The European Debt Crisis – from a Danish Perspective

Title of a new speech from Denmark Central Bank chief. Before this some background.

Denmark  has made a strange choice of opting out of Eurozone but still pegging its currency to Euro.

Basically under this European integration system countries can opt out of certain integration areas. Five countries – UK, Sweden, Denmark, Czech and Ireland have opted out under various areas –

Denmark (four opt-outs), Ireland (two opt-outs), Poland (one opt-out) Sweden (one opt-out, but only de facto) and the United Kingdom (four opt-outs). The Czech Republic will gain their first opt-out under the next treaty to be ratified (likely an accession treaty).

For Euro we have following optouts:

  • Denmark has a dejure opt-out (as in formally negotiated and written in law).  Though Denmark is still a part of EMS_II system and pegs its currency to Euro in a band of +-2.25%
  • UK have dejure opt-outs like Denmark. It has opted to float its currency – Pound
  • Sweden has not negotiated and is a de facto opt-out. Sweden has neither participated in ERM-II nor has  fulfilled the Maastricht conditions

So clearly other two have their own currencies. Danes are ok with Euro pegging but not adopting Euro as their own currency.

This led to problem in the crisis as when ECB was cutting rates, Denmark Central Bank was raising rates to prevent capital outflows (fixed exchange rates are messy most of the time). This prompted Denmark Central Bank chief to suggest that Denmark should join the Euro. He even looked at what would have happened if Denmark was part of Euro.

However, all these speeches were being made before this European crisis was unfolding. Now most Danes might say they just don’t want to be part of EMS as well. I think the right q is whether fixed exchange rate system is useful for Denmark especially in a crisis. As it is a small open economy, it might be better off having its own floating currency as experiences of New Zealand and others have shown.

Anyways, here is a new speech from from its central bank chief Nils Bernstein. He looks at this problem of Denmark agreeing to be part of the new Euro pact of fiscal compact and still remaining out of Euro. He says Danes have no choice but to adopt the framework:

The Danish government has stated that it will be decisive for an eventual Danish participation that it does not conflict with our euro opt-out, which can only be changed by means of a referendum. I will not at this junction speculate over possible legal and pure political aspects but only comment on the aspects concerning the economic policy.

If the euro Member States decide between themselves a stronger and more binding framework for the economic policy, including fiscal policy, then Denmark as a small open economy with a fixed exchange rate regime vis-avis the euro has no other option than either to take part in as much of the agreement as we can, respecting our euro opt-out, or place us as close as possible at the new euro compact without formal participation. 

In other words, a stronger discipline in the economic policy in the euro  member States should result in just as tough conditions for Denmark irrespective of whether or not we decide to participate in the new agreement. In reality we will hardly get a higher degree of manoeuvrebility in the economic policy by staying outside – quite the contrary. If we decide to stay outside, we have to make sure that it is not mistakenly seen as a signal of less commitment to sustainable economic policy.

He says till this crisis, fixed exchange rate system worked well. Denmark faced  similar problems like Europe now in 1980s but sorted it out. It pegged its currency via D-mark in 1982 which helped the country import the virtues of German stability:

For close to 30 years, the fixed-exchange-rate policy (slide 9 – the krone rate) has been a cornerstone of Danish economic policy – and has served Denmark well. Inflation and interest rates are in line with those of the best performing euro area  ember States, and the Danish level of prosperity matches that of our neighbouring countries.

Prior to the pegging of the Danish krone to the D-mark, the situation in Denmark was similar to that of the problem economies in the euro area today. Denmark had been through a period of slow growth and large imbalances as regards government budgets, the current account and the labour market, which was affected by high unemployment throughout the 1970s in the wake of the oil crises. In 1982, inflation reached 12 per cent and interest rates 22 per cent. The government yield spread to Germany peaked at 12 percentage points (Slide 10 – long-term yields). This level of interest rates would be devastating to any economy.

The pegging of the Danish krone to the D-mark in 1982 marked the beginning of a long period in which structural imbalances in the economy and fiscal inadequacies were gradually addressed politically. But this was not without setbacks.

This legacy has been carried forward and as a result they have been better off in this crisis. But still the economy was impacted because of built up of credit bubble in 2006:

The Danish economy has performed relatively well – also after the introduction of the euro in 1999. This can be attributed to a stability oriented economic policy with a medium-term focus, and to the implementation of structural reforms in the labour market and elsewhere during the 1990s. It is also a fact that, in practice, the economic policy pursued outside the euro area must be at least as tight as that pursued in the euro area in order to safeguard the credibility of the fixed-exchange-rate policy. The conclusion is clear. The credibility of the economic policy pursued is more important than the choice of exchange-rate regime. This also applies if fixed-exchange-rate policy is introduced in the form of participation in a monetary union.

Thanks to our relatively solid starting point, Denmark has been less affected by the debt crisis than many other countries. The most important real economic issue is that Danish economic growth is low partly due to poor consumer and business confidence. The steady stream of negative stories from the euro area is no doubt a contributing factor, but is far from the only reason. The Danish economy was severely overheated from 2006 to 2008, with very strong credit growth and a housing bubble. We are now struggling with the repercussions of the overheating. The situation was aggravated by the financial and debt crises, but these are far from the only reasons for the lack of consumer and investor confidence that is currently hampering economic growth.

He further says Denmark banks exposure to peripheral Europe is less and not a problem.

Well fixed exchange rates work both ways – they import both stability and instability.

Denmark’s case takes you to Great Depression when central banks raised rates to maintain the currency and capital outflows (gold outflows in Great Depression). It has neither adopted Euro nor a flexible exchange rate like UK and Sweden.

Going by the way European crisis has gone, it should take a call on which way it wants to go…


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