Sweden’s economic blunder

Stockholm, Sweden

Few developed economies rebounded as quickly as Sweden did from the global financial crisis. After contracting 5% in 2009, Sweden’s economy expanded 6.6% a year later, swelled another 2.9% in 2011 and has grown since, even if at a lesser rate.[1]

The remedies that drove Sweden’s revival were the same cures that helped Australia avoid recession after the global financial crisis struck in 2008. Fiscal stimulus and aggressive cuts in interest rates by the central Sveriges Riksbank nurtured an economy that was in reasonable shape when Lehman Brothers folded in 2008. Sweden went into the crisis with a central budget surplus of 3.6% and low net government debt, at around 40% of GDP, having conservatively managed official finances and its banks since the country hosted a banking crisis in the early 1990s (just as Australia did).[2] Another boost was that the EU member has its own currency, the krona, because Swedish voters wisely decided against adopting the euro in a referendum in 2003 – which means, of course, that the country has its own monetary policy.

Having the ability to alter interest rates and other monetary tools to suit economic conditions, however, comes with no guarantee that this power will be used astutely. The Nordic country looks set for some harsh years ahead because its central bank has misjudged the economy. Sweden’s misfortune is that officials at the world’s oldest central bank used monetary policy to attack a frothy housing market, record household debt and largely imaginary inflation. It’s to be hoped that other central bankers (including those at Martin Place, Sydney) are studying the mistakes made at the Riksbank because many of their economies face the same challenges.

With housing in Sweden estimated to be 32% overvalued when judged against rents[3] and household debt at a troubling 175% of disposable income, the Riksbank under Governor Stefan Ingves raised its benchmark rate seven times from July 2010 to July 2011 and looks to have inflicted long-lasting damage on Sweden. In March this year, Sweden became the eighth EU country and the first in the north to record deflation over a 12-month period (over which time Swedish consumer prices fell 0.4%).[4] Five central-bank rate cuts from December 2011 to December 2013 don’t look like averting the counterproductive pain any time soon. The most self-inflicted damage is that deflation, among its many poisons, increases the real burden of household debt.

Sweden’s challenges aren’t just due to mistakes by a central bank founded in 1668, it must be pointed out. The country’s biggest market, the eurozone, is tottering, thus curbing export sales. The collapse of demand across Europe is a big source of the deflationary pressure swamping Sweden. The largest Nordic economy is still growing – it expanded 1.5% in 2013 – and there’s no sign that Sweden will enter a protracted recession any time soon, just years of puny growth. It’s not the central bank’s fault that Sweden’s welfare state discourages saving, thus encourages hyper borrowing, especially for housing. But the country is shaping as an example of the damage anti-inflation zealots can incur when they gain control of monetary policy and use it against a threat that doesn’t exist (inflation) and wield it to fight an asset bubble and rising household debt better controlled by other means.

Murdering a recovery

The Riksbank claims a colourful 350-year history that includes financing the wars during Sweden’s so-called Age of Liberty from 1718 to 1772 to even figuring in the assassination in 1792 of King Gustaf III, the autocratic regent who killed off parliamentary rule 20 years earlier.[5] Its more-mundane inflationphobia and anti-housing-bubble mindset probably traces to the more-recent financial, banking and housing crisis of the early 1990s. During this time, the Swedish central bank raised interest rates to 500% to defend its then fixed-exchange rate and struggled with a collapsing economy where household debt had soared to at least 130% of disposable income from only 95% in 1980.[6] One year after the krona was floated in 1992, the central bank was charged with keeping prices stable, a mandate the Riksbank interpreted as keeping consumer inflation close to, but under, 2%.

Inflation wasn’t a threat after Lehman collapsed in 2008 and the Riksbank was fervent in helping Sweden navigate the crisis. It cut the target repo rate, the level at which banks can deposit or borrow from the Riksbank for seven days, from 4.75% to 0.25% in seven cuts from October 2008 to July 2009. So accommodative was the Riksbank, it pioneered negative interest rates on overnight deposits held at the central bank. The Riksbank set this rate at minus 0.25% from July 2009 to September 2010, to encourage banks to lend rather than park reserves at the central bank. (Denmark cut to below zero in July 2012 while the European Central Bank did so this month.)

Then came the decisions from mid-2010 to raise rates in seven steps to 2%, verdicts that were never unanimous among central-bank board members. Lars Svensson, an influential academic who was deputy governor of the Riksbank from 2007 to 2013 and the advocate of negative rates, opposed tighter monetary policy and he has let the world know of his disapproval – Svensson has a website that hosts posts and other material slamming the Riksbank.[7] Svensson resisted rate cuts because he said inflation was too low (at 1.2% at the time of the first rate increase), unemployment was too high (at 8.8% in mid-2010) and because fighting housing bubbles with interest rates would prove counterproductive.

The Riksbank raised rates over 2010 and 2011 because it judged “a lower repo-rate path can contribute to increased indebtedness” among households and this in itself can lead to “an unfavourable scenario … in the form of a fall in housing prices,” the central bank said in its Monetary Policy Report of July 2013, the month of its last rate increase.[8]At this time, inflation in Sweden adjusted for the impact of rising mortgage costs was running at an annual rate of only 1.6% and unemployment stood at 7.9%.

The Riksbank’s actions showed the majority of its board were swayed by proponents of the strategy of “leaning against the wind” to control Sweden’s bubbling housing market. This is the tactic for central banks to tighten monetary policy more than necessary to suppress inflation to counter hasty credit growth and rising asset (housing) prices. Opponents of this stance (such as Svensson) say the temporary fall in inflation becomes permanent while the resulting drop in size in new mortgages is too insignificant to affect total nominal mortgage debt. In Svensson’s words: “That total nominal debt falls quite slowly means that movements in real debt and the debt-to-GDP ratios are dominated by faster movements in the price level and nominal GDP.”[9] In short, debt ratios worsen. The five rates cuts since December 2001 that have reduced the repo rate to 0.75% and the fact that the Riksbank forecasts household debt to reach 180% of disposable income by 2016,[10] double to where it fell in the mid-1990s after the banking crisis, would appear to vindicate Svensson’s claims. Perhaps even more damning, Sweden’s government is considering greater oversight of the country’s central bank.[11]

Many goals, many tools

The actions and failures of the Riksbank feed into the debate about whether central banks should extend their remit beyond price stability to financial sturdiness. For if the global financial crisis did anything, it has destroyed the notion that low inflation engenders economic stability. Large asset bubbles that led to a global recession made worse by erratic swings in global capital flows revealed the limpness of only targeting inflation with one instrument, interest rates.

The IMF, in another backpedal since 2008, now sympathises with those who call for central banks to concern themselves with financial stability as well as price stability. An IMF staff discussion released in April this year says that central banks could broaden their remit to financial and external stability (which means the exchange rate and capital flows) and sometime use the cash rate to achieve these goals. “Where possible, these (goals) should be targeted with new or rethought instruments (macro-prudential tools, capital-flow management, foreign-exchange intervention),” the paper says. “But should these prove insufficient, interest-rate policy might have a role to play.”[12]

Central banks have notched some success in heading off financial imbalances, though usually not with interest rates. The Swiss National (central) Bank has stood by its pledge of 2011 to keep the Swiss franc from falling below 1.20 euros (which means stop it rising) but that entails unlimited buying of the euro with Swiss francs and then mopping up excess francs through daily market operations. But there are many problems with a broader mandate for central banks. Financial stability is harder to judge than inflation. Bubbles are easier to spot in retrospect than when they are occurring – central banks may well smother healthy activity if they misdiagnose a spurt in asset prices. An expanded central-bank mandate would inject central bankers into political debates that could put at risk the perceived independence allowed central banks when they only worry about inflation. While judging interest rates entails a political choice between savers and borrowers, decisions on exchange rates and capital controls pit exporters against importers, restrict investors and hit different businesses in various ways, to name just some of the wider political decisions involved. Targeting financial stability could place central bankers in a situation whereby they enrage vested interests for raising interest rates when inflation is low. It’s hard for anyone to argue that a calamity that never occurred has been averted.

Another reason not to make financial stability as another target for monetary policy is that regulatory powers already exist to choke credit booms, controls that often sit within central banks. (The Reserve Bank of Australia lost these powers to the Australian Prudential Regulation Authority in 1998.) Bank regulators can easily suffocate credit frenzies by boosting bank reserve requirements, tightening rules around mortgage lending such as restricting low-deposit lending or capping the amount borrowed to a certain percentage of a person’s income. Regulators in Canada, New Zealand, Norway and Singapore have taken such steps recently. Politicians, as opposed to regulators, can stifle credit booms by altering fiscal policy. Lawmakers can raise stamp duties and other taxes on property or change (or even threaten to alter) tax laws to make housing a less-alluring investment. Sweden’s property boom is partly a result of lax regulation of bank mortgage lending, interest-only loans (no principal is repaid, which means home owners are essentially paying rent to their banks) and that fact that Swedes can claim tax deductions on a percentage of mortgage costs.

Even with all these shortcomings, central bankers, though, are bound to pay more attention to financial stability to avoid a repeat of 2008. The RBA appears to see financial stability as a long-term part of its mandate to keep inflation low and the economy at full employment. It’s “leaning” against Australia’s housing market (that the OECD judges is more overvalued than Sweden’s[13]) by warning about over-rapid price increases and by moving to a neutral stance with monetary policy. But, if you believe media reports, the government[14] is among those that are unhappy with the RBA’s efforts. The central bank, to its critics, is failing to stimulate a sluggish economy when inflation is tame (2.7% in the 12 months to March this year) and likely to slow, and is propping up the Australian dollar, at a cost to exporters and the government’s coffers. It is to be seen whether the RBA under Glenn Stevens is as successful as it was under Ian Macfarlane at calming a sizzling housing market or if, Riksbank-style, it causes a bigger mess.

by Michael Collins, Investment Commentator at Fidelity