Abstract
The Global Financial Crisis (GFC) of 2008 hit Denmark particularly hard. In this paper we argue that a combination of innovation in mortgage finance and the need to defend a euro-exchange rate peg was partly responsible. Sustained pressure against the Danish krone forced the central bank to increase policy interest rates consecutively in the last quarter of 2008. Monetary tightening in the midst of the GFC deepened the ongoing recession for the usual Keynesian aggregate demand reasons. Innovations in mortgage finance, which had made the economy more sensitive to changes in the policy rate, exacerbated this effect.
This is a preview of subscription content, log in via an institution to check access.
Similar content being viewed by others
Notes
Denmark has operated a currency peg since 1982 – first against the D-mark and from 1999 against the euro. The country has formally participated in ERM II since 1 January 1999, and the Danish krone observes a central rate of 7.46038 kroner to the euro with a narrow fluctuation band of ±2.25%.
The move to raise interest rates is reminiscent of the 1930s when countries raised interest rates in order to avoid the hemorrhaging of gold reserves. The United States famously raised interest rates in 1931 when there was a threat to the country’s gold commitment. This move is generally thought to have driven the US economy deeper into depression (Eichengreen and Temin, 2000). The issue of raising interest rates in the midst of a crisis also caused a lot of controversy in connection with the Asian crisis of 1997/1998. Stiglitz (2002) has thus strongly criticized the IMF-mandated increases in interest rates, which, according to him, generated a string of bankruptcies that deepened the confidence crisis and further contributed to the slowdown.
Among these five countries, Finland, a well-run Nordic country, arguably stands out. The worldwide recession and the attendant collapse in trade hit Finland particularly hard. Real GDP fell by more than 9% from the peak in mid-2008 to 2009Q2, driven to a large extent by declining export volumes (which fell by close to one third). Finnish exports depend strongly on the Russian market, which was hit hard by the crisis (OECD, 2010).
The correlation between OECD-country growth rates in the two periods is 0.61 ( p-value is 0.0001).
This was of course a direct implication of being outside the Eurozone. Another implication of being outside the Eurozone was that it took a longer time for Denmark’s central bank to arrange a liquidity agreement with the Federal Reserve than it did for the ECB. Moreover, being outside the Eurozone also complicated the communication of the content of the rescue packages for Danish banks to financial markets. Both factors added to uncertainty and thus pushed up the level of money-market interest rates (Erhvervs- og Vækstministeriet, 2013).
The spectrum of interest rates is very broad, depending on quality of instruments, horizon, and so on. Here we focus on short-term (money market) interest rates, as it is these that are very much influenced by monetary policy. While the central banks influence policy rates, such as repo rates, the standard measure used for short rates is usually the 3m interbank offer rate (Carnot et al., 2011). We will stick to this convention here. For completeness, however, note that the correlation between central bank’s main policy rate and the three-month interest rate is more than 0.98 in both Denmark and Germany during 1999Q1–2014Q1.
The introduction of ARMs changed the structure of mortgage debt significantly. As late as 1999 virtually all mortgages were fixed-rate loans, but by 2006 these accounted for only about 40% of total outstanding mortgage debt (OECD, 2006).
A 1-year ARM is funded via 1 year bonds; a 2-year ARM is funded via 1-year and 2-year bonds; a 3-year ARM is funded via 1, 2, and 3-year bonds; and so on and so forth (Nielsen, 2007).
The short-term bonds behind ARMs are very safe. In fact, during its two centuries of existence, the Danish mortgage system has ensured that investors have always been paid in full (Realkreditrådet, 2012). The key feature of the Danish mortgage system is the so-called ‘balance principle’ when issuing bonds, which limits the risk mortgage banks (MBs) may incur. When MBs grant a customer a loan for the purchase of real property, they must first raise the funds. MBs will issue and sell bonds to investors, which then fund the loans. During the term of the loan, borrowers make principal and interest payments to MBs, which then transfer the sums to investors. MBs are unaffected by any changes in loan rates. In case of falling interest rates, the MB will receive a lower interest payment from the borrower, but is only required to transfer the same lower interest amount to investors (bondholders). Consequently, such changes affect only investors and borrowers (Realkreditrådet, 2012).
An interest rate set on the December auction has force as of 1 January.
Before the GFC, the OECD warned about the possibility of something resembling such an unhappy scenario (see OECD, 2006, p.135).
Appendix Figure A1 provides a graph of all the time series used in this section.
There is a growing literature that emphasizes the importance of macroeconomic and policy uncertainty for economic growth and fluctuations more generally. Bernanke (1983) is an early contribution. He shows that a temporary increase in uncertainty can cause an immediate decline in firms’ investment. Bloom et al. (2012) is a recent contribution. They develop a measure of uncertainty using census microdata from 1972 to 2010, which they use to show that uncertainty rises sharply in recessions. Next they build a DSGE model in order to investigate the effects of uncertainty on aggregate outcomes. Model simulations demonstrate that growing uncertainty makes it optimal for firms to adopt a wait-and-see policy, which in turn leads to significant falls in hiring, investment, and output. Bloom (2014) provides a survey of this literature in which he notes that there is a general appreciation among leading policymakers of the important role played by uncertainty in driving the Great Recession (2008–2009) and the sluggish recovery.
The initial uncertainty impulse in the market for ARMs may have spilled over to other parts of the economy. Specifically, uncertainty about the economic outlook because of the reduction in consumption spending may have led firms to put off investment plans until the economic outlook became clearer (ie, firms adopted a wait-and-see strategy), which in turn caused additional uncertainty. In this sense, an initial impulse may set in motion uncertainty dynamics that contain elements of a feedback loop (see Bloom, 2014).
Fernández-Villaverde et al. (2011) argue that this effect is likely to be high in a small open economy.
Homeowners can of course reschedule their ARMs to fixed rate mortgages, but that was not profitable at the time given the level of long-term interest rates.
Two attempts at neutralizing some of these contradictions deserve brief mentioning. First, since June 2014 ARM refinancing auctions take place each quarter (ie, in March, June, September, and December). This is thought to reduce macroeconomic refinancing risks. Second, a legislative amendment, which introduces contingent maturity extension of mortgage bonds, was adopted in March 2014. The maturity extension takes effect if an auction fails or if the interest rate rises by more than five percentage points (the so-called the interest-rate trigger). Note, however, that to the extent that the uncertainty effect is important, quarterly auctions may be less effective than expected as consumers react strongly to uncertainty. Moreover, the interest-rate trigger would not have been activated in 2008Q4 (had the legislation actually been adopted at that time).
References
Alexopoulos, M and Cohen, J . 2009: Uncertain times, uncertain measures. Working Paper, tecipa-352, University of Toronto: Toronto.
Andersen, AL, Duus, C and Jensen, TL . 2014: Household debt and consumption during the financial crisis. Danmarks Nationalbank Monetary Review 1st Quarter 61–71.
Andersen, TB and Malchow-Møller, N . 2014: Denmark’s fixed exchange rate regime and the delayed recovery from the Global Financial Crisis: A comparative macroeconomic analysis. Unpublished manuscript. University of Southern Denmark: Odense.
Baker, SR, Bloom, N and Davis, SJ . 2012: Measuring Economic Policy Uncertainty. Chicago Booth Research Paper No. 13–02: Chicago.
Bénassy-Quéré, A, Cæuré, B, Jacquet, P and Pisani-Ferry, J . 2010: Economic policy: Theory and practice. Oxford University Press: Oxford.
Berlingske Tidende. 2008a: Flekslånere kan få rentechok, 8 October.
Berlingske Tidende. 2008b: Rentehop rammer boligejerne hårdt, 25 October.
Bernanke, B . 1983: Irreversibility, uncertainty, and cyclical investment. Quarterly Journal of Economics 98 (1): 85–106.
Bloom, N . 2014: Fluctuations in uncertainty. Journal of Economic Perspectives 28 (2): 153–176.
Bloom, N, Floetotto, M, Jaimovich, N, Saporta-Eksten, I and Terry, SJ . 2012: Really uncertain business cycles. NBER Working Paper 18245, National Bureau of Economic Research: Cambridge, MA.
Børsen. 2008a: Boliglån: Stor usikkerhed om rente på flekslån, 1 December.
Børsen. 2008b: Redningsplaner sender fleksrenter skarpt ned, 4 November.
BT. 2008: 200,000 står til rentesmæk, 8 October.
Carnot, N, Koen, V and Tissot, B . 2011: Economic forecasting and policy, 2nd Edition Palgrave Macmillan.
Danmarks Nationalbank. 2009: Monetary policy in Denmark, 3rd Edition.
Dixit, AK and Pindyck, RK . 1994: Investment under uncertainty. Princeton University Press: Princeton, NJ.
Eichengreen, B and Temin, P . 2000: The gold standard and the great depression. Contemporary European History 9 (2): 183–207.
Erhvervs- og Vækstministeriet. 2013: Den Finansielle Krise i Danmark – Årsager, konsekvenser og læring. Erhvervs- og Vækstministeriet, 15 September, http://www.evm.dk/publikationer/2013/18-09-13-den-finansielle-krise-i-danmark, accessed 30 December 2014.
Fernández-Villaverde, J, Guerrón-Quintana, P, Rubio-Ramirez, JF and Uribe, M . 2011: Risk matters: The real effects of volatility shocks. American Economic Review 101 (6): 2530–61.
Gundersen, P, Hesselberg, S and Hove, S . 2011: Dansk realkredit. Danmarks Nationalbanks Kvartalsoversigt 4th Quarter 59–82.
IMF. 2010: Staff Report for the 2010 Article IV Consultation. IMF Country Report No. 10/365, International Monetary Fund: Washington DC.
Johansen, PU and Trier, M . 2013: Danmarks økonomi siden 1980 – en oversigt. Handelshøjskolens forlag: København.
Kraka. 2014: Den danske finanskrise – kan det ske igen?. Finanskrisekommissionen: København.
Nielsen, S . 2007: Håndbog i Boligfinansiering. Forlaget Thomson: København.
OECD. 2006: OECD economic surveys: Denmark. Organization for Economic Co-operation and Development: Paris.
OECD. 2009: OECD economic surveys: Denmark. Organization for Economic Co-operation and Development: Paris.
OECD. 2010: Economic survey of Finland 2010: Overcoming the crisis and beyond. Organization for Economic Co-operation and Development: Paris.
Økonomi-og Erhvervsministeriet. 2010: Boligmarkedet og boligejernes økonomi, Økonomisk Tema nr. 9, April.
Politiken. 2008a: Kunder løber storm på møder om flekslån, 18 October.
Politiken. 2008b: Boligejere med flekslån skal have is i maven, 14 October.
Politiken. 2008c: Redningsplan på vej til flekslånere, 29 October.
Politiken. 2008d: Et rentefald er eneste hjælp til flekslånere, 1 November.
Realkreditrådet. 2012: Den klassiske danske realkreditmodel. Realkreditrådet.
Rodrik, D . 2006: The social cost of foreign exchange reserves. NBER Working Paper 11952, National Bureau of Economic Research: Cambridge, MA.
Romer, CD . 1990: The great crash and the onset of the great depression. Quarterly Journal of Economics 105 (3): 597–624.
Romer, D . 2012: Advanced macroeconomics, 4th Edition McGraw-Hill: New York.
Stiglitz, JE . 2002: Globalization and its discontents. W. W. Norton & Company: New York.
Sørensen, PB . 2010: Nedturen i Dansk økonomi – Hvor meget var selvforskyldt? Samfundsøkonomen 1 (Marts): 29–35.
Sørensen, PB . 2012: Vismændene og dansk økonomi i 00erne. DØRS Jubilæumsskrift 32–47.
Wooldridge, JM . 2013: Introductory Econometrics, 5th International Edition South-Western.
Acknowledgements
The authors would like to thank Mikkel Barslund, Thomas Harr, Jesper Gregers Linaa, Morten Skak, and Peter Sandholt Jensen for helpful discussion about this project. They also thank an anonymous referee for comments that helped us significantly improve the paper. Errors and omissions belong only to the authors.
Author information
Authors and Affiliations
Appendix
Rights and permissions
About this article
Cite this article
Andersen, T., Malchow-Møller, N. Innovations in Mortgage Finance and the Onset of the Great Recession in a Small Open Economy with a Euro Peg. Comp Econ Stud 57, 711–734 (2015). https://doi.org/10.1057/ces.2015.10
Published:
Issue Date:
DOI: https://doi.org/10.1057/ces.2015.10