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13. FINLAND: THE BIG DEPRESSION IN THE 1990s

an exceptionally deep depression, historically and internationally, in Finland and Sweden

a banking crisis escalating into a fully-fledged economic depression

Simplest characherization: boom-bust related to financial deregulation

1. What happened?

2. Why did it happen?

3. What are the policy lessons?

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1. What happened?

The process of financial deregulation globally and in Finland

On the domestic side, and with regard to capital flows

Strong capital inflow during the boom in the late 1980s (which even accelerated when domestic interest rates were raised)

Boom: Strong credit expansion of banks to the general public

Boom: Housing boom and euphoria in the stock exchange

Boom: High level of consumption and investment, rapid GDP growth, low unemployment

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Bank lending to the public increased strongly in 1987-1991(outstanding stocks of loans and deposits, % of GDP)

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Bank lending and deposits, %-change

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Credit expansion during boom and bust: typical pattern

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Crisis: a typical pattern

Rapid credit expansion, rising asset (e.g. real estate) prices, euforia

Bad news, bubble bursts, credit losses, fear takes hold

BANKING CRISIS

Credit crunch, deep recession, falling tax revenues, bank support

PUBLIC DEBT CRISIS

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House prices and the stock exchange

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Household indebtedness (right scale) and saving rate (left scale)% of GDP

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Saving and investment rates

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GDP growth

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Cont: the bust period (1991-)

What goes up, comes down, when the bubble bursts. Both house and equity prices started to decline already during 1989 and the decline subsequently accelerated

Credit expansion stopped and was followed by credit contraction

High interest rates and low inflation caused killingly hig real interest rates

Bankruptcies increased, as did credit losses of banks, some banks were taken into public ownership (the savings banks), the state had to give guarantees for the funding of banks and make capital injections into all of them…

Consumption, investment and output declined dramatically

Exports suffered from weak competitiveness and weak foreign demand as well as the collapse of the Soviet Union and exports to the east

The banking system had difficulties with foreign refinancing, the government had also for this reason to increase its borrowing from abroad

Budget deficits increased and central government debt grew very rapidly

In late 1991 the markka was devalued (12 %) and in September 1992 it was set floating

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Bankruptcies

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Unemployment

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Central government debt, % of GDP

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General government deficit, % of GDP, in the big depression and the big recession

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GDP in Finland in 1989-1998 as compared to 2007-2016 (forecast)

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Unemployment in 1989-1998 as compared to 2007-2016 (forecast)

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2. Why did it happen?

The crisis was a boom-bust process associated with or triggered by a process of financial deregulation, which was not well managed (as they seldom are)

A characterization of the causes of the crisis, which was often used then and which still seems pertinent, is:

1. Bad banking

2. Bad policies

3. Bad luck

Nota bene: ex post nobody (almost) would claim that the crisis was due to the welfare state or the fault of the labor markets (though such arguments were made then).

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1. Bad banking Bank lending increadsed very fast in the late 1980s, in 1989 even by 30 per cent per

annum. Banks underestimated the credit risks of borrowers, did not eplain the exchange rate risks of foreign currency loans to their customers, were highly dependent on short-term money that could quickly become very expensive etc.

The banks did not understand the risks that financial and capital market deregulation would be associated with. They did not strengthen their capital base, they did not strengthen their internal controls of risk-taking, they resisted politically any moves towards tighter regulation or supervision of banking

They also resisted any attempts at elimination of such tax advantages that were to the benefit of banks: deposit interest rates were not taxed and interst payments on loans were fully tax deductible in taxation (reducing significantly the after-tax rate of interest)

In the bust phase the government could have been more brutal with banks and taken more of them into government ownership. Also, the assets in the bad bank set up by the government should have been held far longer than was done (to minimize losses from ’fire price sales’.

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2. Bad policies

FINANCIAL REGULATION:

Financial deregulation, notably liberalization of capital imports, was unfortunate with regard to its timing, undertaken a bit before the cycle became strong (in the last years of the 1980s),

the sequencing of deregulation was mistaken: domestic financial markets should have been deregulated before capital imports

The tax system shoud have been adapated to the conditions of a finacially liberalized economy: nominal tax deductibility of interest expenses should have been eliminated or reduced, and interest rates on deposits should have been taxed and, above all, the deposit interest-rate cartel abolished

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CONT.

MONETARY AND/OR EXCHANGE RATE POLICY

The stubborn commitment to the fixed exchange rate seems in retrospect a main error.

Reflections on the ’trilemma’ should have helped avoid it: you cannot combine a fixed exchange rate with free capital movements and indpendent monetary policy (one will have to give). Given up the fixed or pegged exchange rate was not perceived as an option at the time (anywhere in Europe). Eliminating capital import restrictions then meant that monetary policy could not prevent the overheating of the economy – at least not with conventional monetary policy means. (A ceiling on bank lending was imposed but too late to have much effect.)

The devaluation in 1991 was too small, it would (with the benefit of hidsight) have been better to set the markka floating earlier

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Cont.

FISCAL POLICY

Fiscal policy waS insuffificently tight in the boom phase (last years of the 1980s), as both the prime minister (Harri Holkeri) and the finance minister (Erkki Liikanen) failed to convince their parties of the necessity of preventing overheating

Also, a main ambition of the government was to undertake tax reform, and the government did not want that reform to be associated with tax increases

In the bust phase the government decided repeatedly on packages for cutting expenditure and raising taxes (hastily and without good preparation)

Arguably the government should have postponed the implementation of many of the contractionary fiscal policy decisions untli growth had resumed (in order to avoid deepending the depression by ’austerity’ measures.

The depression in the 1990s was a huge failure of economic policy and politics

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3. Bad luck

The timing of financial deregulation was unfortunate, as we know ex post, but that was not at alla obvious at the time (no boom expected)

The German reunification led to a construction boom in former East-Germany, which had the consequence of raising interst rates in Germany and in Europe as a whole, which added to the difficulties of Finland in the midst of the depression

Above all, the collapse of the Soviet Union in 1991 led to a dramatic decline of Finnish exports to the east (they fell almost to zero). This export, based on bilateral trade deals, had been very profitable for Finnish manufactring corportatioins (this trade was the ’source of 20 per cent of volume but 80 per cent of profits’). It was not possible to redirect this export to western markets (due to its composition and quality).

On the ohter hand, after 1995 Finland benefited from stronger demand in its export markets.

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3. What are the policy lessons

It is important to have an understanding among decision makers (and the general public if possible) of the working of the financial system, including of an unregulated system, and of the interaction of the financial system with the rest of the economy (theory, empirical studies, historical experience).

It is dangerous to base policy too much on past experience or of fighting the last war: decision makers were ready to fight hard for the fixed exchange rate because of their interpretation that past devaluations had been useless. However, even if that view would be correct (which is open to debate), conditions had changed in ways which should have been taken into consideration (e.g. deregulation).

Be careful not to understimate the effects of rapid changes in the after-rax real rate of interest. Before the crisis it was often negative due to high inflation and tax deductibility of interest payments. Subsequently it rose dramatically because of declines in inflation (and expected inflation) in combination with reductions in tax deductibility.

Try to avoid procyclical monetar policy: interest rates were too low in the boom phase (due to the large capital inflows) and then very high in the bust phase when lack of confidence in the markka caused capital outflows and forced the central bank to rais interst rates. So: devalue or let the currency float.

Ditto fiscal policy: try to tighten in the boom asap even if it is politically difficult. Allow automatic stabilzers to operate fully in the recession/depression and undertake disretionary expansion if financial conditions permit (provided such policies do not raise interest rates significantly).

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Cont.

• It is important but not enough to have microprudential supervision of banks, meaning that the health of individual banks is monitored. There should also be a process of macroprudential superivision, meaning that the economic consequences of the financial system as a whole are considered (’systemic issues’).

• If in a banking crisis, then the action of the government needs to be quick, decisive, transparent with a view to safeguarding the liquidity and solvency of the baking system – if need be by capital injections by the government, while at the same time imposing PSI or ’private sector involvment’ meaning that bank owners and creditors (other than depositors) loose thei money. Also, bad assets may be put into a bad band and kept on the books until the crisis is over.

• Do not opt for a fixed but adjustable exchange rate system (except for Denmark). Choose either a flexible exchange rate or membership in the monetary union. (WHICH IS THE BETTER CHOICE?)