Download Depression in Finland in the early 1990s

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?)
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