International Affairs Forum: How good is the comparison between the Finnish and Swedish financial crises in the early 1990s and what's happening currently in the US and EU now?
Seppo Honkapohja: First of all there are some aspects where the comparison is reasonable, and obviously there are big differences. Let me start with the differences. First, obviously, the US is a large country versus the small Nordic countries. These Nordic countries were much smaller open economies where international trade played a bigger role than in the US today, relatively speaking. That is an important difference.
Secondly, if you compare the US and European financial systems today with the Nordic countries in the early 90s, you find that the financial systems currently are much richer and more complex.
The origin of the current crisis is in some ways different. The current crisis is the result, if you want to use a popular term, of bad banking. Financial systems and financial innovations were the source of the problem.
The crisis really started in August 2007 and has taken quite a lot of time to spread to other countries and to the so called real economy, i.e. the consumers and firms; which we are seeing this fall. In comparison, the Nordic crisis of the 90s started for three reasons: bad luck, bad policies and bad banking. It was a combination of the three. There was some bad luck in that the small countries were hit by external shocks and bad situations internationally.
Secondly, there were certain policies used by Finland and Sweden which contributed to the crisis in quite a clear way. In particular the fixed exchange rate regime and the defense of fixed exchange rate from speculative attacks was one of these problems.
IA-Forum: When you're talking about bad banking would you characterize both situations as having the same features?
Dr. Honkapohja: Well yes, but the details are different. We didn't have what you call these sub-prime loans or other complicated instruments. But the idea that there was too much risk-taking, that the risks were not very well understood, that there was too much debt, and that somehow when debt financing dominates the world to a great extent is very similar. There was a boom at first in the Nordic countries, where a lot of leverage was taken and debt financing was used a lot; firms and consumers became highly indebted. So that broadly speaking is the same feature today as well. There was a long boom in the US economy and also in the Western world, and that encouraged extra risk-taking and debt finance was used a lot in this process.
Then things turned around. Now we are facing a de-leveraging process, as the technical term goes, which means that you have to get the debt levels and indebtedness in the economy to more reasonable levels.
IA-Forum: One of the measures the Finnish Government implemented was the guarantee of the banking system in the 1990s crisis. What conditions allowed of the Finnish government to be able to do this?
Dr. Honkapohja: In the Finnish case the problem part of the banking system was concentrated significantly within the savings banks. These banks were a significant player in the Finnish banking system before the 90s crisis. They had gone into the game of speculation and financing questionable projects and investments. So when things turned around and the crisis began the banks became exposed and if you look at the credit losses that the banks made, the savings banks were far worse than the other parts.
There were problems in other parts of the system as well but they were much much bigger in the savings bank system and the government had to take a heavy hand to restructure it. There were several steps involved and in the end most of the savings banks have disappeared from the scene.
IA-Forum: And now there are only a few left?
Dr. Honkapohja: Absolutely. What happened was that these savings banks were local banks and there was a central bank for them, which was legally a commercial bank. Most of the local banks got into this business of financing questionable projects which then turned into credit losses. Then there were a few conservative savings banks which kept to very traditional modes of banking and did not get into this game and they exist even now. So we do have some savings banks left, but the savings banks are a much smaller part of the Finnish banking system nowadays.
IA-Forum: Looking at Europe now, Ireland tried to guaranteeing their banking system and was met with huge opposition from other governments in Europe. In the 1990s there were three countries involved; Norway Sweden and Finland. What prevented capital rush in Scandinavia in the 1990s that does not exist in Europe now?
Dr. Honkapohja: I should first say that several of the measures that were used in the Nordic country crises, such as the idea of recapitalizing and guaranteeing banks and bank's obligations, are of course similar to what is being introduced currently. The blanket guarantee that the Finnish and Swedish governments made in the 1990s was a general guarantee which both the government and parliament passed in Finland. In the end it wasn't very much used. What happened was that at that time Finland and Sweden were not even members of the EU, but part of the European Economic Area.
Overall the EU and Europe was less integrated than nowadays, and the Nordic countries were more isolated so they could get away with it. And of course these countries had their own currencies as well, and there was a currency risk which made it more difficult to move funds around. Where if you compare it to today, there are much better guarantees in a Euro Area country relative to others, and there are incentives for savers and depositors to move funds to better protected countries. But in the earlier times with currency risks and exchange rate risks, there was significant risk involved and that was less likely to happen.
IA-Forum: If I could steer you towards the $700 billion question, what would you say are the key lessons which came out of the crises in Finland, Sweden and Norway which perhaps the United States, Britain and countries within the EU have not really looked at?
Dr. Honkapohja: The Paulson plan, or a ‘tarp plan’, especially in the first version, was not focused on the idea that you have to keep certain key banks in the running; you do that by recapitalization and ensuring that there is enough capital in the system. Banks need capital to provide lending to the rest of the economy. Especially the first version of the Paulson plan focused very much on the idea of taking away bad assets, and that is a less efficient way to support the banking system. What is sometimes referred to as bad banks or bad asset management companies also existed in the Nordic countries but they were a secondary phenomenon. In the case of Finland's, the savings banks had to eventually be split and sold to the other banks. The government had to take some of the worst assets off, because you couldn't really sell those, and then these assets were placed in an asset management company.
If a crisis becomes deep, such asset management companies become one ingredient of a solution. The problem, especially in the first version of the Paulson plan, was that this was made the central part of it. And clearly it shouldn’t be; clearly the much better way is to think of possibly very clever ways of refinancing and re-capitalizing the banks. That is really crucial. It doesn't mean that they necessarily become socialized. You can do it by preferred shares with the clear intention that the government will later on, when times are normal, get rid of its ownership in these banks. Also, of course, one must determine how the government should act for the years that it plays a role.
A big question in the Nordic crises was to determine how to create a level playing fields so that government ownership didn't affect the competitive behavior of public banks vis-à-vis private banks.
IA-Forum: In some of your previous work you discussed the creation of independent crisis resolution agencies as being a central pillar to resolving the Nordic crisis in the 1990s. Given that the economy now is more complex and interdependent, would that type of approach be equally successful today?
Dr. Honkapohja: In the case of Finland with the saving banks, the government really had to take a heavy-handed approach because that part of the banking system was in such bad shape and making huge losses. Then this agency played a central role in thinking about reorganization. It also mediated the recapitalization schemes that the government introduced. An agency like that is usually in a better position to do it then a minister of finance or the Federal Reserve which has a lot of other important duties during a financial crisis period.
IA-Forum: I’m not aware of Finland or Sweden being forced to take drastic action during the current crisis when compared to what many of the countries in Europe have done. Did the experience in the 90s significantly improve how Finland has approached the crisis now?
Dr. Honkapohja: Yes, I think so. So far of course, we don't know what the future brings. So far the Finnish banks are doing fine; obviously the situation is tighter and one is worried now about the slowdown of the real economy. Our banks have been profitable and did not get into the sub prime and other exotic securities and did not make any losses from those. There was some exposure in Sweden to some of these problems, but on the whole very little. So we've kept to more traditional modes of banking and that, in this situation, has helped us a lot. The Nordic countries are in a relatively good position.
IA-Forum: Initially, there was talk of how this crisis could potentially break apart the EU; that the Euro could be in big trouble. How do you see this playing out now? Do you think that the agreement on a more or less cordoning approach of trying to save the banks will see the European Union weathering this crisis?
Dr. Honkapohja: At the moment I think it will. I should really say that this was quite a big achievement to be able to formulate these common guidelines to secure the banking system in the Euro Area countries. It was a big achievement that in a difficult moment countries could do it together and establish these common guidelines. Of course the various details are a little bit different from country to country, but there are common guidelines. Obviously in tense situations, such as existed before the agreement was reached, countries start to think in terms of protecting their own people. That is a situation where nationalist tendencies start to rise. So the agreement was very successful in containing those tendencies.
Of course one should also say that the Euro system and the European Central Bank have been a big stabilizing force. If one imagines that these didn't exist, then each country would have to manage its own monetary and exchange rates policies with its own currency separately, and that would have probably led to quite a lot of volatility inside Europe.
So the Euro Area and Common Currency Area have been a big stabilizing force. The future is uncertain and these nationalist interests and therefore, correspondingly, the weakening of the European Union, could still happen in the future, but for the time being things worked out. Obviously you do see certain countries taking actions to rescue companies and so forth. So various issues are going to pop up and the future is not clear, but this one step with the banking system was a big achievement.
Seppo Honkapohja is a Member of the Board of Governors at the Bank of Finland. He has been a Professor of Economics at the Universities of Helsinki and Turku in Finland, and a Professor of International Macroeconomics at Cambridge University in Britain. He has been an editor for the Scandinavian Journal of Economics and for the European Economic Review, in addition to sitting on executive committees for the European Economic Association and International Economic Association. Dr. Honkapohja has written extensively for both books and in academic journals and received the Yrjo Jahnsson Foundation Anniversary Prize in Economics in 2004.
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