Swedish lessons show even deflation cannot cure the house price bubble
Sweden now finds itself in much the same boat as the depressed periphery countries of the eurozone, at least in terms of price inflation
Stockholm, one of the world's most expensive cities
The reason Stockholm’s plight is attracting more attention than the rest of Europe, where eight countries are now in price deflation, is because Sweden came through the financial crisis relatively unscathed. Photo: ALAMY
By Jeremy Warner
Last week Sweden became the first northern European country to report that it had fallen into outright price deflation, a state of affairs that worries economists because if consumers and companies expect falling prices, they tend to postpone purchases, investment and hiring, potentially leading to a downward spiral in demand.
The reason Stockholm’s plight is attracting more attention than the rest of Europe, where eight countries are now in price deflation, is because Sweden came through the financial crisis relatively unscathed.
Unlike others, it also still has its own currency and therefore retains control over monetary policy. Yet, despite these apparent advantages, Sweden now finds itself in much the same boat as the depressed periphery countries of the eurozone, at least in terms of price inflation.
How did this come about and what lessons does it hold for Britain, where some of the pressures on monetary policy – including fast inflating house prices and relatively high levels of household indebtedness – look remarkably similar to those of Sweden?
The standard script goes something like this. Having had its own very deep banking and economic crisis back in the early 1990s, Sweden was much better prepared for the latest one than most other European countries. In the early stages of the crisis, it also did many of the right things.
Sweden’s Riksbank became the first ever central bank to introduce a negative deposit rate. Careful husbandry of the public finances over the preceding decade also gave Sweden the fiscal strength to introduce other very effective forms of stimulus, including tax cuts and infrastructure spending.
But then came mistakes. To Lars Svensson, an internationally renowned expert on the perils of deflation and former deputy governor of the Riksbank, there is absolutely no doubt who was to blame.
Yes, it was the Riksbank itself, which in short order, after the immediate crisis receded, raised bank rate all the way from minus 0.25pc to plus 2pc, a policy which Mr Svensson consistently opposed.
CPI inflation has been falling well short of target almost ever since, reaching minus 0.6pc in March. Belatedly, the monetary gears have been ground into reverse and interest rates are again being cut.
To Mr Svensson’s mind, the Riksbank was guilty of declaring victory before it had been won. Rather than focusing on the continuing risk of deflation and stagnation, the Riksbank instead turned its attentions to surging house prices, rising household debt and the threat they pose to financial stability.
In the jargon, it “lent against the wind”, and attempted to take the heat out of the housing market by raising interest rates even though inflation was low and likely to remain so.
The parallels with Britain, with its resurgent housing market and now again growing levels of household indebtedness, are obvious – only in Britain, with a much more serious banking crisis to deal with, the Bank of England has adopted the opposite approach, and allowed inflation to overshoot target rather than, as in Sweden, to undershoot.
Growth has now finally returned to the UK but it is of a type which, for the moment at least, seems worryingly dependent on surging house prices. This, in turn, throws up an old dilemma. Does the Bank of England let house prices rip or do something about them? So far, the answer has been of the do nothing variety. Conveniently, Sweden seems to point unambiguously to the dangers of dealing with emergent house price bubbles by raising interest rates.
Or does it? No doubt the Riksbank has made mistakes. Yet even in Britain inflation is now below target and that’s without lifting the foot off the monetary accelerator for as much as a moment. The same is true of the US, where tapering is merely a toning down of monetary stimulus, not a tightening as such. This suggests structural disinflationary forces way beyond the effects of domestic policies.
For Europe, it is not hard to see where they are coming from. The eurozone has begun to exert a strong deflationary bias not just within its own boundaries but more or less everywhere. Low inflation in Sweden, and fast abating inflationary pressures in Britain, are basically about weak demand on the Continent; they are not much to do with domestic monetary policy.
Nor at this stage is it possible to regard Sweden’s predicament as particularly dire. Unemployment remains elevated by Swedish standards but, despite virtually zero inflation, growth was 1.5pc last year and the government has recently raised its forecast for this year to 2.7pc, just a tad below the rates of growth Britain is experiencing. This can hardly be seen as policy failure.
Continued tax cutting by the Reinfeldt government has, meanwhile, further added to the pressure on house prices and household debt, which now stands at an astonishing 170pc of disposable incomes, a considerably bigger number than Britain. Swedish house prices have more than doubled since 2000, rising 11pc last year alone. Is it any wonder that the Riksbank is worried about these trends?
When debt is this high, you need to be particularly careful about disinflation, for there is nothing more guaranteed to add to the burden of debt than price and wage deflation. But the Riksbank can hardly be blamed for wanting to choke off the countervailing upward climb in house prices and credit.
In Britain, the Bank of England hopes to achieve the same effect through use of so-called “macro-prudential tools”, or credit controls by another name.
To the Bank’s mind, the process has already begun. Mortgage finance has been withdrawn from the credit easing of its Funding for Lending Scheme. Other measures, such as higher capital requirements for mortgage lending, or even strict loan to value caps, could soon follow.
At the Treasury, George Osborne, the Chancellor is known to be frustrated at those who accuse him of engineering another house price bubble for electoral purposes.
For him, the whole purpose of fiscal and monetary reform has been about achieving greater financial stability. It would be perverse of him deliberately to flout this objective.
Can macro-prudential deliver? Suffice it to say that experience from abroad has not been particularly encouraging. Meaningful supply side solutions seem sadly to have gone by the wayside, leaving only the blunt and undesirable instruments of interest rates and property taxes to fall back on.
The Bank of England is loath to use the former for fear of wrecking the recovery; the Government is all over the place on the latter.
One thing that plainly is a bad idea, however, is to bank the benefits of disinflationary forces coming from abroad as if they are all down to the genius of domestic inflation targeting.
This was one of the mistakes made in the run-up to the crisis, when apparently obedient inflation, caused as much by globalisation as improvements in productive potential, disguised inappropriately loose monetary policy which was in turn helping to stoke the credit bubble.
And it may be starting to happen again. There is a sense in which weak demand on the Continent is forcing the Bank of England to support domestic demand and asset prices at unsustainable levels.
The Riksbank sort of gets this, even if it may have gone too far in allowing outright deflation.