The worldwide recession hit Finland harder than most other OECD countries. Export volumes fell by almost a third from their mid-2008 peak, reflecting the dominance of incomesensitive capital goods and exceptional exposure to hard hit markets such as Russia. The well supervised and prudent financial sector has weathered the crisis well, although there was some inevitable slowing in credit growth. A significant fiscal stimulus and monetary loosening by the ECB have cushioned the downturn. Recovery has been slow, potentially dampened by deteriorating competitiveness due to an appreciating exchange rate, large industry-level bargained wage increases and slowing productivity growth. Centrally co-ordinated wage deals with more room for local flexibility could deliver more competitive wage outcomes, while in the longer term potential output would be boosted by reforms to higher education. Fiscal consolidation should start once the recovery takes hold.

While Finland was insulated from the direct effects of the recent global financial crisis due to its prudently managed financial sector, the worldwide recession and collapse in trade hit the country harder than most other OECD countries. Real GDP declined by over 9% from the peak in mid-2008 to the second quarter of 2009, led by declining export volumes which fell by close to one third. This extraordinary collapse in trade can to a large extent be attributed to the composition of Finnish exports, with a high dependence on information and communication technology (ICT) and capital goods, and exceptional exposure to hard hit markets such as Russia. Compared to other OECD economies, exports have also been slow to recover. Fast rising unit labour costs due to high wage increases and an appreciating effective exchange rate have deteriorated competitiveness over the last few years, potentially denting Finland’s export performance. The high wage increases boosted household income and sustained consumption through the downturn, but the negative effects on exports from lower competitiveness can weigh more heavily as the world economy rebounds. While underlying inflation in the past was lower than the euro area average, it has been higher since mid-2008 despite a wide output gap.

Finland was among the most affected OECD countries during the crisis as demand for its mainly capital-goods intensive exports collapsed. The financial sector weathered the shock well, but credit contracted, reflecting both demand and supply factors. Employment has been aided by the scheme of subsidies for temporary layoffs, as well as labour hoarding. Despite supportive fiscal and monetary policies, recovery has been slow. This is likely to reflect a muted pick-up in world capital goods trade, structural rigidities in the labour market, potentially weakened competitiveness due to the strength of the euro and large wage increases prior to the downturn, and a slowdown in productivity growth. While the largely appropriate fiscal stimulus and active labour market policies are likely to have mitigated the impact of the crisis on demand, the post-crisis fiscal outlook has substantially worsened due to a largely permanent fiscal stimulus and lower potential output. Consolidation plans should be announced as soon as possible, to be implemented as the recovery takes hold. More attention to structural reforms to increase labour market flexibility and boost competitiveness and productivity would help to restore stronger growth and raise living standards over the longer term.

The costs of the recession and ageing are a challenge to fiscal sustainability. The estimated fiscal sustainability gap has increased from 3 to 8% of GDP due to a sizeable permanent stimulus and lower potential output. A consolidation plan should be articulated now to ensure a smooth exit from stimulus once the recovery firms. Consolidation should encompass efficiency-enhancing tax measures such as an upward harmonisation of the value added tax (VAT) and higher property taxes, and constrain rising expenditures in municipalities. As discussed in Chapter 3, sustainability would also benefit from pension reforms that include tightening of benefits and eligibility conditions which would lower overall spending and boost labour supply. Tuition fees and a switch from grants to loans in tertiary education would also alleviate expenditure pressures (Chapter 1). A major overhaul of the municipal system could increase efficiency in service provision. Consolidation would be facilitated by revising the currently over-targeted fiscal framework and linking it more to long-term sustainability targets. This should include a lengthening in the fiscal planning horizon and linking structural annual deficit targets to long-term sustainability targets as well as setting up a fiscal council to monitor fiscal policies.

Maintaining high participation and employment in the face of the current recession and a rapidly ageing population are major challenges for policy makers. The recession of the early 1990s showed that high unemployment can leave long-lasting scars on labour markets, while rapid ageing requires longer working lives to ensure sustainable public finances. Minimising the effect of the recession on the labour market calls for nominal wage increases in line with economic conditions, greater flexibility in wage setting, ensuring earlier activation of unemployed and reforming unemployment and social benefits to better support work incentives. Finland has an unusual combination of elevated unemployment replacement rates and late referral to labour market activation, which contributes to high levels of inactivity and a large number of beneficiaries. This combination risks building up greater structural unemployment over time. More ambitious activation needs to be accompanied by lower replacement rates in the unemployment insurance and related schemes to support labour market participation, job search and employment. Institutional responsibilities in labour market policies should be simplified and made more transparent. With an already low effective retirement age, additional early permanent exit from the labour market needs to be discouraged. The recent success of restricting access to the unemployment pipeline should be followed up by a complete abolition of the system. Stricter criteria for entry into disability pensions should also be applied. The 2005 pension reform was a step in the right direction, but the old-age retirement system should be further adjusted to lower fiscal costs, raise the minimum retirement age and increase work incentives for older individuals.

Income distribution in Finland remains among the most equitable in the OECD, although, as in a number of other countries, disparities have widened considerably over the past decade. While the tax and transfer system has been effective in reducing income inequality, changes made to the income tax system in the early 1990s have contributed to rising disparities by encouraging income shifting among high earners. Disparities have also been increasing across regions, particularly in labour market outcomes. This reflects the dramatic structural change that has occurred since the early 1990s, and the lack of policy success in tackling this transition. These growing disparities in regional labour market outcomes have contributed to serious demographic imbalances building up in the regions. These are especially prevalent in the smaller municipalities and challenge the very sustainability of these entities. Misuse of the tax system by high income earners should be addressed, and regional labour market discrepancies should be tackled by increasing the flexibility of the labour force. This includes sharpening incentives for retraining that would promote sectoral and regional mobility. Sustainability of the municipalities system requires further rationalisation, including forced mergers.