Currency union and asymmetrical supply shocks - the case of Finland
This morning I am flying to Finland to speak about the outlook the Polish economy at a seminar in Helsinki. That is the inspiration for what I will talk about in this post - or rather I will tell the story of how an asymmetrical negative supply shock - combined with euro membership - has sent the Finnish economy into recession. It is (partly) a story of the demise of Finland's best known company Nokia. A cornerstone in Optimal Currency Area theory is that two countries should only join in a currency union if the shocks that hit the economies tend to be symmetrical. Hence, economic shocks should tend to hit both economies at the same time and by more or less the same magnitude. A shock the oil price is a good example of a symmetrical supply shock to the euro zone countries as all the euro area countries tend to be oil importers. However, in recent years the Finnish economy has been hit by an asymmetrical supply shock - a shock which have not hit the other euro area countries. Nokia's lagging competitiveness as a negative supply shock Do you remember this cell phone? Nokia used to be the Apple of the day. Today everybody have iPhones, but back in the 1990s and the early 2000s everybody had a Nokia cell phone. I still sometimes miss my old reliable Nokia cell phone - I have had a few. However, within the past 10 years things have changed. Nokia no longer command the technological superiority that it once used to have - even I who certainly is no expert on the Telecoms sector realises this. There is really nothing unusual about Nokia's story in the since that companies come and go. However, what is unusual is just how important Nokia became in 1990s for the Finnish economy. I personally remember when Nokia 10-15 years ago was close to 90% of the overall market cap for the Finnish stock market. The Finnish economy was Nokia. However, over the past 10 years things have changed for Nokia. The company has been loosing in the technological race between the global telecoms companies. In economic terms this is a negative shock to what economists like to call Total-Factor-Productivity (TFP). I like to think of TFP as a measure of how well we are at putting together the production factors we have - labour, capital and raw materials. Obviously Nokia makes more technological advanced phones today than 15 years ago, but Nokia's global competitors have just developed even faster. I most stress that I am generalising wildly here - after all I am not expert on the telecoms industry or on Nokia and the purpose is not to talk about Nokia as company, but the macroeconomic impact of the negative TFP shock to Nokia. Hence, a negative TFP shock for Nokia is a negative TFP shock for the entire Finnish economy. As usual the AS/AD framework is useful We can think of the negative TFP shock to the Finnish economy as a negative and permanent supply shock to the Finnish economy. Within the AS/AD framework this shifts the long-run aggregate supply (LRAS) curve to the left as illustrated in the graph below. A negative LRAS shock, which shifts the LRAS curve to the left, reduces longterm real GDP growth to y' from y and increase inflation from p to p'. Or this would be the story if we were in an nominal GDP targeting regime where the central bank essentially ensures a stable growth rate of aggregate demand - the AD curve is fixed. However, this is not the story for the Finnish economy. A negative TFP shock becomes a negative demand shock Finland is a member of the euro area and this have clear implications for how the negative shock to Finnish TFP has been playing out. In a situation where Finland had not been in the euro area and the central bank had been targeting NGDP a negative TFP shock would have caused the Finnish currency - in the old days the Markka - to depreciate. That would have kept aggregate demand growth "on track", but it would still have lower real GDP growth in the longer run as the shock to TFP is assumed to be permanent. Hence, the Finnish economy would have gone through an adjustment to the lower productivity growth oath through a depreciation of the currency. This option is not possible for Finland today as a member of the euro area. To understand the transmission mechanism of the shock through the Finnish economy it is useful to think of the initial level of inflation, p, as also being the level of inflation in the euro area overall. A negative shock to Finnish productivity increases inflation to p’ - hence above euro zone inflation (p). Hence, this is essentially a negative competitiveness shock. The shock to Finland’s competitiveness has been very visible in Finland current account situation over the past decade Finland’s current account surplus has collapsed. This is a very interesting difference between Finland and other crisis hit euro zone economies. In the case of the so-called PIIGS countries we have seen a sharp improvement in the overall current account situation in countries like Ireland and Spain. This is mostly due to a collapse in aggregate demand (NGDP) since crisis hit in 2008, but also due to improved competitiveness due to lower inflation and lower wage growth. In some ways one can say that Finland’s economic troubles are worse than that of the PIIGS in the sense that one could expect growth to pick swiftly in the PIIGS continues if just the ECB eased monetary policy (I will believe it when I see it...), while monetary easing would do nothing to improve the competitiveness of the Finnish economy. Said in another way - Mario Draghi can increase aggregate demand in Ireland or Spain, but he cannot invent the cell phone of the future. Therefore, for Finland there is indeed a “New Normal” - real GDP growth looks set to be permanently lower than it was in the 1990s and 2000s. And that will be the case no matter what monetary regime Finland has. That is not to say the monetary policy regime is not important for Finland. In fact euro membership is likely to be a drag on growth as well at the moment. To understand this we return to the AS/AD framework. Finland cannot not permanently have higher inflation (and unit labour costs) than the other euro zone members. Hence, in the AS/AD framework we need to see inflation drop back to p (the euro zone inflation) from p’. This happens “automatically” in a currency union through what David Hume termed the specie-flow mechanism. As the current account situation has worsened Finland have seen an increasing currency outflow. In a currency union or any other fixed exchange rate regime such currency outflows automatically lead to a similar decline in the money base, which lower nominal spending/aggregate demand in the economy - this is pushing the AD curve to the left. This monetary contraction will basically continue until competitiveness is re-established and inflation is back at the euro zone level (p). This is what is illustrated in the graph below. This process would be smooth if prices and wages were fully flexible. However, that is obviously not the case (in the short-run the AS curve is not vertical, but rather upward sloping) - particularly not in Finland. In fact particularly wage growth seems to have shown considerably downward rigidity in Finland in recent years. As a result unemployment has increased. While there is not much to do about the long-term productivity problem monetary policy can help ease the pain when shifting to a lower level of productivity growth. Hence, had Finland - like for example Sweden - operated a floating exchange rate regime - then the needed adjustment in competitiveness could have happened via a weakening of the currency rather than through lower wage and prices. This would not have “solved” the productivity problem, but at least the unemployment problem would have been significantly smaller - at least in the short to medium term. However, as a member of the euro zone Finland does not have that option (other than of course leaving the euro). Furthermore, while weak demand growth is a problem for the wider euro zone and hence one can argue that the ECB should do something about that (and hence help the PIIGS) it is harder to argue that the ECB should act to ease the pain from an asymmetrical shock, which have only hit Finland. We didn’t think of that... When the euro was set-up it was the general assumption that asymmetrical supply shocks were rare and economically not important. However, the economic development in Finland over the past decade shows that asymmetrical supply shocks indeed can be very important economically. As I am landing in Finland I am reminded that another asymmetrical shock has just hit the Finnish economy - Finland’s most important trading partner is Russia. The Russian economy is heading for recession - that is hardly something that will help the Finnish economy... PS I should once again stress that this is a post about asymmetrical shocks in a currency union rather than about Nokia. Furthermore, there is a lot more to the Finnish story rather than just Nokia (for example the server problems in the paper and pulp industry).