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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  1. Ravi

     /  August 2, 2012

    Thanks Lars – this is really helpful.

    • Ravi, that is my pleasure. I am not happy to write to much about my own country and I would never claim to be an expert on the Danish economy – I know much more about for example the Polish economy – but I think this discussion pretty illustrates some of the key mechanisms in the present crisis.

  2. jpirving

     /  August 2, 2012

    What do you make of the Q2 Swedish RGDP numbers Lars? The q/q change was over 5% at a yearly rate! Hard to square with unemployment still over 8%, plus the tighter monetary conditions.

  3. JP, it is correct that the Q2 GDP numbers were quite strong, but I would be a bit cautious with reading too much into the annualized q/q numbers. The high Swedish unemployment is to a large extent structural. In the years prior to the crisis (2000-2007) Swedish unemployment average around 7%. So I would say that unemployment in Swedish is only slightly above NAIRU. That said, unemployment seems set to increase from here on unless Riksbanken ease monetary policy more aggressively.

  4. Blue Aurora

     /  August 3, 2012

    Out of curiosity Lars, have you ever heard of a man by the name of Dr. Michael Emmett Brady? He’s a scholar of decision theory based in California who has written extensively on J.M. Keynes’s probability theory and decision theory. I was wondering: What do you make of his reviews on Friedman’s “Money Mischief” and “A Monetary History of the United States”?

    According to Dr. Michael Emmett Brady, Friedman’s theory can only deal with risk. He can’t deal with Keynesian uncertainty or Ellsbergian ambiguity.

    If you would like to read more of Dr. Michael Emmett Brady’s papers, I recommend that you look up “Michael Emmett Brady” on Google Scholar or go to his SSRN account.

    • Blue Aurora, nope I am not familiar with Brady’s work. However, I would actually the discussion about Risk versus Uncertainty was well known to Friedman as Frank Knight who Friedman of course knew from the University of Chicago discussed this in his masterpiece Risk, Uncertainty, and Profit.

    • Blue Aurora

       /  August 3, 2012

      Did you read Dr. Michael Emmett Brady’s review of “A Monetary History of the United States”, or his review of Friedman’s other book? Friedman deals with risk by assuming it fits a standard normal distribution, when the empirical evidence by Benoit Mandelbrot suggests that financial markets are much more prone to uncertainty/ambiguity than Friedman argues. He may have been familiar with Frank Knight’s book, but whether he deals with uncertainty/ambiguity properly is another question.

      This isn’t to say that Market Monetarism isn’t interesting – I do find it’s policy recommendations to be useful. I’m just saying that Keynes, Ellsberg, and Mandelbrot may still have a point with regard to this form of Monetarism.

  5. Thanks to the wonders of Kindle for iPad, I am now working my way through Money Mischief, being prompted by your recommendation. It is a great, and enlightening, read.

    I can now add FDR’s silver purchase policy forcing China off the silver standard to my historical examples of how being on a silver/gold standard can make your monetary system, and so economy, vulnerable to the actions of other governments.

    • Lorenzo, great you are reading Money Mischief. I think the 4-5 chapter on bimetalism and silver is extremely good and much underestimated and generally unknown to economists.

      David Laidler kindly reminded me recently about the words of William Jennings Bryan

      “If they dare to come out in the open field and defend the gold standard as a good thing, we shall fight them to the uttermost, having behind us the producing masses of the nation and the world. Having behind us the commercial interests and the laboring interests and all the toiling masses, we shall answer their demands for a gold standard by saying to them, you shall not press down upon the brow of labor this crown of thorns. You shall not crucify mankind upon a cross of gold”

      That cross of gold today is the golden starts in EU’s flag and the failed euro project.

      Friedman obviously writes about William Jennings Bryan in Money Mischief.

  6. Markku

     /  August 8, 2012

    You claim the continued rise of Swedish property prices is obviously due to easing… but how does that square with Finland? Finland is in the Eurozone yet property prices barely budged before continuing upwards. The conventional wisdom in Finland is that prices held up due to an urban housing shortage, and I’ve heard similar sentiments about Sweden. The picture for Denmark seems to be mixed so as an outsider I have a bit of a difficulty judging supply and demand there.

    • Markku,

      I am certainly no expert on the Finnish property market, but I would say that when I here stories justifying an increase in the property market like an “urban housing shortage” I become very skeptical. By the way that was also common “wisdom” in Denmark prior to the Danish property market bust in 2006-7 – since then property prices have continued to decline.

      Will Finnish property prices decline from here? Well, I have no clue about it, but there are pretty clear signs the Finnish economy is slowing and even though Finland is doing much better than the rest of the Euro zone – with Germany as another exception – slower growth is unlikely to be good for property prices.

      I in general believe that property prices are determined in the long-run by what it cost to build. In the short-run supply constrains, monetary policy, taxes and bubbles etc. might could impact prices, but in the long run property prices tend to rise in line with other prices. A good benchmark is probably to compare property prices with wages or nominal GDP. I find it unlikely that property prices can outpace nominal GDP or wage growth in the long-run.

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