NORDICS IN GLOBAL CRISIS Vulnerability and resilience Thorvaldur Gylfason, Bengt Holmström, Sixten Korkman, Hans Tson Söderström, Vesa Vihriälä The Research Institute of the Finnish Economy (ETLA) Publisher: Taloustieto Oy ETLA B242 ISBN 978-951-628-495-1 ISSN 0356-7443 Printed in Yliopistopaino, Helsinki, 2010 PREFACE The world is experiencing its worst slump since the Great Depression in the 1930s. The Nordic countries have, with the exception of Norway, been hit harder than most. Due to its sharpness and depth, the crisis is opening up or reviving a broad agenda of important policy issues. This report raises a number of the issues and discusses the scope for economic policies to contribute to the resolution of key economic problems. The report can be seen as a sequel and as complementary to an earlier report on the Nordic Model, presented two years ago by a team including three of the authors of the present report. While the earlier report was focused on structural issues, the one at hand is about macroeconomic and financial issues. The members of the team are eminent economists and authoritative experts on the issues covered. The report is a joint product, reflecting extensive discussions and cross-comments on individual contributions. The efficiency and speed of the editing by Kimmo Aaltonen and Laila Riekkinen is without comparison. Financial support from the TT-foundation is gratefully acknowl- edged. Helsinki 19 January 2010 Sixten Korkman THE AUTHORS Thorvaldur Gylfason is Professor of Economics at the University of Iceland and Editor of the European Economic Review. A Princeton Ph.D., he has worked at the International Monetary Fund and taught at Princeton, and was long associated with the Institute for International Economic Studies at Stockholm University. He has published over 100 scholarly articles and fifteen books, including seven collections of essays in Icelandic as well as Understanding the Market Economy (with Isachsen and Hamilton, 1992), available in 17 languages, and Principles of Economic Growth (1999). He has lectured extensively around the world. He writes a weekly column for Iceland’s largest daily newspaper, Fréttablaðið. His current research is mostly in the field of economic reforms and growth. His most recent publication is “Seven patriotic songs” for mixed choir in Skírnir, the Nordic countries’ oldest literary journal (est. 1823). Bengt Holmström is the Paul A. Samuelson Professor of Economics in the Department of Economics at MIT. He has a joint appointment with MIT’s Sloan School of Management. He has worked on the theory of the firm, particularly in the areas of contracting and incentives. His recent research has focused on the demand and supply of liquidity in financial markets and the financial crisis. Holmström is a fellow of the American Academy of Arts and Sciences, First Vice President and fellow of the Econometric Society, and fellow of the European Economic Association and the Euro- pean Corporate Governance Institute. He is a Research Associate of the National Bureau of Economic Research (NBER) and a member of the executive committee of the Centre for Economic Policy Research (CEPR). He has served on the board of Nokia Oyj since 1999. Sixten Korkman, pol.dr., has since 2005 been managing director of the Research Institute of the Finnish Economy (ETLA) and the Finnish Busi- ness and Policy Forum (EVA). He has previously served as Head of Office at the Bank of Finland (1983–1988), as Director General in the Ministry of Finance in Finland (1989–2005), and as Director General in the secretariat of the Council of Ministers in the European Union (1995–2005). He has written articles on macroeconomic and other policy issues and a book on the economic policies in the European Union. Hans Tson Söderström was from 1970 until 1984 Research Fellow, Sen- ior Fellow and finally Deputy Director at the Institute for International Economic Studies at Stockholm University. Between 1985 and 2002 he served as President and CEO of SNS – the Swedish Center for Business and Policy Studies. From 1985 to 1995 he was chairman of its Economic Policy Group presenting annual reports on Swedish economic policy. Since 1992 Söderström has served part time as Adjunct Professor of macroeconomic analysis and policy in the Department of Economics at the Stockholm School of Economics (SSE). Between 2004 and 2006 he was responsible for the school’s executive education branch, first as President and CEO, then as executive chairman. Professor Söderstöm’s main area of research is macroeconomic policies in small open economies. He has produced a number of scientific papers and textbooks in the area and has also served widely as policy advisor. Vesa Vihriälä is, since February 2004, State Under-Secretary in the Finnish Prime Minister’s Office and Secretary General of the Economic Council. He received his Doctor of Social Sciences (Econ.) degree from the Uni- versity of Helsinki, where he also worked as a researcher. In addition, he has studied at the Massachusetts Institute of Technology. Dr. Vihriälä had a long career at the Bank of Finland, where he worked on monetary policy and financial market regulation in the 1980s and had a central position in the crisis management activities of the central bank during the banking crisis in the early 1990s. He has also served as Economist at the OECD (1989–1991) and as the Managing Director of Pellervo Economic Research Institute (1997–2004). In his current position Dr. Vihriälä has focused on Finland’s globalization strategy, labour market issues and ageing policy. CONTENTS PREFACE THE AUTHORS 1 INTRODUCTION AND SUMMARY: PUTTING THE CRISIS INTO PERSPECTIVE 11 1.1 Panic strikes: Was the Great Moderation a Great Illusion? 13 1.2 Bashing bankers is not enough: The macroeconomics of lopsided globalization 14 1.3 The Great Stabilization prevented a repetition of the Great Depression 16 1.4 Regulation and stabilization: Do we need more? 18 1.5 Some economies suffered more than others 20 1.6 Lessons from Nordic experiences 20 1.7 The world needs a more robust financial system 22 1.8 Exchange rate flexibility is no panacea 23 1.9 The EMU is increasingly subject to strains 24 1.10 Fiscal policy may not be all that powerful but it is still essential 25 1.11 We need both growth and fiscal consolidation 26 1.12 The Nordic model is both vulnerable and resilient 28 Endnotes 32 2 THE CRISIS AND THE GLOBAL POLICY RESPONSE 33 2.1 The downturn was exceptionally sharp and synchronized 33 2.2 Unprecedented policy response 37 2.3 The US and the EU are different, but is there (some) convergence? 40 2.4 Was the global policy response effective? 46 2.5 Time for exit? 48 Endnotes 51 3 THE PANIC OF 2007–2008: A MODERN BANK RUN 53 3.1 The emergence of shadow banking 54 3.2 Global imbalances in demand and supply of assets 56 3.3 The magic of securitization and structured finance 59 3.4 The shadow banking system – complex intermediation chains 63 3.5 The repo market as surrogate banking 65 3.6 Haircuts and leverage 67 3.7 The panic 68 3.8 Was lack of transparency the problem? 72 3.9 So what happened and what is the future of shadow banking? 75 Endnotes 77 4 LOOKING BACK AT VOLATILITY AND GROWTH 79 4.1 The Great Depression and other avoidable slumps 80 4.2 The confluence of stabilization and regulation 83 4.3 Continental Europe: Similar story 86 4.4 Nordic countries: More of the same 89 4.5 Growing together 94 4.6 Learning from history 95 Endnotes 98 5 DÉJÀ VU: THE CRISIS OF SWEDEN AND FINLAND IN THE EARLY 1990s 101 5.1 Two different policy approaches converge in financial liberalization 101 5.2 Financial liberalisation without stabilization creates an unsustainable boom 104 5.3 External shocks trigger a bust 105 5.4 Monetary easing, fiscal expansion and massive bank support 108 5.5 Swift handling of the banking crises 109 5.6 Lessons learnt 112 5.7 This time is similar – and very different 114 Endnotes 118 6 SAFEGUARDING FINANCIAL INTERMEDIATION: NORDIC LESSONS 119 6.1 Problems must be recognised before action can be taken 120 6.2 Maintaining confidence is key and requires a solid framework for crisis management 122 6.3 There are many ways to support confidence 125 6.4 Asset disposal strategy and rationalisation deserve substantial attention 131 6.5 Saving the intermediaries is not enough 133 Endnotes 135 7 FROM BOOM TO BUST: THE ICELAND STORY 137 7.1 First to freeze 138 7.2 Lopsided liberalization 142 7.3 Privatization among friends 146 7.4 Increased inequality and other signs 155 7.5 Enter the IMF 156 7.6 Checks and balances, and trust 158 7.7 Prospects 160 7.8 Eleven lessons 162 Endnotes 165 8 EMU AND THE CRISIS: BETTER TO BE IN OR OUT? 167 8.1 Why Finland joined the euro and why Sweden did not 168 8.2 The euro in its first decade 170 8.3 The euro has made little difference for Finland and Sweden so far 172 8.4 The crisis and exchange rates: Why did the Swedish krona weaken so much? 178 8.5 Does depreciation help? 181 8.6 The weak krona: Will Sweden benefit? 182 8.7 Is Sweden pursuing a “beggar-thy-neighbour” policy? 190 8.8 What about Denmark and the euro? 193 8.9 Conclusions on the monetary regime 194 Endnotes 196 9 CAN FISCAL POLICY HELP? 197 9.1 Is fiscal policy effective? 197 9.2 Fiscal policy in the euro area 204 Endnotes 211 10 FISCAL CONSOLIDATION AND GROWTH 213 10.1 Cutting expenditure and strengthening the tax base 214 10.2 More growth through lower taxes? 217 Endnotes 230 11 BUILDING A MORE ROBUST FINANCIAL SYSTEM 231 11.1 Excessive leverage and risk taking 231 11.2 Lines of action in financial regulation and supervision 232 11.3 The importance of macroeconomic policy 240 Endnotes 242 12 VULNERABILITY AND RESILIENCE 243 12.1 Stop the world? 244 12.2 Some were harder hit than others 246 12.3 Less vulnerability 247 12.4 More resilience 251 12.5 A crisis of the Nordic model? 255 12.6 A global economy needs more than local policies 257 Endnotes 259 References 260 INTRODUCTION AND SUMMARY: PUTTING THE CRISIS INTO 1 PERSPECTIVE During the past two years, the world has experienced its most se- vere slump since the Great Depression in the 1930s.