The Swedish euro debate disappeared following the negative outcome of the 2003 referendum, but the current global financial crisis has revived euro deliberations in Sweden. Like other small open European economies – the UK, Denmark, Iceland and the Central and Eastern European EU members outside the euro – Sweden is now assessing the costs and benefits of remaining outside the eurozone. Public opinion in these countries (with the notable exception of the UK) seems to be moving in favour of joining the euro (e.g., New Europe, 2009, Grahn 2009).
When the Swedish electorate delivered a resounding rejection of euro membership in 2003, the popular perception was that euro adoption would involve relinquishing monetary policy independence to a pan-European body. Sweden would certainly have handed over monetary sovereignty to the ECB, but would it have necessarily lost its monetary independence?
In a recent paper (Reade and Volz, 2009a), we ask whether Sweden has any operational independence for its monetary policy. The answer to this question has serious implications for the cost-benefit calculus of Swedish EMU membership, as the loss of monetary policy independence is widely regarded as the main cost of entering a monetary union. Unlike the other EU members that are obliged by EU law to join the euro, Sweden does not stabilise its currency against the euro. Instead, the Sveriges Riksbank has followed a policy of inflation targeting with a flexible exchange rate since 1992, which in theory should provide the Riksbank with full monetary autonomy.
Measuring monetary policy independence with a cointegrated VAR framework
Using a cointegrated vector-autoregressive model, we investigate the degree of monetary independence that the Sveriges Riksbank has had in steering Swedish money market rates. In particular, we consider whether a cointegration vector, or steady-state relationship, exists between Swedish and eurozone interest rates, and, if so, which rate drives which.
Our strategy augments the approach taken by Edison and MacDonald (2003), and we have recently employed it to examine the monetary independence that the original EMU members enjoyed before 1999 (Reade and Volz, 2009b).
Figure 1 shows the policy interest rates of the ECB and the Sveriges Riksbank. It appears that, beginning in 1999, the eurozone rate leads the Swedish rate, and although that gap has diminished recently, the eurozone rate still leads the Swedish rate.
Figure 1. Central bank deposit rates
For our estimates, we use daily interbank interest rates (the Stockholm Interbank Offered Rate, STIBOR, and the European Interbank Offered Rate, EURIBOR, respectively) due to their relevance for monetary policymaking and their availability and variation at high frequency.
The two series are plotted in Figure 2. The time period covered is 1 January 1987 to 19 June 2009, yielding 5,794 observations (pre-euro, the rate was simply calculated for banks in what became the euro area). There is clear co-movement and convergence between the series. In the late 1980s and early 1990s, there is a marked difference between the two series, with Sweden’s interest rates higher throughout. The 1992 Swedish banking crisis has a huge effect on Swedish interest rates, coinciding with the instability of the European Monetary System (EMS) affecting the eurozone around 1992. Apart from a bulge in 1996, post-1992 the two interest rates appear to move much more closely together, with periods in the early part of the 21st century where the Swedish interest rate is below that of the eurozone. The effect of the current financial crisis is evident in the sharp fall in interest rates at the end of 2008.
Figure 2. Swedish and eurozone interbank interest rates, 1987 – 2009
The illusion of Swedish monetary independence
We find a clear cointegrated relationship between eurozone and Swedish rates. The former drives the relationship, as the Swedish rate adjusts to the eurozone rate. The relationship also captures the convergence visible in the data and is robust to different sample sizes and data frequencies. Even when Sweden experienced a severe banking crisis in the early 1990s – a huge idiosyncratic shock – Sweden remained in tow with Europe. While the Riksbank significantly deviated from continental monetary policies when it briefly raised its repo rate to 500% (!) in September 1992 in an attempt to prevent further capital outflows and (unsuccessfully) defend the krona exchange rate and Swedish EMS membership, it quickly returned to European levels, even though Sweden exited the EMS, its economy struggled severely, and Swedish unemployment soared in the years following the banking crisis. We regard this as strong evidence that Swedish monetary movements are dictated more by common shock and Europe’s path than Sweden’s own idiosyncratic shocks.
Overall, our deliberations suggest that the Riksbank, despite staying outside of the eurosystem, is de facto not master in its own house. Rather, we argue that Sweden is lulled by some kind of monetary independence delusion. By joining the euro, Sweden would give up monetary sovereignty, but the cost in terms of a loss of monetary policy autonomy would be negligible. The argument made by the Calmfors Commission (which was mandated by the Swedish government to assess the consequences of Swedish EMU membership) and others that through EMU membership Sweden would “no longer have the opportunity to pursue an independent monetary policy” (Calmfors et al., 1997: 312) and hence face serious consequences for stabilisation policy is therefore flawed. The cost of ceding monetary sovereignty would arguably be outweighed by Sweden gaining a seat in the ECB’s governing council, where the governor of the Riksbank would have a say in formulating the common European monetary policy stance. Instead of being a passive bystander to the ECB’s interest rate decisions, the Riksbank could play an integral part in European monetary policy making.
Given the tight integration and convergence of the Swedish economy with the eurozone (which we document more broadly in our paper), we see little reason why Sweden should abstain from adopting the euro. In contrast, we believe that in staying outside the eurozone Sweden, a small open economy with an internationally exposed financial sector, is forgoing benefits that it would otherwise enjoy from adopting an international currency. As pointed out by Buiter (2008), being part of a monetary union that features a global reserve currency holds significant benefits for financial market stability, a point clearly demonstrated in the recent financial market upheavals. While Sweden did not have to defend its exchange rate by raising interest rates in the midst of the financial crisis like Denmark (which is in ERM II), it had to activate swap arrangements with the ECB to secure euro liquidity for its internationally operating banks. We hence believe that the answer to the question of whether Sweden should join the euro is an unqualified “yes”.
Buiter, W.H. (2008), ‘Why the United Kingdom Should Join the Eurozone’, International Finance 11(3), 269-282.
Calmfors, L., H. Flam, N. Gottfries, M. Jerneck, R. Lindahl, J. Haaland Matlary, C. Nordh Berntsson, E. Rabinowicz and A. Vredin (1997), EMU: A Swedish Perspective, Kluwer Academic Publishers, Boston, Dordrecht and London.
Edison, H. and R. MacDonald (2003), ‘Credibility and Interest Rate Discretion in the ERM’, Open Economies Review 14(4), 351-368.
Grahn, Ralf (2009): ‘Swedish opinion on euro turns’, Grahnlaw Blogspot, 19 April,
New Europe (2009), ‘2008 financial crisis gives Euro new Europe-wide popularity’, New Europe, Issue 815, 5 January.
Reade, J.J. and U. Volz (2009a), Too Much to Lose, or More to Gain? Should Sweden Join the Euro?, Economics Series Working Papers 442, Department of Economics, University of Oxford, Oxford.
Reade, J.J. and U. Volz (2009b), Leader of the Pack? German Monetary Dominance in Europe Prior to EMU, Economics Series Working Papers 419, Department of Economics, University of Oxford, Oxford.