Finnish reforms show EU how to enter a virtuous circle

Finland is often held up as a model for other EU countries grappling with economic reform. So perhaps it is worth charting some of the economic policymaking twists and turns that Finns have had to live with. The financial market liberalisation that began back in the 1980s was finally completed in 1993 when the remaining restrictions on capital movements and domestic financial markets were removed. Foreign ownership of shares in Finland was also deregulated in the same year, when Finland became a member of the European Economic Area (EEA) as a step towards its EU membership.

Following this financial liberalisation, Finland experienced a major banking crisis and a collapse of its fixed exchange rate regime. The economy underwent what was arguably the most serious recession seen by any industrialised country since the Great Depression of the 1930s, including the formerly Communist countries of eastern Europe; real GDP declined by over 10%. The factors that accelerated the effects of the crisis were a sudden drop in trade due to the collapse of the Soviet Union, the bursting of a speculative bubble in the stock market and in real estate and uncontrolled lending by the banking sector that inevitably had led to a credit crunch for both households and companies that had taken on excessive debt.

But the financial crisis was a cloud with a silver lining, because it triggered a process of creative destruction in which many of the country’s most inefficient enterprises were swept away and replaced by new ones with much more potential. The recovery was fast and Finland experienced strong growth throughout the rest of the 1990s. At the same time, the structure of Finnish industry shifted; metal and paper manufacturing was replaced by knowledge-based industries, with the real star being the ICT sector. The driving force for economic growth moved from traditional production factors to innovation and creativity. By the end of the last century, Finland’s R&D expenditure in relation to GDP was well above 3%, making it one of the highest in the world.

Finland’s financial markets were also reorganised. In the 1980s the Finnish banking structure was largely closed and was akin to the financial systems of Japan and Germany. By the end of the 1990s it had changed dramatically. The stock market gained a great deal of influence and bank debt played a much smaller role in financing new investment. Restructuring the financial markets was a key element in increasing investment in R&D and the new high-tech industries. And because medium-sized companies were also seen as important for Finland’s economic growth, all these changes created a new hunger for foreign capital.

Foreign ownership in Helsinki’s stock exchange increased dramatically, so by 2000 over 70% of Finnish market capitalisation was in foreign hands; the Helsinki stock exchange had become one of the most internationalised in the world.

Finland’s model of corporate governance also underwent profound change. The traditional continental European system with its stakeholder framework was replaced by the Anglo-American system based on shareholder framework. This was a shift that undoubtedly increased the efficiency of Finnish business.

During all this time the public sector, too, had undertaken significant reforms. Social security benefits were cut and the pension system was reformed to reduce costs and improve its incentive effects. Government ownership was reduced considerably in many companies, and quite a few of them were sold to private investors. Double taxation of dividends was removed, with the result that entrepreneurs and the owners of smaller companies were able to accumulate a reasonable degree of private wealth. The result was that corporations showed higher profits and the corporate tax revenues collected by the government increased. This in turn made it possible to lower personal income tax rates considerably.