Finland: How bad policies turned bad luck into a recession

Finland’s depression in the early nineties was not just the result of the collapse of its major trading partner, the Soviet Union, and the sharp rise in European interest rates. A new study by two leading economists from the University of Helsinki, Seppo Honkapohja and Erkki Koskela, shows that poor institutions and poor policies made a bad situation worse. Their work appears in the October issue of the journal Economic Policy.  

Finland’s real GDP dropped by about 14% from its peak in 1990 to 1993. By 1994 unemployment had reached nearly 20%, up from 3% four years earlier. According to the authors, the story begins with a poorly designed deregulation of financial markets. After deregulation, the authorities decided to stick with a fixed exchange rate regime. The private sector built up heavy foreign debts and subsequently interest rates started to rise as a result of emerging credibility problems and developments in Western Europe.

 “Finland’s depression was due to a classical financial crisis and offers some comparisons with Chile, Mexico, some east Asian countries and Sweden”, say the authors.  The economy up to 1990 had been stable, and had not suffered the rise in unemployment that hit most OECD countries after the oil crises of previous decades. But inflation started to take off in the late eighties.

In 1991 trade with Russia dropped by 70%: the timing was bad for the hard markka policy which had been introduced in 1989 and was rigorously pursued until the currency was allowed to depreciate in November 1991. It was also in 1991 that the authorities tightened bank supervision and prudential regulation. Rules in these areas had been left unchanged during the period of deregulation which began nearly a decade earlier. Many factors contributed to a surge in bank lending and real asset prices during the boom: when policy was tightened, lending dropped by 25% and asset prices halved. 

That meant substantial bank losses while the depreciation of the markka raised the real burden of foreign debt servicing: the share of foreign currency loans in total lending was about 15%.

Honkapohja and Koskela write “International illiquidity, real exchange rate appreciation and lending booms are central characteristics of many recent crises that followed financial deregulation”.  Although Finland eventually recovered, their research shows that the equilibrium rate of unemployment increased due to  the crisis.

The lessons of the Finnish crisis are far-reaching. Deregulation drove saving rates to zero and then high interest rates pushed them up sharply. Asset prices displayed the opposite movement. The authors show that direct financial restraints played a large part in cutting aggregate demand. 

Finland presents a classic case of how everything went wrong together. Tight monetary policies were imposed on a highly indebted corporate sector in the context of a tax system which favoured debt over equity finance. Borrowing abroad was encouraged by a hard currency policy and a fixed exchange rate. The authors say a flexible exchange introduced earlier would have helped. They add: “One clear lesson is financial market deregulation should not be carried out in isolation. It should include a reform of the tax system and tightened bank supervision.”

Notes for Editors :

Economic Policy is published in association with the European Economic Association for the Centre for Economic Policy Research, the Center for Economic Studies of the University of Munich and the Département et Laboratoire d’Economie Théorique et Appliquée (DELTA), in collaboration with the Maison des Sciences de l’Homme.  

For further information about CEPR, please contact Rita Gilbert, Tel: (44 20) 7878 2917 or email: rgilbert@cepr.org, or contact James Morgan, Tel: (44 20) 8225 7262.

The Authors : 

Seppo Honkapohja and Erkki Koskela are Professors of Economics at the University of Helsinki.

Economic Policy No. 29

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