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

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.

When forward guidance fails: the Fisher equation and the Swedish paradox

On 3 July the Swedish central bank, Riksbanken, cut its key policy rate by 50bp to 0.25%. Most analysts – and the markets – were taken by surprise by this decision. It was particularly surprising as Riksbanken’s governor Stefan Ingves had been voted down by a majority of Riksbanken’s board.

Most people – including myself – would say that when a central bank cuts it key policy rate more than expected, it is monetary easing, and it seemed that was how the market was interpreting Riksbanken’s move – the Swedish krona weakened significantly and Swedish share prices spiked. However, something was not as it should be – Swedish inflation expectations dropped (!) on the back of the rate decision, e.g. Swedish 2-year breakeven inflation dropped from around 0.85% before the rate decision to around 0.65% after the rate decision. This is a paradox – a Swedish paradox: when you cut rates you get lower inflation expectations. So judging from the inflation expectations Riksbanken had actually tightened monetary conditions rather than eased.

BE inflation expectations Sweden

The Fisher equation and focusing on the wrong target

So what went wrong? The answer in my view is that Riksbanken is focusing on the wrong policy target. Hence, the bank communicates in terms of interest rates rather than inflation expectations. And yes, the interest rates are an intermediate target.

Riksbanken controls the Swedish money base and it can use this to control money market rates – in the short term. However, the so-called Tinbergen rule also tells us that a central bank can only hit one target if it has one instrument.

Therefore, if Riksbanken targets interest rates it cannot at the same time effectively target inflation (expectations). Unless it uses an additional “instrument”, such as credibility. If the market believes that Riksbanken will always adjust monetary parameters to ensure that it hits its 2% inflation target, it will be able to move the money market rate (temporarily) away from the ‘natural’ interest rates.

Hence, if Riksbanken’s inflation target is fully credible, inflation expectations will basically be pegged at 2%. However, if the inflation target is not credible, the story is very different, and as inflation expectations are presently well below 2%, it is very clear that the 2% inflation target is presently not credible and has not been credible for years.

A way to illustrate this is to have a look at the so-called Fisher equation:

(1) i = r + pe

i is the nominal interest rate, r is the real interest rate and pe is inflation expectations. When we talk about money market rates we can also see i as the policy rate.

It follows logically from (1) that if the inflation target is fully credible – that is, if pe is ‘fixed’ – a cut in i will ‘automatically’ lower r. On the other hand, if inflation expectations are not well-anchored, a cut in i might as well reduce pe.

I believe this is exactly what happened in Sweden on the back of Riksbanken’s surprise cut.

Not only is Riksbanken communicating in terms of interest rates (rather than inflation expectations) but it is also communicating in terms of the interest rate path. Hence, Riksbanken is not only announcing rate decisions but it is also communicating about future expected changes in the policy rate.

In that regard it is important that Riksbanken actually lowered its expectations for interest rates in two years even more than it lowered its present key policy rate. In other words, Riksbanken flattened the money market rate curve. So for a given real interest rate Riksbanken is actually indirectly telling the market that it expects inflation expectations to decline even further in the coming two years.

Obviously this is not what Riksbanken meant to say (I hope) but when it chooses to focus on interest rates rather than inflation expectations, this is what the market will focus on as well. Riksbanken’s interest rate focus therefore ‘overruled’ the focus on inflation expectations. In fact, in Riksbanken’s statement there was no reference to the market’s inflation expectations.

Lesson: central banks should focus on the ultimate policy target rather than the intermediate one 

I think the lesson we can learn from thisis that central banks should not focus on intermediate targets – such as interest rates and the interest rate path – but should focus on the ultimate policy goal – in the case of Riksbanken expected inflation.

Imagine that Riksbanken had issued the following statement last week:

‘Inflation expectations are presently well below Riksbanken’s 2% inflation target. This is unsatisfactory and as a consequence the repo rate is now being cut by 0.5 percentage points to 0.25% and Riksbanken is fully committed to introducing further monetary easing if needed to ensure that market expectations will fully reflect its 2% inflation target. If needed the repo rate will be cut further and Riksbanken will actively intervene in the currency markets to ease monetary conditions through the FX channel until inflation expectations are at 2%’.

I think it is pretty clear that such a statement would have caused an immediate jump in (market) inflation expectations to 2%. This would obviously also have caused a significant drop in real interest rates – both as a result of the lower nominal rates AND, more importantly, through higher inflation expectations.

What a difference a few words make…

PS Riksbanken is not alone in terms of these problems. The ECB faces a similar problems, while the Fed and the Bank of Japan are focusing on the ultimate policy goal rather than on intermediate targets. However, during Operation Twist in 2011-12 the Fed was facing Riksbanken-style problems.

PPS In Swedish CPI there is an explicit (mortgage) interest rate component, weighing around 5% of total CPI (and hence, of course, incl when calculating breakeven inflation), implying that shorter breakeven inflation should indeed come down by some 0.3 p.p. if a full pass-through into mortgage rates from the cut. That, however, does not really change the point. The Riksbank is targeting CPI so it is really irrelevant why inflation is too low.


Related blog posts:

Committed to a failing strategy: low for longer = deflation for longer?
Riksbanken moves close to the ZLB – Now it is time to give Bennett McCallum a call
A scary story: The Zero Lower Bound and exchange rate dynamics


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 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.

The luck of the ‘Scandies’

This week we are celebrating Milton Friedman’s centennial. Milton Friedman was known for a lot of things and one of them was his generally skeptical view of pegged exchange rates. In his famous article “The Case for Flexible Exchange Rates” he argued strongly against pegged exchange rates and for flexible exchange rates.

Any reader of this blog would know that I share Friedman’s sceptical view of fixed exchange rates. However, I will also have to say that my view on exchange rates policy has become more pragmatic over the years. In fact one can say that I also in this area have become more of a Friedmanite. This could seem as a paradox given Friedman’s passionate defence of floating exchange rates. However, Friedman was not dogmatic on this issue. Rather Friedman saw exchange rate policy as a way to control the money supply and he often argued that small countries might not have the proper instruments and “infrastructure” to properly control the money supply. Hence it would be an advantage for certain countries to “outsource” monetary policy by pegging the currency to for example the US dollar. Hong Kong’s currency board and its peg to the dollar was his favourite example. I am less inclined to think that Hong Kong could not do better than the currency board, but I nonetheless think Friedman was right in the sense that there fundamentally is no difference between using for example interest rates to control the money supply and using the exchange rate.

In his highly recommendable book Money Mischief Milton Friedman discusses the experience with fixed exchange rates in Chile and Israel. Friedman documents Chile’s horrible experience with fixed exchange rates and Israel’s equally successful experience with fixed exchange rates. It is in relation to these examples Friedman states that one never should underestimate the importance of luck of nations. That credo has been a big inspiration in my own thinking and has certainly helped me understand the difference in performance of different economies during the present crisis. It is not only about policy. With the right policies this crisis could have been avoid, but on the other hand despite of less than stellar conduct of monetary policy some countries have come through this crisis very well. Luck certainly is important.

The Scandinavian economies provide an excellent example of this. Denmark and Sweden are in many ways very similar countries – small open economies with high levels of GDP/capita, strong public finances, an overblown welfare state, but nonetheless quite flexible product and labour markets and a quite high level of social and economic cohesion. However, Denmark and Sweden differ in one crucial fashion – the monetary policy regime.

Denmark has a fixed exchange rate (against the euro), while Sweden has a floating exchange rate and an inflation targeting regime. The different monetary policy regimes have had a significant impact on the performance of the Danish and the Swedish economies during the present crisis.

2008-9: Sweden’s luck, Denmark’s misery

When crisis hit in 2008 both Denmark and Sweden got hit, but Denmark suffered much more than Sweden – not only economically but also in terms of financial sector distress. The key reason for this is that while monetary conditions contracted significantly Sweden did not see any major monetary contraction. What happened was that as investors scrambled for US dollars in the second of 2008 they were selling all other currencies – also the Swedish krona and the Danish krone.

The reaction from the Danish and the Swedish central banks was, however, very different. As the Danish krone came under selling pressures the Danish central bank acted according to the fixed exchange policy by buying kroner. As a result Denmark saw a sharp contraction in the money supply – a contraction that continued in 2009 and 2010, but the peg survived. The central bank had “won” and defended the peg, but at a high cost. The monetary contraction undoubtedly did a lot to worsen the Danish financial sector crisis and four years later Danish property prices continue to decline. On the other hand when the demand for Swedish krona plunged in 2008-9 the Swedish central bank allowed this to happen and the krona weakened sharply. Said in another way the Swedish money demand dropped relative to the money supply. Swedish monetary conditions eased, while Danish monetary conditions tightened.

It is often said, that Sweden’s stronger economic performance relative to Denmark in 2008-9 (and 2010-11 for that matter) is a result of the relative improvement in Swedish competitiveness as a result of the sharp depreciation of the Swedish krona. However, this is a wrong analysis of the situation. In fact the major difference between the Swedish economy and the Danish economy has very little to do with the relative export performance. In fact both countries saw a more or less equal drop in exports in 2008-9. The big difference was the performance in domestic demand. While Danish domestic demand collapsed and property prices were in a free fall, domestic demand in Sweden performed strongly and Swedish property prices continued to rise after the crisis hit. The difference obviously is a result of the different monetary policy reactions in the two countries.

This is basically luck – the Danish monetary regime led to tightening of monetary conditions in reaction to the external shock, while the Swedish central bank to a large extent counteracted the shock with an easing of monetary conditions.

2012: The useful Danish peg and the failures of Riksbanken

Today the Danish economy continues to do worse than the Swedish economy, but the luck is changing. And again this has to do with money demand. While the demand for Swedish krona and Danish kroner collapsed in 2008-9 the opposite is the case today. Today investors as a reaction to the euro crisis are running scared away from the euro and buying everything else (more or less). As a result money is floating into both Denmark and Sweden and the demand for both currencies (and Swedish and Danish assets in general) has escalated sharply. So contrary to 2008-9 the demand for (local) money is now rising sharply. This for obvious reasons is leading to appreciation pressures on the Scandinavian currencies.

Today, however, the Danes are lucky to have the peg. Hence, as the Danish krone has tended to appreciate the Danish central bank has stepped in and defended the peg by expanding the money base and for the first time in four years the Danish money supply (M2) is now showing real signs of recovering. This of course is also why Danish short-term bond yields and money market rates have turned negative. The money markets are being flooded with liquidity to keep the krone from strengthening. Hence, the Danish euro peg is doing a great job in avoiding a negative velocity shock. For the first time in four years Danes could be true happy about the peg.

On the other hand for the first time in four years the Swedish monetary policy regime is not work as well as one could have hoped. As the demand for Swedish krona has escalated Swedish monetary conditions are getting tighter and tighter day by day and the signs are pretty clear that Swedish money-velocity is contracting. This is hardly good news for the Swedish economy.

Obviously there is nothing stopping the Swedish central bank from counteracting the drop in velocity (the increased money demand) by expanding the money base and legendary Swedish deputy central bank governor Lars E. O. Svensson has been calling for monetary easing for a while, but the majority of board members in the Swedish central bank seem reluctant to step up and ease monetary policy even though it day by day is becoming evident that monetary easing is needed.

Good policies are the best substitute for good luck

Obviously neither the Danish nor the Swedish monetary policy regime is optimal under all circumstances and this is exactly what I have tried to demonstrate above. The difference between 2008-9 and 2011-12 is the impact on demand for the Danish and Swedish currency and these differences have been driven mostly by external factors.

Obviously one could (and should!) argue that Sweden’s problem today is not the floating exchange rate, but rather the inflation targeting regime. If Sweden instead had been targeting the (future) nominal GDP level then Riksbanken would already had eased monetary policy much more aggressively than has been the case to counteract the contraction in money-velocity.

Finally, it is clear that luck played a major role in how the crisis has played out in the Scandinavian crisis. However, with the right monetary policies – for example NGDP targeting – you are much more likely to have luck on your side when crisis hit.


Related posts:

Milton Friedman on exchange rate policy #1
Milton Friedman on exchange rate policy #2
Milton Friedman on exchange rate policy #3
Milton Friedman on exchange rate policy #4
Milton Friedman on exchange rate policy #5
Milton Friedman on exchange rate policy #6
Is monetary easing (devaluation) a hostile act?
Danish and Norwegian monetary policy failure in 1920s – lessons for today
“The Bacon Standard” (the PIG PEG) would have saved Denmark from the Great Depression
Bring on the “Currency war”
Exchange rates and monetary policy – it’s not about competitiveness: Some Argentine lessons


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