Finland’s Problem Isn’t the Euro

Despite modest debt and a competitive economy, the Nordic country is on course for a fourth year of recession, but don’t blame the common currency

The Wall Street Journal

By SIMON NIXON

Nov. 25, 2015 5:30 p.m. ET

8 COMMENTS

Which has been the worst performing economy in Europe this year, excluding Greece? The surprising answer is Finland. In the third quarter of this year, Finland’s economy contracted by 0.6%, putting it on course for a possible fourth consecutive year of recession. Since 2008, its output has shrunk by 6%, faring only slightly better than Italy’s roughly 8% decline over the same period.

This might seem an odd record for a country whose sovereign debt still enjoys the rare accolade of a Triple-A rating, whose government debt-to-GDP ratio remains a relatively modest 62%, and which didn’t experience a banking bust. Finland is ranked by the World Economic Forum among the top 10 most competitive economies in the world, and its governments have taken a consistently hard line toward eurozone crisis countries. Now it looks increasingly like a stressed economy itself. How has this happened?

The simplistic answer is to blame the euro, which hardly helped the country deal with a series of shocks in recent years: the implosion of Nokia, Finland’s biggest employer; the collapse of the paper industry, reflecting the decline of newspapers and the bursting of the commodity bubble; the euro crisis and the European Union’s Russian sanctions regime, which hit Finland’s biggest export markets. The cumulative result is that Finland’s export market share has shrunk by a third since 2008, wiping out what was a large current-account surplus and accounting for much of the decline in growth.

If Finland had retained its own currency, it could have responded to these shocks by devaluing to regain competitiveness, as it did in the aftermath of its financial crisis in the 1990s. The U.K. and Sweden, which did devalue in the early stages of the 2008 global financial crisis, have seen GDP rise by 6% and 8% respectively since then. In contrast, Finland has been forced to attempt a painful internal devaluation, trying to regain competitiveness by forcing down labor costs through wage cuts and austerity. Paavo Vayrynen, a former foreign minister and now a member of the European Parliament, has collected 50,000 signatures for a petition demanding that the Finnish parliament debate whether the country should exit the euro.

But this explanation doesn’t tell the whole story. First, it is easy to exaggerate the role devaluation played in the British and Swedish recoveries. The U.K. recovery began only as its substantial postcrisis devaluation started to reverse. In a world of increasingly open economies and interconnected supply chains, the benefits of devaluations aren’t clear-cut, potentially pushing up manufacturing costs and depressing consumer demand. Conversely, two of the fastest-growing economies in the EU now are Ireland and Spain, both of which are in the eurozone.

Second, Finland’s euro membership has allowed it to benefit from unprecedentedly low funding costs since the start of the euro crisis, unlike other stressed eurozone countries that saw their funding costs soar. That reflects Finland’s high levels of fiscal credibility, based on its low debt and deficits and its commitment to complying with the eurozone’s fiscal rules. It is an open question what would have happened to Finland’s funding costs had it retained its own currency and tried to devalue and spend its way back to growth.

The more pertinent question is why Finland’s current ultralow funding costs haven’t helped fuel a recovery. The answer lies in the structure of Finland’s economy. What the U.K., Ireland, Sweden and—to a lesser extent—Spain have in common is that they have all taken steps over the past decade and more to make their economies more flexible. Sweden, for example, has in recent years largely abandoned the traditional Scandinavian model: Public spending has been cut from over 60% of GDP in the mid-1990s to just over 50% now, the top rate of tax cut from over 85% to 56%, and the tax and benefits system completely overhauled to spur those of working age to take jobs. Sweden’s renaissance owes far more to comprehensive free-market structural reforms than it does to devaluation.

In contrast, Finland’s economy today more closely resembles that of France than Sweden. Its public spending and tax revenues account for an eye-watering 59% and 56% of GDP respectively, higher even than France’s. Its labor market is one of the most rigid in the world, ranked 103rd out of 144 countries for labor flexibility in 2015 by the World Economic Forum. That explains why labor costs continued to soar even as the economy dived and productivity tanked; Finnish unit labor costs are now 20% higher than those of Germany. And thanks to Finland’s highly generous benefits system, the proportion of the working-age population that is economically active is five percentage points below that in Sweden—a serious problem for a country whose workforce is already shrinking as a result of having the worst demographic profile in the EU.

Finland’s challenge is to undertake the kind of deep structural reforms of its public sector, labor rules and welfare system necessary to enable it to compete in an open, global economy—as its new center-right coalition government is trying to do. This would be essential regardless of whether the country was in the euro or not. Indeed, quitting the euro would arguably incur very substantial short-term costs for limited gain—a point clearly not lost on all Finland’s major political parties and the 62% of its voters who polls show continue to support euro membership despite the continuing slump.