The WaPo has a new piece out entitled “Five Economic Lessons from Sweden.”  But it actually only contains one lesson—use monetary stimulus aggressively when demand is falling.

The first two points note that Sweden mostly relied on automatic stabilizers for its fiscal policy.  For some strange reason the WaPo infers from this fact that fiscal policy was a big help in aiding recovery.  So why aren’t we doing better?

Reason five discusses the Swedish banking system, which was reformed after the severe collapse of the early 1990s.  But they also note that:

Swedish banks didn’t make it through the 2008 crisis without major losses. To the contrary, they had lent heavily in the Baltic nations of Lithuania, Latvia and Estonia, which suffered an economic collapse.

The banks relied on funding in dollars that they borrowed from other banks “” and during the crisis that funding all but disappeared as banks hoarded dollars. Had the Federal Reserve not made billions of dollars available to the Riksbank through “swap lines,” which were then lent to Swedish banks, there surely would have been a devastating collapse of the banking system.

So it’s not that the Swedish banks managed things perfectly. But they experienced more manageable losses than did their counterparts in the United States and much of Europe, and are now back to playing their normal role of making loans and supporting growth.

I don’t get this.  Sweden’s doing much better than all of the other Western European economies, even those without banking crises.

So we are left with 3 and 4.  Monetary stimulus and the flexible exchange rate required to make easier money possible:

The Federal Reserve has won both plaudits and criticism for responding aggressively to the financial crisis, pumping money into the financial system in epic fashion. But by one key measure, the Swedish central bank was even more aggressive.

Like the Fed, the Riksbank lowered its target short-term interest rate nearly to zero. But it also expanded the size of its balance sheet more than the Fed did relative to the size of its economy, flooding the financial system with even more cash during the height of the crisis.

In summer 2009, the Riksbank had assets on its balance sheet equivalent to more than 25 percent of the nation’s gross domestic product. For the Fed, that level never got much over 15 percent.

In 2009, the Riksbank even moved one key interest rate it manages below zero. Under this negative interest rate, banks that parked money at the central bank actually had to pay 0.25 percent for the privilege. That made them all the more eager to lend the money to one another rather than park it at the central bank, though in practice, Swedish officials and bankers said that the negative rate had more symbolic consequences than practical ones.

They left out plenty, such as Lars Svensson’s advocacy of targeting the forecast, but this is certainly much better than what you usually see from the mainstream press.  Just one question.  If Sweden was doing the right thing, why didn’t our economic pundits tell us that back in 2009, when it might have done some good over here?  Why not tell us before the rapid growth in Sweden materialized?

Not to pat myself on the back, but . . . well, let’s be honest, this link is to pat myself on the back.  And this one too.

Update:  I forgot to mention that Marcus Nunes has some excellent posts on Australia and Sweden/Poland.

Here’s BloombergBusinessweek, with a picture for those too lazy to read:

They are taking to the streets in Stockholm, but not with demands. Swedes, this month, ask for no more than a spare patch of grass or dockside granite to bask in the midsummer. The country has never really gone in for protest anyway, and right now there’s nothing to protest about. The economy grew at an annual rate of 6.4 percent in the first quarter, after 5.7 percent last year, which was the strongest recovery in the European Union. And Sweden still has its krona.

Australia is another success story.  It maintained a higher trend NGDP growth rate than other countries during the pre-crisis period, which meant higher trend nominal interest rates.  During the crisis it was able to cut rates from 7% to 3%, and avoid a liquidity trap.  No PSST problem in Australia either.  Ditto for Poland.  Interesting that countries that avoid PSST problems are pretty much the same as countries that avoid excessively tight money.

A recent article in The Economist provides a graph that illustrates the destructive nature of Gordon Brown’s economic policies:

When Labour took power in 1997, public spending was about 19 percentage points lower than in Sweden (58% vs. 39%.)  Tony Blair and his chancellor of the Exchequer Gordon Brown initially tried to reassure markets with a responsible fiscal policy.  But in their second term Brown started raising spending as a share of GDP.  Today UK spending is only about 2 percentage points behind Sweden (53% vs. 51%.)  Some progressives excuse this performance by pointing to the fact that spending normally rises in recessions.  But this argument fails for several reasons.  First, if true then spending should fall as a share of GDP during good times.  But Brown did exactly the opposite during the preceding boom years.  He ran the same sort of deficits that Krugman excoriated Bush for running, but Brown received praise from Krugman.  Not only did spending not decline as a share of GDP during the boom years–it actually rose.  And of course Britain also had many of the same dysfunctional banking policies as the US, such as privatizing gains and socializing losses.

There is another problem with the recession excuse for high UK spending; it isn’t clear that the UK will recover from the recession.  This may be the new normal.  And that’s because the huge expansion of the British state has damaged the supply-side of the UK economy, leading many economists to predict trend growth for the foreseeable future.  No wonder the Cameron government sees a need to restrain spending.

Some might argue that the British state is still slightly smaller than the Swedish state, and Sweden is doing relatively well.  Yes, but Sweden has much more pro-market policies in many other areas, and indeed is moving towards capitalism as the UK becomes more socialistic.  Here are some examples from the article in The Economist:

Without dumping the generous Swedish social model, the government has tweaked it in the direction of lower taxes and smaller welfare benefits. Mr Borg calls this “reinforcing the work ethic”. Mr Reinfeldt talks simply of making work pay.

The results have been spectacular. After long being a case study in jobless growth (except in the bloated public sector), Sweden has become a big creator of private-sector jobs. The government has narrowed the “tax wedge” that deters employment and whittled away at sickness benefits: Sweden no longer stands out for welfare excesses. The retirement age has risen to 67. Inheritance and wealth taxes have gone. Mr Borg and Mr Reinfeldt believe firmly in ownership as a driver of prosperity.  . . .

Unlike Britain, Sweden is happy to let private schools and hospitals make profits from taxpayer-financed services if outcomes are better.  . . .

Some 40 years after becoming the only continental European country to switch its motoring from left to right, Sweden is making a similar political shift. By 2014 Mr Reinfeldt will have been in power for eight years. Given the economy’s strength, few would bet against his winning again. To many on Europe’s left, Social Democratic Sweden was once a statist paradise. Now it is the right that looks north for inspiration.

Cameron is a fan of the Swedish center-right government, and would like to move the UK in that direction.  But he will probably fail.  British voters have no stomach for the savage inequalities of Swedish-style laissez-faire.  They won’t tolerate public money going to for-profit schools or health care.  Instead, Cameron has signed on to increasing the top rate of income taxes from 40% to 50%.  Eliminate inheritance taxes?  I don’t think so.  Follow Denmark in privatizing firefighting?  Don’t make me laugh.  The British public likes big government, and they are going to get it.

BTW, some progressives blame Britain’s problems on fiscal austerity.  In the next post I’ll show why that argument is false.

Bruce Bartlett sent me a new paper by Peter Ireland.

This paper uses a New Keynesian model with banks and deposits, calibrated to match the US economy, to study the macroeconomic effects of policies that pay interest on reserves. While their effects on output and inflation are small, these policies require important adjustments in the way that the monetary authority manages the supply of reserves, as liquidity effects vanish and households’ portfolio shifts increase banks’ demand for reserves when short-term interest rates rise. Money and monetary policy remain linked in the long run, however, since policy actions that change the price level must change the supply of reserves proportionately.

I found the long run neutrality of monetary policy to be quite interesting, as I’d assumed that relationship broke down with interest on reserves.  The fact that IOR has little effect on inflation and growth is also interesting, but I would caution that this sort of finding needs to be interpreted with caution.

In December 2007 the Fed was trying to decide between cutting rates by 1/4 and 1/2 point.  They actually cut them by 1/4 point, and the Dow promptly fell by 300 points.  Because fed funds futures showed a 58% chance of a 1/4 point cut and a 42% chance of a 1/2 point cut, we can infer that the Dow would have risen about 400 points with a 1/2 point cut.  (One of the few things even anti-EMH types accept is that the expected return on the Dow over any 2 hour period is roughly zero.)

Are there any models that predict that a 1/4 swing in the fed funds target would mean 700 points on the Dow?  I doubt it, because most models look at these things rather mechanically.  But in the real world the effect of a change in almost any monetary policy variable (fed funds rate, the base, IOR, M2, etc) depends almost entirely on how the change impacts the expected future path of policy.

I agree with Peter Ireland that a decision to pay IOR will have very little macroeconomic impact, ceteris paribus.  On the other hand, ceteris is rarely paribus.  It’s possible that an IOR decision might lead to changes in the expected path of monetary policy.  For instance, it might lead to fears that future QE would be less effective, as banks would have an incentive to hoard any extra cash.  Or markets might have already been expecting QE (to provide liquidity during a banking crisis) and the additional step of IOR might lead them to think the QE will not immediately drive short term rates to zero.

Since the impact of a policy depends on its impact on the expected future path of policy, it is almost impossible to model these effects.  They are highly contingent on the economic situation in which they occur.  For instance, the December 2007 quarter point cut would normally have had little market impact, but coming on the edge of the Great Recession, its impact was greatly magnified.  It made investors far more pessimistic about future Fed policy (correctly pessimistic, I might add.)

Does this mean there is no hope of ever being able to estimate the impact of policy decisions?  Far from it.  Louis Woodhill looked at the only three IOR decisions in the Fed’s 98 year history.  In each case stocks fell very sharply around the time of the decision:

At the time of the Fed’s IOR announcement, the S&P 500 was down by a total of 12.18% from its pre-Lehman close, 15 trading days earlier. However, the day that the Fed announced IOR, the S&P 500 fell by 3.85%, and it was down by a total of 17.22% three days later.

On October 22, 2008, the Fed announced that it would increase the interest rate that it paid on reserves. The S&P 500 fell by 6.10% that day, and it was down by a total of 11.11% three days later. On November 5, 2008, the Fed announced another increase in the IOR interest rate. The S&P 500 fell by 5.27% that day, and it was down by a total of 8.60% three days later.

To play it safe it’s probably better to go with the single day returns, as the EMH suggests the effect on asset prices should be immediate.  On the other hand, the concept of IOR was fairly unfamiliar to Wall Street, so arguably there might have been some delay as the program was discussed and explained.  But even using the more conservative one day window, what are the odds of three drops like that occurring on the only three days in history when the IOR was raised?  I’d guess no more than 1 in 10,000.  Economists get published with results no more unlikely than 1 in 20, and yet I am so skeptical of statistical significance that even 1 in 10,000 seems merely suggestive to me.  I think IOR might have had a significant contractionary impact, but I am not certain.

Whenever the model says one thing and the markets say another, I always go with the markets.  The markets seemed to think the IOR program was a big mistake, and the QE2 program was an important step in the right direction.  That’s all we know right now, and probably all we’ll ever know.

PS.  After the third and final increase in IOR, the S&P500 actually fell 10% in just two days.  Thus the market declined over 38% in 10 trading days–October 6, 7, 8, 9, October 22, 23, 24, 27, and November 5, 6.  Think about what it means for US equities to lose 38% of their total value in 10 trading days.  Coincidence?  Maybe, but a pretty unlikely one.  Using 2 day windows the total drop was about 24%.  Even the three single day drops add up to more than a 15% decline.

And then there is Sweden, with its negative IOR and record RGDP growth.  Hmmm . . .

Memo to Bernanke:  Cut the IOR to 0.15%.  It will give banks a bit less incentive to just sit on all the QE you’re sending their way.  But it will still be high enough to prevent the MMMFs from going belly up.  And you guys at the BOG can do it on your own–no pesky regional bank presidents to deal with.  Even Ron Paul will approve—less subsidy to fat cat bankers.  Git er done.

Here’s Matt Yglesias and Brad DeLong touting the success of Sweden’s negative IOR program.  Ryan Avent also links.

I published the idea back in early 2009.  And I blogged on Sweden’s policy move back in mid-2009.  At the time, I was frequently criticized for talking about IOR.  “Surely it can’t matter that much, just a quarter point.”

If you want to read what other bloggers will be talking about in 2011, be sure to read my blog in 2009.

PS.  I doubt that negative IOR played a significant role in Sweden’s success; although it’s hard to know for sure because so much of monetary policy is about signaling.  But monetary stimulus did speed up Sweden’s recovery.

PPS.  DeLong’s post is entitled “Matthew Yglesias Makes a Good Catch”  Matthew knows where the fishing is good.  🙂