The age of wealth accumulation is over

Voters and politicians agree it is time to slice the economic pie more evenly

Rana Foroohar

© Matt Kenyon

Roughly four decades ago, America kicked off the developed world’s last major economic paradigm shift — the supply side revolution.

Capital gains taxes were slashed. President Ronald Reagan and UK prime minister Margaret Thatcher took on air traffic controllers and coal miners. The power of unions faded and that of corporations grew. Some people got very rich. But inequality rose, and eventually, overall trend growth slowed.

Watching the Democratic presidential primary debates last week, I couldn’t help but think that we may be witnessing the next great shift, from an era of wealth accumulation to one of wealth distribution. Moderates like Joe Biden and John Delaney tried to argue for middle of the road answers on issues like healthcare and trade.

But the pole positions were set by Bernie Sanders and Elizabeth Warren, who hold similar views on everything from shifting Americans on to a national healthcare system and relief for indebted students. Both also seek higher taxes for the wealthy and tougher rules for corporations.

While little of this would seem radical in many other parts of the world, in the context of US politics, it was truly something new. The set point for economic debates, even for Democrats, used to be how the government could help the markets work better. Now it’s how the public sector can rein them in, and slicing the economic pie more fairly.

What’s more, it’s not only Democrats. Some Republicans are looking for a paradigm shift as well. Marco Rubio, an influential Republican senator who hopes to be president someday, recently put out a paper on the problems with shareholder capitalism and the merits of industrial policy.

The signs of this new post-supply side era are all around us. Witness the rise of the B-corporations, which balance purpose and profit, and the growth of investing based on environmental, social and governance factors.

In government, note the growing bipartisan enthusiasm for tougher antitrust scrutiny and calls for trade protection, as well as efforts to politicise the US Federal Reserve. It’s not just President Donald Trump’s tweet seeking rate cuts but also progressive Democrats who see “modern monetary policy” as a way to pay for their priorities without having to fund them through tax rises agreed upon by Congress.

These views are increasingly part of the mainstream. Last week, two senators introduced a bipartisan bill that would force the Fed to devalue the dollar in order to boost exports and balance current accounts with China.

This isn’t passing populism, but something much bigger, argues Kiril Sokoloff, founder of 13D Global Strategy & Research, who has been ahead on recognising previous turning points, from supply side economics and the slowing inflation that began in the early 1980s, to the rise of China and the spread of smartphones. “What we’re about to see is a backlash against the second gilded era, and it will have a massive impact on the world — and the markets.”

One likely impact will be fundamental changes in who holds wealth. The Democratic race reflects the growing conflict between two primary US voting groups — the baby boomers, represented by candidates like Mr Biden, and the millennials, who backed Mr Sanders in 2016, and now like him and younger candidates such as Pete Buttigieg. A decade of loose monetary policy has benefited the former, who have seen their assets appreciate, at the expense of the latter, who cannot afford to get on the housing ladder.

One of the big political battles will be over who gets what share of what looks to be a slower growing pie in what appears to be a slower growth economy.

Another battle will be between capital and labour. Rising wages are taking a bite out of US corporate profit margins and, frankly, they should. When consumer spending makes up 70 per cent of the economy, we need a bit of wage inflation to ensure that people have money to spend. That’s particularly true at a time when governments aren’t investing, and the shift from a tangible to an intangible economy has led to decreased private sector capital expenditure.

But it has taken trillions of dollars in unconventional monetary policy to cook up relatively small wage increases. And for many Americans the gains are immediately eaten up by increases in healthcare premiums or prescription drug prices, two other hot topics on the campaign trail.

That’s one of the reasons there’s now broad support for higher taxes on the wealthiest.

It remains to be seen when and what form tax rises will take. But the age of wealth distribution is coming and will have major investment consequences. The value of US equities has probably peaked, and hard assets like gold, other commodities, housing, even art — anything in fixed supply — may benefit relative to the equity and debt of multinational companies.

This isn’t the end of the world — we’ve been going through cycles of wealth accumulation and distribution forever. But it does mean that the rules of the road for investors are changing. Some asset prices may fall, but it’s possible income growth will be higher. That would come with an upside of its own, economically and politically.

As the Fed Frets, Retailers Rake in Sales

Strong results from Target, Lowe’s are latest indication the U.S. consumer is doing just fine

By Justin Lahart

Target Corp., the nation’s eighth largest retailer by sales, said Wednesday its sales and profit rose in the latest quarter. Photo: David Williams/Bloomberg News

Before Federal Reserve ChairmanJerome Powellputs the finishing touches on a speech he is delivering Friday, maybe he should take some time to listen to a playback of Target ’s earnings conference call.

Or Walmart ’s, Home Depot ’s and Lowe’s. Strong results from some of America’s biggest retailers suggest worries that an unsettled global environment is about to send U.S. consumers into retreat are overblown.

Target, the nation’s eighth largest retailer by sales, said Wednesday it earned $1.82 a share in its fiscal second quarter, with same-store sales up 3.4% from a year earlier, easily topping analyst estimates. Its stock rose around 18% in early trading.

Lowe’s, the country’s ninth largest retailer, on Wednesday also beat analysts’ estimates for second-quarter earnings and same-store sales, sending its stock up around 11%.

Those moves follow pleasing results from Home Depot, the sixth largest retailer, on Tuesday and Walmart, number one, last week.

Yet worries about the U.S. economy are pitched enough that the Fed appears on track to cut interest rates again when it meets next week. And at the Federal Reserve Bank of Kansas City’s annual symposium in Jackson Hole, Wyo. on Friday, Mr. Powell will likely point to the possibility of further rate cuts if those worries intensify.

President Trump, meanwhile, continues to castigate the Fed for not cutting rates enough, and said he is considering new tax cuts.

What makes the disconnect even more remarkable is that big retailers aren’t just reporting good results, they are expressing a lot optimism. Target raised its earnings forecast for 2019, as did Walmart. Home Depot said escalating tariffs with China might rattle consumer confidence, but also that real-time data don’t show this yet.

“Consumer confidence is near record-high levels, and wages are up over 3% from last year,” Home Depot Chief  Financial Officer Carol Tomé said.

To be sure, it isn’t sweetness and light for all retailers, with department stores such as Macy’s continuing to do poorly. But those woes seem to reflect shifts in the ways Americans shop rather than any downshift in overall spending. Unless the job market shows signs of faltering, it is hard to see why consumers might suddenly get cold feet.

At a certain point, the dangerous downshift in consumer spending the Fed is wary of is either going to come, or the central bank will have to conclude its fears were misguided.

With Troop Buildup, China Sends a Stark Warning to Hong Kong

By Steven Lee Myers and Javier C. Hernández

SHENZHEN, China — The Shenzhen Bay Sports Center rises along the shore with the green hills of Hong Kong visible across the water. It normally bustles with a variety of youth sports programs and dance, art and language academies, including one that advertises a “Hong Kong Style Education.”

In recent days, however, it has become a staging ground for olive-green military transports and armored personnel carriers that arrived on Aug. 11 and disgorged hundreds of security officers from the People’s Armed Police, a Chinese paramilitary force, who are loudly running through daily exercises and drills.

By massing the troops within view of Hong Kong, the semiautonomous territory convulsed by protests, China’s Communist Party is delivering a strong warning that the use of force remains an option for Beijing. It is also a stark reminder that military power remains a bedrock of the party’s legitimacy.

“It’s a credible threat,” Minxin Pei, a professor at Claremont McKenna College in California, said. “The Chinese government does not want to leave any doubt that, if necessary, it will act.”

China’s leader, Xi Jinping, has governed with an increasingly iron fist, including over the military. The deployment does not appear to be the prelude to a military intervention in Hong Kong, but few analysts expressed doubt that China would act if Mr. Xi believed the country’s sovereignty over the territory was jeopardized.

“How can he regard the Hong Kong movement as a pure democratic movement?” Tian Feilong, executive director of a research institute on Hong Kong policy in Beijing, said in an interview. Mr. Xi is likely to perceive the protests not just as a call for democracy in Hong Kong, but also as an effort to topple the Communist Party itself, he said. “He is very politically alert.”

Mr. Xi’s government, he said, has most likely completed preparations for an intervention but is holding off as long as the local authorities manage to keep the protests contained. That calculus could change, he and other analysts said, if the protests succeed in crippling the government or other institutions, like the courts, which will soon begin hearing the first cases of those arrested in the demonstrations. In what some observers see as a worrying sign, officials in Beijing have called the protesters’ actions “close to terrorism.”

Chinese exercises at the stadium in Shenzhen have included drills on controlling crowds. Credit  Thomas Peter/Reuters

The use of force, however, would be fraught with risks for Mr. Xi, who is already juggling economic headwinds and deteriorating relations with the United States under President Trump.

The country and the party are still haunted by the use of the People’s Liberation Army to crush the Tiananmen Square protest movement 30 years ago this summer, which resulted in international isolation and sanctions. A military crackdown could spell the end of Hong Kong’s role as an international financial center and the unique political formula under which Beijing grants the territory freedoms unseen on the mainland.

“The military solution would have many urgent and disruptive effects,” said Wu Qiang, a political analyst in Beijing. “It would be political suicide for the Communist Party of China and the ‘one country, two systems’ arrangement of Hong Kong.”

More nationalistic voices have brushed aside such fretting, noting that China is a much stronger and diplomatically confident nation than the one that endured international opprobrium after the Tiananmen crackdown.

“The Hong Kong matter will not be a repeat of the political disturbance of 1989,” Global Times, a Communist Party newspaper, wrote Friday in an editorial, referring to the year that military troops in Beijing crushed the Tiananmen protests. It said Beijing had not decided to use force to intervene in Hong Kong, but had the legal right to do so if needed.

“Washington will not be able to intimidate China by using the turmoil 30 years ago. China is much stronger and more mature, and its ability to manage complex situations has been greatly enhanced,” the editorial said.

The deployment in Shenzhen was clearly meant to focus attention in Hong Kong and beyond. A white bridge that connects Shenzhen to Hong Kong is only two miles down the road.

The message was amplified by no less than Mr. Trump, who disclosed on Twitter that American intelligence agencies had spotted the Chinese troops massing at the border. “Everyone should be calm and safe!”

It remains to be seen how effective Beijing’s posturing will be. The authorities have from the start misjudged the depth of the anger driving people into the streets. While the deployment and increasingly blunt warnings from officials have rattled nerves, they seem to have had little impact on those who view the struggle as one crucial for preserving Hong Kong’s freedoms.

Fu Guohao, a reporter for a Chinese state-run newspaper, being rushed from Hong Kong’s airport last week after protesters tied him up and beat him.CreditLam Yik Fei for The New York Times

The growing threats of military action came as violent clashes have escalated. Public anger on the mainland spiked last week when protesters at Hong Kong International Airport tied up and beat two men from China.

Three days after protesters defaced the central government’s liaison office in Hong Kong with paint and graffiti on July 21, the chief spokesman of the Ministry of National Defense curtly noted that the People’s Liberation Army had the authority to intervene in the territory, if requested, to keep order.

The law that details relations between Hong Kong and the army limits its role to external defense, but allows it to intervene, when sought by Hong Kong’s leaders, to maintain public order or assist in cases of natural disasters.

The Hong Kong garrison of the People’s Liberation Army is based in what was formerly the British military headquarters. The garrison includes 19 sites around the territory, but many of its soldiers — estimates of the total vary from 6,000 to 10,000 — live and train in bases across the border in Shenzhen.

“Those who want to stir up unrest should know that Hong Kong has a P.L.A. garrison,” Han Dayuan, a law professor at Renmin University in Beijing, said during a government-organized news conference. “They should consider that for a moment when there is turmoil, there is also a need to resolve it quickly.”

The deployment of the People’s Armed Police, though, shows Beijing has options other than the army. The armed police force has a mission of maintaining internal security on the mainland, including responding to terrorist attacks, riots and rebellions.

Tens of thousands of protesters marched Sunday in Hong Kong despite a downpour, defying a police ban on extending the rally beyond Victoria Park.CreditLam Yik Fei for The New York Times

It was founded in 1982 and has 1.5 million members, making it bigger than most militaries in the world. It has in recent years been deployed extensively in Xinjiang, where the government has harshly cracked down on what it views as the threat of Islamist extremism among Uighur Muslims.

As part of Mr. Xi’s efforts to streamline the military command structure, a core part of his consolidation of power since 2012, the People’s Armed Police was put last year under the leadership of civilian party authorities and the Central Military Commission, which he controls as its chairman.

Video of its deployment in Shenzhen appeared in China’s state media within hours of the arrival of the vehicles at the stadium on Aug. 11. The reports said the troops there were taking part in a drill across all of Guangdong Province.

The troops at the stadium appear to have settled in on its grounds. Backpacks and other personal equipment could be seen neatly arrayed in the stadium’s causeways, while officers milled about during breaks from drills, which could easily be heard, if not seen, from the streets around the stadium.

One officer, when asked, said the deployment was a summer training exercise.

There appeared to be little effort to disguise the activity. The People’s Daily posted a video late Saturday showing the force in Shenzhen standing in formation and conducting mock clashes with protesters wielding sticks. One officer with a megaphone warned in Cantonese, the dialect spoken in Hong Kong: “Stop the violence, repent and be saved.”

The exercises do not seem to have resonated in Hong Kong, suggesting that Beijing’s messaging could be falling short.

For now, analysts said, officials in Beijing appear willing to watch and wait, continuing to offer support for Hong Kong’s beleaguered leaders, to dangle carrots and sticks at business and cultural leaders, and to try to undermine public support for the protests. Giving in to the protesters’ demands would be an unacceptable sign of weakness for them.

The deployment in Shenzhen of the People’s Armed Police, a paramilitary force, showed that China has options other than its army in seeking to maintain order. CreditNg Han Guan/Associated Press

Mr. Wu, the analyst in Beijing, said the government’s overriding goal now was “to prevent Hong Kong’s movement from spreading to the Chinese mainland.”

That effort at least appears to be succeeding here in Shenzhen, a factory town that kicked off China’s remarkable economic transition 40 years ago and that now has aspirations of being a global high-tech hub.

Two rivers and Shenzhen Bay separate the city from Hong Kong. So does a heavily fortified border with passport and customs checks at six crossing points. There is also a cultural and political gulf that has barely narrowed since Hong Kong was returned to Chinese control in 1997.

Shenzhen does not feel like a city mobilized for military action. Several people, when asked, said they had heard little of the protests, or declined to discuss them.

Others expressed support for Hong Kong’s police. Cathy Huang, who is 23 and works for an insurance company, said mainlanders attached “more importance to the police” than people in Hong Kong did.

“It is not that it cannot be solved by force,” she said in a shopping center a short drive from one of the border crossings. Her view starkly contrasted with that of many of Hong Kong’s protesters about excessive use of force, which has now become one of the complaints driving more protests.

“It depends on the attitude,” she said. “To a certain extent, we would even support the police adopting slightly harsher measures.”

Steven Lee Myers is a veteran diplomatic and national security correspondent, now based in the Beijing bureau. He joined The New York Times in 1989, and has previously worked in Moscow, Baghdad and Washington.

Javier C. Hernández has been a China correspondent in Beijing since 2014. He joined The New York Times in 2008 and previously covered education and politics.

Steven Lee Myers reported from Shenzhen, and Javier C. Hernández from Hong Kong and Beijing. Amy Qin contributed reporting from Beijing, and Christoph Koettl from New York. Claire Fu contributed research from Shenzhen, and Zoe Mou from Beijing. 

China, Mexico and US Trade

China is no longer the United States’ top trade partner. What does this mean for Mexico?

By George Friedman

Last week, it was widely reported that in the first half of 2019 Mexico replaced China as the United States’ top trade partner. China is now in third place, while Canada is in second. There has been a great deal of discussion in the media about what this means for U.S.-China economic relations. Much less attention has been devoted to what this new alignment means for economic relations within North America.
A Third World Country?
The importance of U.S.-Mexico trade may surprise some. In the minds of many Americans, Mexico is still a Third World country whose largest export is poor people looking for jobs. Truth is, Mexico has the 15th largest economy in the world measured in U.S. dollars. Australia ranks just one spot above Mexico, and countries like Spain, South Korea and Canada are not too far ahead either.

Measured in purchasing power parity, however, Mexico ranks as the 11th largest economy in the world. PPP measures economic activity against the ability of a country’s currency to buy goods. Both PPP and nominal gross domestic product measurements have their flaws. Measuring purchasing power in a country as diverse as Mexico is tough, to say the least. Measuring it against the dollar is also difficult, as currencies fluctuate against the dollar all the time, thereby changing their GDP totals and rankings even though the economy itself hasn’t grown or declined. (Those who already knew this – and those who didn’t want to know this – please forgive me for explaining this in detail.)

The important point here is that Mexico’s economy, whether it’s ranked 11th or 15th, isn't a developing economy. It is a major economy and a major target for investment. Some parts of Mexico, particularly those in the south and some areas of major cities, resemble the Third World. But most countries have major regional inequalities. Mexico’s are somewhat larger than the average, but its economy is nonetheless substantial. The U.S. and Chinese economies are highly intertwined, but so too are the U.S. and Mexican economies – Mexican auto parts, for example, are indispensable to U.S. car makers. Mexico is also an aeronautical hub, housing Airbus and Bombardier manufacturing plants.

We’re presented, then, with two geopolitical realities. First, North America’s trading bloc is now larger than the European Union in terms of both population and GDP. Many believe that the alternative to globalism is insular nationalism. Many also believe that the only path to regional integration is a high degree of political integration. The European Union demonstrates that excessive politicization of a trade block can breed potentially uncontainable tension. The North American trade system has no significant joint political structure. The U.S., Canada and Mexico have not compromised their sovereignty, yet they are part of a successful trade system that was renegotiated in such a way that maintained the level of interdependence between the three major trade partners, despite expectations that renegotiation would lead to a decline in trade.

The second geopolitical reality is that increased trade creates increased vulnerability. China learned that excessive dependence on exports to the U.S. gives Washington leverage. Exports are essential to economic development but pose political risks. Interdependence – particularly in economic terms – seems an innocuous concept. But it also means vulnerability to forces in other countries that are less reliant on the trade relationship.

In Mexico’s case, the sense of vulnerability goes back to the 19th century, when the United States defeated Mexico in the Mexican-American War and seized much of what is today the American southwest. Mexico remained in a subordinate position to the United States for more than a century. In emerging from its past and becoming an increasingly potent economic player, Mexico can neither avoid the relationship nor feel comfortable with it. The size of the U.S. economy makes it less dependent on Mexico than the Mexican economy is on the United States. And that leads to political friction.

Political friction between nations is inevitable. It also exists between Canada and the U.S. The U.S. has the same economic advantage over Canada that it has over Mexico. But having economic advantage doesn’t necessarily mean a country will use it – at least, not without political cause, as the U.S. had with China. Even in unequal relationships, the less powerful party can still have an economic impact on the more powerful party.
The Migration Issue
The problem is that there are both historic and contemporary political issues with Mexico, primarily over migration. Mexican migration to the U.S. has declined significantly. Mexicans used to migrate north for economic reasons, but economic conditions in Mexico over the past few years make it more attractive to remain in Mexico than to go north. The current wave of migrants crossing the U.S. southern border comes from Central America. In an ironic twist, Mexico doesn’t want Central American migrants to enter Mexico, but like the U.S., it can’t seal its southern border to stop them from crossing into its territory. Until recently, Mexico did not want to give them asylum, and those it could not block or expel were permitted to move north to the U.S. border.

Migrants are often the cause of tensions between and within countries. Historically, the U.S. metabolized Mexican immigrants. Mexico has had more difficulty metabolizing Central American migrants because the regions they entered in the south were among the poorest in Mexico, Mexican institutions are not well-equipped to handle the influx, and some Mexicans have objected to the influx. Mexico, therefore, sought to shift the burden north, triggering a political confrontation with the U.S.

Mexico knows that it cannot press the U.S. too hard. Mexican politicians threaten impractical retaliations, but they know the U.S. can absorb an economic rupture with Mexico more than Mexico could bear one with the United States. The U.S. can’t press Mexico too far, either. Imposing a heavy economic penalty on Mexico would not only disrupt access to the agriculture and manufacturing supplies on which the U.S. economy depends and hurt the economies of border states like Texas and California, but it would also threaten to energize 130 million people with a historic grievance and an economy that is now world-class.

Mexico has come a long way and is now the United States’ leading trade partner. But that position makes it vulnerable and limits its political options against the U.S. China has discovered what that vulnerability can lead to if it engages in political actions unwelcomed by its biggest trade partner. Mexico understands the U.S. far better than China did. But what will happen if Mexico moves from the 11th-largest economy to the fifth-largest? At a certain point, the risk-reward ratio shifts.

A final point on what Mexico becoming the United States’ largest trade partner means for China. China is following Japan’s path. Japan was the leading exporter to the United States in the 1980s, but it was increasingly squeezed by higher costs, falling profit margins and competition from other countries. There was also significant political tension between the United States and Japan over informally closed Japanese markets. It did not lead to massive tariffs because Japan buckled under the weight of its own economic weakness and became a less-important trade partner for the U.S.

China was doing the same before the U.S. imposed tariffs. Its products were facing stiff competition, inflation was pushing its own costs higher, and profit margins in key sectors were falling. As with Japan, China faced serious problems with its banking system. U.S. tariffs compounded China’s problems and perhaps accelerated the process, but the path it is following is not new.

The Fed as Trade-War Enabler

The re-escalation of President Trump’s trade spat with China make more rate cuts from the Federal Reserve seem like a certainty

By Justin Lahart

Federal Reserve Chairman Jerome Powell Photo: andrew caballero-reynolds/Agence France-Presse/Getty Images

The U.S.-China trade fight has suddenly heated up again, and it now looks as if the Federal Reserve is going to be cutting rates much more deeply than seemed likely just last week. It all feels a bit familiar.

The tariffs President Trump imposed on a broad range of Chinese goods last year, and the countermeasures taken by China, stirred worries about U.S. growth, pushing stocks sharply lower late in 2018. Ultimately, the Fed decided to stop raising rates, sparking one of the sharpest U.S. stock rallies ever to start a year. Then Mr. Trump stoked tensions again in May. By June, the Fed signaled it would be cutting rates.

When it did last Wednesday, Chairman Jerome Powell indicated that it might hold off on further cuts if economic data didn’t worsen. The next day, Mr. Trump, who had asked for a deeper cut and said that Mr. Powell “let us down,” announced the U.S. would set new tariffs on Chinese goods starting in September, sending stocks sharply lower. On Monday, China allowed its currency to break through a key psychological threshold, hammering stocks. Suddenly, more rate cuts seem like a sure thing.

The risk is that the Fed and Mr. Trump have entered into an adverse feedback loop, Bank of America Merrill Lynch economists warn. In it, the Fed cuts to steady the economy in times of stress. But when worries subside and stocks recover, the Trump administration re-escalates the trade fight, leading to renewed risks that prompt the Fed to ease up again.

If a loop has taken hold, there is really no way for the Fed to break free from it. It is mandated by Congress to support the economy, not to pass judgment on policy. And the belief that China’s trade policies, in particular, have been unfair is one area where Mr. Trump draws some support from Congressional Democrats.

But this can’t go on forever. The Fed’s target range on overnight rates is now just 2% to 2.25%, and investors now expect it to be at least a half-point lower by year-end. That is starting to get uncomfortably close to the so-called zero bound.

Even now, overnight rates are dangerously low. To combat past recessions, the Fed typically has had to cut rates by about 5 percentage points. If a downturn really hits, the central bank will again have to tap unconventional policies such as bond buying. Those haven’t proven nearly as effective in restarting the economy as deep rate cuts.

That could throw everybody for a loop.

Fed Chairman Powell Calls Rate Cut a ‘Mid-Cycle Adjustment’
At a press conference following the Federal Reserve’s rate-cut announcement, Fed Chairman Jerome Powell explained that there was an “insurance aspect” to the decision. Photo: Reuters

ECB Loosening Is Not Enough

The European Central Bank's negative interest rates and quantitative easing measures cannot by themselves address the pervasive risk aversion holding back the eurozone economy. Eurozone policymakers must, therefore, find the political will to design a comprehensive package of financial and fiscal measures aimed at injecting new energy into the European Project.

Lucrezia Reichlin


LONDON – If indications of disappointing economic growth in the eurozone are confirmed, the European Central Bank will loosen monetary policy further in September. Last week, outgoing ECB President Mario Draghi signaled a further likely cut in the ECB’s rate on commercial banks’ overnight deposits with the central bank, which is already -0.4%. In addition, the ECB is discussing a new program of asset purchases.

Economic stimulus is clearly needed. Annual inflation is well below the ECB’s target of “close to, but below 2%,” and financial markets expect it to remain so for years. What’s more, the eurozone has grown more slowly than the US economy since the 2008 global financial crisis. Growth has flagged since peaking in the third quarter of 2017, and slowed again in the second quarter of this year.

It is also clear that national governments in the eurozone are reluctant to provide a coordinated fiscal stimulus, despite the urgings of the ECB and many economists. Willingly or not, the ECB remains the only game in town.

The question is whether monetary policy alone can help to improve real growth and the inflation outlook in the eurozone. Monetary policy can be a powerful tool. The key to President Franklin D. Roosevelt’s successful effort to revive the US economy in the 1930s was not deficit spending, but rather the large monetary stimulus resulting from America leaving the gold standard before continental European countries did. Today, the ECB needs to engineer something similar with different tools.

In principle, taking the ECB deposit rate further into negative territory should remove the restriction on future expected short-term interest rates turning negative, and therefore flatten the forward yield curve. A rate cut should also put downward pressure on the euro’s exchange rate, potentially making eurozone exporters more competitive.

But such a move would be controversial, in particular because it would dent the profitability of banks that cannot pass on negative ECB deposit rates to their customers. Such policies have heterogeneous effects across banks, and mitigating action, although feasible, requires complex engineering.

According to an analysis by the ECB’s staff, “strong” eurozone banks are able to pass on negative rates to their corporate clients; “weak” banks cannot.

The ECB is therefore considering ways to mitigate this – in particular by granting very favorable conditions on the special loans that it will offer under the TLTRO III program, which are likely to be taken by the “weak” banks. In addition, a tiering system is being considered in which reserves below a certain threshold would not be subject to negative rates. But this is likely to benefit the strongest banks of stronger core eurozone countries such as Germany, France, and the Netherlands, which together hold about one-third of total deposits at the ECB.

Beyond these technical considerations, policymakers must grapple with two root causes of excess demand for central-bank reserves among strong eurozone banks. One is very high demand for safe assets in general – and banks in core eurozone countries have little incentive to hold their own governments’ debt when the interest rate is below the ECB deposit rate.

Another cause is the segmentation of the eurozone’s interbank market, which, if the ECB implemented tiering, would prevent strong banks from benefiting from arbitrage opportunities by lending to weak banks at a rate above -0.4%. Both causes are the result of the eurozone’s dysfunctional banking system, in which demand for safe assets involves both a “home bias” and a strong demand for core countries’ sovereign debt.

In these circumstances, the ECB will not find it easy to implement a policy that would remove the constraint of the zero lower bound on interest rates, while ensuring that the policy’s distributional effects on banks and EU member states are neutral. Doing so will involve many instruments and complex design, far from the simple one-tool-for-one-target framework that was best practice before the financial crisis.

Moreover, negative rates become less effective over time and, if protracted, may have undesirable effects – for example, by inducing savers to de-risk, thereby potentially generating asset-price bubbles and increasing financial disintermediation. The positive stimulus from the depreciation of the euro’s exchange rate could offset these effects, but only if other central banks – and in particular the US Federal Reserve – do not ease at the same time. And on July 31, the Fed announced a widely expected quarter-percentage-point cut in its benchmark interest rate, while further future cuts cannot be excluded.

But the main problem is that neither negative rates nor quantitative easing can by themselves address the pervasive risk aversion holding back the eurozone economy. The ECB is trying to discourage demand for safe assets by making them more expensive to hold, but it cannot address the causes of the increase in such demand.

This is a global trend driven by several factors, including demographic changes, widespread uncertainty linked to technological transformation, and political risks such as trade wars and nationalism. But in the eurozone they are exacerbated by the lack of reform of the single currency.

More than ten years after the financial crisis, the eurozone’s financial markets are still fragmented, and the supply of safe assets is limited by the conservative fiscal policy of northern European countries, particularly Germany. Eurozone policymakers must, therefore, find the political will to design a comprehensive package of financial and fiscal measures aimed at injecting new energy into the European project. Such a combined approach is essential to address the deep-rooted risk aversion sapping growth across the eurozone.

In the 1930s, America’s key stimulus was monetary rather than fiscal, but a vital ingredient of success was a comprehensive set of reforms coupled with a strong message capable of unifying the country. Today, Europe needs a twenty-first-century version of that policy.

Lucrezia Reichlin, a former director of research at the European Central Bank, is Professor of Economics at the London Business School.

George Friedman’s Thoughts: China and a Global Economic Contraction

The protests in Hong Kong must be understood in the context of a global economic slowdown.

By George Friedman

There has been much talk recently about economic problems in key economies around the world. Early Wednesday morning, for example, I spoke on Bloomberg Surveillance about the situation in China. Before I went on air, Bloomberg News was covering multiple stories on the decline in bond yields and its effect on the U.S. economy, weakness in the German economy, and so on. I then realized how closely this issue is linked to the protests in Hong Kong.

It has been about 10 years since the last U.S. recession, and we would expect to see another one soon. Since the United States is the world’s leading importer, an American recession always leads to a weakening of the global economy. Massive exporters like Germany and China are particularly vulnerable to such downturns. China’s economy was significantly weakened by the 2008 financial crisis. It has, until recently, managed to stave off U.S. attempts to try to level the imbalance between Chinese exports to the U.S. and U.S. exports to China. But it has now lost the ability to manage the United States. And at the same time, Hong Kong is rising.

The uprising occurred because China was increasing its control over Hong Kong, including taking much greater control of the criminal justice system. In 1997, when the United Kingdom relinquished control of Hong Kong to China, Beijing was willing to allow Hong Kong to have a high degree of independence because Hong Kong was the financial interface between China and the world. China could not afford to undermine Hong Kong’s dynamism.

But China is in a very different position today, and it can no longer accept a strong and independent Hong Kong. Even before the U.S. trade actions, the Chinese economy was in serious trouble, and its banking system was nearly in shambles. The introduction of new tariffs by its largest customer has created deeper problems in the economy, which are seen in industrial production data and other sector statistics. The accuracy of these statistics is always uncertain to me, but that China is publicly revealing its economic weakness is significant. When it admits that it has problems, it likely means the problems are serious indeed.

Today’s China was built on economic growth and the promise of prosperity. Maoism still exists, but it is on the margins. Chinese elites, like elites everywhere, expect greater wealth and, at minimum, that the wealth they have already accumulated will be protected. And the public expects a better life for themselves and especially their children. The Communist Party of China, therefore, now derives its legitimacy not from communist ideology but rather from the promise to deliver prosperity to the people, coupled with national pride. But as the economy weakened, China engaged in major international initiatives to try to encourage pride in its global standing, from exaggerating its military power, to lending money to other countries, to building a route to Europe. The more concerned China was about delivering prosperity, the more it leaned on pride in Chinese power and the idea that the U.S. would be bypassed by the Chinese in every way possible.

But the Chinese realize that their relationship with the United States has gotten out of control. On one hand, they depend on the U.S. to buy their goods. On the other hand, they want to show that they are pushing back against the United States. In the end, national pride goes only so far in a country that is divided into many social classes, with millions left out of the economic boom and others having benefited but remaining resentful of the avariciousness of the elite. The foundation of China is prosperity; national pride is just a substitute.

Right now, that prosperity is threatened not only by U.S. demands to redefine economic relations between the two countries, but also by the last thing China needs: a global economic slowdown. It is always the exporters who are hurt the most by such downturns.

China tried to dramatically increase its control of Hong Kong, not out of confidence but out of fear. If the Chinese economy contracts, Hong Kong doesn’t want to be taken down with it. But the people of Hong Kong couldn’t predict how far they would be able to separate the island from China’s problems, so they wanted to ensure their security apparatus had control of Hong Kong. The Chinese resistance to these steps was what really led to the uprising. From my point of view, it also points to a critical Chinese weakness. China relies on its internal intelligence system to maintain order, but it failed to anticipate the uprising in Hong Kong. That raises the question of whether a pillar of the Chinese system, its internal controls, is weakening.

Another major concern for Beijing is that the unrest in Hong Kong may spread to the rest of the country. People in other Chinese cities might sense Beijing’s weakness and, facing tough economic conditions, take their concerns and resentments into the streets. This is why Beijing cannot appear to have lost control of Hong Kong. If it does, China’s global image as a confident, leading power would be transformed into one of a brutal and repressive regime, fighting its own people.

Hong Kong has not triggered a reaction on the mainland, but Chinese President Xi Jinping has been wrong on several fronts, so the Central Committee may not be in the mood to let him handle this problem. But it is caught between its need to suppress the protests in Hong Kong and its fear of the consequences if it does. When decisive action becomes a threat, it’s a sign that a regime is in trouble. China has tried to appear patient, but it is increasingly appearing impotent to its own people. And that is the one thing it can’t tolerate.

Economic downturns have a tendency to trigger political responses. Consider 2008 and how the political landscape changed in many countries in the following years. While 2019 may not be as intense as 2008, many countries’ economies are struggling, having never fully recovered from the global financial crisis. It is in this context that I am beginning to think of China. It’s easy for an exporter to prosper in a robust global economy. It’s much harder to sell to a world facing an economic downturn. Such exporters are battening down the hatches – China’s approach to Hong Kong is one example. Having encountered resistance, it fears the consequences of decisive action. And it fears not acting. China doesn’t know quite what to do, and that is not the behavior of a formidable rising power.

In office but not in power

Are Western democracies becoming ungovernable?

Politicians sometimes say so, but mean different things in different countries

ASPECTRE IS haunting the rich world. It is the spectre of ungovernability. “Ungovernability in Italy is a great risk,” averred its former prime minister, Matteo Renzi, in 2017. “It will be impossible to govern Spain until they face the political problem in Catalonia,” predicted the spokeswoman of the Catalan regional government in February (just before that government was closed down). Emmanuel Macron, for whom to govern is to reform, warned that “France is not a reformable country”, evoking the spirit of General de Gaulle who once asked how anyone could govern a nation with 246 kinds of cheese.

When you survey the political landscape of rich countries, you see an unusual amount of chaos and upheaval. Prague has seen the largest demonstrations since the overthrow of communism. More than a quarter of the current parliaments in Europe were elected in polls that were called early. In Britain the mother of parliaments has been at the gin bottle and opinion polls everywhere show increasing numbers of people losing patience with democratic niceties and hankering after a strongman.

But experiencing protests or having weak governments does not make a country ungovernable. Moreover, as Tolstoy might have written, each ungovernable country is ungovernable in its own way. The problems of Italy, Spain and Britain are all different. So what, if anything, does ungovernability mean when applied to democracies? And if it is a problem, is it worse now than in the recent past?

Ungovernability can be thought of in four ways. No Western country is ungovernable in every one. But there are a few features that exist in more than one country and a few countries that look ungovernable in more than one sense.

First, some countries cannot form a stable government either because (in first-past-the-post systems) the largest party does not command a majority in parliament, or because (in countries with coalitions) parties cannot organise a stable alliance on the basis of election results. Spain has had three elections since the end of 2015 and may have to call a fourth following its failure to negotiate a new coalition. In Britain an election in 2017 stripped the ruling Conservatives of their majority and their subsequent period in office has been tumultuous. In both countries, stable two-party systems have given way to wobbly four- or five-party ones. (And both, incidentally, have seen the collapse of large regional governments, in Catalonia and Northern Ireland.)

In the 28 European Union countries, eight of the most recent legislative elections were snap polls, called before the end of the normal parliamentary term. This is not a trivial share, though it does not suggest widespread chaos, either.

Joining up is hard to do

More common, countries with coalition governments have suffered unusually protracted negotiations. Sweden’s lasted four months ending in January 2019; the country now has an ineffective minority government. Finland held an election in April and it took until the end of May to create a left-right coalition. These cases pale in comparison with the eight months that it took to produce a Czech government in 2018, to say nothing of the record 535 days that Belgium endured without a government in 2010-11. After its vote in 2018, Italy did manage to cobble together a coalition between populist right and populist left, though they cannot stand one another. These countries should probably be called precarious, rather than ungovernable.

Next, ungovernability can mean that governments fail to pass basic laws on which the operations of the state depend. Spain’s could not pass a budget this year, triggering the election in April. Italy did pass its budget for 2019, but by busting the financial limits imposed by the EU, though confrontation has so far been avoided.

Broken by Brexit

Britain has seen an unprecedented failure: a thrice-repeated defeat by huge margins in the House of Commons on the most important issue of the day, Brexit. Had this happened at any other time, the government would have resigned, precipitating an election. As it was, the defeats triggered a contest for leadership of the Conservative Party, resulting in a government which expects to crash out of the EU without an agreement, pitted against a parliament determined to prevent such a thing happening (see Britain section). This is an extraordinary turn of events in a system which is not supposed to permit divided government. If Britain is sliding towards ungovernability will depend on whether it does crash out and what happens at the expected early election. At the moment, with a one- or two-seat majority, the government is running on fumes.

But the home of failure to pass meaningful laws is the United States, where both Republicans and Democrats have given up on passing legislation until after the presidential election of 2020. This continues a long-standing failure. Appropriation (budget) bills routinely fail to be approved on time. Between 2016 and 2018, Republicans controlled both branches of government but failed in their main legislative goal, to repeal the Affordable Care Act (“Obamacare”), and did not try to win approval for a promised deal to improve America’s crumbling infrastructure. America is not ungovernable in most senses of the term but its legislature and executive are locked into paralysis.

A third aspect of ungovernability is the systematic corruption of constitutional norms, making political processes haphazard or arbitrary. This does not always make countries ungovernable. Sometimes, as recently in Hungary, for example, it does the opposite, increasing state power at the expense of democratic checks and balances. But the undermining of norms can also hamper decision-making, as in Britain. There, cabinet responsibility and party discipline have broken down, ministers break the ministerial code of conduct and traditions of parliamentary procedure, such as holding a Queen’s Speech to outline legislative proposals, are ignored.

America is not quite as bad. But President Donald Trump shut down the federal government twice in a year—compared with once in Barack Obama’s eight years. The second Trump shutdown, in 2018-19, was the longest in history. Mr Trump has flouted Congress over a tax law and urged his administration to resist Congressional requests for information. The former British ambassador to Washington called his administration dysfunctional, unpredictable, faction-riven, diplomatically clumsy and inept. And that is the view of America’s friends. America’s political system is not designed to operate smoothly. But it is becoming dysfunctional in ways the framers never envisaged.

Western countries are not ungovernable in the sense of paralysed by riots or crises. They have not lost control of the streets. Nor are they Congo. But their governments are riven by disputes and are too weak to implement big reforms—to pensions, say, or social care. They are not impossible to govern in the sense of chaotic or anarchic but more than a few are ungovernable in the sense that their governments cannot do anything of importance.

Lastly, the past year has seen a return to the streets of mass demonstrations. In France, the gilets jaunes (yellow jackets), a populist grassroots movement, have blocked roads and staged some of the most violent demonstrations the country has seen since 1968. In Britain campaigners against Brexit claimed 1m people joined a demonstration in London in March 2019, which would make it one of Britain’s largest-ever rallies. Prague has seen the largest demonstrations since the Velvet revolution of 1989. And there have been smaller anti-government rallies in Spain, Serbia, Hungary and Slovakia in 2018-19.

The nature of these demonstrations, however, is a reminder of what today’s ungovernability is not. It is not mob rule. No one is burning down the presidential palace or executing the king. Protests in Western capitals have mostly been placid compared with the 1960s and 1970s. During riots after the assassination of Martin Luther King in 1968, machineguns were posted on the steps of the Capitol.

That point of comparison suggests an odd feature of contemporary politics: it turns the experience of the 1970s upside down. Then, inflation was rampant, unemployment high and strikes common. There were riots and assassinations and, in America, conscription into an unpopular war. Yet, with exceptions such as the Watergate scandal, the business of government continued to rumble along. Within a couple of years of the riots in 1968, Richard Nixon had set up the Environmental Protection Agency; de Gaulle won a legislative election just after the Paris événements. Paul Keating, later Australia’s prime minister, said of his country’s government in the 1980s that “the dogs may bark but the caravan moves on” (ie, the government kept going, critics notwithstanding). Now, matters seem to be reversed. Inflation is tamed, unemployment is low and wages are inching up. But governments are stalemated. Compared with the 1970s, societies are less disorderly but politics is more so.

Perhaps this will prove short-lived. Maybe politicians are just facing a temporary double-whammy of unpopularity. Voters are not giving them credit for economic recovery and are angry about the costs of austerity. If so, governments might one day reap electoral rewards and normal governance will resume.

The party’s over

But longer-term trends seem against that, notably the secular decline of large political parties which has gone furthest in Europe (see chart). At their height, the two largest parties in Britain, Spain and Germany were winning 80-90% of the vote. Now, they are down to two-thirds or less.

In 1960, 15% of electorates in western Europe were affiliated with a party. Now the share is below 5%. Britain’s two big parties were once the largest civic organisations in the country.
Now their combined membership is less than that of the Royal Society for the Protection of Birds.

Membership of unions and churches has fallen, marginalising the institutions that buttressed the centre-left and centre-right, respectively. And, except in America, voters are more fickle. Alessandro Chiaramonte of the University of Florence and Vincenzo Emanuele of Luiss University in Rome found that 8% of European voters changed their votes between national elections in 1946-68; in 1969-91, 9% did so; in 1992-2015, 13% changed their minds.

Everywhere, parties are finding it harder to recruit and retain members and to mobilise voters. Parties are the organising forces of parliamentary democracy. They pick candidates, approve manifestos and get out the vote. Coalitions usually revolve around one large party. If parties continue to decline, political systems are likely to become at least more fluid, and at worst harder to govern.

Challenges for New ECB Head

Will Christine Lagarde Pursue Tighter Monetary Policy?

By Tim Bartz, Martin Hesse and Christian Reiermann

Christine Lagarde, current head of the IMF, is moving to the European Central Bank in November.

As Christine Lagarde prepares to head the European Central Bank, the ECB's critics are urging her to stop the flow of cheap money. At stake is the economic stability of eurozone member states -- and the savings of millions of ordinary people.

If there's one thing Christine Lagarde can't complain about as she prepares to take over the presidency of the European Central Bank on Nov. 1, it's that there has been a lack of care on the part of her predecessor. There are only three months left before Mario Draghi vacates his office in the imposing double towers in Frankfurt's Ostend neighborhood, and until then, his goal is to provide his successor with as smooth a start as possible.

And so it was on Thursday, after the meeting of the Governing Council, that Draghi did everything in his power to prepare the European public for the further loosening of monetary policy. "A significant degree of monetary stimulus" continues to be necessary, he announced. The ECB didn't mention any concrete measures, but in view of the bleak economic outlook, Draghi indicated that he wanted to lower interest rates again in the autumn. He would also like to relaunch the purchasing program for government bonds, which the Germans are particularly suspicious of. In short, Draghi is plotting a course to maintain the status quo.

The latest figures provide him with useful fodder: The International Monetary Fund (IMF) expects growth of only 1.3 percent in the eurozone this year, with Italy and Germany delivering especially weak performances. Meanwhile, inflation in the currency area is stuck at 1.3 percent, far below the ECB's target.

Flooding the Markets With Money

In view of the weak forecasts, it seems appropriate to boost growth with cheap money. But Draghi's radical easing course harbors risks and side effects. At the same time, there is growing concern that the ECB, under the leadership of the ex-politician Lagarde, may be tempted to yield to growing pressure from governments to provide cheap money on a permanent basis, making it easier for them to service their debts. But the Fed, the central bank in the United States, is currently experiencing just how difficult this can be. It will likely yield to the constant pressure from U.S. President Donald Trump and lower interest rates soon.

Banks and depositors are already feeling the downside of the ECB's low-interest policy. Fixed deposit and overnight money accounts are barely yielding any interest anymore -- and that is unlikely to change anytime soon. In addition, now depositors are threatened with penalty fees for having too much money in their accounts, fees that in past have been directed largely at credit institutions or big companies. Life insurers, pension funds and financial institutions are already suffering from the fact that it is growing increasingly difficult to invest in profitable ways.

Lagarde will likely maintain Draghi's course for the foreseeable future. As the head of the IMF in Washington, she has earned a reputation for viewing central banks as a kind of all-purpose weapon for all sorts of problems. Under her aegis, the IMF regularly urged central bankers to flood the markets with money. As head of the ECB, she'll likely tone down her rhetoric, but her election is a further sign that the German central bank's time as a role model for the ECB has come to an end. When the ECB was founded 20 years ago, the Bundesbank provided both organizational and conceptual inspiration. The Germans, in particular, were skeptical and needed to be convinced of the stability of the euro. To this day, the Bundesbank is regarded as the seat of the monetary policy hawks, as those who advocate a strict course geared toward price stability are called.

Hawks vs. Doves

Under Draghi's patronage, however, the so-called doves -- the supporters of monetary easing measures by the ECB -- have gained the upper hand. Draghi is the first ECB president who did not raise interest rates a single time during his entire term in office. Of course, this largely had to do with the fact that the sovereign debt crisis threatened to completely destroy the eurozone.

At the same time, Draghi has also refrained from bringing the key interest rate back up from zero as the economy has recovered. The interest rate turnaround that was announced months ago has so far failed to materialize. And Draghi has continued to buy bonds. As a result, the ECB is poorly equipped for the impending economic downturn.

And now, of all times, the Executive Board, which heads the ECB and prepares the decisions of the Governing Council, is struggling with a brain drain of sorts. Chief Economist Peter Praet left in May, while Vice President Vitor Constancio said his goodbyes a year ago. Benoit Coeure, another board member, is also planning to leave this year.

Experienced monetary policymakers and seasoned economists are increasingly being replaced by former government ministers without any real monetary policy experience. Lagarde's deputy, Luis de Guindos, left the Spanish government directly for the ECB's Executive Board. Lagarde, for her part, used to be France's finance minister. The ECB's new chief economist, Philip Lane, who was previously the head of Ireland's central bank and a university professor, is the only economist with academic merits on the board.

"The danger of a politicization of monetary policy is clear," warns Clemens Fuest, the head of the Ifo Institute, a Munich-based economic think tank. Low inflation apparently gives politicians the idea that monetary policy can be a panacea without costs or risks. "It's seductive and it pressures central banks to justify themselves, and at the same time, it's very dangerous," Fuest says.

He views Lagarde's appointment favorably, "but she should make it clear to the public as soon as possible that she stands for an independent monetary policy and for an ECB that is limited to its mandate," Fuest says.

Back-Door Remedies

Ansgar Belke, an economics professor at the University of Duisburg-Essen, sees the recruitment of ex-politicians as an attempt by euro member states to remedy a fundamental error in the currency union through the back door. The eurozone's central monetary policy lacks a fiscal counterweight. "The appointment of former finance ministers to the Executive Board of the ECB has indirectly brought fiscal policy interests on board at the central European level," Belke says. Many finance ministers in the member states seem to be OK with this at a time when the lines between monetary and fiscal policy are blurred and when the ECB is involved in bailouts for cash-strapped states, handles banking supervision and, by buying government bonds, ensures that governments have access to cheap money.

When the ECB purchases government bonds, the price of those bonds rises and interest rates fall as a result. Higher inflation would also take some of the pressure off eurozone countries, including those currently facing high debt loads like Greece and Italy, but also Lagarde's home country France.

Since 2008, the average interest rate on Italy's national debt has fallen from 4.9 to 2.8 percent, saving the country 260 billion euros ($289 billion). For all countries in the eurozone, interest savings over the past 10 years came out to 1.4 trillion euros, according to the Bundesbank's calculations. Germany, too, has benefitted: From 2008 to 2018, federal, state and municipal governments have saved almost 370 billion euros in interest payments.

The ECB has increasingly become a lender to the euro member states. Its balance sheet contains more than 2.6 trillion euros worth of government bonds. This corresponds to 22 percent of the eurozone's economic output. The hawks on the ECB Governing Council fear Lagarde could now begin seeking debt relief for highly indebted states, such as Italy, by printing money.

German Reservations

Resistance within the central bank is unlikely. When he was in the running for the ECB's top job, Bundesbank President Jens Weidmann, abandoned his previous criticism of the European Central Bank's bond-buying programs in what many observers saw as an effort to make the candidate more palatable to other eurozone countries. Now that he has come away empty-handed, those reservations could well return. Otherwise, Lagarde is striking a chord in the ECB's Governing Council, according to insiders at the bank. "There's a broad majority among the doves," says one German central banker.

This does not bode well for depositors in Germany. The future looks bleak for the financial sector, too. Commercial banks can borrow money inexpensively on the capital market, but they have trouble lending it at higher interest rates the way they did before.

Although meager interest rates are a global phenomenon, for which there are myriad reasons, Germans are particularly angry about them. "With its glut of money, the ECB is laying the foundations for a new financial crisis," says Florian Toncar, financial policy spokesman for Germany's business-friendly Free Democratic Party (FDP) in the German parliament. "The more unconventional measures the ECB takes on, the less incentive there is for reform," he believes, with a view to Europe's southern countries.

"If the ECB mutates into a perpetual interest rate brake, it is risking the next crisis," says Andreas Jung, deputy leader of the conservative Christian Democrats in parliament. "Cheap money causes a flash in the pan -- and all that remains after a flash in the pan is ashes." Behind the fierce middle-class criticism is not only concern about the savings of Germans, but also fears that the ECB's cheap money policy could drive new voters to the euroskeptic and right-wing populist Alternative for Germany (AfD) party.

Helmut Schleweis, the president of the German Savings Banks Association (DSGV), points to Japan as a warning. Interest rates there have remained at extremely low levels for more than 20 years, which has contributed to a banking crisis in the country, without the economy regaining its momentum. "If the negative interest rate phase continues or is even further aggravated, this will be clearly noticeable for the economy and for everyone in this country. Given the experience in Japan, we can only warn against underestimating these long-term negative effects," says Schleweis.

Debatable Impact

More than anything, Schleweis is worried about the business model of the banks whose interests he represents. On Thursday, Draghi hinted that he could further reduce the deposit rate that banks have to pay if they park surplus money at the ECB. Currently, that rate is at -0.4 percent, but it could fall even lower in the future.

Draghis' penalty interest, or negative interest, is intended to ensure that banks lend money to boost the economy rather than bunker it at considerable expense. That sounds logical, but it is still controversial today, even within the ECB.

The authors of a working paper issued by the central bank in August 2018 concluded that banks issue even fewer loans and instead tend to invest surplus deposits in riskier ways that offer potentially higher returns. As such, the positive impact on the economy is limited and the policy instead creates considerable uncertainty on the financial markets. It's an astonishing finding that makes the justification for the penalty interest seem absurd.

The authors also have some prominent backers.

"I don't believe that the higher penalty interest is going to lead banks to issue more loans," says IFO head Fuest. "It might lead banks to make investments that could backfire and destabilize the system."

A Growing Problem

German banks, in particular, are suffering as a result of Draghi's penalty interest. It cost them a total of 2.4 billion euros in 2018. And they cost all banks across the euro zone a combined total of 7.5 billion euros. It is true that the penalty interest on German banks is miniscule and manageable when you consider the 85.5 billion euros that domestic banks and savings banks earned in 2017 alone as net interest income, their primary source of revenue.

But the problem is growing, because even as penalty interest rates are rising, banks' net interest income has been shrinking for years. This is particularly problematic for institutions to which customers entrust a great deal of money: savings banks and credit unions.

"They still profit from the fact that they have invested money in high interest-bearing investments and granted long-term loans at higher interest rates," says Oliver Mihm, founder and head of the consulting firm Investors Marketing. But many of these securities and loans are set to expire soon. "In 2020 and 2021, the dangerous interest rate confluence will have full impact on the banks' interest results and will reduce net interest income by 20 percent or more in the next three years -- even at the current interest rate level."

If the ECB were to lower the deposit rate further, the effect would be even more pronounced, Mihm predicts. So far, many financial institutions assumed in their calculations that the interest rate may soon be raised slightly. But that illusion is now being shattered.

In addition, during the economic upswing of the past 10 years, many banks have dramatically reduced their risk provisions for loan defaults in order to increase their profits. If the economy falters, that could also change abruptly.

Passing Costs Down to Customers

What does seem clear is that financial institutions want to recover the penalty interest in the easiest possible way: through their customers. For some time now, account fees have been rising almost across the board. In some places, banks have introduced penalty interest for particularly wealthy people, a legally delicate step. For example, the Nassauische Sparkasse (Naspa) based on the prosperous city of Wiesbaden, collects 0.4 percent of the deposited sum as negative interest from private customers who have parked more than 500,000 euros in current and money market accounts.

Alternatively, like many other institutions, Naspa is increasingly talking to customers in an effort to convince them to invest their money in shares or funds, for which the banks collect commissions. Germans have always been notoriously wary of stocks and securities, and they display some pretty bizarre behavior when it comes to investing: They're risk averse, preferring to hold on to their cash and spurn opportunities for the kinds of returns the stock market can deliver.

So what's to be done? It's unlikely financial institutions will also introduce penalty interest for small-scale depositors, because doing so would trigger a wave of lawsuits, says Niels Nauhauser of the Baden-Württemberg Consumer Advice Center. He says only borrowers can be required to pay interest. "The Civil Code does not contain negative interest rates for financial investments," he says.

That may sound reassuring, but there is another term that is creeping into the debate that could prove to be extremely explosive: a "custody fee." Banks already collect custody and storage fees when they hold securities, jewelry or gold, but in the future the same trick could also be applied to deposits.

'ECB Policy Has Reached Its Limits'

Larger savings banks and banks have already been charging such custody fees to corporate customers and institutional depositors such as pension funds for some time now. The Stadtsparkasse München savings bank, for example, charges 0.4 percent for balances starting at over 250,000 euro and offers the justification that this is the market standard today. Legally, such fees could also be agreed in the private customer sector, but on an individual basis and not simply by changing the terms and conditions, says Nauhauser.

Peter Schneider, president of the Savings Banks Association of Baden-Württemberg (SVBW), recently made clear where the journey may be heading. If the ECB were to cut interest rates even further and not take countermeasures, there would be no way around a broad front of banks demanding money for the custody of account balances. If the savings banks are preempted by the competition, he says, they will have no choice but to follow suit.

But even if it were possible to pass on at least the full penalty interest burden to consumers, the situation would still remain fragile. "The ECB's negative interest rates are like a bacteria attacking the immune system of more and more banks," says bank consultant Mihm. Still, officials in Brussels are unlikely to pay much heed to these complaints from German banks and savings banks. "The EU Commission would like to see a market shakeout in the fragmented banking market, anyway," he says.

In view of the growing side effects of the ECB's policy, the question arises all the more as to whether it is achieving its objectives.

Ifo President Fuest has his doubts. "The ECB policy has reached the limits of its effectiveness."

And that's not good news for Christine Lagarde.