A Truth about Sweden’s Recession & Raising its Interest Rates
Within an economy, there are different industries. and each industry would require a different central bank interest rate to function best. But there cannot be a different interest rate from a central bank for each and every industry.
What happened when Sweden raised its interest rate?
We hear that Sweden raised its interest rate a few years ago and their economy went into a recession. But here is Adair Turner from an interview with INET. (link) Listen to between 23:45 minutes and 26 minutes. In this space of time, he says…
“Essentially, the economy is not efficient and rational enough that we can assume that all sectors have the same concept of what the rate of return is… and therefore respond in an equal way to a rate of interest increase. We’ve seen this actually within the last few years in Sweden. 3 years ago back in 2011-2012 the Swedish central bank, Riksbank, was worried about a credit-asset price bubble getting going in Stockholm property in particular. It decided against the trend of central banks to raise its interest rate. It raised… didn’t make a blind set of difference to the credit and asset price cycle in Stockholm, but what it did do was drive the Swedish economy into a recession.”
The implication of his words is that interest rates are set low enough that even the most marginal of industries will get a break. Thus interest rates have fallen to the level of the least healthy industries, while some industries benefit greatly from low interest rates.
So these questions then arise… Does any industry struggle with low interest rates? What industry might require a zero % interest cost? And are these industries then socially optimal?
Limits on Development
Even for those industries, like high-end housing, that might laugh at low interest rates because they could still do well with much higher interest rates, there are still limits to their investment, such as demand. They can only develop their investments within the limits of the demand in the market. So interest rate costs become a non-issue. They have all the money they would need to develop their investments. So interest rates are not a limiting factor.
What about the industries where a rise in interest rates would be a limiting factor? These industries are marginally profitable. They hold back other costs too such as wages. In the end, these businesses hold back social benefits, like wage increases, by not being profitable in a socially beneficial sense. They can also drag down the Wicksellian natural real rate which further justifies low interest rates.
Giving out Grades
Take a generation of doctors going through school. Let us say that the standards for passing the examinations are lowered so that even the students who barely passed their classes have an easier time getting their medical licenses and eventually a job. The best students will still get good jobs and perform good medicine. But there will be a larger percentage of doctors that are not so good. They will make more mistakes. The growing numbers of these doctors lowers the social benefits of the medical industry.
Yet, there are reasons to lower the standards of the examinations. Those students have to pay back their student loans. The creditors expect those students to pay back the loans. The students need to pass the licensing exams. The country may need more employment. Schools need to show success rates for their students and so on.
Sweden’s Recession in Context
It is becoming generally accepted that interest rates will stay low and maybe near the zero-lower bound for a long time. The economy does not want to risk a recession. Many point to Sweden as proof that raising interest rates would cause a recession. But the truth of Sweden reveals that many marginal socially-beneficial businesses would be at risk. And remember, the recession in Sweden was not any greater than elsewhere in Europe. (This graph is from Paul Krugman’s post on Denmark.)
Whereas Sweden raised its Riksbank interest rate from 1% to 2%, Denmark only raised it from 0.7% to a little over 1% for a shorter period of time. It looks like Denmark had more adverse effects, and that Sweden grew better afterwards.
Europe as a whole did much worse over the same period of time. The European central bank raised its benchmark rate during 2011 from 1% to 1.5%. (link to data for graph at trading economics)
Sweden looks to be doing better than most. So why is the Swedish rise in their interest rate such a scary thing?
My view is that a moderated rise in the Fed rate would clean out some marginal sectors of the economy. There would be some businesses that fall out. But then afterward the Fed rate could come down and growth would be better. Sweden raised their rate more than others for a longer period of time, and lo and behold, they bounced back better.
Just like I would think based on viewing the global economy as a flooded engine. Sweden shows me the value of raising the interest rate for a period of time and then lowering it in order to un-flood the engine.
I think you may have touched on the fatal flaw of Central Bank Economics. Where is the incentive for the Central Back to turn a profit on it’s loans? There is none. So they will lend to marginal companies.
Private lenders, however, what both a return on their principal and a return OF their principal — income and security. So they will charge marginal companies more by bidding less for their bonds.
In a sense, banks do not want to loan into this environment as you pointed out. They would rather loan at a higher rate or not at all. So corporations have turned to selling corporate bonds.
The real value of corporate bonds has been rising.
What about bank loans? Not so much…
When you compare this business cycle to the one before the crisis, this cycle has more sales of corporate bonds and much less credit extended.
EL – You say:
My view is that a moderated rise in the Fed rate
would clean out some marginal sectors of the
economy. There would be some businesses
that fall out. But then afterward the Fed rate
could come down and growth would be better.
So you want to raise rates to “clean out” some companies. Can you give us an example of a company (or two) that you think is marginal and should be put to death?
One cannot give examples. This question is always asked, but an answer cannot be given. Only the logic of the situation can tell us that companies like this are out there.Th logic comes from what happens in UK, Sweden, China, other countries and reports from the US.
Think of China. People know that there will be non-performing loans, but nobody points the finger at specific companies, because one does not know how things will wash out as tightening comes.
At the same time, businesses are greatly interconnected. The failure of one business could tip another into failure. So one business that looks good is actually vulnerable to tightening because of its connections to a weak business.
And businesses are good at hiding their weaknesses even internally within the company.
EL – you tout yourself as an economist. You advocate a policy where the Fed would create a monetary recession for the sole purpose of “to clean out some marginal sectors of the economy”. Yet you cant’ even name a “sector” you would like to kill off, much less a company that would be in your cross hairs. But you are sure “they” are out there someplace and you want to shoot bullets in the hope that one of them hits a marginal player. A joke. What right to you have to shoot bullets?
On the basics. The Fed conducts monetary policy based on authority from Congress to achieve 1) Maximum employment and 2) Stable prices. The Fed has no mandate to create recessions to achieve destruction. What you advocate has no basis in law, or Fed policy. Delusional.
You want a recession that would hurt companies and their employees. You want higher corporate failures, higher unemployment, reduced tax revenue and increased government costs for automatic stabilizers.
Do you remember the days of military waste when a hammer would be bought for $450 and posted as a multidirectional impact generator on the invoice?
In those days, people knew there was waste but could not point their fingers at anyone unless they were able to view the paperwork. According to the system in place in the military of checks and balances, waste was going to happen. People knew waste was there. Some people said that the whole military was full of waste. But even that was wrong. It was even wrong to deny that there was waste. But where was the waste? People would ask for proof. Well somebody had to start looking for it. When they found it, measures of discipline began to be implemented.
The same goes for the economy. We have an environment where banks have an incentive to not let companies go under for balance sheet and other reasons. We also have an environment of low corporate taxes, lots of loopholes and low wages. Companies have power to get low wages. There is an environment where businesses are able to hide true weakness in the sense of social efficiency.
Even Bernanke said that some executives should have been prosecuted.
Even Milton Friedman wrote a paper about how firms have the primary responsibility to the shareholder and that they do not have a social responsibility. So there has been created an environment where waste can develop.
But where is the waste? Is it in restaurants that pay low wages? Is it in the automobile industry with their two-tiered pay structure as the phase in lower wages? Is it in the increasing part-time jobs? Is it with the teacher assistants in universities who receive low wages for doing professor work? Is it in the companies where over-time without extra pay became accepted? Is it in energy companies that use old and inefficient machinery that produces environmental pollution? Is it in the lack of government services? Is it in a military that is bigger than it really needs to be? Is it in Walmart since their profits went way down?
There is a sense that there is waste out there, but you will not know exactly where it is unless you can see the books of the companies.
So now I ask you… Do you deny that there is waste out there? Do you deny the role of tighter regulation and monetary policy to clean out waste?
The key is to clean out in a safe and measured way. The key is not to rapidly hike the Fed rate. The key is to tighten and clean in a measured way. In the end, the economy will respond better… just look at Sweden after their apparent mistake of raising the interest rate. They are doing better than the rest… and Why is that? People look at the little slump that occurred and call it bad, very bad and unnecessary. I look at the healthier growth afterward and I recognize the medicine of the slump to heal socially inefficient units in the economy.
The process of healing those inefficiencies is broad-based. Like Adair Turner said, some companies will not be affected at all by a rise in the interest rate. Yet, the ones that will be affected are the ones on the margin. The big question one has to ask is… To what extent are the companies on the margin dragging down social efficiency of the economy? Then is it worth it in the long run to try to clean up those inefficiencies?
If people think that the whole system is that fragile that a measured rise in the interest rate would trigger a big socially catastrophic recession, then who really is being delusional?
Remember when Sweden raised its rate, people criticized the action. But now look at Sweden… they are doing much better than the rest. They have surpassed the rest since then…
What does that tell you?
EL You think you solve the $450 hammer problem with a higher Federal Funds rate? You’re kidding with that one, right? The two have nothing to do with each other.
Again, the Fed has no mandate (no authority) to create a recession to cleanse sectors of the economy. The Fed would never accept this, Congress would never approve it. You’re pushing for something that has ZERO chance of ever being in existence. Whey pound the table for something that will never happen in your lifetime? An intellectual exercise, or a waste of time….
Sweden has 9m people, USA 315m. Comparisons between the two will draw wrong conclusions.
EL shouts from his pulpit, “We need a recession, and we need it now!”
Talk about voodoo….
You got irrational in your reply…
People compare US to Sweden all the time by saying that a rise in interest rates here would have the same consequence as in Sweden. And you hear people compare US to Zimbabwe and Greece. So comparisons can be made… some hold water, some bring the horse to the water.
and you completely missed the point of the $450 hammer. The point was waste created by an environment. In that environment, one cannot know where the waste is until the paperwork can be seen.
And of course, the Fed is not going to listen directly to what I say, nor even Krugman. Yet there is a formation of ideas in the econoblogosphere. It is not a waste of time. For example, how often do you hear people pointing to the Swedish recession but then recognizing that Sweden bounced back better than others? I never do… I am the first one that I can see. And yet it is the truth.
And I am not calling for a recession. I see that a slight rise in the fed rate could stimulate a mild cleansing. Then the fed rate can come down and produce an effect.
Are you going to be irrational again?
I think the idea of a beneficial cleansing in the current context is really about the debt , just as it was on the eve of the crisis. There’s still too many businesses and individuals holding on by their fingernails , trying to maintain their debt service with little or no income growth to aid them , and with little prospect of even lower interest rates coming to their rescue , either. The Fed has tried , and failed , to generate inflation that would reduce their debt burdens even in the absence of real income growth. In short , they’re stuck , Ponzi-style.
A managed debt reduction or restructuring would be one way to go , but our leadership and institutions either don’t have the will or the way for that , so it may well be , as Edward suggests , that as an alternative a mild shock , followed by a ripple ( not a tsunami ) of bankruptcies , would do some good , as current debt-smothered consumers and effectively-insolvent businesses are given a fresh start.
It could help. Just ask Trump.
I do not believe that macroeconomics should be separated from behavioral economics.
It will eventually require a new generation of economic and business leaders that believe that businesses have a social responsibility, and that the primary responsibility is not to profit for the shareholders. Friedman was so wrong.
So many problems will be solved so quickly.
I am not sure if Trump is in that category.
I’m pretty certain Trump isn’t the answer. He’d likely make matters worse , in fact. I only used him as an example of someone who had benefited greatly from the fresh start afforded by bankruptcy. Four times , IIRC.