This is going to be a short thought piece. But the takeaway should be that the convergence to zero will continue unabated as the threat of inflation is muted given the combination of excess capacity, high private debt and unfavourable demographics. The subject is monetary policy.

Last week, when Mario Draghi spoke to the press after the ECB’s decision to conduct large scale asset purchases of euro area government bonds, his language was clear and telling. He indicated at that time that he believed ECB policy, while not wholly effective in lieu of fiscal policy, had two ways in which to work.

The first way Draghi saw policy working was via the portfolio balance channel. Draghi explained the effect by noting that banks which sell bonds to the central bank must redeploy capital, and in doing so they have “an incentive” to not just let the reserves they receive for their assets sit idle as those reserves would be taxed due to the ECB’s negative rate policy. In Draghi’s view then, this would provide an incentive for lending, not just for redeploying money into other government bonds or into riskier assets.

The second way that Draghi saw policy working is through expectations. He believes that inflation expectations would be pushed up as a result of ECB action and that the expectation of higher inflation would feed through into actual consumer prices in some fashion, leading to higher inflation, which I assume he believes is a good thing even in the absence of higher real wages.

I do not agree with either line of argument. However, rather than trying to pick apart Mario Draghi’s view, let me supply an alternative line of thinking.

First, our monetary system is really a credit system because it is credit that matters, rather than narrow base money or monetary aggregates that most people use as a proxy of the broader money supply. What we want to see for economic growth to occur is that financial institutions are making loans to productive parts of the economy that have the greatest impact on sustainable long-term economic growth. Further, we want to see this economic growth underpinned by household and business income that supports further growth down the line. The key here is that the growth comes not from the financial sector or financial assets but from productive assets that throw off income which can be used by businesses and households to repay the debt and take on even more as productive ventures become available.

In this process, the loans that are made create a deposit in the banking system that then requires an individual lender to increase its reserve balances. It is the loan that creates the need for the reserves. And to the degree the individual bank does not have enough reserves, it can borrow them in the inter-bank market. Moreover, to the degree that the whole of the banking system is at its reserve limit when this loan creates a reservable deposit, the central bank will increase the reserves in the system. Two things are notable here. One, not increasing the system-wide reserves at any one discrete point in time when the system is at a limit would create a disruption in the payments system, whose function the central bank is legally mandated to ensure. So the central bank will supply the reserves. Second, to the degree the central bank wants to stop supplying more reserves to the system, it will have to raise its policy rate or regulate the banks’ credit allocation process more assiduously.

The modern central bank is an interest-rate targeting monopoly supplier of reserves because central banks know that they can reliably hit a target for overnight interest rates since they are the only game in town. However, the trade-off in setting an interest rate is that the central bank is forced to meet the reserve needs of the system irrespective of how great those needs are. To the degree the central bank believes the need for reserves is too high because credit growth is too high and the economy is overheating, then it can always raise the overnight lending rate. But it cannot restrict the supply of reserves or the payments system breaks down and inter-bank payments clearances begin to fail.

All of this is important to point out because it is the supply of credit that determines the need for reserves, not the other way around, as often stated directly or implied through money multiplier analogies in economic textbooks. Thus, when you think about quantitative easing and its transmission into the real economy, it’s clear that If the central bank injects base money into the financial system in its large scale asset purchase program as a swap for government bonds, this increased amount of base money does not force credit creation to occur. This does not directly drive growth. It only works via some sort of portfolio balance effect. And here I am not implying that banks will lend, rather I am saying that they financial institutions will alter the composition of their portfolios in response to perceived easing. They can reach for yield and increase risk, knowing that the central bank is effectively backstopping them by signalling accommodation for the foreseeable future. The portfolio balance effect comes from the accommodation signal that a central bank supplies, which allows players to engage in ‘carry’ strategies with a longer exit timeframe. This is not a real economy effect. It is a financial economy effect. And so we should expect asset prices to rise and for the real economy only to receive a tertiary flow through.

Now, to the degree the portfolio balance effect does impact the real economy, if private debts are high, sustainable credit growth will be more limited without wage growth. Yes, credit can grow but unless wages are also growing in real terms, credit would have to be growing relative to income, which is dangerous when private debt is already high. Moreover, demographics work against credit growth as older people are less likely to substantially increase credit given their shorter high-income time horizon and accumulated savings.

On negative interest rates, I will be brief; they are a tax. And like all taxes, this tax reduces net financial assets in the private sector. It is highly dubious that taxing deposits will give an incentive to banks to lend responsibly. What we should expect instead is for banks to either eat the losses from the tax, pass on the tax to customers, or to try and recoup the loss through increasing risk or leverage. In short, negative interest rates are, while a deterrent to hot money flows, not stimulative to the domestic economy.

The bottom line, then, is that I expect QE style strategies to fail both in creating inflation and in creating economic growth. I believe we are going to see a continued downtrend in nominal GDP until wages rise or debts fall relative to wages. The strategies being employed by indebted developed economies are not geared to either wage growth or debt reduction relative to wages. And that is why we should expect nominal GDP to continue to decline, and long-term interest rates as well.