Time For Denmark To Float The Krone

Includes: EDEN, EWD, FXS
by: Lars Christensen

Twenty-five years ago, Danes voted no to the Maastricht Treaty, and therefore no to participating in the single European currency - the euro. In 2000, they confirmed this decision in a separate referendum asking specifically about joining the euro area.

The irony in this anniversary is that when it comes to monetary policy, Denmark has de facto been a euro member since the currency made its debut in 1999. That's because the krone moves in lockstep with the euro thanks to the Danish National Bank's fixed exchange rate policy.

Fixed convictions

There is nothing unusual in the fact that Denmark has steadfastly supported a fixed exchange rate, despite changing governments and ruling majorities.

The policy's origins are sometimes mistakenly traced to a decision by Prime Minister Poul Schlüter's government in 1982. In fact, Denmark has followed a fixed exchange rate regime in one form or another more or less continuously since 1873, when the Scandinavian Monetary Union was introduced.

At first the country adopted the gold standard, then linked its currency to the British pound. After World War II, the krone was fixed to the U.S. dollar under the Bretton Woods system, then to a basket of currencies in the European Economic Community's 'snake in the tunnel' trading band, then to the Deutsche Mark, and now to the euro.

The only short-lived exception was in 1931-33, where Denmark followed Great Britain out of the gold standard and allowed the currency to float freely to a certain extent.

Sweden's example

But while the fixed exchange rate policy has certainly been the historical norm in Denmark, that does not mean it is the best monetary policy regime.

The obvious example is Sweden, which was forced to abandon its own fixed rate policy in November 1992 and let the Swedish krona float freely. If one gives credence to Danish adherents of the fixed exchange rate, that could only end in disaster for the Swedish economy.

But if one compares developments in the two countries over the past 25 years, there is nothing to suggest that Denmark has outperformed Sweden. Rather, the contrary.

Especially after 2008, when the Swedish Riksbank responded to the global economic and financial shock by aggressively lowering interest rates and allowing the Swedish krona to weaken significantly, Sweden's economy has grown significantly faster than Denmark's. In contrast to the Riksbank's relaxed monetary policies, the Danish National Bank had to raise interest rates and intervene heavily in the currency market to defend the krone's fixed exchange rate.

A better alternative

While it's easy to point out the shortcomings of a fixed exchange rate policy, it's something else to come up with a better alternative. The obvious option would be to simply "copy-paste" Sweden's or Norway's monetary policy: just let the krone float freely and set the inflation target at 2%.

But this set-up is not necessarily optimal, either. In the short term, inflation can be affected by demand and supply shocks (e.g. fluctuations in oil prices), but only the former can be shaped by monetary policy. It would therefore make sense for the central bank to focus on ensuring stable demand growth. This can be done by having a policy target for nominal GDP growth or nominal wage growth.

How would this work in practice? Since Danish productivity growth has averaged about 1.5% per year over the past couple of decades, one could imagine the central bank setting a target of 3.5% for nominal wage growth - assuming it wants to keep annual inflation close to 2%.

This sort of target would have kept Denmark's monetary policy significantly tighter (higher interest rates and a stronger krone) in the years immediately preceding 2008, and would have relaxed it much more in the post-crisis period.

In other words, if Denmark had had a floating exchange rate and a 3.5% nominal wage growth target over the past 25 years, its boom-bust cycle would have been much less pronounced. Exactly as was the case in Sweden.

Not all traditions are worth keeping, and Denmark's fixed exchange rate policy is an example of that. It's time to cast off the krone's shackles and let it float.

This article was first published in the Danish business daily Børsen on June 2 2017. See here (in Danish).