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Stabilizing an Economy: Finland

Author(s):
International Monetary Fund. External Relations Dept.
Published Date:
June 1966
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John Tvedt

FINLAND, lying at the periphery of the Western world, is in approximately the same latitude as Alaska, but westerly winds, warmed by the northern arm of the Gulf Stream, keep its climate moderate. Its well-educated population, totaling some four and a half million at the end of 1963, is largely concentrated in the South. Slightly less than a third of the working population is employed in agriculture and forestry, a little more than a third in industry and construction, and the remainder in commerce, transportation, and other service trades.

Its great forests are Finland’s main natural resource and have provided the key to its economic development. In the nineteenth century, electric power and the machine-saw liberated the Finnish economy by permitting the establishment of paper and pulp mills. This development, coupled with technological advances in pulp and paper making and reductions in ocean freight rates, formed the basis for modern industrialization. Finland became a major exporter of forest products, and the earnings from those products made it possible to establish and develop other manufacturing industries. Between the two World Wars in particular, Finland was a model for any country moving from successful exploitation of a single primary product into a more extensive diversification of its economy.

Difficulties After World War II

In the first few years after World War II, however, Finland ran into economic difficulties. The cession of territories to the U.S.S.R. involved the loss of 9 per cent of the country’s cultivated area, 11 per cent of its forests, and 11 per cent of its production facilities. The resettlement of nearly half a million Finns living in the ceded areas called for a land reform costing the equivalent of about $300 million. There were also war reparations, totaling $227 million in the period 1945-53, and heavy investments needed for reconstruction. Finland overcame all these handicaps—but at a price. Under the threat of serious inflation, the authorities had to impose strict control over prices and wages and introduce a system of subsidies on consumer goods. These measures were not wholly successful. They did not prevent large increases in costs; at the same time, they distorted the economy. In order to keep up an adequate flow of exports, the markka had to be devalued on several occasions.

Nevertheless, economic growth in the early postwar years was rapid. As early as 1947, production reached the prewar level; and in the following three years, it increased by a further 18 per cent. The rapid recovery of the economy was in part made possible by an inflow of foreign long-term capital which enabled Finland to finance an import surplus to supplement scarce domestic resources.

The year 1951 was a good one for Finland; the world market was favorable to Finnish exports, and the country’s balance of payments improved considerably. But the next year was a difficult one. Because of the substantial amounts of foreign currency that had been available in 1951, Finnish importers had ordered large quantities of goods for delivery in 1952. In that year, however, Finland’s exports declined, partly because of restrictions on timber purchases imposed by the British Government. When an economy depends very largely on a few products, a deterioration in export conditions is likely to affect the entire economy immediately. This happened in Finland; production stagnated, and unemployment increased sharply. Holdings of foreign exchange fell. Although reserves were much larger than at the end of 1950, they consisted mainly of currencies that were of little help in meeting current obligations.

To solve this payments problem, Finland made a drawing of $4.5 million on the Fund in December 1952. Further drawings, totaling $5 million, were made in January and May 1953, under the terms of a stand-by arrangement.1 At that time, stand-by arrangements were still new; this was the second such arrangement between the Fund and a member country. The deterioration in the balance of payments was short-lived. In the years after 1952, improved conditions in the major markets for Finnish exports and increased production capacity, together with the cessation of reparation payments, helped to enlarge the real resources of the country. In January 1955, all drawings on the Fund were fully repaid.

In the mid-1950’s, however, the Finnish economy again ran into trouble. Production stagnated and the standard of living declined. Although there was also a slowing down in economic activity in several western countries, which—as always—adversely affected the demand for Finnish exports, the difficulties at that time were due mainly to internal factors. Fiscal policy had weakened after 1954, and early in 1956 a large deficit in the government accounts began to show up. Measures were undertaken to restore equilibrium, but they proved inadequate. Although the rate of wage increases permitted under Finland’s incomes policy might have been in line with the rise in productivity, the prices and costs that emerged after any given increase tended to be above those abroad. A sharp increase in total money income in 1956 resulted in strong inflationary pressure. To finance the deficit in the balance of payments, Finland had to dig deeply into exchange reserves accumulated over the preceding three years.

FINLAND

In order to stop the deterioration, a decision was made in November 1956 to increase import restrictions. At the same time, the Governor of the Bank of Finland requested technical assistance from the Fund. To meet this request, two members of the Fund staff were made available to the Finnish authorities in November to discuss stabilization measures. These discussions were continued in January 1957 during the visit to Helsinki of a regular Fund consultations mission.

The Stabilization Program

Finland’s economic position in 1956 was serious enough to convince everyone concerned that action had to be taken to bring about stabilization and to improve the competitive ability that must form the basis of future economic progress. After the discussions with the Fund representatives, the Finnish Government drew up in 1957 a comprehensive program of economic reform to be carried out over a period of two years.

The program included a large number of fiscal measures, such as substantial increases in taxes and in prices of public utilities, and reductions in subsidies. These measures were supported by the Bank of Finland, which continued its efforts to prevent an inflationary expansion of private bank credit by increasing penalty rates for rediscounting.

The program, of course, depended heavily on success in restraining wage increases. Collective wage agreements, settling a 19-day general strike, had been signed in March 1956. They provided that the agreements could be terminated and wage negotiations reopened if the cost of living index should increase by a further five points, to 112. By August 1956, the five-point increase had occurred, but it was not until the late summer of 1957 that new agreements were signed.2 These agreements, roughly in line with the government recommendation, provided for only two-thirds compensation instead of full compensation for rises in the cost of living index; in any event, new wage adjustments would not be granted at all unless the cost of living index reached 130. Therefore, between March 1956 and the end of 1957 there were no significant wage increases.

The drastic fiscal measures and the wage agreement set the stage for a substantial improvement in the Finnish economy. But they were not by themselves—especially in the international economic climate of 1957-58—sufficient to alleviate the pressure on the balance of payments. This called for a severe reduction in imports, which could be brought about quickly enough only by intensified restrictions. In March 1957, the Government instructed the Licensing Board to revise the import licensing system in such a way as to reduce imports from the Western countries by 25-30 per cent of their 1956 value. The Government was, however, alive to its international obligations; it attempted to avoid any increase in discrimination by making a major part of imports from these countries subject to global quotas. The program was made public at the end of March 1957 and was presented to the “Helsinki Club,” i.e., the Governments of Austria, Belgium, Denmark, France, the Federal Republic of Germany, Italy, the Netherlands, Norway, Sweden, Switzerland, and the United Kingdom. Negotiations were prolonged, and a multilateral agreement was not signed until July 25, 1957. It was made retroactive to April 1, 1957. The restrictions were maintained in their full severity for only a short period of time; thereafter, however, they were relaxed only gradually.

Because of the downward trend in demand for timber and timber products on world markets, and falling prices, action to bring about a realignment of Finnish and world market prices became unavoidable. Accordingly, with the concurrence of the Fund, the Government on September 15, 1957 devalued the markka by 28 per cent. At the same time, all multiple currency practices were abolished, and the Government instructed the Licensing Office to liberalize Finland’s trade with the West. Since a great increase in the amounts of markkas received for exports might have been inflationary, an export levy was introduced for a period of one year. After the devaluation, prices were frozen to the end of 1957, mainly in order to postpone an increase in wages.

Effects of the Program

Economic activity in most Western countries slowed down during 1957 and 1958, so that—unfortunately—Finland’s stabilization program had to be carried out under difficult international economic conditions. This makes it rather hard to distinguish the effects of the program from events that would have occurred in any event as a result of the international recession. To begin with, the reversal of the international business trend had only relatively small effects on the Finnish economy; exports of goods and services in 1957 were some 10 per cent higher than in 1956. In 1958, however, exports declined by 2 per cent, as Finland was harder hit by the international recession. Private investment, being decided upon in the light of current and prospective market conditions, also dropped, while public expenditures on goods and services increased at a much slower rate than in the preceding years. Because taxation (among other factors) was reducing incomes, private consumption and savings declined. As a result of the slowing down in domestic demand, internal activity stagnated, employment declined, and imports, which were affected also by the extension of import regulations during most of the year, fell by about 2.5 percent.

Although the international recession continued throughout 1958, results of Finland’s stabilization program appeared more clearly in the course of the year. Domestic demand continued to slacken, but because of changes in relative prices brought about by the devaluation, a larger share of total demand was directed toward domestic production, and activity remained the same as in 1957. Despite import liberalization, the volume of imports declined sharply.

By the middle of 1958, the full impact of the devaluation was felt in the price structure in Finland. It did not raise prices by quite as much as had been expected. This was due to declining prices of raw materials in the world market, keener price competition—brought about by the liberalization of imports—and weakening domestic demand. The price index of imports reached a peak during the first quarter of the year, when it was 25 per cent above the average of the third quarter of 1957. The wholesale price index rose by 11 per cent, but the cost of living index, under the influence of wage restraint, rose by a smaller amount. Not until February 1958 did it reach 130; then, in accordance with the collective wage agreements, wages were raised. For 1958 as a whole, nominal wages were about 4 per cent higher than the average for 1957. Since the increase in prices was greater, this meant a slight decline in real wages, which was unavoidable if Finnish export industries were to become more competitive in a hurry. That Finland’s competitiveness improved considerably there can be no doubt, since the country’s share of total sales in the major Western markets rose sharply during 1957-58.

The stabilization measures had an immediate and marked effect on the balance of payments. Despite a striking deterioration in the terms of trade in the first half of 1957, mainly brought about by an increase in prices of Finland’s imports, the current account of the balance of payments improved rapidly—from a deficit of $59 million in 1956 to a surplus of $76 million in 1958. As capital continued to flow in, foreign exchange reserves accumulated; from the devaluation on September 15, 1957 to the end of 1958, they increased by $160 million.

The Economy Transformed

The stabilization program—comprising a major fiscal reform, a substantial devaluation, and a radical change in the process of income determination—brought about a transformation of the Finnish economy by the end of 1958. Steps could then be taken to stimulate domestic demand, particularly investment demand. It was not until late 1958, however, when the international recession came to an end, that some signs of recovery appeared. In the following years, better conditions in Western countries, available capacity in Finnish industries, and improved conditions for Finland’s future industrial development brought about by increased competitiveness made it possible for Finland to increase its exports and to continue the economic progress which had been experienced until the setback of the mid-1950’s.

To say that Finland’s economic difficulties are over would, of course, be wrong. Indeed, there are signs now that developments in the last few years have again brought to the fore some of the difficulties that were evident, in much greater degree, in the mid-1950’s. Whether these can be overcome without the lengthy halt in economic growth which characterized the earlier difficulties will depend on the Finnish authorities’ success in preventing the erosion of Finnish competitiveness which alone can ensure the continued economic progress of this highly democratic republic.

1An arrangement with the Fund by which a member country obtains assurance that it may draw up to prescribed amounts during a specified period of time; the arrangement is usually conditonal upon undertakings by the member to pursue certain policies.
2When the first of these new agreements was concluded, the index was 122.

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