The Quantity Theory of Money: Lessons from Sweden’s Age of Freedom

Throughout the 17th and early 18th century, Sweden had a significant empire in northern Europe. In 1700, an alliance of Denmark-Norway, Russia, and others attacked the Swedes. While Charles XII, then the king of Sweden, had initial success against this alliance, he was eventually wounded and the Swedes never really recovered. Charles died in 1718. Charles had taken power at the age of 15 and spent virtually his entire adult life at war. He never married nor did he have children. When he died, there was uncertainty about who had the rightful claim to the throne. Charles’s sister Ulrika claimed that she was the rightful heiress since she was the closest living relative. Ultimately, the Swedish Riksdag agreed to recognize Ulrika in exchange for eliminating the absolute monarchy and setting up a parliamentary system. In this new system, the political power was concentrated in the Riksdag. The period from 1721 – 1772 is therefore known as “Frihetstiden”, or the Age of Freedom.

During the Age of Freedom, the Riksdag was dominated by two political parties that were referred to as the Hats and the Caps. The Hats controlled power for nearly 30 years beginning in 1738 and were mercantilists (their motto was “Svensker man i svensk drakt”, or “Swedish men in Swedish clothes”). In 1739, The Hats used the Swedish central bank, the Riksens Standers Bank (what is now known as the Riksbank), to give loans to private industry. These loans were funded with the creation of bank notes. In addition, the Hats started an ill-fated war with the Russians over parts of Finland. During this time, Sweden was effectively on a copper standard, but the expansion of bank notes for the provision of private lending and the use of the bank to finance the war ultimately led to the suspension of convertibility into copper in 1745. The increase in the provision of private credit by the central bank continued. In the 1750s, Sweden entered the Seven Years War to fight alongside their French allies. Sweden was particularly involved in the Pomeranian War with Prussia over land that they had lost in the Great Northern War under Charles XII (discussed above). The Hats were hesitant to levy any new taxes to pay for the war because to do so would require calling the Riksdag and therefore divulging the state’s budget. As a result, loans to the Crown increased substantially during the war and the supply of bank notes increased correspondingly.

The Hats seemed to view the money supply as a limiting factor in development. They thought that an increase in the money supply would increase aggregate demand, which would encourage greater production and entrepreneurship. Increases in the money supply could apparently have a permanent effect on output. The opposition party, the Caps, countered that this increase the supply of bank notes was excessive and that the excess supply of money was causing rising prices and a depreciation of the exchange rate. By 1765, the public voted the Caps into power and the Hats become the main opposition party. Upon taking power the Caps decided to decrease the money supply in order to restore the price level and the exchange rate to what it had been prior to this expansion. What followed was a major decline in the supply of bank notes and a very costly deflation. The deflation was so costly that it pushed the Caps out of power and returned the Hats to power. Ultimately, a coup ended the parliamentary system and restored the monarchy. Shortly thereafter, Sweden adopted a silver standard.

So why give you all of this history? The reason is that this series of events represents a sort of quasi-natural experiment regarding monetary policy. The Hats engaged in a deliberate increase in the money supply to increase economic activity and finance a war. What followed were significantly higher prices and a depreciation of the exchange rate. The increase in the money supply can be considered exogenous in the sense that the change in the money supply was brought about through deliberate policies by the Hats and is therefore immune to claims that higher prices were causing an increase in the supply of bank notes. The subsequent reduction of the money supply by the Caps brought about a significant deflation. Again, this was a deliberate attempt by the Caps to reduce the money supply and is therefore immune to claims of reverse causation. As Johan Myhrman notes “it is almost like a controlled experiment.” Below is a line graph of the monetary base and the price level during the period in question (the source is Riksbank historical statistics). I have also plotted the best linear fit of the data. As shown in the figure, there is a standard quantity theoretic interpretation of the data. Given the quasi-experimental nature of the period, this would seem to provide strong evidence in favor of the quantity theory of money under an inconvertible paper money.