Erkki Liikanen: Finland, EMU and the euro
Remarks by Mr Erkki Liikanen, Governor of the Bank of Finland, at Norges Bank (Central
Bank of Norway), Oslo, 8 May 2009.
* * *
Introduction
A few years ago, the Nobel laureate, economist George Akerlof heard that his distant
relative had bought a house in Trondheim for more than USD 1 million. To him, it was a lot
of money anywhere, but particularly a sign of high property values in Scandinavia.
He later told this story to Robert Shiller, another well-known economist. Perhaps this was
not only a Scandinavian story. They decided to look at it at greater length for the insight it
offers into the patterns of booms and busts and notably the twin crises of confidence and
crisis that are currently everywhere in the world.
These reflections were recently published as a book by Akerlof and Shiller, "The Animal
Spirits". The distant Norwegian relative was the inspiration for a very interesting analysis.
This was the first time I have seen a Nordic experience presented as the first sign of the
excesses that lead to the boom and bust cycle we are going through today.
In contrast, the Nordic banking crises of the late 1980s and early 1990s and their resolution
have, for some time, been part of most major analyses that have aimed at putting the present
financial crisis in an historical context. That time, Finland, Norway and Sweden had similar
institutional arrangements and shared qualitatively similar experiences. In today's crisis,
things are different. Finland is the only Nordic country that has joined the Euro area. It may
be interesting to have a brief discussion on how this situation came about and how we in
Finland feel about it in the current situation.
* * *
Finland applied for membership of the European Union in March 1992 while the country was
experiencing a prolonged bust; in fact, a depression. We concluded negotiations early March
in 1994, a few days before Norway.
Finland did not ask for any derogation in the Treaty of Maastricht. We joined the EU in 1995
and became part of ERM in 1996. And consequently, in 1999, Finland joined the euro area
as one of the founding group of eleven countries.
To pool our currency with 10 others was no small decision. On the political side, it marked a
major step towards deeper integration within the EU. On the economic side, it established a
whole new framework for the Finnish economy and economic policies.
We have today more than a decade of experience of life as a small member of a large
currency union. This decade has spanned a diverse set of economic circumstances. It
started with the dotcom boom that soon turned into a bust. Finland was a part of it, due to a
significance of her ICT industries.
It continued with the deflation scare, gradual recovery, through the long-rate conundrum, and
into the commodities boom. And finally, it turned into the second decade amidst a
spectacular, vertigo-inducing collapse of some global financial and trade structures that we
started to take for granted.
Even though Finland had not asked for any derogation when joining the EU, the decision to
adopt the euro was not without challenges. Initially, there was a lot of scepticism. In 1996
opinion polls put support for the euro below 30 per cent.
But that scepticism soon started to dissipate. Strong political leadership certainly played an
important role. Today three quarters of the population consider the euro beneficial to the
Finnish economy, on the whole. Among economists, there are hardly any voices questioning
the wisdom of our decision to join the euro.
In this speech I shall try explain how an unpopular currency became popular. I will illuminate
our experience from three angles, each of which was present in the debate leading to our
eventual decision to join.
The first angle is one of business cycle management.
Finland was not really seen as a part
of an optimal currency area with the rest of the eleven countries. We had our own, rather
idiosyncratic business cycle. Would the common monetary policy exacerbate cyclical
volatility in Finland?
The second angle is one of crisis management. At the time when the decision to join was
made, Finland's deep depression of the early 1990's was fresh in our memories. At that time,
our recovery was aided by a substantial depreciation of the Finnish markka. How would the
loss of exchange rate policy affect our ability to survive truly adverse economic
circumstances?
The third, and final, angle deals with politics and decision making; to what extent would we
have a say on our own fate? Apart from the obvious aspect of shared monetary policy, our
membership in the euro area also meant closer cooperation and coordination of fiscal and
financial policies and in international fora. Would we be able to find ourselves an active role
in the Eurosystem, or become a passive bystander while the bigger players take decisions?
Let me start with business cycle management.
Euro and the business cycle
Before we joined the EMU, there was a lively debate about its pros and cons. It was
generally acknowledged that EMU would reduce certain sources of uncertainty. In particular,
there would be less exchange rate uncertainty, and also interest rates were expected to be
more stable - and, on average, lower. EMU would also bring about microeconomic efficiency
benefits such as lower costs of currency exchange, more price comparability and greater
competition, as well as deeper, more competitive and more efficient money and other
financial markets.
On the other hand, a great deal of attention was devoted to the asymmetry of economic
structures in Finland vis-à-vis the rest of the euro area. While macroeconomic trends in the
core EU countries such as Germany, France and the Benelux countries usually were
broadly similar, economic fluctuations in Finland had historically diverged a lot from the core.
Our cycles had had different timing and greater amplitude than other members.
This was due to the specialised structure of the Finnish economy. Production and foreign
trade were dominated by a narrow group of industries. A traditional major player was the
paper and pulp industry, which had a history of large fluctuations in both prices and
quantities.
An increasingly important contribution was also made by the ICT (Information and
Communication Technology) industry, the growth of which was largely driven by the success
of one company, Nokia. The Finnish economy was becoming sensitive to developments in
the telecom sector, although this was not yet fully understood at the time of the "asymmetry
debate".
Finland stood apart from the euro area also with respect to its geographical trade
specialisation. Only one third of our exports went to the euro area, which made Finland
particularly vulnerable to disturbances outside the currency union.
Exchange rates were seen as a particular risk: fluctuations in the external value of the euro
could have a disproportionally strong effect on Finnish production. This concern was
magnified by concerns that Sweden and the UK, our most important trading partners, might
stay outside the currency union - or even the exchange rate mechanism - as in fact
happened.
So, in economic terms, there were cons as well as pros, to joining the currency union, and it
was not clear which were more important. The final decision was driven by political
considerations at least as much as by economic ones. Membership in the currency union
guaranteed Finland a seat at all the tables where decisions were to be made. If an "inner
circle" were to emerge inside the EU, Finland would be part of it.
So, Finland joined the ERM in October 1996, and introduced the euro in 1999. What has our
experience been over the ten years? To what extent have the fears or the benefits
materialised?
Interestingly, many of the asymmetric shocks feared by the opponents to Finland's adoption
of the euro have already materialised over this relatively short period.
The ICT industry experienced a strong boom-bust cycle around the turn of the century. In
Finland the downturn of the cycle was reflected more in growth expectations and asset prices
than in production quantities. The price index, which is dominated
Helsinki Stock Exchange
by the ICT industry, tripled between early 1999 and early 2000, compared with an increase of
DJ Euro Stoxx of about 50% over the same period. Thereafter, both indices fell. By early
2003 the Helsinki index was about 75% below its peak, compared to about 60% for the DJ
Euro Stoxx.
Also Finland saw large fluctuations in its exchange rates. The exchange rate of the euro
visà-vis the dollar first depreciated nearly 30% and then appreciated by 50%.
Contrary to the EMU opponents' expectations, neither the positive external shock
experienced at the turn of the century nor the initial depreciation of the euro served to push
Finland's economy into an inflationary spiral. And later on, the Finnish economy was also
able to weather the recession of the ICT industry and the appreciation of the euro relatively
painlessly.
The Finnish inflation rate, which was brought under control during the inflation-targeting
regime before joining the EMU, has remained modest. On average, since 2000, Finnish
inflation has been within the range of the ECB's definition for price stability and below the
euro area average. The GDP growth in Finland has fluctuated more or less in tandem with
the euro area, but the average rate of growth has been about one percentage point higher in
Finland than in the euro area. Throughout these years, and until very recently,
unemployment continued along a steadily declining path.
Why have the asymmetries manifested themselves in such a subdued manner? No doubt
part of it was luck. The effects of these asymmetric shocks were, to some extent, mitigated
by other coincident factors, such as the success of Finnish exporters on the growing Chinese
market.
But I believe structural factors have also been significant, and the euro has been an
important factor in bringing about structural change. The single currency, and the
commitment to succeed within its constraints, has contributed to a process of transformation,
which in turn has changed the Finnish economy in a profound fashion. This change started
already before the single currency, but the euro has brought further discipline and helped to
a few such structural factors.
sustain the momentum. I will list
First, wage setting. With no exchange rate policy available to correct mistakes, wage setting
must be done responsibly. By and large, and notwithstanding some slippages, this has been
the case. At the aggregate level, wage setting has been anchored by low and stable inflation
expectations and guided by long-term competitiveness rather than short-term cyclical
developments. (The one important exception took place in the wage negotiations of 2007). At
the same time, wage flexibility at the microeconomic level is now acknowledged as an
important part of a well-functioning market economy.
Second, public finances. Single currency, and the stability and growth pact, has supported
the resolve for fiscal consolidation in Finland. Since the turn of the millennium, and until this
year, the Finnish public sector has stayed in surplus, all the while bringing tax rates gradually
down. This has been an important factor underpinning confidence in the Finnish economy
throughout economic fluctuations. Strong emphasis on fiscal discipline is important now,
amidst the crisis, and will be even more important in the years to come, given the
demographic transformation Finland is entering.
Third, the euro has supported Finland's commitment to making itself into an open and
competitive economy.
Openness to trade has been recognised as a prerequisite for growth,
particularly for a small country. A small country can only exploit economies of scale by
specialising, becoming a world player in a few fields, and importing most of the rest. Finland's
economic strategy has been geared to this aim. Governments of various political coalitions
have sought to keep the business climate favourable. Research and development has been
a priority - Finnish R&D expenditure as a share of GDP ranks at the top of Europe, alongside
with Sweden. And of course, high-quality education is a crucial part of an innovation-driven
society.
Of course the euro alone has not made this happen. But the euro sealed a clear break with
the past. It gave us truly independent central banking institutions with an assured orientation
to price stability. It sealed our transition from an economy where past mistakes could always
be corrected and unprofitable industries propped up by devaluing the currency, to an
economy where decisions had to be made for the long term and competitiveness was more
about quality and know-how than price.
All in all, the experience so far, in terms of our ability to withstand asymmetric shocks, has
been overwhelmingly positive. Instead of accentuating the economic cycle, the euro has in
fact proved to be a stabilising factor - an anchor that has helped to make the whole economy
more long-term oriented and less prone to cyclical fluctuations.
Let me next move on to the second broad angle, namely crisis management in a currency
union.
Euro and crisis management
The world economy is today going through an unprecedented crisis. The crisis is remarkably
symmetric: For the large majority of countries, it cuts 5-8 percentage points off their growth
rate this year.
Finland will take a hit comparable to that experienced by other open economies whose
production is weighted towards investment goods, such as Germany, Sweden and Japan.
Visibility remains very poor but, at this point, we anticipate that the Finnish economy will
contract by some 5 per cent this year.
Clearly, the symmetric nature of the crisis has consequences for the role of the exchange
rate as a policy tool. An asymmetric shock may change a country's equilibrium exchange rate
so that its market exchange rate needs to adapt to restore equilibrium. A symmetric shock,
on the other hand, does not change the equilibrium exchange rate. An attempt to
compensate for its effects by changing the exchange rate would be merely
beggar-thyneighbour policy and a recipe for trouble on the international front. So, the active use of
exchange rate policies would be out of the question.
Norway and Finland are both part of the Nordic-Baltic Constituency of the IMF and the
World Bank. In this Constituency we have a broad range of different monetary policy
regimes as well as floating and fixed exchange rate regimes. Some countries have done
well; others have been under considerable stress. For some, independent exchange rate has
been unproblematic, for others it has been a source of vulnerability. Right or wrong, for those
experiencing the greatest difficulties, membership in the euro area has become a
centrepiece of their strategy out of the crisis.
So, does the euro form a shelter or a straitjacket in this crisis? Put another way, how would
the Finnish markka do today, if it still existed? This is a difficult question, not least because
this kind of counterfactual analysis is inherently impossible, and I will not pretend to know the
answer. But let me just say that we have been happy to sit out the storm within the euro area
rather than outside it.
The exchange rate is not a straightforward policy instrument. Although in principle, it may
support faster adjustment of real imbalances, experience has shown that it becomes difficult
to control precisely when the challenges are greatest. In times of crisis, the exchange rate
tends to respond to financial disturbances rather than to real imbalances and, more often
than not, it becomes a constraint on policies rather than a useful adjustment channel.
Membership in the euro area eliminates one potential adjustment channel, but above all, it
eliminates a major source of uncertainty at times when uncertainty is already high. We are
glad to accept that trade-off.
The final viewpoint to euro membership relates to the role of a small national central bank in
the decision making process of a large currency union.
Decision making in the Eurosystem: Getting your voice heard
This is one aspect of the single currency that is often misunderstood; what actually is the role
of national central banks in the ECB and in the Eurosystem? Over the past ten years we at
the Bank of Finland have been asked often why the Bank of Finland still matters. Isn't
everything decided in Frankfurt? What is the role of National Central Banks?
How do the ECB and Eurosystem operate? As a result of the Maastricht Treaty and practices
established over these ten years, the institutional structure of the Eurosystem is carefully
balanced. The hub remains relatively small in comparison to the spokes. In important ways,
the Eurosystem remains highly decentralised.
All important decisions are taken by the Governing Council, which usually meets in Frankfurt.
A large majority of the Council (all but six members of the Executive Board) are governors
from National Central Banks.
They sit around the table making decisions in their personal capacity as members of the
Governing Council, not as representatives of their countries. They are fully independent in
this role as are the members of the European Commission or the European Court of Justice.
But when each of them is also a head of a National Central Bank, it is clear that their staff is
deeply involved in preparing all issues on the agenda of the Governing Council meetings. So
when the governor takes off to Frankfurt, he is thoroughly prepared and carrying loads of
papers and briefing notes in his briefcase.
The single currency has delivered many important benefits, but higher productivity in the
making of monetary policy is not one of them. All important decisions are prepared at the
ECB and in the 16 National Central Banks in parallel.
There is a certain degree of division of labour, but much of that work is done at the same
time by all. This is important. It serves as a mechanism of checks and balances. It helps to
avoid the pitfalls of "groupthink" - a sort of consensual corporate culture that stifles creativity
and critical thinking - and it ensures that relevant viewpoints seldom get neglected. This is a
way to guarantee that decision-making is "wisdom-based" as a senior central banker once
said.
The ECB always produces its own analysis, and in a way has preferential access to the
Council agenda, but the ECB analysis is tested against the analysis prepared in each of the
national central banks and the judgment of the members from the Governing Council.
One must also remember that the implementation of monetary policy is decentralised. The
National Central Banks are responsible for liquidity operations with their counterparties,
which can be any financial institution from an EEA country which has a counterparty status in
the country of the NCB. This means that National Central Banks are active in the market
every banking day.
Decision making by the Governing Council is supported by a web of ECB expert committees,
working groups and task forces where a governor nominates a member. These bodies have
no decision making power, but they serve as fora in which some differences can be ironed
out and the groundwork laid for the Council. Roughly 80s Bank of Finland officials travel
regularly to meetings of such groupings.
Finland is one of the smaller shareholders in the Eurosystem. The Bank of Finland holds less
than 11⁄2 per cent of the ECB's subscribed capital. But when it comes to monetary policy
decisions, everyone has one voice and one vote around the table. It would be naïve to claim
that the size of the country has no effect on the weight of one's voice, but in reality size
matter less than one might think. By and large, it is the weight of one's arguments, not the
size of the country that is key to influence in the Eurosystem.
What is clear, though, is that a small central bank has fewer resources to devote to
preparatory work than a larger central bank. This is why a small central bank must make
efficient use of its limited resources. Small size can sometimes be turned into an advantage.
Communication is easier in a small organisation, and excess bureaucracy is less of a risk.
A small central bank also must prioritise - it cannot be a jack-of-all-trades. It must decide
early on which issues and processes to invest in, pick those issues that matter the most and
try to master them thoroughly.
Being influential means following research closely and, if necessary, investing in research of
one's own. But it also requires the right attitude, being forward looking and mentally prepared
to take an active role. And, of course, it requires constant networking and the ability to listen,
not only to lecture.
After ten years of experience as part of the euro area, we at the Bank of Finland do not feel
that giving up our own currency has diminished our ability to influence our own fate. On the
contrary, we feel that we have managed to establish a role as a decision maker in tables that
would be far beyond our reach if we were still managing our own currency. Not all decisions
coming out of those tables are to our liking, but this, again, is a trade- off that we are happy
to accept.
* * *
I have presented you with three viewpoints to life as a small country with a larger currency
area. And from each of these viewpoints, our experience has been a positive one. In terms of
cyclical stabilisation, Finland has been able to absorb and adapt to sizeable asymmetric
shocks without substantial macroeconomic difficulties. At the same time, leaving exchange
rate policies behind has helped Finland develop a structurally stronger economy.
In terms of crisis management, the experience has been equally reassuring. In a financial
storm, a big ship with a strong anchor is the place we prefer to be. We do not miss our small,
old, boat, even though in that boat, we held the rudder and could, in theory, steer ourselves.
And finally, in terms of decision making, we feel as much in charge of our fate as we ever did
before. We have lost one potential policy instrument or adjustment channel, but we have
gained a say on issues and at tables in which The Bank of Finland is still very much an
organisation with a mission.
All in all, membership in the euro area has served Finland very well so far. This view is
widely shared, by the general public as much as by economists. Ten years is still a short time
to make a final judgment, so perhaps this should be seen as an interim report. But, given the
quite varying challenges thrown at us by this decade, our ride could have been a good deal
bumpier. So, at least, I think this qualifies as a good start.