Fixed Exchange Rates in Europe and the Case of Denmark

After the Second World War, much of Europes infrastructure was left in ruin, and

it was clear that a new global economic order was necessary to moderate and stabilize the

process of reconstruction and a return to growth. Even before the end of the war, Allied

leaders began negotiating for a new monetary regime, beginning with the 1944 Bretton

Woods Conference in the eponymous resort town in New Hampshire. Led by Harry

White, Dean Acheson, and John Maynard Keynes,1 prominent Commonwealth and

American policy makers, the idea was not unheard of; the Nazi finance minister Walther

Funk had already publicized plans for Germany to lead a new postwar financial order.

Bretton Woods sought to use the International Monetary Fund and the World Bank,

conceived by White and his superiors at the U.S. Treasury several years prior, as tools to

enforce a new exchange regime and ensure stability of the currency markets.2 The

outcome of Bretton Woods was a monetary order built on fixed exchange rates, with the

gold-backed U.S. dollar as the international reference currency.3 Bretton Woods, of

course, did not survive global economic challenges and American internal problems in

the late 1960s and early 1970s, and the system met its end with Nixons moratorium on

the dollars gold convertibility in 1971. By 1973, the EEC exited the Bretton Woods

System in search of another rate regime that would be more tailored to European

interests.

The demise of Bretton Woods left the European Economic Community to seek another

method of exchange rate management to ensure currency stability: in 1979, it introduced

1 Raymond F. Mikesell, The Bretton Woods Debates: A Memoir Essays in International Finance no. 192 (1994)
http://www.princeton.edu/~ies/IES_Essays/E192.pdf 13-14
2 Ibid 2-3, 29
3 Ibid 46
the European Currency Unit (ECU), a trade-weighted average of the currencies of

participating nations effectively a joint float in which currencies were tied to the

Deutsche mark and monetary policy could be guided by the West German central bank.4

This was a success, reducing foreign exchange market volatility and contributing to

further integration of the Internal Market. Historically, European nations have been

hesitant to float their currencies, citing the hyperinflation Germany suffered in the

interwar years and the Common Agricultural Policys need for a stable currency. With

this decision, according to the Mundell trilemma, they have instead opted to forgo

independent monetary policy.5 According to analysis in The Economist, it is in the best

interests of small economies with high mobility to tie themselves to a larger, stable

neighbor.6

It is especially interesting to consider the case of Denmark. After the collapse of Bretton

Woods, Denmarks policymakers implemented a fixed exchange rate with the Deutsche

Mark. Later, when members of the Economic and Monetary Union adopted the euro,

Denmark fixed the krone to the new European currency. Because of geographic

proximity and the openness of the Danish economy, this decision greatly contributed to

Danish economic vitality and made the nation a model for other Scandinavian countries.7

However, the recent euro crisis has placed a great deal of stress on the krone-euro peg.

Under Denmarks fixed exchange rate regime, the sole objective of the Danish

central bank is the defense of its currency peg. In committing to fluctuating with the euro,

4 Towards a Single Currency Europa, July 19, 2011

http://europa.eu/legislation_summaries/economic_and_monetary_affairs/introducing_euro_practical_aspects/l25007_en.htm
5 Robert Mundell in 1961 theorized that a nation could only employ two of: full capital mobility, fixed exchange rates, and
independent monetary policy
6 Fear of Floating, The Economist, June 11, 2009, http://www.economist.com/node/13767437
7 Northern Lights The Economist, February 2, 2013, http://www.economist.com/news/special-report/21570840-nordic-countries-
are-reinventing-their-model-capitalism-says-adrian : Lant Pritchett and Michael Woolcock, of the World Bank, have coined the
term getting to Denmark to describe successful modernisation.
the Danmarks Nationalbank follows the decisions of the wider European central banking

system. Historically, further integration into the European community has been unpopular

among Danish citizens who, via referenda in 1992 and 2000, rejected the Maastricht

Treaty and the adoption of the euro.8 Though its people have been squarely against closer

economic ties with the euro area, Denmarks leaders are very much pro-euro.

Since the crisis, Denmark has suffered the consequences of its decision to opt out

of the euro area. Proponents of euro adoption in Denmark argue that without a seat at the

European Central Bank, the nation is forced to follow ECB policy moves without having

a say in the bodys decision-making process.9 Denmarks central bank must set its rates

according to ECB decisions, and it has accrued substantial foreign currency reserves in

defending the peg. Though not to the extent of Switzerlands currency reserves during its

era of intervention, Denmarks foreign currency reserves amount to around one-third of

GDP and have grown at an astonishing rate in recent months, showing how costly

expansionary ECB policy can be to a nation with no say in the decision. In the first month

of 2015, Denmarks foreign currency reserves grew by around one hundred billion

kroner, after having increased by a monthly average of three billion kroner during 2014.

The Danish central bank has also been forced to adopt a negative deposit rate in an

attempt to boost liquidity, following the ECBs lead.10

The Danish central bank is having to undertake increasingly costly policy

measures to maintain its policy of fixed rates with the Eurozone, though it has no say in

the decisions of the ECB. Interestingly, the Danish view this autonomy deficit differently

8 To opt in or not to opt in, The Economist, January 14, 2012 http://www.economist.com/node/21542766
9 Those Awkward Danes, The Economist, September 21, 2000 http://www.economist.com/node/374415
10 Richard Milne, Denmarks Central Bank Slashes Rates to Record Low, Financial Times, February 5, 2015. http://
www.ft.com/intl/cms/s/0/1a54cae6-ad4c-11e4-bfcf-00144feab7de.html#axzz3S2LHEBIj
than do the British, another economy with strong ties to the euro area but serious

sovereignty concerns. While the United Kingdom wishes to reclaim some of the authority

it transferred to Brussels, Denmark prefers to increase its own presence at the European

Unions negotiating tables.11 No matter in which direction Denmark goes toward or

away from increased participation in the euro area it will benefit from increased

sovereignty over its own policies.

11 To Opt In or Not to Opt In

 WORKS CITED

Fear of Floating, The Economist, June 11, 2009,

http://www.economist.com/node/13767437

Northern Lights The Economist, February 2, 2013,

http://www.economist.com/news/special-report/21570840-nordic-countries-are-
reinventing-their-model-capitalism-says-adrian

Raymond F. Mikesell, The Bretton Woods Debates: A Memoir Essays in International

Finance, No. 192 (1994) http://www.princeton.edu/~ies/IES_Essays/E192.pdf

Richard Milne, Denmarks Central Bank Slashes Rates to Record Low, Financial
Times, February 5, 2015. http:// www.ft.com/intl/cms/s/0/1a54cae6-ad4c-11e4-
bfcf-00144feab7de.html#axzz3S2LHEBIj

Those Awkward Danes, The Economist, September 21, 2000

http://www.economist.com/node/374415

To opt in or not to opt in, The Economist, January 14, 2012

http://www.economist.com/node/21542766

Towards a Single Currency Europa, July 19, 2011

http://europa.eu/legislation_summaries/economic_and_monetary_affairs/introduci
ng_euro_practical_aspects/l25007_en.htm
Norways Experience with Resource Wealth

The 1960s and 1970s saw the discovery of large quantities of petroleum in the North Sea,

occurring in the exclusive economic zones of Germany, Norway, the Netherlands, and the

United Kingdom. Each of these nations felt the impacts, both positive and negative, of

this oil boom. Along with the well-documented effects of the resource curse,12 The

Economist would dub the negative economic consequences of resource discovery the

Dutch disease, after fears in the Netherlands created by the North Sea oil boom. In the

following decades, Norway pursued a distinct resource and income strategy that sets it

apart from its oil-producing neighbors.

A nation that discovers a large quantity of a resource acquires a comparative

advantage in its extraction. According to a Dutch disease model, the new industries built

around the resource shift the nations economic and scientific focus away from other

sectors and into the sector of the discovered resource. Their demand for labor increases

the equilibrium wage, putting upward pressure on employment costs in existing

industries. Taken further, rather than merely finding it more expensive to hire and

maintain a workforce, non-petroleum companies can face a shortage of skilled workers.

Further, the sale of oil on the world market leads to the accumulation of a great deal of

foreign currency.13 Repatriation of these proceeds means currency appreciation, as

domestic companies must sell foreign currency and purchase domestic currency.

Currency appreciation, of course, means a decrease in the competitiveness of domestic

industry as foreign goods become more affordable relative to domestic goods on the

world market.

12 Generally speaking, economies reliant on natural resources will grow and develop more slowly than would be expected due to
the exchange rate and employment effects of Dutch Disease.
13 Thorvaldur Gylfason, Lessons from the Dutch Disease, 2001 Statoil Conference (2001): 1
 For several decades after the beginning of the North Sea petroleum boom,

Norway, the Netherlands, and the United Kingdom saw declines in manufacturing as their

economies shifted to accommodate the new norm of oil extraction. Fears of Dutch

disease in the region did not come to fruition on any significant timescale,14 but the latter

two economies did not enjoy many long-lasting benefits of resource wealth. Norway, on

the other hand, emerged in a much stronger position than any of its neighbors. Norways

experience differs greatly from other oil producers around the North Sea and in the

developing world for two reasons.

First, as a founding member of the OECD, Norway already had a stable

government and a fairly industrialized economy by the 1960s. Though it was the poorest

of the Scandinavian economies until the 1970s,15 it still approached its newfound oil

wealth from a developed, western lens. Unlike producers elsewhere that counted oil

revenue as the principal funding for national development, Norway does not suffer

unduly from a resource curse. Second, through wise management of its global resource

revenues, Norway has alleviated the economic pressures of oil extraction more

effectively than have other countries. Critics of the United Kingdoms approach, in

comparison, complain that the government erred in not putting oil revenue in savings.16

Like the UK and other northern European countries, Norway still used the growth of its

oil industry as an opportunity to expand the scope of the public sector. In the five decades

since significant petroleum extraction began, Norway has drastically increased education

14 Lessons from the Dutch Disease 2-3

15 Erling Red Larsen, Escaping the Resource Curse and the Dutch Disease? When and Why Norway Forged Ahead of its
Neighbors, American Journal of Economics and Sociology, Vol. 65 No. 3 (2006): 605-606
16 Running on Fumes The Economist, March 1, 2015. http://www.economist.com/news/britain/21597890-scottish-nationalists-
are-right-charge-britain-has-mismanaged-north-sea-oil-unionists Gavin McCrane, an economist and former government adviser,
calls Britains failure to save its oil money a serious mishandling of the greatest opportunity for the economy in the last half
century
and social spending; public spending now amounts to over half of GDP.17 But the impacts

of petroleum wealth did not end with increased flow into government services. Unlike in

the United Kingdom, Denmark, or the Netherland, the Norwegian government began

contributing its oil surpluses to a rainy day fund in 1990.

In the last twenty-five years, Norway has diverted a large portion of its realized

petroleum wealth into the Government Pension Fund Global (GPF-G). It is not

uncommon for oil producers to maintain large sovereign-wealth funds, but Norways is

by far the largest. Projected to reach 1.1 trillion US dollars by 2020,18 it is over $100

billion larger than the Abu Dhabi Investment Authority, the worlds second largest SWF.

Management of such a large fund comes with many challenges.

With a nearly indefinite investment horizon, there is at times disagreement among

policymakers on the funds management. Wisely, Norway separates ownership and

governance of the GPF-G, with the Ministry of Finance appointing central bankers to the

Norges Bank to manage the fund.19 Because of this, a significant gulf can develop

between long-term appointees and elected officials who must answer to the public. Such

discord was evident in 2010, when the Ministry of Finance produced a highly critical

study of the funds management. The government felt that the GPF-Gs active

management was not worthwhile; the fund missed many yield-increasing opportunities

due to risk aversion, and the country would have been better served by a more passive,

index-based strategy. The government, understanding that Norway would be unlikely to

17 The Rich Cousin, The Economist, February 2, 2013, http://www.economist.com/news/special-report/21570842-oil-makes-

norway-different-rest-region-only-up-point-rich
18 More Money than Thor, The Economist, September 14, 2013, http://www.economist.com/news/business/21586268-changes-
norways-gigantic-sovereign-wealth-fund-will-be-felt-around-world-more-money
19 Dag Detter and Stefan Flster, Hidden Assets, Foreign Affairs, November 24, 2014,
http://www.foreignaffairs.com/articles/142398/dag-detter-and-stefan-foelster/hidden-assets
dip into the GPF-G for a long time, determined that Norges Bank could pursue a strategy

of higher risk.20

Aside from political conflict, the GPF-G faces ethical questions due to its size and

duty to reflect the values of the society it benefits. Though it is now consistently one of

the most transparent SWFs in the world,21 there were numerous ethical outcries that led to

the establishment of an oversight council for responsible investment. Over the past two

decades, the GPF-G has compiled a list of companies and sectors from which it has

divested on moral grounds.22 Importantly, Norway does not employ these divestments in

order to punish the offending corporations. Rather, it is the view of the funds governors

that investments should parallel public sentiment. Another ethical concern is the scope of

the fund. It is estimated that the GPF-G holds around one percent of global stocks.23 This

is an almost unfathomably large figure, considering the scope of the global equities

market. The GPF-G is prohibited from purchasing more than 10% of a companys

shares.24 Still, ownership on the scale of a few percent gives the GPF-G a great deal of

leverage to influence corporate governance. Whether public fund managers should be

allowed this degree of control over foreign corporations remains an unresolved ethical

problem.

Though Norway has not suffered as much as its neighbors, its skillful income

management has not eliminated the plight of petroleum-rich economies. In the last six
20 Passive Aggressive, The Economist, February 4, 2010, http://www.economist.com/node/15453041
21 Gordon L Clark and Ashby H Monk, The Legitimacy and Governance of Norways Sovereign Wealth Fund, Environment and
Plannnet, Volume 42 no. 7 (2010): 1731 By Truman's (2007) assessment, based on publicly available information, the GPF-G scored
92 out of a possible 100 in terms of its adherence to best-practice. In doing so, it came second only to the Alaska Permanent Fund
(which scored 94)

22 Ibid 1733. Since 2002, the list of excluded companies range from Wal-Mart, Boeing, and EADS to Rio Tinto, Barrick Gold, and
Lockheed Martin. The reasons cited include human rights abuse, environmental damage, and proliferation of nuclear and cluster
armament.
23 The Rich Cousin
24 Gordon Clark, 1732
years, economic growth has been nearly five times the OECD average, housing prices

have increased at an annual rate in the high single digits, and Norway consistently ranks

at or near the top of The Economists Big Mac Index, an informal measure of

international price levels. Moreover, the average wage in Norway is twice the EU

average.25 These recent trends renewed fears that Norway will contract some form of

Dutch disease in the near future. The GPF-G will provide a cushion against this. By 2030,

Norways oil production is expected to decrease to one-third of its current level,26 and

contributions to the fund will inevitably wither as well. Ultimately, Norway will face

challenges in returning to an economy dominated by fishing, logging, and services. The

economy will require time to adjust to decreased demand for employment and derivative

services wages will return to more reasonable level, and Norway will no longer have to

protect itself against the negative effects of resource ownership. The GPF-G will

minimize the shocks of this transition.

25 The Rich Cousin. Housing prices have risen at 7-8% per year. McDonalds charges $7.69 for a Big Mac in Norway, vs. $4.37 in
the US.
26 Gordon Clark, 1728
WORKS CITED

Dag Detter and Stefan Flster, Hidden Assets, Foreign Affairs, November 24, 2014,
http://www.foreignaffairs.com/articles/142398/dag-detter-and-stefan-
foelster/hidden-assets

Erling Red Larsen, Escaping the Resource Curse and the Dutch Disease? When and
Why Norway Forged Ahead of its Neighbors, American Journal of Economics
and Sociology, Vol. 65 No. 3 (2006): 605-606

Gordon L Clark and Ashby H Monk, The Legitimacy and Governance of Norways
Sovereign Wealth Fund, Environment and Plannnet, Volume 42 no. 7 (2010)

More Money than Thor, The Economist, September 14, 2013,

http://www.economist.com/news/business/21586268-changes-norways-gigantic-
sovereign-wealth-fund-will-be-felt-around-world-more-money

Passive Aggressive, The Economist, February 4, 2010,

http://www.economist.com/node/15453041

Running on Fumes The Economist, March 1, 2015.

http://www.economist.com/news/britain/21597890-scottish-nationalists-are-right-
charge-britain-has-mismanaged-north-sea-oil-unionists

The Rich Cousin, The Economist, February 2, 2013,

http://www.economist.com/news/special-report/21570842-oil-makes-norway-
different-rest-region-only-up-point-rich

Thorvaldur Gylfason, Lessons from the Dutch Disease, 2001 Statoil Conference
(2001): 1