John FitzGerald: Exchange rate control no panacea for economic crisis

Prior to the start of Economic and Monetary Union (EMU) in 1999, there was a lively debate in Ireland about its possible economic consequences. Opponents suggested that retaining control over our exchange rate could be an important instrument to use if the economy was hit by a severe shock. Those arguing for EMU membership believed that the value of the exchange rate as an instrument for adjusting to shocks was overrated: if governments adapted their policies to the new circumstances of EMU, the loss of the exchange rate instrument would not be missed.

As it turned out, the debate about the exchange rate was rather off-target. Neither supporters nor opponents of EMU focused on features of EMU that proved particularly problematic in the crisis of 2008-2012. Little attention was given to how EMU affected the vulnerability of economies to financial crises, or to the potential problems posed by the lack of co-ordination of fiscal policy.

It is instructive to compare the 2008-2012 economic crisis in Ireland with a similar crisis in Finland between 1990 and 1993. While there are many similarities, a key difference is that in the Finnish crisis of the 1990s, Finland still controlled its own exchange rate.

Like the later Irish crash, the Finnish crisis of the 1990s had origins in a property boom which got out of hand.

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Foreign borrowing

In the late 1980s, Finland depended on substantial foreign borrowing to fund a galloping property market, which left it very vulnerable in a collapse. When the inevitable property crash happened in 1990, the economic impact was exacerbated by Finland's heavy reliance on a Soviet market, which had dried up after the Berlin Wall fell. The combined effects of these events was a financial crisis affecting Finnish banks. It could have been a warning to Ireland, if we had paid attention.

Though smaller than our Irish crash, the impact was still large. By 1992, Finland’s national income was about 10 per cent below its 1989 peak. Unemployment which had been 3 per cent in 1989 reached 17 per cent in 1994.

By 1993, Finland had devalued its exchange rate by about a quarter, aiming to dramatically reduce Finnish wage costs relative to its trading partners. It was hoped this would cushion some existing companies and enable other businesses to expand their output.

However, while the initial impact of the exchange rate change was to dramatically improve labour cost competitiveness, within two years about half of this advantage had been wiped out, largely through higher inflation.

Furthermore, the response to the improvement in competitiveness was weak. In the end, it took three years for output in Finland to recover from its nadir in 1993 to reach its previous 1989 peak level.

In the Irish case, the fall in output from the peak in 2007 to the trough in 2012 was twice as big as the equivalent fall in Finland. As a euro member, Ireland had no control over the exchange rate. Nevertheless, Irish wages became considerably more competitive in the post-crash period relative to the EU15.

Wage competitiveness

This was primarily because average wages fell slightly in Ireland while wages continued to grow elsewhere. Six years on from the crash, Irish wage competitiveness had improved by 15 per cent relative to its 2008 peak, with no exchange rate adjustment.

For Finland, six years on competitiveness had risen by 20 per cent, aided by devaluation.

So if labour cost competitiveness was the key to recovery, Ireland, without devaluation in its toolbox, did almost as well as Finland.

In the Irish crash, a major problem had been that excess resources had been devoted to the property market – loss of competitiveness had not been the primary cause of the disaster. While regaining competitiveness helped us rebound, what was much more important for us was the underlying resilience of our export sector, and the rebalancing of our economy to give it greater weight.

Finland took three years from the bottom of its crash to regain its previous peak. Ireland, which had suffered a much steeper fall in output, took four years from the trough in 2012 to regain its previous peak output by 2016.

Comparing the two countries’ experience of crash and recovery suggests that an independent exchange rate is not a cure-all for an economic crisis.

In both countries, flexible outward-looking economies, with well-educated workforces, helped achieve recovery to earlier levels of output. But the key lesson is to reduce the risks of economic collapse in the first instance, by avoiding property bubbles and other imbalances, and maintaining financial stability.