Economic woes of Finland

“Finland has indeed seen a rapid rise in ULC (unit labour costs), but not because of a wage explosion; it’s all about collapsing manufacturing productivity”, wrote Paul Krugman recently, without providing any data in support for his claim.

Eurostat compiles a labour cost index; 2008 = 100 which shows the development of an hourly labour cost. By the 4^th quarter 2014, the index rose in the Eurozone to 112.1, in Germany to 115.1, but in Finland to 117.6!

So, after the international debt crisis Finland continued to internally revalue in respect of Germany and the Eurozone indeed at the same pace as before the crisis. From 2000 to 2007 Finland revalued internally six per cent in respect of the Eurozone while Germany internally devalued by seven per cent.

A wage explosion is behind the loss of competitiveness of Finland. It has nothing to do with Euro.

Finland has continuously suffered of the same disease during the post second world war era and devalued her currency markka by one third once per decade, more often at the end of the 1940’s.

Is euro overvalued?

“There is only one route for the euro, towards 1.08 in the US dollars by the end of this year and towards the eventual parity in 2011”, forecast an expert in a TV interview during the heydays of the euro crisis in the beginning of June 2010. The actual exchange rate was then 1.20 US dollars per euro.

Only two years before, in May 2008, when the euro hovered at 1.55, another currency strategist forecast: “there is only one route for the US dollar, towards 1.70 by the year end”. Incidentally, the euro touched 1.25 half a year later – and 1.50 in subsequent November in 2009.

Forex-strategists may in passing mention purchasing power parity (PPP), but most often emphasize short-term trends that may not at all be based on a convergence towards PPP but on recognition by technical analysts, that is, by those who try to find out recurring patterns in the historical data. PPP is a theory of the intrinsic value of a currency: the equilibrium exchange rate equates the cost of an average goods basket in the two currency areas. When PPP holds true, a dollar or a euro buys the same basket irrespective of the country where it is expended.

The best available estimate for the correct long-term value of the euro in the US dollars is based on the average goods basket of the OECD countries as calculated by the Ifo Institute in Munich, Germany, the most recent value of 1.17 being published in CESifo Forum 3/2010, p. 39. Were the US basket the reference the parity of the two currencies would roughly represent the PPP indeed. And in respect of the German basket, the PPP value is not far from the current exchange rate of 1.40.

The euro zone contains countries with a lower level of general prices than in Germany. Hence the rise of the euro to 1.55 in 2008 may not have represented any drastic overvaluation in terms of the euro-zone basket of goods. In fact, during the Carter administration the US dollar was much weaker, about 1.70 dollars per euro.

The preferred OECD purchasing power parity of 1.17 in contrast to the current exchange rate of 1.40 implies about a 10 per cent overvaluation of the euro. But, how quickly does the exchange rate of a currency converge to its PPP value?

The established robust econometric result during my life-time of teaching was that any discrepancy from the PPP would be halved over the medium term which most researchers interpreted as anything from one and half years to three years. From this perspective the forecast for the dollar exchange rate of the euro for November 2011 is that the euro would slightly depreciate against the US dollar. – And experience shows that we will experience much wider fluctuations.

This leaves ample room for the real actors in the currency (forex) markets: find a trend, trade the trend, and ride the trend. For a forex trader a trend in an exchange rate is like bureaucracy: it does not pay to fight against it.

Stress test

Why does mayhem in world financial markets continue without a clear sign of ending? Why recovery of real economies delays? Economists seem to join lemmings in the political market and to succumb to its guiding forces, populism and opportunism, in their proposals to implement tighter regulation of financial institutions and looser budgetary policies. Shouldn’t they rather stick to the basic body of their science?

When politicians slightly open the strings of their purses, it pays for the actors in private markets to delay their decisions in the hope for milking more generous subsidies and expenditure programs. That is why sound fiscal policy would now call for an end of constructing new such programs. The worldwide downturn will anyhow immensely deteriorate public budgets through automatic forces, by reducing tax revenues and increasing social transfers because of stalling production and enhanced unemployment. Thus lesson no. 1 is that a responsible piece of economic advice would not only limit public budgets to their present stance but would also kill the option to delay in taking private action.

In monetary policy, central banks have largely emptied their ammunition, steering rates of interest set at their historical bottom; quantitative easing remains, i.e., central banks buy unconventional assets from the banking system to directly create loanable reserves.

Only the ECB has room for additional maneuver in its steering rate. – You guessed it! I do not recommend the ECB to cut the rate of its main lending facility on April 2. In the current circumstances it is time for thinking about future; price developments in the euro zone, the harmonized index of consumer prices rising 0.4 per cent in the month of February, are not encouraging for a rate cut. The lags of monetary policy are notoriously long and variable. Sticking to the most basic lesson of monetary policy – inflation is always and everywhere a monetary phenomenon, lesson no. 2 – would kill the option to delay the start of lending by big banks.

The “too-big-to-fail” –doctrine is not economics but sociology of economic policy. Politicians and their economic advisors should abandon it in favor for admitting the fact that in mayhem, as the current one, all financial institutions are zombies if strict mark-to-market financial accounting were applied to them. Therefore no kind of discretionary cleansing of banks from their bad loans would make the system safer.

The banks were lured to risk taking by regulation itself, by the incentives that softened the impact of regulatory red tape on them. And, those incentives were hugely fuelled by the Fed’s lax monetary policy since Alan Greenspan’s acclaim “irrational exuberance” - acclaim because he did not act accordingly.

Banks are currently passing through a real stress test. Therefore it is irresponsible economic management by the ministries of finance and by the central banks if they try to benefit from the difficulties of the banks. Rather, I would see the ministries of finance advancing credit on equal terms to every bank regulated by the Fed and the ECB at the same interest rate as the governments can raise themselves. But after a two year’s grace period, a progressive penalty rate over the next 5-7 years need be applied to such loans to recover the taxpayers’ funds. Banks and individuals will react to changes in relative prices; so, lesson no. 3 is that let the markets decide which bank will fail and which stay.

Lesson no. 4 is to get rid of other kind of bank regulation, except for requiring the top managers and the major owners of the banks to be fit-and-proper professionals, in the first instance, and for preventing them from looting their banks in case a bank will walk plank. Part of such preventive rules would be to install a claw-back clause on the managers’ future compensations so that their remunerations will retrospectively - perhaps over the last five years before a bank failure - be reduced to a decent benchmark.

Bad “bad bank”

The task of a bad bank should be to sell their good assets to the good banks and to other potential buyers as to the “vulture” funds. When Chairman Bernanke’s approach is followed: “to set up and capitalize so-called bad banks, which would purchase assets from financial institutions in exchange for cash and equity in the bad bank”, we get exactly the incentive problem that caused yesterday’s jitter in the markets: how to value the toxic assets. The pricing of such asset categories too low would make many big banks insolvent while purchasing at an inflated price above market values means the taxpayers handing a subsidy to the banks.

In the banking crisis of Finland in the beginning of the 1990s, the “bad banks” were fallen angels, banks fallen to the control of the government, which sold their good assets to the remaining healthier banks and to foreign financiers. Thereafter the bad banks managed their portfolio of sour loans and real estate holdings as every bank is accustomed to do.

Pretty soon after the first fallen angel emerged, all banks were offered a capital loan on equal terms in proportion to their risk-weighted assets and off-balance commitments. Such funding was junior enough to count as tier I capital: interest could only be paid after the receiving banks had fulfilled their other commitments, but dividends on preference shares and common stock could be distributed after the banks had paid interest on the capital loans.

In practice, the government’s capital loan offer funded “mating”. During the consolidation process the banks were able to raise private co-finance, both equity and long-term debt, in the financial markets. Those banks that did not find a stronger partner ended up as bad banks.

Besides the customary political process, the delay in solving the Finnish banking crisis was caused by the lack of a government agency that received fallen angels. But, the USA has an experienced government agency for that purpose, the FDIC.

US Treasury Secretary Geithner need allocate the remaining TARP funds to the FDIC. What the USA is lacking is a government offer for funding that would facilitate the amicable mating ritual on equal terms for every partner.


It is not the purpose of a government agency to profit from solving the banking crisis. It was astounding to read in today’s press Chairman Bernanke to have announced yesterday that the Fed expects to make big profits from its increased role in the credit markets.


The task of the Fed and other federal agencies is to breathe new life to the speculative confidence of private actors as well as strengthening credit creation. This follows from Keynes’s analysis in Chapter 12 “The state of long-term expectation of his General Theory (p. 158): “the recovery requires the revival of both”. The whole chapter eloquently covers the difficulty of valuing long-term investments in the stock market.

Preventing the world from central bankers’ ego

Instead of Keynes, would the old Friedman rule be worth studying again? Milton Friedman invented his rigid rule for monetary growth to save the citizens of a free society from the central bankers’ ego unlike Lenin’s instruction to most effectively destroy a society by destroying its money.

Friedman was fearful of “the assignment of wide discretionary powers to a group of technicians, gathered together in an ‘independent’ central bank” and wanted “to establish institutional arrangements that will enable government to exercise responsibility for money, yet at the same time limit the power thereby given to government and prevent this power from being used in ways that will tend to weaken rather than strengthen a free society”; Capitalism and Freedom (1962, p. 39). Friedman introduced the idea of a constant annual rate of growth of money stock, regardless of changing economic conditions, to curtail the discretionary power of the monetary authorities in A Program for Monetary Stability (1959).

“The fact is that the Great Depression, like most other periods of severe unemployment, was produced by government mismanagement rather than any inherent instability of the private economy”; the Federal Reserve System exercised its power to conduct monetary policy “so ineptly as to convert what otherwise would have been a moderate contraction into a major catastrophe” (C&F, p. 38).

By Friedman’s hindsight, the error list of the Fed included the unusually tight monetary conditions since mid-1928 culminating in an attempt to curb “speculation”, but leading to the 1929 stock market crash - that is, the Fed pricked the bubble which Greenspan’s Fed declined to carry out; the money stock declined by nearly 3 per cent from August 1929 to October 1930 – “a larger decline than during the whole of all but the most severe prior contractions”; prior to October 1930, there had been no sign of a liquidity crisis, or any loss of confidence in banks, but thereafter the economy was plagued by recurrent liquidity crises, runs on banks and waves of bank failures, but the Fed “stood idly by” because of “will, not of power”; Britain went off the gold standard in September 1931 inducing gold withdrawals from the USA, but two years of severe economic contraction did not prevent the Fed from defending the dollar and ending the gold drain by raising the discount rate – the rate at which it lent to member banks; the US money stock fell by one third from July 1929 to March 1933 with over two-thirds of the decline after Britain’s departure from the gold standard.

No wonder, Friedman wanted to avoid important policy actions being “highly dependent on accidents of personality” by introducing his rule of money growth that would also prevent monetary policy from being subject to the day-to-day whim of the politicians.

Was Alan Greenspan’s ego too big because of Friedman’s infamous research on and critique of the US monetary policy of the 1930s in A Monetary History of the United States 1967-1960 with Anna Swartz (1963)? Did Alan want to show how the Fed’s errors of the 1930s can be avoided? Alan fought preventively against “deflation”, a continuous downward spiral of prices and wages, in 2003-2005 during the most rapid global economic growth ever experienced! Greenspan’s Fed ridiculed active monetary policy by inventing to raise the steering rate of interest at a “measured” pace – the flip side of Friedman’s rule of a constant rate of growth of money supply?

What went wrong? The world is a global village was already taught in the mid-1960s. With a number of emerging market currencies pegged to the US dollar and the pound sterling and the euro shadowing the US policy rate changes, the USA is no longer a small open economy. The Fed ought to have a surveillance of monetary and fiscal conditions in the whole dollar block, not only the US economy, before taking decisions.

Also, the new rule of raising the steering rate at a “measured” pace softened the signal of monetary policy to the market participants in contrast to the previous policy actions and greatly increased long-term uncertainty about inflation and interest rates though making the next policy step more predictable - and lulled all financial journalists as well.

Is Ben Bernanke’s ego also too big? He earned his academic credentials by research on the Great Depression, lectured as a Governor of the Fed on quantitative easing, Deflation: Making Sure "It" Doesn't Happen Here, by using the balance sheet of the Fed. He is regarded as THE expert on financial crises, on exactly those sequences of events the world has experienced during the past two years.

This crisis has shown that Keynes's green cheese, money created by the banks and other financial intermediaries, is no substitute for the US treasuries in case of real excess demand for the “moon”, currency and highly liquid government bonds. So, global imbalances and their financing patterns matter for monetary policy.

Friedman confessed in the 1986 Economic Inquiry that his “rule” did not satisfy the most basic incentive scheme because it was not in the self-interest of the Fed hierarchy to follow the hypothetical policy of such a rule. But in the end, Friedman was after getting rid of the whole Fed: private markets would deliver financial and price stability at equal or less resource cost.

From Regulation Failure to Non-Regulation of Banks

Regulation of banks was never before based on such a sophisticated system as during the past 20 years, from the solvency rules of Basel I and Basel II to internal risk-metrics of individual banks. Yet we have seen banks gone bust as for centuries earlier. Also, there is nothing new in bailing out banks with taxpayers’ money.

Sveriges Riksbank, today’s central bank of Sweden, was in huge difficulties in the mid-1760s after having during the so-called Freedom Era extended credit to the merchants of Stockholm the most of which had gone sour. The difficulties were preceded by years of rapid inflation, credit growth and money printing. But, because the bank operated under the guarantee of the Parliament (Sweden had a parliamentary system at that time) it was of course gradually rescued by the taxpayers’ money. The years were politically stormy, two main parties competing for power. But in the end, a “third party” - the king party - won so that King Gustav III could again re-establish an authoritarian kingdom in a bloodless revolution in 1772.

Today the Federal system has assumed functions that traditionally do not belong to a central bank. It has purchased commercial paper issued by big US companies, for example. So the next “too-big-to-fail” institution may be the Fed; Obama’s Court, please be beware of! The situation in Britain and Ireland may essentially not be very different from the US quandary.

After regulation failure of the current scale, a tighter regulation hardly is the course to be followed as pointed out by immediate popular comments; tighter controls would not have prevented East Germany from collapse because German Democratic Republic did not exist.

If effective regulation of banks does not exist, why not consider shifting to a regime of non-regulation?

Regulate banks and other financial institutions only when they are granted their operation permit, but with the obligation to participate in the rescue of any failing member of banking business. This would internalize the costs from aggressive business strategies of one member. Any bank that walked over the bridge for lender-of-last-resort funds would know it to be the end of its business as an independent operator.

The banking business would thus operate under a mutual guarantee.

The task of the regulators would only be to promote transparency in banking, for example, by requiring banks and other financial intermediaries to publish their balance sheets every month in the main national and local newspapers.

Taxpayers’ greed will retard growth. Music started!

The UK and US Treasuries succumbed to taxpayer populism and set too demanding conditions on the preference shares acquired in the partially or wholly socialized banks so that the banks would concentrate on purchasing the stakes held by the governments and that the taxpayers’ funds would be reimbursed without losses.

A 10 percent dividend yield on such shares is well above any long-term real rate of return on equities. Therefore the banks will maintain the present high margins on their lending to businesses and households to safeguard that the governments receive their dividends and that no additional socialization (nationalization) will occur. But, high margins on lending rates of interest will also prevent the economies from a quick recovery. That is, the taxpayers’ ultimate investment losses will only convert into a slower rise of their living standards.

Of course, there is the other route. The contracts are in nominal terms. Therefore by setting on a higher rate of inflation over the next five years or so, the governments can erode the real value of their claims in the banks but to secure a nominal capital gain on the taxpayers’ investments. That is why music started again – the recent aggressive cuts of the steering rates all over the world.

However this route causes additional losses in the financial system by melting the bubble in the government bond prices which further retards world growth, because the losses can only be covered from operating cash flows of the basic lending business; see trough of the US debt crisis.

Farewell inflation targets! Goodbye independence of central banks!

PS. Alternatively, the governments could have advanced amicable cannibalism within the banking sector by granting access to the government loans on equal terms for every regulated bank, but with less government money at risk.