Is Finland’s Slump A Glimpse Into Europe’s Future?

Poor demographics, poor productivity could be the new normal for Europe.

The debate about Europe’s economic problems tends to focus heavily on the need for countries such as Italy and Greece to introduce “structural reforms” to boost growth. However, Europe’s slump ranges far wider than southern European countries with a reputation for inefficiency and lax fiscal policy.

The Financial Times filed an interesting report on Finland last week. Finland’s governments were among the more enthusiastic in recent years in chastising high-debt countries about the need to cut deficits and focus on structural reforms. But things aren’t going so well in Finland these days. GDP has contracted for three years in a row (see page 28 of the European Commission’s statistical release).

The FT are a bit confused by these developments, admitting “the prescription for the current crisis is not as clear” as it was during Finland’s early-90s post-Soviet crash.

The truth, however, is that Finland’s slump isn’t so complicated. In fact, it’s a simple story that you can expect to see played out in many of Europe’s countries, most notably Germany, in the coming decades. Two factors are driving Finland’s slump: Poor demographics and poor productivity growth.

Demographics

The first key element of Finland’s slump is identified by the FT: Finland is ageing rapidly. As a result, the fraction of the country’s population aged in the usual “working age” bracket of 15 to 64 has been falling. This has meant there has been no growth in employment over the past four years despite a slight increase in the participation rate of those aged between 15 and 64 and limited changes in the unemployment rate over this period.

Eurostat project this demographic pattern is set to continue over the next decade. Even if the unemployment rate falls in Finland in the coming years, there is unlikely to be any growth in employment in the next decade. In this sense, as I have explored in a paper co-authored with Kieran McQuinn, Finland is leading the way for other countries.

Most notably, the fraction of Germany’s population aged 15 to 64 is set to plummet in the coming decade, falling below Finland’s by 2030 and then declining further. The pattern in the Euro Area 12 group of countries (i.e. the original 11 plus Greece) is relatively similar, also falling below Finland’s level in the 2030s. See below for Eurostat’s forecasts.

Productivity

A weak employment performance is one aspect of Finland’s bad economic performance. The other aspect is a poor out-turn for the amount of real GDP produced by each worker, what economists term labor productivity.

This is an area in which Finland had traditionally performed a bit better than the rest of the euro area. As the graph below shows, labour productivity grew steadily in Finland from the late 1960s until 2007. However, in the seven years since 2007, Finnish labor productivity has fallen by about 3 percent.

This development may be a nasty surprise to people in Finland but this is an area where Finland is conforming to the European norm. Productivity growth in the euro area has been slowing for a long time. In fact, in my paper with Kieran McQuinn, we argue future European productivity growth may be even worse than it has been over the past decade because a lot of this growth has been due to capital accumulation and this factor is likely to weaken.

Structural Reforms? Pension Systems

So the recipe for slow growth in Europe is now playing out in Finland. Population ageing means no growth in employment and weak productivity performance means no growth in GDP.

The response from Europe’s politicians to slow growing economies is familiar: “Structural reforms.” The phrase is used so often that it can be forgotten sometimes that its invocation is rarely ever backed up by specific policy recommendations. But for any program of reforms to work in a country like Finland, it must do something to address the two factors described here: Employment and productivity.

In relation to employment, Finland has an unemployment rate of 8.8 percent. This is below the euro area average despite the country’s current slump, so there are likely to be limited gains from reforms aimed at reducing average unemployment rates.

Another potential area for reform is pension systems. Many European countries have generous pension systems and very low labor force participation rates among older cohorts. Finland, however, does pretty well on this count.

The graph below compares Finland’s labor force participation rates for older cohorts (the brown lines) with those of the euro area 12 group of countries (the blue lines) and those of Switzerland (the black lines). The latter is chosen because organisations such as the OECD and the European Commission have picked out Switzerland as a model for high rates of old-age labour force participation. The graph shows that Finland performs far better than the rest of the euro area and is generally much closer to Switzerland than the rest of the euro area.

My paper with Kieran McQuinn discusses the potential for pension reform to boost growth in Europe. We report that a pension reform that saw Finnish workers staying in the labour force at the same rate as their Swiss equivalents would boost GDP growth by 0.12 percentage points per year over the next thirty years. That’s a pretty modest impact. Overall, it’s clear that pension reform is not a route for Finland to return to growth.

Structural Reforms? Productivity

The other area for potential reform that is commonly mentioned is pro-business reform that reduces red tape and boosts productivity. Unsurprisingly, the FT’s man in Finland found various people (an opposition leader and a former Swedish finance minister) to discuss “the huge need for structural reforms.”

Like all countries in the world, Finland isn’t perfect and I’m sure there are plenty of business-friendly reforms that could be introduced there. But it is important to discuss this issue in a proper context. The World Bank’s Doing Business survey collects a huge range of indicators on how easy it is to conduct business and it now ranks Finland 9th in the world. This is the top ranking in the euro area and behind only the UK and Denmark in the EU.

Based on these figures, it seems unlikely that Finland is in a position to structurally reform its way to a significantly higher productivity growth rate.

What about other countries? Our paper discusses the potential impact that structural reforms could have on growth in each of the euro area 12 group of countries. In some cases (such as Spain and Greece) these reforms can have very positive impacts. But, on average, reforms are unlikely to work against the impact of poor demographics and existing productivity trends to restore growth to the levels previously seen in Europe.

The future for growth in Europe appears to be Finnish.