Denmark should let the krone float
One thing which has puzzled me (and challenged my ideological prejudice) is that Denmark has fared so poorly these last few years, especially compared with less liberal Sweden. Denmark has possibly the most economically efficient laws in the world, really only held back by inefficiently high taxes (but the Danes like them so who am I to judge). At any rate, because the population and fiscal regime are more or less the same as in Sweden, Denmark should be growing at least as fast as Sweden, all else equal. Things aren’t equal however, as Denmark is pegged to the Euro.
Sumner used some data I compiled (my proudest moment) a few weeks back to show how ECB policy was probably way, way too tight these last three years, at least for Denmark and Finland in the wake of the crisis. Essentially, we know Sweden had easier money (the Krona fell 20% vs the Euro), we know Denmark and Finland are economically similar to Sweden, except that they use the Euro, and we know policy in Sweden and the Eurozone was essentially the same up until the crisis (interest rates and exchange rates moved together). Finally, we know that Sweden is the fastest growing economy in the rich world. Perfect natural experiment. Tells me that the ECB could have printed way more money and seen little inflation, but lots of real growth.
I am examining this issue in my Masters Thesis and it just occurred to me that it might be interesting to see how Denmark and the ECB compare to Sweden on Milton Friedman’s favored measure of monetary policy-M2 growth. M2 is a standard measure how how much
of money there is in the banking system of an economy. It is beyond the point of this post, but there is good reason to think that if M2 drops precipitously, that spending will fall and that the economy will grow below its potential. Unfortunately we cannot see M2 for Finland alone as there is no real way of distinguishing between the stock of Euros within the Finnish economy, and those in the broader world. The Danish crown however is something like that radioactive dye physicians inject into peoples veins so that they can see the circulatory system on an xray. The Danish currency is essentially the Euro, except that we can track it by the fact that it has pictures of Viking longships on it if it is currency, or a DKK currency ID next to it if it is electronic money.
Because Denmark fixes the price of the Danish Crown in terms of Euro, the central bank is constrained in how it can stabilize M2. Central banking is, at the end of the day, pretty simple (no to be confused with easy). The only thing the bank can really do is change the quantity of money and see how the market reacts. Most of the time, central banks pick an interest rate they think appropriate and print money or pull it from circulation (by selling financial assets or foreign currency they have accumulated) until the interest rates moves where they want it. When interest rates fall to zero, central banks need to pick other variables to guide their money printing decisions, such as stocks, exchange rates, consumer prices or nominal GDP. In the case of Denmark, the central bank targets the exchange rate against the Euro by buying and selling the Danish crown in currency markets so that its rate against the Euro never changes. As Denmark is an open economy with free capital flow, this means that they have essentially no control over their monetary policy. Danish interest rates and money supply have to adjust to whatever is necessary to keep the Euro rate stable.
As the plot below shows, this policy of fixing the currency is causing the supply of money to fall well below trend.
[Note: the plot now uses seasonally adjusted figures, it was pointed out that the old one was unadjusted. For expedience I seasonal adjusted the IMF figures]
One thing which stands out to me is that Sweden has the most stable M2 path, Milton Friedman would have said that of the three, the Riksbank was doing the best job. I am not quite a monetarist (Friedman’s school of thought) but I agree that good monetary policy will usually mean fairly stable M2 growth, and that M2 falling as hard as it has in Denmark is probably holding spending growth back and keeping the economy below potential. Moreover, note how Danish M2 tends to move with the EMU for most of the Euro era (1999 onward), but seems to have diverged in the recession. Time for Denmark to break the peg, or at least devalue and rejoin at a 10 or 20% lower rate. If they would do this, the economy would recover like it has it Sweden.
As I don’t think the agreeable Danes would want to irritate the EU by breaking the peg, this makes me want to borrow millions and millions of dollars and go long Swedish supermarkets and short Danish supermarkets. I would be rich!