The Nordic Experiment – Inside and Outside the Euro

In the middle of the euro area crisis two Nordic neighbours, Finland and Sweden, seem to offer an interesting case for a pairwise comparison and a “test laboratory”. The both countries joined the EU at the same time in 1995. While Finland was one of the first-wave EU countries to adopt the euro, Sweden has not chosen to join the euro. Instead it has kept its own floating currency, krona. Both countries are export-oriented small open economies that have managed to combine competitiveness with the welfare state with relatively small income differences.

The different monetary regime with the similar societal background sounds nearly an ideal case for lessons about the advantages and disadvantages of euro. However, the economic outcomes of these two countries have been surprisingly similar during the euro era. Both Sweden and Finland have performed better than the rest of Europe on average. This good performance is reflected in higher than average GDP and employment growth and in relatively strong public finances. Admittedly, the sudden drop in exports in 2009 was larger in Finland, but this outcome results from the heavy reliance on investment goods in Finnish exports and not from the euro itself.

Being inside or outside the euro has not dictated the destiny of a small open economy (on periphery) – at least thus far. The economic policies that have otherwise been pursued have been more important and they have resembled each other in these Nordic countries quite closely. Since the economic outcomes of the two countries have in general been favourable it is also understandable that both countries have been satisfied with their original choice related to the euro.

With the euro now in crisis it is still useful to remember the different reasonings in Finland and Sweden prior to the decision whether or not to join the monetary union. These reasonings are well-documented in both countries since both the Finnish government and the Swedish government nominated a high-level expert group to analyse the advantages and disadvantages of EMU membership. Their reports give an ex ante view on the risks related to the euro, for instance. Finland as a euro member country gives also an opportunity to ex post analysis, i.e. whether the risks originally anticipated have been realized and whether new risks have emerged.

In the Swedish report the emphasis was on the proper trade-off between short-run employment stabilisation and long-run growth. The expert group emphasized the stabilisation objective and an independent monetary policy was seen as a better tool for that. The Swedish expert group then decided itself to make a recommendation: Sweden should not join the EMU at the start, but only later when the macroeconomic problems, especially relatively high unemployment, had been sorted out.

The Finnish expert group did not openly make any direct recommendation and the stand taking was left to politicians. Basically they took a positive attitude towards the monetary union and the Finnish membership in it. The chairman of the Swedish expert group Professor Lars Calmfors has commented the work of the Finnish expert group by saying that its economic analysis downplayed the risks of asymmetric shocks and exaggerated gains in form of low inflation, low interest rates and larger trade. According to him their analysis was to a large extent used by politicians to justify a decision taken for other reasons. These other reasons were geopolitical ones i.e. the closer ties to Western Europe.

Despite of this criticism the asymmetric shocks were, also in Finland, seen as the major problem related to monetary union: the exports could be hit by country-specific demand shocks that can not be helped with common monetary policy. This fact would put pressure on domestic fiscal policy and on wage formation and the related institutions if Finland were to join EMU.

The clear recommendation related to fiscal policy was to reduce government debt quite rapidly. Firstly, this would help to fulfil the Maastricht Treaty criteria. Secondly, strong enough public finances would also allow contra-cyclical fiscal policy to operate in the case of economic slowdown.  In practice joining the euro gave an extra impetus to rapid debt reduction and budget discipline has indeed been apparent since the early years. On the other hand, Sweden outside the euro has kept its public sector finances well in order as well.

Two challenges for labour markets were seen: the first one was related to the low inflation target and the second one was the need for greater flexibility in nominal wages. Wage increases had to be lower than the earlier ones in order to keep the price competitiveness in the low inflation regime. Greater flexibility in nominal wages was called for because cost competitiveness could not be restored with devaluations in EMU if needed. The expert group recommended more flexibility in wage formation at the local level. This has actually happened quite rapidly during the euro era in Finland.

The idea of the credible monetary policy was tempting for a country like Finland with the history of unstable exchange rates and generally high rate of inflation. Accordingly, there was understandable need to look for shelter against speculative attacks against own currency on periphery. The central bank having the reputation of the Bundesbank could bring in increased credibility with lower average inflation and lower and more stable real interest rates.

The first years of the global financial crisis seemed to confirm that this argument was justified:  the currencies of some small non-euro countries were already in trouble because of the crisis. Compared to that situation it was possible to judge that the common currency gave shelter to Finland. Now that the problems within the euro area seem much more severe, it is not clear at all that this conclusion holds true.

It is worthwhile to notice that many of the institutional problems that are relevant today were seen already when the monetary union was created. For instance, the Finnish expert group was criticizing the relative weights that were given to the annual deficit criteria versus the debt criteria. The deficit criteria were and have been in focus, even though it is public debt that determines the interest burden and is vital in the public sector solvency problems. They also saw the trade-offs related to the size of the monetary union. The efficiency benefits would be the greater the larger the number of participating countries. On the other hand, the credibility of monetary policy requires at least the first stage of monetary union to be limited to a relatively small number of countries. This clearly reminds us about the topical discussions related to the membership of Greece, for instance.

There seems to be at least two things that were missing in the original agenda when the advantages and disadvantages of common currency were analysed at national level and also at EU level. The first is the possibility of large and growing divergence in cost competitiveness among the member countries. This has actually happened – the crisis countries have witnessed low productivity growth and high wage increases in relation to productivity. The well performing countries have either had moderate wage increases or high productivity growth or both. This has brought severe imbalances within the euro area and imbalances that are quite difficult to reverse.

The second missing piece is connected to the risks of the banking sector.  Financial institutions operate across the borders and the linkages between the banks in different countries are very close. Their importance to economic stability and the need for the tools to handle the banking crisis were not considered when countries decided whether or not to join the euro. As a result monitoring and supervision of the banking sector at European level were neglected.

All in all, the Finnish case gives us some preliminary lessons. The country-wise risks that were originally seen critical have not proved to be unbearable. For instance, asymmetric shocks have been manageable and domestic fiscal policy and wage formation have been able to function as expected in the new monetary regime. The greater risks seem to be related to the system risks within the euro itself. It is never too late to learn from past mistakes?

References:

Calmfors, Lars (2009), The role of research and researchers in economic policy-making: some reflections based on personal experiences, Finnish Economic Journal 1/2009 (in Finnish)

The Prime Minister’s Office (1997), Finland and EMU – EMU Expert Group report.

SOU (1996), Sverige och EMU. Statens Offentliga Utredningar 1996:158.

This column is part of the Eurozone Scenarios Project of the Friedrich-Ebert-Stiftung and Social Europe Journal. The long version of the scenarios paper can be downloaded here. A Statistical Annex is also available.