Urban Bäckström: The business cycle and interest rate policy Speech by Speech by Mr Urban Bäckström, Governor of the Sveriges Riksbank and Chairman of the Board of Directors and President of the Bank for International Settlements,.at the Euroforum’s Conference, Örebro, 10 October 2001. *  *  *  First a word of thanks for the invitation to discuss matters to do with the business cycle and interest rate policy here with you in Örebro. We are living at present in turbulent times. Political events on the world stage have considerable economic and other repercussions in Sweden. Today I shall be saying something about my view of the business cycle’s current phase and also try in some measure to look into the future. Weaker activity in the rest of the world Global economic growth slackened appreciably in the first half of this year. The downward phase has lasted longer and become deeper than many observers had counted on at the beginning of the year. For the first time in over a decade we are experiencing a synchronous slowdown in all the leading economies. The terrorist attacks on 11 September have accentuated the risk of the downward phase being more pronounced and protracted. At the same time it should be underscored that the attacks can hardly be expected to disrupt the conditions for growth in the longer run, either in the industrialised countries or in what are commonly referred to as the emerging markets.
But the dilemma goes further - given that it is rational for others to expand their budgets it becomes rational for your own country to do so too - even if your instinct is not to “free ride”. Otherwise you might rationally expect to end up among the small minority that does not expand and at the same time still have the tighter monetary policy that results from everyone else expanding. This is the classic “prisoner’s dilemma” from game theory. The conclusion is that it is necessary to have rules for fiscal policy that limit deficits and debt when monetary policy is united and fiscal policy divided, and that these rules need to be followed. But the conclusion is also that the pressure to over-expand is as strong during an upturn as during a downturn. In fact this is what we have seen in the euro zone during the heyday of the late 1990s - a much too expansionary fiscal stance in some euro zone countries, which led to tighter monetary policy and thus an incentive for others to weaken fiscal discipline. The euro zone then started the downturn with large deficits, considering the earlier boom, instead of surpluses. What the Pact then required, a 180-degree turnaround in fiscal policy to a tighter stance, reinforcing the downturn, was considered by some as stupid. In fact it was the lack of savings during the boom that was stupid.