Economics and politics - comment and analysis
17. October 2018 I Heiner Flassbeck I General

Denmark in the hands of the capital markets?

Originally posted in German at Makroskop

Translated and edited by BRAVE NEW EUROPE

I was invited to Copenhagen last week to talk about the euro crisis and its impact on nations such as Denmark, which still have their own currency, but which are quite firmly pegged to the euro. At the conference it was remarkable to what degree Danish economists and Danish politicians are influenced by the euro ideology in terms of economic policy and how a country like Denmark, which actually has considerable room for manoeuvre in its economic policy, tends not to make use of it under the influence of prevailing neo-liberal economic dogma.

At first I was astounded when the conference reported on the naive way in which politics in Denmark had for many years been persuaded to firmly believe in the so-called non-Keynesian factors, i.e. in the fact that austerity policy can have expansionary effects (something that not only we, but almost all respected economist have refuted). Obviously, high-ranking Danish politicians brought the this cant from Brussels to Copenhagen, claiming that there were highly respected scientists (Alberto Alesina was mentioned in particular) who at the beginning of the euro crisis had stated in hearings of the Commission that there were empirical examples that economies had grown despite pronounced restrictive policies of the state and consequently could fundamentally grow if the state consolidated its budget (austerity).

Expansive austerity policy is …

Such a message is of course well received in a country that is currently going through a crisis, especially when the public and politicians are fearful of high public debt. These harbingers explain to the public that their nation, so to speak, is the born candidate for this policy and implement it with ease, because there is no political resistance whatsoever to measures that – allegedly – help reduce national debt but at the same time stimulate economic growth.

Only domestic economists who are self-confident and influential enough to break into the phalanx of the coalition of debt phobics, which runs across all parties, could offer real resistance in such a case. This is not easy in a small country, however, when the slogan of austerity is propagated by the highest authorities that practically all EU member states are convinced of this “wonderful solution”. Even in Germany (and within the framework of the G20) the Federal Ministry of Finance in Berlin peddled the non-keynesian effects for a while, but they didn’t really get through.

… very easy to refute

A convincing economic argumentation refuting austerity is basically easy to make if politicians and the public are familiar with fundamental macroeconomic relationships. However, this is seldom the case, which is why pseudo-scientific arguments, which come along with great empirical brouhaha, i.e. above all with the all-purpose weapon of mainstream econometrics, can almost always be used as unassailable arguments.

There is no question that one can find nations and cases in which the economy has grown even during an austerity phase. This does not mean, however, that the so-called non-keynesian effects exist, but only that the expansionary effects coming from the non-state sector of the economy are greater and stronger than the negative effects from the reduced expenditures of the state sector. For this policy to succeed, however, certain requirements must be fulfilled: a massive real devaluation and the subsequent expansion of net exports, or the emergence of a large current account surplus, or the disappearance of a deficit in the current account.

The fear of the capital markets …

Even more impressive for me in the discussion in Denmark was the fact that there seems to be a broad consensus, even among relatively progressive economists, that international capital markets are quickly and consistently punishing countries with higher interest rates that do not adhere to the (unwritten) “rules” for sound public finances. In particular, they are convinced this applies to small open economies, even if, like Denmark, they have their own currency.

In the Danish discussion, this belief even goes so far that many people are convinced that a “buffer” must be created between what they “allow themselves” to do and what is demanded, for example, in the European Monetary Union (EMU). Denmark’s public debt currently stands at around 30 percent of GDP. This is precisely what creates a “nice safety buffer”, namely the gap between Denmark’s own 30 percent and the 60 percent that is generally strived for in EMU. This is an incredibly absurd position, because it is assumed that the capital markets “demand risk premiums” if public debt exceeds certain thresholds. The evidence for this? Absolutely zero.

We have shown time and time again that there is no correlation between the debt ratios discussed in public (i.e. government debt in relation to GDP) and the interest that a government pays on its bonds. This means that there is also no evidence for capital market participants on which to base the assessment that there is a risk of losses in government bonds if a state increases its debt (in its own currency). The classic example of a non-existent relationship is Japan, where the lowest interest rate in the world and the highest government debt in the world for decades have gone hand in hand.

…is based on confusion

The fear of capital markets simply demonstrates the problems that can arise when a state is indebted in foreign currency into one pot with those of indebtedness in its own currency and concludes that the markets always have a decisive say. But that is nonsense. If you are indebted in your own currency, you also have an institution that can produce this currency in any quantity in a very short time. and thus nip in the bud any speculation by the capital market against the state. This institution is called the central bank.

The ECB has now been demonstrating for two years that this is possible and that the central bank can systematically depress interest rates on government securities. The fact that it is currently not doing so with Italian securities, but is letting speculation run its course within certain limits (which leads to higher interest rates and a higher spread, i.e. a higher spread between Italian and German interest rates for government bonds over the same term), is due to political considerations: because this policy is highly controversial in Germany. Germany and the Federal Constitutional Court are invoking the anchoring of a ban on state financing by the central bank in the Maastricht Treaty.

But just as the ECB argues (supported so far and probably also in the future by the European Court of Justice) that its purchases are not public financing, but the use of a monetary policy instrument, one can equally argue that combating speculation with government bonds has nothing to do with public financing, but merely serves to keep the markets from misinterpreting public finances. In this case, the markets simply do not have better information than the competent states and their central banks, but clearly worse, because this is the macroeconomic interpretation of data. No one can seriously claim the markets have an advantage here.

How was Switzerland able to hold its own against the world’s capital markets?

So, although there are extremely good reasons for putting a stop to speculation with government bonds  once and for all, the intervention of the central bank in this case is taboo in a country like Denmark. However, as is usually the case with such taboos, there are no objective reasons for this, but they are based purely on ideology. Because the (“efficient”) financial markets (only ten years after the great global crisis caused by disoriented financial markets and rating agencies!) are assumed, again without any objective justification, to have the ability to adequately assess public finances and impose sanctions, it is assumed that any state intervention is inefficient and thus reduces prosperity.

One wonders how great the reduction in prosperity actually was, which was accepted by the Swiss National Bank when it intervened in the foreign exchange market for years after 2015 in order to keep the price of its own currency, the Swiss franc, artificially low. After all, the central bank has used hundreds of billions of francs created out of nothing to show the markets that the market participants’ idea of the value of the Swiss franc is wrong. Why is this accepted to a large extent, but why is intervention in the capital markets declared a taboo elsewhere?

There is no reason for this and there is no reason to believe in any rationality in the financial markets. The fact that entire countries and their governments are being driven by financial markets´ threat of sanctions must be seen as one of the most fundamental aberrations of the human mind.