Within the last decade, Denmark has experienced important changes in both its external economic situation and its economic policy. Since these changes might provide some lessons for other small open economies, this paper will discuss the recent Danish experience with stabilization policy in general and financial markets and monetary policy in particular.

Within the last decade, Denmark has experienced important changes in both its external economic situation and its economic policy. Since these changes might provide some lessons for other small open economies, this paper will discuss the recent Danish experience with stabilization policy in general and financial markets and monetary policy in particular.

The business cycle and changes in overall economic policy since 1979/80 will be discussed, followed by a consideration of the conduct and the efficiency of financial markets. The paper concludes with a discussion of the reduction in the nominal rate of interest that occurred between 1983 and 1985 and the question of autonomy in monetary policy.

I. Internal Balance, External Balance, and Economic Policy

The turn of the decade 1979/80 is a good starting point for an evaluation of the recent Danish experience with general macroeconomic policy. At that time, the worldwide increase in oil prices had worsened the international economic situation and turned the terms of trade against Denmark and other oil importing countries. Also in 1979, Denmark joined the system of fixed but adjustable exchange rates within the European Monetary System (EMS).

The period 1979/80 to the present can be divided into two periods (1979–82 and 1983–87). The two general instruments of economic policy—expenditure-switching policy and demand management—were both used in these two periods, but the way in which they were used differed. Thus, from 1979 until October 1982, the competitiveness of the Danish economy was increased through successive devaluations, and fiscal policy was relatively expansionary; nevertheless, the Danish economy went into a recession. In the period from October 1982, the exchange rate was stable within the EMS, and fiscal policy was tight in most years; nevertheless, the Danish economy grew rapidly until 1987.

The international economic scene also changed in 1982/83, from a situation of high inflation, increasing rates of interest, and slow or almost no economic growth, to one of rapidly declining inflation and interest rates and somewhat higher rates of growth.

The Recession, 1979–82

The international recession that followed the second oil shock led to a reduction in the growth rate of Danish export markets from 3–3½ percent a year in real terms to around zero in 1981–82. Also in this period, the competitive position of the Danish economy improved by somewhat more than 20 percent as a result of a few devaluations within the EMS (Figure 1). Exports, in real terms, increased by almost the same amount.

Figure 1.
Figure 1.

Danish Competitiveness, 1978–86

(Index, 1985 = 100)

Sources: Economic Council (1987); and Danish Economy (December 1987).

The stated objective of fiscal policy in this period was to increase employment and at the same time to reduce, or at least not to increase, imports. To that end, public consumption was allowed to grow at rates between 2¼ percent and 4 percent a year, but public investment was constrained. Taxes were increased to restrict both private consumption and imports (Tables 1 and 2).

Table 1.

Denmark: Changes in Selected Economic Indicators, 1980–86

(Absolute changes m billions of Danish kroner, in constant 1980 prices)

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Source: Economic Council (1987).
Table 2.

Denmark: Changes in Selected Economic indicators, 1980–86

(In percent, based on constant 1980 prices, unless otherwise noted)

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Source: Economic Council (1987)

The purposes to which demand management were put during this period appear to suggest that fiscal policy was expansionary. According to measures used by the Organization for Economic Cooperation and Development (OECD), the total change in the cyclically adjusted balance of the general government was -4.1 percent of gross domestic product (GDP) for all three years (OECD (1986)). Since taxes were increased mostly at the beginning of the period and expenditure was increased mostly at the end of the period, fiscal policy would appear to have become increasingly expansionary in the three years (Table 3).

Table 3.

Denmark: Discretionary Fiscal Policy, 1980–86

(In percent of GDP)

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Sources: Organization for Economic Cooperation and Development (1986 and 1987);Finansredegrelsen (Copenhagen: Government of Denmark, December 1985); and Economic Ministry, various publications.Note: A positive sign (+) indicates a move toward restriction (surplus), and a negative sign (-) indicates a move toward expansion (deficit).

Despite the expansionary stance of fiscal policy, gross fixed capital formation, both residential and nonresidential, fell by over 25 percent during 1979–82 (nearly 30 percent during 1979–81), and private consumption declined by 6 percent in 1980–81 and recovered only slightly in 1982. However, since Denmark’s competitive position and its exports increased, the decline in gross capital formation and private consumption can most likely be ascribed either to the supply shock caused by the oil price increase or adverse expectations generated by fiscal policy.

Only a small part of the reduction in private demand can be accounted for by the long-term rate of interest, which rose from around 16 percent in 1979 to 21 percent in 1982, since quantitative restrictions on lending by banks and mortgage institutions were relaxed and inflation increased over the same period. A more likely explanation for most of the reduction in private demand is the deterioration in real disposable income of the private sector, which, after increasing by 3½ percent on average in the three years before 1979, grew by only ½ of 1 percent a year in the period 1979–82. Since the change in the terms of trade amounted to only about two thirds of the increase in direct taxes in 1980–81, it is reasonable to assume that in addition to the effects of the oil shock, the fall in the growth rate of private sector disposable income also had a significant negative effect not only on private consumption, but also on capital formation and, in particular, private residential investment.

Since private capital formation and real consumption in absolute terms fell by much more than the increase in public consumption, fiscal policy can be said to have had a negative effect on total domestic demand. This assertion is borne out by the soaring deficit on the government accounts, which might also explain some of the rise in the interest rate during the period.

During each of the first two years of the first period (1979/80 and 1980/81), total domestic demand fell by 4 percent, but recovered to some extent in 1982. With imports of goods and services following the same pattern, net exports in real terms increased by more than 7 percent of GDP between 1979 and 1981, and then fell somewhat in 1982. The offsetting effect of net exports kept production from following domestic demand, and GDP declined by only a little more than 1 percent between 1979 and 1981, and then increased by 3 percent in 1982. Over the period 1979–82, employment fell in line with declining production and rising labor productivity. With a growing labor supply, unemployment rose from 7 percent of the total labor force in 1979 to 10 percent in 1982 (Table 2 and Figure 2). Finally, despite the considerable increase in net exports in real terms, the terms of trade deteriorated, and the current account showed a deficit of 3–4 percent of GDP in each of the years 1980–82.

Figure 2.
Figure 2.

Unemployment, 1978–86

(In percent)

Sources: Economic Council (1987); and Danish Economy (December 1987).

The Recovery, 1983–86

The second period was characterized by an international recovery and an even stronger recovery in Denmark, owing to circumstances specific to Denmark. Beginning in 1983, with the improvement in the international economic situation, Danish export markets grew by 2–3 percent a year in the next three years. The competitive position improved somewhat in 1984 and deteriorated in 1986, but was almost unchanged compared to 1982 (Figure 2). Exports in real terms grew by more than 4 percent a year in 1983–85, and leveled off in 1986.

With the formation of a new government in the autumn of 1982, economic policy was almost completely reversed. Fiscal policy was tightened as overall public expenditure was frozen and taxes slightly but successively increased. Exchange rate policy, which had been characterized by small, successive devaluations, was also changed, and the Danish krone was kept stable against other currencies within the EMS. Incomes policy was tightened, and inflation was reduced through the abolition of price indexation of wages and other provisions. However, since inflation abroad also fell, the competitive position of the Danish economy improved only in the early part of the second period.

The restrictive effects of the fiscal policy could have been offset somewhat by a steep fall in the nominal rate of interest and the associated capital gains in 1982/83 and again in 1985. But since inflation was also being brought down, the real rate of interest, measured as the difference between simultaneous values of nominal interest rates and inflation, did not fall nearly as much as the nominal rate.

Domestic demand increased by only 1½ percent in 1983, but picked up to 4–6 percent in 1984–86. Import growth kept pace with domestic demand in the first years of the period, but shot upward in 1985-86. The balance of goods and services, after showing some improvement, later deteriorated sharply in real terms, as production grew more steadily than domestic demand and imports. GDP grew by 2½ percent in 1983 and 3½–4 percent a year during 1984–86.

Although fiscal policy was considerably tighter in 1983–86 than in 1979–82, employment, which might have been expected to fall, actually increased by more than 7 percent from 1982 to 1986. The increase was almost exclusively in the private sector. Likewise, the international recovery and the improvement in the competitive position of the Danish economy during the first period might also have been expected to improve the current account balance. However, although the deficit in the current account moved from 4 percent of GDP in 1982 to 2½ percent in 1983, it later doubled to about 5 percent of GDP in 1985 and remained at that level in 1986, even after falling oil and other import prices had improved the terms of trade.

The 1983–86 period saw a remarkable improvement in the government budget. From a deficit of 9 percent of GDP in 1982, the balance turned to a surplus of 3 percent of GDP in 1986, although it fell somewhat in 1987. The improvement was due to discretionary as well as to automatic changes. According to OECD calculations, 75 percent of the improvement of 12 percent of GDP in the balance of the general government budget between 1983 and 1986 was due to discretionary fiscal policy (including fiscal drag; see Table 3). However, half of this improvement took place in 1986, and some of the remaining fiscal changes in 1983–85 reflected the effects on the government budget of lower interest rates and a new tax on the interest income of pension funds. Thus, part of the improvement in the government’s budget in 1983–85 was due to special circumstances that were unrelated to the tightening of fiscal policy, and part of the improvement took place in 1986 following discretionary measures that reduced economic activity primarily in 1987–88.

Business fixed investment almost doubled from 1981 to 1986. In each year, capital formation was more or less evenly spread over the open sectors as well as the sheltered sectors of the economy, with a slightly decreasing proportion in domestic services (Economic Council (1987)). There thus appears to have been little evidence of capacity constraints in the open sectors.

The two main reasons for the upturn in business investment were probably the international recovery and the more favorable competitive position of the Danish economy following the devaluations in 1979–82. As noted previously, domestic demand surged, after some delay, in the second period. A possible reason for the delay is that due to adjustments, irreversibility, and the slow return of credibility, investment took some time to respond positively to the perceived increased profitability of capital. A similar, but less delayed, reaction by the general public with respect to private consumption and the financial markets provides additional evidence in support of this explanation.

The stabilization of public expenditure might also have contributed to rising expectations about a stabilization of the future tax burden. Thus, even as current taxes were increased, the improvement in the government budget might have prompted the rise in consumption and residential investment. The effects of rising expectations can be seen in the private consumption income ratio, which increased by 8–10 percent between 1982 and 1986.

Two extreme explanations might be advanced for the increase in production and employment. The increases were either due to a pickup in total demand in a Keynesian demand-constraint regime or to a profit-determined but lagged reaction in a classical regime.

A less radical explanation might be the gradual change from a Keynesian regime in 1982–84 to a classical regime in 1985–86. This explanation better accounts for the parallel increase in domestic demand and production from the bottom and in the first part of the upturn, on the one hand, and the subsequent strong increase in net imports, on the other hand. The increase in domestic demand might then be viewed as taking place in a demand-constraint regime; and the increase in net imports might be viewed as a consequence of the trade balance being determined as the difference between the high domestic demand and production constrained by real wages in response to profitability conditions.

The even distribution of investments over sectors is not at odds with this point of view. The lagged reaction by investment to changing conditions owing to adjustment costs and irreversibility is more obvious than it is for production and employment. Therefore, the changing regimes appear to be a reasonable explanation.

Some Policy Lessons Learned

Both the reduction of domestic demand in the first period and its revival along with production in the second period demonstrate the importance of expectations and credibility in the determination of private investment and consumption. Therefore, the impact of exchange rate policy and fiscal policy has to be evaluated with due regard to their intertemporal or expectational effects on private demand. The Danish experience during 1982–84, compared to that of 1985–86 (and perhaps 1979–81), provides some evidence of how an economy, even a small one with unemployment, may operate under different regimes (that is, demand-restraint as opposed to profit- or real-wage-constraint).

The change in regimes does not exclude the possibility that the increasing credibility of the policy pursued in 1983–86 may have influenced the demand for investment and consumption goods and, in particular, the response in the financial markets (see below). But this credibility might not have been established had not the real exchange rate of the Danish krone remained at the same level following the devaluations in 1979–82. The reason is that long-term credibility in an open economy requires a real exchange rate near or gradually approaching the rate compatible with equilibrium on both the labor and the foreign exchange markets.

The two periods provide some evidence of the comparative advantage of employing the two general economic policy instruments in a small open economy like Denmark. In particular, under the classical regime in 1985–86 (and possibly in 1979–81), domestic demand management tended to have the greatest impact on net exports of goods and services, and much less on employment. But employment was much more strongly influenced, compared to net exports, by switching policies. The conclusion seems to be that in a small open economy like Denmark, demand management should be employed to deal with the current account, and switching policies should deal with employment.

II. Financial Markets and Monetary Policy

The working of the financial markets and institutions in Denmark changed considerably in the 1980s. These changes should be seen in connection with changes in the exchange rate regime and in monetary policy.

Liberalization of Internal and External Restrictions

Compared with other Nordic countries, Denmark has a relatively liberal tradition with respect to internal restrictions and regulation of financial markets (OECD (1987)). However, in the period 1969/70 to 1980/81 various restrictions on financial institutions were successively imposed and tightened. The overall purpose was to keep interest rates lower than they would have been in a free market.

Reserve requirements for both commercial and savings banks were introduced in 1965 along with restrictions on lending by mortgage institutions. In 1970 the reserve requirements for banks were converted to ceilings in absolute terms based on total lending of the individual banks. This action potentially tightened the restrictions on the market for bank loans, but in such a way that in case of a binding restriction, the normal competitive connection between the deposit or money market rate and the lending rate was cut off. When the demand for loans picked up a few years later, the banks tended to substitute price rationing for the original quantity restriction. The margin between the lending and the deposit rates thus increased considerably (Figure 3). In 1975, as a consequence, a law was enacted introducing a maximum margin between the average lending and deposit rate for each bank.

Figure 3.
Figure 3.

Denmark: Average Margin Between Bank Lending and Deposit Rates, 1965–87

(In percent)

Sources: Economic Council (1987); and Danish Economy (November 1986).

The two restrictions made portfolio choice and rate setting much more complicated for the banks than would have been the case in a free market. Since it was possible for banks to charge the lending rates for the higher cost of deposits without losing business, the interest rate policy of the central bank was out of order. In addition, a maximum average deposit rate was introduced for each bank (later replaced by a maximum average lending rate).

In 1980/81, following the onset of the recession brought about by the second oil shock, all of the restrictions on banks were abolished. The lending activities of mortgage institutions were also liberalized in an attempt to stem the recession that had hit residential construction, which was also beset by externally induced rising interest rates.

A large part of the changes in the margin between the average lending and average deposit rates can be explained by the monetary policy instruments used in the 1970s. The Danish experience indicates that quantitative restrictions work against the efficiency of the financial markets and are inappropriate as monetary policy tools.

The change in the 1980s from a system of quantity constraints to a market-oriented monetary policy was followed by the introduction in 1985 of a system of direct management of the money market rate in place of the former system of fixed allocations of central bank credit to the banks. The interest rate had already become, by the late 1970s, the major instrument in the markets for medium- and long-term bonds, because from 1975 the Government had been financing its current account deficit by the sale of medium- and long-term bonds (this form of financing continued into 1985). As a result of the liberalizations in the 1980s, the interest rate finally became the main instrument both on the customer market and on the money market.

Restrictions on external capital flows were tightened just before Denmark joined the EMS in 1979. The restrictions were prompted by the occurrence of an inflow of capital, mainly in the form of exports of medium-term government bonds. The restrictions were meant to preserve the high domestic interest rates that prevailed at a time when the country was entering an exchange rate system with more or less fixed exchange rates, and, thereby, to maintain some autonomy over domestic monetary policy. In the years following entry into the EMS, the Danish krone was devalued a few times, and some bonds were sold back to Denmark, although the interest rates on these bonds were higher in Denmark than abroad (Jensen and Hald (1986)).

From May 1983, the restrictions on the purchase of Danish bonds by foreigners were lifted. Exchange restrictions on capital flows were further relaxed in January 1984 and in June 1985. Danish foreign exchange restrictions, which apply mainly to bank deposits and short-term money market papers, are now among the most liberal within Europe (OECD (1987)).

Some market participants might have taken the progressive liberalization of capital flows as a signal of permanently fixed exchange rates. But since it is still possible to change the exchange rate within the EMS overnight or over the weekend, the external liberalization has not had much effect on expectations or uncertainty about the exchange rate. Therefore, although the liberalization might have reduced the autonomy of domestic monetary policy, the new exchange rate policy in operation since 1982 has probably had a much greater impact.1 The external liberalization did intensify the competition among banks in the financial markets that had already begun with the internal liberalization in 1980/81.

Several lessons can be drawn from the Danish experience with internal restrictions and the subsequent liberalization on the financial markets. Quantity restrictions tend to increase the margins and decrease the efficiency of financial institutions and markets. Ceilings (or floors) on lending and deposit rates are in many respects preferable to quantity constraints, but financial flows tend to circumvent all kinds of artificial constraints. Similar problems arise with respect to foreign exchange restrictions, which is why these restrictions are no longer used as an instrument of monetary policy in Denmark.

The liberalizations have increased competition on the financial markets, and the instruments of monetary policy have changed accordingly. Since 1985 the interest rate on the money market has been the central bank’s main instrument. To some extent, but less visibly, price-fixing on long- and medium-term government bonds has also been used.

The Exchange Rate and the Interest Rate

In September 1982, faced with increasing unemployment and deficits on both the current account and government finances and saddled with an economic policy that had resulted in a number of devaluations and increasing interest rates, the government resigned. In contrast to the other Nordic countries, which were devaluing their currencies, the new government announced that the exchange rate would be kept fixed within the EMS. The government also announced that incomes and fiscal policy would be tightened.

In mid-October 1982, the Danish Parliament passed legislation that imposed a temporary standstill on wage and profit margins and suspended (later abolished) all price indexation of wages. This signal of a switch to a nonaccommodating policy was immediately followed by a reduction in bond yields, which in September had been around 21–23 percent. Later in the same year, fiscal policy was tightened, and early in March 1983 an agreement to limit wage increases to about 4 percent, or half the previous increases, was concluded between the trade union federation and the central employers’ association.

Later in March, the financial markets were sent another signal of the nonaccommodative policy and exchange rate regime, when, following a realignment of exchange rates within the EMS, the government kept the Danish krone stable against other currencies. Following these events, bond yields dropped to about 15 percent. In mid-April the government announced the liberalization of foreign capital controls, effective May 1, and short bond rates dropped again, but only by 1½ to 2 percentage points.

The relaxation of foreign capital controls had only a small impact on Danish interest rates and only on short-term bonds, since the liberalization was announced only after most of the reduction in Danish interest rates had already taken place. The same reasoning applies to the role fiscal policy played in bringing down interest rates through its effect on the government budget (Figure 4).

Figure 4.
Figure 4.

Denmark: Interest Rates, 1978–86

(In percent)

Source: Economic Council (1987).

During the period from October 1982 to May 1983, interest rates within the EMS (that is, German interest rates) were also reduced, but far less than the Danish rates. As a result, the differential between Danish and foreign long-term bonds was sharply reduced from 14 percent to a little less than 7 percent (Figure 5).

Figure 5.
Figure 5.

Denmark: Nominal Long-Term Interest Rates, 1978–86

(In percent)

Sources: Economic Council (1987); and International Monetary Fund, International Financial Statistics (various issues).

The argument that the reduction in the margin between Danish and foreign interest rates was the result of a highly expansionary monetary policy in Denmark has to be ruled out, because banks’ liquidity with the central bank and the rest of the world decreased steeply in both 1982 and 1983 (OECD (1987)). A more likely explanation is that the credibility of the new exchange rate regime, supported by economic policy in general, increased dramatically during the period from October 1982 until May 1983.

The money supply of the general public increased by 25–30 percent as the difference between the yield on long-term bonds and the money market rate narrowed, and banks’ holdings of long-term bonds increased rapidly. This asymmetric behavior on the part of the banks and the general public with respect to deposits and the bond market can be attributed to differing expectations regarding changes in prices on the bond market. The increasing perceived credibility of the new exchange rate regime and supporting economic policies made the banks willing to finance larger bond holdings by an even smaller spread between the interest rate for long-term bonds and the short-term deposit rate. Consequently, the banks assumed a speculative position on the bond market as soon as the Government and Parliament signaled the change to a nonaccommodating exchange rate policy. However, the increase in the demand for money and deposits by the general public can also be explained to a large extent by the narrowing of the spread between interest rates, taking taxes into account (Christensen and Jensen (1987)).

The credibility of exchange rate and economic policy in general was the main reason for the banks’ reduction of the long-term interest rate from 21–23 percent in October 1982 to 12–14 percent in May 1983. The banks took a speculative position on the bond market, thereby bringing down the interest rate, while the general public adjusted its portfolio to the differential between the prevailing interest rates.

Following the steep decline in 1982/83, the long-term yield fluctuated somewhat, but generally stayed around 14½–15 percent until the beginning of 1985. Following a breakdown in the biannual wage negotiations between the trade unions and the employers’ organization in March 1985, legislation was passed authorizing wage increases of only 2 percent in each of the two subsequent years. Subsequent to the passage of the incomes policy by Parliament, the central bank reduced the money market rate by 2 percent, and by a further 1 percent effective August 1. The long-term bond yield dropped in stages from approximately 14½ percent at the beginning of 1985 to around 10 percent at the end of the year. The short-term rates also fell, but to a varying and slightly lesser degree. The lower level of interest rates and the associated capital gains contributed to an increase in domestic demand and the current account deficit in both 1985 and 1986.

The fall in Danish interest rates again reduced the margin between Danish and foreign rates. The difference between the yield on Danish and German long-term government bonds thus narrowed from 7 percent at the beginning of 1985 to 3 percent at the end of the year.

Even though the balance of payments deficit increased to DKr 29 billion in 1985, official international liquidity rose by about half that amount. Capital imports of the nongovernment sector contributed DKr 41 billion, although this amount was unevenly distributed throughout the year due to the phased reduction of Danish interest rates. For the year as a whole, however, net loans abroad by the government increased. Since the Treasury has easy and reversible access to external borrowing facilities, the monetary authorities presumably did not consider the international liquidity position to be adequate without official borrowing.

Interest rates were reduced in 1985, not because of an undesirable increase in foreign exchange reserves, but rather for domestic reasons. Therefore, even if the fall in interest rates contributed to the increase in the deficit on the current account, the reduction of the margin between Danish and foreign interest rates cannot be taken as evidence of a diminution or an elimination of the autonomy of Danish monetary policy (Vastrup (1986b)).

In 1986 and 1987 Danish interest rates did not follow foreign interest rates at all closely. As a combined result of monetary policy and a recovery in bond prices following uncertainty arising from a European Economic Community referendum in January 1986, bond yields began to rise in May 1986 from a low of 9 percent. Later in the year, the deficit on the current account reduced credibility, and yields rose to between 11 percent and 13 percent. The margin between yields on ten-year Danish and German government bonds fluctuated between 3.3 percent and 6.2 percent in 1986–87.

Some conclusions can be drawn from the reduction in Danish interest rates in 1982/83 and 1985. First, the reduction in 1982/83 was due to an increase in the credibility of the exchange rate policy in particular, and economic policy in general.2 Second, the private sector did not react homogeneously to the increasing credibility of the new exchange rate regime. The banks reacted before the general public, with the consequence that the money supply rose. Third, the liberalization of the restrictions on external capital flows contributed only to a small extent to the reduction in interest rates in 1982/83. Fourth, the interest rate reduction in 1985 did not signal any lessening of the autonomy of Danish monetary policy, but was rather the result of a deliberately expansionary monetary policy.

The Autonomy of Danish Monetary Policy

The margin between Danish and foreign yields can sometimes be attributed to the reduced credibility of the fixed exchange rate regime and sometimes to deliberate monetary policy used mainly for domestic purposes. Accordingly, the degree to which the monetary authorities are able to pursue an independent monetary policy within the EMS depends on the specific circumstances. It has been argued that autonomy is not possible in a fixed exchange rate regime, but this argument depends on the assumption that a fixed exchange rate attains credibility either immediately or after a short learning process.3 If credibility is assumed, perfect substitutability follows, and, with no transaction costs and no restrictions, a state of perfect capital mobility is implied. In small open economies, this assumption implies that the interest rate is exogenously given.

However, if shocks occur and some uncertainty with respect to credibility prevails, substitution is no longer perfect, and even small open countries with fixed but adjustable exchange rates will retain some monetary policy autonomy. Asymmetric behavior with limited changes in deposit and bond holdings is an indication of lack of perfect substitution. Under such circumstances, it is reasonable to assume that the degree of autonomy depends on the deviation of the actual from the desired value of all the main goals of the economic policy pursued—that is, unemployment, inflation, and the current account. Therefore, the degree to which the central bank may use monetary policy for domestic stabilization depends on the extent to which fiscal policy and incomes policy do not succeed in stabilizing the economy.

Since private capital flows normally occur when the central bank uses monetary policy for domestic purposes, a necessary condition is the willingness of either the central bank or the Treasury to use official reserves or foreign borrowing/lending to sterilize the private capital flows. Therefore, given some degree of autonomy, monetary policy should not necessarily be restricted only to the stabilization of official exchange reserves to ensure that private capital inflows are sufficient to finance a given deficit on the current account.4

III. Summary and Concluding Remarks

Despite a deficit on the current account (2–3 percent of GDP), external debt equal to 40 percent of GDP, and rising unemployment (but still low, compared with average unemployment in the rest of OECD Europe), the Danish experience with the general instruments of macroeconomic policy has generally been satisfactory.

The recession of 1979–82 demonstrated that a switching policy could produce strong results, even if they were somewhat delayed and primarily affected employment (and interest rates). Changes in domestic demand in 1979–81 and 1985–86 (and 1987) showed that, in the absence of a depression, proper demand management in an open economy like Denmark mainly affects the current account.

The experience of 1982–84 suggests that if both the international and the domestic economy are in a depression, an open economy might be operating under a Keynesian demand-constraint regime. But it is still true, as Neary (1980, p. 427) says, that “taking all possible regimes together, exchange rate policy was found to exert a more predictable influence on the level of employment than fiscal or monetary policy, whereas the reverse was true of the influence of these two sets of instruments on the trade balance.”

The Danish case also shows that it is not reasonable to discuss the role of monetary policy in an open economy under the assumption of perfect substitutability between foreign and domestic bond yields. Therefore, the “monetary approach to the balance of payments” is not the proper framework. A “portfolio balance approach” seems more promising, because uncertainty about the future value of a fixed but adjustable exchange rate could invalidate the assumption of perfect substitutability.

If the central bank, in the absence of perfect credibility and substitutability, retains some autonomy in setting the domestic rate of interest, there may be good reason for not limiting monetary policy to the task of financing the current account with private capital flows. If public borrowing and lending on foreign capital markets were used for this purpose, monetary policy, along with fiscal policy, could be applied to domestic stabilization.


Giorgio Basevi

In his paper, Professor Vastrup examines two periods in Denmark’s recent experience with economic policy. During the first period—from October 1979 to October 1982—the authorities could rely on at least two policy instruments: management of the exchange rate for external equilibrium (expenditure-switching policy), and management of aggregate demand (expenditure-reducing policy). In the second period, the new minority government took the exchange rate constraint implied by the European Monetary System more seriously. Thus, only aggregate demand management was left as an instrument, mainly through the tool of fiscal policy, since monetary policy was losing autonomy under the pressure of the exchange rate constraint and the liberalization of capital movements. On this latter point, however, the author holds a view that is at odds with the conventional one.

Notwithstanding the loss of instrument implied by the change in the exchange rate regime—or perhaps precisely because of it—the results seem to have been more successful in the second than in the first period, at least with respect to the reduction of inflation and the improvement in government finances. In fact, by tying their hands with a fixed exchange rate, the authorities might paradoxically have enlarged their room for maneuver. The apparent intent to discontinue using the exchange rate as a way to keep the country competitive might have been interpreted as a resolve not to allow the real value of the public debt to be reduced by means of inflation; such signals could have generated stabilizing expectations about the future behavior of the government with respect to both fiscal and monetary policy.

On the basis of these positive expectational effects generated by the decision of the authorities to discontinue using the exchange rate instrument while simultaneously liberalizing capital movements, the author posits a reinterpretation of the “new Cambridge school.” According to this theory, fiscal policy is more effective in controlling external than internal equilibrium, and what is left of switching policy under a fixed exchange rate regime is relatively more effective in maintaining internal equilibrium.

I shall come back in a minute to the author’s reinterpretation of this theory. But I first want to note that in contrast to his emphasis on expectational effects, the author has almost completely ignored the striking performance of the Danish authorities, who, under a minority government and within a few years, effected a sharp turnaround in the fiscal position. With what means and how, politically and economically, they could implement such a drastic change in policy remains a mystery, at least in Vastrup’s paper. In any case, the success was remarkable not only in fighting inflation, but also, up to 1986, in promoting economic growth. As Table 1 shows, the Phillips curve seems to have flattened on the basis of these two variables—or in terms of inflation and the level of unemployment—during the period 1983–86.

Table 1.

Denmark: Selected Economic Indicators, 1983–87

(Annual changes in percent, unless otherwise noted)

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Source: Commission of the European Communities

Table 1 depicts the impressive and rapid turnaround in the public sector borrowing requirement (PSBR), but it also shows that this improvement was not accompanied by an improvement in the current account of the balance of payments, which, in fact, deteriorated in the period 1983–86. Thus, the author’s assertion that aggregate demand policy is relatively more effective when applied to external equilibrium can be viewed as a reinterpretation of the “new Cambridge school,” whereby external equilibrium is defined not in terms of the current account but rather in terms of the overall balance of payments. Table 2 shows how the current account deficit was financed in the period 1981–86.

Table 2.

Denmark: External Financing, 1981–86

(In billions of Danish kroner)

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Source: Organization for Economic Cooperation and Development

The improvement in the PSBR in 1983–86 was reflected not in the current account balance, but rather in net private capital inflows, at least up to 1985, as shown in Table 2. The improvement in net private capital flows was probably a consequence of the new confidence inspired by the authorities’ decision to follow a more stringent exchange rate policy while at the same time liberalizing capital movements.

As a consequence of these successes, by 1987 the growth and investment performance of the economy had become quite modest. In the light of this slowdown, it seems reasonable to ask why the author should agree with the Organization for Economic Cooperation and Development and the European Economic Community that Denmark’s current account deficit should be reduced quickly and substantially. It would appear more appropriate for a small country like Denmark, having accepted a more or less fixed exchange rate regime vis-à-vis its main European trading partners and having liberalized its capital movements, to stick to all the rules of the game and not try to finance the current account deficit with large public borrowing abroad. Rather, the deficit should be financed with private capital inflows or changes in international reserves until such time as the inflows are reabsorbed through the classical adjustment mechanism. After all, for a country in a situation such as Denmark’s, monetary policy retains little or no autonomous control over internal equilibrium—contrary to what the author tries unconvincingly to maintain; but monetary policy does become a powerful instrument for controlling the level of international reserves. Thus, the attempt to avoid losing reserves by borrowing abroad not only slows down the classical adjustment mechanism, but also reduces the government’s credibility in being able to repay its accumulating foreign debt. It would seem to make more sense to leave the determination of the appropriate rate of growth of foreign debt to the private international markets.

Concentrating on reducing the external deficit after the government deficit has been successfully corrected is more appropriate for large countries such as the United States. For a small country like Denmark, already on the path toward losing autonomy over monetary policy, it is probably better to stop worrying about the current account.


Charles Bean

I first have to say that I found this an extremely interesting and thought-provoking paper. I knew that Denmark in the 1980s was a somewhat curious case, but I had not realized until I read this paper and looked at the data just how peculiar. Denmark’s case is an odd one, because it really does seem to support the idea that fiscal retrenchment can be associated with an expansion in activity and a worsening rather than an improvement in the current account—what one might call the German view that the multipliers on fiscal expansion are negative because of the adverse effects of budget deficits on expectations.

The period Vastrup considers falls naturally into two parts: 1979–82 and 1983–86. In the first period, as Vastrup documents, there was an increase in government spending that was only partially matched by an increase in taxes. The intention was to increase demand while at the same time switching it from foreign to domestically produced goods, thereby sustaining activity in the face of “OPEC II” [second oil price hike by the Organization of the Petroleum Exporting Countries] without leading to a deterioration in the current account. In the event, the latter aim was achieved, but not the former. Growth fell and unemployment rose; and the general government financial balance fell from -1.7 percent of gross domestic product (GDP) in 1979 to - 9.1 percent of GDP in 1982. Of course, some of the deterioration in the public sector finances was due to the decline in activity, but the adjusted deficit figures in Table 3 in Vastrup’s paper (p. 92) confirm that there was a significant expansion in fiscal policy over this period.

After the formation of a new (minority) conservative administration in the second half of 1982, things changed. Government spending was held constant in real terms and therefore declined as a proportion of GDP, and taxes were steadily increased. At the same time, the government switched from a policy of continued devaluations within the European Monetary System to one of maintaining parity with the deutsche mark. This fiscal contraction, far from producing a fall in activity, led to a fall in unemployment, from a peak of 10.4 percent in 1983 to 7.8 percent in 1986. As a result of the fiscal contraction and sustained growth at about 3.5 percent a year, there was a drastic fall in the government financial deficit, so that balance was achieved by the end of 1985. However, as a reflection of the rapid growth in activity, the current account deteriorated markedly.

Can the massive slump in investment and consumption over 1979–82 be primarily attributed to adverse expectational effects from the fiscal expansion? Can the boom in private spending in 1983–86 likewise be attributed to beneficial expectational effects from the fiscal contraction? If the answer to both questions is yes, then the implication is for something like 125 percent crowding-out. Because the idea of expectational effects is so influential in certain quarters, it is worth discussing this possibility in detail. Such expectational effects certainly exist, but I refuse to believe they are of the required order of magnitude. There is nothing wrong that dividing by 10 cannot solve!

First, is it reasonable to attribute the slump in investment in 1980–81 to expectational effects? I think not. For a small open economy like Denmark whose long-term real interest rate is primarily determined by the rest of the world, the usual channel through which a “permanent” fiscal expansion produces a fall in bond yields and a rise in the long real rate is cut off. Another problem with the expectations story is that the timing is all wrong. The surge in investment in 1982 predated the introduction of the new fiscal measures, and the sluggish growth of investment in 1983 came after the introduction of the measures and after credibility had been established. The effects of OPEC II seem to be a plausible alternative candidate, and indeed, the slump in investment was roughly the same as that experienced in 1974–75.

Second, what about consumption? We are told that the savings ratio fell about 8–10 percentage points over 1982–86, and Table 1 (p. 90) suggests that it must have risen over the first period. Need these movements reflect expectational effects as Vastrup suggests (consumption-smoothing and backward-looking expectations go the other way)? I think the answer is no. Inflation accelerated between 1978 and 1980 and subsided between 1982 and 1985. We know from experience in, say, the United Kingdom that increases in inflation are associated with rises in the savings ratio as people react to the erosion of the real value of nominal assets by reducing consumption. My guess is that consumer behavior can be adequately explained without having to resort to expectational effects. (Incidentally, I would find the argument for important expectational effects more persuasive if moderately well-specified investment and consumption equations displayed large residuals at this time.)

I therefore think the key feature in an understanding of the Danish experience—which is only touched upon in Vastrup’s paper—is the behavior of the labor market. How was the implied reduction in wage-push achieved so effortlessly? And, in particular, why was the March 1985 settlement of 2 percent, imposed unilaterally by the government, accepted by the unions without a struggle (I gather things have been unwinding since)? There are surely important lessons to be learned here.

Another important question is why the disinflationary process had so few adverse real effects. The process had three main components: fiscal consolidation; a pegging of prices via maintenance of the exchange rate; and a pegging of wages via incomes policy. This dual nominal anchor feature is reminiscent of the Israeli stabilization plan, which also seems to have been fairly successful. I think the reason that credibility was achieved so rapidly in the Danish case was that the new policies were put to the test very soon. The Danish authorities did not follow the devaluations by other Nordic countries, and this policy immediately and credibly signaled the government’s intentions.

An interesting issue is whether the fiscal consolidation—although necessary for other reasons—was also necessary for the disinflationary program to work. In high-inflation countries like Israel, the answer is clearly “yes,” because the loss in seigniorage must be made up somehow; but it is less clear that the same argument holds for Denmark where seigniorage is a minimal part of government revenues.

Incidentally, it is also worth noting that the Danish experience highlights the fact that current account deficits should not be something to worry about if they are associated with an investment boom and the deficit country is acquiring a real asset to offset its new financial liability.

I have few comments on the second part of the paper relating to monetary developments, which for the most part seem uncontroversial. Vastrup does make the interesting point that if the fixed exchange rate regime is less than 100 percent credible, then bonds denominated in different currencies will be imperfect substitutes. This leaves open the possibility that interest rate policy can be directed toward domestic ends while intervention is used to maintain the exchange rate. This view seems to suggest that a lack of credibility might be a good thing, because it adds another instrument to the authorities’ portfolio. However, I am not sure that this is an appropriate conclusion, because the possibility of a realignment may provoke a speculative attack, which would reduce the room for maneuver on both the fiscal and monetary front. Working out the optimal degree of commitment to an exchange rate target under these circumstances seems to be an interesting topic for future research.


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See the 1985 report of the Economic Council (1985), which emphasizes the importance of the external liberalization.


See also Andersen and Risager (1988), Christensen (1987), and Vastrup (1986a) for a similar interpretation.


See the Economic Council’s report for 1985 (Economic Council (1985)) for an exposition of this view. In the Economic Council’s report for 1986 (Economic Council (1986)), the position had changed to the one presented here.


In OECD (1987), recent Danish monetary policy was unjustifiably criticized for not maintaining stable private capital inflows to finance a (given) part of the current account deficit.

Editor: Mr. Mario Monti