The Money Trolls

Money is made round to go 'round.

   A bank's job is to put money to work, and to do that, money must move. But if the only movement is among banks and between banks and government, the general public -- consumers -- benefit not at all.

   If you had to pay a bank to hold your money, would you do it? Not likely. People set up savings accounts so they can earn interest on their money. Preferably, the interest rate should be higher than the rate of inflation, because otherwise you lose money as your cash declines in value.
    Moreover, why should banks offer you next to zero interest on your savings as they buy government bonds that pay them interest, and they pocket the difference?
  In effect, banks gobble up your savings as you try to cross a bridge to prosperity.
   So if money doesn't go 'round -- consumers don't buy and companies don't invest so they can produce more -- the money flow slows or stops. Picture a water wheel, where money is the stream that drives the mill that powers the economy. If the stream runs dry, the mill shuts down.
   The problem, then, is to make sure the money keeps flowing. That's what central banks are for, to regulate monetary policy -- the money flow -- and thereby encourage smooth production and a growing economy. And a small amount of inflation -- an increase in the money supply and rising prices -- can help to do that.
   But interest rates, or the price of borrowing money, can't be too close to each other, or there's no incentive to lend. Thus, if banks don't lend and firms don't borrow, the cash flow stops and the economy sags. In brief, that's what's been happening in America and in Europe.

   Meanwhile, to kickstart a national economy, central banks can lower key interest rates so that commercial banks have easy access to funds, and they can pass on the lower cost to borrowers. But when that key interest rate drops to zero and nothing happens, it's time for a more drastic measure.
  That's what the European Central Bank has done. It has put its deposit rate -- the interest it pays to commercial banks that park funds at the Central Bank -- to below zero. In other words, the customer must pay the bank to hold its cash. Since the deposit rate was already at zero and the European Union economy was not improving, the Central Bank cut its deposit rate to -0.1 percent.
   The ECB stressed that this move affects only commercial banks, and not consumers in the general public. Even so, the principle is there. Why pay someone to hold your cash for you when you can earn a profit by lending it to someone else?
   That's the latest in Europe. Will something similar happen in America? Perhaps. The Federal Reserve, America's central bank, has already reduced its key lending rate -- the price it charges commercial banks to borrow funds -- to near zero, and still the economy stumbles along.
   As  mentioned in this blog earlier this week, if consumers don't spend and firms don't invest, government must step in to jumpstart the economy through increased spending.

   Recession is the best time for firms to invest in new equipment to expand production for better days to come. Why? Because borrowing costs are low, wages are reasonable and labor is readily available and eager for work.
   However, if firms lack the confidence that an upturn in consumer spending will come soon, they may delay investment and/or reduce production further. As that happens, consumers -- many already unemployed -- lose their confidence also and cut back their purchasing. As consumption drops, so does production. And so it goes, as one factor pulls the other down in a vicious recessionary cycle.

   So, how to solve the dilemma? The move by the European Central Bank is an attempt to discourage commercial banks from parking their cash and to encourage them to lower their own interest rates and increase their commercial lending activity.
   In a statement, the ECB admitted that commercial banks "may of course choose to lower interest rates for savers. At the same time, though, consumers and businesses can borrow more cheaply and this helps to stimulate economic recovery."
   In the U.S., similar thinking has prompted the Fed to push borrowing costs to very low levels, even though the key rate it charges commercial banks is still barely in positive territory and consumer savings accounts fail to outpace inflation.

  So the question becomes, why save? If the rate of inflation is higher than the savings rate, I'm losing money, people think. Besides, spending money is the best way to pull the country out of recession.
   A good point, but for those out of work, and those who have already drained their savings, the point is moot.