THE LESSON OF FINLAND S DEPRESSION OF THE 1990 S: WHAT WENT WRONG IN FINANCIAL REFORM?

Abstract

THE LESSON OF FINLAND\'S DEPRESSION OF THE 1990\'S: WHAT WENT WRONG IN FINANCIAL REFORM?*

by Pekka Ahtiala Department of Economics 33014 UNIVERSITY OF TAMPERE FINLAND

ABSTRACT

The role of economic policy in Finland's depression of the 1990's is analyzed with a simple model of an open economy, and the conditions for a successful financial reform derived: Let the system adjust after the removal of interest rate ceilings, and the domestic interest rate then be aligned with foreign rates before liberalizing international capital flows. In Finland, the financial system was liberalized simultaneously with international capital movements, with the domestic shadow interest rate initially considerably higher than the international market rates. A capital inflow the size of the monetary base followed, leading to the "crazy years" of 1987-89. With a large current account deficit, the Bank of Finland tightened money sharply, causing a banking crisis practically wiping out the savings bank sector. The GDP declined by 13 %. Several lesser policy measures aggravated the crisis.

JEL classification number E58, E65, O52 Key words: Financial reform, Finland\'s depression of the 1990\'s

*Journal of Policy Reform no.1, 2006, forthcoming