Over the past year or two, the European Central Bank has periodically talked about the possibility of engineering negative nominal interest rates in the EU.  What it is talking about?

There are two possibilities:

1.  In overly simple terms, money policy is stimulative if the real (that is, after subtracting inflation) interest rate is less than zero.  For example, if inflation is 3% and the nominal interest rate is 1%, the real interest rate is -2%.  So cash is a loser, giving a sharp economic incentive to individuals and corporations a sharp incentive to borrow money and to invest their cash balances in projects that will cause economic growth.

Suppose there’s no inflation, though, or that prices are falling by, say, 2% per year.  If the best that money policy can do is bring nominal interest rates down to zero, the real interest rate is still +2% from holding cash.  So cash is a big winner.

In this deflationary scenario, the only way to achieve a positive real interest rate is to get nominal interest rates down to, say, -4%.  How to do so?  …tax bank deposits.

That’s not enough, though.   …and here’s where things get a little wacky.

If I’m going to lose 4% a year by keeping my cash in the bank, I’m going to buy a safe, withdraw my money and keep bills and coins in my house.  Scrooge McDuck writ small!!

Government can’t accept this.  So it puts “use by” dates on currency, so money expires at the rate of 4% a year if it isn’t spent (I said this wad going to be wacky).

But wait…  Citizens won’t accept this move, either.  They run to currency dealers (or gold merchants) and convert their money into non-imploding stuff.

Government responds by imposing controls on purchases of metals, foreign currency and maybe other commodities, too.

…and so on.

Anyway, this recipe for political and economic chaos can’t be what the ECB is talking about.

2.  As evidence has been mounting that the EU economy has passed its cyclical bottom and has begun to perk up a bit, the euro has been strengthening.  From early July until late last month, for instance, the currency had risen by about 8% against the US$.  A bit of that is fallout from the government shutdown in the US, but most is because investors are beginning to reallocate funds away from other parts of the world and toward the EU, where they sense surprising positive economic momentun.  Trade is starting to increase, as well.  Both developments increase demand for the €.

Once an uptrend like this starts, it also attracts speculative inflows of cash from large banks, hedge funds–sometimes gigantic inflows–who want to bet that the uptrend will continue.

What’s wrong with this?

It’s that a rise in a currency acts very much like a rise in interest rates–it slows down economic growth.  Not exactly what the ECB wants.

So it’s jawboning.  It’s threatening to tax large inflows of speculative cash, most likely by at least enough to offset any anticipated currency gain.  It’s hoping to fend off speculators by announcing the actions it will take to drive them away.

So far, the ECB has been successful.  It wouldn’t be entirely out of the realm of possibility, however, to see taxes placed on large bank deposits (after all, big speculators are going to deal in electronic money, not bills and coins) at some point to drive speculators away.   The main point to remember is that this won’t be some loony scheme to create overall negative nominal interest rates, just losses for currency speculators.

The main effect on investors will be to lessen the attractiveness of pure domestic EU plays and to retain some allure for EU-based multinationals.