The Nordics in the global crisis

Thorvaldur Gylfason, Bengt Holmstrom, Sixten Korkman, Vesa Vihriälä, Hans Tson Söderström, 10 February 2010

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The Nordic countries – Denmark, Finland, Iceland, Norway and Sweden – are champions of free trade and open markets. And for a good reason; they see international specialisation within a global framework as a means of raising productivity and income. Much of the Nordic socio-economic model can be interpreted as aiming at collective risk sharing with a view to fostering acceptance of open markets, new technologies and the need for change.

In a broad sense the model includes a set of labour market organisations, with an important role for negotiations, a comprehensive safety net and a high rate of publicly supported investment in human capital. Embracing globalisation and sharing risk are mutually reinforcing planks of the Nordic Model, as discussed in Andersen et al. (2007).

Is the Nordic model an asset or a liability?

The current crisis is not only a financial and economic crisis but also a crisis of the much heralded globalisation process itself. It therefore raises many key questions for small open economies, not least the Nordics. What are the lessons of the crisis for economic policies? Is the future of the global economy more unstable than the past, and does that perspective call for a fundamental review of the economic policy strategy? Is the Nordic model an asset or a liability in the light of the crisis?

As we discuss in our new report (Gylfason et al. 2010), the crisis is best seen as the outcome of a lopsided globalisation process that overwhelmed the global financial system. The global savings glut was largely absorbed by the US shadow banking system, because of its capacity to create innovative products. It seemed to offer safe investment outlets at attractive rates of return, while at the same time encouraging excessive leverage. Once the bubble burst and the world economy went down, the Nordics, with their high dependence on exports of investment goods and consumer durables, were particularly hard hit (with the exception of oil-rich Norway). Their GDP in 2009 declined at rates between 4.5% and 7%.

While the sharpness of the global downturn was a surprise, so was the early stabilisation, which started around the middle of 2009. At this point the recession has been declared over in many countries and a recovery – though weak and hesitant – seems to be underway. There is little doubt of the explanation; policies matter. Authorities have demonstrated an unprecedented activism in monetary and fiscal policy as well as inventiveness in financial crisis management. While the world escaped a repetition of the Great Depression, the crisis has nevertheless left a legacy of difficult issues and challenges.

The Nordics are vulnerable but also resilient. While Iceland is a case of its own, we believe that the Nordics have the capacity to recover and to continue combining economic efficiency with high social ambitions. Sweden and Finland experienced a severe banking crisis in the early 1990s, thereby learning a lot about the need for better financial regulation and supervision.

Lessons were learnt about the need for a solid crisis management framework, the pros and cons of a blanket government guarantee for financial institutions, the need for precautionary and other capital injections, the problems of transferring assets into “bad banks”, and the case for not shying away from the government taking over institutions in certain circumstances. Many of these lessons were useful in avoiding mistakes in this crisis and they have attracted interest in other countries. This is also why companies and banks in the region have had balance sheets strong enough to weather the crisis pretty well (we obviously leave out Iceland again).

The effect of the euro

The Nordics have all had different monetary regimes since the euro. Given their similarity in other respects, a comparison of Finland and Sweden is especially interesting. It is almost a laboratory experiment. Sweden has a floating exchange rate and an independent central bank geared to price stability, while Finland is part of the Eurozone. Who has made the better choice?

The krona was mostly stable and developments in Finland and Sweden were strikingly similar during the first decade of the euro. Once the crisis erupted, however, the krona fell significantly relative to the euro, thereby strengthening the price competitiveness of Sweden relative to Finland and the euro area. One might expect this to help Sweden come through the crisis at less cost than Finland, arguably benefitting at the expense of its neighbour by capturing market shares.

The decline in exports and output in 2009 was indeed smaller in Sweden than in Finland, and GDP growth is forecast to be somewhat faster. However, the differences do not seem large. Also, manufacturing output shows little response to the change in competitiveness, and unemployment is rising in parallel with developments in Finland.
Either the effects of the improved competitiveness are relatively modest or the lags are long, or a depreciation of a floating currency has less effect on export and output volumes than a devaluation of a pegged currency used to have. What is clear is that the floating exchange rate does not insulate an economy from external shocks, and the economic differences between the two exchange rate regimes seem smaller than often claimed in the heated debate about the Eurozone.

An effective fiscal stimulus?

For small and open economies, in particular, one may question the power of fiscal expansion as an instrument of demand management. Nevertheless, we still find that an expansionary fiscal policy is helpful in a crisis. It is a useful complement to monetary policy when the interest rate hits its lower bound or when the credit system becomes dysfunctional. Also, fiscal action may alleviate particular problems such as long-term or youth unemployment. Furthermore, automatic fiscal stabilisers allow the government to avoid hasty and unduly harmful measures. The social contract is very valuable in a crisis as it tempers the panic and gives the government more time to plan and undertake measures to reignite growth in an orderly manner.

Of course, sustainable public finances need to be restored, and it is useful to consider the merits of alternative means of fiscal consolidation. Public expenditure may be cut or its composition twisted in a growth-friendly direction, and efficiency in the provision of public services improved. The tax base may be broadened by measures to raise the employment rate, particularly by prolonging the length of working careers. There is some scope for changing the structure of taxation with a view to encouraging economic growth, notably by reducing the share of taxes that fall directly on corporate profits and wage income.

The Nordics were in a position to pursue fiscal expansion in the crisis because these countries were – in contrast to the US and almost all other EU countries –running sizeable budget surpluses in the preceding decade. The government debt level of the Nordics is only half of what it is in the OECD on average and they continue to borrow at very favourable terms. Given their track record, there is reason to believe that the Nordics will continue to be countries with relatively sound public finances, retaining the scope for fiscal policy to be used when needed.

Safety in numbers

Most importantly, the Nordic model itself contributes to resilience. The comprehensive safety net, one of the attributes of the Nordic model, has proved to be robust also in times of crisis. The entitlements are not tied to the fate of individual companies or particular markets, and risks are widely shared in the society. While forest plants are shutting down in Finland and car manufacturing is sharply contracting in Sweden, the governments are firmly rejecting requests for support of ailing industries. Still, there are no crowds protesting in the streets, largely because flexible work arrangements, based both on general and company-specific agreements between businesses and labour, alleviate a rise in unemployment. Structural change is enhanced by the employment protection legislation, which is more liberal than in most other EU countries. A well-educated labour force, another of the attributes of the Nordic model, facilitates adjustment by making it easier to upgrade skills through additional training.

Provided that governments continue to be able to take the decisions needed to safeguard competitiveness and the sustainability of public finances, the Nordic model can be both robust and resilient. The Nordic model with its welfare state, labour market institutions and high rate of investment in human capital, is not the source of the current problems. On the contrary, the Nordic model, properly implemented, can be part of the solution.

References

Andersen, Torben, Bengt Holmström, Seppo Honkapohja, Sixten Korkman, Hans Tson Söderström, and Juhana Vartiainen (2007), ”The Nordic Model – Embracing Globalisation and Sharing Risks”, The Economic Research Institute of the Finnish Economy ETLA, Helsinki

Gylfason, Thorvaldur, Bengt Holmström, Sixten Korkman, Hans Tson Söderström, and Vesa Vihriälä (2010), "Nordics in Global Crisis – Vulnerability and Resilience”, ETLA, Helsinki

Topics: Europe's nations and regions, Global crisis
Tags: global crisis, Nordic countries, welfare state

Thorvaldur Gylfason
Professor of Economics, University of Iceland and CEPR Research Fellow
Paul A. Samuelson Professor of Economics at Massachusetts Institute of Technology
Managing Director of EVA
Adjunct Professor of Macroeconomic Analysis and Policy in the Department of Economics at Stockholm School of Economics
Managing Director of the Research Institute of the Finnish Economy (ETLA)