Ladies and gentlemen,
Many years ago I used to come to Copenhagen on a regular basis. At that time, some of my colleagues used to say that Asia started on the Swedish side of the Öresund. I suspect that it was not altogether meant as a compliment. When I was preparing my speech, this memory came back to me. Today, however, my purpose is to explain why Sweden’s recent growth performance to a large extent is a result of the exchange rate regime we have chosen.
Denmark and Sweden have both rejected to participate in the European Monetary Union. In fact, Denmark has done so twice. The policy reactions to having said no have however been very different. Denmark has opted for a fixed exchange rate and Sweden for a floating exchange rate.
The belief underlying the Danish choice is that reduced exchange rate uncertainty for business and lower transaction costs will bring an increase in economic welfare. And it is true that under certain restrictive and advantageous circumstances currency unions may offer economic benefits.
However, removing exchange rates as a policy tool, also removes a very effective mechanism for adjusting imbalances that necessarily arise between countries. In the Danish discussion this was not really considered as a problem. The European Central Bank conducts a Europe wide monetary policy, which may not apply to Denmark. But, the argument goes, the Danish economy is so intimately linked to the German economy that the loss of separate national monetary policy would not matter. However, that argument now seems possible to question.
I would, on the contrary, argue that linking up to the Euro-zone might be unfortunate for two reasons. The first reason, and this is increasingly recognised among most economists, lies in the Euro-zone itself. It is not an optimal currency zone today and is unlikely to become one for the foreseeable future. The necessary adjustments are simply not likely to happen for economic and political reasons. I will touch upon that later.
The second reason, and this is in my view even more important, is that linking up with, or, for that matter, joining the Eurozone means that policymakers give up crucial policy instruments needed to conduct an effective stabilization policy. Furthermore, stabilization policy, which in itself requires swift and targeted action, gets bogged down in the political process and tends to distract politicians from the issues that politics should focus on, such as structural issues like welfare, business climate and long-run growth policies.
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Let me illustrate that point with the Swedish experience over the past twenty years.
The rejection of Euro in Sweden has been grounded in our historical experiences of a fixed exchange rate regime. The Swedish combination of collective wage bargaining and a fixed exchange rate repeatedly resulted in high relative unit labour costs and a loss of competitiveness. This forced us to go through a string of devaluations between 1971 and 1992.
One consequence was that, during this period, Swedish governments focussed almost exclusively on the short-term issues of economic stabilisation and wage setting.
First, government saw as its main economic task to parry the business cycle with stimulus packages that actually had no or even negative effects. The usefulness of the central bank in this context was limited, since monetary policy was essentially needed to defend a fixed exchange rate.
Second, government also saw as its main task to intervene again and again in the labour market. Since wages determined the competitiveness of the economy, government incessantly inserted itself in the wage bargaining process. Incentives were offered in exchange for wage restraint, increasing the power of the unions. A typical example was the Security of Employment Act, which curtailed the employers’ possibilities to lay off staff.
Being trapped in this activity, government lost its capacity to deal effectively with the long-run issues of growth. Very little energy went into issues like deregulation, business climate and investment.
This changed when Sweden let the exchange rate float in the autumn of 1992. One effect was a drop in the value of the Swedish Krona by almost 25 percent in four years. These were years of adaptation.
In 1999 the adaption period was complete. This same year the Euro was introduced in 11 countries, now extended to 16 countries. Sweden held a referendum on whether to join the Eurozone or not. Despite a massive campaign on the side of the political elite for joining, the unenlightened Swedish people, and I was one of them, handed back a clear message. 57 % said no to the Euro.
Incidentally, the same year on 1st January the Riksbank was given independence to pursue the policy goal of low stable inflation. Inflation policy should be pursued symmetrically with an inflation target of 2 per cent, ±1 percent. As a comparison, in the Eurozone, the ECB pursues an assymetrical inflation policy with a target of less than 2 per cent.
Now, with almost two decades of floating currency behind us, and more than one decade with an independent central bank, we can see clear evidence that this exchange rate regime actually has delivered flexibility and a well–aligned exchange rate. It falls in times of crisis and gets stronger when times are good. If we measure exchange rate as a trade weighted value of Sweden’s trading partners, the Swedish Krona has been stable since 1999 – with variations during the crises in 2001 and 2008. The value of the currency has not declined in more than a decade and relative labour costs remain competitive.
Here we need to get the causalities right. This stable exchange rate is the result of the economic strength of the country; it is not the reason for our economic success. If we look for an explanation for Sweden’s economic success we must instead look to the major restructuring of the entire political economic structure that took place in Sweden during the 1990s.
One crucial step in this restructuring process consisted in transferring stabilisation policy from the government to the central bank.
Let me stress, as a starting point, that it is more efficient to parry the business cycle through monetary policy than through fiscal policy. Thus, once the political framework – inflation targeting and a flexible exchange rate – had been agreed, stabilisation policy was essentially removed from the political debate.
The importance of this must be strongly underlined. Stabilisation policy had been the subject of intense political disagreement and fierce political debate. Now politicians, Social Democrats and the liberal-conservative opposition arrived at a political consensus on the inflation target and on the independent role of the Riksbank.
Policymakers could focus on long-run structural issues, such as the size of the public sector and on welfare issues rather than on short-run stabilization. The benefits have been twofold. First, politicians could concentrate on politics. Second, relying on fiscal policy for conducting stabilization policy leads to stabilization policies becoming bogged down in the political process and mixing short-run and long-run perspectives and measures in a very unfortunate way.
Instead, in Sweden and once the exchange rate was flexible, the government did not need to worry about the competitiveness of Swedish exports. If wages increased more than productivity, this would result in inflation. Higher inflation would force the Riksbank to raise interest rates, which would put pressure on industrial output and raise unemployment and thus exert a downward pressure on wages. In this way, there was a natural mechanism for preserving the competitiveness of Swedish industry.
In addition, with the change in exchange rate regime, two issues disappeared that for decades had exhausted the energy of successive Swedish governments. Government was free to focus on long-term reforms. And it did so with gusto. A long overdue pension reform was launched; a new budget process introduced; telecoms, energy, postal services, health care, schools, public transport were deregulated; and state run businesses sold. After a decade these reforms now result in higher growth, surplus in government finances and lower unemployment.
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Would it not have been possible to achieve these results within the Euro zone?
My answer is no!
One important reason for Sweden’s relative success despite a turbulent economic and financial global environment is that the country has been quick on its feet and has made flexible use of a wide range of monetary policy instruments. A necessary condition would obviously be that these policy instruments have been at the disposal of policy makers in Sweden. That would not have been the case if we had handed over monetary policy to the European Central Bank or, for that matter, if Sweden had opted for a fixed exchange rate.
The present economic and financial turmoil within the Eurozone bears this out. Out of 16 countries within the Eurozone only 4 have managed to meet the criteria in the Stability and Growth Pact concerning budgetary discipline. I would argue that a major reason for this disastrous failure, because there can be no other name for it, is that the countries only have had financial policy at their disposal for handling stabilisation policy within their country. It clearly shows how inadequate these instruments are in this respect.
A common argument of the Euro-zone apologists is that national politicians could have tighten fiscal policy more in good times to cool down their overheated economies. While correct in theory it is incorrect in practice. To implement controversial fiscal policy one needs a consensus between different political parties, which is hart near impossible to get in good times. And the right fiscal policy therefore often is several years delayed.
Another important reason, as I mentioned at the beginning, lies in the Euro-zone itself. It is not an optimal currency area. The European economies have not converged. Interest rates that are set may be correct in one part of the zone but unsuited in other parts. The common currency is therefore a recipe for economic stagnation and higher structural unemployment.
In theory high relative labour costs could be adjusted through lower wage increase. For the currency to survive, the economies of Southern Europe would need to exert unparalleled wage restraint for decades and at the same time achieve German productivity growth. Neither seems probable. Substantial and sustained fiscal transfers would also be needed. It is doubtful that the countries in the north are politically motivated for such large-scale intra-European transfers.
Another possibility might be large-scale South-North migration. However that is highly unlikely to happen. Aside from political aspects, there would be problems related to skills matching. Another would be that the sustainability of the pension systems would be further eroded.
At its core, common currency has been a political project motivated by a will to create a European identity. However, to succeed in the long-term, this must be built on the consent of the people. And, it is here that the project ultimately will fail. It will not be the first time. Currency unions have collapsed in the past. Ireland’s departure from the sterling currency area comes to mind.
Let me finish by coming back to my initial reflection. Since the bridge over Öresund was built and the currency was freed, Sweden may well have moved closer to Asia. At least in the sense that Swedish trade with this dynamic region has increased relatively more than with our European trading partners. The joke about Sweden being part of Asia, now seems more of a compliment and more correct.
