Failed cyclical policy can undermine growth policy

Economic policy assessment requires a clear distinction between short-term cyclical policy and long-term growth policy. As Finland is part of the euro area and monetary policy is set by the European Central Bank, the role of fiscal policy in stabilisation is correspondingly more important.

Cyclical policy is challenging for Finland for two main reasons. First, Finland’s cyclical position is weaker than the euro area average, which is reflected for example in significantly lower consumer price inflation. Second, Finland’s ability to offset an overly tight monetary stance with more expansionary fiscal policy is constrained by relatively high public debt and a rapid pace of indebtedness.

Among economic experts there is fairly broad agreement that Finland’s public finances require corrective measures. There is more divergence of views on three issues: the scale of adjustment required, its timing over the coming years, and its composition in terms of expenditure cuts versus tax increases and other revenue measures, including their distributional impacts across households and firms. The latter is largely a political question, although it should also take into account empirical research on the economic effects of different taxes and spending cuts.

Attention then turns to the first two issues. The size of the fiscal adjustment need depends crucially on future growth prospects. The outlook is weakened by a declining working-age population and insufficient compensating immigration. On the other hand, there is potential for so-called “catch-up growth” in the corporate sector due to underutilised productivity capacity built up during recent years of weak performance. If ongoing structural changes in firms begin to yield results, growth could exceed recent weak trends and ease fiscal pressures. However, weak domestic demand risks delaying this adjustment process.

The economic downturn has turned out deeper and more prolonged than previously forecast. This increases the risk that fiscal tightening measures are implemented too early in the cycle, thereby prolonging the recession. One adverse side effect is that firms typically reduce investment in intangible capital during downturns, which can weaken future productivity growth and thereby worsen the structural fiscal balance. In this respect, government measures aimed at strengthening incentives for research and development can be seen as positive.

Finland’s labour market has performed better than its reputation would suggest, both in terms of short-term adjustment and long-term competitiveness. Wage moderation has followed changes in economic conditions, and firms have been able to implement productivity-enhancing organisational changes. These developments suggest improved potential for productivity growth over time.

However, it remains uncertain how recent labour market policy interventions will affect the economy’s ability to adjust to future cycles and to support productivity-enhancing restructuring at firm level. In the worst case, disruptions in collective bargaining and labour market functioning could weaken both short-term adjustment capacity and long-term productivity growth. (AI translation)

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