MACROECONOMIC PERSPECTIVES ON THE DANISH ECONOMY

Macroeconomic Perspectives on the Danish Economy Edited by Torben M. Andersen, Svend E. Hougaard Jensen and Ole Risager

MACROECONOMIC PERSPECTIVES ON THE DANISH ECONOMY

This page intentionally left blank

Macroeconomic Perspectives on the Danish Economy Edited by

Torben M. Andersen Professor of Economics University of Aarhus

Svend E. Hougaard Jensen Head of Research Division Ministry of Business and Industry Copenhagen

and

Ole Risager Professor of Economics Copenhagen Business School

Selection, editorial matter and Chapter 1 © Torben M. Andersen, Svend E. Hougaard Jensen and Ole Risager 1999 Chapter 3 © Stean Nielsen and Ole Risager 1999 Chapter 7 © , Ninette Pilegaard Hasen and Svend E. Hougaard Jensen, Martin Junge 1999 Chapter 9 © Torben M. Andersen and Torben D. Schmidt 1999 Chapters 2, 4–6, 8, 10–11 and comments © Macmillan Press Ltd 1999 All rights reserved. No reproduction, copy or transmission of this publication may be made without written permission. No paragraph of this publication may be reproduced, copied or transmitted save with written permission or in accordance with the provisions of the Copyright, Designs and Patents Act 1988, or under the terms of any licence permitting limited copying issued by the Copyright Licensing Agency, 90 Tottenham Court Road, London W1P 9HE. Any person who does any unauthorised act in relation to this publication may be liable to criminal prosecution and civil claims for damages. The authors have asserted their rights to be identified as the authors of this work in accordance with the Copyright, Designs and Patents Act 1988. First published 1999 by MACMILLAN PRESS LTD Houndmills, Basingstoke, Hampshire RG21 6XS and London Companies and representatives throughout the world ISBN 0–333–73331–2 A catalogue record for this book is available from the British Library. This book is printed on paper suitable for recycling and made from fully managed and sustained forest sources. 10 08

9 07

8 06

7 05

6 04

5 03

4 02

3 01

2 00

Printed and bound in Great Britain by Antony Rowe Ltd, Chippenham, Wiltshire

1 99

Contents List of Figures

vii

List of Tables

ix

Preface

xi

Acknowledgements

xii

Notes on the Contributors

xiii

1

2

3

4

5

6

Macroeconomic Perspectives on the Danish Economy: Problems, Policies and Prospects Torben M. Andersen, Svend E. Hougaard Jensen and Ole Risager

1

EMU and the Outsider Nations Niels Thygesen

40

Comment by Arne Jon Isachsen Comment by Jesper Jespersen

56 61

Macroeconomic Perspectives on Stock and Bond Investments in Denmark since the First World War Steen Nielsen and Ole Risager

66

Comment by Tom Engsted Comment by Björn Hansson

92 99

Would the Flat Tax Fall Flat in Denmark? Søren Bo Nielsen, Niels Kleis Frederiksen and David Dreyer Lassen

106

Comment by Michael Lundholm

131

The Danish Tax Reform Act of 1993: Effects on the Macroeconomy and on Intergenerational Welfare Kathrine Lange, Lars Haagen Pedersen and Peter Birch Sørensen

134

Comment by Peter Broer

162

Minimum Wage Contracts and Individual Wage Formation: Theory and Evidence from Danish Panel Data Lars Haagen Pedersen, Nina Smith and Peter Stephensen

165

Comment by Donald O. Parsons Comment by Jan Rose Sørensen

188 191

v

vi 7

8

9

10

11

Index

Contents Government Solvency, Social Security and Debt Reduction in Denmark Ninette Pilegaard Hansen, Svend E. Hougaard Jensen and Martin Junge

193

Comment by A. Lans Bovenberg

221

Economic Expansions and Fiscal Contractions: International Evidence and the 1982 Danish Stabilization U. Michael Bergman and Michael M. Hutchison

225

Comment by Frank Barry Comment by Anders Møller Christensen

257 261

The Macroeconomics of the Welfare State Torben M. Andersen and Torben D. Schmidt

264

Comment by Per Callesen Comment by Douglas A. Hibbs, Jr

285 290

The Welfare State and Economic Incentives Jørgen Søndergaard

294

Comment by Torsten Sløk Comment by Thorvaldur Gylfason

325 330

Effort Commitment in Active Labour Market Policy Claus Thustrup Hansen and Torben Tranæs

335

Comment by Niels Blomgren-Hansen Comment by Jørgen Elmeskov

359 363 365

List of Figures 1.1 1.2 1.3 1.4 1.5 1.6 1.7 1.8 1.9 1.10 1.11 1.12 1.13 1.14 3.1 3.2 3.3 3.4 3.5 3.6 3.7 3.8 C3.1 C3.2 C3.3 4.1 5.1 5.2 5.3 5.4 5.5 5.6 5.7

Real GDP for Denmark, EU and the United States, 1960–97 Real GDP for Denmark, 1973–97 Labour supply and employment, 1960–97 Wage and price inflation, 1972–97 Current account in per cent of GDP, 1960–97 Relative wage and employment, 1948–91 Nominal interest rate and interest rate spread to Germany Nominal and real interest rates Foreign debt and current account Gross investment and saving, 1973–96 General government expenditures, 1960–96 General government revenues, 1960–96 Gross government debt, 1960–96 Projected changes in demographic structures, 1995–2040 Annual nominal stock returns, 1921–95 Real stock price index, 1921–95 Nominal bond yields, 1921–95 5-year nominal equity premium, 1921–90 Bounds on moments of m and sample estimates Perfect foresight stock price decomposition, 1921–95 Dividend yield, 1921–95 Perfect foresight stock prices under the consumption-CAPM and real interest rate discounting, 1921–95 Cumulative real return index for Swedish and Danish stocks from 1922–96 Cumulative real return index for Swedish and Danish long-term government bonds, 1922–96 95 per cent confidence interval for Danish stocks and bonds, constructed from bootstrapping of annual data Tax as percentage of income: single person, no children, Denmark, 1992 Aggregate employment (hours) Aggregate human wealth Aggregate non-human wealth Physical consumption of non-durables Aggregate physical stock of business capital Aggregate physical stock of housing capital Intergenerational welfare effects vii

2 3 4 5 5 10 15 15 17 19 22 23 26 33 69 70 73 78 82 84 85 87 100 101 104 115 148 149 150 151 152 153 154

viii 6.1 7.1 7.2 8.1 8.2

List of Figures

Frequency of wage rates Macroeconomic effects of debt elimination Welfare effects of debt elimination Actual and expected private consumption, 1982:3–1987:4 Historical decomposition of unexpected private consumption attributable to structural shocks, 1982:3–1987:4 9.1 Budget sensitivity and public sector size measured by revenue to GDP ratio, EU countries, 1995 9.2 Public sector size and standard deviation of cyclical measure for total activity, 1971–90 9.3 Growth and public sector size, 1971–90 10.1 Dependence on public support among the 18-66-year-olds, 1960–96 10.2 18-66-year-olds dependent on different types of social security 10.3 Annual working hours (manufacturing) and part-time frequency (all sectors), 1948–94 10.4 Labour market survival rates for active at age 50, 1970 and 1994 10.5 Retirement on early retirement scheme for unemployed aged 50–59, 1994:1–1996:4 10.6 Participation in leave schemes, 1994:1–1996:4 10.7 Index of log GDP per capita, 1884–94 C10.1 Equality and efficiency C10.2 Size of government and growth 11.1 Beveridge curve for Denmark, 1980–96 11.2 The basic incentive problem 11.3 The effort–benefit system 11.4 Productivity below the threshold 11.5 Wage setting

171 209 211 251 252 268 268 275 305 306 309 312 313 314 321 331 333 342 344 345 349 353

List of Tables 1.1 1.2 1.3 1.4 2A.1 C2.1 3.1 3.2 3.3 3.4 3.5 3.6 C3.1 C3.2 C3.3 C3.4 4.1 4.2 4.3 5.1 5.2 5.3 5.4 6.1 6.2 6.3 7.1

Average real GDP growth, 1960–97 Unemployment rates for 25–64-year-olds, by level of educational attainment, 1995 Structure of the tax system in Denmark, EU and USA Working-age population, employment and recipients of public transfer payments, 1960–97 Reserves and monetary base To be or not to be a member of EMU Average annual stock market returns, 1922–95 Average 5- and 10-year bond and stock returns, 1922–95 Return–risk of stock and bond portfolios, 1922–95 Equity premium for the sample Variance–covariance between annual returns, yields and consumption growth rate, 1922–95 What amount, X, would make a person with CRRA utility indifferent? Annual real returns, 75 observations, 1922–96 Real returns per annum for 5-year investment horizons, 71 overlapping observations, 1922–96 Real returns per annum for 10-year investment horizons, 66 overlapping observations, 1922–96 Real returns per annum for 20-year investment horizons, 56 overlapping observations,1922–96 Flat tax rates and personal allowances Changes in disposable income, by flat-tax income groups Changes in disposable income, by gross income groups Statutory marginal tax rates on labour income, before and after the 1993 tax reform Statutory marginal tax rates on capital income, before and after the 1993 tax reform Estimated effective tax and subsidy rates, before and after the 1993 tax reform Calibration of the EPRU model Sample means in 1990 Test of instruments Fixed-effect estimation of wage function Principal budget components, unemployment, interest and growth rates, 1960–95 ix

2 10 25 29 53 56 70 73 74 77 79 84 101 102 103 103 112 121 123 135 136 138 145 180 182 184 195

x 7.2 7.3 7.4 8.1 8.2

List of Tables

Alternative measures of public debt and the deficit, 1995 Magnitude of required fiscal adjustment Generational accounts of current and future generations Fiscal consolidation and macroeconomic performance Structure of fiscal consolidation and macroeconomic conditions prior to the first year of consolidation 8.3 Danish fiscal adjustments following the October 1982 announcement 8.4 Forecasts published by Economic Council, 1982–7 9.1 Government spending and revenues: international comparison, 1993 9.2 Cyclical sensitivity of budget revenues and expenditures in the EC, 1995 9.3 Cyclical properties of tax rates and social security transfers 9.4 Variance decomposition ∆y 9.5 Regressions of volatility in private sector activity on various measures of taxes and social security transfers 9.6 Public debt, transfers and public consumption 10.1 Characteristics of the Danish system of income transfers 10.2 Combined effective marginal tax rates, 1996 10.3 Welfare state expenditures, 1960, 1980 and 1995 10.4 Expected welfare state incentive effects on labour force participation 10.5 Reported attitudes and search activity among unemployed with at least 3 months of unemployment, 1994 C10.1 Denmark, Sweden and the world: investment, trade and growth

200 201 205 234 236 243 247 265 267 270 271 273 280 298 303 304 310 318 332

Preface This volume contains the proceedings of the conference ‘Macroeconomic Perspectives on the Danish Economy’, held in Hornbaek, Denmark (19–20 June 1997). The conference was jointly organized by the Economic Policy Research Unit, University of Copenhagen and the Department of Economics, University of Aarhus. The book contains 11 chapters, including an introductory survey on the Danish economy. The aim of each chapter has been to illuminate an important policy issue confronting the Danish economy, using the insights of up-todate methodology and the most recent evidence. Each chapter is followed by comments from a leading international expert. This should, we hope, make the book of interest also to readers outside Denmark. In any case, many European countries are faced by problems and prospects similar to those addressed in the book. Several chapters have also benefited from the perspectives offered by Danish economists responsible for the practical conduct of macroeconomic policies. In editing the book we have, therefore, had a broad readership in mind: our own colleagues in academia, civil servants involved with day-to-day aspects of the Danish economy, economists in other countries working with related issues and last, but not least, students of economics who feel a need to bridge the gap between topics addressed in economic theory and the so-called real world. To put it more bluntly: it is our ambition that this volume will be an indispensable text to anyone who is seriously interested in the Danish economy. Our principal debt is to the contributors and the conference participants, who have all helped making us feel that this project has been a worthwhile undertaking. For financial support we are grateful to the Danish National Research Foundation who provides the prime funding of EPRU. Thanks are also due to the Danish Social Research Council through its funding of the project ‘The Welfare State: Threats, Problems and Possible Solutions’, which has initiated the research underlying some of the papers in the book. Grethe Mark, EPRU’s administrative secretary, has handled the logistics of the conference with professionalism and she also supervised the conference’s financial arrangements. Finally, competent assistance by Christoffer Kok Sørensen and Ian Valsted has been essential to the book’s swift publication. Copenhagen

TORBEN M. ANDERSEN SVEND E. HOUGAARD JENSEN OLE RISAGER

xi

Acknowledgements The editors and publishers acknowledge with thanks permission from the Journal of Financial Economics for permission to reproduce Table 3.6, from N.G. Mankiw and S.P. Zeldes, ‘The consumption of stockholders and nonstockholders’ (1991).

xii

Notes on the Contributors Authors Torben M. Andersen, Professor, Institute of Economics, University of Aarhus and Research Fellow, Centre for Economic Policy Research, London. U. Michael Bergman, Associate Professor, Department of Economics, University of Lund, Sweden. Niels Kleis Frederiksen, PhD student, Economic Policy Research Unit, University of Copenhagen. Ninette Pilegaard Hansen, Economist, Computable General Equilibrium Modelling, Statistics Denmark. Claus Thustrup Hansen, Assistant Professor, Department of Economics, University of Copenhagen and Research Fellow, Economic Policy Research Unit, University of Copenhagen Michael M. Hutchison, Professor, Department of Economics, University of California at Santa Cruz and Research Fellow, Economic Policy Research Unit, University of Copenhagen. Svend E. Hougaard Jensen, Head, Division of Economic Analysis, Ministry of Business and Industry and Research Fellow, Economic Policy Research Unit, University of Copenhagen. Martin Junge, Research Assistant, Department of Economics, University of Copenhagen. Kathrine Lange, Research Assistant, Economic Policy Research Unit, University of Copenhagen. David Dreyer Lassen, Research Assistant, Economic Policy Research Unit, University of Copenhagen. Søren Bo Nielsen, Research Professor, Economic Policy Research Unit, University of Copenhagen and Research Fellow, Centre for Economic Policy Research, London. Steen Nielsen, PhD student, Economic Policy Research Unit, University of Copenhagen. Lars Haagen Pedersen, Head, Computable General Equilibrium Modelling, Statistics Denmark.

xiii

xiv

Notes on the Contributors

Ole Risager, Professor, Department of Economics, Copenhagen Business School and Research Fellow, Economic Policy Research Unit, University of Copenhagen. Torben D. Schmidt, PhD student, Institute of Economics, University of Aarhus. Nina Smith, Professor, Department of Economics, Aarhus School of Business, Research Fellow, Center for Labour Market and Social Studies, University of Aarhus and Chairman, Council of Economic Advisors, Denmark. Peter Birch Sørensen, Professor, Department of Economics, University of Copenhagen, Research Fellow, Economic Policy Research Unit, University of Copenhagen and Chairman, Council of Economic Advisors, Denmark. Peter Stephensen, Economist, Computable General Equilibrium Modelling, Statistics Denmark. Jørgen Søndergaard, Director, Danish National Institute of Social Research, Copenhagen. Niels Thygesen, Professor, Department of Economics, University of Copenhagen and Research Fellow, Economic Policy Research Unit, University of Copenhagen. Torben Tranæs, Associate Professor, Department of Economics, University of Copenhagen and Research Fellow, Economic Policy Research Unit, University of Copenhagen. Discussants Frank Barry, Professor, Department of Economics, Trinity College, Dublin, Ireland. Niels Blomgren-Hansen, Professor, Department of Economics, Copenhagen Business School. A. Lans Bovenberg, Professor, CentER, Tilburg University, the Netherlands, Research Fellow, OCFEB, Erasmus University, the Netherlands and Research Fellow Centre for Economic Policy Research, London. Peter Broer, Economist, Netherlands Bureau for Economic Policy Analysis and Research Fellow, OCFEB, Erasmus University, the Netherlands. Per Callesen, Deputy Permanent Secretary, Ministry of Finance, Denmark. Anders Møller Christensen, Vice Director, Danmarks Nationalbank. Jørgen Elmeskov, Chief Economist, OECD, Paris. Tom Engsted, Associate Professor, Department of Finance, Aarhus School of Business.

Notes on the Contributors

xv

Thorvaldur Gylfason, Professor, Department of Economics, University of Iceland and Research Fellow, Centre for Economic Policy Research, London. Björn Hansson, Docent, Department of Economics, University of Lund, Sweden. Douglas A. Hibbs, Professor, Department of Economics, University of Gothenburg, Sweden. Arne Jon Isachsen, Professor, Centre for Research in Monetary Economics, Handelshøyskolen BI, Oslo, Norway. Jesper Jespersen, Professor, Department of Economics, Roskilde University Centre. Michael Lundholm, Professor, Department of Economics, University of Uppsala, Sweden. Donald O. Parsons, Professor, Department of Economics, George Washington University, USA. Torsten Sløk, Economist, Ministry of Business and Industry, Denmark. Jan Rose Sørensen, Associate Professor, Institute of Economics, University of Aarhus.

This page intentionally left blank

1 Macroeconomic Perspectives on the Danish Economy: Problems, Policies and Prospects1 Torben M. Andersen, Svend E. Hougaard Jensen and Ole Risager 1.1

INTRODUCTION: TRENDS AND CYCLES

Countries are often ranked according to their GDP per capita, properly adjusted for differences in price levels. Based on the purchasing power parity (PPP) adjusted GDP statistics, Denmark is one of the most affluent societies in the world. Compared to the EU average and the OECD average, Denmark was, respectively, 12 and 9 per cent ahead in 1995, and only a few countries B including Luxembourg, Norway, Switzerland and the United States – had a higher GDP per capita (The Economist, 1997). The level of real GDP was in 1997 about three times as large as in 1950 and, from the perspective of economic welfare, it is also important to note that over the same time period the average annual working hours have fallen by about a third. However, Denmark’s GDP growth rate has been slightly lower than in a number of other countries. Figure 1.1 shows real GDP for Denmark, (the average of) 15 EU countries and the United States; in all three cases real GDP is indexed to 100 in 1960. Over the whole period 1960–97, Denmark enjoyed an average real GDP growth rate of 2.8 per cent. With the corresponding number being 3.0 per cent for both the EU and the United States (see Table 1.1), the difference in growth performance has been fairly small. However, if this difference also persists into the next century, Denmark will of course not be able to retain its high position among the world’s richest countries. It is also remarkable that the two sub-periods, 1960–72 and 1973–97, respectively, are characterized by very different growth performances. Indeed, for Denmark and the EU as a whole the GDP growth rates in the second sub-period were only half as high as in the first. While US growth rates have also fallen, the decline in Europe is much more dramatic, a phenomenon sometimes referred to as ‘eurosclerosis’. 1

Andersen, Jensen and Risager

2 Figure 1.1

Real GDP for Denmark, EU and USA, 1960–97

300

250

200

150

100

50 1960

1963

1966

1969

1972

1975

Denmark

1978 EU15

1981

1984

1987

1990

1993

1996

USA

Note: Index numbers (1960 = 100). Source: OECD.

The slow growth period 1973–97 was characterized by deep recessions but also by impressive upswings. As indicated by Figure 1.2, this period saw three recessions and two expansionary periods with growth significantly below and above the mean, respectively. The first two recessionary periods occurred in the mid-1970s and at the beginning of the 1980s, and were mainly triggered by well known international events such as the two OPEC shocks and the associated economic policies adopted by the leading OECD economies. The two expansionary periods – one from 1983 to 1987, and another from 1993 until today – were, however, mainly driven by domestic factors, as we shall explain in more detail below. In both upturns, economic policy has played an important role in triggering the upswing in the economy. Economic policy also played a role in Table 1.1

Denmark EU USA Source: OECD.

Average real GDP growth 1960–97 per cent 1960–97

1960–72

1973–97

2.8 3.0 3.0

4.4 4.6 3.8

2.1 2.3 2.6

Problems, Policies and Prospects Figure 1.2

3

Real GDP for Denmark, 1973–97

280 260

Contractionary policy: Potato Diet

240 Expansionary policy: Tax cuts

220 200

OPEC II OPEC I New non-accomodative non-accommodative New policy policy regime

180 160 1974

1976

1978

1980

1982

1984

1986

1988

1990

1992

1994

1996

Note: Index numbers (1960 = 100). Source: OECD.

setting off the recession that started in 1987 and continued until 1993, a period in which Denmark’s major trading partners were booming, at least until the late 1980s. Hence, it is interesting to note that domestic factors and Danish economic policy in particular have played an important role in the performance of the economy.2 However, it is also important to stress that owing to the economy’s fairly high degree of openness – as indicated by an export share of GDP around 35 per cent as well as strong financial linkages with the rest of the world – the economy is of course also vulnerable to international shocks. The international recessions associated with the two OPEC shocks are cases in point. As shown by Figure 1.3, these shocks were followed by sharp declines in employment, while labour supply continued to grow, actually at an increasing rate following the first OPEC shock. The expansionary period in the mid1980s and the current boom starting in 1993 were both associated with sharp increases in employment, but it has not so far been possible to bring the unemployment rate down to the level prevailing prior to the adverse shocks of the 1970s. Over the years, a number of measures have therefore been adopted to cope with the unemployment problem. Most of the measures have been passive in nature, aiming at reducing the registered unemployment rate by lowering labour supply through early retirement schemes, paid leave schemes and so forth. More recently, initiatives have been taken which directly aim at bringing the unemployed back to work again (see section 1.3). The persistent high level of unemployment has had strong effects on the government budget, as elaborated in section 1.6. This is to be expected for a welfare state like the Danish one since a key objective is to moderate the

Andersen, Jensen and Risager

4 Figure 1.3

Labour supply and employment in heads, 1960–97

3100 2900 2700 2500 2300 2100 1900 1960 1963 1966 1969 1972 1975 1978 1981 1984 1987 1990 1993 1996

Labour supply

Employment

Note: Numbers are in thousands. Figures for 1997 are preliminary. Source: Statistics Denmark and Ministry of Economic Affairs.

effects of recessions. There has thus been a rapid increase in public sector transfer payments, while traditional public sector activities have not increased relative to GDP since the 1970s. The number of individuals living on UI benefits and other public transfer payments has thus increased enormously (see section 1.7). Although the tax burden also has been increasing, there has been a persistent gap between revenues and expenditures. This has, of course, led to increasing government debt over the years. While the current government debt-to-GDP ratio is below the average in the EU, it remains a fact that the debt and the burden of debt service are significant. Moreover, it may be argued that the government finances are intergenerationally imbalanced, suggesting that significant bills will be passed onto future generations. The extent to which this is the case is discussed further in section 1.8. The high growth in the 1960s led to a gradual build-up of goods and service price inflation which culminated in the mid-1970s owing to the sharp increase in energy prices and the wage hikes (see Figure 1.4). Following these events, inflation declined but both price and wage inflation remained high until the beginning of the 1980s. In late 1982, there was a shift in economic policy towards a disinflationary policy strategy that helped bringing inflation under control. This is addressed in greater detail in section 1.4. An important element of this non-accommodative policy strategy was the shift towards a fixed exchange rate policy. Earlier, policy makers had quite often resorted to currency devaluations in an attempt to offset the deteriorations in competitiveness and the current account that resulted

Problems, Policies and Prospects Figure 1.4

5

Wage and price inflation, 1972–97

25.0%

20.0%

15.0%

10.0%

5.0%

0.0% 1972

1974

1976

1978

1980

1982

1984

1986

1988

% Increase Increase in in Hourly hourly wage % Wage ininmanufacturing Manufacturing

1990

1992

1994

1996

% Increase in GDP deflator

Source: OECD.

from high wage and energy price increases. Indeed, as we discuss at length in section 1.5, the external (im)balance was for long seen as the Achilles’ heel in the Danish economy. This is witnessed by the fact that there was a deficit on the current account in each of the consecutive years from 1964 to 1989 (see Figure 1.5).

Figure 1.5

Current account in per cent of GDP, 1960–97

4% 3% 2% 1%

-2% –2% -3% –3% -4% –4% -5% –5% -6% –6%

Source: Statistics Denmark.

1996

1994

1992

1990

1988

1986

1984

1982

1980

1978

1976

1974

1972

1970

1968

1966

1964

1962

1960

0% –1% -1%

6

Andersen, Jensen and Risager

As a background to the more detailed treatment of selected issues of importance for the macroeconomic performance of the Danish economy, section 1.2 provides a brief overview of the different economic policy strategies that have been pursued in recent decades.

1.2

GENERAL ECONOMIC POLICY STRATEGIES

The growth period in the 1960s led to an optimistic view about the possibilities for fine-tuning the macroeconomy. The subsequent developments showed that macroeconomic management was very difficult and a variety of different policy strategies were pursued in an attempt to improve upon macroeconomic performance. The initial response to the international recession and the rise in unemployment in the mid-1970s was a so-called ‘bridging policy’. This policy was based on the perception that the recession was temporary and could therefore be mitigated by an expansionary demand management policy. The perception that the recession was temporary soon proved wrong, and the overall policy strategy from the mid-1970s up to 1982 was guided by a so-called ‘switching strategy’, according to which the twin problems of unemployment and current account deficits could be solved by switching private demand with a high import ratio into public demand with a low import ratio. As a consequence, numerous policy packages included tax increases to curtail private demand and expansions of public demand and in particular public employment programmes. These changes did not necessarily take place simultaneously as the policy had a ‘stop–go’ character with tax increases in times where the current account was considered out of control and public expansion in periods with focus on the unemployment problem. This was also the prime time for policy packages, appearing frequently in an atmosphere of acute need for intervention. A loose exchange rate policy (crawling peg) was part of this strategy since discrete devaluations were believed to undo the harm caused by excessive domestic wage increases. Underlying this policy view was an accommodative attitude towards the labour market in the sense that the government accepted a responsibility for the employment level. Accordingly, the labour market policy was fairly passive, mainly concentrating on reducing labour supply and mitigating the economic consequences for the unemployed. This policy strategy was not very successful in terms of solving the overall macro problems. The problems of current account deficits and unemployment remained unsolved, while inflation and public debt were growing. In the autumn of 1982, a centre-right minority coalition replaced a Social Democratic minority government. The new government launched a new economic programme based on the idea that the problems underlying the

Problems, Policies and Prospects

7

Danish economy could be solved in a medium-term perspective only by an expansion of private sectors capable of facing international competition. The programme consisted of a disinflationary policy grounded in a fixed exchange rate policy and a tight fiscal policy. The policy shift signalled that the government was attempting to leave more responsibility for the determination of employment with the labour market. This disinflationary policy was initially very successful and a change in the economic mood was observed accompanied by increases in private demand, higher GDP growth and a fall in unemployment from 1983 to 1986 (see Figure 1.7, p. 15). This policy was to some extent killed by its own success (see Andersen, 1994; and Bergman and Hutchison, Chapter 8 in this volume). The tremendous upturn in the mid-1980s was associated with a substantial increase in domestic demand as both private consumption and investment soared, but it turned out that supply capacity could not match this increase. The capacity problems applied both to the production capacity of firms and the availability of labour with the necessary qualifications. As a consequence, it led to a further deterioration of the current account and wage increases (in 1987) much in excess of the norms of the disinflationary policy. The development over this period was interesting since domestic demand was booming. Therefore, shortage of aggregate demand could be ruled out as the primary reason for the unemployment problem. The fact that substantial wage increases were released at an unemployment rate around 8 per cent was taken as strong indication that there were severe adjustment problems in the labour market. A fairly pessimistic view on the unemployment problem developed during the late 1980s and early 1990s, and the view that ‘we have to live with unemployment’ and ‘there is no need for so much labour’ became fairly widespread. A minority coalition government led by the Social Democrats took over in 1993. Among its new initiatives was a paid leave scheme aiming at distributing the burden of unemployment more equally. It also launched a fiscal expansion, partly financing the transition period of a tax reform designed so as to lower marginal tax rates and broaden the tax base. Although a shift in the business cycle was to be expected after a prolonged recession, there is little doubt that the expansionary fiscal policy had a role in triggering the boom in economic activity and the fall in unemployment. The accompanying increase in employment motivated a more active labour market policy focusing much more explicitly on the incentive effects of various labour market policies. The policy shift towards youth – involving a tightening of the incentive structure – is a prime example of this. There is some indication that the wage formation process has been affected, but it is still too early to judge how fundamental these changes are. Nonetheless,

8

Andersen, Jensen and Risager

recent developments have shown that a combination of demand and active supply measures – a two-handed approach – can be successfully used to boost employment.

1.3 WAGES AND STRUCTURAL SHIFTS IN THE LABOUR MARKET Denmark experienced increasing wage inflation during the 1960s. In the mid1970s, wage inflation reached a climax as nominal wages increased by more than 20 per cent, see Figure 1.4. This led to an increase in real (consumption) wages by almost 10 per cent. Since then wage inflation has gradually declined. The major downward adjustment occurred from 1982 to 1983–4, where the annual wage increases fell from around 10 to less than 5 per cent. The considerable decline in wage inflation shows that the shift towards the low-inflation, non-accommodative policy stance in late 1982 gained a fairly high degree of credibility rather quickly among the wage setters in the economy. Since then wage inflation has been fairly low. The only exception to this rule is 1987, where there was a revitalization of wage inflation primarily due to rapid growth and increasing employment, which coincided with a new round of collective wage bargaining. Due to the wage hike in 1987 and the tightening of economic policy, unemployment increased substantially whereas wage inflation declined. It is only very recently that employment has started to rise again; from the beginning of 1993 to late 1997, total employment increased by around 150,000 persons or by almost 8 per cent. The considerable rise in employment that has taken place since 1994 has not so far led to an accelerating wage inflation, which is somewhat surprising given past experience. There are several potential explanations for this. First, it should be noted that the present employment increase is not as big as the one observed in the mid-1980s, where private sector employment grew by almost 200,000 persons. Second, the coincidence of a low and stable inflation and falling unemployment may simply reflect a learning process. Thus, the experience in the 1980s clearly demonstrates that pressing for ‘too’ high wage increases is futile as the only certain outcome is higher unemployment and very little else. Third, fierce competition in goods and service markets associated with the increased international integration process, often noted by the business community, may also have helped to hold back wage and price increases. Indeed, since the coincidence of low inflation and falling unemployment is also a world-wide phenomenon, a truly international explanation has some appeal. Fourth, the labour market reforms outlined below may also have contributed, as argued by Hansen and Tranæs in Chapter 11. These reforms, undertaken in 1994 and 1996,

Problems, Policies and Prospects

9

represent a gradual tightening of previous policies (see also BlomgrenHansen’s comments on Chapter 11). There are several elements in these reforms. First, there is an increased attempt to avoid mismatch and bottlenecks. Thus, regional labour market councils have been endowed with additional instruments in order to avoid the fallacies of the mid-1980s. Second, there has been a tightening of benefit eligibility requirements. Access to UI benefits now requires 52 weeks of work over the last three years as opposed to 26 weeks before. The maximum period on benefits has been reduced to five years. Third, insured unemployed persons can no longer extend their period on UI benefits through job training, and uninsured unemployed persons (outside the UI benefit system) can no longer earn their right to UI benefits through subsidized jobs provided by local authorities. The previously existing possibility of receiving UI benefits ‘for life’ thus no longer exists. Fourth, work availability requirements and enforcement have also been tightened in general and in particular as regards young unemployed workers below 25 years of age. The new rules stipulate that benefits should be activated after an unemployment spell of less than six months, and at a 50 per cent reduction of the benefit level. Finally, each unemployed is, in collaboration with the local authority, supposed to work out a plan for education or job training that eventually will lead to an exit from unemployment. Another interesting feature of the wage formation process is the compression of wages that occurred until the beginning of the 1980s. To illustrate this phenomenon in a simple way, Figure 1.6 plots the relative wage between unskilled and skilled male workers over the period 1948–91. The diagram also shows the relative employment level between the two types of labour measured along the right-hand axis. In the period from 1964 to the beginning of the 1980s, the relative wage between unskilled and skilled labour increased – that is, wage differentials declined. Declining wage differentials were, however, also associated with declining job opportunities for the unskilled workers insofar as the relative employment level declined. As unskilled labour became more expensive in relative terms, firms reduced their demand for unskilled workers and increased their demand for skilled labour (see Risager, 1993). This study therefore lends support to the view that the concentration of high unemployment among unskilled and inexperienced workers is in part due to the compressed wage structure. The unequal unemployment distribution is documented in Table 1.2. There is clear evidence that Denmark suffers in particular from high unemployment among low-skill groups, but it also appears that unequal unemployment distribution is an international phenomenon. It is therefore likely that there are other important explanations to which we return when we have further highlighted the role of wages.

Andersen, Jensen and Risager

10

1.8

0.9

1.7

0.88

1.6

0.86

1.5

0.84 1.4 0.82 1.3

0.8

1.2

0.78

Relative wage

1990

1988

1986

1984

1982

1980

1978

1976

1974

1972

1970

1968

1966

1964

1962

1960

1958

1956

1954

1

1952

1.1

0.74

1950

0.76

Unskilled employment/Skilled employment

Relative wage and employment, 1948–1991

0.92

1948

Wage for unskilled/Wage for skilled

Figure 1.6

Relative employment

Note: Employment figures are only available only 1991 due to a new wage– employment survey method. Source: Risager (1993) and Danish Employers’ Federation.

Jensen, Rosenholm and Smith (1994) also show that part of the unemployment problem in Denmark has to do with too high wages, and in particular with too high entrant wages. Their statistical analysis shows that 25 per cent of young unemployed men and 15 per cent of young unemployed female workers are unable to live up to the entrant wage – that is, their productivity is not high enough – and that is why firms are unwilling to employ them. However, they also show that a fall in the entrant wage by 10 per cent Table 1.2

Countries Austria Denmark Germany Netherlands USA

Unemployment rates for 25–64-year-olds, by level of educational attainment, 1995 Below upper secondary education 5.7 14.6 13.3 7.9 10.0

Source: OECD (1997a).

Upper secondary education 2.9 8.3 7.9 4.8 5.0

Non-university tertiary education 1.4 5.3 5.2 na 3.6

Universitylevel education 2.1 4.3 4.7 4.1 2.5

All levels of education 3.5 10.0 8.1 5.6 4.7

Problems, Policies and Prospects

11

will lead to a substantial increase in employment among this group of workers. Proposals of this kind have been ‘vetoed’ by the trade unions. Our interpretation of their attitude is inspired by contemporary economic labour market theory: as a fall in entrant wages is likely also to reduce wage growth for the incumbent workers due to increased outsider competition, a fall in entrant wages is likely to lead to a loss for the majority of the incumbent workers. Against this, we have the gain associated with the increase in employment and income for those who change status from unemployed to employed. However, as the latter group is a minority amongst the members of the unions, the trade union policy stance seems clear. Another concern has been the extent to which a reduction in entrant wages will lead to social imbalances. It is therefore of interest briefly to discuss the income distribution effects of a fall in entry wages. In the short term, income distribution among the employed workers will obviously become more unequal, whereas the distribution within the potential workforce is a more complicated matter as those workers who move from unemployment into employment will experience an increase in income, provided that UI benefits also are reduced in line with entrant wages. In order to get a feeling for the long-term effects, it is important to know something about wage dynamics – that is, the speed by which workers move up the income ladder. Bingley, Bjørn and Westergård-Nielsen (1994) have studied this issue by following a group of workers belonging to the lowest income decile in 1981. After five years, 75 per cent of those workers had climbed up the ladder. Hence, there were only 25 per cent left in the low wage decile. More than 55 per cent had reached the third decile or higher plateaus in the earnings hierarchy. The fairly high degree of wage mobility shows that ‘low pay status’ is not a life-time stigma for the vast majority of the wage earners. The introduction of low entrant wages will therefore provide opportunities to many outsiders who are unable at present to get a job. Needless to say, there will always be a small group who are unable to move up the ladder. Many of these persons are now squeezed out of the market, living on UI benefits or other transfer payments. Finally, as regards the functional income distribution, a stretchning of the income distribution towards a higher proportion of incomes just below the present minimum wage will of course increase the return to capital. Because the UI system sets a maximum benefit level, UI benefits are of greater value to the low-paid than to the high-paid unemployed workers, and it is therefore also likely that the UI system is an important explanation of the narrow wage differentials (see Andersen and Risager, 1990, and Hansen, Pedersen and Sløk, 1996). Pedersen, Smith and Stephensen (Chapter 6 in this volume) estimate wage equations using panel data, and they also find

12

Andersen, Jensen and Risager

that UI benefits affect workers’ wage demands – as indeed any labour market model would suggest. Moreover, the effects are largest for low-income groups. Since probably all political parties in Denmark – at least those likely to take office – seem unwilling to cut the unemployment benefit level in a significant way, as recommended by, for example, the OECD (1997b), the option ‘reduce benefits–lower wages–increase employment’ is not really on the policy agenda. In this context it should, however, be noted that the OECD’s summary measure of benefit generosity shows that Denmark has the most generous system among all 21 countries in the OECD (1997b) study. A recent study by the Danish Economic Council (Det Økonomiske Råd, 1997) also shows that a large proportion of low-skilled/low-paid have no incentives to get employed when account is taken of taxes and transfers. Thus, more than 40 per cent of those who are unemployed for more than 80 per cent of the year, have an effective replacement ratio that exceeds 90 per cent. Moreover, there are also many low-paid employed workers who have no economic incentive to work. The philosophy of the present government is to preserve the high benefit level while at the same time increasing the demands that society puts on those who collect benefits and welfare money in general. In this context, it is interesting to note that following the tightening of the work availabilty and benefit eligibility conditions for young unemployed workers mentioned earlier, the unemployment problem for this group of workers disappeared rather quickly; it is probably important to note that the elimination of the youth unemployment problem occurred simultaneously with an upswing in the economy. Finally, it should be mentioned that the generous UI system has made it easy for firms to lay-off workers not only in recessions but also at other times where firms find it desirable to reduce the workforce. That feature of the system is one among several reasons why the Danish hiring–firing system is highly flexible in an international context (see also Emerson, 1988). The latter aspect may also help to explain why employers’ federations seem to have accepted the high UI benefit level in spite of the fact that it increases firms’ direct wage costs. The concentration of unemployment among low-skill groups is likely to reflect a compressed wage structure, but other factors are probably also at play, as indicated by the simple observation that other countries like the United States, characterized by a very unequal wage distribution, also to some extent suffer from this problem. Technological progress may play a role insofar as investments in new technology may lead to an increase in the demand for skilled and highly educated persons relative to unskilled workers. Unfortunately, it is hard to measure technical progress and how it has changed over time. This clearly complicates testing this hypothesis (see, however, Economic Council, 1997).

Problems, Policies and Prospects

13

Owing to the unwillingness to implement policies that make lowproductivity workers more competitive via the (wage) price mechanism and to the view that part or probably most of the unemployment problem is caused by technical progress and an inadequate skill structure, increased emphasis has been put on making the unemployed more competitive via education and training efforts. Whether the strong emphasis on education and training is enough to bring about a substantial reduction of the structural unemployment problem is an issue that goes beyond the scope of this chapter. However, there is evidence which indicates that some of these initiatives have very little impact. For example, a statistical study of the (unemployed) individuals who participated in the so-called AMU (labour market training) programmes shows that the probability that they get a job afterwards is not higher than non-participants’ probability of finding a job, controlling for a number of other factors (see Jensen and Jensen, 1996). The social return of this targeted but fairly expensive investment in education programmes has therefore been questioned. Another policy option that has been discussed recently is to give low-income individuals better incentives to participate actively in the labour market through a so-called earned income tax credit (see Sørensen, 1997, and Danish Economic Council, 1997). In recent years, the Danish collective wage bargaining system has changed from being a mixture of centralized and decentralized bargaining to a predominantly decentralized system. Thus, since the beginning of the 1990s almost 90 per cent of the workers in the manual labour market have been on the so-called minimum wage system. Under this system, trade unions and their counterparts on the employer side negotiate a base wage level. The minimum wage level varies across occupations. To give some indication, the average Danish base wage level is roughly twice as high as the legislated minimum wage in the United States. On top of that, there is a supplement negotiated at the local level between management and workers. The bottom line is thus that entrant wages in firms may be considerable above the minimum wage level. The movement towards more decentralized wage bargaining has so far not led to an increase in wage differentials across workers. In view of the fact that the public sector is a large employer, it should be noted that wage negotiations in the public sector often follow private negotiations. Moreover, the agreements usually mimic the agreements in the private market – that is, certain wage indexation clauses attempt to link wage increases in the public sector to the wage increases granted in the local private negotiations. For more than a decade, wages in the public sector have, however, declined relative to the private sector. In the public sector, there has also been an attempt to increase the element of decentralized wage negotiations and to allow for more flexibility in the pay schedule.

14 1.4

Andersen, Jensen and Risager EXCHANGE RATES, PRICES AND INTEREST RATES

Denmark has over the years taken part in various schemes for monetary cooperation in Europe, starting with the so-called ‘snake’ arrangement set up in 1972, and at present Denmark participates in the exchange rate mechanism (ERM) within the European Monetary System (EMS). 3 The official position has for long been that Denmark pursues a fixed exchange rate policy, but what that really means has changed over the years. In particular in the late 1970s a crawling peg policy was effectively followed as the Danish government undertook four discrete devaluations in the period 1979–82. The crawling peg era was abandoned in late 1982 when the new government declared a fixed exchange rate policy as an integral part of its disinflationary policy. This policy remains in force and enjoys broad political support. Although the precise meaning of the fixed exchange rate policy has never been explicitly defined it is understood to have the D-mark as its reference point. The shifts in exchange rate policy are clearly mirrored in the development of inflation (Figure 1.5) and in nominal interest rates (Figure 1.7). Indeed, nominal interest rates peaked in 1982 and fell fairly rapidly after the initiation of the disinflationary policy based on a fixed exchange rate policy (see Andersen and Risager, 1988). Since then inflation has remained at a low level below the European average. That the fall in nominal interest rates is tightly related to the exchange rate policy is also seen from Figure 1.7, which shows the interest rate spread between Denmark and Germany. It is apparent that along with the establishment of a credible fixed exchange rate policy and, accordingly, an inflation convergence to the German standard, the interest rate spread has diminished dramatically. The fact that there in periods has been a moderate interest rate spread between Denmark and Germany can be taken to reflect the fact that financial markets do not rule out the possibility of a return to a more inflationary policy, in particular given the Danish opt-out position on Economic and Monetary Union (EMU). Although nominal interest rates have fallen rapidly, this is not the case for real interest rates, as revealed by Figure 1.8. The real after-tax interest rate is still fairly high, but has nevertheless fallen since 1993. The fairly high interest rates that have prevailed since the late 1970s is an important explanation why the excess return on stocks relative to bonds has been modest. However, in the last 30 years, the market portfolio of stocks has outperformed bonds, but not by as much as in many other countries (see Nielsen and Risager, Chapter 3 in this volume, and the comments by Björn Hansson). The shift towards greater ‘fixity’ in the conduct of exchange rate policy has gone hand in hand with initiatives to deregulate capital markets. Thus, capital markets have been gradually liberalized since the late 1950s, both

Problems, Policies and Prospects Figure 1.7

15

Nominal interest rate and interest rate spread to Germany, 1969–97

25

Interest rate/Spread

20

15

10

5

0 1969 1971 1973 1975 1977 1979 1981 1983 1985 1987 1989 1991 1993 1995 1997

Nominal interest rate Nominal Interest Rate

Interest rate spread Denmark-Germany Interest Rate Spread Denmark-Germany

Note: Nominal interest rate: effective rate of return on bonds (iwbz), interest spread: nominal interest rate less effective rate of return on long-term bonds in Germany (iwbdm). Source: ADAM databank, Statistics Denmark.

Figure 1.8

Nominal and real rate rates of interest, 1951–97

25

Interest

rate

20 15 10 5 0 –5 -5 1951 1954 1957 1960 1963 1966 1969 1972 1975 1978 1981 1984 1987 1990 1993 1996

Nominal interest rate

Real interest rate

Real after tax interest rate

Note: Nominal interest rate: effective rate of return on bonds (iwbz), real rate of interest: nominal interest rate less actual inflation measured by the GDP deflator, real after-tax interest rate: nominal interest rate after tax (tsa0u) less actual inflation. Source: ADAM databank, Statistics Denmark.

16

Andersen, Jensen and Risager

domestically and towards the international capital markets. These reforms were completed in the early 1980s when practically all legal restrictions on international capital mobility (in and out of Denmark) were eliminated. Rules and regulations for financial intermediaries have also been liberalized, implying that binding credit constraints for private households have been eased. These liberalizations were important for not only the reduction in the interest rate spread but also for the fall in interest rates. As the interest rate spread is primarily determined by exchange rate expectations, there would be no spread with fully liberalized capital movements and a credible fixed exchange rate. Financial factors have been important for the expansionary period in both the 1980s and the 1990s. In both periods there was a tremendous increase in loan-financed consumption. In the latter period house-owners had an opportunity to make loan conversions to exploit the falling nominal interest rates, and this clearly contributed to fuelling private consumption. The development in the real estate market is very important in this respect, because the value of owner-occupied houses constitutes by far the most dominant wealth item for most households. Moreover, in both of these periods substantial increases – in the order of 20–30 per cent – in the real price of houses have been observed. This has caused large wealth increases which in turn have boosted private consumption. Capital market liberalizations have clearly contributed to strengthen this channel, and empirical evidence shows now a closer relationship between changes in consumption and changes in wealth than previously (see, for example, Christensen, 1987, and Callesen, 1997). As is well known, the Maastricht Treaty implies three nominal convergence criteria and two fiscal convergence criteria. A broad political spectrum in Denmark remains committed to the underlying principles of nominal convergence and fiscal discipline. Based on 1997 figures Denmark fulfils all the economic criteria for entering EMU. Also, Denmark is at the forefront of implementing the directives behind the EU’s Internal Market programme. Despite these tendencies to play the role as Europe’s ‘top boy’, Denmark has stated that it will not participate in the third stage of EMU in Europe. Indeed, Denmark has already exercised its right to opt out through the so-called Edinburgh Agreement in the European Council in December 1992. Denmark may reverse that position, but this would be subject to a positive outcome of a referendum. Currently, it seems difficult to predict the chances of full Danish participation in EMU. The official Danish position is clearly to seek the closest possible arrangement with EMU participants. Since it now turns out that the euro will become a reality from the beginning of 1999, a likely approach to be followed by Denmark is one of a unilateral peg vis-à-vis the euro. This would be an arrangement similar to that pursued by Austria of pegging to the D-mark for

Problems, Policies and Prospects

17

about two decades before Austria joined the EU and the EMS (see Thygesen, 1996, and his discussion in Chapter 2 of this volume of the relationship between insiders and outsiders in EMU). Indeed, such an arrangement might provide an adequate defence for the krone, as long as macroeconomic policies remain closely aligned with those of the EMU countries.

1.5 SAVING, INVESTMENT, THE CURRENT ACCOUNT AND FOREIGN DEBT The current account of the balance of payments is the difference between national saving and investment. Any gap between national saving and investment is thus filled by foreign saving – that is, by foreign lending/financing of domestic private or public investments. Hence, the current account leads by definition to a change in a country’s net foreign asset position by a figure that is equal to the current account itself. On top of that, the net foreign asset position may change due to re(de)valuations or asset price changes in general, which alter the value of assets and liabilities denominated in foreign currency. Below, we outline both the trend and the cyclical movement of the current account. The Danish current account was in deficit every single year in the period 1963–90. The persistent deficits have, of course, led to a gradual build up of the country’s foreign debt position (see Figure 1.9).

Figure 1.9

Foreign debt and current account, 1960–96

45%

25%

15%

-15% –15%

Foreign debt/GDP

Source: Statistics Denmark.

Current account/GDP

1996

1994

1992

1990

1988

1986

1984

1982

1980

1978

1976

1974

1972

1970

1968

1966

1964

–5% -5%

1962

5% 1960

Per cent of GDP

35%

18

Andersen, Jensen and Risager

The magnitude of the debt burden measured in terms of annual GDP culminated in 1988, where the debt–GDP ratio was around 40 per cent. Owing to the persistent current account surpluses since 1990 and to the growth in GDP, the debt–GDP ratio has now fallen to about 20 per cent – that is, there has been a significant reduction of the country’s foreign indebtedness. There are of course many reasons underlying the persistent historical tendency to run deficits, and the turning around of this trend which took place in 1990 (see Nielsen and Søndergaard, 1991). Below, we concentrate mainly on the most important explanations of the recent surplus trend. To this end it is useful to consider the private and public saving– investment diagrams, which show two important things. First, there was a considerable increase in private sector saving after 1986. Secondly, the investment share was low, in particular in the private sector until the mid1990s. Both tendencies contribute to the turning around of the current account balance. The private sector is now a net creditor vis-à-vis the rest of the world. In an accounting sense, the entire foreign debt is therefore a liability of the public sector, and mainly the government. The two most important explanations of the considerable increase in private saving are the so-called ‘potato diet’ (credit market tightenings) introduced in late 1986 and the tax reform in 1987. The latter led to a drastic rise in the after-tax interest rate. As the nominal interest rate was around 10 per cent in 1987, the after-tax interest rate increased from 2.8 per cent to 5 per cent for many private citizens. Because the private sector at that time was a net debtor, not only the substitution effect (it became more costly to borrow) but also the income effect (the debt service burden increased) worked in the direction of an increase in saving. The rise in private saving has more than offset the fall in public saving. Hence, the national saving rate has gone up. Since 1987, the investment share has been low, and it is only very recently that the investment share has reached previous heights. New national account figures have led to a considerable upward revision of investment figures, partly because IT expenditures now are classified as investments and not as intermediate inputs. In 1996, the new estimate for the investment share is 0.21. Likewise, savings figures have also been revised in an upward direction. Due to the appearance of the new national account figures for the period 1988–96,4 earlier worries about too low thrift and business capital investment have faded somewhat. The movement of the current account is closely related to the business cycle. The general picture is that high growth is accompanied by a weaker current account, and vice versa. The last three business cycles clearly illustrate this phenomenon. The boom from 1983–7, driven by high growth in consumption and investment, caused a big deficit in 1986 of nearly 6 per cent of

Problems, Policies and Prospects

19

Figure 1.10 Gross investment and saving, 1973–96 (a) Private

Per cent of GDP

25% 20% 15% 10% 5%

Private gross investment/GDP

1996

1995

1994

1993

1992

1991

1990

1989

1988

1987

1986

1985

1984

1983

1982

1981

1980

1979

1978

1977

1976

1975

1974

1973

0%

Private gross saving/GDP

(b) Government 12% 10% 6% 4% 2% 1993

1994

1995

1996

1993

1994

1995

1996

1992

1991

1990

1989

1988

1987

1986

1985

1984

1983

1982

1981

1980

1979

1978

1977

1976

1975

-4% –4

1974

0% –2 -2%

1973

Per cent of GDP

8%

-6% –6 -8% –8 Government gross investment/GDP

Government gross saving/GDP

(c) Total 30%

Per cent of GDP

25% 20% 15% 10% 5%

Total gross investment/GDP

1992

1991

1990

1989

1988

1987

1986

1985

1984

1983

1982

1981

1980

1979

1978

1977

1976

1975

1974

1973

0%

Total gross saving/GDP

Source: Statistics Denmark.

GDP. This motivated a tightening of economic policy in general and a change in the tax treatment of interest payments in particular, and this marked the beginning of a long period from of low growth 1987 to 1993. As a consequence the external account improved. Following the economic recovery in

20

Andersen, Jensen and Risager

1993, the current account has gradually become weaker as anticipated, but the new tendency is that the current account has remained in a surplus. However, as the current account plays a key role for Danish macroeconomic policy making, a considerable weakening is also the signal that may lead the present government to tighten policy. The role of the current account as a discipline device on macroeconomic policy making has been criticized in recent years (see Corden, 1994; Lund, 1989; and Nielsen, 1988). The point of departure of this criticism is the intertemporal approach. According to this line of thinking households and firms make their saving and investment decisions such that they fulfil their intertemporal budget constraints, which is basically saying that over their whole life-time agents do not spend more than they earn. When that is the case they do not pass burdens onto future generations – that is, there is no risk of free-riding on future generations. Hence, households consumption– saving decisions are what they should be and firms’ investment decisions are also optimal. Now since the current account is essentially the difference between saving and investment, the current account is what the current account should be. Thus, if households decide to have very high consumption for a decade, say, and hence supply very little savings to finance firms’ investment projects, then that is perfectly acceptable because firms can then get the finance via international sources. According to this so-called ‘new view’, the associated current account deficit should be of no concern for policy makers. The only snag here is the public sector. Because it is not clear what the public sector is optimizing, the public sector may have a tendency to run too large deficits, reflecting the fact that politicians have an incentive to give presents rather than taxing individuals in order to be popular and get reelected. Hence, according to the ‘new view’, the current account is only a political problem if the public sector is imbalanced. In order briefly to discuss the ‘new view’, it is important first to note that it is certainly true that a deficit may be perfectly sensible insofar as it may simply reflect high domestic profitability (above the foreign level) and investment. In such a situation it will of course be foolish to run surpluses because it is more profitable to channel domestic saving into domestic than into foreign investments. The underlying view that private saving–investment decisions should not be of any concern is, however, problematic for many reasons; only a few will be discussed here. Although frequently assumed in textbooks, international capital markets are by no means ‘perfect’. Country risk is a well known and important practical phenomenon. Thus, if a country runs large deficits and accumulates high foreign debt, it becomes more costly and difficult for otherwise sound investment projects to get finance in the international markets. Hence, there is an externality (negative) from the country’s outstanding debt to individual

Problems, Policies and Prospects

21

loan conditions, and the aggregate debt is thus a figure that policy makers should be concerned with, as they should be concerned with other externalities in the economy. Many examples in history also show that persistent current account deficits tend to make countries more vulnerable to speculative currency attacks, in which case foreign investors pull their money out of the country, which in turn may lead to turmoil and impede a sensible development of the economy. This may also reflect capital market imperfections, but it may also reflect the fact that markets rationally discount that high debt is associated with a positive probability that countries will renege on their payback promises,5 in which case foreign investors may prefer not to park their capital in that particular country or region of the world. Again, policy makers should care about the current account to avoid too large deficits. Besides capital market imperfections, deviations from rationality may also justify some current account targeting. Thus, if agents over several years behave as if it is cheap to borrow just because nominal interest rates are low, whereas real interest rates are actually high, governments and central banks with a highly professional staff may also try to correct such false beliefs, and in practice this may result in, for example, interventions against private consumption because announcements in themselves may have little credibility and hence impact on the private sector. The ‘new view’ has had little effect on policy making in Denmark, but the school’s emphasis on finding the reasons underlying a(ny) particular current account figure is certainly valuable.

1.6

PUBLIC EXPENDITURES AND TAXATION

The government has been increasingly involved in the Danish economy over the last 35 years (see Figure 1.11). The ratio of general government expenditures to GDP has more than doubled, from 25 per cent in 1960 to 62 per cent in 1997. It is mainly within the ‘core’ areas of the welfare state that outlays have increased (see also Andersen and Schmidt, Chapter 9 in this volume). The most expanding area has thus been transfer payments, which have increased fourfold. Government consumption, including health and education costs, grew rapidly in the 1960s, but has grown more or less in line with GDP since the mid-1970s. Government investment, on the other hand, has been in decline as a share of GDP. Reflecting the steady increase in public debt since the early 1970s, interest expenditures have also risen. The rise in transfer payments is to a large extent attributable to the rise in (the structural rate of) unemployment. Not only has the registered rate of unemployment increased substantially, but there has also been a rise in the number of working-age persons depending on some sort of income-

Andersen, Jensen and Risager

22 Figure 1.11

General government expenditure in per cent of GDP, 1960–96

70% 60% 50% 40% 30% 20% 10%

Interest Payments Interest payments Total expenditure Total Expenditures

1996

1994

1992

1990

1988

1986

1984

1982

1980

1978

1976

1974

1972

1970

1968

1966

1964

1962

1960

0%

Transfer Payments Transfer payments Government consumption Government Consumption

Source: ADAM databank, Statistical Yearbook (1962, 1968, 1972), Ministry of Finance.

compensating public transfer payment other than unemployment benefits. In particular, two tendencies can be identified: the workforce is retiring earlier, and a larger number of (mainly low-skilled) workers have been expelled from the labour market. These developments have clearly had budgetary effects: the costs of benefits for the unemployed and retirees have increased and tax revenues have fallen. Although a rising share of government spending to GDP is a phenomenon that has been observed in most industrial countries (see Masson and Mussa, 1995), Denmark has, like other Scandinavian countries, undoubtedly carried the welfare state further than most other European countries, both in terms of coverage and generosity (see Hagen et al., 1998). For example, safety nets have not only been provided for the less fortunate in society, but as a result of the so-called ‘universalist’ approach to the welfare state, relatively generous social programmes have been extended to the general population. The generosity of the Danish welfare programmes may also be reflected in the way many transfer payments have been indexed. For example, in the area of public pensions to the elderly, evidence shows that the purchasing power of public pensions increased by more than real wages of blue-collar workers over the period 1970–92 (see Socialkommissionen, 1993). A certain ‘sense of entitlement’ may also have become particularly widespread in Denmark and other Scandinavian welfare states. An example is

Problems, Policies and Prospects

23

early retirement benefits which were introduced in 1979 as a temporary measure to improve job opportunities for young workers by stimulating elderly workers to leave the workforce. However, most people now feel themselves entitled to receive public retirement benefits at the age of 60, regardless of their health status (or other conditions). It has, therefore, become difficult to scale back these benefits. The extent of public sector involvement in the Danish economy may also be assessed from the revenue side of the (general) government budget (see Figure 1.12). While the total revenue share is above 60 per cent, the revenue from taxes constitutes about 50 per cent of GDP. Against an EU (average) and US comparison, these numbers may appear very high (see Table 1.3). Indeed, it is remarkable that the total revenue–GDP ratio in Denmark is almost twice as high as the corresponding US figure, with the EU average being somewhere in between. However, when comparing the Danish tax burden with that of other European countries, it should be kept in mind that most EU countries, unlike Denmark, pay transfers on a net-of-tax basis. Another difference has to do with the way households are supported: in some countries this takes the form of deductions from the tax base, whereas in Denmark this is done through direct transfer payments. These factors have been found to account for almost five percentage points of the difference in the gross tax rate between Denmark and Germany (see Ministry of Finance, 1994; Lassen and Nielsen, 1996).

Figure 1.12

General government revenues in per cent of GDP, 1960–96

70% 60% 50% 40% 30% 20% 10%

Total revenues Revenues Total Indirect Indirect taxes Taxes

1996

1994

1992

1990

1988

1986

1984

1982

1980

1978

1976

1974

1972

1970

1968

1966

1964

1962

1960

0%

Personal Personal Income income Taxes taxes Other Revenues revenues Other

Source: ADAM databank, Statistical Yearbook (1962, 1968, 1972), Ministry of Finance.

24

Andersen, Jensen and Risager

From a public finance perspective it is not only the level but also the structure of taxation which is of interest. Table 1.3 compares the relative importance of the major tax sources in Denmark, the EU (average) and the United States. There are several notable differences between Denmark and the rest of the world. First, the earmarked contributions (payroll taxes to social security) of employers and employees count relatively more in the EU and, especially, in the United States. Indeed, while such payroll taxes only constitute about 4 per cent of total taxes in Denmark, they constitute about a fifth in the EU as a whole and even higher in the United States. The tendency in Denmark is, however, to give a higher priority to such taxes in the future. Second, personal income taxes make up a significantly larger share of the tax revenue in Denmark than in Europe in general and in the United States. More precisely, while the revenue from personal income taxes constitutes more than a half of the total tax revenue in Denmark, the corresponding figures for the EU and the United States are only about a quarter and a third, respectively. Third, corporate taxes are used on a relatively smaller scale in Denmark than in the rest of the OECD, notably in the United States. Fourth, the revenue collected from taxes on goods and services has in recent years converged on the European average, now amounting to about a third of the total revenue. In the United States, however, indirect taxes count much less. VAT is by far the most important indirect tax in Denmark, accounting for more than 50 per cent of the total indirect tax revenue. Fifth, since much of private sector interest income benefits from special tax concessions, while interest payments are fully deductible from taxable income, capital income tax in Denmark yields a negative net revenue.6 This fact partly explains why the residual category ‘other taxes’ is substantially lower in Denmark than in other parts of the world. Although the share of government revenues has risen strongly in this period, increases have not been sufficient to balance government budgets. As a result of persistent deficits, primarily since the mid-1970s, there has been a substantial increase in the (gross) government debt–GDP ratio, from 5 per cent in 1970 to almost 80 per cent in 1996 (see Figure 1.13). Apart from the falling debt ratios in the mid-1980s, and again more recently under the current upturn, the ratio has been steadily increasing. Although the government budget thus displays a cyclical pattern, an important asymmetry can be identified: the surplus in ‘good’ years (if a surplus) is significantly smaller than the deficit in ‘bad’ years. For example, while the Danish economy is currently experiencing a strong boom, the government only ran a small budget surplus in absolute amount in 1997. The major contribution to the falling debt–GDP ratio currently observed is thus the high GDP growth rates (‘the denominator’) rather than big surpluses on the government budget (‘the numerator’). However, according to official

Problems, Policies and Prospects Table 1.3

25

Structure of the tax system in Denmark, EU and USA, 1994 Denmark

EU

USA

(% of total tax receipts) Social security contributions Employees’ Employers’ Personal income taxes Corporate taxes Taxes on goods and services Other taxes Total tax receipts (% of GDP)

2.5 0.7 53.8 3.7 32.0 7.3 51.6

10.2 8.1 26.5 6.4 31.4 9.2 42.5

10.8 13.3 35.7 8.9 17.9 13.3 27.6

Source: OECD (1998).

projections the government is expected to run more substantial budget surpluses, thereby supporting the official debt target of the government which is a debt–GDP ratio of 40 per cent by year 2005.7 It should also be noted that since the late 1970s inflation has increasingly been anticipated, so inflation has become a less powerful device for eroding the real value of government debt. The more recent phenomenon of low (expected and actual) inflation, which has led to low nominal interest rates, has clearly diminished the burden of existing government debt in nominal terms. While the public sector has grown larger in the Scandinavian countries than elsewhere in the OECD, this is not the case as regards the size of public debt. When looking for reasons behind the substantial growth in public debt–GDP rates after 1973, Denmark does not, therefore, constitute a ‘special case’. New theories based on various political-economy models of government behaviour have offered some explanations why public debt has increased so much in many countries. For example, it has been found that in countries with a frequent turnover of government power, each government is likely to overspend when in power, thereby leaving a higher public debt to its successor (see Alesina and Tabellini, 1989). In particular, as demonstrated by Roubini and Sachs (1989), coalition governments tend to have the largest deficits, thus suggesting that if the government is formed by parties of different colour it is difficult to agree on painful measures to keep the budget balanced. Since Denmark for most of the period since 1973 has had minority governments made up of more than one party, the record of public debt in Denmark is not inconsistent with the explanation of the deficit bias in fiscal policy as offered here.

Andersen, Jensen and Risager

26 Figure 1.13

Gross government debt in per cent of GDP, 1960–96

90% 80% 70% 60% 50% 40% 30% 20% 10%

1996

1994

1992

1990

1988

1986

1984

1982

1980

1978

1976

1974

1972

1970

1968

1966

1964

1962

1960

0%

Source: ADAM databank, Statistical Yearbook (1962, 1968, 1972), Ministry of Finance.

Since the convergence criteria for EMU qualification became guidelines for the conduct of macro policy in Europe, Denmark has like other EU countries – despite its reservations for EMU participation – steered its fiscal policy with a view to the public debt–GDP targets implied by the debt and deficit criteria. It would, however, take us far beyond the scope of this chapter to seriously discuss the role of the Maastricht Treaty as an appropriate device for enhancing fiscal responsibility. Two tax reforms have been enacted within the last decade or so.8 The first reform was introduced in 1987 and had as its prime objective stimulating saving, with the ultimate goal of bringing the ongoing foreign debt accumulation to a halt. In particular, although the reform did not attack the right to deduct all interest expenses from taxable income, the tax value of interest expenses was cut, corresponding to the lowest marginal tax rate of the income tax system (see section 1.5). Tax reform was also a key ingredient in the policy package of the new centre–left government taking office in January 1993. That reform largely followed the recommendations put forward in the report from the Tax Reform Committee (1992). It was designed in the same spirit as most other tax reforms introduced in the OECD area in recent years, namely cuts in marginal income tax rates financed through various measures to broaden the tax base. Also in line with most other tax reforms in the OECD area, the Danish reform has led to a drop in the degree of tax progressivity. Detailed examinations of the 1993 tax reform include Lange, Pedersen and Sørensen (Chapter 5 in this volume) and Knudsen et al. (1997).

Problems, Policies and Prospects

27

The reform has been phased in over a period of five years. By 1998, the reform promised a maximum marginal tax rate on labour income of 58 per cent, to be compared to the pre-reform maximum marginal tax rate of 68 per cent. However, due to the introduction of so-called ‘labour market contributions’ – which are virtually payroll taxes, amounting to 8 per cent of gross labour income – the fall in the effective marginal tax rates is relatively modest. Specifically, since the personal income tax is levied on labour income net of payroll taxes, the effective marginal tax rate for high levels of personal income (above 234,900 kroner) is 61.4 per cent. The revenues from the payroll taxes are earmarked for various labour market initiatives, including unemployment insurance, active labour market programmes and sickness and maternity benefits. It has been estimated that the reform will lead to a fall in the ratio of income tax revenue–GDP from 26 per cent in 1993 to 21 per cent in 1998. From an international perspective a novelty of the reform is the introduction of environmental fees. The so-called ‘green taxes’ are levied on households (most important is the tax on water consumption), but the emission of carbon dioxides from the business sector is also subject to taxation. Since Denmark was among the first countries in the world to impose green taxes on the business sector, there has been a lively debate on what impact it would have on Danish companies exposed to international competition, particularly the most energy-intensive part of industry (see Jensen, 1998). Overall, the 1993 reform is regarded as a revenue neutral broadening of the tax base, and the introduction of payroll taxes has been motivated by the need to harmonize Denmark’s tax structure with the rest of the EU. The reformed tax structure is also relevant to the domestic debate about the need for welfare reforms. Indeed, the tax system may have crucial effects on incentives to work and hire, savings behaviour, the ‘black’ economy, do-ityourself activities and so on. Finally, it should be noted that the introduction of payroll taxes and other earmarked budget items represent a departure from the principle of centrally pooled public finances. Current debates on future tax reforms centre around the question of whether wage taxes can be replaced by green taxes to an even larger extent than has already taken place, thereby reaping a so-called ‘double dividend’ in the sense of both improving labour market structures and helping the environment. Also, the issue of making further cuts in the taxation of capital income (including corporate taxes) and (imputed) returns to owner-occupied housing has been put on the agenda. If implemented, this would be accompanied by initiatives to limit the deductability of interest expenses. While such initiatives can be seen as natural extensions of the tax reforms of the 1980s and the 1990s, a more radical approach to tax reform has also been heard, namely the so-called ‘flat tax’ (FT) (Hall and Rabushka, 1985;

28

Andersen, Jensen and Risager

see Nielsen, Frederiksen, and Lassen, Chapter 4 in this volume). Basically, as suggested by its name, the FT proposal involves giving up the progression built into the tax system currently prevailing in Denmark, and placing instead a single fixed tax on wages and cash flows in domestic firms. Nielsen et al. have calculated that a flat tax rate of 44 per cent would suffice to generate the same revenue as the current tax system generated in Denmark in 1992, even under an ‘no change in behaviour’ assumption. If allowing for efficiency gains likely to accompany a reform of that kind, such as increases in labour supply and saving, the FT rate might be even lower. Compared to the current tax system, the FT system would thus have the advantages of (a) reducing the administrative burden, (b) generating a given revenue at lower marginal tax rates and (c) removing some asymmetries. On the negative side, however, a switch towards a FT system would involve some adverse distributive effects which eventually might render it undesirable. The ‘traditional’ trade-off between efficiency and distribution thus also seems to be present here. Nevertheless, if supplemented by initiatives to preserve the redistributive properties of the current tax and transfer system, a future tax reform along the lines suggested by the FT system might be worth considering.

1.7

THE WELFARE STATE AND MARGINALIZATION

The redistributive capacity of the Danish tax and transfer system is quite significant. Although the distribution of incomes between ‘rich’ and ‘poor’ is not particularly equal, even before taxes and transfers, the distribution of disposable incomes has been found to be much more equal (see Førster, 1994). Unlike what has been found in several other OECD countries, the redistributive effects of taxes and transfers seem to be enhanced by the provision of public services, such as education and subsidized child-care (see OECD, 1996). While this would normally be regarded as attractive properties of the tax and transfer system, the question is whether the extensive welfare system in Denmark has a negative impact on the microeconomic balance of the economy, such as providing disincentives to work. This question appears to be an important one as there has, over the past three decades or so, been a rather sharp increase in the number of working-age persons being dependent on income transfers from the public sector, now amounting to about a quarter of the working-age population. Table 1.4 summarizes some facts about the total number of working-age (15–66) persons, persons in employment, recipients of public transfers (divided into various categories) and, as a residual, the number of ‘nonrecipients’ within that age-group.

Problems, Policies and Prospects Table 1.4

29

Working-age population, employment and recipients of public transfer payments, 1960–97 1960

1970

1975

1980

1990

1995

1997

(000 persons aged 15–66) A Working-age population B Employment C Recipients of public transfers Unemployment benefits Cash benefits – of which unempl. Rehabilitation benefits Early retirement benefits Transitory benefits Leave benefits – of which education Early retirement pension Sickness benefits Maternity benefits D Non-recipients (A–B–C)

2.968 2.137 184 31 39 8

3.232 3.329 2.341 2.338 307 496 24 108 41 77 5 23

3.427 2.442 634 159 107 25 9 54

3.596 2.564 784 217 116 55 22 104

103 205 259 236 10 29 37 54 3 9 16 16 647 584 495 351 (% of persons aged 15–66) E Employment ratio (B/A*100) 72.0 72.4 70.2 71.3 F Recipient ratio (C/A*100) 6.2 9.5 14.9 18.6 G Non-recipient ratio (D/A*100) 21.8 18.1 14.9 10.2

251 43 32 248 71.3 21.8 6.9

3.682 3.721 2.521 2.603 961 908 238 183 138 129 51 37 16 16 120 136 23 43 77 46 28 22 271 272 42 49 36 35 200 210 68.5 26.1 5.4

70.0 24.4 5.6

Source: Ministry of Finance (1997); own calculations.

Between 1960 and 1997, the population of working-age (15–66) has increased by 750,000 persons. While total employment has increased by 460,000 persons, largely concentrated within the public sector, unemployment has over the same period risen by 150,000 persons. In addition to the rise in unemployment, there has been a steep growth in the number of recipients of other public transfer payments – that is, benefits not explicitly related to unemployment; for more details see Søndergaard (Chapter 10 in this volume). This phenomenon is strongly associated with developments in the public pension system. In particular, there has been a sharp rise in the number of recipients of early retirement pension, from 103,000 in 1960 to 272,000 in 1997. This scheme includes persons who for health or social reasons are unable to participate in the labour market. Likewise, the number of recipients of early retirement benefits has increased greatly since the inception of this scheme in 1979. These benefits are available to persons aged 60 and

30

Andersen, Jensen and Risager

above provided they have been members of an unemployment insurance fund for at least 20 years. As a more recent phenomenon, arrangements have been introduced which enable members of the labour force to take paid leave up to one year, either for child-minding or for participation in education and training programmes. On their introduction the leave schemes proved rather popular, as reflected by the fact that about 80,000 persons (more than 2 per cent of the labour force) participated by the end of 1995, but as a result of various tightenings thereafter the number of participants in 1997 had fallen to about 40,000 persons. See Andersen, Appeldorn and Weise (1996) for a detailed study of the leave schemes. A large number of persons also receive cash benefits, available to uninsured unemployed persons from households with an income and wealth below a certain threshold. In principle, cash benefits are granted on the condition that the recipients are available to the labour market. However, the numbers show that less than a third of those receiving cash benefits are actually registered as unemployed. The rest would normally be regarded as permanently excluded from the labour market. The upshot of these developments is that the so-called ‘recipient ratio’ (the number of recipients of public transfers as a percentage of the total number of working-age persons) has risen dramatically over the years, from 6.2 per cent in 1960 to 27.7 per cent in 1995. The good news, however, is that the ratio has actually been falling since 1995, albeit only on a small scale. Against this, it would be relevant to know how many of those recipients actually have the ability to work. Indeed, some critics have interpreted the above numbers as evidence that the ‘true’ rate of unemployment is much higher than the registered rate. For example, Ølgaard (1995) has argued that about 18 per cent of all working-age persons are non-employed but should in principle have the ability to work. While many recipients of public transfers have their status because of disabilities of various kinds, and hence are unable to participate actively in the labour market, it is undoubtedly true that others could, if offered, take a job. From a social viewpoint, it would count as an enormous success if marginalized people could change their status from a passive life on welfare money to a more active and independent life. From a broader economic perspective such a process would not only help in improving government finances, but would also ease the current pressure on the labour market in Denmark where some sectors now appear to be operating at the margin of full capacity utlilization. Less pessimistic conclusions have also been drawn from this evidence. For example, as Table 1.4 shows, it has been noticed that the employment rate (the share of of working-age people in employment) has proved very stable since the early 1960s. Hence, the rise in unemployment is closely related to the rise in the labour force. In particular, the phenomenon must be seen in the light of the significant increase in the labour market participation rate among women.

Problems, Policies and Prospects

31

While this is true, it could be said that a well functioning labour market should be capable of absorbing such an influx to the labour market. It has also been argued that rather than associating the enormous rise in the number of recipients of public transfers with a dramatic increase in de facto unemployment, it simply reflects a change in political priorities in favour of granting public benefits to persons who previously would have been provided for by family or other ‘local’ safety nets, if provided at all (see Callesen, 1995). Hence it is a result of the expansion of the welfare state, as indicated by the dramatic fall in the so-called ‘non-recipient’ ratio in Table 1.4. In other words, a person of working-age who is not working and who is not a recipient of welfare money is today almost a non-existing phenomenon. It is difficult to judge the impact of this development on social welfare. From a social viewpoint, the perhaps most important problem facing today’s society is the number of truly marginalized persons or social outcasts. These individuals are typically concentrated in certain inner-city areas and many of them are second-generation immigrants. The real challenge to the welfare system in the coming years is to bring this marginalization process to a halt. While basically a matter of definition, the question about the ‘true’ number of marginalized individuals has become subject to controversy among different policy-creating communities in Denmark. For example, the so-called Welfare Commission (1995) found that 250,000 persons were truly marginalized in 1995, a number also reported by the Danish National Institute of Social Research. Using an alternative definition, the Ministry of Finance (1995, 1997) reports a much lower number for 1994, namely 104,000, a number projected to fall to 40,000 by 1999. Since it is the rise in public transfer payments which explain why public expenditures have risen over the years, the following question often arises: ‘can we really afford to pay these transfers?’ It is certainly true that the rise in expenditures allocated to public transfers has not only led to higher (marginal) tax rates, but it may also have crowded out expenditures which might otherwise have been allocated to public consumption, including the provision of various services and investments in infrastructure, etc. While high marginal tax rates are well known to have distortionary effects, a continuous fall in the share of expenditures to public service production and infrastructure relative to public transfer payments may in the longer term threaten the legitimacy of the welfare state (see Ingerslev and Ploug, 1996). The point is that many so-called middle-class persons/families may find it increasingly difficult to see their tax money being spent on transfer payments – from which they themselves may derive only little utility – instead of being spent on public services – from which they are likely to derive a lot more utility. Another criticism frequently raised is this: ‘it doesn’t really pay to work any more!’ In general, the incentives offered by the welfare system to

32

Andersen, Jensen and Risager

participate in the labour market are rather mixed. On the one hand, the combination of generous unemployment benefits and relatively long benefit periods should induce people to enter the workforce. Moreover, government subsidization of daycare for children adds to this incentive. On the other hand, the early retirement benefits would typically operate in the opposite direction. Indeed, this scheme has contributed strongly to reducing the effective retirement age from nearly 66 in 1979 (the year when the early retirement benefits were introduced) to about 61 in 1997. A recent study by Pedersen, Smith and Stephensen (1998 – and in Chapter 6 of this volume) shows that 20 per cent of the insured people in work in Denmark have no or only weak economic incentives to remain in employment. Similarly, unemployed persons receiving the maximum UI benefits have only little, if any, economic incentive to accept low-paid jobs, since the benefits typically exceed the minimum wage in the manual labour market (see also section 1.3).

1.8 POPULATION AGEING AND INTERGENERATIONAL REDISTRIBUTION In addition to the pressure on public finances induced by the large number of working-age recipients of public transfers, the projected changes in the age structure of the population are likely to challenge the fiscal system. Indeed, the trends of modest economic growth, high real interest rates, ageing populations and high levels of (existing) public debt have led many economists to question the long term sustainability of fiscal policy as currently practised. A closely related issue is whether, and to what extent, financial burdens are passed onto future generations if current fiscal policies continue without adjustments. Since changing demographics are the major driving force behind the threats to public finances in the future, we start with a brief look at the population projections. Following standard age demarcations we may define the working age population as those between the ages of 20 and 64, the elderly population as those aged 65 and above, and the very old as those aged 80 and above. It is most interesting to look at the development in the ratio of elderly to working-age persons, N65+/N20,64, and the ratio of very old to the general population of elderly, N80+/N65+. While the development in the former ratio provides information about the general ageing process, the latter tells which of either the young or the old group of elderly is growing most rapidly. If both ratios are rising at the same time, we have the phenomenon often referred to as ‘double ageing’. Both ratios are displayed in Figure 1.14, for a projection period ranging from 1997 to 2030.

Problems, Policies and Prospects Figure 1.14

33

Projected changes in demographic structure, 1995–2040

0.40 0.35 0.30 0.25 0.20 0.15 0.10

N65+/N20,64

2039

2037

2035

2033

2031

2029

2027

2025

2023

2021

2019

2017

2015

2013

2011

2009

2007

2005

2003

2001

1999

1997

0.00

1995

0.05

N80+/N65+

Source: Statistics Denmark, own calculations.

The first remarkable observation is the ‘j-shaped’ nature of the N65+/N20,64 trajectory: over the next 10 years or so the overall demographic dependency burden is falling, whereupon it increases rather dramatically. By international comparison, the prospect of a demographic ‘breathing space’ is rather unique. Second, there seems to be a tendency for the two curves to move in different directions, at least over the next 25 years: during the first 10–15 years, the share of the very old is rising, and when general ageing sets in, the share of the very old is falling. From about 2020, however, there will be some ‘double ageing’ in Denmark. From an economic perspective, the apparent absence of double ageing until 2020 may be quite important. Evidence shows, see Socialkommissionen (1993), that there is a strong positive relationship between age of the elderly and public outlays on old-age services. The point is, of course, that very old persons’ need for medical care, home care, etc. is substantially higher than young elderly’s need for those services. To get a first impression of the budgetary significance of population ageing, we may treat government outlays to the elderly as if they constitute a separate government budget. Under a pay-as-you-go financing scheme, the per-period budget constraint says that current government spending on the elderly must be equal to the taxes levied on working-age persons. Recent evidence shows that, given realistic indexation schemes of per capita spending on services and income transfers to the elderly, the taxes needed to cover all old-age expenditures would rise from about 11 per cent of GDP in 1993 to about 15 per cent of GDP in 2030 (see Ministry of Finance, 1995; Jensen and Nielsen, 1995). A more detailed analysis of the relevant issues is offered by Jensen, Hansen and Junge (Chapter 7 in this volume).

34

Andersen, Jensen and Risager

The overall effects of changing demographics may also be studied using the device of generational accounting. Recent work has studied the requirements put on fiscal policy in order to ensure that current and future generations are burdened equally (see Jensen and Raffelhüschen, 1997, 1998). Hardly surprising, the main finding is that in order to equalize the fiscal burdens on newborns and future generations, current generations would have to face tighter fiscal policies. More concretely, the required fiscal tightening is quantifed to a rise of 3.4 per cent in the revenue from all taxes; or a cut of 4.7 per cent in all transfer payments, or a cut in the level of government consumption of almost 10 per cent (see Jensen and Raffelhüschen, 1998). While this might suggest that fiscal policy in Denmark is strongly intergenerationally imbalanced, it has also been demonstrated that if unemployment rates could be brought further down, this could have very positive effects on the generational stance of fiscal policy. A condition for this is of course that the additional taxes paid by current generations are spent in a sensible way – that is, to bring down existing public debt so that future generations will be burdened less. The tax reform act of 1993 also seems to help redressing the generational imbalance, see Lange, Pedersen and Sørensen (Chapter 5 in this volume). The question is what else can be done to temper the effects of population ageing. In view of the breathing space, Denmark seems to have a unique opportunity for improving the fiscal positions over the next decade – that is, to bring down public debt relatively fast. Also in the area of public pensions, some policy options are open. However, since for at least half of today’s pensioners, and for at least a third of pensioners 30 years from now, the public pension benefit will represent the only (or certainly the most important) means of old-age security, it is difficult to think of a significant fall in the replacement rate being possible. Instead, an obvious measure would be to raise the retirement age. In particular, this would involve a reform of the so-called early retirement benefit scheme. At a more general level, it seems that the appropriate policy response to the ageing effect would be to increase the workforce. In that respect, the apparent constancy of the employment rate over the last three decades may have serious implications for the extent to which the ageing problem can be overcome by expanding the workforce. Indeed, if it is a ‘stylized fact’ that the employment rate is virtually decoupled from the growth in the workforce, it would be pointless to induce people to postpone their retirement from the labour market. From the point of view of economic theory, however, it would be very hard to believe in such a peculiar relationship in the medium-to-long run.

Problems, Policies and Prospects 1.9

35

CONCLUDING REMARKS

Over the last 25 years the Danish economy has had difficulties in growing as fast as other EU countries and the United States. While the average growth difference is small, it signals that if this trend persists into the next century, Denmark will not be able to maintain its high position in the world income hierarchy. Moreover, during these years, the number of individuals living on transfer incomes have increased dramatically. Although we interpret both tendencies as signals of structural weaknesses, we are also aware that these developments may reflect that other goals in economic policy have been pursued, such as protecting the environment and/or achieving certain redistributive objectives. The Danish experience shows that economic policy has significant effects on the economy. Thus the upturns in the beginning of the 1980s and 1990s were both intimately linked to policy reforms. Similarly, the recession starting in 1987 was also to a large extent caused by economic policy. Hence, it does matter what governments do. In particular, while the scope for pursuing macroeconomic stabilization policies in traditional sense may be limited, a lot can be done in the area of structural reform. The current upturn in the Danish economy is of great interest since it has to some extent been underpinned by structural reforms, mainly in the labour market. Although the current business cycle situation is favourable, it is not realistic that growth can be maintained without further policy initiatives. Further labour market reforms are essential both for the direct effect on unemployment and the possibility of giving a larger group of the population a genuine chance of entering the labour market, but also for the indirect effects it has on the public budget. It is not realistic to make substantial improvements in public finances without a reduction in the number of individuals on transfers. In a longer-term perspective this will also be an important step in creating leeway to deal with the problems of an ageing population. As part of the reform policy further tax reforms are needed both to strengthen the incentive to work and to save. It is also important to continue the deregulation process to ensure more competition in product markets and to create a more flexible and efficient public sector. For a society aiming at a high and fairly equally distributed living standard, it is essential in a world of intensified international competition that the labour force has a level and distribution of qualifications which makes it possible to attain this target on market terms. An important challenge for the future may thus be to have an efficient and flexible educational system to ensure that qualifications relevant for the labour market are provided.

Andersen, Jensen and Risager

36 Notes 1. 2.

3.

4.

5. 6.

7.

8.

Comments from Per Callesen, Ole Jørgensen, Jan Olesen and Peter Birch Sørensen are gratefully acknowledged. We also thank Christoffer Kok Sørensen for highly effective research assistance. The importance of economic policy for the behaviour of the economy and for welfare in general is an important motivator for this book. Thus, we believe that a better understanding lays the foundation for better policies that may improve the Danish citizens’ economic well-being. Countries participating in the ERM of the EMS fix a parity relative to the ECU. The exchange rate was initially allowed to fluctuate around this parity by ±2.25 per cent, but after the European exchange rate crisis in 1993 this was widened to ±15 per cent, effectively meaning that the bands are now nonbinding. Because the new National Accounts only cover the short period 1988–96, we are forced to use the old figures to get a historical perspective. However, the old figures are also likely to be more reliable the further we move back in time. IT investments were, for instance, of much less importance 10 years ago. Another difference between the two systems is the use of base year; the old system is based on 1980 which is fine in (say) 1986, but probably not in 1993, and the new system therefore uses 1990 as a base year. Finally, there has also been a sectoral redefinition. Notice that this is the case where there is a default risk usually ignored in the intertemporal deterministic approach, but nobody can afford to ignore this in the real world. As to the principles of taxation, Denmark was the first Nordic country to move away from the principle of global income taxation where a single progressive tax schedule is applied to the sum of the taxpayer’s income from all sources toward a system of so-called dual income taxation where the taxation of capital income is separated from the taxation of other sources of income (see Sørensen, 1994). Discussions of public debt are often confused by the fact that several alternative definitions are offered. The debt ratio mentioned here refers to what is called ‘gross government debt’ which includes the government’s outstanding (domestic and foreign) debt in the form of bonds. This is different from the so-called ‘EMU debt’, used by the EU for intercountry comparisons, and which in 1996 constituted 69.9 per cent of GDP. If some specific Danish institutional features are allowed for, including a state-owned pension fund’s holdings of non-government bonds and the state’s deposits in Danmarks Nationalbank, the ratio actually falls below 60 per cent. Further details on recent tax reforms in Denmark are provided by Sørensen (1990, 1994), Matthiessen (1994) and Lange, Pedersen and Sørensen (Chapter 5 in this volume).

References Alesina, A. and G. Tabellini (1989) ‘A positive theory of fiscal deficits and government debt in a democracy’, NBER Working Paper, 2308. Andersen, D., A. Appeldorn and H. Weise (1996) ‘Orlov – evaluering af orlovsordningerne’, Socialforskningsinstituttet, Rapport, 9611. Andersen, T.M. (1990) ‘Stabilization policies towards internal and external balance in the Nordic countries’, Scandinavian Journal of Economics, 92, pp. 177–202.

Problems, Policies and Prospects

37

Andersen, T.M. (1994) ‘Disinflationary stabilization policy: Denmark in the 1980s’, in J. Åkerholm and A. Giovannini (eds), Exchange Rate Policies in the Nordic Countries (Cambridge: Cambridge University Press for the Centre for Economic Policy Research). Andersen, T.M. and O. Risager (1988) ‘Stabilization policies, credibility, and interest rate determination in a small open economy’, European Economic Review, 32, pp. 669–79. Andersen, T.M. and O. Risager (1988) ‘Wage formation in Denmark’, in Chapter 3 L. Calmfors (ed.), Wage Formation and Macroeconomic Policy in the Nordic Countries (Oxford: Oxford University Press). Bergman, M. and M. Hutchison (1996) ‘The “German view”, fiscal consolidation and consumption booms: empirical evidence from Denmark’, EPRU Working Paper Series, 1996–10. Bingley, P., N. Bjørn and N. Westergård-Nielsen (1994) ‘Determination of wage mobility in Denmark in the 1980s’, Working Paper, Centre for Labour Market and Social Research, Aarhus. Callesen, P. (1995) ‘A note on policies to reduce structural unemployment’, Ministry of Finance, mimeo. Callesen, P. (1997) ‘The policy experience of structural reforms in Denmark’, Ministry of Finance, mimeo. Christensen, A.M. (1987) ‘Indkomst, formue og privatforbrug’, Danmarks Nationalbank, mimeo. Cordon, W.M. (1994) Economic Policy, Exchange Rates, and the Intertemporal System, Chapter 6 (Oxford: Oxford University Press). Dalgaard, E. (1996) ‘Kan velfœrdsstaten opretholdes?’, in E. Dalgaard, O. Ingerslev, N. Ploug and B.R. Andersen, Velfœrdsstatens Fremtid (Copenhagen: Handelshøjskolens Forlag). Det Økonomiske Råd (Danish Economic Council) (1994) Danish Economy (June). Det Økonomiske Råd (Danish Economic Council) (1997) Danish Economy (Autumn). Economist, The (1997) Guide to Economic Indicators. Emerson, M. (1988) ‘Regulation and deregulation of the labour market: policy regimes for the recruitment and dismissal of employees in the industrialized countries’, European Economic Review, 32(4), pp. 775–817. Frederiksen, N.K., P.R. Hansen, H. Jacobsen and P.B. Sørensen (1995) ‘Subsidising consumer services: effects on employment, welfare and the informal economy’, Fiscal Studies, 16, pp. 71–93. Førster, M. (1994) ‘Measurement of low incomes and poverty in a perspective of international comparisons’, OECD Labour Market and Social Policy Occasional Papers, 14. Giavazzi, F. and M. Pagano (1990) ‘Can severe fiscal contractions be expansionary? Tales of two small European countries’, in O. Blanchard and S. Fischer (eds), NBER Macroeconomics Annual, pp. 75–123 (Cambridge, Mass: MIT Press). Hagen, K.P., E. Norrman, P.B. Sørensen and G. Teir (1998) ‘The Nordic welfare states and European economic integration’, in P.B. Sørensen (ed.), Tax Policy in the Nordic Countries (London: Macmillan). Hall, R.E. and A. Rabushka (1985) The Flat Tax (Stanford: Hoover Institution Press). Hansen, C.T., L.H. Pedersen and T. Sløk (1996) ‘Danske resultater om sammenhången mellem marginalskat og løn’, Nationaløkonomisk Tidsskrift, 134, pp. 153–74. Ingerslev, O. and N. Ploug (1996) ‘Velfœrdsstatens Udvikling’, in E. Dalgaard, O. Ingerslev, N. Ploug and B.R. Andersen, Velfœsstatens Fremtid (Copenhagen: Handelshøjskolens Forlag).

38

Andersen, Jensen and Risager

Jensen, A.M. and P. Jensen (1996) ‘The impact of labour market training on the duration of unemployment’, Working Paper, Centre for Labour Market and Social Research, Aarhus. Jensen, J. (1998) ‘Carbon abatement policies with assistance to energy intensive industry’, Ministry of Business and Industry, mimeo. Jensen, P., M. Rosenholm and N. Smith (1994) ‘Unemployment and minimum wages – a micro-econometric analysis’, Working Paper, Centre for Labour Market and Social Research, Aarhus. Jensen, S.H. (1996) ‘Recent developments in the Danish economy: problems, policies and prospects’, EPRU Analyses, 13, Economic Policy Research Unit, Copenhagen. Jensen, S.H. and S.B. Nielsen (1995) ‘Population ageing, public debt and sustainable fiscal policy’, Fiscal Studies, 16, pp. 1–20. Jensen, S.H. and B. Raffelhüschen (1997) ‘Generational and gender-specific aspects of the tax and transfer system in Denmark’, Empirical Economics, 22, pp. 615–36. Jensen, S.H. and B. Raffelhüschen (1998) ‘Public debt, welfare reforms, and intergenerational distribution of tax burdens in Denmark’, in A. Auerbach, L. Kotlikoff and F. Leibfritz (eds), Generational Accounting Around the World (Chicago: Chicago University Press). Jensen, S.H., B. Raffelhüschen, P. Jacobsen and M. Junge (1996) ‘Et generationsregnskab for Danmark’, Nationaløkonomisk Tidsskrift, 134, pp. 39–60. Knudsen, M.B., L.H. Pedersen, T.W. Pedersen, P. Stephensen and P. Trier (1997) ‘Modelling structural reform: a dynamic CGE analysis of the Danish Tax Reform Act of 1993’, paper presented at the OECD conference on The Effects and Policy Implications of Structural Adjustments in Small Open Economies (Amsterdam) (23–24 October). Lassen, D.D. and S.B. Nielsen (1996) ‘Skattebyrder i Danmark og andre EU-lande’, Nationaløkonomisk Tidsskrift, 134, pp. 209–22. Lund, L. (1989) ‘Kritik af betalingsbalancemålsæjtningen’, Ekonomisk Debatt, 2, pp. 116–27. Masson, P. and M. Mussa (1995) ‘Long-term tendencies in budget deficits and debt’, in T. Hoenig, (ed.), Budget Deficits and Debt: Issues and Options, Federal Reserve Bank of Kansas City. Matthiessen, L. (1994) ‘Perspektiver på skattereformen’, Nationaløkonomisk Tidsskrift, 132, pp. 36–58. Mendoza, E., A. Razin and L. Tesar (1994) ‘Effective tax rates in macroeconomics. Cross-country estimates of tax rates on factor incomes and consumption’, Journal of Monetary Economics, 34, pp. 297–323. Ministry of Economic Affairs (various issues), Økonomisk Oversigt. Ministry of Finance (1994, 1995), Finansredegørelse. Ministry of Finance (1995) Pensionssystemet og fremtidens forsørgerbyrde (Copenhagen). Ministry of Social Affairs (1994) Den sociale indsats for sindslidende og socialt udstødte (Copenhagen). Nielsen, L.T. (1988) ‘Udlandsgæjldens årsager og konsekvenser’, Økonomi og Politik, 61(2), pp. 32–40. Nielsen, S.B. and J. Søndergaard (1991) ‘Macroeconomic policy and the external constraint: the Danish experience’, in G. Alogoskoufis, L. Papademos and R. Portes (eds), External Constraints on Macroeconomic Policy: The European Experience (Cambridge: Cambridge University Press). OECD (1996) Economic Surveys, Denmark (Paris: OECD). OECD (1997a) ‘Education at a glance’, OECD Indicators, Centre for Educational Research and Innovation (Paris: OECD).

Problems, Policies and Prospects

39

OECD (1997b) ‘Implementing the OECD jobs strategy: lessons from member countries’ experience’ (Paris: OECD). Ølgaard, A. (1995) ‘Borgerløn ad bagdøren’ (Copenhagen: Børsen). Pedersen, P.J. and N. Smith (1996) ‘Indkomstskatter og arbejdsudbud’, Nationalkonomisk Tidsskrift, 134, pp. 1–23. Risager, O. (1993) ‘Labour substitution in Denmark’, Oxford Bulletin of Economics and Statistics, 55, pp. 123–37. Roubini, N. and J. Sachs (1989) ‘Government spending and budget deficits in the industrial countries’, Economic Policy, 11, pp. 100–32. Socialkommissionen (1993) De œldre – en belysning af œldregenerationens forsørgelse (Copenhagen: DBK Bogdistribution). Sørensen, P.B. (1990) Dansk skattepolitik i 1990’erne (Copenhagen: Jurist- og Økonomforbundets Forlag). Sørensen, P.B. (1994) ‘From the global income tax to the dual income tax: recent tax reforms in the Nordic countries’, International Tax and Public Finance, 1 May), pp. 57–79. Sørensen, P.B. (1997) ‘Public finance solutions to the European unemployment problem?’, Economic Policy, 25 (October), pp. 221–65. Tax Reform Committee (1992) (Copenhagen: Danish Government). Thygesen, N. (1996) ‘The prospects for EMU by 1999 and reflections on arrangements for the outsiders’, Swiss Political Science Review, 2, pp. 172–7. Vastrup, C. (1989) ‘Economic policy and adjustment in Denmark’, in M. Monti (ed.), Fiscal Policy, Economic Adjustment and Financial Markets (Washington, DC: IMF). Welfare Commission (1995) (Copenhagen: Danish Government).

2 EMU and the Outsider Nations1 Niels Thygesen 2.1

INTRODUCTION

It has been predictable since the drafting of the Maastricht Treaty in 1991 that not all EU Member States would join the third stage of Economic and Monetary Union (EMU) at the same time. Some might want to preserve a right not to join – an ‘opt-out’ – others were likely to find themselves unable to meet the economic criteria for entry. The Treaty therefore had to deal with the prospect of so-called ‘variable geometry’ in relation to EMU. Section 2.2 reviews how this was achieved. Since all EU Member Stares are, in principle, obliged to regard their macroeconomic policies as a matter of common concern and, in particular, to observe the principles of the so-called Stability and Growth Pact – though with the important proviso that non-participants in EMU cannot be subjected to the sanctions that may ultimately bite (i.e. deposits and fines) – the most obvious question in relation to the outsiders is how exchange rate cooperation will be organized between them and the euro area. Section 2.3 addresses this issue by analyzing critically the framework agreement for an ERM 2 reached in the course of 1996. The agreement in question seems unlikely to be up to the task of preparing for future cooperative relations in the most reassuring way. Section 2.4 therefore discusses a bolder proposal than ERM2 for countries close to convergence – an ‘associate status’ in EMU. A brief section 2.5 offers some conclusions.

2.2

VARIABLE GEOMETRY

What are the institutional, economic and political consequences of the form of variable geometry foreseen in the Treaty? Does it represent a serious hurdle for EMU, especially for those willing, but temporarily unable? The institutional problems of variable geometry are already addressed in the Treaty which explicitly regulates how the ECB (and to some extent ECOFIN) will have to deal with a variable number of participants in the third stage. The initial group of countries will, of course, have more influence than 40

EMU and the Outsider Nations

41

the latecomers on the institutions since the Treaty stipulates that only the countries that participate in the initial group will decide on the composition of the Executive Board (the President, Vice-President and up to four other members) of the ECB.2 Even if it is decided that not all six members are appointed immediately (this possibility is already foreseen in the Treaty), the members of the Executive Board will initially have an important position in the Council of the ECB because experience with Federal central banks such as the Federal Reserve and the Bundesbank shows that the members of the daily management (Board, Direktorium) tend to play a major role within the larger governing bodies (FOMC, Bundesbankrat). The initial group of countries participating in EMU will also take certain decisions concerning the implementation of the common monetary policy and the instruments to be used by the ECB that will have to be accepted by the countries that join later. These are minor issues, however, compared to the economic and political ones. It is tempting to compare the transitional arrangements for EMU to those that have always been made for weaker member countries (and for new members). There is one crucial difference, however. In the legal field, the transitional periods can be defined and limited exclusively in terms of time. In the monetary field, this is not possible, because what counts are the results – i.e. the fulfilment of the convergence criteria – and they cannot be guaranteed by the passage of time. What are the incentives created by the Maastricht provisions? In general, the gains from EMU increase with the number of participants. The old adage ‘the more the merrier’ thus applies to EMU as well. However, once a core group that includes at least France, Germany and some other countries has started EMU, the marginal gains in strictly economic terms from adding ‘peripheral’ countries are modest, because the latter account only for a small share of trade and output of the Union. This is not necessarily true the other way round: for a ‘peripheral’ country, the gain from participating in EMU might be very large indeed. In general, this implies that the nature of EMU will be affected by the composition of the group of countries that takes the first step. The latecomers will have to adapt to what has already been decided (see Pisani-Ferry, 1996). The asymmetry in interests between the core and the rest could create problems. For example, it has been argued (see, among others, de Grauwe, 1997, and Genberg, 1997) that if the initial group perceives that it has a higher preference for price stability than the rest of the EU, it might be tempted to increase the requirements for subsequent participation by the countries that are thought to be weaker. In this view, it would even be possible that the countries that cannot participate in EMU from the start might be excluded indefinitely. It is difficult to see how this could come about in reality, however, since the convergence criteria are defined in

42

Thygesen

objective terms. For the main exception – i.e. the rule on public debt – it is possible to devise a rule of thumb that would eliminate most arbitrariness from this criterion as well (see Gros and Thygesen, 1998, Chapter 8). Furthermore the prudence created by the interpretation of the convergence criteria for the first group will in practice become binding for subsequent entrants as well. A more important reason why variable geometry is likely to create problems is that the countries that are not part of the initial core will fear financial market pressures as EMU goes ahead without them. For example, the reaction of financial markets to the remarks by the German Minister of Finance in October 1995 shows that news about the likelihood of participation in EMU can have important consequences. The most obvious impact was on Italy; the lira depreciated immediately by several percentage points and interest rates rose by more than one percentage point. This and other similar episodes suggest that the uncertainty about the composition of the participants is likely to lead to increased financial market volatility for those countries that would like to participate in EMU and undertake adjustment efforts mainly for that purpose. If markets perceive that the efforts are undertaken not because fiscal adjustment is desirable in its own right, they might conclude that if the interest rate is high the country will not be able to participate in EMU (because the deficit will be high). This attitude might also lead to a slackening of adjustment efforts. However, another equilibrium is also possible: if interest rates are low, the adjustment required to enter EMU is smaller and hence it is more likely that it will actually be undertaken. Italy has appeared at times to exemplify the ‘bad’ equilibrium, whereas Belgium seems to exemplify the ‘good’ equilibrium. All this implies that for some countries financial market uncertainty could persist until the European Council takes its final decision in May 1998. Until then, financial markets could oscillate between the two equilibria causing large swings in exchange rates and interest rates. Countries that are close to fulfilling the criteria but may not be admitted into the first group because they fall a little short will fear a strong reaction from financial markets. Hence, they could plead that a vital national interest is at stake for them and that EMU should therefore be postponed until they can also join. This would require, however, a Treaty revision, which would put the EU in an extremely difficult position. Alternatively they might even refuse to ratify the Amsterdam Treaty agreed in 1997. The main problems created by variable geometry in the monetary area thus come from economic and political mechanisms that are amplified by financial markets. In a nutshell, the problem is that countries that cannot participate in EMU in 1999 might try to delay its start if they are close to satisfying the convergence criteria. In this sense, it is the ‘near periphery’

EMU and the Outsider Nations

43

that creates more of a problem than the ‘far periphery’ – that is, those countries that are clearly some way from satisfying the convergence criteria or the opt-outs.3 Whether or not countries that are excluded, despite nearly fulfilling the criteria, will suffer a confidence crisis depends mainly on two factors: first on their determination to press ahead with convergence efforts so that they can join the near future and, secondly, on the exchange rate regime between the common currency of the core and the countries with a derogation. This issue is taken up in section 2.3.

2.3 WHAT EXCHANGE RATE MECHANISM FOR THE OUTSIDERS? One of the convergence criteria in the Treaty is ‘the observance of the normal fluctuation margins provided for by the exchange-rate mechanism of the European Monetary System, for at least two years, without devaluing against the currency of any other member state’ (Article 109J). Article 109K2 then goes on to say that once EMU has started, there has to be, at least every two years, an examination of the countries with a derogation. A country can join EMU after such an examination only if it fulfils all the convergence criteria. Hence, the Treaty implicitly assumes that the exchange rate mechanism (ERM) of the EMS will continue to exist. This does not necessarily imply, however, that the system has to continue in exactly its present form. Since the circumstances will change radically once Stage III begins, one could even argue that it has to change. This is indeed what has been decided. The 1995 Madrid European Council asked the EMI to provide a blueprint for an ERM 2 which was agreed upon one year later at Dublin. The main elements are: (1)

(2)

(3)

Participation in the new ERM is voluntary (as for the old one). It could hardly be otherwise. But participation in it for two years is likely to remain a condition for EMU membership later, though this provision is challenged by the United Kingdom (and Sweden). The new exchange rate mechanism operates on the hub-and-spoke system: it is to be based on central rates against the euro, not on a grid of parities, as in the old one. There will be ‘relatively wide’ margins of fluctuation around the central euro rates; the Amsterdam European Council has since confirmed that margins will be ± 15 per cent as in the ERM, but individual ad hoc arrangements to limit the fluctuation margins are possible for countries with good convergence performance.

44 (4)

(5)

Thygesen In principle intervention is unlimited at the margins, but both sides (in practice, the ECB) can refrain from intervening if this would threaten price stability. Adjustment of the central rates should be done in a timely fashion. Both sides, including the ECB, will have the right to initiate a (confidential) procedure to realign an outsider currency.

We have already emphasized that countries which cannot participate in the first wave should make clear that they will continue and perhaps even increase their convergence efforts to be able to join EMU at the next possible date. This would help to reduce the potential financial market instability, but it might not be sufficient to rule out speculative attacks. It was difficult to evaluate the blueprint for the ERM 2 when it appeared because what kind of system will be desirable (and feasible) in 1999 depended on the number of countries likely to remain outside initially and whether or not they had a credible perspective of joining soon. Consider the following two extreme scenarios which both appeared possible in 1996 when ERM 2 was drafted: (1)

(2)

By early 1998 11 countries have made enough progress to participate in EMU and in addition the United Kingdom, Sweden and Denmark elect to ‘opt in’. Only Greece still has an excessive deficit, but she too has made so much progress that she will probably be able to join a couple of years later. Only France, Germany and four to six other small countries start the third stage in 1999. The United Kingdom, Sweden and Denmark confirm their intentions to opt out and convergence in the rest of the Union has been slower than planned so that the remaining countries will need some years before they can join EMU.

It is apparent that the nature of the exchange rate system that will be needed will be radically different, depending on which of these two scenarios is closer to reality. Under the first scenario – which became the more realistic one as to initial economic readiness, but not regarding the opt-outs – there is little need for a fully-fledged exchange rate system, since exchange rates are likely to be stable anyway. By contrast, under the second scenario, there would be a real need for some system to limit exchange rate fluctuations. However, a few simple considerations show it is unlikely under any circumstance that it will be possible to recreate the old EMS. The main reason is the difference in size, which has two implications: asymmetry and bilateralism (or, rather, ‘hub and spokes’): (1)

Asymmetry: The core (even assuming it contains only Germany, France and some smaller countries) will be several times as large in terms of GDP and trade as the set of countries that are outside (excluding the

EMU and the Outsider Nations

(2)

45

United Kingdom which anyway would not be interested). 4 The difference would be even larger in terms of the size of financial markets and the reputation for stability. A formally symmetric system like the EMS becomes impossible under these circumstances. In the pre-1992 system Germany played a central role, although in terms of trade and GDP, she never accounted for more than 45 per cent of the area covered by the ERM. ‘Hub and spokes’: The trade of the periphery with the core that will represent the ‘hub’ of the system is several times larger than the trade among the ‘spokes’ (that is, the likely outsiders). Hence the new system will not be multilateral. It will effectively be bilateral in the sense that it regulates the bilateral relationship between the ECB and each national central bank of the outsiders.

This does not imply that each outsider should have a different agreement. On the contrary, the same type of arrangement could be offered to all outsiders. However, even if all outsiders are willing to sign up to the same system it will de facto not work in the same way for each participant. The case of the United Kingdom does present a particular problem since the British government decided to opt out and also refused to enter into an agreement concerning the exchange rate of sterling, an example that might be followed by Sweden. The other opt-out country, Denmark, has already indicated that it will seek a narrow-margins arrangements with the ECB. Hence, Denmark and the remaining non-participant (Greece) are likely to be willing to cooperate with the ECB to stabilize exchange rates. It is sometimes argued that countries that remain outside will be tempted to resort to competitive devaluations. But this fear, which is based on recent experience, seems to be unfounded. First of all, exchange rates are difficult to control since they evolve with market expectations about future policy. Hence, it will be difficult for any government (or national central bank) to ‘engineer’ a competitive depreciation without running a serious risk of starting a cycle of inflationary expectations and high interest rates that is difficult to control. Moreover even large exchange rate changes tend to have only a limited impact on unemployment and the trade balance. Finally, since the criterion on exchange rate stability will continue to apply, any country that is tempted by this policy would know that the price for a ‘beggar-thy-neighbour’ policy of this type would be a further delay in EMU membership. Over most of 1996 the EMI prepared a framework arrangement for ERM 2 which was accepted first by ECOFIN and later by the European Councils in Dublin and Amsterdam. It was a difficult compromise and it will remain incomplete until it can be finalized by the ECB, in the light of the considerations outlined, including the number of non-participants.

46

Thygesen

How should one evaluate the compromise reached on ERM 2? It might seem ungenerous to criticize the proposed solution to an issue that seemed extremely difficult at the outset. When the discussion of an arrangement for the ‘outs’ started in 1995, pessimism prevailed. Given the strongly divergent views of exchange rate constellations at the time, accentuated by allegations of competitive devaluations, aversion to intervention commitments for the ECB and divergence of interests among thc prospective outsiders, the odds on agreeing on a workable ERM 2 seemed highly unfavourable. It is quite an achievement that the EMI was in the end able to come up with an agreed report, even though on closer examination some important provisions remain more open-ended then is desirable. When reading the text issued by the EMI in October 1996 and annexed to the Dublin conclusions one is, however, struck by the impression that it appears to to have been drafted not so much with the more immediate problems of what to do with the non-participants in Stage III as EMU starts on 1 January 1999 as with the longer-term problems in an EU with several new Member States from Central and Eastern Europe some time over the coming decade. Another interpretation is that officials were concerned about winning the last war – that is, they wanted to avoid at all cost a repetition of the problems of 1992–3 and 1995, not recognizing that circumstances will be totally different from 1999 onwards. Not only is participation in ERM 2 to be voluntary – as was already admitted above, that may have been unavoidable – but the whole framework is not tailored for countries that have long been actively involved in convergence efforts under the Maastricht Treaty and have subscribed to the Stability Pact. Some of those initially left outside, maybe all except Greece, might have missed entry narrowly with an economic performance only marginally inferior at the photo finish to those of the entrants. To them, some of the provisions must seem less than reassuring. This will also apply to the two countries which presently express a preference for remaining outside ERM 2 (Sweden and the United Kingdom), providing them with an additional argument for doing so. It certainly applies to Denmark, which is openly seeking a tighter arrangement despite its opt-out from monetary union itself. Two provisions in the framework point toward this interpretation. The ECB commitment to intervention is to be conditional and the ECB reserves – indeed emphasizes – its right to suggest realignments of the central rates for outsider currencies. An important substantive point in any future arrangement between an outsider and the ECB is the extent to which interventions will be, in principle, unlimited and unconditional at the margins. It can be argued that focusing mainly on mandatory interventions at the margins is misleading, as long as the margins are anything like as wide as in the present EMS (see below). A currency that is driven to its wide margins will no doubt need to be defended

EMU and the Outsider Nations

47

strongly by raising domestic short-term interest rates – or a realignment will have to be undertaken. Intramarginal interventions will then become the important ones, but unfortunately little is said to reflect the new situation relative to present arrangements which are to continue in the form agreed at Basle–Nyborg in 1987. This Agreement implies that unilateral intramarginal interventions by an outsider in euro will be subject to prior approval by the ECB above certain thresholds and that access to the Very Short-Term Financing Facility (VSTFF) for intramarginal interventions will continue to be subject to the ceilings agreed upon nearly 12 years ago. However, these ceilings no longer seem adequate in tomorrow’s climate of very high capital mobility, which did not exist in 1987. It is important not to restrain the freedom of action of the outside currencies in defending their central rates; in any case, the short duration of the credit facilities constitutes a deterrent against excessive reliance on them. An overhaul of the Basle–Nyborg Agreement seems overdue. Maintaining the principle of mandatory interventions at the wide margins is more important than it may seem, because margins may be narrowed when EMU starts. Countries missing entry in 1998 may in the end seek narrow margins, as part of an understanding that they will enter soon – even though the prospective ‘pre-ins’ have not so far asked for that. They clearly want to give prime emphasis to their candidacy for the first group rather than to give the impression that they are actively seeking a reinforcement of the safety-net arrangements available to outsiders. So although only Denmark has so far shown an interest in a narrow-margins arrangement of the pre-1993 EMS type, others may still do so in 1998 or later. Fortunately the possibility of setting up stronger links with outsiders than the presently envisaged continuation of the lax EMS, with some limited modification to reflect its future euro-centred nature, has been retained; they could take the form either of publicly announced narrower margins or of informal target ranges inside the normal margins, provided the out-country has achieved a sufficiently high degree of convergence. Another potentially worrisome feature of the framework is that all parties to the agreement, including the ECB, would have the right to initiate a confidential procedure aimed at reconsidering central rates (EMI, 1997, p. 69). In other words, flexibility in the form of wide margins was not considered enough; realignments are openly envisaged. Jointly, these provisions amount to a revival of the so-called ‘Emmingerletter’ of 1978 summarizing the understanding between the German Federal Government and the Bundesbank that otherwise mandatory interventions might be suspended and a realignment initiated if interventions were perceived to threaten price stability in Germany. This understanding, which had almost been allowed to lapse into oblivion, was finally invoked in September 1992 when interventions in support of the then weak currencies

48

Thygesen

of the EMS, notably the lira, seemed to throw Germany’s capacity to stick to its chosen monetary target into doubt. In retrospect, the problem looks less serious than was claimed at the time – and still today – by German officials (see Gros and Thygesen, 1998, Chapter 3). If the problems turned out to be manageable in the situations of extreme tension in 1992–3, they are more likely to be manageable also for the ECB, which will be much larger relative to any outsider currency than was the Bundesbank. A greater readiness to contemplate the constructive role of interventions also in periods of considerable tension would have seemed appropriate, both vis-à-vis the Southern European countries likely to be only in the ERM 2 for a short transitional period (if at all) and for the two reluctant outsiders, Sweden and the United Kingdom, who need to be persuaded that the new system does offer a more reassuring option than individual floating. (That they have doubts on this point is understandable in view of their painful experience of futile individual defence of their currencies in 1992). In short, the ERM 2 framework does not appear to be helpful and confidence-inspiring for countries that for one reason or the other are unable to join the first EMU group. If the participants in the euro area are as keen as they proclaim to be to retain a close grip on the exchange rate relations with the initial outsiders, the ECB will have to come up with some improvements to the outline prepared by the EMI – or, at least, with a bold interpretation of the possible tighter linkages foreseen in the framework. Particularly for a pre-in country which might have only just missed entry into monetary union, a radical approach would be to offer linkage to the euro with narrow, or even zero, margins while still leaving the responsibility for defending the currency to the out country. The latter would give up all monetary autonomy in return for this link, much as happens for a currency board which has linked the value of its currency to a major international currency and the issue of it to fluctuations in its reserve holdings of the latter (the euro). A concrete proposal is developed in section 2.4.

2.4

A CONCRETE PROPOSAL

If one or more countries are to be excluded from the start of EMU, despite a desire to participate, is there anything that can be done to limit the damage? For Italy, in particular, with high public debt, a strong reaction by financial markets could make the fiscal adjustment even more difficult through a higher interest burden. The fear in financial markets (and of many politicians) is that the constitution of the core group is not only a temporary measure and that it will be more difficult to join later. This is certainly not the intention of the Treaty. But what if initial exclusion makes convergence much more difficult, even if there is some exchange rate mechanism for the outsiders?

EMU and the Outsider Nations

49

One solution could be to grant an associate status in EMU. The country concerned could be invited to come under the EMU umbrella to benefit from lower interest rates, but it would not participate in the management of EMU until it had converged in fiscal terms as well. This arrangement could be achieved technically by a unilateral declaration that the country concerned accepted all the obligations arising from membership in EMU,5 but it would be preferable to have a formal agreement between the ECB and the country concerned, with the political support of the ECOFIN Council because this would make it much more credible with the markets. The agreement would specify that the national central bank agreed to follow the monetary policy of the ECB as if it were a full member of the EMU. At the same time, however, it would be clear that for purposes of decision making in the ECB (and ECOFIN), the country would continue to be treated as having a derogation. In essence, the country would give up its national monetary policy and replace it with that of the ECB. More precisely, this means that the exchange rate would be irrevocably fixed, the payments systems would be unified, actions by the ECB would have direct effect in the country concerned and the decisions of the ECB would have to be applied by the national central bank, a portion of whose foreign exchange reserves would be pooled in the ESCB like those of the full participants. Moreover, the country concerned would be subject to the full excessive deficit procedure.6 All this would be officially acknowledged by the Union in conjunction with a convergence programme outlining how the country would, with the help of lower interest payments, satisfy the fiscal criteria by a certain deadline.7 Acknowledgement by both the Union and the ECB would make this arrangement credible and would ensure that market interest rates in the country concerned converge quickly to the level in the core.8 This sort of associate status in EMU will deliver the benefits in terms of lower interest rates, however, only if it is credible. Credibility should come already from the endorsement given by the ECB, but it would be immensely strengthened if markets see that the exchange rate can be defended under any circumstance. This should be the case if one views the proposed arrangement as a ‘Currency Board’. A Currency Board is credible if the national central bank possesses adequate foreign reserves to guarantee conversion of all of its liabilities (the monetary base) into the common currency of the core. Would this be the case? Most of the central banks that might be candidates for this status do indeed have enough reserves to make the currency board approach credible (see the Appendix, p. 53). All the candidates for associate membership in EMU could thus be confident of operating a tight link with the core even under a worst-case scenario. If the markets know that there is no chance that they can force a break in the link to the common currency of the core, they will regard it as

50

Thygesen

credible. Any country that chooses this approach could increase credibility even further by passing a law that obliges the national central bank to defend the exchange rate through unsterilized interventions. Moreover, it is likely that if there were really a totally unjustified speculative attack, the ECB would help the country concerned. If the underlying fundamentals are sound, credibility should thus not be a problem. If the fundamentals are not sound, the ECB would not in any event recommend this approach and no country would (or should) dare to try it against its advice. Technical viability is of course only a necessary, and not a sufficient, condition for the stability of a currency board arrangement. The reason why central banks usually sterilize their interventions is that the large increases in interest rates that might result if they did not are unacceptable, either because of their macroeconomic consequences (the United Kingdom in 1992), or because they could endanger the stability of the banking systems (Sweden also in 1992). Central banks and governments will have to convince markets that they will be willing to accept interest rate increases if the market tests their resolve. The experience of Belgium, which faced a test of its commitment in 1993, shows that it is possible to present this case persuasively. Of course, associate membership in EMU can not constitute a magic wand that eliminates all problems. But it could represent an option for countries that are close to qualifying for full membership in 1998 or on future occasions. Irrevocably fixing the exchange rate with the prospect of full participation in EMU after a couple of years is fundamentally different from fixing exchange rates in the environment of the 1980s (with high inflation and variable exchange rates) or during the early 1990s (when some currencies were clearly overvalued). The argument that experience has shown that fixing the exchange rate is impossible because financial markets could attack any exchange rate should thus not be overrated. There will be little reason for financial markets to attack an exchange rate if inflation is low, deficits are close to 3 per cent of GDP (possibly even below), debt ratios are declining and the external current account indicates a good competitive position. The political viability of this idea depends upon its presentation. If it is characterized as a means of circumventing the convergence criteria, which is not the purpose of this proposal, the core will veto it. The scheme merely aims to help the peripheral countries bridge the gap that separates them from the core without softening the convergence criteria for full participation in EMU. Only countries that have done their basic homework could be encouraged to pursue this approach. In order to qualify, the deficit when recalculated at German interest rates should at a minimum fall below 3 per cent of GDP. This guideline would also ensure that the debt ratio would be declining once

EMU and the Outsider Nations

51

the lower interest rates took effect. It bears reiterating that the country in question would have a derogation in the decision making organs of the ECB, which would underline that the convergence criteria had not been suspended. In a sense, Belgium and Austria have already in the past successfully opted for this course by pegging unilaterally to the D-mark. Could others follow their example? The real test of this approach will come in the case of a large country, for example Italy. Large countries have always experienced more problems in acquiring stability through the exchange rate. But in this case, they would not attempt to use the exchange rate to force adjustment in prices or wages. Their problem is that they are stuck in a low credibility–high interest rate trap out of which it is difficult to escape without outside help. The decision to participate in EMU, even if essentially on a unilateral basis, would constitute one large step away from this trap. Of course, this can only facilitate adjustment. It is in no way a substitute for the resolute fiscal action that has to be taken anyway.

2.5

CONCLUSIONS

This chapter has argued that, given the fact that the original ambition, expressed for example in the Delors Report, that all EU Member States would join EMU from the start, has turned out to be impossible to achieve, the Treaty has dealt in a realistic way with the issue of variable geometry in European economic integration. Furthermore, in view of the diversity of the prospective outsiders, the arrangements for them have to embody some flexibility. But the recent evolution in the prospects for participation, which may in the end confine the group of outsiders to those countries which are likely to opt out (the United Kingdom, Denmark, Sweden) plus Greece and – maybe – Italy suggests that the approach to arrangements with the outsiders should now become more targeted. The framework agreement on ERM2 is a start, but it may turn out to be an empty shell: the United Kingdom and Sweden appear to want to invoke the voluntary nature of participation to remain outside ERM 2, while Denmark has indicated its preference for a much tighter arrangement. If Italy were not to join initially for economic reasons a firmer arrangement for the lira would have to be sought to minimize the costs of exclusion and facilitate subsequent entry. The chapter suggests a form of associate status in this case. On closer examination, the proposed ERM 2 may be suitable only for Greece and for the new Member States from Central and Eastern Europe which are expected to join the EU early in the next century. The ECB, the ECOFIN Council and the European Council will therefore have important matters on the agenda also after the contours of the first group of participants emerges in May

52

Thygesen

1998. In their own interest the EMU participants will have to devote further attention to relations with outsiders within the EU. So will, obviously, the outsiders themselves. This chapter has not looked primarily at the choice facing them from their own point of view. Some who remain outside will have a choice between joining ERM 2 and continuing with a purely domestic stabilization objective – that is, an inflation or a price level target – and they will exercise this choice on the basis of their particular historical experience and their evaluation of the risks of speculative attacks in an ERM 2 caused either by monetary shocks in EMU or divergence in their own performance, as well as of their own likely future exclusion from EMU by remaining outside ERM 2. It is in the interest of the EMU participants to encourage the outsiders to enter ERM 2 by making the latter a more genuinely cooperative arrangement than the present outline and the historical experience with the present system suggest. In this context it is encouraging that several of the prospective outsiders – the United Kingdom, Sweden and Denmark – have taken the main principle of the Stability and Growth Pact more literally to heart than have most of the EMU candidates by all aiming for balance – or a small surplus – in their public finances on average over the business cycle. This will help to assure that their convergence is sustained without the formal underpinning of participation in EMU itself.

Appendix: Technical Conditions for the Viability of a Currency Board Technically a currency board is viable if the central bank has enough reserves to exchange all its liabilities (the monetary base) into foreign currency. This is the case if the foreign exchange reserves are larger than the monetary base. Column (3) in Table 2A.1 below) shows that the ratio of foreign assets to the monetary base is above, or close to, 1 for all countries except Italy. If one takes into account that, even in a worst-case scenario, few people will exchange their holdings of cash, it would be sufficient for a national central bank to have enough foreign assets to cover the remainder of the monetary base (that is, required reserves). Column (4) shows that this is the case by a large margin for all the countries considered below, with the exception of Italy and Finland. Even for these two countries, however, the shortfall is rather limited since the existing foreign exchange reserves already cover 100–110 per cent of the reserves held by banks with the central bank. In the Italian case, this result is due to the unusually large reserve requirements imposed on banks in Italy. The reserve ratios in Italy are at present much higher than in the rest of the EU and have to be lowered anyway if Italy wants to participate in EMU. If reserve requirements were halved in Italy, still leaving them much above the EU average, the

Table 2A.1

Greece (bill. Drachma) Italy (bill. Lira) Portugal (bill. Escudo) Spain (bill. Peseta) Sweden (bill. Kroner)

Reserves and monetary base

(1) Base money

(2) Foreign assets

2500.1

Ratios based on: Monetary base (3) = (2)/(1)

Required reserves (4) = (2)/((1) – cash in circulation)

2975.5

1.2

4.6

150.0 3001.3

86.6 3706.7

0.6 1.2

1.0 1.6

7.800 163.8

6.152 175.7

0.8 1.1

4.8 1.8

Source: International Monetary Fund, International Financial Statistics.

53

54

Thygesen

international reserves of the Banca d’Italia would be much larger than the mobile part of the monetary base. (Some margin is needed since part, say 20–25 per cent, of the foreign reserves will be pooled in the ECB.) Hence, even Banca d’Italia could defend the exchange rate if it previously lowered required reserve ratios towards the EU average – provided, of course, that it did not engage in sterilization, as so often in the past.

Notes 1.

2. 3.

4. 5.

6.

This chapter draws on Gros and Thygesen (1998), and the author wants to record his appreciation of a number of years of cooperation with Daniel Gros. Comments from my two discussants, Arne Jon Isachsen and Jesper Jespersen are acknowledged, even though I have not followed their advice to broaden the chapter with an analysis of the likely stability of EMU. Nor have I systematically updated the chapter to take into account the more recent (March 1998) developments surrounding participation in EMU; the chapter stands much as delivered in June 1997. Research at EPRU has been financed by a grant from the Danish National Research Council. See article 109k5. In principle, all countries signed up to the conclusions of the Madrid Council of December 1995. But important politicians in some countries stated in public that postponement should be considered. It would, however, be dangerous to yield to a demand for postponement because there will be differences in the time required by the ‘near periphery’ to fulfil the convergence criteria. Establishing the principle that everybody should wait for the ones that are close to catching up might set in motion a long chain of countries that were formerly far from meeting them and then come close to being able to participate, as others graduate from being close to actually fulfilling the convergence criteria. In the meantime, all candidates would have to bear the cost of the higher risk premia that will persist until EMU really comes into existence. Moreover, it is important to establish the principle that no single country should impede the others from going ahead. A Protocol to the Maastricht Treaty was designed to achieve this. The combined GDP of France, Germany, the Netherlands and Finland, plus Ireland and Luxembourg is about 3,000 bn ecu, compared to 800 bn ecu for Portugal, Italy, the United Kingdom, Greece, Belgium, Sweden and Denmark. The government would have to declare that it accepted the obligations arising from Articles 104c(9) and (11) (excessive deficits procedure); 105(1), (2), (3) and (5) (monetary policy); 105a (notes and coins); and 108a (empowering the ESCB). The national central bank would also accept the obligations resulting from the ESCB statutes (Articles 3, 9, 12.1, 14.3, 16, 18, 19, 20, 22, 23, 30–34 and 52). However, the restrictions specified in paragraphs 3–6 of article 43 of the ESCB statutes would apply. In addition, the country concerned would not participate in decisions under Articles 109 (exchange rate system with rest of world) and 109a(2)(b) (membership of the executive board of the ECB). Unilateral restricted participation would in effect be a sort of Anschluss much like the period when the D-mark was introduced in the territory of the former GDR. This might not be a very enticing example. In the case of the EU, however,

EMU and the Outsider Nations

7. 8.

55

convergence will take place before, not after, monetary unification. Hence, the economic difficulties that followed German unification should not occur. Acknowledgement by the Union should not necessarily imply that the ECB, when setting its monetary policy, would take into account economic conditions in the country that participated in the same way as those of ‘regular’ participants. The actual debt service burden would decline only gradually, however, until the outstanding high interest debt is retired. Depending on the maturity structure, this might take two years.

References De Grauwe, P. (1997) ‘Exchange-rate arrangements between the ins and the outs’, CEPR Discussion Paper, 1640 (London: Centre for Economic Policy Research) (May). European Monetary Institute (EMI) (1997) The Single Monetary Policy in Stage Three (Frankfurt: EMI) (January). Genberg, H. (1997) ‘Monetary and exchange-rate policy outside a European Monetary Union’, Swedish Economic Policy Review, 4, pp. 155–88. Gros, D. (1996) ‘Towards Economic and Monetary Union: problems and prospects’, CEPS Paper, 65 (Brussels: Centre for European Policy Studies) (January). Gros, D. and N. Thygesen (1998) European Monetary Integration: From the European Monetary System to Economic and Monetary Union (London and New York: Addison Wesley Longman). Pisani-Ferry, J. (1996) ‘Variable Geometry’ in Europe (Paris: CEPII). Thygesen, N. (1996a) ‘The prospects for EMU by 1999 – and reflections on arrangements for the outsiders’, paper presented at the Centre for Economic Policy Research/Banca Nazionale del Lavoro Conference (Rome) (26 February). Thygesen, N. (1996b) ‘Interpreting the Exchange-rate Criterion’, in Peter B. Kenen (ed.), ‘Making EMU happen – Problems and Proposals: A Symposium’, Princeton Essays in International Finance, 199 (Princeton: Princeton University) (August).

Comment Arne Jon Isachsen 1

INTRODUCTION

In the Nordic countries Professor Niels Thygesen is ‘Mr Euro’. Not only has he studied the issue of monetary union in Europe, as a member of the Delors Committee he has also contributed directly to the drafting of the process of creating one. The rest of us, his fellow Nordic economists, can only express gratitude to Niels for his continued interests in and analysis of developments in European monetary affairs. In his Chapter 2, after having argued that Italy may find a Currency Board Arrangement (CBA) within ERM 2 attractive, Professor Thygesen submits that: On closer examination, the proposed ERM 2 may be suitable only for Greece and for the new Member States from Central and Eastern Europe which are expected to join the EU early next century. Professor Robert Mundell, who provided us with the concept of Optimal Currency Area (OCA), goes even further, arguing that Greece may also join EMU in the first wave. Mundell also reminds us that: Before the middle of 1996, few economists would have given Portugal, Spain and Italy much chance for entering the EMU in the first group (Mundell, 1997, p. 215). Clearly, the forecasting of developments in European monetary affairs is a risky business. At present (December 1997) it seems that any remaining uncertainties about the timely launching of the EMU have more to do with France and Germany than with Spain and Italy. In what follows we assume that the European monetary union gets on the air on schedule, and that it turns out to be reasonably successful.1

2

A SUGGESTED TAXONOMY

For a starting point, when studying the process of monetary integration in Europe, each of the 15 EU countries could be allocated to its proper cell in Table C2.1.

Table C2.1

Would like to join Would not like

To be or not to be a member of EMU Is able to join

Is unable to join

1 3

2 4

56

Comment

57

Countries in cell 1 are the ‘ins’; the other three cells are inhabited by ‘outcountries’. As already alluded to, since mid-1996 several countries have moved out of cell 2 and into cell 1 (Italy, Spain and Portugal). The only remaining country in cell 2 seems to be Greece. With close to a blocking minority of countries in cell 2, the launching of the EMU project would have been more difficult. Cell 4 is probably empty, although two years ago, with public finances out of control, Sweden arguably belonged here. Cell 3, those who are able to join but will refrain from doing so, is occupied by Denmark and the United Kingdom, and more recently by Sweden, although it never secured a formal opt-out clause.2 Summing up: Cell 1 contains 11 countries. Of the remaining four, Greece is in cell 2, and Sweden, the United Kingdom and Denmark in cell 3. Of the latter three it seems reasonable to assume that Sweden and the United Kingdom will continue with inflation targeting for the next few years and thus not be interested in the fixing of exchange rates through ERM 2. Thus, in the short term Professor Thygesen’s discussion of how ERM 2 should be organized is relevant only for Greece and Denmark. Prospective new EU members from Central and Eastern Europe, however, may position themselves in light of the rules governing ERM 2. Estonia is a case in point.

3

ERM 2 – TOO FLEXIBLE AN ARRANGEMENT?

Today’s ERM is based on a parity grid, meaning that the value of each currency must not deviate by more than 15 per cent from its central rate against any other currency in the mechanism. This implies that the room for fluctuations between any pair of currencies is much more limited. ERM2 maintains fluctuation margins of 15 per cent. However, as each currency in ERM2 will be pegged to the euro, between any pair of ‘outs’ in ERM2, much larger fluctuations in exchange rates are feasible. To illustrate, assume two ERM2 countries with currencies A and B, respectively, and with central rates on par with the euro. Now, letting currency A in period 1 appreciate to its allowed maximum and currency B likewise depreciate, only to reverse the situation in period 2, the following picture emerges: Central rates: At t = 1: At t = 2:

100 A = 100 euro = 100 B 85 A = 100 euro = 115 B 115 A = 100 euro = 85 B

From period 1 to period 2 the price of 100 B, in terms of A, increases from 74 A to 135 A – that is, a depreciation of currency A against currency B of 82 per cent. A professor in linguistics, I presume, would object to calling such an arrangement a fixed peg system. The scepticism in Sweden and in the United Kingdom to the requirement of participating in ERM2 at least two years before joining EMU is well founded. However, joining an exchange rate mechanism with such wide bands makes the continuation of inflation targeting unproblematic. With the option of entering into narrow-margins arrangements with the ECB, the concept of a fixed peg can still be retained. Denmark may well consider such an arrangement, having successfully adhered to a hard currency policy in the last 15 years. The ultimate peg, however, would be, as suggested by Professor Thygesen, a Currency Board Arrangement (CBA).

58 4

Isachsen A CURRENCY BOARD ARRANGEMENT MAY SUIT GREECE

Professor Thygesen argues that a formal agreement between an out country and the ECB, in which the out country concerned gives up its national monetary policy and replaces it with that of the ECB, is worth considering. Such an arrangement ‘would ensure that market interest rates in the country concerned converged quickly to the level in the core’ (p. 49). However, he adds that the benefit of such a CBA will materialize only if it is credible. Credibility, in turn, means adequacy of foreign reserves – that is, enough to cover the monetary base. In an Appendix Professor Thygesen reveals that in Greece, foreign reserves exceed the monetary base by 20 per cent. However, Frankel (1996) maintains that to deal with potential banking crises, enough reserves to back the entire domestic money supply may be required. Frankel is probably asking for too much. During the banking crisis in Norway in the early 1990s, the government had to spend 25 billion kroner (NOK) to shore up failing banks. At the time base money amounted to 40 billion NOK – that is, public support to the banking system came to more than 60 per cent of the monetary base. With reserves measured in NOK of about 140 billion, rescuing the banks had only minor effects on the exchange rate.3 With a CBA for the drachma against the euro, a similar crisis situation could have been difficult to contain without more ample supply of foreign exchange. Professor Thygesen, however, claims that Greece has enough reserves to make the CBA approach credible. If ‘credibility’ is taken to mean that the interest rate on the drachma ‘would converge quickly to the level of the core’, he might perhaps be a little too optimistic. In a recent paper from the IMF it is argued that a large outstanding stock of shortterm government debt, even if the current fiscal deficit is sustainable, may make CBAs ‘vulnerable to bond-led speculative attacks’ (Balino and Enoch, 1997, p. 15). With government debt of 110 per cent of GDP in Greece one should not completely rule out such an unpleasant possibility. Obviously, the viability of a CBA for outs would improve with increased lines of credit from the ECB. As noted by Professor Thygesen, an overhaul of the Basle–Nyborg Agreement seems overdue. Estonia established a CBA in June 1992, and has been able to hold on to this arrangement in spite of a severe banking crisis the following year.4 After five years of keeping the Estonian kroon steady against the German mark, at 8:1, the interest rate differential is still coming down. During the first three quarters of 1997 the 3-month interbank rate in Estonia fell by one percentage point, from 8 to 7 per cent. In this period, the comparable German interest rate hovered around 3.3 per cent. Now, it seems reasonable to assume that Professor Thygesen’s idea of a CBA for Greece, based on a formal agreement with the ECB, would be more credible than Estonia’s unilaterally fixed peg. By way of illustration, let a Greek CBA bring the interest rate on new government debt down to 6 per cent, that is, a reduction of four percentage points. With outstanding debt of 110 per cent of GDP, totally refinanced in the course of a good year, government interest payments would amount to about 6.6 per cent of GDP. Maintaining a surplus on the primary balance of 4.7 per cent of GDP (as forecast for 1997), Greece would then meet the 3 per cent deficit criterion. Reduced interest payments on government bills and bonds mean less transfer of resources to holders of these assets. For high-interest rate countries this is probably the greatest short-term advantage of joining the EMU. Through a CBA also Greece could probably reap some such benefit. New member countries from Central and Eastern Europe will imply a reduction in net EU transfers to the ‘Club-Med’ countries. However, in terms of lower interest

Comment

59

rates on government debt, this latter group of countries stands to gain the most from the EMU. From a political point of view ‘deepening’ as a prerequiste for ‘widening’ then becomes easier to understand.

5

BUT FOR DENMARK A CBA DOES NOT SEEM APPROPRIATE

Currently Denmark is one of the five EU countries not subject to surveillance under the excessive-deficit procedure applying under the second stage (OECD, 1997, p. 32). Economically fit for the EMU, Denmark is not politically. Joining the EMU requires a referendum, and with the ‘No’ to Maastricht of 2 June 1992 fresh in mind, the government is not likely to put the EMU issue on the ballot in this century. A CBA, which must be considered as a prelude to full membership of the EMU, would not go well down with Danish voters. A more realistic solution is membership of ERM 2. As indicated by Professor Thygesen the option of narrow-margins may suit Denmark well. When the rationale for having a separate currency is to keep the option of later devaluating it, a positive risk premium on the interest rate seems appropriate. However, Denmark does not have economic incentives to abandon her hard currency policy. Thus, the argument that staying outside the EMU may ‘entail a lasting premium to long-term interest rates’ (OECD, 1997, p. 36) may not be valid. If the EMU turns out to be ‘softer’ on inflation than envisaged by most experts, over time the Danish krone may be increasingly appreciated by wealthy owners, thus commanding a negative risk premium versus the euro. Von Hagen (1997), for one, would not be surprised if a large EMU also becomes a soft one. The concept of deepening the EU is not a particularly popular one in Denmark. A primary cause for Denmark to join the EEC in 1972 was the modest one of securing higher prices for agricultural export. However, the option of remaining outside the EMU as, say, Sweden and the United Kingdom join, will be less tempting. More generally, staying put in cell 3 in our Table C2.1 may not be a viable solution in the long run.5

Notes 1.

2. 3. 4. 5.

Professor Martin Feldstein is one of several American economists who is very sceptical about EMU. France, according to Feldstein (1997), wants the EMU in an aspiration for equality, which is incompatible with Germany’s expectation of gaining hegemony through the establishment of a monetary union. He argues further (p. 31) that with a politically determined exchange rate policy, the average level of future inflation ‘will almost certainly’ increase. In formal terms, not being a member of the ERM should ‘qualify’ Sweden for ‘not qualifying’ to join the EMU. The total money stock (M3) amounted to about 540 billion NOK (see Isachsen, 1997). Here also the option of having a CBA for Norway is discussed. In the course of 1993 the number of commercial banks in Estonia was sharply reduced, from 42 to 22. Feldstein (1997, p. 14) maintains that ‘when Danish voters initially rejected EMU and decided against ratifying the Maastricht treaty, Denmark was threatened with losing the free trade benefits of the Single Market’.

60

Isachsen

References Balino, T.J.T. and C. Enoch (1997) ‘Currency Board arrangements. Issues and experiences’, IMF Occasional Paper, 151 (Washington DC: IMF). Feldstein, M. (1997) ‘The political economy of the European Economic and Monetary Union: Political sources of an economic liability’, NBER Working Paper, 6150, Journal of Economic Perspectives, 11(4) (fall). Frankel, J. A. (1996) ‘How well do foreign exchange markets function’?, NBER Working Paper, 5422. Isachsen, A.J. (1997) ‘Norsk penge- og valutapolitikk i støpeskjeen’, Internasjonal Politikk, pp. 505–27. Mundell, R.A. (1997) ‘Currency areas, common currencies, and EMU’, American Economic Review, Papers and Proceedings (May), pp. 214–16. OECD (1997) OECD Economic Surveys 1996–1997. Denmark (Paris: OECD). von Hagen, J. (1997) ‘Monetary policy and institutions in EMU’, Swedish Economic Policy Review, pp. 51–116.

Comment1 Jesper Jespersen 1

INTRODUCTION

Niels Thygesen has presented an analysis of some aspects of the macroeconomic implications for the non-EMU countries of different exchange rate arrangements with the EMU. He explicitly leaves out the discussion of the conditions for intra-EMU stability which I shall argue is a severe limitation of the analysis. Furthermore, his theoretical presumption is a preference for institutional arrangements that imply a high degree of monetary stability within the entire EU. Thygesen does not consider real sector instability as a long-lasting problem when deciding upon currency matters. It is hypothesized that the functioning of the entire EU with regard to macroeconomic stability would be increased if the ‘outsiders’ formally obtained exchange rate links with the EMU. Hence, the chapter is concluded on this point by recommending a bilateral currency arrangement between each ‘outsider nation’ and the European Central Bank which in practice may entail a functional membership of the EMU (‘without voting rights’). Thygesen also considers an alternative case where a so-called ‘ERM 2’ is established with the euro as the core currency. In that case, the chapter favours even more narrow margins than those prevailing before the 1992–3 crisis. The possibility of another breakdown of such an arrangement is not contemplated within the chapter. On the contrary, Thygesen concludes that an ‘ERM 2’ arrangement is a second-best solution because of too much monetary flexibility – better suited for would-be members of EU in Central and Eastern Europe.

2 CAUSES OF MACROECONOMIC INSTABILITIES – AN UNSETTLED QUESTION Beneath the chapter’s arguments there is a vision of a basically stable market economy – especially with regard to the real sector of the economy. Unemployment is determined by structural factors outside the domain of macroeconomic stabilization policies. Hence, monetary instability mainly (if not only) originates from national (short-sighted) policies. At this point the chapter is, of course, in line with the main conclusions from the Committee for the Study of Economic and Monetary Union (‘the Delors Report’),2 expressing a firm belief that the stronger each country has committed itself to ‘German monetary policy’ the more credible the financial market participants will consider the policy and the faster the convergence to overall macroeconomic stability will take place. One of the few dissenting voices within that Committee came, in fact, from the govenor of the German Bundesbank Karl Otto Pöhl. He expressed severe doubts about the possibility of creating macroeconomic stability solely by Member States committing themselves to monetary policy à la Germany:

61

Jespersen

62

A Monetary Union presupposes considerable shifts in the responsability for economic policy to a central authority … Although complete political and institutional union is not absolutely necessary for the establishment of a monetary union, the loss of national sovereignty in economic and monetary policy associated with it, is so serious that it would probably be bearable only in the context of extremely close and irrevocable political integration (p. 144). Isolated steps in the monetary field would overburden monetary policy in political terms and jeopardize the credibility of the process of unification in the longer run (p. 155). The rising unemployment in EU since the signment of the Maastricht Treaty, especially in the major potential EMU Member States has enforced this view point that the stability of the real sector cannot be taken for granted. Europe is, for the time being, experiencing a high level of unemployment. Taking the restrictive macroeconomic policies pursued through the 1990s within the major EMU countries into consideration, it is difficult to avoid the impression that employment and growth have been hampered and that the effects of that policy seems to be long-lasting. If so, the development through the 1990s gives support to the view expressed by the German Bundesbank governor that a precondition for a well functioning monetary union is a highly coordinated and responsive macroeconomic policy within the common currency area. This is not a part of the institutional framework of the Maastricht Treaty (not to speak about the ‘Stability Pact’). If the EMU starts out with a relatively large number of participants there is even an increased risk of generating strong real sector imbalances inside the EMU. The judgement on what kind of potential destability of the EMU area is of crucial importance when giving recommendations on the best suitable exchange rate arrangements for the ‘Outsider Nations’. In fact, a number of economists with a monetarist inclination (Martin Feldstein, Charles Wyplosz and even Milton Friedman) have quite recently expressed doubts about the EMU project and the destabilizing elements inherent in the process. Whether macroeconomies do converge toward general equilibrium by themselves is still a theoretical unsettled question, but the empirical findings are not very supportive.

3

ERM 2?

On the question of an ERM 2 it is necessary to separate the two different categories of ‘outsider nations’. One group of countries is prepared to join the EMU unconditionally for (mainly) political reasons. This group counts of countries from Southern (and Eastern) Europe. Participation in European Institutions is desirable for them for historical and political reasons. Their main interest is a firm commitment from the core EMU countries not to ‘be left behind’ in the ongoing European integration process. For them, the economic consequences are of second-order magnitude and/or they look forward to be compensated through the Cohesion Fund. I will not comment on these cases. The second group consists of countries from Northern Europe (Great Britain, Sweden, Denmark, Norway and Switzerland). They have expressed different degrees of doubts on the usefulness of a membership of the common European currency. These more hesitant attitudes are a mixture of scepticism towards too fast political integration and uncertainty about the macroeconomic arguments in favour of a Monetary Union at the actual stage of economic integration. I shall concentrate on the latter argument.

Comment 3.1

63

Are the Necessary Macroeconomic Conditions Fulfilled for ERM 2?

From a welfare point of view, a stable exchange rate cannot be a goal in its own right. It might be a useful tool promoting more fundamental considerations: (a) low inflation, growth and employment and/or (b) political aspirations. As mentioned already, Thygesen is in favour of a new ERM 2 containing all EU ‘outsider nations’. At this point he is in concordance with the aspiration of the Danish government. It has worked out a proposal for the future Danish relationship with the EMU which entails a fixed exchange rate with a very narrow band. In fact, the Minister of Economic Affairs has expressed a preference for a margin of exchange rate fluctuations similar to that which prevailed under the Bretton Woods system. The Bretton Woods system was set up in a world economy with very limited financial flows. The main aim was to prevent countries from pursuing a narrow minded ‘beggaryour-neighbour’ exchange rate policy. The system – which lasted for 25 years – built upon three important elements: (1) a stable core currency, (2) a relevant exchange rate adjustment mechanism and (3) limited financial capital flows. The Bretton Woods System (BWS) came to an end when all 3 pillars were undermined: (1) The US economy became overheated, (2) exchange rates were not adjusted speedily and appropriately and (3) the size of international financial capital flows had seized power from the monetary authorities (mainly in the form of euro-dollars). In Europe the BWS was replaced by EMS 1 in 1979 which lasted until 1992–3. The break-down story of EMS 1 is quite similar to the BWS story. EMS 1 worked relatively well during the 1980s due to a stable D-mark, a reasonable degree of exchange rates adjustments and still rather restricted policy towards financial flows. The EMS broke down in early 1990s because of challenges to all three pillars: (1) the German economy was destabilized by unification, (2) further adjustments of exchange rates were given up from early 1987 onwards and finally (3) due to the establishment of the ‘internal financial market’, where capital flows were given free. That led to the turbulent period of 1992–3, which ended by some countries leaving EMS, others accepting a much wider adjustment band (+/– 15 per cent) and an acceptance of the necessity of exchange rate adjustments (for example, the Spanish and Portuguese devaluations in 1995 and the 1997 revaluation of the Irish Punt). What are the prospects for and desirability of a revival of the EMS system á la the Bretton Woods System?3

Stable Core Currency As already discussed the euro will be missing the political superstructure which is needed to be considered a core currency by outsider nations.

Suitable Adjustment Mechanism A semi-automatical adjustment mechanism has to be announced. The idea of unchanged exchange rates for decades has in the past demonstrated a number of rather severe and counter productive side-effects. It may help to stabilize short-term exchange rate expectations, but it impedes (or, more correctly, it delays) the much more important adjustment of the exchange rate to different developments in the real parts of the economy. A pretended fixed exchange rate system opens for a one-way speculative bet (which Mr George Soros has so overwhelmingly demonstrated) that has to be compensated for by high(er) rates of interest than otherwise.

Jespersen

64

Free International Capital Mobility It is a matter of fact that the international financial capital flows have grown immensely and have today very little correspondance to real phenomena like foreign trade and direct investments. Furthermore, these uncontrollable financial floods constitute a persistent threat to the internal stability of any minor currency. Hence, it could easily be argued that any pure financial transaction involving more than one currency should be levied a foreign exchange tax – a so-called Tobin tax with the specific aim of reducing the exaggerated turnover in the foreign exchange market. By such an institutional change the central banks in the coming ERM2 countries could regain some of their lost authority in the guidance of the foreign exchange rate. That would improve the credibility of any formal exchange rate arrangements.

4

CONCLUDING REMARKS

Political and economic arguments are often entangled. From a political point of view a common currency might be judged of great importance for EU. In any case, that should not suppress the fact that the macroeconomic consequences of the EMU are uncertain. That makes the recommendable exchange rate relationship between the EMU and the ‘outsider nations’ a theoretically unsettled question: It is not entirely certain that the EMU will be stable … and the stability is of crucial importance for the economic advantages of participation. (Danish Economic Council, 1997, p. 134, translation mine) The historical experiences derived from different exchange rate systems point at a fundamental instability: when the weakest links of any system are stressed by events it breaks down and is replaced by another. This viewpoint of relativity might be helpful when discussing the EMU-project: the establishment of a monetary union might not be an irreversible step for the entire future. (Statens Offentlige Utredninger, 1996, p. 65, translation mine)

Notes 1.

2. 3.

This comment was prepared for the conference on ‘Macroeconomic Perspectives on the Danish Economy’, as a response to Professor Niels Thygesen’s original paper. The future stability of the EMU was debated at the conference, and since then there have been important new developments on this issue which I have partly integrated. Niels Thygesen was a member of the Committee preparing the report in 1989. This question has been intensively debated since the events of 1992–3. One rather recent and extended discussion can be found in Statens Offentliga Utredninger (1996) taking its starting point from the Swedish case. Although time has passed I still find the discussion between the Americans and Keynes (1941–3) on preparing the Bretton Woods Agreements quite illuminating for the key issues involved (cf. Jespersen, 1996).

Comment

65

References Committee for the Study of Economic and Monetary Union (1989) Report on Economic and Monetary Union in the European Community (Luxembourg). Feldstein, M. (1997) ‘The political economy of the European Economic and Monetary Union: political sources of an economic liability’, Journal of Economic Perspectives, 11(4) (Fall). Friedman, M. (1997) ‘Fra monetær enhed til politisk splittelse?’, Berlingske Tidende (21 October 1997). Jespersen, J. (1995) ‘A post-Keynesian perspective on monetary union and the European Central Bank’, Chapter 11 in P. Arestis and V. Chick, Finance, Development and Structural Change – Post-Keynesian Perspectives (London: Edward Elgar). Jespersen, J. (1996) ‘Keynes on the International Monetary System – and the lessons for today’, Working Paper, Institute of Social Sciences, Roskilde University. Økonomiske Raad (1997) Formandskabet: Dansk Økonomi, maj 1997 (Danmark og ØMu’en) (Copenhagen). Statens Offentliga Utredninger, ‘Sverige och EMU’ (EMU-utredningen, Calmforsudvalget), SOU, 1996:158 (Stockholm). Thygesen, N. (1997a) ‘The prospects for EMU by 1999 – and reflections on arrangements for the outsiders’, EPRU Working Paper, 1995–17 (Handelshøjskolen i København). Thygesen, N. (1997b) ‘EMU and the outsider nations’, paper presented to the conference on ‘Macroeconomic Perspectives on the Danish Economy’ (Hornbæk) 19–20 June. Wyplosz, C. (1997) ‘EMU: why and how it might happen’, Journal of Economic Perspectives, 11(4) (Fall).

3 Macroeconomic Perspectives on Stock and Bond Investments in Denmark since the First World War1 Steen Nielsen and Ole Risager

3.1

INTRODUCTION

The purpose of this chapter is first to characterize the return–risk characteristics of Danish stocks and bonds in the period 1920–95. On the basis of the descriptive background we analyze whether the size and development of asset returns can be explained by the Consumption–CAPM, which has become a popular asset pricing model in recent years. We also briefly discuss whether the existing upper limits on Danish pension funds’ stock investments are reasonable in view of our results on the return–risk characteristics of Danish stocks and bonds. Throughout the chapter, we focus on the economics of the stock market rather than on technicalities. Section 3.2 begins by calculating the return on a 1-year, 5-year and 10-year investment in the market portfolio of stocks, and the associated risk as measured by the standard deviation of the portfolios. Subsequently, the chapter outlines the corresponding government bond yields and risks. Next follows a comparison of stock and bond returns – that is, a characterization of the equity premium and its development since the early 1920s. We also examine whether stock investment is more risky than bond investment, which is a commonly held view. In a Danish context, this view has been attacked by Christiansen and Lystbaek (1994). Our results show that the time horizon is the crucial factor in this issue. In simple terms, stock investments are not more risky than bond investments in the short term, whereas stock investments are not more risky than bond investments in the long term. The most important reason why stocks are as safe as bonds in the long term has to do with a strong tendency for real stock returns to meanrevert. Thus, bad years in the stock market are usually followed by good 66

Stock and Bond Investments in Denmark

67

years, whereas bond returns display positive autocorrelation. The results for Denmark are therefore similar to the findings for the United States reported in Siegel (1994). On the basis of stock and bond returns for the last two centuries, Siegel arrives at the conclusion that ‘although stocks are certainly riskier than bonds in the short run, over the long run the returns on stocks are so stable that stocks are actually safer than either government bonds or Treasury bills’. Section 3.3 goes on to examine whether the behaviour of stock returns can be explained by the Consumption–CAPM (see Breeden, 1979; Lucas, 1978). In line with the majority of the papers in the literature, this paper analyzes short-run stock returns, whereas Nielsen and Risager (1997) looks at longrun stock returns. According to the Consumption–CAPM, stocks should yield a higher return than bonds if stock returns are more correlated with consumption than bond yields, because stocks in that case provide a poorer hedge against fluctuations in consumption. The predictions of this model are consistent with the Danish data in the qualitative sense. Whether the model makes sense quantitatively is another issue, to which we return. The Consumption–CAPM (C-CAPM) is also consistent with data for the United States at the qualitative level, but the model is unable quantitatively to explain the magnitude of the United States equity premiums unless it is assumed that agents are much more risk averse than is commonly believed. That was first demonstrated by Mehra and Prescott (1985) (see also the recent survey of the so-called ‘equity premium puzzle’ literature by Kocherlakota, 1996). Tests of the Consumption–CAPM on Danish data are scarce. As far as we know, Lund and Engsted (1996) is the first paper that investigated this issue. They use the VAR technique developed by Campbell and Shiller (1988) to analyze the behaviour of short-run stock returns, and to estimate the underlying parameters (e.g. the degree of risk aversion). Their estimate of the risk aversion parameter ‘turn out to be of the wrong sign, but with large standard errors, so that the hypothesis of risk neutrality cannot be rejected’. In this chapter, we apply the non-parametric approach due to Hansen and Jagannathan (1991). This gives insight into the likely degree of risk aversion. Our results point attention to a degree of risk aversion that seems reasonable in the short end of the market (see p. 83). In spite of that, it would be premature to conclude that the theory can explain market returns. We therefore proceed to examine another aspect of the model. Thus, in the spirit of the influential paper by Grossman and Shiller (1981), we compare the actual stock market index with the index that would apply if agents had perfect forsight and behaved in accordance with the Consumption– CAPM using the information we have on the likely degree of risk aversion. Despite the fact that this test is informal and based on the assumption of

68

Nielsen and Risager

rational expectations, it gives insight into the model’s ability to explain the level and volatility of stock prices. Section 3.4 discusses the upper limits on Danish pension funds’ investments in the stock market, whereas Section 3.5 briefly summarizes the most important conclusions and implications that can be drawn from the chapter.

3.2 DATA, RETURN DEFINITIONS AND VIEW OF THE LANDSCAPE The stock market data are from two sources. Dividend yields are from our own sample of the listed firms on Copenhagen Stock Exchange, which covers about 70 per cent of the total market capitalization, corresponding to a total of about 100 firms. The dividend yield on the market portfolio is estimated as a weighted average of the dividend yield on each share, where the weights equal the value of each stock relative to the total market capitalization of the the firms in the sample. Capital gains are calculated on the basis of the market index published by Danmarks Statistik. The stock returns presented below therefore refer to the market portfolio. Let us now introduce a few return definitions. The 1-year nominal gross return on stocks S1 is defined in (3.1), and equals the dividend yield plus the capital gain (see list of notation below). This calculation disregards the possibility that dividends are reinvested within the year they are paid out.2 The corresponding 1-year real return SR1 seen from an investor’s point of view is given in (3.2), and is only approximately equal to the more common but less exact definition of the real return given as the nominal return less the rate of CPI inflation.3 The 5-year nominal (real) return equals the geometric average of the consecutive annual nominal (real) returns. The formula for the 5-year nominal return S5 is thus given by (3.3). The formula for the 5-year real return SR5 is defined analogously and is therefore omitted. S 1(t) = D(t) / Q(t − 1) + (Q(t) − Q(t − 1)) / Q(t − 1) 1 + SR 1(t) = (1 + S 1(t))C(t − 1) / C(t) (1 + S 5(t))5 = (1 + S 1(t))K(1 + S(t + 4))

(3.1) (3.2) (3.3)

In the above formulas, D(t) denotes dividends from time t – 1 to t, Q(t) and C(t) are the stock market index and the CPI at time t, respectively. Stock returns are compared to 5- and 10-year (annualized) government bond yields. In the absence of any publicly available 5-year bond yield (and 10-year yield) we have had to construct our own series using the available information on payments (amortization) streams. Because the maturity structure on the outstanding Government debt is narrow in particular in the

Stock and Bond Investments in Denmark

69

beginning of the sample, the 5-year horizon is only approximate in the early period of the sample. The 10-year yield to maturity B10 is also approximate in the early years. From 1960 and onwards we link our 10-year bond yield with OECD’s series, see OECD (1996). The 5-year real bond yield BR5 is proxied by, (1 + BR 5(t))5 = (1 + B 5(t))5 (C(t − 1) / C(t + 4))

(3.4)

where B5(t) is the 5-year annualized nominal bond yield. The 10-year real bond yield BR10 is defined analogously. Short-term Stock Returns, Risk and Wealth Effects The movement of the annual nominal stock market return is illustrated in Figure 3.1. The figure shows that the annual nominal return has fluctuated in a relatively stable manner around a constant mean in the period 1922–82 with the high yield in 1972 as a clear outlier. In the period 1983–95 both the mean return and the variance of stock returns have increased sub-stantially. These observations are confirmed by simple summary statistics listed in Table 3.1. The average nominal yield has thus increased from 9.6 per cent in 1922–82 to 17.8 per cent in 1983–95. Figures for 1996 underscore this tendency to higher stock returns. Along with a rise in the average return, Table 3.1 also shows that the standard deviation of the annual return has more than doubled. The stock market has thus become more volatile in the short term. It is, however, interesting to note that the return–risk ratio in

Figure 3.1 1.2 1 0.8 0.6 0.4 0.2 0 – 0.2 – 0.4

Annual nominal stock returns, 1921–95

Nielsen and Risager

70 Table 3.1

1922–95 1922–82 1983–95

Average annual stock market returns, 1922–95, per cent Nominal return

Std dev.

Real return

Std dev.

11.0 9.6 17.8

22.9 17.5 40.0

6.8 5.3 13.4

21.4 16.4 37.1

Source: Own calculations.

real terms – defined as the real mean return divided by the associated standard deviation – has increased in the period 1983–95. The observation that returns were lower in the past is consistent with the sample evidence in Hansen (1974). He finds that the average annual return equals 7.6 per cent in the period 1920–74. The corresponding real returns display roughly the same behaviour as the nominal returns and the figure is therefore omitted to save space. Spectacular returns are recorded in 1972 (83 per cent) and in 1983 (104 per cent), to which we return later. The bad years are 1931 (–11 per cent), 1940 (–15 per cent), 1974 (–28 per cent), 1984 (–25 per cent), and 1992 (–24 per cent). The sharp declines in 1974 and 1984 followed immediately after spectacular bull markets, indicating that the Danish stock market may also overreact to news – that is, display excess volatility. Figure 3.2 presents the corresponding real stock market index, defined as the nominal index deflated by the CPI. The 1920s are characterized by an Figure 3.2

Real stock price index, 1921–95

Stock and Bond Investments in Denmark

71

upward trend but also with considerable declines in 1922 and 1924, which in part reflects a tough monetary policy that aimed at restoring the real value of the exchange rate. Thus, the consumer price index fell by 20 per cent from 1920–4, which was accompanied by several collapses of major banks and industrial companies (see Olsen and Hoffmeyer, 1968). The Wall Street crash in 1929 is associated with a minor fall in the Danish index in 1930. The major adjustment occurs in 1931, where the index went down by 17 per cent. The stock market recovery sets in immediately after the crash, and the stock market reaches a new peak in 1936. Thereafter, the stock market displays a remarkable trendwise decline until the beginning of the 1980s. The only major interruption to this decline is 1972, which is the year when Denmark joined the EEC (now the EU). Along with this, the Copenhagen Stock Exchange was opened up for foreign investors in 1973, which in turn may have been anticipated by the market. The declining index contributed of course negatively to stock returns, but high dividend yields in this period kept them on a positive scale. Following the long period with a declining index, Figure 3.2 shows a very dramatic rise in 1983. In this year, the stock market goes up by exactly 100 per cent (see below). In 1987, stock markets were worldwide characterized by steep declines, and the Danish index is no exception as the real stock price falls by 9 per cent, but that is immediately followed by a 43 per cent increase in 1988. The first five years in the 1990s are characterized by temporary ups and downs along a fairly constant mean. However, since 1994 the index has been on an upward trend and this upward movement persisted through the first three quarters of 1997. The sharp increase in the index in 1983 is the largest jump that has occurred since the First World War. It is common to attribute the 1983 jump to three factors. First, there is a shift in economic policy in late 1982 towards a non-accommodation strategy with tight fiscal policy and fixed exchange rate policy as key elements (see Andersen and Risager, 1988). This change in economic policy was accompanied by a fall in the long interest rate by around 7 percentage points (see p. 73). Second, a new tax on institutional investors’ real bond yields was passed by Parliament in 1983 to become effective in 1984. Because stocks are not subject to this tax, the current and anticipated after tax return to equity increased sharply relative to bond investments. Third, capital market liberalizations meant that all restrictions on Danish investors foreign equity placements were lifted in 1984, whereas the Danish stock market had been open to foreigners since 1973 (see Eskesen et al., 1984). The liberalizations may have enlarged the window to the rest of the World, and because many markets experienced very high returns in these years this may have had spillover effects to the Copenhagen Stock Exchange. Note, however, that there has not been any formal attempt to test and quantify the various explanations.

72

Nielsen and Risager

The stock market jump in 1983 led to a considerable wealth effect despite the fact that the Danish stock market is relatively small by international comparison, and in particular by comparison to countries with an Anglo– Saxon financing mode. As the total capitalization–GDP ratio in 1983 was about 20 per cent, the boom was associated with a wealth increase of about 20 per cent of GDP. Measured in current Danish Kroner that amounts to about 200 billion kr. That is obviously a substantial wealth increase which, however, is partly reversed in 1984. Note also that the windfall gain is ‘gross’. However, as capital gains are tax free in this period for minority shareholders, provided the holding period is at least three years, the net-wealth increase was substantial. It is an important future research topic to find out whether the sharp rise in stock prices fuelled the subsequent rise in consumption and investment (as suggested by Tobin’s q model), for example, or whether it just mirrored the considerable rise in consumption and sales that occurred in the period 1984–6 along with the substantial fall in interest rates in 1983. Whether the market mainly acts as a leading indicator or actually also has important spillover effects to the real economy is discussed in Poterba and Samwick (1995), for example, on the basis of data for the United States. Long-term Stock and Bond Investment: Return–Risk Characteristics Because stock investments often are (or should be) based on long-term considerations, this section focuses mainly on the return–risk characteristics of stocks relative to bonds in a long-term perspective, that is, over a 5- and 10-year horizon. Our 5- and 10-year bond yields are recorded in Figure 3.3. This diagram shows that there has been very little return difference between 5- and 10-year bond investments. Moreover, bond yields appear to be highly positively correlated over time. In contrast to the Stock Market where bad(good) years quickly are followed by good(bad) years (see Figure 3.1), rising (falling) bond returns often persist over many years even through decades. In order to compare bond and stock investment, which indeed is a complex issue, we need to make some assumptions about investor behaviour. Thus, our bond investor is assumed repeatedly to invest in government bonds. Suppose the investor chooses bonds with maturity equal to the investor’s predetermined holding period. The return on a single investment is given by the yield to maturity on the bond or by the so-called ‘effective rate of interest’. The average return over the period 1922–95 is the arithmetic average of all the effective interest rates that have applied in this period. As the investor is uncertain with respect to future interest rates, such an investment strategy is risky even though the investor knows his

Stock and Bond Investments in Denmark Figure 3.3

73

Nominal bond yields, 1921–95

0.25

0.2

Yield

0.15

0.1

0.05

0

nominal return for certain as soon as he has made his investment. If the investment was a one-shot event all nominal uncertainty of course disappears. The sort of uncertainty that stems from inflation will still be there given that the bond is a nominal claim. In sum, our perspective is an investor who repeatedly invests in nominal government bonds and hence is subject to both interest rate and inflation uncertainty. Table 3.2 shows the average bond yield over a 5- and 10-year investment horizon as well as the average 5- and 10-year stock returns (cf. (3.3)). Table 3.2 shows that the average real return on a 5- and 10-year bond investment strategy equals 3.6 per cent and 3.3 per cent, respectively. The corresponding real stock returns are 5.1 per cent and 4.7 per cent, respectively. Hence, stocks yield on average a higher return than bonds. Table 3.2

Average 5- and 10-year bond and stock returns, 1922–95, per cent Nominal return

Std dev.

Real return

Std dev.

8.0 9.5 8.3 9.6

4.2 7.0 4.6 4.5

3.6 5.1 3.3 4.7

4.2 6.3 4.4 3.6

5-year bond 5-year stock 10-year bond 10-year stock Source: Own calculations.

Nielsen and Risager

74

The standard deviations of the 5- and 10-year stock returns are also presented in Table 3.2. The standard deviations decline as the investment horizon increases. As the return on long-term investments is basically an ‘average’ of of the 1-year returns, this result may simply reflect that the variance of an ‘average’ return declines as the number of observations increase. This measure of risk need therefore not be very informative as regards the riskiness of the portfolio – that is, as regards the variance of the Dollar/Kroner value of the investment (see also Bodie, Kane and Marcus, 1993). Let us therefore also look at the riskiness of the portfolio value of different investment strategies. Suppose an investor has a holding period of one year and that he invests 1 kr in stocks in late 1921 which gives him a certain portfolio value ultimo 1922. He repeats this 1 kr investment every year until 1995. By taking the (natural) logarithm of all these portfolio values and by subsequently calculating the average value and the standard deviation of these (logged) portfolio values we arrive at the first row in Table 3.3, which also distinguishes between the nominal and the real portfolio values. Suppose the holding period is five years. The investment in 1921 accumulates therefore to a certain amount in 1926. At the end of 1926, a new investment is undertaken and associated with this a new portfolio value is recorded in 1931 and so forth. Out of this sequence we calculate the average portfolio value in logs as well as the standard deviation, see

Table 3.3

Return–risk of stock and bond portfolios, 1922–95

Average (logarithmic) portfolio value (nominal)

Std dev.

Average (logarithmic) portfolio value (real)

Std dev.

Stocks 1-year 5-year1 10-year2

0.0872 0.4462 0.9052

0.1814 0.3104 0.4249

0.0486 0.2382 0.4481

0.1786 0.3029 0.3565

Bonds 5-year1 10-year2

0.3818 0.7678

0.2013 0.4671

0.1738 0.3107

0.2075 0.4361

Notes: 1. We have calculated average portfolio values and standard deviations for non-overlapping investments starting in 1921, 1922, 1923, 1924 and 1925. Figures in the table are averages of these numbers. 2. Same procedure as for 5-year investments. Starting years are 1921, … , 1930.

Stock and Bond Investments in Denmark

75

the second row in Table 3.3. Following the same procedure, Table 3.3 also records the relevant statistics associated with a 10-year non-overlapping investment strategy. The results show that a 10-year investment is more risky than a 1-year investment in the sense that the standard deviation of the portfolio value is higher. By calculating the variances it is easy to see that the variance of a 10-year investment is not 10 times as high as the variance of a 1-year investment. If the returns had been independently distributed over time, the variance would have been proportional to the investment horizon as shown below. Thus, suppose that the log of 1 plus the return ln(1 + RR1) is independent and normal distributed with mean
and variance 2. In this case, the portfolio value of a 1 kr investment over T periods equals PV = (1 + RR1(1)) (1+RR1)(2) ... (1 + RR1(T)), whereas the log value equals ln(PV) = ln(1 + RR1(1)) + ln(1 + RR1)(2)) + ... + ln(1 + RR1(T)). Hence, the mean portfolio value equals E(ln(PV)) = T
, and the variance var(ln(PV)) = T2, which is linear in time. The fact that the portfolio variance in the Danish case increases less than proportionally with the investment horizon has profound implications for the optimal portfolio strategy (see below). Consider next a non-overlapping 5-year bond strategy. By assuming that 1 kr is invested in 1921, 1926, 1931, etc. we may calculate the average portfolio value in logs and the standard deviation (see Table 3.3). The same statistics are reported for a 10-year investment strategy. By comparing the stock and bond strategy two results stand out. First, stock investments yield on average a higher return than bond investments. Second, a 10-year stock investment strategy has been less risky than a 10year bond investment strategy.4 The portfolio strategy implication is that stocks are for the long run, whereas bonds are more for the short run. Put differently, a long-term investor should have a higher proportion of stocks in his portfolio than a short-term investor provided these investors are sufficiently risk averse. Thus, stocks should play an important role for young investors who save for retirement purposes (see also section 3.4). Why is it that stocks are more risky than bonds in the short term but not more risky in the long-term? To get a rough answer to this question we briefly examine the time-series characteristics of stock and bond returns. Consider the autoregressive properties of the annual real stock return. The estimated AR(4) process is given below ln(1 + RR 1) t = 0.070 − 0.282 ln(1 + RR 1) t−1 − 0.0901ln(1 + RR 1) t−2 − (0.026) (0.123) (0.128) 0.057 ln(1 + RR 1) t−3 − 0.083 ln(1 + RR 1) t−4 , (0.124) R2 = 0.08(1926 – 95)

(3.5)

76

Nielsen and Risager

where numbers in brackets are standard errors. Our earlier findings indicate strong evidence against the independence assumption insofar as the variance of the portfolios increases less than proportionally with the investment horizon, and this conclusion is further supported by the above regression insofar as the results indicate strong negative correlation in the returns. By gradually deleting those variables that appear to be insignificant5 we arrive at the next regression equation: ln(1 + RR 1) t = 0.064 − 0.286 ln(1 + RR 1) t−1 , (0.021) (0.113)

R2 = 0.08(1923 – 95) (3.6)

which is a simple AR(1) process. The strong negative correlation in the real returns shows that bad years are often followed by good years, and vice versa. The tendency for real returns to mean-revert can also be verified by using the so-called ‘variance ratio test’ applied in Poterba and Summers (1988). This test exploits the fact that if the market follows a random walk such that returns are independent then the return variance should be proportional to the return horizon, as noted also in the earlier discussion. To save space the variance ratio tests are not shown here, but given the earlier findings it is hardly surprising that these tests also lend strong support to the mean reversion hypothesis, and hence provide evidence against the random walk hypothesis. Our test statistics show that mean reversion is a stronger phenomenon in Denmark than in the markets examined in Poterba and Summers (1988). To get further insight into the long-term relationship between risk and return in the stock market, it is instructive to calculate the expected future portfolio value when the return exhibits negative first-order autocorrelation and the variance of the portfolio. Not surprisingly, the mean value of the portfolio grows linearly with time, whereas it can be shown that the variance is growing with a lower speed. Hence, the risk–return ratio declines as the investment horizon increases. It is due to this element of time diversification that stocks can be said to become less risky over time. Bonds behave differently, as indicated also by Figure 3.3. Without going into details, bond yields tend to exhibit positive serial correlation. This can be verified not only by examining the two bond yields presented in Figure 3.3, but also by looking at short interest rates which, unfortunately, are available for only the last 20 years or so. The different time-series properties of the two assets are the most important explanation why stocks are less risky in the long term, notwithstanding that stocks are much more risky in the short term. More on the Equity Premium We have already established that stocks on average yield a higher return than bonds. This return difference shows up in a considerable difference

Stock and Bond Investments in Denmark

77

between bond and stock portfolios, as the following example will show. Suppose an investor had put 100,000 kr into bonds in late 1921 (and subsequently reinvested the coupon and the principal when paid out) whereas another had invested the same amount in shares (and subsequently reinvested the received payments). The real value of these investments in 1995 are 1,660,000 kr and 3,640,000 kr, respectively, using the annual returns and the CPI. Thus, the real value of a stock portfolio is more than twice the value of a bond portfolio. Moreover, it is quite likely that our calculation exaggerates the attractiveness of bond investments insofar as we have used the 5-year interest rate as a proxy for the missing 1-year interest rate. The above calculation shows that stocks clearly have outperformed bonds over long historical periods. That is not the same as to say that stocks always yield higher returns than bonds. Table 3.4 summarizes the equity premium for the entire sample and for the two sub-periods 1922–82 and 1983–93. Over the whole sample the 5- and 10-year equity premium is around 1.5 per cent. In the period 1983–95 the premium is negative. Thus, although the return on stocks is high in this period as noted earlier, the yield on government bonds is even higher. The 1983–95 period is not unique (see Figure 3.4, which displays the 5-year equity premium over a long historical period). Figure 3.4 shows that the premium displays a cyclical behaviour – that is, the premium varies between positive and negative values. There are seven periods in the data, where the equity premium has been negative for more than one year. The equity premium is also negative towards the end of the sample and hence also in 1991. By using the 1996 return data, it can be shown that the equity premium for 1992 is slightly positive. Table 3.4

Equity premium for the sample Nominal

5-year investment 1922–95 5-year investment 1922–82 5-year investment 1983–95 10-year investment 1922–951 10-year investment 1922–82 10-year investment 1983–952

1.5 1.8 –2.7 1.5 1.8 –2.7

Notes: 1. The reason that the 10-year premium in this table is slightly different from the one implied by Table 3.2, p. 73, is that in the present table only bond yields with matching stock returns are included. 2. The premium calculation is based only on three 10-year yields. Source: Own calculations.

Nielsen and Risager

78 Figure 3.4

5-year nominal equity premium, 1921–90

0.2 0.15

Premium

0.1 0.05 0

– 0.05 – 0.1 – 0.15

The Danish premium is lower than the 6 per cent real premium for the United States estimated for the period 1889–1978 by Mehra and Prescott (1985). Note, however, that the premium in Mehra and Prescott (1985) is between 1-year stock returns and T-Bills. In spite of this, there is little doubt that the average historical Danish premium is below the American premium. Thus, a comparison of the 1-year Danish stock return with the 5-year Government bond yield (in the absence of 1-year bond yields) gives rise to a premium of about 3 per cent. The Danish premium is also below the premium in the United Kingdom. Engsted (1996) shows that the UK premium is close to 10 per cent in the period 1919–87. Historical stock returns in Sweden are quite similar to the Danish returns (see Frennberg and Hansson, 1992). In the absence of a well functioning Swedish bond market back in time it is harder to compare equity premia between Copenhagen and Stockholm. The above analysis has been concerned with the return–risk relationship on stocks and bonds in isolation. From a macroeconomic point of view it is of interest to know whether stocks are a poorer hedge against consumption fluctuations than bonds. If that is the case, the Consumption–CAPM asserts that stocks should yield a higher return than bonds. Below, we therefore relate the fluctuations in stock and bond returns to private consumption. Due to the space constraint, the theory testing in this chapter is entirely concerned with the short end of the market; Nielsen and Risager (1997) pits the Consumption–CAPM against the long-run returns. The sample covariance matrix between the 1-year real returns on stocks and bonds and real private consumption growth (per capita) is as shown in Table 3.5.6

Stock and Bond Investments in Denmark Table 3.5

79

Variance–covariance between annual returns, yields and consumption growth rate, 1922–95

Real annual stock return Real annual bond yield Real consumption growth rate

Real annual stock return

Real annual bond yield

0.04558 0.00037 0.00124

0.00285 0.00095

Real consumption growth rate

0.00275

Source: Own calculations.

Table 3.5 shows that stock returns in the short term covary more with consumption growth than do bond returns. At the qualitative level, the Consumption–CAPM is therefore consistent with the data. Hence, it is of interest to test the model in a more rigorous way.

3.3

ASSET RETURNS AND THE CONSUMPTION–CAPM

This section briefly outlines the consumption-based asset pricing model (CAPM), without going into detail with respect to the underpinnings of the model. However, it is important to mention in advance that the fundamental pricing equation derived below can be obtained also in a somewhat less restrictive set-up (see, Kocherlakota, 1996, for example). The most simple version of the model is based on the following three assumptions. First, individuals can be represented by a representative agent with well defined preferences. Second, asset markets are complete. Third, transaction costs are negligible. Under these assumptions, the following equation must always be fulfilled, mu(t)Q(t) = (1 + )–1E [mu (t + 1)(Q(t + 1) + D(t + 1)) | I(t)]

(3.7)

where mu is marginal utility, Q is an asset price or vector of prices,  is the constant subjective rate of time preference, D is dividend, and I is the information set. The left-hand side is the increase in utility that occurs if the investor sells her asset and increases consumption at time t, whereas the right-hand side is the discounted expected loss in utility from the fall in consumption due to not having the asset and obtaining the associated payoff at t + 1. In equilibrium, the utility gain must equal the loss. If, for example, the left-hand-side exceeds the right-hand-side, the investor reduces his asset holdings in t, which reduces the price Q(t) and this will continue until there is equilibrium. By assuming mu (t) > 0 we have,

Nielsen and Risager

80

 (1 +  ) −1 mu( t + 1)  Q( t) = E  (Q( t + 1) + D( t + 1))| I ( t)  mu( t)   = E [ m( t + 1)(Q( t + 1) + D( t + 1))| I ( t)]

(3.8 )

where (1 + )–1mu(t + 1)/mu(t) ≡ m(t + 1) is the intertemporal marginal rate of substitution. Equation (3.8) says that the asset price in t equals the discounted expected value of the asset price and payoff in t + 1, where the discount factor is the intertemporal marginal rate of substitution m(t + 1). From the fundamental pricing equation (3.8) it is straightforward to get the following implication,   Q(t + 1) + D(t + 1) | I (t) 1 = E  m(t + 1) Q(t)   = E[m(t + 1)(1 + R(t + 1))| I (t)]

(3.9)

where R is the return. Because E(m(t + 1)(1 + R(t + 1)) = Em(t + 1) E(1 + R(t + 1)) + cov(m(t + 1)(1 + R(t + 1)) we have,7 E(1 + R(t + 1)) =

1 − cov(m(t + 1)(1 + R(t + 1)) E(m(t + 1))

If m(t + 1) and 1 + R(t + 1) are negatively correlated (when high consumption growth goes hand in hand with a high return R, and low consumption growth goes hand in hand with a low return R), then the asset is risky in the sense that it provides a poor hedge against consumption fluctuations. The mean return ER(t + 1) must thus be relatively high, as noted earlier when we discussed stylized facts for Denmark. There are several ways to test (3.8). Below, we outline the visual Grossman and Shiller (1981) test and the more recent Hansen and Jagannathan (1991) method. Informal Tests of Stock Price Volatility à la Grossman and Shiller Do stock prices vary too much relative to the prediction of the Consumption–CAPM-model? In Grossman and Shiller (1981), this question is addressed (in an informal way) by comparing actual stock price volatility with the volatility implied by a perfect foresight version of (3.8) solved forward in time. Besides this, this method of course also allows one to compare the level of the actual index with the index under perfect foresight.

Stock and Bond Investments in Denmark

81

The starting point is to solve (3.8) forward in time by recursive substitution (see (3.10)). The perfect foresight price Q* is obtained by discarding the expectations operator (see (3.11)). Thus, we calculate the price that obtains if agents had perfect foresight with respect to the sequence of dividends D(t + 1), … , D(T) and the terminal price Q(T), using an appropriate sequence of intertemporal marginal rate of substitution (IMRS) parameters m(t + 1), … , m(T) (see below). Q(t ) =

Q * (t ) =

T − t  mu(T )Q(T ) mu(t + j) D(t + j) + (1 +  )−(T − t ) | I(t ) (3.10) E  ∑ (1 +  )− j mu(t ) mu(t )  j=1  T −t − j mu(t + j) D(t + j) + (1 +  )−(T − t ) mu(T )Q(T ) ∑ (1 +  ) j=1 mu(t ) mu(t )

(3.11)

The IMRS (1 + )–1mu(t + 1)/mu(t) ≡ m(t + 1) is obtained by using a specific parametrization of the utility function (cf. p. 83). Thus, with a specific utility function we can estimtate the marginal utilities using our consumption data. In the expression for IMRS, the parameter  also enters. The latter is estimated by substituting the (sample) mean values of mu(t + 1)/mu(t) and 1 + R(t + 1) into (3.9). In the calculation of mu(t + 1)/mu(t), using a specific utility function, we will usually also have to take a stand on the degree of risk aversion since that affects the marginal utilities. This piece of information is obtained from the Hansen–Jagannathan method. Before we turn to that, we note that Q*= Q + U, where the (expectations) error term U must be uncorrelated with the current price, which implies that var(Q*) > var(Q). Thus, the perfect foresight price should be more volatile than the actual price. Hansen–Jagannathan Bounds for the Intertemporal Marginal Rate of Substitution According to the pricing formula (3.8), the asset price equals the expectation of the product of the payoff, Q(t + 1) + D(t + 1), and the IMRS, m(t + 1). The Hansen–Jagannathan method determines first the IMRS (mean) and its standard deviation that is consistent with asset market data – that is, consistent with (3.8). That is sometimes referred to as the ‘admissible mean’ and ‘standard deviation’ of the IMRS. The second step is to calculate the mean and standard deviation of the IMRS implied by a particular utility function for a representative agent. Next, we compare the mean and standard deviation of the IMRS implied by asset returns with the mean and standard deviation implied by the utility function in order to check whether

Nielsen and Risager

82

the particular utility/consumption-based asset pricing model falls within the admissible region. By taking unconditional expectations of the pricing formula (3.8) we get, EQ(t) = E[m(t + 1)(Q(t + 1) + D(t + 1))]

(3.12)

On the basis of (3.12) one can then derive the admissible region for the mean and standard deviation of the IMRS (see Hansen and Jagannathan, 1991). The standard deviation m is given as, −1

 m ≥ (( EQ − E (Q + D) Em) ∑Q + D ( EQ − E (Q + D) Em))

1 2

(3.13 )

where ΣQ + D is the covariance matrix of asset returns. Under risk neutrality the discount factor is constant – that is, the IMRS is constant, implying that m = 0. Hence, the mean of all asset prices is strictly proportional to the mean of asset payoffs, where the factor of proportionality equals the constant Em. The standard deviation of the IMRS can therefore be thought of as the quadratic form in the deviations of the average prices from their risk neutral prices. Moreover, large deviations from risk neutrality imply large volatility of the IMRS. From (3.13) we then derive the relationship between Em and m – that is, the admissible region consistent with asset market data. Figure 3.5 illustrates such an admissible region. Figure 3.5

Bounds on moments of m and sample estimates

3.5

3 2.5

Bound/Admissible region

2

Sample estimates

1.5

1

0.5

0 0.8

0.9

1

1.1

Mean m

1.2

1.3

Stock and Bond Investments in Denmark

83

A common utility function in this area of research is the one with constant relative risk aversion (see (3.14)), which produces the IMRS given by (3.15). u(Z) = (Z 1− − 1) / (1 − ) −1

(3.14) 

m(t + 1) = (1 +  ) ((Zt ) / Zt−1 ))

(3.15)

where Z denotes consumption. Given data for consumption and guess values for the risk aversion coefficient  and (1 + )–1, we obtain a timeseries for m(t + 1).8 We then calculate the mean and standard deviation of the IMRS consistent with the utility function. This procedure is repeated for different values of . By plotting the pair of mean and standard deviations associated with different risk aversion parameters into Figure 3.5 we may check whether the particular consumption-based asset pricing falls within the admissible region. Notice, that this gives information about the admissible values of the risk aversion parameter. Estimated Risk Aversion and Intertemporal Marginal Rate of Substitution Figure 3.5 shows the estimated bounds on combinations of the mean IMRS and its standard deviation using our asset return data (cf. (3.13)). The mean IMRS and its standard deviation consistent with the CRRA utility function is shown as the dotted line, assuming that the rate of time preference is 1 per cent (i.e. (1 + )–1 = 0.99). As the relative risk aversion parameter  increases, Em first declines but increases at a later stage. The standard deviation is always increasing. For a risk aversion parameter  = 5, the dotted line is in the admissible region – that is, the consumption-based asset pricing model appears to be consistent with asset returns. Figure 3.5 also shows that Em is in the interval (0.9–1.0), which seems to be the interval where most would expect to find the mean value of the IMRS. The standard deviation is high but below 0.5, suggesting that the IMRS shows a great deal of variability. In case (1 + )–1 = 0.97, the risk aversion parameter  will have to equal 3.7 in order for the model to be consistent with market data. A risk aversion parameter of that size may be too high to be credible (see Table 3.6). So far, we have assumed that the utility function is time-separable, implying that individuals are not subject to any form of habit formation. In reality, individuals with a high consumption level today may have strong preferences for maintaining that level in the future. The idea that consumers tend to get spoiled is modelled by the habit persistence utility function. Formally, a high level of consumption today increases the marginal utility of consumption in the future, which therefore pulls in the direction of a high consumption level also in the future. Similarly, when income falls consumers

Nielsen and Risager

84

Table 3.6 What amount, X, would make a person with CRRA utility indifferent between participating in a gamble with equal probabilities of receiving 50 and 100, and receiving X with probability 1? X



70.711 63.246 58.566 53.991 51.858 51.209

1 3 5 10 20 30

Source: Mankiw and Zeldes (1991).

are reluctant in adjusting consumption first – that is, there is a ratchet effect. Habit persistence tends in general to increase the IMRS and its standard deviation; derivations can be obtained on request. Hence, a lower value of the risk aversion parameter is required in order for the CAPM model to be consistent with market prices. Our results show that the risk aversion parameter may be as low as 2 both in the case where (1 + )–1 = 0.99, and where (1 + )–1 = 0.97. As the degree of risk aversion seems to be at a level that does not seem to be too unrealistic, it is of interest to explore further aspects of the consumption-based asset pricing theory. Figure 3.6

Perfect foresight stock price decomposition, 1921–95

Risk averse (real) stock market price under perfect foresight Risk neutral (real) stock market price under perfect foresight Real stock market price

Stock and Bond Investments in Denmark

85

On the Level and Variability of Stock Prices since 1920 What would stock prices be if agents have perfect foresight and behave according to (3.11)? Figure 3.6 plots the actual index Q and the real perfect foresight index Q*, under the assumptions of constant relative risk aversion, (1 + )–1 = 0.99, and  = 3.5, where the relative risk aversion parameter is in the neighborhood of our estimated value. The perfect foresight index traces the market index well until 1933. Thereafter, Q* starts to fall whereas Q rises until 1936. The biggest decline in Q* occurs in 1940. Thus, Q* falls from 121 in 1939 to 47 in 1940. Q only declines from 131 in 1939 to 106 in 1940. Hence, Q is more than twice as high as Q* in 1940. It is of interest to find out why Q* drops by so much in 1940. Recall that Q* equals the discounted dividends, where the discount rates are the IMRS. Because consumption falls very significantly in 1940, owing to the outbreak of the Second World War, marginal utility increases substantially. That leads to a significant reduction in the IMRS, which in part accounts for the large fall in Q*. Put differently, the outbreak of war and the sharp fall in consumption leads to a large increase in agents’ subjective real interest rate. Our calculations show that the latter is high though slightly below 20 per cent during the war, where the subjective interest rate is the internal interest rate implied by the IMRS from 1940 and onwards.9 Besides the increase in the real interest rate, there is also a fall in the dividend yield (see Figure 3.7).

Figure 3.7 0.12 0.1 0.08 0.06 0.04 0.02 0

Dividend yield, per cent, 1921–95

86

Nielsen and Risager

It is possible to show that it is the rise in the discount rate that is the most important explanation of the enormous fall in Q*. Thus, by calculating the perfect foresight path under the assumption of a constant discount rate, we get the risk neutral price line also shown in Figure 3.6. The risk neutral price line displays only a tiny fall in 1940. Hence, it is mainly the rise in the discount rate that explains the jump in Q* in 1940. Insofar as Q falls only relatively little, it is plausible that part of the divergence between Q and Q* reflects a discrepancy between the discount rate used in the market and the discount rate implied by the Consumption– CAPM – that is, a failure of the model to produce a realistic discount rate. This need not be entirely due to the theory; it may in part be due to a relatively imprecise measure of private agents’ consumption. Moreover, the discrepancy between Q and Q* may of course also reflect uncertainty and expectations errors. It is important to stress that the divergence between Q and Q* does not allow us automatically to conclude that the theory is invalid. Simulations by Kleidon (1986) show that if stock prices are non-stationary (follow a geometric random walk) and by construction are consistent with rational valuation models like ours, then it is still possible to have deviations between Q and Q* of the magnitude shown in Figure 3.6, even though the underlying data generating process is the theory model. In this context it is, however, important to recall that our previous results reject the random walk hypothesis, as does the earlier Danish study by Jennergren and Toft-Nielsen (1977). Moreover, the large divergence in 1940, which is mainly due to a large discrepancy between the market and the model discount rate, does indicate that in order to get a better understanding of the stock market we need to get a better understanding of how the market discounts the future dividends. It is interesting to note that the problem with tracing the level of the stock market does not carry over to its variability. Thus, the variances of the rate of change of Q and Q* are almost identical. This is surprising in view of the findings for the United States (see Grossman and Shiller, 1981; Kleidon, 1986). Moreover, it indicates that the market over the entire period 1922–95 has not been excessively volatile. This conclusion is underscored by the fact that the sample variance of the perfect foresight index may be severely downward biased (see Flavin, 1983). It is natural to investigate the implications of replacing the theory-based IMRS with the actual real interest rates as discount factors. Figure 3.8 shows the index when the actual real rate is used in the discounting as well as the actual index and the Consumption–CAPM index also shown in Figure 3.6. It appears that the index based on the actual real interest rate as the discount rate does a slightly better job in tracing the level of the stock market, whereas the Consumption–CAPM index is more in line with reality when it comes to explaining stock market volatility.

Stock and Bond Investments in Denmark

87

Figure 3.8 Perfect foresight stock prices under the consumption–CAPM and real interest rate discounting, 1921–95

Risk averse (real) stock market price under perfect foresight Risk stock market price under real interest rate discounting Real stock market price

3.4

POLICY IMPLICATIONS

As mentioned earlier, Danish pension funds and life insurance companies are subject to an upper limit on their stock investments. The current regulations state that only 40 per cent of these institutional investors’ pension liabilities can be held in stocks. The Wage Earners’ Fund (Lønmodtagernes Dyrtidsfond) and the Supplementary Pension Fund (ATP) are subject to even tougher regulations, as the upper limit for them is 35 per cent. The main reason for the quantitative regulation is the perception that stocks are more risky than other assets. This view is, for instance, expressed very clearly in 1981 when the Government proposed to raise the limit that applied in 1981. In the text of the law, stocks are characterized as ‘risky assets’ as opposed to bonds, and in comments attached to the proposal it is argued that: from the savers’ point of view variation in rates of return due to changes in business profitability implies a risk of receiving less return than could have been obtained elsewhere, even if the investment is viewed over a long time span. (Our translation) Another reason for the quantitative regulation may be various governments’ need to finance their budget deficits – that is, to be able to issue government bonds at a favourable price. This argument applies, of course, only under imperfect international capital mobility, and may therefore be of less

Nielsen and Risager

88

importance nowadays. A third concern is political and has to do with the fear of Fund’s socialism. As documented earlier, stocks are not more risky than bonds provided the portfolio is sufficiently diversified and provided the investment horizon is sufficiently long. Hence, the ‘risk argument’ is based on false premises. There is therefore a need to reconsider the present regulatory framework even though it is only the wage earners’ pension fund that effectively has been constrained by the upper limit. One reason why other investors (for example, insurance companies) have not hit the roof so far is that they are also constrained by certain minimum yield requirements, which distort their portfolios towards assets with low short-term risk (e.g. bonds). There are several potential advantages of liberalizing the investment regime. First, by encouraging pension funds and other investors to allocate a larger proportion of their funds to stocks, savers can obtain a higher return on their investments without incurring a larger risk. Of course, this assumes that the equity premium will apply also in the future and that pension funds are not able perfectly to match bond maturity with liabilities. Simple calculations suggest that the gains of increasing the proportion of stocks in the portfolios are substantial. Second, firms will get easier access to capital, which may encourage investment and growth. Finally, as bond markets are nowadays highly integrated internationally, a further softening of the regulatory framework may not affect governments’ ability to finance deficits. Besides the 40 per cent regulation, there is also a 20 per cent upper limit on the holdings of assets denominated in other currencies than liabilities. Given that the liabilities are in Danish Kroner, this means that these investors can only allocate 20 per cent of their funds to foreign assets. The possibility of having a sufficiently internationally diversified portfolio may therefore be severely restricted. This may lead to portfolios that are inefficiently biased towards home assets. The home-bias issue is outside the scope of this chapter, but we plan to return to this issue in future work.

3.5

CONCLUSIONS

The main achievement of this chapter has been to calculate and report the return–risk properties of Danish stocks and bonds over the historical period 1922–95 using our own database. Thus, we have reported the return–risk characteristics of 1-, 5- and 10-year stock investments, and the yield–risk characteristics of 5- and 10-year Government bond investments. In the subsequent theoretical sections, we have tested whether the behaviour of short-run stock returns can be explained by the Consumption–CAPM using

Stock and Bond Investments in Denmark

89

the non-parametric test by Hansen and Jagannathan (1991) and the informal test by Grossman and Shiller (1981). Our results show that stocks yield a higher average return than bonds and that short-run stock investments are much more risky than bond investments, whereas long-run stock investments are less risky. This chapter’s explanation of this apparently provocative and paradoxical finding, reported also in Christiansen and Lystbæk (1994) and Siegel (1994), is the mean-reversion property of real stock returns. Thus, bad years in the market are usually more than offset by the good years that follow later, whereas bond yields display positive autocorrelation. Because the existing regulatory framework for institutional investors is based on the premise that stocks are more risky than bonds, we have argued that these return–risk results call for a further softening of the quantitative regulations, if not a complete abandonment, simply because pension funds and other institutional investors are able to pursue long-run strategies with highly diversified portfolios. We have also argued that such a policy change will be close to a Pareto improvement insofar as both pensioners and firms listed on the stock market will benefit from such a liberalization. Our tests of the consumption-based asset pricing model yield mixed results. The estimate of the risk aversion parameter under constant relative risk aversion and in particular under habit formation is in the plausible range. However, as the level of the implied perfect foresight stock market index is very far from the actual index from the late 1930s and until the beginning of the 1970s, we have doubts about the validity of the underlying theory even though Kleidon (1988) has shown that this type of information may be too soft to reject the theory. However, Nielsen and Risager (1997) also reject the consumption-based view of stock prices and this is indeed also the typical finding in the international literature. It seems to us that the key issue is to get a better understanding of the discounting process insofar as dividends explain only a tiny fraction of stock market volatility. We plan to return to this issue in future work. Notes 1.

The paper on which this chapter is based has been presented at seminars at the MBA Programme and the Institute of Economics, Copenhagen Business School, and at the conference ‘Macroeconomic Perspectives on the Danish Economy’ (Hornbæk) 19–20 June 1997. We wish to thank Syed M. Ahsan, Copenhagen Business School; Tom Engsted, Aarhus Business School; Lars Lund, Copenhagen Business School; Jan Olesen, Copenhagen Business School; Bjorn Hansson, University of Lund and Paolo Pesenti, Princeton University for useful comments and suggestions. We have also benefited from discussions with Henrik W. Mogensen, Tryg-Baltica. Finally, thanks to Ian Valsted and Michael Wieman for efficient research assistance.

Nielsen and Risager

90 2. 3. 4. 5. 6. 7. 8. 9.

Frennberg and Hansson (1992) show that this is of very little importance for the calculation of Swedish stock returns over the period 1919–89. The difference between the exact and the approximate definition can be large when returns are fairly large, which is not uncommon in stock markets. Despite the importance of this result, it should be mentioned that the statistical significance is unclear (and will remain unclear for many years) as there are obviously too few 10-year periods. Real returns are only normal distributed when we omit observations for 1972 and 1983, but in this case we also get strong negative autocorrelation. We assume that the 5-year bond yield can be used as a proxy for the 1-year yield. We have used the law of iterated expectations. Data is real consumption per capita obtained from Danmarks Statistik and Hansen (1974). The internal interest rate for 1940, for example, is defined as the interest rate that discounts a future stream of income to the same amount as our IMRS from 1940–95 does.

References Andersen, T.M. and O. Risager (1988) ‘Stabilization policies, credibility, and interest rate determination in a small open economy’, European Economic Review, 32, pp. 669–79. Breeden, D. (1979) ‘An intertemporal asset pricing model with stochastic consumption and investment opportunities’, Journal of Financial Economics, 7(3), pp. 265–96. Bodie, Z., A. Kane and A.J. Marcus (1993) Investments (Boston: Irwin). Campbell, J.Y. and R.J. Shiller (1988) ‘The dividend–price ratio and expectations of future dividends and discount factors’, Review of Financial Studies, 1, pp. 195–228. Christiansen, J. and B. Lystbæk (1994) ‘Afkast og Risiko På Aktier og Obligationer 1915–1993’, Finans Invest, pp. 10–13. Deaton, A. (1992) Understanding Consumption (Oxford: Clarendon Press). Engsted, T. (1996) ‘Evaluating the consumption–capital Asset Pricing Model using Hansen–Jagannathan bounds: evidence from the UK’, Working Paper, Aarhus Business School. Eskesen, L., F.D. Jensen, E. Rygner and O. Zacchi (1984) Finansielle Institutioner og Markeder (Jurist- og Økonomforbundets Forlag). Flavin, M.A. (1983) ‘Excess volatility in the financial markets: a reassessment of the empirical evidence’, Journal of Political Economy, 91, pp. 929–56. Frennberg, P. and B. Hansson (1992) ‘Computation of a monthly index for Swedish stock returns 1919–1989’, Scandinavian Economic History Review, 1, pp. 3–27. Grossman, S.J. and R. Shiller (1981) ‘The determinants of the variability of stock market prices’, American Economic Review, 71(2), pp. 222–7. Hansen, K. (1974) Om Afkastet af Danske Aktier i tiden 1900–1974, Nordisk Fjerfabriks Jubilæimsskrift, Nordisk Fjerfabrik, pp. 191–220. Hansen, L.P. and R. Jagannathan (1991) ‘Implications of security market data for models of dynamic economies’, Journal of Political Economy, 99, pp. 225–62. Hansen, S.Å. (1974) ‘Økonomisk vækst i Danmark (Economic Growth in Denmark)’ (Copenhagen: Akademisk Forlag). Jennergren, L.P. and P. Toft-Nielsen (1977) ‘An investigation of random walks in the Danish stock market’, Nationaløkonomisk Tidsskrift, pp. 254–69.

Stock and Bond Investments in Denmark

91

Kleidon, A.W. (1988) ‘Variance bounds tests and stock price valuation models’, Journal of Political Economy, 94, pp. 953–1001. Kocherlakota, N.R. (1996) ‘The equity premium: it’s still a puzzle’, Journal of Economic Literature, pp. 42–71. Lucas, R.E., Jr. (1978) ‘Asset prices in an exchange economy’, Econometrica, 46(6), pp. 1429–45. Lund, J. and T. Engsted (1996) ‘GMM and present value tests of the C–CAPM: evidence from the Danish, German, Swedish and UK stock markets’, Journal of International Money and Finance, 15, pp. 497–521. Mankiw, N.G. and S.P. Zeldes (1991) ‘The consumption of stockholders and nonstockholders’, Journal of Financial Economics, 29, pp. 97–112. Mehra, R. and E.C. Prescott (1985) ‘The equity premium: a puzzle’, Journal of Monetary Economics, 15, pp. 145–61. Nielsen, S. and O. Risager (1997) ‘On the long run stock return puzzle in Denmark and the C–CAPM’, Working Paper, Copenhagen Business School (preliminary). OECD (1996) Statistical Compendium, CD-Rom. Olsen, E. and E. Hoffmeyer (1968) ‘Dansk Pengehistorie 1914–1960’ (Danmarks Nationalbank). Pagan, A. (1996) ‘The econometrics of financial markets’, Journal of Empirical Finance, 3, pp. 15–102. Poterba, J.M. and A.A. Samwick (1995) ‘Stock ownership patterns, stock market fluctuations, and consumption’, Brookings Papers on Economic Activity, 2, pp. 295–372. Poterba, J.M. and L.H. Summers (1988) ‘Mean reversion in stock prices – evidence and implications’, Journal of Financial Economics, 22, pp. 27–59. Siegel, J.J. (1994) Stocks for the Long Run (New York: Irwin).

Comment1 Tom Engsted

1

INTRODUCTION

The equity premium – that is, the difference between expected returns on stocks and bonds – has been the subject of a large number of empirical studies. One of the main findings in this literature is that in most countries the premium is too large to be explained by standard intertemporal equilibrium asset pricing models (the ‘equity premium puzzle’) (see Campbell, 1996 for a recent survey with multi-country empirical results). Chapter 3 by Nielsen and Risager adds to this literature by presenting new results for Denmark, and finds that the Danish equity premium appears to pose a much smaller puzzle compared to other countries. The chapter contains three main sections. (1) A description of Danish equity premia with 5- and 10-year bond and stock returns; (2) Evaluation of the consumption-based capital asset pricing model (C–CAPM) with 1-year returns; and (3) Policy implications. In my discussion, I will make some comments on each of these. The main part of my discussion will focus on (2). In particular, I will discuss the way Nielsen and Risager test and evaluate the C–CAPM, and I will compare their results with my own previous results using similar data (see Lund and Engsted, 1996). I will also express some reservations about some of the analyses and conclusions carried out and reached by Nielsen and Risager, and in particular I will argue that the chapter does not support a lifting of the current regulations on Danish pension funds.

2

THE DANISH EQUITY PREMIUM

It has long been recognized (at least since Lawrence Smith in 1924, see Siegel, 1994) that on average stocks earn a larger return than bills and bonds. The usual explanation given is that stock returns are more volatile than bond returns so the higher return is just a compensation for higher risk. However, recently Siegel (1992, 1994) showed that on US data, long-horizon (10–20 years) stock returns are not only higher than equivalent bond returns, but apparently are also less variable – that is, stocks are safer than bonds at long investment horizons. One of the main results of Section 3.2 of Nielsen and Risager’s chapter is that this also seems to hold for Denmark. Siegel (1992, 1994) and Blanchard (1993) give the following explanation for the large equity premium. The stock market crash in 1929 and subsequent depression in the 1930s caused investors to move from stocks to bonds, thus raising the equity premium on stocks. This went on till around 1950. Then the memories of the 1930s faded, investors returned to stocks, and the premium went down steadily until the beginning of the 1970s when high and unanticipated inflation caused the expected real return on bonds to be much higher than the realized return. Thus, since real stock

92

Comment

93

returns did not change much (as opposed to bonds, stocks are a claim to real payments), the observed equity premium increased again until the beginning of the 1980s where inflation rates decreased, causing the observed premium to decline again. So, the large average equity premium since the 1920s is due to the crash in 1929 in combination with inflation misperceptions in the post-Second World War period. Both Siegel and Blanchard find that the equity premium has decreased quite a lot since the beginning of the 1980s, and they both predict that in the future the premium will be much lower than in the 1930–80 period. Nielsen and Risager also find that on the Danish data the equity premium has been much lower (in fact negative) in the 1983–95 period compared to the earlier one. Thus any clearcut statements about the attractiveness of stocks compared to bonds at long investment horizons must be looked at with major reservations, in particular since the uncertainty associated with estimating long-horizon equity premia is very large. As the authors themselves note, the standard deviations reported in Table 3.2 are severely downward-biased due to the inherent smoothness (serial correlation) of long-horizon returns. In general, n-period overlapping returns will exhibit moving average (MA) properties of order n – 1. Thus, on annual data 5- and 10-year returns will be MA(4) and MA(9), respectively. The method most often used for correcting for such effects is the Newey and West (1987) estimator. By using this correction the standard deviations of 5-year real bond and stock returns change from 4.2 per cent to 10.6 per cent, and from 6.3 per cent to 11.3 per cent, respectively. The changes for 10-year returns are: bonds, from 4.4 per cent to 13.3 per cent; stocks, from 3.6 per cent to 8.7 per cent. This reflects the fact that the effective number of observations is smaller due to overlapping returns. Unfortunately, these new, much larger, estimates must also be interpreted with great care. As shown by, for example, Richardson and Stock (1989), correcting for moving-average terms in time-overlapping returns using the Newey–West estimator (or similar methods) can be very unreliable when the degree of overlap is large, which is surely the case for the 10-year returns. Instead, Nielsen and Risager suggest looking at non-overlapping 5- and 10-year returns (Table 3.3). The problem here again, of course, is that this diminishes the number of observations dramatically. In fact, there are only seven independent 10-year returns over the period 1922–95. The bottom line is that the uncertainty associated with estimating the Danish equity premium is so large that, in my opinion, one should abstain from making any recommendations about investment behaviour based on it. (Note that these concerns may not be raised to the same extent towards the analyses in Siegel, 1994, because his sample is much larger (nearly 200 years of annual US data) and his estimated equity premia are much larger than the Danish premia). Finally, as we shall see shortly, a standard deviation may not be the relevant measure of risk from the outset. In the C–CAPM, for instance, the proper measure of risk is not the standard deviation of returns per se, but rather the asset’s covariation with the intertemporal marginal rate of substitution, IMRS (that is, some function of consumption. Thus, a full understanding of risk cannot be achieved without reference to an underlying economic model. In moving to section 3.3 of the chapter, let me add that I find it peculiar that, whereas section 3.2 deals with 5- and 10-year returns, section 3.3 only deals with 1-year returns. Thereby the connections between the two sections become less transparent. It would have been obvious to include in section 3.2 a comparison of 1-year stock and bond returns, and in section 3.3 to evaluate the C–CAPM at 5and 10-year horizons also. As I have access to Christiansen and Lystbæk’s (1994) 1-year holding period return on long bonds (updated to 1995), a comparison with Nielsen and Risager’s 1-year stock return is easily made. The average 1-year equity

Engsted

94

premium is 2.8 per cent with a standard deviation of 2.0 per cent, hence the premium is not significant.

3

THE C–CAPM

The claim that stocks dominate bonds with respect to both risk and return is counterintuitive from a finance theory point of view. How can an asset on average yield both higher return and less risk than another asset? It seems to pose a major challenge to conventional finance theory. Modern finance theory, however, is much more complex than just comparing the average returns and volatilities of different assets. In the C–CAPM the returns on different assets reflect the amount of risk (measured by the asset’s covariance with the IMRS (typically proportional to consumption growth) and the price of risk (measured by the degree of risk aversion)). Thus, according to the C–CAPM the equity premium is large if stocks covary much more with consumption than do bonds, and/or people are highly risk averse. In modern finance literature, this model is surely the most prominent intertemporal equilibrium model of asset returns. One of the reasons is that it provides the link from the macro-economy to asset pricing that financial economists have always sought – that is, risk premia are explained by assets’ covariation with consumption. The famous equity premium puzzle (cf. Mehra and Prescott, 1985) is built directly on the C–CAPM. The puzzle says that over a 100-year period in the United States, the equity premium cannot be explained by the constant relative risk aversion (CRRA) – and complete markets/no transactions costs – specification of the C–CAPM unless people are extremely risk averse. The reason is that 1-year stock returns only covary slightly more with consumption growth than do T-bill returns or short-term money market returns. In the literature various responses to the puzzle have been brought forward. (1) The C–CAPM framework is fundamentally wrong; (2) The C–CAPM framework is correct, but the CRRA specification is wrong; (3) The C–CAPM/CRRA framework is correct, but markets are incomplete and there are transaction costs. (4) The C–CAPM/CRRA framework is correct and people are extremely risk averse. The problem with (1) of course is to provide a better alternative. The response in (4) is simply to deny that there is a puzzle. The problem then is that extreme risk aversion is both highly counter-intuitive and implies a very large risk-free real interest rate (that is the ‘risk-free rate puzzle’, see Weil, 1989). In my opinion, responses (2) and (3) are the most fruitful, and important new insights have been gained along these lines (see, for example, Constantinides, 1990; Campbell and Cochrane, 1995; Luttmer, 1996) for analyses of time-non-separabilities and market frictions within the C–CAPM framework. The C–CAPM is the topic for section 3.3 of the chapter. The first thing to ask in the present context is whether the equity premium also poses a puzzle in the Danish data? It appears from the results in Nielsen and Risager’s chapter that the puzzle is not nearly as severe in Denmark as in the United States (or other countries, see Campbell, 1996; Engsted, 1997), since the degree of risk aversion  has only to be 5 in order for the IMRS to satisfy the Hansen–Jagannathan volatility bound (the chapter does not allow for sampling error in construction of the IMRSs and volatility bound; doing that would decrease the required value of  even further (see Burnside, 1994). From Table 3.5 in the chapter it is clear that the reason is not that stocks covary much more with consumption than bonds (the two covariances are both close to 0.001). The reason is simply that the Danish equity premium is much smaller compared to the

Comment

95

United States and the United Kingdom, and that Danish consumption is quite volatile (the variance of Danish consumption growth is more than double the variance of US consumption growth (see Table 3.5 in the chapter and Table 1 in Kocherlakota, 1996). One can decrease the level of  even further by allowing for habit persistence. The chapter claims that in the Danish data, and under habit persistence,  can be as low as 2 without the IMRS violating the volatility bound. The overall conclusion from the Hansen–Jagannathan analysis is that one does not need extreme degrees of risk aversion in order for the mean and standard deviation of the IMRS to be inside the admissible region implied by observed Danish asset returns. Thus, apparently there is no equity premium puzzle in the Danish data. This stands in dramatic contrast to the results observed for other countries. However, there is an important difference between Chapter 3 and the related research on the equity premium puzzle – namely, that in the chapter the premium is not defined as the 1-year stock return in excess of a risk-less annualized short-term interest rate, but rather as the 1-year stock return in excess of a risky annualized 5year bond return. This choice is probably partly dictated by the lack of a proper shortterm interest rate in Denmark back to the 1920s. Although fully legitimate in evaluating the C–CAPM per se by means of the Hansen–Jagannathan bounds, it implies that the results in the chapter cannot be directly compared to the results in the related international equity premium puzzle literature. Further, regarding habit persistence, the chapter does not report the value of the habit persistence parameter, which is unfortunate since for some values of this parameter utility is not well-defined. In addition, one should note that allowing for habit persistence is in some sense an artificial way of reducing the required degree of risk aversion, since risk aversion now varies with the level of consumption relative to habit. Thus a value of  equal to 2 does not necessarily imply low risk aversion (for details on these issues, see, for example, Chapter 8 in Campbell, Lo and MacKinley, 1997). Nielsen and Risager also evaluate the model by means of the Grossman–Shiller variance bounds methodology. However, it has long been known that if stock prices and dividends are non-stationary I(1), or nearly non-stationary, then the Grossman and Shiller variance bounds methodology (which builds on Shiller, 1981, is simply invalid, see, for example, Kleidon, 1986). Second, when the discount factor is close to unity, the variance of the perfect foresight price is severely downward-biased in a finite sample (see Flavin, 1983). Nielsen and Risager seem to argue that since Danish stock returns are negatively autocorrelated, stock prices must be stationary – and, hence, Kleidon’s critisism does not apply. However, negatively autocorrelated returns do not in general imply stationary prices. In fact, if dividends are non-stationary, then prices must also be non-stationary according to the C–CAPM. Lund (1992) finds Danish annual real dividends and stock prices to be I(1) over the period 1923–90, and a standard augmented Dickey–Fuller test on Nielsen and Risager’s real stock price series also clearly indicates that it is I(1). Hence, the stationarity assumption required in order to compute the Grossman–Shiller variance bounds appears to be violated in the authors’ data, thereby casting doubt on the claims concerning the variability of prices and perfect foresight prices on pp. 85–7.2 Furthermore, even if we assume stationarity, it is important to note that in general Q* will not be identical to Q when the C–CAPM is true. All one can say is that the variance of Q* should be larger than or equal to the variance of Q. This complicates the interpretation of what happens in specific subperiods during the sample (as, for example, the dramatic jump in Q* in 1940). In my opinion, if one wants to pick out and interpret such specific events, one has to use a method which, in contrast to the Grossman–Shiller method, implies equality between actual and model generated stock prices under the C–CAPM. Such methods have been developed (for example, the Campbell–Shiller method, see p. 96).

96

Engsted

For the reasons stated above, the original variance bounds methodology of Shiller and Grossman and Shiller has been dismissed and replaced by superior methodologies in the recent literature. One such methodology is the vector-autoregressive (VAR) methodology developed by Campbell and Shiller (1988). The idea here is first to obtain a linearized present value model expressed in terms of stationary variables – namely the log dividend-price ratio and first-differences of log dividends and log consumption. Next, a VAR model is estimated for these variables, and a VAR forecast of the present value of future changes in log dividends and log consumption is generated and compared with the actual log dividend–price ratio. By using this methodology on annual Danish data (1923–90) very similar to the data in Chapter 3, Lund and Engsted (1996) find that a substantial part of the variation in stock prices can be explained by rationally expected future dividends, but also that the unexplained part of the variation cannot be accounted for by consumption growth in the manner predicted by the C–CAPM with CRRA utility. Thus, our results are in some sense directly in contrast to the conclusions reached by Nielsen and Risager. Unfortunately, Nielsen and Risager make no attempt to try and reconcile these conflicting results.

3

POLICY IMPLICATIONS AND CONCLUDING REMARKS

In my discussion I have expressed some reservations about parts of the analyses carried out by Nielsen and Risager. In particular I have emphasized the ambiguity and huge uncertainty involved in estimating risks of long-horizon returns, and the problems with the Grossman–Shiller methodology. I therefore suggest that the results obtained by Nielsen and Risager are best interpreted with great care. In particular, the authors’ conclusion that long-horizon Danish stock returns are both higher and less risky than long-horizon bond returns needs to be looked at very critically. Firstly, the estimated mean long-horizon Danish equity premium is simply too small, and its associated standard deviation too large, to conclude with sufficient statistical certainty that Danish stocks yield higher returns, and are less variable, than bonds over the long term. These points are reinforced by noting that, although Danish stock returns have been extremely high in 1996 and 1997, the equity premium in the period 1983–95 has on average been negative, and there are clear indications of lower future premia internationally (see Blanchard, 1993; Siegel, 1994). Secondly, the riskiness of stocks and bonds may not be measured only by their respective standard deviations. Modern finance theory instead suggests that an asset’s risk is intimately related to the asset’s covariation with the underlying economic fundamentals. Thus, in my opinion, there is no support for the authors’ recommendation of a lifting of the current regulations on Danish pension funds (at least not from the results in the chapter). Aside from the reservations stated above, one may argue, as does Finansrådet (1997), that these regulations have actually not been particularly binding or seriously restricted the pension funds’ behaviour. In fact, in 1995 only 15.8 per cent of Danish pensions funds’ wealth was put into stocks, and although this is an increase from 7.4 per cent in 1986, it indicates that for the sector as a whole Danish pension funds actually do not place wealth in stocks up to the limit. As noted by Nielsen and Risager, one possible reason for the small amount of stocks in the Danish pension funds’ portfolios is the specific minimum yield requirements for those funds. However, one should also remember that in Denmark there is a substantial issuance of mortgage bonds to finance real estate. So, from an immunization point of view, it seems reasonable to have a substantial amount of bonds among the private sector’s

Comment

97

assets, such that in case of interest rate changes, which increase the value of private sector’s liabilities, this is offset by a similar increase in the value of its assets.

Notes 1. 2.

I thank my colleagues at the Department of Finance, The Aarhus School of Business, for useful discussions in relation to the Danish equity premium. The usual disclaimer applies. Incidentally, Nielsen and Risager compare the variances of the rate of change of prices (Q) and perfect foresight prices (Q*), although, whether or not prices and dividends are stationary, the model has no implication for such rate of changes. The model has implications only for the variance of the levels of Q and Q*, and then only under stationarity.

References Blanchard, O. (1993) ‘Movements in the equity premium’, Brookings Papers on Economic Activity, 2, pp. 75–118. Burnside, C. (1994) ‘Hansen–Jagannathan bounds as classical tests of asset pricing models’, Journal of Business and Economic Statistics, 12, pp. 57–79. Campbell, J.Y. (1996) ‘Consumption and the stock market: interpreting international evidence’, NBER Working Paper 5610 (Cambridge, Mass.: NBER). Campbell, J.Y. and J. Cochrane (1995), ‘By force of habit: a consumption based explanation of aggregate stock market behavior’, Unpublished working paper, Harvard University and University of Chicago. Campbell, J.Y. and R.J. Shiller (1988), ‘The dividend–price ratio and expectations of future dividends and discount factors’, Review of Financial Studies, 1, pp. 195–227. Campbell, J.Y., A.W. Lo and A.C. MacKinlay (1997) The Econometrics of Financial Markets (Princeton: Princeton University Press). Christiansen, J. and B. Lystbæk (1994) ‘Afkast og risiko på aktier og obligationer 1915–1993’, Finans/Invest, pp. 10–13. Constantinides, G. (1990), ‘Habit formation: a resolution of the equity premium puzzle’, Journal of Political Economy, 98, pp. 519–43. Engsted, T. (1997) ‘Evaluating the Consumption–Capital Asset Pricing Model using Hansen–Jagannathan bounds: evidence from the UK’, Working paper, Aarhus School of Business. Finansrådet (1997) Privates opsparing i Danmark, Danske Pengeinstitutters Forening. Flavin, M. (1983) ‘Excess volatility in the financial markets: a reassessment of the empirical evidence’, Journal of Political Economy, 91, pp. 929–56. Kleidon, A. (1986) ‘Variance bounds tests and stock price valuation models’, Journal of Political Economy, 94, pp. 953–1001. Kocherlakota, N. (1996) ‘The equity premium: it’s still a puzzle’, Journal of Economic Literature, 34, pp. 42–71. Lund, J. (1992) ‘Rationelle bobler i de danske aktiekurser 1923–1991: en empirisk analyse’, Nationaløkonomisk Tidsskrift, 130, pp. 483–97. Lund, J. and T. Engsted (1996) ‘GMM and present value tests of the C–CAPM: evidence from Danish, German, Swedish and UK stock markets’, Journal of International Money and Finance, 15, pp. 497–521.

98

Engsted

Luttmer, E. (1996) ‘Asset pricing in economies with frictions’, Econometrica, 64, pp. 1439–68. Mehra, R. and E. Prescott (1985) ‘The equity premium: a puzzle?’, Journal of Monetary Economics, 15, pp. 145–61. Newey, W. and K.D. West (1987) ‘A simple, positive semi-definite, heteroscedasticity and autocorrelation consistent covariance matrix’, Econometrica, 55, pp. 703–8. Richardson, M. and J. Stock (1989) ‘Drawing inferences from statistics based on multi-year asset returns’, Journal of Financial Economics, 25, pp. 323–48. Shiller, J.R. (1981) ‘Do stock prices move too much to be justified by subsequent changes in dividends?’, American Economic Review, 71, pp. 421–36. Siegel, J. (1992) ‘The equity premium: stock and bond returns since 1802’, Financial Analysts’ Journal (January–February), pp. 28–46. Siegel, J. (1994) Stocks For the Long Run (New York: Irwin). Weil, P. (1989) ‘The equity premium puzzle and the risk-free rate puzzle’, Journal of Monetary Economics, 24, pp. 401–21.

Comment Björn Hansson

1

INTRODUCTION

Nielsen and Risager have in Chapter 3 written a very interesting study of long-run relations on the Danish stock market and fixed income market. My comments will concentrate on their results on the return and risk characteristics of the Danish assets and I will compare their results for the Danish markets with results from my own studies of the Swedish markets. I will also discuss the contentious result that investing in a well diversified portfolio of stocks is less risky than investing in bonds. Thus, an investor with a long time horizon – for example, saving for old age – should tilt her portfolio weights towards stocks. This recommendation is not unusual among practitioners. In fact, it is almost the conventional wisdom that investors with a long horizon should invest more heavily in stocks than investors with a short horizon, since the riskiness of stocks diminishes with the length of the horizon (see Lee, 1990; Thorley, 1995). However, it is also much criticized by well known economists like Paul Samuelson and Robert Merton (see Samuelson, 1994; Bodie, Merton and Samuelson, 1992; Jagannathan and Kocherlakota, 1996). The tentative conclusions from this debate are as follows: the recommendation is correct if stock returns show meanreversion, which means that the returns tend to revert to the unconditional mean, or the relative risk aversion is decreasing – that is to say, with increasing wealth a greater weight should be given to the risk-bearing asset. In this debate an old issue is missing – namely, the so-called ‘estimation risk’, which implies that the estimates of the distribution of asset returns, which are used in practical applications, deviate from the true distribution, which is supposed to be known in the theoretically derived decision rules (see Bawa, Brown and Klein, 1979). This problem can be handled by simulation (see Liang, Myer and Webb, 1996).

2

A DISCUSSION OF THE RETURN CHARACTERISTICS

Figure C3.1 exhibits the development in real terms of 1 SEK and 1 DKK invested in a well diversified stock portfolio from 1922 until 1996 and where all dividends are reinvested.1 The Swedish portfolio significantly outperforms the Danish portfolio, the terminal values in December 1996 are 239 SEK and 36 DKK respectively. A closer look shows that the evolution was very similar up to the Second World War but then the Swedish stock portfolio grows much faster until the beginning of the 1970s.2 Probably, this difference just reflects the enormous Swedish advantage of being lucky enough to stay out of the war; in fact, production went on during the war and the industrial infrastructure came out of the war unscathed to take advantage of the post-war boom. The story of the oil crises in the 1970s is similar despite some differences in economic

99

100 Figure C3.1 1992–96

Hansson Cumulative real return index for Swedish and Danish stocks

policies, Sweden tried to overcome the slump of the mid 1970s by aggressive demand management, while Denmark had more unplanned budget deficits. The driving factor in both countries was probably the great unexpected inflation. The extremely expansionary path of the 1980s, partly dented in Sweden by the collapse of the property markets and some banks in 1990, are also very similar for the two stock markets. Notice that this similarity is despite opposite economic policies: Sweden devalued by almost 20 per cent in 1982 while Denmark followed a non-accommodation strategy. Table C3.1 shows that the annual real return has been higher in Sweden – 9.5 per cent and 6.8 per cent, respectively. However, the risk as represented by the standard deviation has been slightly higher in Denmark; this difference is mainly because of the last period even if the risk on the Swedish stock market has been particularly high during this period. Another way to look at risk is the number of calendar years with negative returns – in Sweden less than 30 per cent of the years have negative returns while there are as many as 43 per cent in Denmark. Looking at the markets for long bonds in Figure C3.2 the development in the two countries is very similar: the cumulative return index for Denmark is slightly better – the bond portfolio has grown by a factor of 10 and while Sweden has grown by a factor of 8.3 The development differs notably only in two periods – the 1930s and the inflationary period of the 1970s. Notice that the Danish economic policy of the early 1980s gave an enormous boost to the bond market, and thus, this policy made a difference to the bond market. A comparison with the figures from the stock market shows that the stock portfolios have done very much better than the bond portfolios. In fact, in Figure C3.2 it is possible to see that for the 30 years following 1945 the bond portfolios hardly had a constant real value.

Comment Table C3.1

101

Annual real returns, 75 observations, 1922–96 Sweden

Arith. mean (%) Std dex. (%) Median (%) Max. (%) Min. (%) P(neg.) (%) P(S
Denmark

Stocks

Bonds

Stocks

Bonds

9.5 20.4 9.2 55.7 –36.3 29.3 37.3

3.4 11.1 1.5 38.3 –37.0 38.7

6.8 21.6 4.3 103.1 –29.6 42.7 45.3

4.0 14.5 1.4 71.8 –19.3 41.3

Notes: P(neg.) shows percentage of negative returns. P(S
3

PORTFOLIO STRATEGIES

In the analysis of the portfolio composition for a long-term investor Nielsen and Risager based their conclusions on a comparison between the real return and standard deviation for investment horizons of five and 10 years, where the return for the bond portfolio is computed from the arithmetic average of all yields to maturity.

Figure C3.2 Cumulative real return index for Swedish and Danish long-term government bonds 1922–96

Hansson

102

For the same type of problem we have constructed the return for the bond portfolio as a strategy where the whole portfolio is rolled over every year and reinvested in bonds with longest possible maturity.4 Tables C3.2–C3.4 show the result for investment horizons of five, 10 and 20 years5 – the mean return is always substantially higher for the stock portfolio in both markets. However, for the 5-year horizon there was still a possibility that bonds were better for 20 per cent of the Swedish observations and 44 per cent of the Danish observations; for the 10-year horizon the probability has fallen to 17 per cent and 28 per cent, respectively. This result is mainly due to a few good years for bonds which is evident from the difference between the mean and median. The overall abysmal performance of the bond portfolio for all horizons is best illustrated by the fact that for approximately 50 per cent of the observations bonds would not even give back the real value of the invested money. To take into account the fact that our estimates are drawn from a random variable, Darenhill (1997) has simulated the returns via bootstrapping and constructed 95 per cent confidence intervals for the returns.5 The results for Denmark are presented in Figure C3.3. There is never the case that the stock portfolio completely dominates the bond portfolio, in the sense that the confidence intervals do not overlap. But for the 20 year-horizon, and almost for the 10-year horizon, the 95 per cent confidence interval for stocks is above the median of the bond strategy. Thus, there was just a probability of 5 per cent that the stock strategy would do worse than the median bond portfolio. Figure C3.3 gives also a nice illustration of the meaning of saying that risk diminishes with the length of the investment horizon: notice the shrinking of the confidence interval for longer horizons. This phenomenon might be explained by mean-reversion. Nielsen and Risager find some evidence for this in an autocorrelation study. On the Swedish market Frennberg and Hansson (1993) have obtained similar results using more powerful statistical methods.

Table C3.2

Real returns per annum for 5-year investment horizons, 71 overlapping observations, 1922–96 Sweden

Arith. mean (%) Std dev. (%) Median (%) Max. (%) Min. (%) P(neg.) (%) P(S
Denmark

Stocks

Bonds

Stocks

Bonds

8.7 19.1 6.4 26.4 –9.6 20.0 20.0

2.8 12.5 0.6 14.1 –10.0 47.1

5.9 16.4 4.5 25.7 –5.6 25.7 44.3

4.1 17.1 1.2 22.7 –8.6 40.0

Notes: P(neg.) shows percentage of negative returns. P(S
Comment Table C3.3

103

Real returns per annum for 10-year investment horizons, 66 overlapping observations, 1922–96 Sweden

Arith. mean (%) Std dev. (%) Median (%) Max. (%) Min. (%) P(neg.) (%) P(S
Denmark

Stocks

Bonds

Stocks

Bonds

8.0 18.4 6.3 23.3 –1.8 7.7 16.9

2.5 14.4 –0.04 11.4 –4.1 53.8

5.5 14.5 4.0 17.3 –0.7 13.8 27.7

3.9 19.3 0.2 15.7 –4.1 49.2

Notes: P(neg.) shows percentage of negative returns. P(S
4

CONCLUSIONS

Looking at the history of stock and bond returns in Denmark and Sweden, the crucial difference is the positive development of the Swedish stock market for almost 25 years after the end of the Second World War. This difference needs to be analyzed further.

Table C3.4

Real returns per annum for 20-year investment horizons, 56 overlapping observations, 1922–96 Sweden

Arith. mean (%) Std dev. (%) Median (%) Max. (%) Min. (%) P(neg.) (%) P(S
Denmark

Stocks

Bonds

Stocks

Bonds

7.0 11.3 6.1 13.0 1.2 0 7.3

1.1 10.6 –0.03 6.1 –2.7 50.9

4.4 9.7 3.8 8.9 0.4 0 20.0

2.2 16.1 –0.2 9.5 –2.8 58.2

Notes: P(neg.) shows percentage of negative returns. P(S
104

Hansson

Figure C3.3 95 per cent confidence interval for Danish stocks and bonds, constructed from bootstrapping of annual data 25% 20% 15% 10% 5% 0% –5% –10%

Is it just a reflection of the fact that Sweden did not take part in the war? On the other hand, although Denmark was occupied during the war there was no substantial damage done to its industrial infrastructure. Or had Sweden, by chance or prescience, an industrial composition which was better positioned to take part in the post-war boom? From a macroeconomic perspective, it would be interesting to do an in-depth study of the development during the last decades. Have the devaluation policies followed by Sweden vs. the different accommodation strategy pursued by Denmark led to any significant differences between the markets? Finally, although I would support the recommendations that the pension funds and other institutional investors should increase their share of stocks, I am certain that the problem of estimation risk or parameter uncertainty has to be taken into consideration. Furthermore, my prior beliefs are such that I find it quite unlikely that future bond portfolios would behave in such an unfavourable way as they did for a long time after 1945.

Notes 1. 2. 3.

4.

The Danish index is taken from Darenhill (1997), which it is quite similar to the figures from Nielsen and Risager; Darenhill has taken the Swedish data from Frennberg and Hansson. We have not taken into account the exchange rate. The inflationary process seems to have been quite similar in the two countries – from 1922 to 1996 the Swedish price level increased by a factor of 19.5 and the Danish by a factor of 20.5. For the Swedish case, we use a consol up until 1949 and thereafter a bond with a duration of approximately 10 years. In the Danish case, the consol is used until 1960, from 1961 until 1983 the bond with maturity in 2007 and finally a 10-year bond for the last period. In the calculation of the mean and the standard deviation we have not taken into account the fact that the data is overlapping.

Comment 5.

105

Darenhill (1997) has used 1-year data as his base for bootstrapping. Ideally one should use moving blocks in order to capture the dependency in the data (see Hansson and Persson, 1998).

References Bawa, V.S., S.J. Brown and R.W. Klein (1979) Estimation Risk and Optimal Portfolio Choice (Amsterdam: North-Holland, 1979). Bodie, Z., R.C. Merton and W.F. Samuelson (1992) ‘Labour supply flexibility and portfolio choice in a life cycle model’, Journal of Economic Dynamics and Control, 16, pp. 427–49. Darenhill, C. (1997) ‘Tidsdiversificering – en empirisk studie av investeringsförhållanden i Sverige och Danmark’, MA thesis, Department of Economics, Lund University. Frennberg, P. and B. Hansson (1993) ‘Testing the random walk hypothesis on Swedish stock prices: 1919–1990’, Journal of Banking and Finance, 17, pp. 175–91. Hansson, B. and M. Persson (1998) ‘Portfolio choice and uncertain parameters’, Department of Economics, Lund University, manuscript. Jagannathan, R. and N.R. Kocherlakota (1996) ‘Why should older people invest less in stocks than younger people’?, Federal Reserve Bank of Minneapolis Quarterly Review, 20, pp. 11–23. Lee, W.Y. (1990) ‘Diversification and time: do investment horizons matter?’, Journal of Portfolio Management, 12, pp. 21–6. Liang, Y., F.C.N. Myer and James R. Webb (1996) ‘The bootstrap efficient frontier for mixed-asset portfolios’, Real Estate Economics, 2, pp. 247–56. Samuelson, P.A. (1994) ‘