Is Paul Krugman right on the credit bubble in Scandinavia?

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In an interview in Copenhagen on January 9, the much derided and staunch monetarist Paul Krugman expressed his concerns about an economic disaster potentially waiting to happen that is presently under the radar for many. That is the credit situation if the Scandinavian countries, and in particular Sweden and Denmark – both of whom have seen their citizens embark on a spending spree as a consequence of low inflation and they are now sitting with record debt burdens.

This situation will seem odd to many as the public sector debt situations of the Scandinavian countries remained healthy while in contrast the debt cancer which hit Europe in 2008 as part of the GFC wreaked havoc on many of these economies. It is in fact rooted in the GFC and the medicine prescribed of worldwide low interest rates that has actually created the conditions which are now prevalent in Scandinavia, namely its citizens taking on more and more private sector debt as interest rates remained low – a familiar story…

With debt investors scared away from most European countries, in particular from the Southern ones, Scandinavia sovereign debt shined as new kind of safe haven. Traditionally US and German sovereign debt have been the “go to” risk-free investments everybody jumps in times of crisis but in recent years it is actually the countries of Sweden and Norway that have benefitted most from this flight to quality.

This has had the effect of pushing down long term interest rates and so facilitating a borrowing binge as credit right throughout the system such as mortgage rates and credit cards was re-priced lower. And of course, if you give a consumer “low cost” or “free” money they will take it! This low interest rate environment spread throughout the whole economy so allowing households to enjoy cheap credit to buy houses, computers, holidays etc etc… Household debt increased substantially without an accompanying rise in the real interest rate. This means that there was no perceived increase in risk for incremental borrowing, even with household debt rising to record levels.

While risk was increasing in Scandinavia, credit rating agencies continued to do their usual (non) jobs and so kept the stellar AAA ratings they have for these countries. This only served to contribute further to the forming of a bubble… The final result of this has been the accumulation of a household debt in Denmark that currently amounts to 321% of disposable income. In Sweden, the same figure is 180%.

With hot money flowing into these countries and their economies growing at higher paces than the rest of Europe, the respective central banks should have allowed for the interest rate to rise. The truth is that the situation in Europe is still fragile but, the consequences of holding interest rates at very low levels may have further repercussions in other nearby economies as we are seeing here.

The Austrian School of Economics would say that (artificially) keeping interest rates below their natural level, generates mal-investments, that is money is directed towards businesses increasing production capacity, but at a time that it isn’t needed. This serves to generate excess capacity, meaning that sooner or later these investment turn sour and a painful labour readjustment is needed.

The economies of Sweden, Denmark and Canada have base interest rates set by their own central banks of 0.75%, 1.50%, and 1.00% respectively. At these ultra low nominal and in fact negative real rates, people are quite simply borrowing too much. Some people are looking at ways of restricting credit without allowing the interest rate to change, including Paul Krugman.

Even though I believe that certain doses of intervention are required to correct business cycle problems and to redistribute wealth when it is unfairly distributed at first hand, my understanding is that at present, central banks are quite simply more part of the problem than of the solution. 

Filipe R Costa

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