Abstract
Festering for a long time now, the financial collapse being witnessed has proven more problematic than any crisis in the past. The global financial meltdown has affected and continues to affect the livelihood of almost everyone in an increasingly interconnected world. Institutions have collapsed, stock markets have plummeted and governments in even the wealthiest nations have been forced to bail out their financial systems. The author compares Finland's economic crisis of the 1990s with that which is sending countries into disarray on a worldwide level today and establishes the reasons and possible solutions for this recession. He notes how fiscal and monetary policy measures alone cannot build a bridge over this severe recession. Moreover, he concludes by stressing that this crisis must be addressed alongside and not to the exclusion of other problems, underlining the importance of strengthening supervisory frameworks at a global and, more precisely, at EU level.
Keywords
The economic situation
We are living, no doubt, amidst the most severe global economic recession since the Great Depression of the 1930s. In this recession the new and worrisome feature is the coincident weakening of economic growth in all of the main economic areas and countries. Also, we do not have a clear picture of the depth of the recession. Month after month the economic forecasts over the past year have become more pessimistic. This makes it more difficult to assess the size and timing of recovery measures.
According to the Commission's forecast of January 2009 the economic growth of EU Member States will decrease by 2% this year and by approximately another 0.5% in 2010. The figures for Finland are a 1.2% decrease this year, while next year we could see growth of the same amount. These figures can be considered as indicative of similar figures in other countries. Indeed, in Finland domestic forecasting institutes have shown distinctly more pessimistic growth figures for us.
As we all know, this recession had its origin in the systemic malfunction of the financial market, with negative impacts now spreading into the real economy. Despite exceptionally strong monetary, financial and fiscal policy measures so far, a cyclical turn seems to be beyond the immediate horizon. This is worrying because economic policy ammunition in various countries is quickly being exhausted.
Boom and bust as a standard model of financial crisis
There have been plenty of financial crises during last 20 years (see for example Lars Jonung, European Economic News, No 12, January 2009). While there are significant differences across countries, the general chain of events seems largely to follow an identical model of boom and bust. Typically, booms begin with the deregulation of financial markets and the adoption of financial innovations combined with expansionary monetary policy–-a rapid increase in credit and low interest rates. Fiscal policy is expansionary as well. The increase in bank lending is channelled particularly into the real estate and stock markets. The higher market value of real estate is used as collateral for new loans and the lending boom becomes a self-sustaining process. The rapid growth in credit contributes to the equally rapid growth of consumption and investment. In the ensuing wave of optimism the perception of risk becomes blurred, whether among policymakers, bankers or the public. At this stage, inflation accelerates, notably in housing prices. The whole economy overheats.
Eventually, growth starts to slow down and the boom turns to bust. Future expectations turn from optimism to pessimism, credit growth turns negative and interest rates rise. The value of real estate and stocks plummet sharply. Consumption stagnates and investment deteriorates, most rapidly in the construction sector. Tax revenues fall and public spending increases as unemployment soars. Government public deficits increase sharply. The economy plunges into a deep recession. At this phase it is usual that governments are forced to support the banking sector with capital injections to guarantee the stability of the financial system.
The economic depression in Finland in the 1990s
There are several similarities between the depression in Finland in the early 1990s and the model described above, even though the 1990s depression originated in the decreased demand in the industrial countries of the Western world. Many special features contributed, however, to cause the economic reversal in the West to develop into a depression of unprecedented depth in Finland:
Finnish institutions and production structures were unable to meet the needs of the new operating environment that revolved around the free movement of capital
economic policy failed in the new environment
the collapse of trade between Finland and the Soviet Union contributed to the sharp fall in exports in 1991.
The economic developments at the start of the Finnish depression are sometimes referred to as ‘Triple B’: bad banking, bad policies, bad luck.
In 1991 GDP decreased by 7% and in the 2 years thereafter, by 3.5 and 1.5%. Unemployment rose sharply from 3.4% in 1990 to 17.9% in 1993. These developments were reflected in the drastic increase of government financial requirements amounting to around one-third of the total expenditures of the central government in 1993 and 1994.
The upturn in the Finnish economy after the depression can be explained by a number of factors whose effects paralleled those that led to the depression. The key element was the general economic policy strategy (developed in 1991) aimed at strengthening the basis of the economy and restoring the credibility of government policy.
Economic policy was focused strongly on a strategy of export-oriented growth, based on good price competitiveness and low inflation. The aims of the policy included balancing the current account, lowering interest rates, bringing investment into new growth areas, reviving the domestic market, setting both industry and employment on a track of robust and sustainable growth, balancing public finances and ensuring the stability of the financial system.
The Finnish currency, the markka, was devalued by 12% in November of 1991, and a final blow to the policy of fixed exchange rates came with the international upheaval of the exchange market in the autumn of 1992: the markka was allowed to float and underwent a devaluation of one-fifth.
The total discretionary savings in central government expenditure during the 1990s amounted to nearly FIM 59 billion, that is, approximately 10% as a proportion of GDP in the year 1996.
Economic recovery programmes
The present recession is different from the Finnish depression inasmuch as the latter was mainly created by domestic policy mistakes, and the recovery plan could be based on an export-oriented strategy. Now, when the recession is global, the medicine must be different.
The European Economic Recovery Plan (EERP) endorsed by the European Council last December calls for a timely and coordinated effort equivalent to around 1.5% of GDP, the share of Member States being 1.2% in total. The aim is that the measures be temporary, timely and targeted. Finland has supported this initiative, underlining the importance of coordination and coincidence of measures.
According to the calculations of the Commission the total amount of support provided by the fiscal policies of the EU-27 in 2009 and 2010 will be 3^% altogether, with discretionary measures being around one-third of this. Finland, in line with its larger-than-average room to manoeuvre, has responded to the requirement of The European Council as follows:
The Finnish Government agreed in January 2009 to a stimulus package having an overall impact of EUR 2 billion. The package will generate at least 25,000 person-years of employment. As a result of the stimulus decisions made by the government, overall GDP this year and next year combined will grow by approximately 1%. The fiscal stimulus will be 1.7% of GDP or EUR 3 billion, a consequence of the decisions concerning the budget and supplementary budget of 2009.
The objective of the supplementary budget is to minimise the number of people who, as a result of the international economic downturn, have become affected by cyclical unemployment, and to carry them through the hard times. The main emphasis is, therefore, on measures that directly promote employment, such as making investments in transport infrastructure, supporting construction and lifting the social insurance contribution. Additional priorities include education and research. The number of places for students in vocational training will be increased, and appropriations allocated to research and development will be raised.
To soften the impact of the quickly deteriorating economic situation, measures will be taken to stimulate the construction and renovation sectors, to bring forward and increase the number of investments in transport infrastructure and to lower labour costs by decreasing the social insurance contribution of employers. As mentioned the impact of the stimulus measures will be to generate at least 25,000 person-years of employment. In addition, the decision to bring forward investments in transport infrastructure will generate 4,300 person-years of employment.
In accordance with the decisions made in conjunction with the supplementary budget, a total of EUR 1.2 billion will be used to increase government expenditure and launch new projects. Lifting the social insurance contribution will produce an annual income reduction of EUR 833 million in the future. The stimulus measures of the supplementary budget will increase the deficit in public finances by EUR 912 million in 2009. The stimulus decisions made will raise the spending limits for 2009 by EUR 216 million.
If we compare these figures with fiscal policy measures carried out by other countries it seems that the US has been, no doubt, most proactive in its recovery policy. According to some tentative figures the size of US stimulation measures will amount to around 6% of GDP. In Japan the respective figure is some 2%. For now it is, however, prudent to look at these figures with some caution.
Financial policy measures
Since the collapse of the investment bank Lehman Brothers last autumn, plenty of measures to restore the efficient functioning of financial markets have been adopted or are under government consideration in all major countries. Most of them have concentrated on guaranteeing depositors’ savings, re-capitalising financial institutions and arranging government insurance for new credit.
In Finland the government has agreed on a sizeable package of measures to boost financial markets. Banks have recently had to focus their efforts on satisfying the financial needs of large-scale businesses. The measures introduced on 27 January aim to stabilise the financial situation of banks and, in turn, to help the finances of households and smaller businesses. This arrangement will allow banks to better support the government's economic policy objectives: keeping Finnish businesses in operation and ensuring their ability to employ people and pay salaries.
In February, the government will submit a proposal to Parliament for state capital investment in deposit-taking banks. The state will offer banks interest-bearing subordinate loans. The subordinate loan can be considered as part of the banks’ core capital (Tier 1 capital). The subordinate loan earns interest totalling the interest rate of the 5-year Finnish Government bond plus six basis points.
A bank taking out a subordinate loan commits itself to paying interest before distributing dividends. Similarly, it will not undertake major business rearrangements without the consent of the government. In addition, banks need to commit to maintaining their lending to households and small and medium enterprises (SMEs) and to reporting their lending activities to the Ministry of Finance on a regular basis.
The government will grant state guarantees to the refunding of Finnish banks in accordance with the authorisation issued by the Parliament in December 2008. A market-based fee will be charged for guarantees. Under a decision of Parliament, the maximum value of state guarantees to be granted is EUR 50 billion. Guarantees are granted until 30 April 2009, and limited to the amounts coming due up to that date. At a later date, the government will carry out a separate evaluation of the need to continue granting guarantees after 30 April. State guarantees can be granted until the end of 2009 at the latest.
Medium-term funding for banks, in particular, has become significantly more difficult over the past months. The Cabinet Committee, therefore, considered that restricted amounts of short-term funding to become due could be refunded as longer maturity funding. The scope of bank lending to the public and to businesses will determine the amount of funding to be extended. It is hoped that the possibility of extending maturity dates will support lending to businesses and the public in general.
The conditions both on subordinated loans as well as on guarantees include restrictions on the pay of the banks’ top management. Banks need to adhere to the common principles set by the Cabinet Committee on Economic Policy to be employed in state-owned companies. In accordance with this, pay is to be reviewed as a whole, and it must not, under any circumstances, result in excessive benefits. Performance and other bonuses need to be results-based, and options must not be given as bonuses.
The Ministry of Finance has decided to grant the State Pension Fund the right to a limited use of the assets in its possession to acquire the commercial paper of significant and financially solid Finnish companies. This decision is intended to promote the recovery of the commercial paper market.
So far the mistrust in the inter-bank markets, with their large spreads, and the lack of SME financing continue to be the most severe threat to the rapid recovery of the world economy. In the end the question seems to be how to hedge the toxic assets on the balance sheets: Should they be transmitted to a ‘garbage’ bank, or should they be granted government insurance, or both? There is no one-size-fits-all solution but, on the other hand, there is no time to be wasted.
Concluding remarks
Huge financial market and fiscal policy rescue packages are either underway or in the political decision-making phase in the EU, the US and other major countries. In my view, in the fiscal policy area, almost all that can be justified on an economic basis has now been decided. Also, those EU Member States which have had more room for manoeuvring have fulfilled their duty, Finland included.
In the area of monetary policy central banks have aggressively cut interest rates, as a result of which the room to manoeuvre is becoming limited. The European Central Bank (ECB), in its policy actions, has been as usual more sluggish than the US Fed (Federal Reserve System). I do not think that this has been a mistake. The institutional position of the ECB is different, and it is important from the viewpoint of credibility and stability that the ECB, in all its actions, takes care of its primary task, price stability. Further, ECB policy has not restricted demand; the main problem has been mistrust between banks.
It is perhaps trivial to say that economic policy measures must always be based on an assessment of the economic situation. Now the problem is exactly that: in a cyclical sense, we do not know precisely where we are going. Therefore, many economists and politicians require that policy measures should be assessed over-expansively rather than the other way round. In Finland we have a saying that there is the risk that ‘the crane will die before the ground thaws’. The danger is, however, that all the cards may be played too hastily. Finding the right balance is naturally a country-specific issue.
We must be realistic and acknowledge that with fiscal and monetary policy measures alone we cannot build a bridge over this severe recession, no more than we can smooth the depth of the pothole and avoid the vicious circle. This underlines the fact that the measures taken should be compatible with ‘tell the truth’ (TTT) principles and also reasonable from a structural viewpoint.
What is important in the short term is to assure that the measures now in the pipeline will be implemented effectively and in a coordinated way, in line with TTT principles. We all have our responsibility in this regard. Also, we have to ensure that the most-indebted Member States with large deficits will construct their 2010 budgets so that they have credible exit strategies in the longer term. Otherwise we endanger the future of the Stability and Growth Pact as our central fiscal policy instrument at the EU level.
How quickly the EU and the rest of world (especially the US) return to the track of solid economic growth depends crucially on how quickly trust can be restored in the financial markets. The longer it takes the more troubled the situation will be in the business sector. At the same time the possibility that the public sector will take a stronger role as the controller of financial markets will increase. This is what we all want to avoid as much as possible.
On the basis of the current crisis, it is obvious that the supervisory framework must be strengthened globally and at the EU level. We should ensure that supervisors are in a position to assess cross-border risks related to particular institutions in a timely manner. Further enhancements to supervisory practices are needed, especially in the context of developing common reporting and risk assessment frameworks. Consideration should also be given to how best to achieve progress in the future, including by assessing the issues related to specific institutional arrangements. We welcome the ongoing work mandated by the Commission last November, and underline that it will important to consider carefully the links between supervision and financial crisis management, responsibility for which lies with the Member States.
With the falling economic growth in most countries, unemployment rates have started to rise. This has raised strains of protectionism on both sides of the Atlantic and also within the EU Member States. We must resist these trends with determination to avoid possible retaliation and the threat of trade wars.
As regards the economic prospects for the next decade, we think that it is still the US that will be the key player in the world economy. The emerging countries, despite their increasing influence, have not shown signs of the capacity to take leadership in the economic or political sphere. Therefore, close cooperation with the US must be a key priority for Europe.
Footnotes