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


National stereotyping is not an explanation for boom-bust – it is mostly about luck

A couple ofweeks ago I visited Lithuania and around a month ago I was in Ireland. Both countries have been through boom and bust and both countries are still not out of the crisis. Tomorrow I fly to another crisis hit place – Dubai. This has reminded me about an issue that have been on mind my mind for some time. Can national stereotyping explain why countries are hit by crisis? My clear answer is no and that should be the answer of most intelligent people. However, surprisingly often both mainstream media and many economists would hint (or say directly) that national characteristics can explain why X or Z country has been hit by crisis.

How often have we not heard that Greeks are lazy or Icelanders are natural risk takers etc. In Michael Lewis’ otherwise excellent new book Boomerang he often uses cultural explanations for why for example Iceland got hit by crisis in 2008. I am not completely neutral on the Icelandic case and I am one of the “sources” and I was quoted on the story in Michael’s book, but I must say that the Icelandic crisis has very little to do with the national character of Icelanders. Yes, there are specific Icelandic issues that can help explain why things ended so badly in Iceland – for example that it is a very small country, which probably meant that regulators and local investors did not have enough knowledge to fully understand the risks, but this has nothing to do with Icelandic “culture” or the national character. Hence, I believe that these national stereotypes have very little explanatory power.

In my view there is another more important, but less fanciful explanation for most crisis and that is the simple one that some nations are simply more lucky or unlucky than others. Hence, even for countries where the institutional set-up is good and the incentives to do the right thing accidents do happen. And the other way around – even countries with highly irresponsible policies can escape crisis if they are lucky.

A good example of this is Norway and Iceland. Icelandic and Norwegian culture in many ways similar and the two countries share a “Viking-history”, but today many would talk about irresponsible Icelanders and about the prudent Norwegians. What’s the difference? Well, Norway has oil and Norway had banking crisis – not very different than the Icelandic crisis – in the early 1990s so bankers and regulators were probably more aware of the risks than was the case in Norway. This is basically about luck about natural resource and the timing of banking deregulation.

Another example is Lithuania and Bulgaria. Both countries are Emerging European economies with fixed exchange rate policies and both countries have gone through boom-bust. Furthermore, both countries’ policy response to the crisis has been more or less the same. The fixed exchange rate policies have been maintained and fiscal austerity measures have been implemented. There are of course differences, but overall the two “cases” are pretty similar, but the strength of the recovery in the two economies has been very different. Lithuanian has grown surprisingly strong in 2011 (probably around 6% y/y GDP growth), while there basically not been a recovery in Bulgaria. Why this difference? My explanation is that it is mostly about “geographical luck”. Lithuania’s main trading partners are the Nordic countries, Germany, Russia and Poland – all countries that have seen relatively strong recoveries. At the same time Scandinavian banks dominate the Lithuanian banking sector. On the other hand Bulgaria is neighbouring crisis-hit Greece and the Greek banks (and Italian banks) play a key role in the Bulgarian banking sector and trade links to Greek are significant.

It is not only when it comes to failure that national stereotyping is often used. The same comes to the success stories. Today we all the time hear about how fantastic the Chinese are and how fantastic Chinese economic “management” is. This despite of the fact that China by any normal standards is a relatively underdeveloped country in terms of wealth and welfare. On a GDP per capita basis China is far from a rich country. Similarly if anybody bother to remember back in the 1980s everybody were talking about a special Japanese management model and that soon the Japan would dominate the world politically, militarily and economically because the Japanese were culturally superior to Western Europe and the US. Whatever happened to that idea??

So culture and national stereotypes tells us very little about economic success and failure. Bad policies and luck is normally the best explanation. It is just much less colourful and “luck” does not really sell books or newspapers.

PS talking about luck back in 2006 Lithuania failed to be allowed into the euro zone because the inflation rate was 0.1%-point too high. Was that luck?


See also my previous post on luck: Never underestimate the importance of luck

See also Scott Sumner’s related comment on “Bad luck and bad decisions”

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