Auf Wiedersehen to the €500 Note

The New York Times recently reported that the European Central Bank (ECB) has made the decision to phase out its €500 note, the highest denomination bill in Europe, by the end of 2018. The Bank's primary reason for the move cites an attempt to make illegal activities that thrive on the transfer of cash (such as money laundering, illicit trafficking and funding terrorist organizations) more difficult by restricting the amount of physical cash that one can store in one space. For instance, a standard briefcase can fit €5 million in €500 notes whereas it would require four more briefcases to carry the same amount held in €200 notes.

However the ECB might have ulterior motives in ending production of the note. One German economist has accused the ECB of artificially lowering interest rates through "negative interest", which charges banks for sitting on their money rather than lending it. With fewer €500 notes in circulation, it is possible that the banks will be persuaded into lending out more money to avoid taking the cost themselves. "It would be significantly more expensive for banks...to store lots of smaller bank notes," the German economist said.

Historic Changes in Europe: How they may affect your business

The Real Cost of Europe's Negative Interest Rate

The economics are simple: if the price of money, the interest rate, falls, buyers will want more of it. The buyers of money, borrowers, see these lower interest rates as a win. Lower interest rates mean reduced monthly payments and buyers may now be able to afford a bigger house, a fancier car, or a bigger education via a loan all paid over time. On the business front real estate developers can borrow more for a larger, new project investments and corporations can put more capital projects to work since the cost to finance them has also decreases. Because of these lower interest rates the economy starts to perk up. What happens, however, when the economy does not "perk up," even with an interest rate close to zero? The trend across some Central Banks, like the EU and Japan, is to go negative.

Normally a potential lender, a Bank, can choose not to lend and just hold onto the funds. That is equivalent to getting a nominal interest rate of zero. Not an ideal situation, but when the risks of lending are too great, this may seem like a feasible option. When interest rates fall below zero, however, a bank does not receive money on deposits; instead, depositors must pay regularly to keep their money in the Central Bank. This monetary policy, in theory, incentivizes banks to lend more freely and businesses and individuals to invest, lend, and spend money rather than pay a fee to hold large amounts of cash in reserves. As of March 10, commercial banks in the EU pay 40 base points (4/10 of a percent) for the privilege of depositing excess reserve funds overnight in the European Central Bank ("ECB").

One upside of negative interest rates may lie in the foreign-exchange market. Essentially, the theory holds that money will flee low return environments, ultimately devaluing the currency. Negative interest rates might send investors in search of better returns abroad, leading to an eventual depreciation of the currency. The now weakened currency, in turn, may increase demand for now cheaper exports and make imports more costly, and potentially creating some desired inflation. In a deflationary economy this should increase production and decrease the unemployment rate. In Europe negative interest rates have led to a nearly 20% drop in the Euro against the dollar. Central Banks in Denmark and Sweden have pursued negative interest rates with the sole objective of fixing their exchange rates with the plunging euro. The long-term risks, however, of negative interest rates with regards to lending and investment are unknown. Negative interest rates create distortions in savings and investment behaviors, eroding long-standing practice and incentives. For banks, negative interest rates can harm profitability by narrowing the margin between lending and holding money in reserve. This may potentially cause banks to be less inclined to extend credit; rather these financial institutions may take on greater risk in an effort to garner higher returns.