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EU Deflation: Second Order Impacts on Consumers and Payment Systems


Economist Edward Hugh has written two excellent articles on the confluence of long-term deflationary trends with the still powerful effects of the 2008 Financial Crisis to fundamentally alter the dynamics of belonging to the European Currency Union. The full articles can be found here[1] and here[2], but the essential message is that deflation has led the European Central Bank to finally acquiesce to the necessity of quantitative easing through the direct purchase of sovereign bonds. This in turn has increased the attractiveness for current members of the Euro through both the direct bond-buying action as well as the secondary impact of monetary devaluation favoring exports outside of the currency area. Meanwhile, the cost of not pertaining to the Euro, especially for European Economic Community members such as Great Britain, Switzerland, Denmark and Sweden has increased through the opposite actions. With the exception of the Bank of England, none of these countries has and economy or central bank of sufficient size to act as a counterweight to ECB action.

Mr. Hugh details the example of Denmark, where the Danmarks Nationalbank has been obligated to cut the short-term lending rate from -0.25% to -0.75% in order to maintain the currency peg with the Euro. Although this has put significant pressure on the Danish financial sector and exporters, the DNB remains committed to the peg and has warned that it has an unlimited balance sheet with which to defend the krone. One of the knock on effects is that Danish banks are now considering charging consumers negative rates on their deposits.

I wish to begin to explore the implications of this phenomenon on consumers by taking a look at Spain, the European market with which I am most familiar due to my residence there. Spain is not yet in negative interest rate territory; far from it, in fact, due to the country’s relatively poor credit rating and high fiscal deficits. Nevertheless, it is a country in sustained deflation with one of the worst demographic profiles in Europe, so the preconditions are in place. If negative deposit rates came to Spain, what would the rational consumer do?

The most logical answer for many consumers would be to withdraw a substantial portion of their deposits, in direct correlation with their income. The wealthier they are, the more likely they would be to minimize their exposure to negative deposit rates[3]. The deposit fee on lower income consumers would probably not be large enough, given their very low average balances, to induce them to withdraw their money.

Spain is a country where many people remain comfortable using cash, and where this medium continues to be used substantially, often in very large transactions. It is not just taxi drivers that are loath to accept payment cards; many tradesmen involved in either won’t accept a bank transfer or will offer a substantial discount on a cash payment, up to the 23% VAT rate (IVA) applied to their services. Even purchasing a property still involves a substantial portion of cash: buyers and sellers agree to the declared sales price and then to an undeclared cash payout for the balance of what the market would actually bear. The notary that prepares the documentation and countersigns the declarations serves no validation purpose whatsoever; they merely engross the total cost of the transaction with their very substantial commissions.

In a market place familiar with cash, where significant cash transactions still exist and with banks charging for the privilege of holding on to people’s money, it is not unreasonable to speculate that there would be a substantial increase in the use of cash as consumers begin to find it less convenient to keep money deposited and more convenient to keep it at home. Why not start paying the gardener with a weekly envelope rather than with a monthly EFT if the former has no fee while the latter is charging me 1% per year for nothing[4]?

This would lead to a reduction in tax revenue for the central government as more transactions and greater volumes become hidden from the Value Added Tax. There could also be a decline in the income tax (IRPJ) as self-employed professionals could earn the same amount of income, but declare less of it, since the cash portion is largely untraceable. In other words, even if they still only earn 100, but the cash portion has gone from 20 to 50, they will only declare an income of 50 rather than 80, so their tax burden falls correspondingly.

Faced with declining tax income, the state would presumably react in two ways: it would spend substantially more on tax audits, seeking to recapture some of the lost revenues; and it would increase tax rates on those portions of the economy that cannot be shielded from scrutiny. In the first effort, the Tax Authority (Agencia Tributaria) would meet with limited success. Although they know perfectly well which transactions and which professional groups are the most likely to “cheat” on their declarations of cash income, the assessment of who is actually cheating and by how much remains problematic. In the past, the government has introduced a lump sum tax for the self-employed which avoids the auditing costs and recognizes that some (large) portion of this tax is simply unrecoverable. This would likely be the conclusion in a future scenario, with the lump sum tax simply being revised upwards based on estimates of undeclared economic activity.

The second effort will meet with greater success as, by definition, the activity and the volumes are all declared. This implies a heavier tax burden on personal incomes and on mid- and large corporate profits. The world being what it is, and tax laws being what they are, these impacts will mostly be felt by middle class salaries. The rich have a greater portion of their wealth derived from non-wage sources: property, businesses and tradable assets. Not only are these taxed at a lower rate, but their sale can be deferred until a more favorable opportunity presents itself. Additionally, those with means are also best able to afford the requisite tax counsel that would enable them to find the most beneficial situation to allow them to avoid the greatest amount of tax. The same goes for large corporations who, as we’ve seen with companies like Google and Apple just to name two, are able to take advantage of loopholes in the fiscal code to literally pay next to nothing in tax despite billions in earnings. And here I am only considering the legal means of avoiding the tax; we can confidently predict that tax evasion will also grow alongside tax avoidance and tax deferment.

Thus we can predict that the heaviest burden of increased taxation will fall on the groaning, and ever shrinking, middle class worker and small to mid-sized entrepreneur: precisely the traditional twin motors of consumption and job creation for the post-World War 2 industrial state.

Another implication involves the digitalization of the financial payments and banking sector in many modern economies. Both for competitive reasons as well as for tax revenue reasons, banks and governments have found it convenient to promote the digitalization of financial transactions. A transaction that passes through a current account or a payments card is a transaction that can be tracked, recorded, measured and taxed with ease, unlike cash. This has resulted in a situation where many transactions are wholly electronic and no possibility of cash payment exists. In Spain, I must have a bank account where my salary is deposited: most large corporations do not offer their workers the possibility of receiving a check or a cash salary. Furthermore, my mortgage or rent payment, my utility bills, the tuition fees for my children’s’ school and busing all are made by direct debit from my bank account. In most of these cases, alternative means of payment are scarce.

Nevertheless, if negative deposit rates were substantial enough (or deposits large enough), there could be an incentive for me to explore alternative financing means. How would this work?

  1. A consumer would set up all my recurring payments with a credit card, rather than a bank account, where possible;
  2. At the beginning of the month, or twice a month, they would withdraw their entire paycheck from the current account where it is deposited, perhaps leaving only 100 euros for small, daily transactions;
  3. Given the long grace period on most credit card and knowing when the payment comes due, they would deposit only a sufficient amount to cover that payment a day or two before the amount is debited from their current account;
  4. Depending on the terms and conditions associated with their current account, they might not even bother with the above. If the bank does not charge a fee for being overdrawn and many do not, they would simply allow the debits to come in and cover the overdrawn amounts by cash deposit once a month.
  5. If large numbers of consumers began to behave in this fashion, the banks would naturally and understandably react. They might react in two ways: by changing their policies and by pressuring the central government to pass new laws protecting their deposits.

In the former case, I would anticipate the swift introduction of fees on overdrafts of current accounts as well as possibly the reduction or elimination of grace periods on credit cards. Banks that today offer benefits and fee waivers for customers who have a paycheck deposit on their account may have their terms and conditions modified so that the benefits apply only if a certain average balance is maintained on those accounts; or by assessing fees retroactively if cash withdrawals exceed a certain amount in a given month.

Banks might also use their substantial political influence to convince lawmakers to establish new regulations over financial transactions; requiring that certain types of payments be made only through direct debit to a current account, for example, or prohibiting the use of credit cards for these types of payments. The latter initiative could even be dressed up as consumer protection, by preventing citizens from using those bad old credit cards to get over indebted.

In either case, the practical impact would be to force consumers to keep their money in their bank accounts. It would essentially be a new tax and a subsidy for the banks, at whatever the negative deposit rate happened to be. Once again, the main impact would be on the middle class: those with enough money to feel irritated by the deposit fee, yet not wealthy enough to find means to shield themselves from the burden. We might assume that Private Banking customers would be less likely to face a charge on their deposits, since banks would be willing to subsidize them in return for all the other profitable bank activity they generate.

I would anticipate that this would lead to further political estrangement between citizens and their governments, as the latter became ever more identified with the “moneyed interest” rather than with “Main Street interests”. Given the rise of anti-establishment parties like Syriza and Podemos in Greece and Spain respectively, a furtherance of the divorce between middle class voters and their national and European representatives would prove dangerous to democracy and European unity. Yet without a credible challenge to current policies, it is difficult to see an alternative to banks and governments shifting the costs of deflation to those sectors least able to resist them via a “least resistance” reflex.

The industrialized capitalist world has not seen a period of sustained deflation since the 1880’s and there is no one alive today with the memory of its impacts or its resolution. The fact that the former crisis was resolved through the Great Power rivalry that led directly to the First World War is not heartening. Today the “industrialized capitalist world” is more or less synonymous with “the world” means that impacts will be global and policy responses ought to be global; yet the political architecture remains largely that of the 19th century nation-state. Even those who insist on maintaining the nation-state as the basic unit of organization must admit that the world needs new international institutions that will assist, yet not supplant, states in meeting the new challenges facing them.

Until those institutions are built, we will be increasingly frustrated in our attempts to control or even mitigate the deep forces at work upon the world[5].


Sources and Notes

[1] Edward Hugh, “EuroGroup – Money For Nothing And Your Debt For Free?,”  Edward.Hugh.Blog, 24 February 2015

[2] Edward Hugh, “Does The Arrival Of Negative Interest Rates Change the Attractivess of Euro Membership?,” Edward.Hugh.Blog, 01 March 2015

[3] I expect there would be an inflection point; at some point, a customer would be wealthy enough that the bank would be willing to subsidize their deposits in order to keep their other profitable business. Private Banking customers, for example.

[4] By this I mean the consumer’s perception of the banks doing nothing; banks will argue that there are costs associated with current accounts that need to be covered, and that the consumer still derives benefits even with a negative deposit rate, such as convenience and security.

[5] Fernando Betancor, “The World Has Moved On,” Common Sense, 26 October 2012

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