Policy advice and economic crises. How do they interact?The case of Sweden 1970-2025

ECONOMICS AND POLICY ADVICE – A FAREWELL SEMINAR FOR MR. ANTTI SUVANTO

Bank of Finland, Helsinki, 11 April 2016.

Lars Jonung, Knut Wicksell Centre, Ekonomihögskolan, Lund University, Lund

It is a great honour for me to take part in this farewell seminar for Antti Suvanto

For me: reunion seminar

A long history of contacts with Finnish economists: in the 1970s Jouko Paunio and Pentti Kouri, in the 1980s Sixten Korkman, Johnny Åkerholm, H C Blomqvist, Antti Suvanto, Seppo Honkapohja, et al.,in the 1990s Pentti Vartia and I got a grant, Jaakko Kiander, Vesa Vihriälä, Mika Tujula, and in the 00s I went to DG ECFIN in Brussels: Sixten Korkman, Anne Brunila and Heikki Oksanen and Antti.And in Lund/Mölle I have met some of you.

Policy advice and economic crises. How do they interact?The case of Sweden 1970-2025

My lecture is focused on stabilization policies (macro):

a) How policy advisors (advice) are influenced by economic crises and

b) How economic crises are influenced by policy advisors (advice)

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Policy advice and economic crises. How do they interact?The case of Sweden 1970-2025

A typo – a printing error – in my title?

A policy advisor should be able to look back as well as ahead and:

a. forecast the next economic crisis and b. forecast the policy response to the next crisis and c. forecast the policy advice emerging after the next future crisis

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Why look at Sweden? Sweden is well suited for a study the interaction of policy advice (policy

advisors) and policy outcomes: 1. The Swedish political system has allowed the government to directly

control the instruments of fiscal and monetary policies, and in particular to influence the central bank until it became independent.

 2. The prevalent Keynesian (Stockholm School) traditions and views have

given the government many instruments and much discretion to use when framing policies. Strong public belief in the power of economic policies.

 3. The Swedish tradition of openness and debate concerning public affairs

has induced policy makers to publish their memoirs and views. This literature represents an extremely fruitful source for research. Here policy makers reveal, sometimes surprisingly frankly, their thinking and their views on the proper conduct of fiscal and monetary policies.

The best book by a Swedish minister of finance ..

Back cover text:

A frank, humorous, informed and unsentimental account – just like Feldt himself...

Baksidestexten på Feldts memoarer:

Kjell-Olof Feldt, Sveriges finansminister under större delen av 1980-talet, avgick under dramatiska omständigheter i februari 1990. Nu skriver han om sin tid i regeringen. Hans bok liknar ingen annan politisk memoar.Den är frank, humoristisk, kunnig och osentimental som Feldt själv.

The head of the Riksbank explains a 500 % overnite rate …

The prime minister explains what he would have done if he just knew…

The minister of taxes explains how he saved Sweden …

The prime minister explains how he cleaned up the mess …

Can we trust these memoirs?

We do not need to trust the memoirs.

We have the record of changes in the instruments, the goals and the institutions for policy-making.

It is the thinking of policy makers that we get from the memoirs – or more correctly how they think they thought

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Why look at Sweden?

Sweden is unique

Through a series of five economic crisis 1970-2015, Sweden went from extreme Keynesianism to extreme rule-bounded anti-Keynesianism in less than 50 years.

From unrestricted fiscal and monetary policies to restricted polices.

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Analytical frameworkWhich is the proper one?

How should we analyze this pattern – as social scientists – as economists?

It is learning process involving two actors:

1. Policy-advisors (the economics profession)2. Policy-makers (the government and the central bank)

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Analytical frameworkWhich is the proper one?

It is learning process – a collective learning process. How do you model it?

Econometrics?Rational expectations?Model with ”representative agents” with

eternal lifespans?DSGE-approach?

Warning for the next picture. Boxes and arrows!

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Figure 1. The policy learning process - an outline.

Lessons fromprevious policies.

Macroeconomicdisturbance ("shock")

affects the economy.

The policy response isbased on current policy llessons learned.

The effects of the policy response appear

with some time lag.

New lessons arelearned when evaluating

the effects of the policy.

New macroeconomicdisturbance.

New policy response. Effects of the policy response.

Newa lessons.

Macroeconomic Policy response The effects of Policy learning disturbance the policy (Lessons)

(1) (2) (3) (4)

Macroeconomicdisturbance

(1)

Policyreaction

(2)

Policyeffects

(3)

Policylearning

(4)

1969-70:Outflow of foreign reserves. Deteriorating current account balance. Tendency towards inflation.

1970-72:Policy of restraint. Contractive fiscal and monetary policy.

1971-73:Rising unemployment.”The lost years.”

Lessons from the Bretton Woodssystem: External balance and a fixed exchange rate.

Lessons of “the lost years”:Expansive Keynesian fiscal policy suitable to maintain full employment.

1973-74:OPEC I.Oil price shock.Supply disturbance.

1974-76:Policy of “bridging over”. Expansion via fiscal policy.

1977-78:”Costs-crisis.” Growing budget deficit and crisis in different industries.

Lessons from OPEC I:Expansive fiscal policy creates imbalances. Devaluations “work”.Devalveringar ”fungerar”.

1979-80:OPEC II.Oil price shock.Supply disturbance.

1980-82:Fiscal austerity package. Devaluation in 1981. Offensive “super-devaluation” in 1982.

1983-85:Strong inflationary impulse. Rising profits.

Lessons from OPEC II: Rule-bound policy based on a fixed exchange rate. Hard currency policy.

Episode 1

Episode 2

Episode 3

Macroeconomicdisturbance

(1)

Policyreaction

(2)

Policyeffects

(3)

Policylearning

(4)

1986-90:Boom due to credit expansion. Overheating. Real interest rate shock. Financial crisis.

1990-92:Strong defense of the fixed krona rate. Government support to the financial system.

1991-95:Rapidly increasing unemployment and budget deficits. Deflation. Floating krona rate.

Lessons of the 1990s:Institutional reforms, independent Riksbank, a stricter budget process. Floating krona or totally fixed rate.

2008-10:Global financial crisis. Sharp fall in exports. Threats against the banking system.

2008-10:Expansionary monetary policy. Tight fiscal policy. Government support to the banking system.

2011-13:Rapid recovery.Strong public finances. Persistent unemployment.

Lessons from the global financial crisis:New regulation and supervision of the banking system. Macroprudential regulation.

The future:Next disturbance or crisis of unknown nature.

Tight fiscal policy. Expansionary monetary policy.

Unknown outcome.

New lessons of tomorrow’s crisis.

Episode 4

Episode 5

Episode 6

The policy learning process 1970-2015

Major conclusions.

1 Crises are the driving force behind the learning process

Economic crises which forced the policy-advisors and policy-makers to evaluate different policy options and thus to search for lessons from the past.

The policy learning process 1970-2015

2. The sources of information for the learning process

The main source of information was the interpretation of the most recent previous domestic economic crisis and its policy outcome.

The policy learning process 1970-2015

3. The character of the learning processa) Learning was built on a comparison between the current crisis and the previous crisis. Learning was therefore backward-looking and of a short-run character: it excluded episodes, that is, information from events further back in time.b) Learning was primarily of a negative character: the lesson was to avoid repeating what was perceived as policy mistakes during the previous crisis (”error-learning”).

The policy learning process 1970-2015

4. The macroeconomic consequences of the learning process • Learning determined the policy response and thus

influenced the path of the macro-economy. Two cases should be distinguished:

• a) When the new crisis was similar to the old crisis, the “mistakes” from the previous crisis were avoided.

• b) When the new crisis differed significantly from the old crisis, the learning process risked creating instability. In this case, policy-makers met the new crisis with the support of misleading lessons. The learning process then became a potential source of instability.

The policy learning process 1970-2015

5. Did policy-makers and policy-advisors learn to learn?

It is difficult for them to learn to learn. They have a short time span in power.

Then they are replaced – by elections or by retirement.

The policy learning process 1970-2015

How can policy-advisor play a more constructive role in preventing the next crisis?

Improve the collective memory:1. The role of the university? 2. Fiscal councils? Central banks?3. Employ old and retired professors/policy-advisors (70+) in the ministry of finance/central bank to sit in the coffee room and talk with the young civil servants fresh out of university?…

Now to the next crises

The learning process is a never-ending story

Learning is a continuous process.

It never ends – unless we have a crisis-free future.

We know for sure that there will be new crisis.

Let us look upon the lessons we thought we learnt from the past crisis. The Lehman crash – the Great Recession – the global financial crisis of 2008

Lessons from the most recent crisis 2008

Now to the next crises…

The present majority view:

Inflation targeting should be the goal of the central bank. And during a crisis the central bank should provide ample liquidity.

Macroprudential regulation should restrict the growth of credit.

Will these lessons from the global financial crisis of 2008 be the correct one?

Now to the next crises…

My forecast for Sweden:

These policy lessons are contributing to serious and growing financial imbalances in Sweden (and world-wide)

Thus paving the way for the next crisis in 2020 +/- 5 years.

Credit growth in Sweden 1963-2014

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70

90

110

130

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170

190

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230

250

1963

K1

1966

K1

1969

K1

1972

K1

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K1

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K1

1981

K1

1984

K1

1987

K1

1990

K1

1993

K1

1996

K1

1999

K1

2002

K1

2005

K1

2008

K1

2011

K1

2014

K1

%

Totala krediter (% BNP) Hushållens krediter (% disponibel inkomst)

Real house prices 1995-2014

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35019

95K1

1995

K4

1996

K3

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K2

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K1

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K1

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K1

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K4

2005

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K1

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K4

2014

K3

Inde

x 10

0 =

1995

Sverige Irland Tyskland Storbritannien USA

Real house prices in the Nordics 1970-2015

Will this time be different?

My forecast: No, it will not be different 2016-2025.

There will be a ”corrrection” in the future.

The policy lessons after the next crisis ?

The policy lesson from the next crisis?a. Control debt/credit?b. Capital controls?c. Freak advice? We have tried demand side policies in various

forms for 1970-2025.

Why not supply side policies?

The future

Will my forecast today turn out to be the correct one?

The future will tell!

Welcome back to a new seminar (farewell to old pre-crisis policy advice) after the next deep crisis!

Policy advice and economic crises. How do they interact?The case of Sweden 1970-2025

ECONOMICS AND POLICY ADVICE – A FAREWELL SEMINAR FOR ANTTI SUVANTO

Bank of Finland, Helsinki, 11 April 2016.

Lars Jonung, Knut Wicksell Centre, Ekonomihögskolan, Lund University, Lund

POLICY LEARNING

Looking ahead through the Rear-View MirrorPublished in 1999 in Swedish

http://www.regeringen.se/content/1/c4/37/48/5ea1caf7.pdf