Jul 27, 2010

The cost of EMU membership in the crisis: A comparison of Finland and Sweden

Admittedly, Sweden and Finland are not exactly alike and I am sure a Swede or a Finn will not like that I use the two countries in the sense of this quasi experiment. But some things they have in common: both face similar trade costs, both have a highly educated workforce, both have rather decent macro management in place and both are highly integrated in and dependent on the world economy. Most importantly, both produce and export similar products and the service sector is a main contributor to employment and GDP. For both, the EU is the main trading partner (though Russia is very important for Finland as well).

Despite the millions of differences between the two countries the key difference is that Sweden has an independent monetary policy and Finland is part of the euro zone. The consequences of which are perfectly seen in the following graphs which should make it into the next editions of textbooks that describe the Mundell-Fleming logic à la IS-LM-BP.

Figure 1: Real effective exchange rate based on 50 trading partners, source: BIS

As the crisis unfolded, most countries started reducing policy rates. So did Sweden. While the ECB reduced also its main rate the change for Sweden was more pronounced. Together with other monetary policy measure this lead to a strong depreciation of the Swedish krona. Thus Sweden could gain very early a competitive advantage over its main trading partners while Finland could not (See figure 1). The otherwise close to parallel pattern of the real exchange rate of the two countries diverged and Sweden managed to attain a real depreciation close to 20% while Finland saw no gain in competitiveness until 2010. Only the recent drop in the euro’s value, due to fears about the rising debt level in several EMU members has started to improve the competitive position of Finish exports.

The real depreciation helped Sweden to cushion the drop in demand and led to a much lower reduction in real exports compared to Finland (Figure 2).

Figure 2: Real export growth, source: OECD

The former experienced a peak drop of -13% while the corresponding value for Finland is - 28%. As a consequence the net trade balance of Sweden dropped only slightly from 8 to 7 percent of GDP while Finland’s net trade balance dropped from 5 to 3 percent of GDP (despite a lower drop of GDP in Sweden compared to Finland!).

Figure 3: Primary government balance in % of GDP, source: OECD

Finland on the other hand saw no alternative to the use of fiscal stimuli while Sweden did not need to increase debt significantly. The primary government surplus quickly became a deficit and contributes currently the fact that Finish debt to GDP outpaces the Swedish ratio despite the fact that for the last 10 years the contrary was true.

Finland pays a high price in this crisis for not having an independent monetary policy in terms of foregone GDP and servicing cost of increased debt.

Figure 4: real GDP growth, source: OECD

The short sighted conclusion from this comparison is that it is preferable not to peg but to maintain a flexible exchange rate. But this conclusion is deeply flawed for several reasons. First, it considers one particular, negative shock and says nothing about the past benefits of being EMU member nor does it tell us anything about what might happen in response to a potential positive shock. Second, the counter factual is likely to be wrong. In a world where Finland has not been part of the EMU many others may not have been. Thus in the counter-factual it is likely that all these other “would-be non-EMU-members” could have forced interest rates down further and most countries end up with a threat of higher inflation and no competitive gain and no boost of net exports.

Nevertheless, ceteris paribus, being a Swedish policy maker or citizen (who will have to repay the debt) appears to be the more appealing option these days. Too bad that being nearly the same is just not the same.

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