Lessons from history not learned

There are times when one may wonder about financial markets.

On 15 January 2015 the Swiss central bank dropped its fixed exchange rate against the euro and a rapid appreciation of the Swiss franc ensued, i.e. the number of Swiss francs it takes to buy a euro dropped as can (perhaps….) be seen from the less-than-impressive Figure 1, which shows the Swiss franc against the euro since 2005. It is fair enough that financial markets hadn’t seen that one coming although the fixed exchange rate at its introduction in 2011 was always meant to be temporary.

Figure 1: Swiss franc against the euro, 2005 – 2015

Source: European Central Bank

What I don’t get about the financial markets is the, seeming, lack of lessons from history. Shortly after the Swiss franc appreciation, financial markets started speculating if Denmark, also with a fixed exchange rate vis-à-vis the euro, would also abandon its peg and let the Danish kroner appreciate.

But what does Switzerland and Denmark have in common, apart from pegging to the euro? OK, rich, small open economies with a triple-A rating. But in terms of the exchange rate much more separates them than unites them and a bit of analysis of the historical circumstances behind the exchange rate pegs should tell financial markets that Denmark will stick to its fixed rate.

As mentioned, Switzerland fixed its currency in 2011 to avoid (even more) overvaluation of its currency (in Figure 1 this can be seen as the rapidly cheaper euro in 2011, i.e. two-thirds to the right in the graph and in Figure 2 it can be seen as a rapid increase in 2011 of its Real Effective Exchange Rate (REER), i.e. as a rapid loss of competitiveness in international markets).

Figure 2: Real effective exchange rates for the euro area, Denmark, Switzerland and USA, 2005 = 100

Source: Eurostat

Denmark’s history in terms of fixed exchange rates is fundamentally different. After a tumultuous decade in the 1970s with chronically high inflation and frequent devaluations of Danish kroner, a new government decided in 1982 to create a low-inflation environment via a fixed exchange rate to the Deutschmark (and from 1999 to the euro). It is thus a fixed exchange rate that has lasted for more than a third of a century and it is seen as a cornerstone of economic policy and certainly not as a temporary measure. It has been very successful in terms of lowering inflation and as can be seen from Figure 2 competitiveness in Denmark and the euro area continue to track each other, as is exactly what they should under a fixed rate. Furthermore, Danish kroner is in the ERM II (the Exchange Rate Mechanism of the monetary union), a formal requirement to adopt (perhaps/eventually) the euro; the Swiss franc is of course not there since Switzerland is not even in the EU.

In short, two cases with, until 15 January 2015, fixed exchange rates to the euro but for fundamentally different reasons and thus not a case where abandoning the fixed rate in one country has any predictive power in terms of path of the second country. A brief look at the history should have told financial markets so but it seems that history books are not important in such markets?!?

And I cannot resist comparison with recent experience here in Latvia: During 2000 – 2007 we had a massive credit boom, fed partly – but certainly not entirely – by Swedish banks. They had been through a very similar experience in the late 1980s back in Sweden and also there the credit and real estate booms ended in tears. Lessons learned? Seemingly not….

For a fascinating (if rather long – but it is an easy read) description and analysis of the Swedish case, check Lars Jonung et al, European Economy: The great financial crisis in Finland and Sweden. The similarities with what happened here some 18 years are striking.

Morten Hansen is Head of Economics Department at Stockholm School of Economics in Riga