a horse to water, but you can't make it drink.

Companies invest not because interest rates are low, rather because the conditions are right. Politics is meant to take care of this through structural reforms. "Structural adjustments are generally done only when there's immense pressure. And the pressure is off again," Freytag said.

This can buy time - which is never used. And so, the problem only gets worse.

DW.DE

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