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Wednesday, July 8, 2009

State of the Art Monetary Policy In Sweden

by Edward Hugh: Barcelona

Animated by last weeks export driven positive PMI result, Sweden has now taken poll position in the quantitative easing process and has committed to keeping 0.25% rates on hold till the end of 2010 at least. Mind you, they are lucky enough to have Princeton economist and avid deflation fighter Lars Svensson in there on the board to steer them through all this. Good for Swedish growth, Krona negative, great for exports. Let's go, let's go, let's go.

Sweden's central bank cut its key interest rate by 25 basis points to a new record low of 0.25 percent in a surprise move on Thursday, and said it would offer one-year loans to banks to foster lending. The Riksbank said it expected interest rates to remain at that level until late 2010. Deputy Governor Lars Svensson disagreed with the decision and advocated a cut to zero. Nearly all economists in a Reuters poll had expected the Riksbank to keep rates on hold at 0.5 percent, in line with a previous central bank forecast that suggested rates would stay around that level at least until early next year.

"The repo rate is expected to remain at this low level until autumn 2010," the central bank said in a statement. "The Riksbank's assessment is that after cutting the repo rate to 0.25 percent it will have reached its lower limit in practice, and that the situation on the financial markets is still not completely normal. "Supplementary measures are necessary to ensure that monetary policy has the intended effect." Those measures entailed offering 100 billion crowns' worth of loans to the banks at a fixed interest rate and a maturity of 12 months. "This should contribute to lower funding costs for the banks and lower interest rates for companies and households," the Riksbank said.

The reaction on the Krona front was swift:

The Swedish krona fell against the euro after the country’s central bank unexpectedly cut its main interest rate. The krona weakened 0.6 percent to 10.7868 per euro as of 9:32 a.m. in Stockholm. The Swedish currency depreciated 0.9 percent to 7.6527 against the dollar. The Riksbank lowered its main rate by a quarter of a percentage point to 0.25 percent. All but one of 17 economists surveyed by Bloomberg forecast no change.

Some people have been saying in response to warnings that the global recovery will be export lead, "exports what exports, I see no exports"? What a load of tripe! Without exports there will be no recovery. And those who say, "but what can my country export" only indicate what a serious problem their country has. The next lesson in abc economics: in times of crisis relative currency values matter more. And to prove it, Swedens PMI just poked into the growth zone, 50.5, following 43.7 last month. The 17% odd devaluation with the euro would have nothing to do with this, would it? Welcome Sweden, the worlds fourth 50+ PMI.

But Is Sweden's Devaluation Really Such A Bad Thing?

Well, I am writing what comes next in the form of an extended comment, since I am supposedly on holiday and availing myself of the excellent wifi facility in the local public library. Still, as I realised as I was going to sleep last night, what I have written above may well cause more irritation and confusion than anything else.

So what follows is more like a stream of consciousness than a post. The global recovery is going to take much longer in coming than most seem to recognise, and meanwhile Sweden still needs to eat. There can be first mover advantage here, and I don't see why others should play at "sour puss" if they simply didn't see this. At the end of the day, is our system a competitive capitalist one, which rewards innovation and smart thinking (and state of the art monetary policy), or isn't it? Sweden seem to be going for Lars Svensson's ideas, and I am with them, so why shouldn't they get the benefit of listening fo what a good economist has to tell them, rather than get all the rubbish which comes your way in a country where the government doesn't bother to take this kind of advice. I think Svensson knows what he is doing in this regard, and bravo!

I also think we need to consider time horizons here. So many people are so busy trashing Keynes, that they forget that his greatest insight was into time horizons and policy, and not about fiscal deficits and stimulus. In the long run devaluation goes nowhere, but in the short run it can be life and death for a patient on the operating table.

So we need to consider short term dynamics here, and not long run "equilibrium" settings. Look at the depth of the Q1 contraction in Sweden. But, while everone else is sitting back and waiting (look at the mess in Japan and Germany, countries with some similarities) Sweden is reacting. Good for Sweden is all I can say.

This kind of move need have no long term implications for whether you do high value or low value work, since it is only about how to kick start an economy. Yesterday's decision by the Swedish National Bank is equivalent to a significant fiscal stimulus, and Svensson knows this very well, and at a time when people are becoming increasingly nervous about rising fiscal deficits, then good old fashioned devaluation can get the same sort of result by different means.

Also, it is important to bear in mind that the principal objective here is to avoid deflation.

Obviously, I am not in favour of "beggar thy neighbourism". But look, what we are testing day in and day out here are economic theories. Some said that having your own currency and having your own monetary policy didn't matter, and those people went off and joined the euro. Economists in the UK and Sweden did not agree, and they maintained some control over their own affairs, are they now to be told by the others that this is unfair?

Basically, Latvians have decided not to devalue. That is their democratic right. But Latvians do not have the right to tell Swedes they are "disloyal" when they do devlaue, I do not follow the logic here.

Latvians are running an experiment, which will need to be followed by many other euro member countries - that of internal devaluation - we need to follow the experiment to see if it can work.

Sweden is making another experiment, people need to keep their minds more open, and be empirical. Let's see what we can learn.

People at the ECB do not think European economies are headed for deflation. They maintain the interest rate at one percent, and do not want to practice quantitative easing. That is their right. But the Swedish National Bank do not agree with them. They think there is a significant risk of deflation in Sweden and they wish to take measures to try to protect themselves. They have the right to do that.

US citizens - according to the opinion polls - are very worried about the fiscal deficit, more worried than they are about low economic growth. That is their right. But this - and the growing concerns from Germany - means that fiscal strategies are going to be very constrained to get us out of this. So the Swedes want to know, what do we do? Answers please.

Basically our economies are stuck - weighted down by all the accumulated debt - in the absence of other adequate instruments, periodic devaluation can work like a kind of implantable cardioverter defibrillator (ICD). An ICD is basically a small device placed in the chest or abdomen. This device uses electrical pulses or shocks to help control life-threatening, irregular heartbeats, especially those that could lead the heart to suddenly stop beating (sudden cardiac arrest). If the heart stops beating, blood stops flowing to the brain and other vital organs. This usually causes death if it's not treated in minutes. Economic biorhythmns may be remarkably similar.

Basically, this our economies are on the critical list right now, and we need some equivalent of that constant electrical stimulus to keep them afloat while we sort out the problem of what to do with all that accumulated debt in the longer term.

I was lead to think about what has happened in Sweden in this way, and about the monetary and fiscal easing potential of rotating devaluations by reading this piece from Barry Eichengreen and Douglas Irwin, where they suggest that the so called "competitive devaluations" carried out in the 1930's may well have had the (positive) and inintended consequence of making much looser monetary conditions available than would otherwise have been the case. My principal argument though is that devaluation can serve as a kind of "short sharp shock"

Countries that remained on the gold standard, keeping their currencies fixed against gold, were more inclined to impose trade restrictions. With other countries devaluing and gaining competitiveness at their expense, they adopted restrictive policies to strengthen the balance of payments and fend off gold losses. Lacking other instruments with which to address the deepening slump, they used tariffs and similar measures to shift demand toward domestic production and thereby stem the rise in unemployment.

In contrast, countries abandoning the gold standard and allowing their currencies to depreciate saw their balances of payments strengthen. They gained gold rather than losing it. As importantly, they now had other instruments with which to address the unemployment problem. Cutting the currency loose from gold freed up monetary policy. Without a gold parity to defend, interest rates could be cut, and central banks No longer bound by the gold standard rules could act as lenders of last resort. They now possessed other tools with which to ameliorate the Depression. These worked, as shown in Figure 3. As a result, governments were not forced to resort to trade protection. his relationship is quite general, as we show in Figure 4. It also carries over to non-tariff barriers to trade such as exchange controls and import quotas.

Basically, the analogy here is that monetary policy is becoming increasingly weaker to have an effect, fiscal policy is either unpopular or unsustainable, and in the absence of either of the former, devaluation can act as something of a surrogate stimulus.