A correspondent recently pointed me to the news from Sweden, which has stopped flirting with deflation and moved right in.
It’s amazing: the country, which at first weathered the recent crisis fairly well and faced none of the institutional constraints membership in the euro zone would have imposed, has managed – completely gratuitously – to get itself into a deflationary trap.
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Riksbank officials say, in effect, that nobody could have predicted this development. But of course the bank’s own former deputy governor – and my former colleague – Lars Svensson, more or less frantically warned last year that Sweden’s central bank was making a terrible mistake by raising interest rates despite low inflation and lots of economic slack. His reward was increasing isolation, and, eventually, he left. You see, all the V.S.S.P.’s – Very Serious Swedish People – knew that it was important to raise interest rates because, well, because.
And getting out of the trap is going to be very hard.
I’d like to imagine that people will admit that Lars was right all along, and that in general the urge to purge has been highly destructive.
But my guess is that he’ll still be considered unsound – he was prematurely anti-deflationist – and that tight-money advocates will continue to be regarded as reliable, prudent people even as they lead everyone into long-run stagnation.
Sweden’s slide into deflation actually offers several lessons relevant to the rest of us.
First, it’s an object lesson in the power of sadomonetarism, the desire of many monetary officials to raise interest rates because, well, because. In 2010 Sweden had high unemployment and low inflation; basic macroeconomics should have indicated that this was no time to raise rates. Yet the Riksbank went ahead and did so anyway. Why?
Officials now say that it was all about financial stability, about fears of excessive house prices and borrowing. But that’s not what it was saying at the time! Stefan Ingves, the Riksbank’s governor, held an online chat in December 2010 on the bank’s Web site in which he declared that raising rates was about inflation: “If the interest rate isn’t raised now,” he wrote, “we’ll run the risk of too much inflation further ahead. This wouldn’t be good for the economy. Our most important task is to ensure that we meet our inflation target of 2 percent.”
Strange to say, when inflation started coming in well below the target, the Riksbank just kept raising rates, and switched to the financial stability justification.
Second, Sweden’s experience helps shed light on a historical controversy over policy in the United States. There is a substantial contingent of critics of the Federal Reserve who insist that the whole bubble-bust cycle of the last decade was the Fed’s fault – that it kept interest rates too low for too long. If you think about it, however, the Fed circa 2003-2004 was facing a situation very similar to that of the Riksbank in 2010: unemployment was still high but coming down, inflation was low and housing prices were rising.
So what Fed critics are saying is that the bank – which was worried about inflation at the time – should have done what the Riksbank did. (Are you still sure about that?)
Finally, the Swedish saga is a stark illustration of the limits of intellectual influence. At the time that policy was going off the rails, Mr. Svensson – one of the world’s leading macroeconomists and, specifically, an expert in deflation risks and liquidity traps – was a deputy governor at the Riksbank. He protested vigorously at the turn policy was taking – and was completely frozen out by colleagues who were sure that they knew better.
And note that this wasn’t a case of his colleagues’ clinging to economic orthodoxy while he was proposing radical new ideas; he was the one making basic Economics 101-type arguments, while they were inventing new rationales for tightening on the fly.