When the global financial crisis broke in 2008, Sweden’s central bank seemed to be one of the best-equipped to fight it. The Riksbank was led by Stefan Ingves, a former senior official at the International Monetary Fund whose expertise lay in financial crises and how to avoid them. One of its deputy governors was Lars Svensson, an expert on Japan’s long battle against deflation and a top thinker on monetary policy.
With these credentials, the two men seemed ideally suited to guide the Riksbank’s policy through the turmoil, says Christian Odendahl, chief economist at the Centre for European Reform. The aftermath of the crisis “was exactly made for these two people on what should be done”, he says.
At first, they found common ground as the Riksbank cut interest rates in 2009 to 0.25 per cent, their lowest level since its founding in 1668. But for the next two years, the duo clashed bitterly over monetary policy. Their debate – about when an economy is healthy enough to stop crisis-fighting measures – is still resonating at central banks from the US Federal Reserve to the European Central Bank and the Bank of England.
The Riksbank’s decision in 2010 to start raising rates – an idea Mr Svensson firmly opposed – has transformed the Swedish central bank from a small but respected institution to a cautionary tale for central banks worldwide.
“Sweden has done an experiment the whole world is interested in,” Mr Odendahl says. “What should we do when monetary policy should be accommodative but there are financial risks? The Swedish lesson is that tightening policy prematurely isn’t the answer.”
Paul Krugman goes further, calling the policy “sadomonetarist”. The winner of the Sveriges Riksbank Prize in Economic Sciences, commonly known as the Nobel Prize in economics, calls the Riksbank’s rate rises “possibly the most gratuitous” policy error of the crisis. “In terms of really having no obvious justification in terms of macro indicators, you would find that hard to match anywhere in the crisis. It is the most out- of-thin-air tightening policy out there,” Mr Krugman told the Financial Times.
Mr Svensson feared that the rate rises could push Sweden closer to deflation, the toxic bout of falling prices that he had observed in Japan. Last year, he resigned from the Riksbank in frustration just as his fears were coming true.
Sweden’s headline inflation was minus 0.1 per cent in October and has only been positive in eight of the past 24 months. After raising rates to 2 per cent in 2011, the Riksbank woke up to the risk of deflation and began to reverse course. Rates were cut to a record low of zero last month.
Throughout this, the Swedish economy has held up, unlike in Japan, with growth in gross domestic product of 1.6 per cent in 2013 and government forecasts of 2.1 and 3 per cent for this and next year. Unemployment remains stubbornly high by Swedish standards at 7.9 per cent, although that is lower than in many European countries.
The Riksbank’s preferred core inflation measure – which excludes the impact of its own rate cuts – was 0.6 per cent in October, a long way from its 2 per cent target. Policy makers remain on edge. “Deflation is definitely a worry. We cannot see that there is an immediate risk that we are very close to it but it is a risk. If inflation is too low, all of a sudden you are there and it’s very dangerous. Just look at Japan,” says Stefan Löfven, Sweden’s prime minister.
Mr Svensson’s association with the Riksbank began during another extreme moment. At the start of the 1990s, he was an adviser to the central bank just as the Nordic financial crisis hit Sweden. The Riksbank briefly – and boldly – raised interest rates to 500 per cent. It also became one of the first central banks to introduce inflation targeting.
Mr Svensson left Sweden at the turn of the century to become a professor at Princeton, where he became friendly with Ben Bernanke, the former Fed chairman, as well as Mr Krugman.
When the Riksbank asked him in 2007 to return as a deputy governor, it was seen as a coup for the central bank. “I could not decline to see how it could be implemented in practice,” Mr Svensson says.
Almost immediately, he was plunged into Sweden’s battle with the financial crisis – but not before he joined Mr Ingves in pushing through an ill-fated interest rate rise just two weeks before the collapse of Lehman Brothers. Weeks later they were cutting rates, including one of the biggest reductions of any western central banks, a 1.75 percentage-point drop in December 2008.
Mr Svensson started expressing dissent soon after. He thought the rate cuts should go faster and then that rates should be reduced all the way to zero rather than the 0.25 per cent where the Riksbank stopped.
A year later came a far more serious disagreement. In June 2010, the Riksbank decided to start raising rates again. Some governors saw the booming economy – growth was 6.6 per cent that year – and began to fret about rising house prices and high household debt. But Mr Svensson, and another deputy, Karolina Ekholm, wanted to keep rates low because inflation was still below the 2 per cent forecast and unemployment near its post-crisis high at 9.6 per cent.
The Riksbank is almost alone among the main western central banks in releasing detailed minutes of its monetary policy meetings that include the specific comments of each committee member. In the June 2010 minutes, Mr Svensson started by saying: “The risks associated with breaking off the expansionary monetary policy too early are still much greater than the risks of continuing to pursue it for too long.”
But Mr Ingves talked of a rate rise helping “a normalisation of monetary policy”. With household debt at a record high of about 170 per cent of disposable income, he added: “A low interest rate for too long could lead to a troublesome situation beyond the forecast horizon as a result of a credit expansion.” For Mr Krugman, this is symptomatic of a divide between policy makers – typically between those in the US and those in Europe – over the merits of low interest rates. “The Riksbank is representative of a current of opinion that thinks there must be something wrong with an extended period of cheap money even if the inflation numbers are below target. They got one of the world’s leading scholars [in Svensson] and then put him in the corner,” he says.
Mr Svensson himself says that had he been at the US Fed he probably would have been seen as a “boring mainstream person” while in Sweden he was an “outlier”. He says the Riksbank’s forecasts in 2010 showed inflation would remain below target until 2013 while unemployment was well above pre-crisis levels. “I wanted to focus on stabilising inflation and unemployment. The forecasts were very similar to those in the US but the policies were very different.”
The majority at the Riksbank and many economists at Swedish banks saw a different world. Sweden seemed to be bouncing back strongly from the crisis, and while there were troubling signs in Greece in the summer of 2010, normal monetary policy rules suggested they should tighten policy.
“If you have a combination of a strong economic rebound, inflation in the area of the target and a policy rate of 0.25 per cent, it is very easy to say that conventional monetary policy analysis should imply a higher policy rate and a beginning of a normalisation in the policy rate,” says Cecilia Skingsley, who has been a deputy governor at the Riksbank since last year and before that was an economist at Swedbank, a local lender.
Others urge critics not to use the benefit of hindsight to beat up the Riksbank. “If anybody had told us that inflation would be zero, we would not have believed it. It is so easy to look back now. You can’t blame Ingves for observing some asset inflation and some fairly good fuel in the Swedish economy,” says Christian Clausen, chief executive of Nordea, the biggest Nordic bank.
Whatever the merits of the debate at the time, the outcome appears to have vindicated Mr Svensson. “With the benefit of hindsight, maybe they should have started to cut somewhat earlier. Faster, quicker, stronger – all that,” says Ms Skingsley, the closest the central bank has come to an admission of error.
Perhaps unsurprisingly, Mr Svensson thinks the Riksbank should go further still, by trying out negative interest rates as inflation is so low. “The Riksbank naively thinks inflation will quite quickly come back to target,” he adds.
The central bank indeed thinks zero rates should suffice to improve the inflation outlook. But Ms Skingsley hints at other options if inflation remains too low. First up is likely to be a commitment to keep rates at zero for longer than the current forecast of a first rise in mid-2016. A currency floor, quantitative easing or negative rates are also possibilities.
The lessons for other central banks from the Riksbank’s actions fall into two broad categories. First, there is the difficulty of using monetary policy not to guide inflation but instead to try to rein in household debt or asset bubbles – what economists call “leaning against the wind”. The ECB is also battling against deflation while some of its members worry about the impact of low interest rates on financial stability. Mr Svensson’s advice is not to confuse objectives: “There is really no evidence that monetary policy has a systematic effect on financial stability.”
Ms Skingsley says she believes the “leaning against the wind argument was blown out of proportion” as it was not crucial for the rate rises. But the Swedish central bank has largely conceded defeat and now says financial regulators should take the lead in tackling debt.
A second lesson for central banks is to be cautious when raising rates after a crisis. “I can assure you that people at the Fed have heard about this and are thinking about it,” Mr Krugman says. Both he and Mr Svensson invoke the Fed’s decision to tighten in 1937 – which is blamed for tipping the US back into recession.
So where does this leave Sweden? Some have sought to compare the country to Japan but Mr Svensson does not agree. “I don’t see it as out of control yet,” he says. “It’s not like Japan where the Bank of Japan did not have control.”
Sweden’s mix of zero rates, no inflation, some growth and expanding credit means its policy makers are set to be in the spotlight for some time. “The Riksbank may have done a great disservice to its own economy but it may have done a service to the global economy,” he says.
Household debt: How much is too much?
The Scandinavian economies top many polls on happiness and living standards. But they also have the worrying distinction of leading the developed world in household debt.
Denmark has the highest household debt-to-disposable income ratio among the world’s richest countries at 310 per cent. Norway and Sweden are not far behind with ratios of 200 and 170 per cent respectively, according to the Organisation for Economic Cooperation and Development.
Policy makers have taken different approaches in each country. In Denmark, officials seem relaxed , arguing that Danes have lots of assets and are able to withstand rising interest rates “The threat to financial stability from [household debt] is therefore not serious in the current situation,” Lars Rohde, governor of the central bank, told Bloomberg this year.
But the Riksbank in Sweden has long worried about rising house prices and household debt levels. The central bank sought (and failed) to gain control over macroprudential policy – measures designed to ensure financial stability, such as capping the amount home buyers can borrow for a mortgage. Instead, macroprudential policy was given to Sweden’s Financial Supervisory Authority, which is already tightening mortgage rules. Today, Swedes only have to repay the interest on mortgages, meaning some loans take as many as 140 years to repay.
The FSA this month proposed that new mortgage holders would have to pay down half of their loans.
The impact of such measures is hotly disputed. Distortions persist in the Swedish and Norwegian housing markets, where there is far greater demand than supply in the biggest cities. Borrowers in both countries are also able to claim tax relief on mortgage interest.
Some argue that reforming these distortions would be the most important change authorities could make. Christian Clausen, chief executive of Nordea, says politicians need to take responsibility for helping create asset bubbles.
On Sweden’s tax incentives to own a house, he adds: “You have a screwed system that wants to over-leverage in principle in an asset that you don’t want to over-leverage on.”