MEMBER STATE PROFILE
The EU’s Nordics: responsive to changing circumstances

Little Mermaid, Copenhagen

The EU’s three Nordic states have a tradition of economic reform and adjustment to changing circumstances, as seen by the deregulation of their markets and the relatively low level of red tape, and it is this that has allowed the three countries to remain competitive in the global market place – more so than other EU Member States.

But how far can these three economies serve as models for other EU members? Will their mix of fiscal and monetary polices survive intact under the twin stresses of globalisation and ageing populations? And how are the three adjusting to the current global financial crisis?

These are some of the questions to be discussed at an upcoming DG ECFIN seminar, ‘The Nordics in the EU: Fiscal Similarities and Monetary Differences’, which will be held on 13 February in Brussels. Georg M. Busch, head of the DG ECFIN unit that keeps track of the three economies, says that while Denmark, Finland and Sweden cannot be considered as blueprints for other Member States to follow, there are lessons to be learned from their economic approaches.

The Nordics’ different approaches to monetary policy demonstrate the wide range currently possible within the EU. Finland is a founding member of the euro area, where a common monetary policy is established through the European Central Bank. Denmark, in contrast, exercises its right under the EU Treaty to opt out of adopting the euro, like the UK. Unlike the UK, however, the country has chosen to peg its currency to the euro through the Exchange Rate Mechanism (ERM II) – a precondition for joining the single currency area. Under ERM II, the Danish krone’s rate is fixed against the euro and can only fluctuate within a plus or minus 2.25% range. In practice, however, monetary policy has ensured that the rate has stayed within a much narrower range. Finally, Sweden’s krona is a freely floating currency under an inflation targeting regime.

High in the rankings

Under these monetary systems the three Member States have all developed modern welfare states with large public sectors and generous public support schemes funded by high tax revenues. Denmark had the highest tax-to-GDP ratio of all EU Member States in 2007, at 49.5%, while Sweden came in second at 49% and Finland had the seventh highest rate at 42.8%, after Belgium, France, Austria and Italy.

Yet these three Member States have managed to combine this high-tax welfare system with open economies that have demonstrated solid economic and fiscal performance over the past decade. All three are characterised by good governance, sound public finances, and low levels of public indebtedness.

These positive qualities outweigh their high tax rates and labour costs in the annual competitiveness rankings of the World Economic Forum, which groups the Nordics among the world’s most competitive economies. This year it ranked Denmark as the third most competitive country in the world, behind the USA and Switzerland. Sweden was ranked in fourth place, and Finland in sixth. Meanwhile, Transparency International ranked Denmark as the least corrupt country in the world in its 2008 global index, a position the country shared with New Zealand and Sweden. Finland was ranked in fifth place, behind Singapore.

Denmark’s strategies during the 1980s and 1990s

Of the three, Denmark was considered the most open economy during the 1970s and 1980s. The country pegged the krone to the ECU in 1982 in a period when the country was marked by economic crisis, weighed down by high unemployment, inflation, interest rates and budget and current account deficits. In combination with fiscal consolidation, the fixed exchange rate led to a significant decrease in inflation and interest rates. The current account deficit was eliminated by 1990 and turned into a surplus of 3% of GDP in 1993.

Narrow street of Stockholm's Old Town

The real GDP growth rate declined in 1993, due to a currency crisis that started in the previous year. During this period the European Monetary System’s exchange limits for the krone were increased to a range within plus or minus 15% compared with the central rate. Denmark adhered to ERM II, when that system replaced the EMS in 1999, and the range was again decreased to plus or minus 2.25%. However, the krone has in fact stayed within a much narrower range of between +0.1% and -0.5%.

In the past decade the country has underperformed the euro-area’s GDP growth rate in every year except for the 2004-2006 period, and only outperformed the EU as a whole for two of those years. In 2007, GDP growth was 1.6%, compared to the 2.9% average for the EU and 2.6% in the euro area, but GDP per capita was 22% higher than the EU average. Inflation was 1.7%, compared to the 2.3% average in the EU and 2.1% in the euro area.

Yet Denmark has been more successful than Sweden and Finland – and most EU Member States – in lowering the unemployment rate. In 2007, Denmark’s unemployment rate was 3.8%, with only the Netherlands achieving a lower rate in the EU. The average unemployment rate in the euro area was 7.4%, and 7.1% in the EU.

Finland’s and Sweden’s adjustments to economic crises

Meanwhile, Finland and Sweden acted as economic twins during the 1980s, when both countries implemented financial deregulation, moves that were partially responsible for a boom in 1988-1989. The boom ended with a real interest rate shock that caused a banking and currency crisis and a deep downturn in the real economy in 1991-93.

The economic crisis deeply impacted the two economies, which both experienced a significant loss in output, employment and industrial production. In Finland, the crisis was particularly harsh due to a meltdown of the financial sector, and the collapse of the Soviet Union, its major export market.

Finland’s real GDP contracted by about 12% in the early 1990s, while Sweden’s economy experienced a 4% contraction. Both countries saw their budget surpluses turn into deficits that peaked in 1993. Over three years, unemployment rose from about 2-3% in the two countries to reach 16% in Finland and 9% in Sweden. The two countries were forced to float their currencies in late 1992. Previously, both had linked their exchange rates to a basket of currencies before pegging them to the ecu in 1990.

Finland and Sweden experienced an economic turnaround in 1993 and since then have had a robust economic performance, led by strong export growth. Finland joined the EU in 1995 and ERM II in 1996 and adopted the euro at its launch in 1999. The country’s real GDP growth has outperformed the EU’s average, and that of the euro area, in every year from 1999, partly thanks to its openness and the emergence of the Nokia cluster. Growth has ranged from a peak of 5% in 2000 to a low of 1.6% in 2002. In 2007, real GDP growth was 4.5%. GDP per capita was 16% above the EU average. Inflation was 1.6%. Unemployment levels fell year on year to reach 6.9% in 2007. Finland has not recovered as quickly as the other two from the huge losses in employment during the recession years of the early 1990s, and has since had a higher level of structural unemployment than the other two Member States.

Like Finland, Sweden joined the EU in 1995. Unlike Finland, however, Sweden chose not to adopt the euro at its launch. However, it made its central bank independent in 1999 and gave it a mandate to maintain price stability. Having implemented a major tax reform in 1991 that lowered tax rates and broadened the tax base, it also reformed its pension system in the late 1990s, putting it on a more sustainable footing.

As in Finland, investment in information and communications technologies played an important role in the ensuing economic rebound, along with efforts to boost labour productivity in the high-tech sector. In almost every year of the past decade, Sweden’s economy has outperformed the EU and euro-area average. Sweden achieved a real GDP growth rate of 2.7% in 2007, when inflation was 1.7%. GDP per capita was about 26% above the EU average. Unemployment was 6.1%.

Labour policies

One of the differences between the three countries relates to labour market flexibility – though throughout the last three decades all three countries have kept to a policy of working towards full employment as a goal.

Helsinki cathedral

Denmark has been particularly successful with what has been termed ‘flexicurity’. Under this policy, Denmark allows companies a wide degree of flexibility in hiring and firing employees while providing income security for workers. Finland and Sweden’s policies include elements from the flexicurity principles, but do not entirely follow the Danish model.

Notable differences relate to the wage formation arrangements in the three countries. In Denmark, minimum wages are mainly negotiated centrally while actual wages are set at a local level. Finland has a tradition of social partners negotiating centralised wage agreements, although the most recent wage-setting round was shifted to sector level. In Sweden, wages are usually negotiated by sector, which set wages under collective agreements, while government maintains the responsibility for helping the unemployed back into work.

Global crisis and reforms to the welfare state

These models of welfare and employment are being tested by the current global financial crisis and the growing stresses caused by increasing globalisation and population ageing. The three are directly exposed to the current crisis but in different ways.

Overall, Denmark is relatively more exposed to the housing market crisis, while Sweden and Finland are more reliant on their export industries, which have been hit by the drop in demand in the global market. Finland is expected to do better, according to the European Commission’s autumn economic forecast, given that its financial sector is relatively well shielded from the direct impacts of the global crisis.

To maintain long-term competitiveness in the face of globalisation – which puts pressure on their high-tax policies – and a reduction in the labour supply due to population ageing, all three countries are refining their welfare state policies by mixing tax cuts or freezes with reductions in government expenditures. They are attempting to improve competition in certain sectors and to adjust their labour markets to meet the challenges identified in the EU’s Lisbon Strategy for growth and jobs.

In particular, Denmark is examining ways to reduce the cost and enhance the quality of labour through education and training. It is also providing better incentives to work in a bid to increase labour participation rates.

Finland has been building up budgetary surpluses to prepare for the effects of population ageing, and public pension schemes have built up large assets. In its national reform programme, the country is targeting structural unemployment, in particular by attempting to increase employment among low-skilled workers and the young. In response to the current global crisis, the government has also approved a package of income tax cuts – amounting to 0.9% of GDP – most of which will occur in 2009.

Meanwhile, in Sweden, the long-term budgetary impact of ageing is expected to be lower than the EU average. Pension expenditures are projected to remain relatively stable as a share of GDP over the long term due to reforms to the system adopted in 1998. In a move to improve the incentives to work, the government reduced income taxes in 2007 and 2008. More cuts are scheduled in 2009. Nevertheless, the unemployment rate is forecast to rise to about 7.5% in 2010 as companies cut jobs in response to weaker demand.

Variation within the EU

The performance of the EU’s three Nordic members indicates the diversity of economic approaches that can coexist within the EU economy, notably in terms of monetary policy. But what Denmark, Finland and Sweden have in common is a useful capacity and readiness to adjust their economic models and embrace globalisation and new technologies. They have been more successful than others in reconciling economic efficiency with social equality. Yet, as globalisation and demographic change impact their public finances and labour markets, the question remains as to whether the traditions of openness and reform willingness will be adequate to preserve their welfare state policies. The Nordics have so far managed to remain competitive but continuous adjustment of their welfare models will be necessary in view of the twin challenges.

Another factor to consider is whether the current crisis will make the adoption of the euro more attractive to Denmark and Sweden. While the global financial crisis is putting stress on their economic models, their fiscal discipline leaves them better prepared to weather the downturn than many other EU members.