Is Finland Really A Closet Member Of The Eurozone Periphery?

At a time when many eyes look hopefully towards the ECB for the kind of action which may prove to be the salvation of the much beleagured Eurozone other, more critical, ones are casting themselves back over the recent track record of the institution itself, and asking what, if any, responsibility the Frankfurt-based bankers have for having allowed Euro Area government finances to fall into the sorry state they are now in.

Lessons From Japan?

No idle question this, since it harks back to the time when a good deal of attention was focused on the Bank of Japan, and how much responsibility policymakers there had for the deflation trap into which the country’s economy eventually fell. Now according to a very influential paper published by the Board of Governors of the US Federal Reserve System back in 2002 (Preventing Deflation: Lessons from Japan’s Experience in the 1990s, by Alan Ahearne and colleagues) the most important concern raised by Japanese policy during the country’s first “lost decade” was not that policymakers did not predict the oncoming deflationary slump –that in itself was not especially surprising, after all, neither did the majority of analysts and  forecasters – but that they did not take out sufficient insurance against downside risks through a continuous precautionary loosening of monetary policy. Simulations carried out at the time using the FRB/Global model lead the authors to the conclusion  that, had the BOJ lowered short-term interest rates by a further 200 basis points at any point between 1991 and early-1995, at least the first bout of deflation could have been avoided.  (On the other hand the model indicated that loosening after the second quarter of 1995 would have been too late to avoid deflation, as by that time inflation had already fallen below zero.)

Well, that was 2002, and who else apart from myself and a few other policy wonks with good memories now remembers the once renowned Ahearne et al paper? The Japan lesson was “learnt”, and then conveniently forgotten it seems. Now, of course, the Euro Area is not actually caught in Japan style deflation, but this isn’t over yet, and we don’t know how the story is going to end. What we do know is that the region is once more falling back into recession, while the economy has been submitted to a triphasic cocktail of fiscal austerity, monetary tightening and regulatory pressure for bank recapitalisation. And, of course, with a massive public and private overhang, a credit crunch that is tightening by the day and a backdrop of rapidly ageing populations the deficiency in domestic demand the region is suffering from looks even more visible to the naked eye than that famous hole which appeared in the side of the Titanic must have been after its unfortunate contact with the iceberg. Which is only another way of saying that the deflation risk is a real and ever present one, and a bit of downside insurance would have been a good thing. Prescient even.

Using The Ejector Seat Without A Parachute

Just to ask the question whether policymakers got their ”mix” right here seems like some kind of sick joke in bad taste. Virtually no insurance was taken out against possible downside risks to the price level (inflation was consistently seen as being a much more pressing problem), even if (going by the PMI output prices, see chart below) price pressures seem to have been on a downward path since early 2011. In any event, what inflation there was in the Eurozone was mainly the by-product of imported commodity prices or the knock-on impact of VAT increases, and in no case could it be seen as the result of domestic demand “overheating” which is really what monetary policy is equipped to deal with.
 

So the much discussed ECB “exit strategy” seems to have been applied far too early and far too systematically. In both the case of extraordinary liquidity measures, and in the case of interest rate policy, Mario Draghi has had to put the motor into reverse gear, and emphatically so. Not that this outcome was that hard to see at the time, as I expained in a post on the CNBC blog back in March (Chronicle of a Policy Error Foretold).

Crunch, Crunch, Something Funny Is Going On Here!

The parallel with Japan in fact extends beyond simple interest rate policy. Issues associated with the capitalisation of the banking system also have a certain parallel, as can be seen in the chart below (which comes from a Richard Koo presentation). Fiscal and monetary measures taken following the outbreak of the crisis worked initially, but since the core of the problem was not addressed keeping all the zombie loans going soon gave the banks funding problems which lead to a second credit crunch.

The interesting point here is that this process seems to be now being repeated in the Eurozone, as a second credit crunch firmly starts to set in. If you look at the chart below (which comes from a report by Unicredit), then you will see that the credit standards applied by banks (as extrapolated from the ECB monthly survey) have been tightening for some months now (and are obviously continuing to do so, hence the recent batch of liquidity measures. As Marco Valli (who wrote the Unicredit report) also points out, these lending conditions move in tandem with the PMIs (red line) which means that as they banks steadily close the lending spiggot activity in the real economy slows correspondingly.

Spread Them Wide

So obviously the ECB has been doing quite a bit wrong since the time of those wonderful “how we saved the world from disaster” speeches, leading to an evident waning of confidence in the institution. How much waning? Well that is currently the source of some debate. One line of reasoning, perhaps best personified by nobel economist Paul Krugman, has been arguing that the key turning point in the whole Euro debt crisis came last March, with the ECB decision to raise interest rates. His evidence, echoing that offered by Rebecca Wilder, comes from an examination of  the divergence between the Finish and Swedish 10 year bond yields, which started to drift apart around April.

As Krugman says: “What happened then? Ah, yes — the ECB started raising rates. And…..that’s precisely when euro bond spreads began their upward march, culminating in the current crisis”.

This idea that it has been ECB policy rate decisions which lie to some extent behind the growing financial turmoil which surrounds the Euro is really quite widepread. FT Alphaville’s Izabella Kaminska, for example,  runs a similar argument vis-avis French spread problems and the ECB’s second rate hike in July. As she says ”it’s clear that something influential happened in July. Something which not only destabilised the balancing system but tipped France, in particular, into the red. Could it have been the ECB’s July 7 rate hike to 1.5 per cent?”

Dutch Disease

While I fully agree with both authors that the application of the ECB crisis exit strategy has done a lot to undermine confidence in the idea that policymakers at the bank were really on top of the problems, I am not that convinced that it has been this stratgey in particular which has fuelled the ongoing crisis (heaven forbid, there are really no shortage of candidates here). One of the reasons I am not convinced by the Krugman case is that the Finnish spread itself has been detaching from other core Euro Area spreads, and this is a little difficult to explain simply by referring to ECB policy decisions.

If we look at the chart below, which was prepared by Marcel Bross at Commerzbank, we can see that the Finnish 10 year spread with the Dutch 10 year bond has been widening since early summer. (The black line shows the spread between the Finnish 10 year bond yield (RFGB) and the Dutch one (DSL) – the yellow lines shows the 5 year spread, which has performed rather differently).

Whatever Happened To My Current Account Surplus?

Now rather than the Swedish yield (Sweden remember is not in the Euro, and thus benefits from safe haven status, in that people can buy Swedish government bonds as a hedge against Euro Area break up), what is more interesting is to examine why Finnish yields might have been rising in relation to Dutch (and, of course, German ones). Does anyone have an explanation for this? I think I might have one. The principal exhibit is this.

The point is that Finland has steadily moved from having a goods trade surplus to having a deficit, and the situation has been deteriorating continuously since the start of the global crisis. Even the much renowned current account surplus has been steadily disappearing in recent years.

What Goes Down Doesn’t Necessarily Come Back Up Again

The interesting point is that while exports fell sharply (as they did in say Germany) during the recession, they didn’t recover again afterwards.

In part this could be a question of the product mix they were relying on (and difficulaties in the land of Nokia), but having said that we couldn’t be facing another one of those good old Euro periphery competitiveness issues, could we?

Strange how as the Finnish real effective exchange rate has drifted away from the German one, and now the Finnish 10 year bond yield is doing the very same thing. I wonder if there is a connection?

In fact Finland up to the onset of the crisis had a pretty competitive export driven economy. Then came the great recession, and peak to trough Finnish GDP was down by almost 10%. However, even after the onset of the recovery Finnish  GDP was still nearly 3% below the pre-crisis high at the end of Q3 2011, and now, evidently, as recession starts to fall over Europe output is falling back again.

Growth in Finland resumed in Q1 2010, but the economy has already started to show signs of slowing again, with annual growth falling from 5.4% in Q4 2010 to 2.7% in Q3 2011.

We Couldn’t Have Another One Of Those Credit Driven Housing And Consumer Booms On Our Hands, Could We?

Another part of the picture is the way in which – in contrast to exports – household consumption recovered quite strongly in Finland. Not only did consumption recover, but at the end of Q2 it was 1.5% above the pre crisis high.

So the question is why did this happen? In some ways Finland could be thought of as the good student, steadily correcting one of those horrid imbalances which so worry everyone. But how did it do this? Well ECB interest rates and a house price boom certainly form part of the picture. The low interest rate environment generated in the wake of the global financial crisis has meant that those developed economies which did not experience a major housing boom-bust during the first decade of this century and still have housing market momentum have been running an elevated risk of experiencing one.

In particular the situation in three Scandinavian countries – Norway, Sweden and Finland – has attracted a lot of attention. In each case there was a minor house price correction around the time of Lehman Brothers, following which prices continued on their earlier upward path. And the comparison between the way industrial output failed to recover, while construction output really took off is another warning signal.

Finnish house prices have effectively been rising in real terms since the slump of the early 1990s. They fell back slightly during the crisis, but supported by ultra low interest rates from the ECB – some 95% of Finnish mortgage loans are variable – they soon resumed their upward path. In fact Finland is one of the few examples of a Eurozone country where the monetary stimulus may have actually worked. Let’s just hope they won’t live to regret it.

Anyway, one day or another some sort of correction was inevitable, as even the most reluctant of students among us must surely now have learnt that property prices do not continue to rise forever. To my eyes it seems that that fated day may finally have arrived in Finland in June this year.

Confidence data certainly reinforce this impression.

Don’t Worry, Be Happy!

But why worry, since as I said above, surely this is all part of that very much needed Euro Area rebalancing process? Finland has been running a property boom, but the population is not heavily indebted. Private sector debt is not especially high by some Southern European standards, and government debt is still low (and indeed under 60% of GDP), while the fiscal deficit has not breached the EU 3% limit.

So things are not too bad, unless…. unless you take seriously my ageing populations, export dependency hypothesis, in which case the recent loss of competitiveness is about to pose serious problems. The country is now the fifth oldest on the planet – after Japan, Germany, Italy and Austria – with a median age of 42.5.

This level of ageing is normally associated with low or volatile growth (think Germany and Japan), heavy export dependence, or both. The country has an ageing and declining workforce, and this, as the EU Commission noted in its most recent country forecast looks set to further take its toll on competitiveness and growth.

“The Finnish labour market is confronted with a notable demographic shock. Due to the retirement of a large baby-boom generation, the working-age population is projected to decline by over 5% of the current labour force by the end of the decade…(hence)…. taking account of the weakening of the growth potential of the Finnish economy due to its declining working-age population, the recovery will be more subdued than in previous recovery cycles….”

Conclusion: the country’s debt dynamics are far from unsustainable at this point, but given the weakening in the country’s export performance and the steady unwinding of the housing boom we can now anticipate I would expect growth to be weaker than either the EU or the IMF are currently anticipating, and pressure on the country to increase fiscal spending to maintain expectations to rise, with the implication that pressure on the Finnish spread over 10 year German bunds will continue, as the country risks drifting off from being part of the core towards the growing periphery, at least in the eyes of investors. So finally, coming back to the ECB and movements in the policy rate, it could well be the case that perceptions about rising future interest rates played their part in encouraging individuals not to leverage their balance sheets further thus weakening the housing boom, but my feeling is that in  the Finnish case the catalyst for the coming property implosion may not have been the recent 50 bps interest rate rises from the ECB, but rather the ongoing impact of the sovereign debt crisis on confidence, subsequently reinforced by the inbound shock from the recessionary wave now steadily sweeping Europe.

This post first appeared on my Roubini Global Economonitor Blog “Don’t Shoot The Messenger“.

This entry was posted in A Fistful Of Euros, Economics, Economics and demography, Economics: Country briefings by Edward Hugh. Bookmark the permalink.

About Edward Hugh

Edward 'the bonobo is a Catalan economist of British extraction. After being born, brought-up and educated in the United Kingdom, Edward subsequently settled in Barcelona where he has now lived for over 15 years. As a consequence Edward considers himself to be "Catalan by adoption". He has also to some extent been "adopted by Catalonia", since throughout the current economic crisis he has been a constant voice on TV, radio and in the press arguing in favor of the need for some kind of internal devaluation if Spain wants to stay inside the Euro. By inclination he is a macro economist, but his obsession with trying to understand the economic impact of demographic changes has often taken him far from home, off and away from the more tranquil and placid pastures of the dismal science, into the bracken and thicket of demography, anthropology, biology, sociology and systems theory. All of which has lead him to ask himself whether Thomas Wolfe was not in fact right when he asserted that the fact of the matter is "you can never go home again".

14 thoughts on “Is Finland Really A Closet Member Of The Eurozone Periphery?

  1. Cheers Edward.

    Have a look at this Finnish report from 2005:

    http://pre20090115.stm.fi/is1121411544723/passthru.pdf

    They predicted “the size of the working age population will begin to decrease in 2010″.

    A rather precise prediction no?

    It is clear Europe is not facing a financial crisis, but a demographic crisis.

    I know Krugman has fervently argued against austerity measures, but I fail to understand how fiscal or monetary policy can counteract these adverse demographics.

    I also note that in the last year, migration flows to Italy and Spain have slowed and possibly reversed, how long will they be able to maintain their welfare states without a steady flow of migrants to improve their dependancy ratios?

  2. Jan, thanks for pointing this out, I will ammend the text somehow. I wrote the bulk of this piece a couple of weeks ago, and didn’t check for revisions. The interesting thing is, if you look at the data, the result is more the effect of revising down growth earlier in the year, since Q1 seems to have gone from 0.3 to 0.2, Q2 from 0.6% to 0.1% and then Q3 upwards from 0.3% to 0.9%. So the change seems to have more to do with GDP being lower than thought earlier (which naturally pushes up the Q3 level in relations say to the Q4 2010 one. This position becomes even clearer when you look at the evolution in the year on year data, which is down from 5.4% in Q4 2010 to 2.9% in Q3 2011.

    The statistics office put the situation like this:

    “Revisions put the change in the volume of GDP in the second quarter of 2011 at +0.1 per cent from the previous quarter (was +0.6%) and at +1.9 per cent from twelve months back (was +2.9%). The downwards revision of GDP in the second quarter was mainly due to the revisions in the value added of the electrical and electronics industry. Corrections had to be exceptionally made in the electrical and electronics industry (26-27) to the erroneous basic data originally supplied to Statistics Finland concerning the second quarter. These corrections also had an effect on the upwards revision of exports of services in the second quarter. The data of the seasonally adjusted and trend series always become revised as new observations become available. Revisions especially at turning points of economic trends may be significant, which should be taken into consideration when using seasonally adjusted and trend data”.

    I think the statement “revisions especially at turning points of economic trends may be significant” is the important one, since we are evidently at a turning point. At the moment we have the really weird situation that the economy is slowing while the statistically prepared GDP number seems to show acceleration.

    This result goes against all the short term data we have, and I wouldn’t be at all surprised to see these numbers given a significant seasonal adjustment reshuffle.

    In the meantime I am quite happy with my substantial argument: the Finnish housing market has turned, and given the decline in export potency the economy will not now (without major fiscal injections which I doubt we will see) be supported by domestic consumption.

  3. Hi Asdasdasd,

    I basically agree, a large part of the crisis we have is about debt unsustainability in the light of lower growth and increased welfare costs due to having smaller and older workforces, although debt isn’t really a Finnish problem (at this point anyway) while lower growth almost certainly will be.

    On austerity, let me put my opinion like this, I think Angela Merkel is basically right in the longer run, we have to go for stability and sustainability over trying to stimulate growth we cannot achieve. In the short term we can use fiscal policy to some extent, provided it is directed towards achieving the structural changes we need to make, and not simply a way to buy time hoping that things will eventually get back to normal.

  4. When are we going to read something about the elephant in the room, something like:
    .
    IS THE UNITED KINGDOM AS MUCH A PIG AS ALL THE PIGS TAKEN TOGETHER?
    .
    Today’s article is about trade balances, well, the UK has a larger trade deficit than Portugal+Italy+Greece+Spain

    http://epp.eurostat.ec.europa.eu/cache/ITY_PUBLIC/6-16122011-BP/EN/6-16122011-BP-EN.PDF

    If you want you can add the trade balances of Ireland, Finland, Poland, Bulgaria, Romania, Latvia, Estonia, Lithuania and three or four more peripherics to the PIGS side and you do not reach the trade deficit of the United Kingdom. All those economies are more than four times larger with more than five times the population… but not enough trade deficits between them if compared to the UK.
    The same happens with fiscal balances. As a whole number the UK fiscal deficit is larger than that of Portugal+Italy+Greece+Spain taken together and this is after Cameron austerity measures.
    Are we going to keep looking away?

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  6. Edward,

    the problem with your suggestion of course is that Merkel cannot afford this long term/short term separation, because stimulation will be seen by key parts of the electorate as handing free money to people who have proven not to be able to handle it responsibly. Merkel is in a volatile position, since her coalition partners, the Free Democrats, are currently so low in the polls that come election time, she knows she would have no one to gain a majority in parliament with. At the same time, the Free Democrats, clinging desperately to some core political program, are refusing to budge fearing they’ll alienate the last handful of voters remaining to them.

    In essence, the German policy is thus currently held hostage by a party polling in at 2-3%.

  7. Jeronimo, Portugal, Greece, Ireland, and Spain added together have only a slightly greater population than the UK. in other news, Russia, Canada, and Australia taken together have a vastly greater surface area than the EU – should we be worried?

  8. @Jeronimo: In the worst case the UK can crank up the printing press and use inflation to pay off the debt, none of the PIGS can. They’ve just got 20 years of austerity (at the very minimum) because that’s the way Germany wants it. Whatever the PIGS do, the UK can delay things while the PIGS fall. Whether the UK uses this just to delay the inevitable or buy time for structural reform is something else.

  9. @”Me”

    Funny. And here I thought we have elections in Germany every four years – in fact, the current government could be out far more quickly.

    But your account is wrong on another point: The UK has a trade deficit. If the UK cranks up the printing press, those imports will quickly become unaffordable. Rather than delaying the inevitable, cranking up the printing press will put an economic decline on overdrive. Which is precisely why the Greek want to stay in the Euro.

  10. @Me,

    Well yes, you can do a “Mugabe” for a while but then things get ridiculous and at some point if you want to sell some debt, or simply roll it over, the investors start asking you to issue it in dollars or euros or yens or yuans and forget about the pounds. Then all the chickens come home to roost suddenly. What you call “20 years of austerity at the very least” (!!) feels then like paradise.
    How long can the UK sustain double the trade deficit per capita (hello Alex) than the GIPS?

    That is not the only problem… in 2010 the UK also had 60% more fiscal deficit per capita than those countries taken together.
    http://epp.eurostat.ec.europa.eu/cache/ITY_PUBLIC/2-21102011-AP/EN/2-21102011-AP-EN.PDF

    (150 Billion pounds for UK, 210 Billion euros for Greece+Italy+Portugal+ Spain)

    In 2010 the figure isn´t out yet, but it points towards double the fiscal deficit per capita in the UK than in those countries taken together.

    So its a double whammy of deficit finance.

    But look at Edward: he is worried about Finland, which in 2010 had a fiscal deficit of -2.5% of GDP (UK had -10.3%) and has a trade deficit of -1.2% of its GDP in Jan-Sep 2011 (UK had -5.5% of its GDP) So if Edward is worried at Finland’s figures, how worried should he be if the figures were FOUR TIMES (!!) as bad as they are in the UK?

    In this analogy of coming out of the closet it might happen that we have a Drag Queen in the room and no body is paying much attention.

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