The Finnish Economy

Vaasa University, October 2008 1

The Finnish Economy

An introduction


The Finnish economy post-WWII Liberalisation & deregulation

– foreign trade– financial markets– utilities

Closer integration with Western Europe


A few important milestones

The Helsinki Club 1957. The FINEFTA agreement 1961. The EEC agreement 1974. EU membership 1995. EMU membership (among the original

11) 1999.


The first two decades

In the 1920’s and 1930’s, economic policy strongly focused on agriculture & the countryside, ”laissez faire” for the rest of the economy (except exchange rate policy).

Nevertheless, rapid growth & development of manufacturing.


A good start

In the 1920’s and 1930’s, Finland was still very much an agricultural economy exporting goods with low value-added.

In 1938, Finland was nevertheless Europe’s 8th richest country as measured by GDP per capita!


The Finnish economy after WWII

At the end of WW II, Finland still predominantly an agricultural society.– around 1/3 of labour force employed in

agriculture

The forest industry by far the most important industry.– export share over 90% at its highest


The war damages… War damages to the USSR USD 300

million at 1938 prices, to be paid within 6 yrs (extended to 8 yrs in 1945).

Per capita war damages of German allies:– Finland USD 80– Hungary USD 30– Romania USD 15


… and how they were paid

The war damages were paid in the form of various industrial goods, of which– machinery & equipment 33.6 %– newly built ships 20.1 %– paper industry products 19.7 %– wood industry products 13.7 %– cables & related products 8.3 %


Consequences of the war damages

On the one hand, considerable additional burden on the economy.

On the other hand, the war damages gave a boost to industrialization and laid the foundation for future trade between Finland and the USSR.


The bilateral trade with the USSR Due to foreign currency shortage in the

USSR, trade with Finland took the form of clearing trade.

Finland exported mainly machinery & equipment and consumer goods, imported mainly oil and other raw materials.


Trade with the USSR: some figures

Finland’s trade with the USSR peaked in 1983, with 27% of total imports and 25% of total exports.

In 1989, the USSR was still Finland’s biggest trading partner in terms of exports (14.5%) and third biggest in terms of imports (11.5%)!


The macroeconomic role of trade with the USSR

+ Stabilisation of output and employment+ Cheap Soviet oil ‘buffer’ against oil price

shocks in the 1970’s

- Inefficiencies in some industries (notably clothing & shoes)

- Suboptimal resource allocation


Between East and West

On the one hand, participating in the trade liberalisation process in Western Europe (EEC and EFTA) became increasingly important to Finland.

On the other hand, the USSR highly suspicious of Finland’s W-European involvement.


The first steps towards freer trade

In 1950, Finland signed the GATT treaty.

In 1957, the ‘Helsinki Club’ agreement granted Finnish exports the same treatment as exports between OEEC countries.


Organisation for European Economic Co-operation

Emerged in 1948 from the Marshal Plan (= U.S. economic aid package for Europe).

This being the case, the OEEC thus had a political dimension = problematic for Finland.


Nordic or European?

The Nordic Council 1954 ➨ revival of plans for a Nordic customs union.

However, with the creation of the EEC, interest in the Nordic customs union faded ➨ plans abandoned for good in 1959.


The FINEFTA agreement 1961

EEC membership impossible for political reasons ➨ EFTA (the European Free Trade Association) an attractive (but not unproblematic) alternative.

Through the FINEFTA agreement in 1961, Finland became an associated member of the EFTA.


Nordic cooperation revisited

In the latter half of the 1960’s, revival of plans for deeper economic integration between Nordic countries ➨ common Nordic market NORDEK.

Negotiations 1968-69, but the resulting draft agreement did not satisfy Finland and Sweden ➨ NORDEK finally buried with Danish & Norwegian EEC application.


The EEC agreement 1974

With the EC enlargement (Denmark, Ireland and the UK) in 1973, securing Finland’s position in the W-European markets increasingly important.

Full EC / EEC membership still politically impossible ➨ free trade agreement in 1974.


Moving closer to the EC…

In 1986, Finland (finally!) became a full member of the EFTA.

In 1989, talks about closer cooperation between the EC and the EFTA ➨ European Economic Area (EEA).


… and finally towards full membership

With the fall of the Soviet Union, the last obstacles to full Finnish EC membership were removed.

After Sweden had filed its membership application in 1991, Finland followed in 1992 ➨ membership in 1995.


EU membership and foreign trade

The EU accounts for 56% of Finnish imports and 54% of Finnish exports.

For the euro area, the corresponding figures are 33% for imports as well as exports.


Other economic aspects of EU membership Taxation

– Increasing pressure towards tax harmonisation within the EU (e.g. sales tax on alcohol).

Competition in the single market– what advantages and disadvantages do

Finnish companies have in an increasingly competitive EU market?


General government tax and non-tax receipts (% of GDP) 2005

Finland 53.2 Euro area 45.3 Sweden 59.1 Slovak Republic 34.7 U.S. 32.8 Japan 31.7

Source: OECD


Tax harmonisation in the EU

So far, strongest pressure for harmonisation of capital income taxes + partial harmonisation of VAT and other indirect taxes.

By contrast, no immediate pressure for harmonisation of income taxes.


Competition in the Single Market

In the ‘old’ EU (12 members), Finnish labour costs close to the EU average.

However, with the 2004 (and 2007) enlargements, competitive pressure on labour costs has increased – though wages are rapidly catching up in some new Member States.


Advantage Finland...

Strong position in high-tech – for now.

Relatively low taxation of corporate profits.

Relatively flexible labour market (by ‘old EU’ standards).


... and disadvantage Finland

Relatively high level of prices and costs.

High income taxes (for middle and high incomes).

Below-average labour productivity (although big differences between sectors + ‘public sector bias’)


Labour productivity per hour of work 2005

90 92 94 96 98 100 102 104

EU 15

Euro 12

Finland

Sweden


Finland and the EMU

On January 1, 1999, Finland joined the EMU together with 10 other EU Member States.

From a historical perspective, EMU membership is a major economic policy regime shift for Finland.


Exchange rate policy: an overview

1945-82: Active exchange rate policy

1983-91: The ‘strong’markka

1992-95: The floating markka

1996-98: ERM participation


From defensive to aggressive devaluations

The three devaluations in 1945 (75, 40 and 12 % respectively) defensive measure against post-war inflation.

The 1957 devaluation (39 %) already partly ‘aggressive’, and the 1967 devaluation (31 %) openly so.


Exchange rate policy and the forest industry

‘The Finnish markka is devalued whenever the interests of the forest industry require it’.

Net benefits of devaluations to the forest industry significant because of low ratio of imported inputs to exports.


The ‘strong markka’ regime

Already in the latter half of the 1970’s, problems of the ‘devaluation cycle’ became evident.

Following the European trend towards exchange rate stabilisation (the EMS 1979), Finland adopted a fixed exchange rate regime in 1983.


The end of the strong markka period

By the beginning of the 1990’s, the markka already significantly overvalued, start of the ‘countdown’:– ECU peg in June 1991– Devaluation (14%) in November 1991– On September 7, 1992, the markka was

floated and subsequently depreciated by around 30%


The floating markka 1992-95

After the September 7 floating, the markka depreciated strongly until Q2 / 1993.

From mid-1993 onwards the markka started to recover ➨ fixed again within the ERM in 1996.


Meeting the convergence criteria

Fiscal discipline imposed by the 1991-93 crisis + favourable economic conditions in the latter half of the 1990’s made it relatively easy to meet convergence criteria.

In 1997, only Finland and Luxemburg fulfilled all the convergence criteria!


The EMU experience so far

Given Finland’s long track record of active exchange rate policy, adjustment to the EMU has been surprisingly painless.

Adjustment facilitated by the increasing internationalisation of the Finnish industry ➨ production across currency areas.


The EMU and public finances

At present, public finances are healthy (budget in surplus, public debt well below Maastricht limit).

But downward pressures on taxes and upward pressures on public expenditure will become a challenge in the near future.


The EMU and the labour market

Until recently, centralised bargaining delivered relatively modest wage increases.

The current round of industry-level negotiations, by contrast, has so far produced significantly higher increases.


Advantages of the EMU

Low and stable interest rates (at least compared to a fixed markka regime).

Reduced foreign exchange risks (on trade with other EMU members).

Access to an EMU-wide financial market.


(Potential) disadvantages

Risk of asymmetric shocks– structure of production & exports– FX exposure of foreign trade

Unsustainable development of wages and costs– will history repeat itself?


The 1991-93 crisis

After a period of exceptionally strong economic growth in the latter half of the 80’s, Finland was hit by a severe crisis in 1991.

In 1991-93, GDP fell by 14% in volume terms!!!


What caused the 1991-93 crisis?

Policy mistakes– uncontrolled financial deregulation– failure to curtail inflation in late 80’s– defence of an overvalued markka

External shocks– collapse of the Soviet Union– recession in Western Europe


Financial deregulation in the 80’s

Following the general international trend, Finland started to deregulate financial markets in the 1980’s.

Problem: fixed exchange rates + free international capital mobility = monetary policy ineffective.


The credit boom and the asset price bubble Financial market deregulation caused

rapid credit expansion:– from 1985 to 1989, total lending doubled– foreign currency credits tripled

Credit expansion fuelled growth of domestic demand ➨ overheating, asset price ‘bubble’.


‘It hurts when bubbles burst’

Higher interest rates + decline in economic growth burst the asset price bubble in the early 90’s.

Floating of the markka inflated the (markka) value of foreign currency debt.– cost of banking crisis around EUR 6.5 bn!


Economic policy during the crisis

In 1991-92, fiscal policy still accomodating.

In 1993, shift towards a contractive stance.– restraints of the ‘double deficit’– threat of liquidity crisis


Recovery from the 1991-93 crisis

Thanks to the depreciation of the markka, exports started to recover already in 1993.

Real GDP reached its pre-crisis level in 1996.


The crisis in hindsight Should the markka have been devalued

or floated earlier?– decline in GDP less severe with earlier

devaluation (9% compared to 14%)

Should fiscal policy have been more accomodating?– with the benefit of hindsight yes, but…


Finland and the other Nordic countries

Finland and Sweden: forest & engineering (including electronics).

Norway: oil & gas.

Denmark: agrifood.


Finnish-Swedish cooperation

In recent years, several big cross-border mergers between Finnish and Swedish companies:– Stora-Enso (forest industry)– Nordea (banking)– Telia-Sonera (telecommunications)


The Nordic welfare society

The Nordic welfare society is based on ‘the Swedish model’.

The general principle is that the benefits of the welfare society should be available to everyone (and not, for example, work-related).


The future of the welfare society

So far, the ’Nordic Model’ has been quite successful in combining equality and economic efficiency...

...but faces challenges from international tax competition and an aging population.


The Nordic countries and the EU

Finland: EU + EMU

Sweden and Denmark: EU but not EMU

Norway: EEA only


Different choices, different objectives

Norway: strength of the ‘oil economy’ makes advantages of EU membership less obvious than for other Nordics.

Denmark: strong & stable currency = no obvious need for EMU participation.


Different choices, different objectives Sweden: domestic economic policy

objectives come first ➨ ‘wait and see’ attitude towards EMU.

Finland: in addition to economic aspects, EU membership also has a strong political dimension.


The future of the Finnish economy

Demographic changes: with a rapidly aging population, the labour force will start to decline in the near future.

De-industrialisation: manufacturing is to an increasing extent being relocated to countries with lower labour costs and /or rapidly growing markets.


Where have all the young Finns gone..?

Working-age population (15-64 yrs)

2900

3000

3100

3200

3300

3400

3500

3600

2010 2020 2030

10

00

pe

rs.


The vital role of productivity

Long-term economic growth determined by growth of the labour supply and growth in labour productivity.

As the labour force starts to decline, growth will depend entirely on the growth in labour productivity!

Documents

The Finnish Economy