Why the Norwegian krone (NOK) became a shitcoin

Norwegians pay roughly twice as much for the dollar and fifty percent more for the euro than we had to 15 years ago. Our currency is "chronically ill" and "nobody does anything." Everyone wonders why, and few become wiser by reading what the media writes.

It is the politicians who want a weaker krone and who control the most important instruments for getting what they want. I have written this piece so that everyone can get some insight into the topic. It focuses on providing an overview of foreign exchange market participants where exchange rates are set and their incentives and capabilities for influencing the value of the krone in one direction or the other. Finally, I write about the consequences of politicians allowing the value of the krone to decline.

On the first of November, Norway’s biggest financial newspaper, Dagens Næringsliv, published an interview with currency trader Tor Vollaløkken. He is known as "the man who destroyed the Norwegian krone in 1992", while he was head of foreign exchange trading in DnC, a bank owned 100% by the Norwegian state. The interview shed some light on the foreign exchange market, which is a good place to start.

Vollaløkken points out that in the ten years that have passed since 2013, foreigners have only invested NOK 1,000 billion in Norway, while Norwegians have invested as much as NOK 3,000 billion abroad. During this period, foreigners have bought few kroner to invest in Norway, while Norwegians have sold many kroner to invest abroad. Vollaløkken believes this explains about two-thirds of the krone's decline in value during this period.

The question, however, is why foreign investors have invested so little in Norway and why Norwegian investors have invested so much abroad. There are two reasons:

One reason is that, for example, US equities have historically had higher returns than Norwegian equities.

The second reason is that investors believed that the value of the krone would fall. When the value of the krone falls, it pays for Norwegians to invest abroad. If they receive the same nominal return, for example on a US stock fund as on a Norwegian stock fund, the real return will be higher when they sell their stakes and switch back from dollars to NOK that have fallen in value against the dollar in the period after they made the investment.

The interesting question, however, is why investors expected the value of the krone to fall.

There are three important reasons why the krone has fallen.

First, this is because the krone is subject to political control. In other words, it is not "a commodity" produced in a free market. Economic agents know that they can influence politicians and that politicians have a vested interest in monetary policy.

The second factor is that the krone is a small currency. This means that it is easier for large players to influence its value than if it had been a major currency.

The third reason is the influential players’ incentives. As we shall see, this is the main cause. Incentives are the root of the evil, but unfortunately the journalist in Dagens Næringsliv doesn’t discuss it with Vollaløkken.

Before we take a closer look at the agents and their incentives, we dive into some fundamental features of our monetary system.

Exchange rates are influenced partly by the quantity of a currency that is produced and enters circulation. If there are many units of a currency in circulation, its value decreases compared to if there are fewer units in circulation. For example, when the Argentine peso is so weak, this is primarily because the Argentines let the "printing press" run hot.

This is a managed system, and it’s easy to understand how it works. The system is pretty much the same all over the world. The state requires everyone to pay their taxes to Norway with Norwegian kroner. Absent this obligation, Norwegians would have used other countries' currencies. It is thus the obligation to pay tax in Norwegian kroner that ensures that the government has a monopoly in money creation.

The state shares its monopoly with the banks. More than 97.5% of all Norwegian kroner in circulation are actually created by banks lending money to their customers. So, our money is created by debt. It’s not a claim on bank reserves, such as gold, as it was until World War I in 1914.

The money is therefore created out of nothing.

The reason politicians want to have a monopoly on money creation is because it allows them to increase their political power, and because those who have the biggest economic muscles in the country get huge financial benefits from it. In exchange for receiving these benefits, they support the politicians. Together, politicians and those with the greatest economic muscles accumulate great power in society. We have probably had this symbiosis for as long as the states have had a monopoly on money creation.

It is the central bank, in Norway - Norges Bank, that coordinates banks' lending growth and thereby the money production. The most important tool it has is to set the key policy rate. If we keep all other factors unchanged (“ceteris paribus” assumption), it works like this:

When the central bank raises its key interest rate, banks also raise their lending rates. People will then borrow less money, which slows down the money supply and causes the krone to rise in exchange rate against other currencies. Banks are also raising deposit rates, which leads to increased demand, also from foreigners, in depositing money into Norwegian banks' accounts, which also causes appreciation of the krone.

Conversely, when the central bank lowers its key rate, banks reduce lending rates, people borrow more money, the money supply increases, foreigners deposit less money in Norwegian banks and the krone falls in value measured against other currencies.

Banks are thus part of a cartel mandated by law, where the quantity they produce of their "goods", i.e., the money they lend, and the price they charge for the money they lend and what they offer to get people to put their money in the bank, i.e., interest rates, are coordinated by the central bank.

The state likes this system partly because it is one of the first to get the pleasure of being able to use the new money created out of nothing.

Banks, on the other hand, get the pleasure of earning income, among other things, in the form of interest for something that they have created out of nothing. This provides considerable wealth for banks. In 2019, Magne Geber wrote his master's thesis "The Art of Creating Money in the Modern Economy." He calculates that Norwegian banks' earnings as a result of their ability to create money are between 0.54% and 0.95% of GDP.

The Norwegian government receives a share of this directly, partly because it owns banks (which is typical in socialist and social democratic countries). For example, it owns much of DNB, Norway's largest bank. However, this is not the reason why politicians want a weaker krone.

Let us now look at the main participants who buy and sell NOK in the foreign exchange market and their incentives. In the interview with DN, Vollaløkken lists five groups of actors, but he actually points to six groups.

The first group consists of the companies that produce oil and gas on the Norwegian continental shelf. They have income primarily in dollars and euros and their expenses primarily in kroner. The companies must pay tax to the state once a quarter. They then exchange dollars and euros for NOK. This means that they are a major player when it comes to buying kroner.

When it comes to their incentives in terms of whether they want a weaker or stronger krone, the most important thing is to understand that they are exporters. Normally, export companies want to reduce the value of the currency of the country in which they operate. The reason is that it reduces their costs, which directly increases profitability and makes them more competitive with producers in other countries. The effect may be short-term. Over the longer term, it will be expensive for them to acquire skills, as those with high competence move to other countries where they receive higher real wages.

The other major player in the foreign exchange market is the state. It sells NOK and buys foreign currency, primarily dollars and euros, which it deposits in the oil fund, the second largest sovereign wealth fund in the world. Norges Bank does this on behalf of the Ministry of Finance.

The incentives in relation to the value of the krone are influenced in particular by “the budgetary rule.” It states that the government can spend 3% of the real return, which the fund is expected to generate. Because the oil fund is denominated in foreign currency, while most government spending is made using NOK, politicians have more money to spend if the krone depreciates in value than if it appreciates. For every one percent in which the krone depreciates against the currencies in which the fund's assets are invested, the real transfers from the fund to the fiscal budget increase by one per cent.

There is much that politicians can do to reduce the value of the krone, other than to regulate the pace of the printing press. However, this remedy is the one that has the most immediate effect. Reduce interest rates and increase money production and the value of the krone falls.

In other words, politicians have both incentives to reduce the value of the krone so that they can spend more money over the central government budget and the instruments necessary to achieve this. And when they depreciate the value of the krone, they increase their power at the expense of almost all of the rest of society.

The third large group in the foreign exchange market is the other export companies. Some of them are large and have considerable political influence. This applies, for example, to salmon farming companies and large mechanical manufacturing companies, such as Aker. Typical export companies also benefit short-term from a depreciation of the krone, for the same reason as oil companies. I expect that salmon producers are now using the harmful effects of the ground rent tax (a brand new tax that our inventive government recently burdened this sector with) as an argument to persuade politicians to continue with a policy that results in a weak krone.

The fourth large group in the foreign exchange market is Norwegian and foreign participants who invest capital in equities and bonds. It is a fragmented group that has in common that it wants the greatest possible real return on its capital. Capital flows to the countries where they expect to generate the highest return, which means they must buy and sell foreign exchange. Over a longer period, they probably do not have incentives as a group to steer developments in the value of the krone.

The fifth is foreign hedge funds that trade currencies. Vollaløkken says he has about 20 of the largest foreign investment portfolios as his clients. He says that they can be invested with up to NOK 100 billion at a time, that for a period this spring they were up to NOK 60-80 billion, and that they can hold their positions for as long as one year.

Vollaløkken says, "This is a point that is a little difficult to be open about, but we have so much customer funds in circulation here when we do some bigger things that they often become a little self-fulfilling." This means, as I understand Vollaløkken, that this group is so large and has so much power in the foreign exchange market that they can affect the value of the krone in the short term, but only for up to one year, which is their maximum time horizon.

I draw from this that the hedge funds that Vollaløkken assist have little influence on the long-term development of the value of the krone, and that they do not attempt to do so. This group doesn’t appear to have any incentive to influence the long-term development of the value of the krone.

The sixth large group that trades in the foreign exchange market are those who buy a large share of goods and services from abroad and who sell mainly to Norwegian customers. They have much of their costs in foreign currency and their income in NOK. This group's incentives are also easy to understand. In contrast to the first three groups, this group wants a strong krone that reduces their import costs. A strong krone also means that their income in Norway in real terms becomes more valuable. The problem for this group is that it has little capability to influence the long term value of the krone. Its agents are too fragmented, both to be able to influence exchange rates appreciably as a group and to influence monetary policy.

To sum up, three of the players (the state, oil companies and the large, traditional export companies) want a weaker krone. They have incentives to work to ensure that the krone is weak, can coordinate and are in a good position to succeed in achieving the monetary policy they want. Two of the participants, investors who trade equities and bonds, and hedge funds that trade currencies, are neutral with regard to developments in the krone exchange rate over a longer period. They therefore do not care about spending resources on influencing monetary policy in one direction or the other. The last group, Norwegian companies that import factor inputs from abroad and sell to Norwegian customers, is a large group, but it is also the only group that wants a stronger krone. This group is fragmented, has limited ability to influence policy and will therefore not spend significant resources on trying.

Of the factors that I have highlighted, it is probably the “budgetary rule” that is most important. When politicians want the krone to be weak, the other actors who benefit from it do not need to spend resources on influencing them. It all runs smoothly by itself.

When the krone depreciates over time, this becomes self-reinforcing, as export companies gain ever more influence and the group that wants a strong krone steadily gains less power. Over time, we produce less and less for ourselves and more and more for the foreigners.

The redistributive effect of weakening the krone is enormous. The biggest losers are we the people who get less and less bang for the money we try to earn by working. Norwegian capital owners who have not adapted for export are also deprived of the wealth they have accumulated.

In the short term, export companies earn more money, while politicians benefit from it.

Over time, however, only foreigners, primarily “the big money,” benefit from this. The weaker the krone, the cheaper raw materials they get from Norway. Then they can focus on getting more profit out of processing and manufacturing in other countries.

The effect on Norwegians and Norwegian companies is that they are increasingly focused on picking up crumbs that fall from the king's table, by engaging in various forms of rent-seeking activities. We already see this in full force as people and companies line up for the ever growing climate change policy subsidies.

In the end, Norway ends up being a commodity-producing banana republic with chronically weak currency. This is happening faster than many believe, as evidenced by the crazy fall in the value of the krone over the past 15 years.

When we look at monetary policy together with the energy policy (the politicians started exporting enormous amount of our electricity in 2020, resulting in huge spikes in domestic electricity prices) and the wealth tax (which benefits foreign investors who escape the tax because they live outside our country, while it forces Norwegian successful entrepreneurs to emigrate, most of them to Switzerland) the overall picture is that politicians are selling off our country piecemeal in order to gain short-term benefits for themselves.

It's almost like watching the crew loot a sinking ship and jump in the lifeboats without letting passengers accompany them.

The question is what it will take to change politicians' incentives. Is it enough to change the budgetary rule? Must the krone collapse before anything happens? Or do we just have to completely remodel our monetary system?

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