The Euro – A Monetary Strangulation Mechanism

In my previous post I claimed that the ‘Greek crisis’ essentially is not about Greece, but rather that the crisis is a symptom of a bigger problem namely the euro itself.

Furthermore, I claimed that had it not been for the euro we would not have had to have massive bailouts of countries and we would not have been in a seven years of recession in the euro zone and unemployment would have been (much) lower if we had had floating exchange rates in across Europe instead of what we could call the Monetary Strangulation Mechanism (MSM).

It is of course impossible to say how the world would have looked had we had floating exchange rates instead of the MSM. However, luckily not all countries in Europe have joined the euro and the economic performance of these countries might give us a hint about how things could have been if we had never introduced the euro.

So I have looked at the growth performance of the euro countries as well as on the European countries, which have had floating (or quasi-floating) exchange rates to compare ‘peggers’ with ‘floaters’.

My sample is the euro countries and the countries with fixed exchange rates against the euro (Bulgaria and Denmark) and countries with floating exchange rates in the EU – the UK, Sweden, Poland, Hungary, the Czech Republic and Romania. Furthermore, I have included Switzerland as well as the EEA countriesNorway and Iceland (all with floating exchange rates). Finally I have included Greece’s neighbour Turkey, which also has a floating exchange rate.

In all 31 European countries – all very different. Some countries are political dysfunctional and struggling with corruption (for example Romania or Turkey), while others are normally seen as relatively efficient economies with well-functioning labour and product markets and strong external balance and sound public finances like Denmark, Finland and the Netherland.

Overall we can differentiate between two groups of countries – euro countries and euro peggers (the ‘red countries’) and the countries with more or less floating exchange rates (the ‘green countries’).

The graph below shows the growth performance for these two groups of European countries in the period from 2007 (the year prior to the crisis hit) to 2015.

floaters peggers RGDP20072015 A

The difference is striking – among the 21 euro countries (including the two euro peggers) nearly half (10) of the countries today have lower real GDP levels than in 2007, while all of the floaters today have higher real GDP levels than in 2007.

Even Iceland, which had a major banking collapse in 2008 and the always politically dysfunctionally and highly indebted Hungary (both with floating exchange rates) have outgrown the majority of euro countries (and euro peggers).

In fact these two countries – the two slowest growing floaters – have outgrown the Netherlands, Denmark and Finland – countries which are always seen as examples of reform-oriented countries with über prudent policies and strong external balances and healthy public finances.

If we look at a simple median of the growth rates of real GDP from 2007 until 2015 the floaters have significantly outgrown the euro countries by a factor of five (7.9% versus 1.5%). Even if we disregard the three fastest floaters (Turkey, Romania and Poland) the floaters still massively outperform the euro countries (6.5% versus 1.5%).

The crisis would have long been over had the euro not been introduced  

To me there can be no doubt – the massive growth outperformance for floaters relative to the euro countries is no coincidence. The euro has been a Monetary Strangulation Mechanism and had we not had the euro the crisis in Europe would likely long ago have been over. In fact the crisis is essentially over for most of the ‘floaters’.

We can debate why the euro has been such a growth killing machine – and I will look closer into that in coming posts – but there is no doubt that the crisis in Europe today has been caused by the euro itself rather than the mismanagement of individual economies.

PS I am not claiming the structural factors are not important and I do not claim that all of the floaters have had great monetary policies. The only thing I claim is the the main factor for the underperformance of the euro countries is the euro itself.

PPS one could argue that the German ‘D-mark’ is freely floating and all other euro countries essentially are pegged to the ‘D-mark’ and that this is the reason for Germany’s significant growth outperformance relative to most of the other euro countries.

Update: With this post I have tried to demonstrate that the euro does not allow nominal adjustments for individual euro countries and asymmetrical shocks therefore will have negative effects. I am not making an argument about the long-term growth outlook for individual euro countries and I am not arguing that the euro zone forever will be doomed to low growth. The focus is on how the euro area has coped with the 2008 shock and the the aftermath. However, some have asked how my graph would look if you go back to 2000. Tim Lee has done the work for me – and you will see it doesn’t make much of a difference to the overall results. See here.

Update II: The euro is not only a Monetary Strangulation Mechanism, but also a Fiscal Strangulation Mechanism.


If you want to hear me speak about these topics or other related topics don’t hesitate to contact my speaker agency Specialist Speakers – e-mail: or

Awesome LEGOnomics – positive TFP shocks and the Danish economy

The Christensen family has been spending an awesome weekend at LEGO-land (Billund) so that is a good excuse for me to write a post on how to understand the impact of a corporate success story like LEGO on a small open economy with a pegged exchange rate regime like Denmark.


The background – “LEg GOdt”

Every kid in Denmark knows and loves LEGO – as do their parents. But LEGO is not just a loved brand in Denmark, but across the world. In fact the LEGO brand today undoubtedly is one of the strongest corporate brands in the world.

This is what LEGO writes about its corporate history:

“The name ‘LEGO’ is an abbreviation of the two Danish words “leg godt”, meaning “play well”. It’s our name and it’s our ideal.

The LEGO Group was founded in 1932 by Ole Kirk Kristiansen. The company has passed from father to son and is now owned by Kjeld Kirk Kristiansen, a grandchild of the founder.

It has come a long way over the past almost 80 years – from a small carpenter’s workshop to a modern, global enterprise that is now one of the world’s largest manufacturer of toys.”

And yes, the company has come a long way – and it is not only a “brick producer”, but also an extremely innovative company that continues to come up with great new products. In macroeconomic terms we can think of this as an increase in what macroeconomists call Total Factor Productivity (TFP).

LEGO as positive shock to Danish Total Factor Productivity (TFP)

Macroeconomists rarely speak about companies and certainly very rarely about the importance of individual companies. The case obviously is that it is rare you would say that an individual company is large enough to have a major macroeconomic importance. Nokia’s success – and later its failure – and it’s importance for the Finnish economy, however, provides a useful example of a company, which have had major macroeconomic effect (See my later blog post on this here).

Is LEGO such a company? I am not sure (I have not done a proper analysis of it), but it is nonetheless notable that the (renewed) global success of LEGO over the past decade to some extent coincides with a rather positive development in Denmark’s terms-of-trade. Another company – and likely even more important from a macroeconomic perspective – is the multinational pharmaceutical company Novo Nordisk, which also over the past decade or so has been remarkably successful internationally.

The purpose of this post is not to analyse the magnitude of the macroeconomic impact of LEGO’s success, but rather to look at the mechanisms that are in play. However, I believe the easiest way to think about LEGO’s macroeconomic impact is to think of the success of LEGO as a positive Total Factor Productivity shock, which essentially increases the competitiveness of the Danish economy. Said, in another way the success of LEGO (and Novo Nordisk for that matter) has caused an improvement in Danish terms-of-trade (export prices have risen relative to import prices).

As LEGO is a major play on the global toy market and because the global toy market is an imperfect competition market, with differentiated products, LEGO has some pricing power in the global toy market. Consequently LEGO can therefore ask for higher prices for its famous bricks than otherwise would have been the case. This of course is why LEGO’s success supports Danish terms-of-trade.

In an AS/AD set-up we can think of this as a positive Aggregate Supply (AS) shock, which shifts the long-run AS (LRAS) curve to the right. The graph below this illustrates this.


Notice that I here look at the AS/AD framework in terms of inflation and real GDP growth rather than in terms of the price level and the level of GDP. You see here that the positive AS shock causes Danish inflation to drop (from p to p’) and increase real GDP growth (from y to y’). This should of course not be confused with LEGO’s prices (or Danish export prices). The improvement in LEGO’s TFP causes LEGO’s prices (and Danish export prices) to increase relative to Danish domestic prices.

Essentially a positive TFP shock means that Denmark is becoming a more wealthy nation, which in turns causes wages, profits, property prices, equity prices and real GDP etc. to increase. That is pretty awesome.

The LEGO-monetary transmission mechanism

However, this is not the only impact we have of a positive TFP shock. Hence, as Denmark operates a fixed rate regime supply shocks will also cause a quasi-automatic change in monetary conditions.

When TFP improves it causes an improvement in Danish competitiveness, which then leads to an improvement in Denmark’s trade balance and the current account. This will tend to strengthen the Danish krone. However, as the Danish central bank pursues a fixed exchange rate policy it will counteract the strengthening of the krone by easing monetary policy – either by cutting the key policy rate or intervening in the currency market.


This process of “counteracting” monetary easing will in our AS/AD framework cause the AD curve to shift to the right, which will cause inflation to rise (back to p from p’) – offsetting the downward pressures on inflation caused by the initial positive TFP shock. This process will essentially continue until the “competitiveness effect” of the positive TFP shock has been eroded by higher inflation due to monetary easing. This is what Hayekians would term “relative inflation” and Hayekians would also argue that this could lead to economic misallocation.

The problem from a Hayekian perspective is not the positive TFP shock – LEGO’s innovative success – but the monetary response, which directly follows from Denmark’s pegged exchange regime. But nonetheless there is given Denmark’s monetary regime a link between LEGO’s improved Total Factor Productivity and the development in Danish monetary conditions.

Awesome LEGO

The international success of a relatively few Danish companies such as Novo Nordisk and LEGO over the past 10-15 years likely has played a much bigger role for the overall performances of the Danish economy than is normally realized – both by economists and by the wider public in Denmark.

My kids think LEGO is awesome (as do I) and so should Danish taxpayers, labour unions and consumers think.

Asymmetrical shocks in a currency union, the Crime of 1873 and the of a guy called Sven Persson

I have never been particularly interested in genealogy, however, that has changed after my dad recently sent me a picture of Sven Persson. Sven Persson was my great-great grandfather.

I had seen the picture before and I knew that I have Swedish family roots – Sven was born in Hjärsås, Skåne, Sweden on July 26 1861 – but I have not really thought much about it before, but seeing the picture of Sven (and his family) again triggered something in me probably because I realized that the story of Sven is closely related to some key historical economic and monetary events in Scandinavia and indeed in the world.

Sven og familie

I must admit that I have not done a lot of research (yet) into Sven’s story, but I know enough to tell the story of the economic realities he lived under and I believe his life to a very large extent was shaped by these events. In this post I will try to tell that story – in the light of economic and monetary events in the world and Scandinavia during the years Sven lived.

Sven – The typical immigrant from Skåne (Scania) 

I think what triggered me to look into Sven’s story was his immigrant background and particularly the fact that I pretty fast realized that Sven likely came to Denmark in the early 1880s. I already knew that during that period a lot of Swedes came to Denmark to work.

In fact in the early 1880s nearly 10% of the population in Copenhagen where Swedish. So while many Danes today would say that the level of immigration to Denmark is unprecedented in size that is not really true. 130 years ago the story was much the same as today and the discussions about immigration was quite similar – the Swedes are stealing the jobs from Danes, they push down salaries and they are more criminal than Danes. Not much have changed in that sense regarding the debate over immigration.

So why did Sven come to Denmark? Well, we of course don’t know, but if Sven was a normal Skåning (a inhabitant of Skåne in Southern Sweden) then he would have come for economic reasons.

Research (see here) done on Swedish emigration to USA during the 1880s shows that both “pull” and “push” factors were important for the decision of Swedes to emigrate to the US. Hence, Swedes both ran away from poverty in Sweden and for economic opportunities in the US. It hard not to believe that the same factors motivated Swedes – including my great-great grandfather – who emigrated to Denmark in the 1880s.

This is what the Danish economic historian Richard Willerslev has to say about number of Swedish immigrants to Denmark (my translation from Danish, cf. page 228):

After some years of stagnation the immigration to Denmark once again picked up and remained steady at a very high level from the mid-1870s and toward 1890.

Now compare that with the relative development in real GDP in Denmark and Sweden.

Sweden Denmark relative GDP 1870

(S0urce: Angus Maddison’s “Dynamic Forces in Capitalist Development”)

It is fairly easy to see that there was a sharp relative decline in the level of  Swedish real GDP compared to Denmark. This of course coincides with the sharp increase in Swedish immigration to Denmark. Sweden’s relative decline came to an end in 1882-1883 – coinciding with the stagnation in the Swedish emigration levels (at a high level).

So what I about Sven? I am not entirely sure when Sven emigrated to Denmark, but public records show that he left his native city of Hjärsås in 1880. The public record I have found on Sven is that he married the Dane Bertine Kirstine Frederiksen on November 14 1890. Hence, we can conclude that Sven came to Denmark between 1880 and 1890 and most likely in the early 1880s.

This makes Sven into a very “average” immigrant. He was in his early twenties and an unskilled labourer with a poor background (his farther Per Jeppsson was an unskilled farm worker).

Currency union and the asymmetrical shock to the Swedish economy after 1873

So how do we explain Sweden’s relative decline compared to Denmark in mid-1870s? We need two explanations – one for the absolute decline in real GDP growth and one for the relative decline in real GDP.

Around 1871-73 a massive transformation of the global monetary system started and the process that lasted only a few years meant the end of bimetalism as a monetary standard and the total global domination of the gold standard. A number of factors contributed to ending bimetalism and establishing the gold standard’s global dominance.

Milton Friedman has pointed to the U.S. Coinage Act of 1873 as the major contributing factor of this transformation of the global monetary system (See here). This was the so-called Crime of 1873. There was a similar European – or a German-French – Crime of 1873 driven by among other things the German decision to introduce the gold standard in 1871.

No matter what the explanation is for the triumph of the gold standard over bimetalism in the early 1870s the result was a global deflationary shock as demand for gold spiked. That kicked of what has come to be known as the worldwide Long Depression normally said to have lasted from 1873 to 1879.

The graph above clearly shows that Sweden was hit by the Long Depression, which coincided with a sharp increase in Swedish emigration to Denmark.

1873 also happen to be the year the Scandinavian Currency Union was established between Denmark, Sweden and Norway. The SCU was based on the gold standard. Prior to that the three Scandinavian countries had been on different bimetalistic standards.

The fact that a wide difference in growth between Denmark and Sweden emerged in the second half of the 1870s can be interpreted as an asymmetrical shock and I believe that it is this asymmetrical shock – growth was higher in Denmark than in Sweden – that fundamentally caused my great-great grandfather Sven and thousands of other Swedes to emigrate to Denmark during the 1870s and 1880s. The size of the asymmetrical shock in my view also shows that the SCU was indeed not an optimal currency area. Had it been then Sven likely would never have come to Denmark.

I have not spend much time studying the reasons for this asymmetrical shock, but I overall have three hypotheses that might explain the differences in growth.

First, the Danish krone might have been undervalued at the unset of the currency union, while the Swedish krona might have been overvalued.

Second, sectoral differences might have played a role – with the Swedish agricultural and mining sector being harder hit by the global deflationary shock than the dominant Danish economic sectors. This also includes the relative importance of the UK and German economies for the economies of Denmark and Sweden.

And finally the third explanation might be differences in fiscal policy. Denmark undertook major railway and defense investments in those years. I should stress this is hypotheses.

I would obviously appreciate comments from my readers on these hypotheses and links to relevant research.

The Great Depression and the death of Sven

I don’t know much about the life of Sven in Denmark. But he got married and he (likely) got four children. He likely continued to work as an unskilled worker in Denmark, where he died at the unset of the Great Depression on October 4 1929.

So we can say that my great-great grandfather was brought to Denmark because of a depression and he lived in Denmark until the unset of another depression.

Monetary policy failure surely can have great impact on the life of people – including on the decision to live in one or the other country. My family heritage is proof of that.

PS if you want to have a look at my very incomplete family tree please have a look here.

Cato Institute says Denmark is more economically free than the US

The Cato Institute and Fraser Institute have published their annual report on Economic Freedom of the World. As always it is interesting stuff. One can of course always debate the methods used to rank different countries in Economic Freedom ranking, but I nonetheless think it gives a pretty fair description of the overall tendencies.

One thing I always like to look at is the relative ranking of the Nordic countries versus the US. Interestingly enough all of the Nordic countries tend to rank as very economically free in both the Cato/Fraser rankings and in the similar ranking from the Heritage Foundation. This is despite the fact that the Nordic countries have very large public sectors and a high level of taxation. However, that is generally more than “compensated” by low levels product and labour market regulation and very open economies with free movement of capital and goods.

This is the 2013-ranking for the US and the Nordic countries:

(7) Finland

(14) Denmark

(17) United States

(29) Sweden

(31) Norway

(41) Iceland

So there you go – both Denmark and Finland are more economically free than the US at least according to Cato/Fraser.

I sure that a lot of Danish libertarians and conservatives would object to Denmark high ranking and they would undoubtedly stress that it is impossible to argue Denmark is more “economically free” than the US due to the fact that the Danish public sector is among the largest public sectors in the world and level of taxation is very high in Denmark. However, looking in all other areas Denmark is indeed a very free economy.

I am looking forward to comments from both Danes and Americans. Is Fraser and Cato right?

Denmark and Utah – Miles Kimball and me

Scott Sumner has an interesting new post in which he argues that Utah is “America’s Denmark”. I like Scott’s theory a lot. Mostly because I think of Utah is how Denmark used to be. I really don’t like to write about Denmark, but this topic is too interesting to miss.

I left a long answer to Scott on his blog. This post is based on that answer.

Lets start out with Scott’s PS:

“I knew Miles and Lars had something in common”

Scott obvious thinks of Miles Kimball and yours truly. If I am not wrong Miles grew up in Utah as a Mormon (Miles in no longer a Mormon).

Miles and I indeed have a lot in common. So Scott is on to something – Utah in fact is “Danish” in the sense that a large share of the early Mormon pioneers in Utah in fact came from Denmark. In fact Miles is 1/4 Danish. Miles’ grandfather was named Elmer (Madsen). Elmer happens to be my son’s middle name (a very rare name in today’s Denmark).

Last year I spoke at Brigham Young University in Utah. At my presentation I was asked how the Danish welfare model could work. My answer was “because we are like you”. Ever since I visited Utah last year I have been thinking about the early Mormon society as an anarchic form of a welfare society. A society where collective goods problems are solved through common norms (religion). Denmark of the 1950s and Utah of the 1860s probably have that in common. That is not a surprise – a lot of the people in both places of course were/are Danes. As Miles’ grandfather and my grandfather. In fact I have for some time had the crazy idea that I want to try to write a book in the topic of how collective goods problems were solved in early Mormon society in Utah. As a Dane I might have a comparative advantage in that endeavor (The other thing is that I don’t have time to undertake this task… )

My argument was that the “original” Danish welfare state really just is a form of the Mormon style welfare system. Everybody in society are very similar and as a consequence there is little difference between a “one-size-fits-all” tax funded system and a private based system like the Mormon private based welfare system.

The interesting thing here is that the Mormon pioneers in Utah established a basically anarchic welfare system that basically covered everybody. That worked fine and I believe that is not really that different in the foundation form the Danish Welfare system. What is different is how the two systems developed over time. In fact I believe that had Utah not become part of the United States Utah might very well have developed into Danish style welfare state. This of course is somewhat os a paradox – anarchic welfare society that develops into a society with a very large public sector. Maybe some of the Bleeding Heart Libertarians have a view on this topic.

However, I am too optimistic on the future of the Danish welfare model. First of all I think it is extremely important to notice that the Danish model really was largely private sector based until the late 1960s. In fact until the mid-1960s the size of the public sector in Denmark (and all the other Nordic countries) was smaller than in public sector in the US (as share of GDP). Hence, when Milton Friedman wrote Capitalism and Freedom (in 1962) Denmark really was closer to his ideal than the US was.

In the end of the 1960s the public sector in Denmark started growing very dramatically until the early 1980s. In that period Denmark also started its relative income decline.

Finally I would note that in a society where everybody “normally” works and where most people are very similar people would tend to be “honest” and not misuse public benefit systems and because your neighbours come knocking on your door and tell you to get your act together if you want to be invited over for BBQ etc. That undoubtedly was the case in Denmark until the early 1970s. However, that changed in the 1970s.

Two things happened. First of all, unemployment rose dramatically in Denmark in the early 1970s as a result of the first oil crisis AND a sharp increase in benefits levels. That made it “socially acceptable” to be unemployment and live of taxpayer money. Second, Denmark saw a sharp increase in immigration from the late 1960s and until the early 1980s. That changed Denmark from an extremely homogeneous society to a more multicultural society. These two factors in my view removed the implicit ‘social threat’ that your neighbors would think of you as an idiot if you remained on the dole for years. That effectively sharply reduced the cost of misusing the public welfare system.

As consequence while Dane used to the work ethics as Utah Mormons Denmark today is a “leisure society” with low work ethics. This in my view probably is the biggest threat to the “Danish model”. A new working paper by Casper Hunnerup Dahl has an interesting discussion of this topic.

Finally, the strength of the “flexicurity system” in my view is mostly a myth. Yes, we have a very flexible labour market in Denmark with low levels of labour market regulation. There is for example no official state sponsored minimum wage and firing and hiring rules are liberal. However, high benefit levels is a massive burden to public finances and in the long-term the model will not survive in its present form.

Denmark, however, still benefits from have a fairly homogenous society in the sense that it probably has positive impact on the political system. Hence, while the welfare state is overblown Danish policy makers over the last three decades in general have agreed on the overall need for scaling back the public sector and continue economic reforms. Hence, since the early 1980s different (left and right) governments have tried to reform the welfare state. Hence, had it not been for the policy mistakes of the late 1960s and early 1970s Denmark would probably have had a public sector of a similar size to Switzerland. Incredibly enough the present centre-left government has – much against its voters wishes – pushed from reforms of welfare benefits, educational reform and pension reforms.

Concluding, I believe Scott in general is right. Utah might be America’s Denmark, but it is probably the Denmark of 1960 rather than of today.

PS I hope Scott will soon visit Denmark to take a look for himself. I know Miles will soon be here.

The Kuroda recovery will be about domestic demand and not about exports

There has been a lot of focus on the fact that USD/JPY has now broken above 100 and that the slide in the yen is going to have a positive impact on Japanese exports. In fact it seems like most commentators and economists think that the easing of monetary policy we have seen in Japan is about the exchange rate and the impact on Japanese “competitiveness”. I think this focus is completely wrong.

While I strongly believe that the policies being undertaken by the Bank of Japan at the moment is likely to significantly boost Japanese nominal GDP growth – and likely also real GDP in the near-term – I doubt that the main contribution to growth will come from exports. Instead I believe that we are likely to see is a boost to domestic demand and that will be the main driver of growth. Yes, we are likely to see an improvement in Japanese export growth, but it is not really the most important channel for how monetary easing works.

The weaker yen is an indicator of monetary easing – but not the main driver of growth

I think that the way we should think about the weaker yen is as a indicator for monetary easing. Hence, when we seeing the yen weakeN, Japanese stock markets rallying and inflation expectations rise at the same time then it is pretty safe to assume that monetary conditions are indeed becoming easier. Of course the first we can conclude is that this shows that there is no “liquidity trap”. The central bank can always ease monetary policy – also when interest rates are zero or close to zero. The Bank of Japan is proving that at the moment.

Two things are happening at the moment in the Japan. One, the money base is increasing dramatically. Second and maybe more important money-velocity is picking up significantly.

Velocity is of course picking up because money demand in Japan is dropping as a consequence of households, companies and institutional investors expect the value of the cash they are holding to decline as inflation is likely to pick up. The drop in the yen is a very good indicator of that.

And what do you do when you reduce the demand for money? Well, you spend it, you invest it. This is likely to be what will have happen in Japan in the coming months and quarters – private consumption growth will pick-up, business investments will go up, construction activity will accelerate. So it is no wonder that equity analysts feel more optimistic about Japanese companies’ earnings.

Hence, the Bank of Japan (and the rest of us) should celebrate the sharp drop in the yen as it is an indicator of a sharp increase in money-velocity and not because it is helping Japanese “competitiveness”.

The focus on competitiveness is completely misplaced

I have in numerous earlier posts argued that when a country is going through a “devaluation” as a consequence of monetary easing the important thing is not competitiveness, but the impact on domestic demand.

I have for example earlier demonstrated that Swedish growth outpaced Danish growth in 2009-10 not because the Swedish krona depreciated strongly against the Danish krone (which is pegged to the euro), but because the Swedish Riksbank was able to ease monetary policy, while the Danish central bank effectively tightened monetary conditions due to the Danish fixed exchange rate policy. As a consequence domestic demand did much better in Sweden in 2009-10 than in Denmark, while – surprise, surprise – Swedish and Danish exports more or less grew at the same pace in 2009-10 (See graphs below).

Similarly I have earlier shown that when Argentina gave up its currency board regime in 2002 the major boost to growth did not primarly come from exports, but rather from domestic demand. Let me repeat a quote from Mark Weisbrot’s and Luis Sandoval’s 2007-paper on “Argentina’s economic recovery”:

“However, relatively little of Argentina’s growth over the last five years (2002-2007) is a result of exports or of the favorable prices of Argentina’s exports on world markets. This must be emphasized because the contrary is widely believed, and this mistaken assumption has often been used to dismiss the success or importance of the recovery, or to cast it as an unsustainable “commodity export boom…

During this period (The first six months following the devaluation in 2002) exports grew at a 6.7 percent annual rate and accounted for 71.3 percent of GDP growth. Imports dropped by more than 28 percent and therefore accounted for 167.8 percent of GDP growth during this period. Thus net exports (exports minus imports) accounted for 239.1 percent of GDP growth during the first six months of the recovery. This was countered mainly by declining consumption, with private consumption falling at a 5.0 percent annual rate.

But exports did not play a major role in the rest of the recovery after the first six months. The next phase of the recovery, from the third quarter of 2002 to the second quarter of 2004, was driven by private consumption and investment, with investment growing at a 41.1 percent annual rate during this period. Growth during the third phase of the recovery – the three years ending with the second half of this year – was also driven mainly by private consumption and investment… However, in this phase exports did contribute more than in the previous period, accounting for about 16.2 percent of growth; although imports grew faster, resulting in a negative contribution for net exports. Over the entire recovery through the first half of this year, exports accounted for about 13.6 percent of economic growth, and net exports (exports minus imports) contributed a negative 10.9 percent.

The economy reached its pre-recession level of real GDP in the first quarter of 2005. As of the second quarter this year, GDP was 20.8 percent higher than this previous peak. Since the beginning of the recovery, real (inflation-adjusted) GDP has grown by 50.9 percent, averaging 8.2 percent annually. All this is worth noting partly because Argentina’s rapid expansion is still sometimes dismissed as little more than a rebound from a deep recession.

…the fastest growing sectors of the economy were construction, which increased by 162.7 percent during the recovery; transport, storage and communications (73.4 percent); manufacturing (64.4 percent); and wholesale and retail trade and repair services (62.7 percent).

The impact of this rapid and sustained growth can be seen in the labor market and in household poverty rates… Unemployment fell from 21.5 percent in the first half of 2002 to 9.6 percent for the first half of 2007. The employment-to-population ratio rose from 32.8 percent to 43.4 percent during the same period. And the household poverty rate fell from 41.4 percent in the first half of 2002 to 16.3 percent in the first half of 2007. These are very large changes in unemployment, employment, and poverty rates.”

And if we want to go further back in history we can look at what happened in the US after FDR gave up the gold standard in 1933. Here the story was the same – it was domestic demand and not net exports which was the driver of the sharp recovery in growth during 1933.

These examples in my view clearly shows that the focus on the “competitiveness channel” is completely misplaced and the ongoing pick-up in Japanese growth is likely to be mostly about domestic demand rather than about exports.

Finally if anybody still worry about “currency war” they might want to rethink how they see the impact of monetary easing. When the Bank of Japan is easing monetary policy it is likely to have a much bigger positive impact on domestic demand than on Japanese exports. In fact I would not be surprised if the Japanese trade balance will worsen as a consequence of Kuroda’s heroic efforts to get Japan out of the deflationary trap.

HT Jonathan Cast


PS Scott Sumner also comments on Japan.

PPS An important non-competitiveness impact of the weaker yen is that it is telling consumers and investors that inflation is likely to increase. Again the important thing is the signal about monetary policy, which is rather more important than the impact on competitiveness.

‘The Myth of Currency War’

I know that most of my readers must be sick and tired of reading about my view on ‘currency war’. Unfortunately I have more for you. My colleague Jens Pedersen and I have written an article for the Danish business daily Børsen. The piece was published in today’s edition of Børsen. It is in Danish, but you can find an English translation of the article here.

Regular readers of this blog will not be surprised by the main message in the article: The talk of a “dangerous” ‘currency war’ is just silly. It is not really a ‘currency war’, but rather global monetary easing. Global monetary easing even helps the euro zone despite the ECB’s extreme reluctance to ease monetary policy.

Jens has recently also written an extremely interesting paper on the consequence of the ‘currency war’ for the Danish economy. Jens concludes that the currency war – or rather global monetary easing – is good news for Danish exporters despite the fact that the Danish krone has been strengthening in line with the euro (remember the krone is pegged to the euro). The reason is that global monetary easing is boosting global growth and that is outweighing any negative impact on exports from the strengthening of the krone.

Take a look at Jens’ paper here.

The root of most fallacies in economics: Forgetting to ask WHY prices change

Even though I am a Dane and work for a Danish bank I tend to not follow the Danish media too much – after all my field of work is international economics. But I can’t completely avoid reading Danish newspapers. My greatest frustration when I read the financial section of Danish newspapers undoubtedly is the tendency to reason from different price changes – for example changes in the price of oil or changes in bond yields – without discussing the courses of the price change.

The best example undoubtedly is changes in (mortgage) bond yields. Denmark has been a “safe haven” in the financial markets so when the euro crisis escalated in 2011 Danish bond yields dropped dramatically and short-term government bond yields even turned negative. That typically triggered the following type of headline in Danish newspapers: “Danish homeowners benefit from the euro crisis” or “The euro crisis is good news for the Danish economy”.

However, I doubt that any Danish homeowner felt especially happy about the euro crisis. Yes, bond yields did drop and that cut the interest rate payments for homeowners with floating rate mortgages. However, bond yields dropped for a reason – a sharp deterioration of the growth outlook in the euro zone due to the ECB’s two unwarranted interest rate hikes in 2011. As Denmark has a pegged exchange rate to the euro Denmark “imported” the ECB’s monetary tightening and with it also the prospects for lower growth. For the homeowner that means a higher probability of becoming unemployed and a prospect of seeing his or her property value go down as the Danish economy contracted. In that environment lower bond yields are of little consolation.

Hence, the Danish financial journalists failed to ask the crucial question why bond yields dropped. Or said in another way they failed to listen to the advice of Scott Sumner who always tells us not to reason from a price change.

This is what Scott has to say on the issue:

My suggestion is that people should never reason from a price change, but always start one step earlier—what caused the price to change.  If oil prices fall because Saudi Arabia increases production, then that is bullish news.  If oil prices fall because of falling AD in Europe, that might be expansionary for the US.  But if oil prices are falling because the euro crisis is increasing the demand for dollars and lowering AD worldwide; confirmed by falls in commodity prices, US equity prices, and TIPS spreads, then that is bearish news.

I totally agree. When we see a price change – for example oil prices or bond yields – we should ask ourselves why prices are changing if we want to know what macroeconomic impact the price change will have. It is really about figuring out whether the price change is caused by demand or supply shocks.

The euro strength is not necessarily bad news – more on the currency war that is not a war

A very good example of this general fallacy of forgetting to ask why prices are changing is the ongoing discussion of the “currency war”. From the perspective of some European policy makers – for example the French president Hollande – the Bank of Japan’s recent significant stepping up of monetary easing is bad news for the euro zone as it has led to a strengthening of the euro against most other major currencies in the world. The reasoning is that a stronger euro is hurting European “competitiveness” and hence will hurt European exports and therefore lower European growth.

This of course is a complete fallacy. Even ignoring the fact that the ECB can counteract any negative impact on European aggregate demand (the Sumner critique also applies for exports) we can see that this is a fallacy. What the “currency war worriers” fail to do is to ask why the euro is strengthening.

The euro is of course strengthening not because the ECB has tightened monetary policy but because the Bank of Japan and the Federal Reserve have stepped up monetary easing.

With the Fed and the BoJ significantly stepping up monetary easing the growth prospects for the largest and the third largest economies in the world have greatly improved. That surely is good news for European exporters. Yes, European exporters might have seen a slight erosion of their competitiveness, but I am pretty sure that they happily will accept that if they are told that Japanese and US aggregate demand – and hence imports – will accelerate strongly.

Instead of just looking at the euro rate European policy makers should consult more than one price (the euro rate) and look at other financial market prices – for example European stock prices. European stock prices have in fact increased significantly since August-September when the markets started to price in more aggressive monetary easing from the Fed and the BoJ. Or look at bond yields in the so-called PIIGS countries – they have dropped significantly. Both stock prices and bond yields in Europe hence are indicating that the outlook for the European economy is improving rather than deteriorating.

The oil price fallacy – growth is not bad news, but war in the Middle East is

A very common fallacy is to cry wolf when oil prices are rising – particularly in the US. The worst version of this fallacy is claiming that Federal Reserve monetary easing will be undermined by rising oil prices.

This of course is complete rubbish. If the Fed is easing monetary policy it will increase aggregate demand/NGDP and likely also NGDP in a lot of other countries in the world that directly or indirectly is shadowing Fed policy. Hence, with global NGDP rising the demand for commodities is rising – the global AD curve is shifting to the right. That is good news for growth – not bad news.

Said another way when the AD curve is shifting to the right – we are moving along the AS curve rather than moving the AS curve. That should never be a concern from a growth perspective. However, if oil prices are rising not because of the Fed or the actions of other central banks – for example because of fears of war in the Middle East then we have to be concerned from a growth perspective. This kind of thing of course is what happened in 2011 where the two major supply shocks – the Japanese tsunami and the revolutions in Northern Africa – pushed up oil prices.

At the time the ECB of course committed a fallacy by reasoning from one price change – the rise in European HICP inflation. The ECB unfortunately concluded that monetary policy was too easy as HICP inflation increased. Had the ECB instead asked why inflation was increasing then we would likely have avoided the rate hikes – and hence the escalation of the euro crisis. The AD curve (which the ECB effectively controls) had not shifted to the right in the euro area. Instead it was the AS curve that had shifted to the left. The ECB’s failure to ask why prices were rising nearly caused the collapse of the euro.

The money supply fallacy – the fallacy committed by traditional monetarists 

Traditional monetarists saw the money supply as the best and most reliable indicator of the development in prices (P) and nominal spending (PY). Market Monetarists do not disagree that there is a crucial link between money and prices/nominal spending. However, traditional monetarists tend(ed) to always see the quantity of money as being determined by the supply of money and often disregarded changes in the demand for money. That made perfectly good sense for example in the 1970s where the easy monetary policies were the main driver of the money supply in most industrialized countries, but that was not the case during the Great Moderation, where the money supply became “endogenous” due to a rule-based monetary policies or during the Great Recession where money demand spiked in particularly the US.

Hence, where traditional monetarists often fail – Allan Meltzer is probably the best example today – is that they forget to ask why the quantity of money is changing. Yes, the US money base exploded in 2008 – something that worried Meltzer a great deal – but so did the demand for base money. In fact the supply of base money failed to increase enough to counteract the explosion in demand for US money base, which effectively was a massive tightening of US monetary conditions.

So while Market Monetarists like myself certainly think money is extremely important we are skeptical about using the money supply as a singular indicator of the stance of monetary policy. Therefore, if we analyse money supply data we should constantly ask ourselves why the money supply is changing – is it really the supply of money increasing or is it the demand for money that is increasing? The best way to do that is to look at market data. If market expectations for inflation are going up, stock markets are rallying, the yield curve is steepening and global commodity prices are increasing then it is pretty reasonable to assume global monetary conditions are getting easier – whether or not the money supply is increasing or decreasing.

Finally I should say that my friends Bob Hetzel and David Laidler would object to this characterization of traditional monetarism. They would say that of course one should look at the balance between money demand and money supply to assess whether monetary conditions are easy or tight. And I would agree – traditional monetarists knew that very well, however, I would also argue that even Milton Friedman from time to time forgot it and became overly focused on money supply growth.

And finally I happily will admit committing that fallacy very often and I still remain committed to studying money supply data – after all being a Market Monetarist means that you still are 95% old-school traditional monetarist at least in my book.

PS maybe the root of all bad econometrics is the also forgetting to ask WHY prices change.

The exchange rate fallacy: Currency war or a race to save the global economy?

This is from

Faced with a stubbornly slow and uneven global economic recovery, more countries are likely to resort to cutting the value of their currencies in order to gain a competitive edge.

Japan has set the stage for a potential global currency war, announcing plans to create money and buy bonds as the government of Prime Minister Shinzo Abe looks to stimulate the moribund growth pace…

Economists in turn are expecting others to follow that lead, setting off a battle that would benefit those that get out of the gate quickest but likely hamper the nascent global recovery and the relatively robust stock market.

This pretty much is what I would call the ‘exchange rate fallacy’ – hence the belief that monetary easing in someway is a zero sum game where monetary easing works through an “unfair” competitiveness channel and one country’s gain is another country’s lose.

Lets take the arguments one-by-one.

“…countries are likely to resort to cutting the value of their currencies in order to gain a competitive edge.”

The perception here is that monetary policy primarily works through a “competitiveness channel” where a monetary easing leads to a weakening of the currency and this improve the competitiveness of the nation by weakening the real value of the currency. The problem with this argument is first of all that this only works if there is no increase in prices and wages. It is of course reasonable to assume that that is the case in the short-run as prices and wages tend to be sticky. However, empirically such gains are minor.

I think a good illustration of this is relative performance of Danish and Swedish exports in 2008-9. When crisis hit in 2008 the Swedish krona weakened sharply as the Riksbank moved to cut interest rates aggressive and loudly welcomed the weakening of the krona. On the other hand Denmark continued to operate it’s pegged exchange rate regime vis-a-vis the euro. In other words Sweden initially got a massive boost to it’s competitiveness position versus Denmark.

However, take a look at the export performance of the two countries in the graph below.

Starting in Q3 2008 both Danish and Swedish exports plummeted. Yes, Swedish dropped slightly less than Danish exports but one can hardly talk about a large difference when it is taken into account how much the Swedish krona weakened compared to the Danish krone.

And it is also obvious that such competitiveness advantage is likely to be fairly short-lived as inflation and wage growth sooner or later will pick up and erode any short-term gains from a weakening of the currency.

The important difference between Denmark and Sweden in 2008-9 was hence not the performance of exports.

The important difference on the other hand the performance of domestic demand. Just have a look at private consumption in Sweden and Denmark in the same period.


It is very clear that Swedish private consumption took a much smaller hit than Danish private consumption in 2008-9 and consistently has grown stronger in the following years.

The same picture emerges if we look at investment growth – here the difference it just much bigger.


The difference between the performance of the Danish economy and the Swedish economy during the Great Recession hence have very little to do with export performance and everything to do with domestic demand.

Yes, initially Sweden gained a competitive advantage over Denmark, but the major difference was that Riksbanken was not constrained in it ability to ease monetary policy by a pegged exchange rate in the same way as the Danish central bank (Nationalbanken) was.

(For more on Denmark and Sweden see my earlier post The luck of the ‘Scandies’)

Hence, we should not see the exchange rate as a measure of competitiveness, but rather as an indicator of monetary policy “tightness”.When the central bank moves to ease monetary policy the country’s currency will tend to ease, but the major impact on aggregate demand will not be stronger export performance, but rather stronger growth in domestic demand. There are of course numerous examples of this in monetary history. I have earlier discussed the case of the Argentine devaluation in 2001 that boosted domestic demand rather exports. The same happened in the US when FDR gave up the gold standard in 1931. Therefore, when journalists and commentators focus on the relationship between monetary easing, exchange rates and “competitiveness” they are totally missing the point.

The ‘foolproof’ way out of deflation

That does not mean that the exchange rate is not important, but we should not think of the exchange rate in any other way than other monetary policy instruments like interest rates. Both can lead to a change in the money base (the core monetary policy instrument) and give guidance about future changes in the money base.

With interest rates effectively stuck at zero in many developed economies central banks needs to use other instruments to escape deflation. So far the major central banks of the world has focused on “quantitative easing” – increasing in the money base by buying (domestic) financial assets such as government bonds. However, another way to increase the money base is obviously to buy foreign assets – such as foreign currency or foreign bonds. Hence, there is fundamentally no difference between the Bank of Japan buying Japanese government bonds and buying foreign bonds (or currency). It is both channels for increasing the money base to get out of deflation.

In fact on could argue that the exchange rate channel is a lot more “effective” channel of monetary expansion than “regular” QE as exchange rate intervention is a more transparent and direct way for the central bank to signal it’s intentions to ease monetary policy, but fundamentally it is just another way of monetary easing.

It therefore is somewhat odd that many commentators and particularly financial journalists don’t seem to realise that FX intervention is just another form of monetary easing and that it is no less “hostile” than other forms of monetary easing. If the Federal Reserve buys US government treasuries it will lead to a weakening of dollar in the same way it would do if the Fed had been buying Spanish government bonds. There is no difference between the two. Both will lead to an expansion of the money base and to a weaker dollar.

“Economists in turn are expecting others to follow that lead, setting off a battle that would benefit those that get out of the gate quickest but likely hamper the nascent global recovery and the relatively robust stock market”

This quote is typical of the stories about “currency war”. Monetary easing is seen as a zero sum game and only the first to move will gain, but it will be on the expense of other countries. This argument completely misses the point. Monetary easing is not a zero sum game – in fact in an quasi-deflationary world with below trend-growth a currency war is in fact a race to save the world.

Just take a look at Europe. Since September both the Federal Reserve and the Bank of Japan have moved towards a dramatically more easy monetary stance, while the ECB has continue to drag its feet. In that sense one can say that that the US and Japan have started a “currency war” against Europe and the result has been that both the yen and the dollar have been weakened against the euro. However, the question is whether Europe is better off today than prior to the “currency war”. Anybody in the financial markets would tell you that Europe is doing better today than half  a year ago and European can thank the Bank of Japan and the Fed for that.

So how did monetary easing in the US and Japan help the euro zone? Well, it is really pretty simple. Monetary easing (and the expectation of further monetary easing) in Japan and the US as push global investors to look for higher returns outside of the US and Japan. They have found the higher returns in for example the Spanish and Irish bond markets. As a result funding costs for the Spanish and Irish governments have dropped significantly and as a result greatly eased the tensions in the European financial markets. This likely is pushing up money velocity in the euro zone, which effectively is monetary easing (remember MV=PY) – this of course is paradoxically what is now making the ECB think that it should (prematurely!) “redraw accommodation”.

The ECB and European policy makers should therefore welcome the monetary easing from the Fed and the BoJ. It is not an hostile act. In fact it is very helpful in easing the European crisis.

If the more easy monetary stance in Japan and US was an hostile act then one should have expected to see the European markets take a beating. That have, however, not happened. In fact both the European fixed income and equity markets have rallied strongly on particularly the new Japanese government’s announcement that it want the Bank of Japan to step up monetary easing.

So it might be that some financial journalists and policy makers are scare about the prospects for currency war, but investors on the other hand are jubilant.

If you don’t need monetary easing – don’t import it

Concluding, I strongly believe that a global “currency war” is very good news given the quasi-deflationary state of the European economy and so far Prime Minister Abe and Fed governor Bernanke have done a lot more to get the euro zone out of the crisis than any European central banker has done and if European policy makers don’t like the strengthening of the euro the ECB can just introduce quantitative easing. That would curb the strengthening of the euro, but more importantly it would finally pull the euro zone out of the crisis.

Hence, at the moment Europe is importing monetary easing from the US and Japan despite the euro has been strengthening. That is good news for the European economy as monetary easing is badly needed. However, other countries might not need monetary easing.

As I discussed in my recent post on Mexico a country can decide to import or not to import monetary easing by allowing the currency to strengthen or not. If the Mexican central bank don’t want to import monetary easing from the US then it can simply allow the peso strengthen in response to the Fed’s monetary easing.

Currency war is not a threat to the global economy, but rather it is what could finally pull the global economy out of this crisis – now we just need the ECB to join the war.

Bob Murphy on fiscal austerity – he is nearly right

Bob Murphy has a very good discussion on Econlib about “What Economic Research Says About Fiscal Austerity and Higher Tax Rates”.

Bob has a very good discussion about why the traditional keynesian thinking on monetary policy is wrong and has a good discussion about what Bob terms “Expansionary Austerity”, but what also have been termed expansionary fiscal contractions.

Bob among other points to Giavazz and Pagano’s pathbreaking 1990 study “Can Severe Fiscal Contractions Be Expansionary? Tales of Two Small European Countries.”  Giavazz and Pagano in their paper highlight two cases of expansionary fiscal contractions. That is Denmark 1982-1985 and Ireland 1987-89. In both cases fiscal policy was tightened and the public deficit reduced dramatically and in both cases – contrary to what (paleo?) Keynesian theory would predicted – the economy expanded.

The Danish and Irish cases are hence often highlighted when the case is made that fiscal policy can be tightened without leading to a recession. I fully share this view. However, where a lot of the literature on expansionary fiscal contractions – including Bob’s mini survey of the literature – fails is that the role of monetary policy is not discussed. In fact I would argue that Denmark was a case of an expansionary monetary contraction – a the introduction of new strict pegged exchange rate regime strongly reduced inflation expectations (I might return to that issue in a later post…).

In all the cases I know of where there has been expansionary fiscal contractions monetary policy has been kept accommodative in the since that nominal GDP – which of course is determined by the central bank – is kept “on track”. This was also the case in the Danish and Irish cases where NGDP grew strong through the fiscal consolidation period.

My view is therefore that that fiscal austerity certainly will not have to lead to a recession IF monetary policy ensures a stable growth rate of nominal GDP. This in my view mean that we will have to be a lot more skeptical about austerity for example in Spain or Greece being successful. Spain and Greece do not have their own monetary policy and therefore the countries cannot counteract possible contractionary effects of fiscal austerity with monetary policy. That of course does not mean that these countries should not tighten fiscal policy – in my view there is no other option – but it mean that austerity in these countries are not likely to have the same positive growth effects as in Denmark and Ireland in the 1980s.

Therefore, in my view the future research on expansionary fiscal contractions should focus on the policy mix – what happened to monetary policy during the periods of fiscal consolidation? -instead of just focusing on the fiscal part of the story.

All the cases of expansionary fiscal consolidations I have studied has been accompanied by a period of fairly high and stable NGDP growth and the unsuccessful periods have been accompanied by monetary contractions. My challenge to Bob would therefore be that he should find just one case of a expansionary fiscal contraction where NGDP growth was weak…

PS the discussion above it about the business cycle perspective. Obviously if we take a longer term perspective then supply side factors dominate demand side factors. In these cases I think is it fairly easy to demonstrate that cuts in public spending will increase potential or long-term real GDP growth. I am pretty sure that Bob and I fully agree on this issue – others might not…




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