Denmark Should Cut Loose From Euro
Europe's currency war is picking up speed. On Monday, with the Danish krone appreciating against the euro, the Danish central bank sought to make the currency less attractive to safe-haven investors by cutting the deposit rate to -0.2 percent and the lending rate to 0.05 percent.
After the Swiss National Bank abandoned its peg to the euro and cut interest rates, bankers and traders wondered which country would be the next to follow suit. No sooner had the franc zoomed upward than the Danish central bank prepared for an onslaught.
Defending the krone's peg to the euro could get a lot harder once the European Central Bank begins its government bond-buying program, widely expected on Thursday. Yet maintaining the peg is an act of faith in Denmark.
The central bank should rethink its commitment. With a more flexible monetary policy, it could have done more to stimulate the economy since the global financial crisis, just as it could have prevented some of the overheating that took place in the years running up to the crisis.
The krone has been pegged to the euro since 1999, and to the deutschemark before that. It's allowed to fluctuate no more than 2.25 percent from 7.46038 to the euro. In practice, the central bank tries to keep the fluctuations within 0.5 percent. It also marches to the ECB's monetary drum, including changing interest rates on the same day as ECB decisions, or in response to exceptional pressures on the euro-krone exchange rate.
The peg was put in place to stabilize Danish monetary policy after a period of high inflation, which peaked at 12.3 percent in 1980. It’s not clear that the peg is a good idea now. Unlike Sweden, which has a floating currency and until 2010 had a more sensible monetary policy, Denmark hasn't fully recovered from the global economic crisis. Real gross domestic product per capita is still more than 7 percent below the pre-crisis peak.
The desirability of the peg, however, is beyond debate in political and economic policy circles. When a prominent economist and former Danish government economic adviser was asked to compare the performance of the Danish economy with Sweden’s in December 2013, he was unable to name any area of economic policy where the Swedes did better. Monetary policy wasn't mentioned at all; only structural reforms such as marginal tax rates and labor market policies were.
Whenever abandoning the peg is mentioned -- which isn't often -- economists and politicians are almost offended. They regurgitate standard arguments without much substantive evaluation of the benefits and costs.
A country with a fixed exchange rate has to rely on fiscal policy as the only source of countercyclical economic policy, and on structural reforms and internal devaluation to fix deeper imbalances. Successive Danish governments have been diligent at implementing these structural reforms. What is unique about Denmark is that monetary policy is simply not discussed.
When I studied economics at the University of Copenhagen, we learned about the macroeconomics of small open economies, various exchange-rate regimes from both a theoretical and historical perspective, and optimal currency areas. But when it came to Danish monetary policy, we weren't asked to apply any of that. Instead, we were simply told that abandoning the peg was impossible: Foreign investors would immediately dump all their holdings of Danish government bonds and the economy would be in ruins.
Danish voters rejected the Maastricht Treaty, which created the euro, in a referendum in 1992 and only approved it a year later with four new opt-outs, including from the euro. A referendum was held in 2000 on euro membership, which was rejected by 53.2 percent of voters. During the 2000 referendum campaign, one of the main arguments in favor of euro membership was that Denmark was already de facto a euro-zone country. Abandoning the peg was unthinkable, and joining formally would give Denmark a seat at the table.
The opposing arguments were mainly on nationalist or sentimental grounds. (We’ll lose our nice notes, and think of how much it would cost to upgrade all the cash registers!) I don’t recall anyone arguing that it might be a good idea to abandon the peg, or to at least keep the option open, as an argument for voting no.
Given the still sluggish performance of the Danish economy, an attack on the peg now will most likely be inflationary, yet the consequences may not be that bad. Even if it starts to have real costs on the economy, I predict that the central bank will continue to defend the peg at any price, and that all the major political parties will support the policy. There are simply not enough policymakers who have the ability to even contemplate abandoning the fixed exchange-rate policy. The governing classes are still living in the Danish version of the 1970s.
I am no fan of the peg, as you can tell by now, but I have absolutely no hope that it will be abandoned any time soon. The best I can hope for is that all the speculation coming from outside the country, and possible economic costs in the years to come, will lead to a more substantive debate over Danish monetary policy.
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