Should Finland leave the eurozone?

Question

Finland's economic recovery from the shock of the global financial crisis of 2007–2008 has been very weak. The country has been in recession for the past three years, with GDP expected to expand by only 0.8 percent this year. See Chart 1 below (Source: Mehreen Khan, "How sleepy Finland could tear apart the euro project," The Telegraph, April 18, 2015):

Before Finland adopted the Euro, the common European currency, it faced two severe recessions (or depressions) during its years of independence after 1917. The first was the Great Depression of the 1930s and the second was during the early 1990s (the causes of which included the collapse of the Soviet Union in 1991 and a banking crisis in the Nordic countries).

As Lars Christensen, Danske Bank's chief analyst, has pointed out in his blog, Finland recovered from its economic downturns in the 1930s and the early 1990s, at least partially as a result of devaluing its currency, the Markka. Finland gave up the gold standard in October 1931, which was followed by a very strong economic recovery. Similarly, during the early 1990s, Finland followed a "strong Markka" policy of high interest rates, tying the Markka's exchange rate to the ECU currency basket (in the run-up to the launch of the Euro in 1999). This policy was abandoned in September 1992, allowing the Markka to float freely and devalue, which was followed by a strong economic recovery. See Chart 2 (Source: Lars Christensen, "Great, Greater, Greatest -- Three Finnish Depressions", November 16, 2014) below, which compares the performance of the Finnish economy during three depressions:

As can be seen from Chart 2, the tight monetary policy of the ECB in the years after the 2007–2008 global financial crisis has been accompanied by a very weak recovery in the Finnish economy. In fact, as Christensen notes, the ECB's interest rate hikes in 2011 were followed by a contraction in the Finnish economy after some initial recovery.

The evidence strongly suggests that Finland needs to devalue its currency to recover from serious recessions. Devaluations boost the country's important export sector, including the forest products industry. As a member of the eurozone, Finland cannot devalue its currency and its monetary policy is set by the European Central Bank.

These problems were foreseen in the 1990s by economists and commentators, with Bernard Connolly's book The Rotten Heart of Europe: The Dirty War for Europe's Money being among the most vociferous criticisms. Connolly was fired by the European Commission for criticizing the European Exchange Rate Mechanism, which he used to help run. He saw the Euro as primarily a political project, not an economic one, part of the French and German project of ever-greater political integration in Europe.

As Connolly and others warned before the launch of the Euro, small countries situated on the periphery of Europe with economies whose structures differed from Germany and France, would suffer from asymmetric shocks that could not be appropriately dealt with as the small countries would lack an independent monetary and exchange-rate policy. The Finnish economy, for example, relies to a great extent on exports for economic growth. An asymmetric shock is a situation in which a shock to supply or demand differs from one geographic region to another, or when such shocks do not change in tandem.

The classic arguments in favour of flexible exchange rates are made by Milton Friedman in "The Case for Flexible Exchange Rates," (in Essays in Positive Economics, The University of Chicago Press, 1953, pp. 157–203) and Robert Mundell in "A Theory of Optimum Currency Areas" [The American Economic Review, Vol. 51, No. 4 (September, 1961), pp. 657–665]. However, later in his career, Robert Mundell offered an argument in favour of a shared European currency.

Should Finland leave the eurozone and return to its old national currency, the Markka? In light of my comments, obviously my strong suggestion is that it should, but leaving the eurozone would undoubtedly have various negative consequences, both for Finland and the European Union. Would these negative consequences outweigh the positive effects?

Answer 1

The closest we can get to an answer would be by looking at previous exits from currency unions. Rose published a paper studying extensively all exits after WWII.

The abstract resumes well the conclusions of the paper:

This paper studies the characteristics of departures from monetary unions. During the post-war period, almost seventy distinct countries or territories have left a currency union, while over sixty have remained continuously in currency unions. I compare countries leaving currency unions to those remaining within them, and find that leavers tend to be larger, richer, and more democratic; they also tend to have higher inflation. However, there are typically no sharp macroeconomic movements before, during, or after exits

The effect denoted are very small, which leads me to conclude the choice should be made on political, not economical grounds, but everybody is free to have their own answer about this.

Answer 2

(I guess a long answer can be fitting to a long question...)

The current state of knowledge as to "how to run a socioeconomic area (SEA)" could be grossly summarized as follows:
There is a Government that has the right to collect taxes and conducts fiscal policy, in order to provide some public goods, and also to partially smooth economic inequality through redistribution (not because we are good and humanitarian people, but so as not for the inequality to eventually threaten the SEA's existence).
There is the area's fiat money, backed by the Government's sovereignty.
There is a Central Bank that makes loans to the Government, so as for monetary policy to be a "negotiated outcome" between the Government and the Central Bank, attempting to partly offset the short-horizon that politicians are forced (or like) to have. The Central Bank has also the role of "lender of last resort" for the commercial banks, so as to secure the stability of the fiat money system.

If a SEA-wide shock hits, and an economic recession or crisis sets in, monetary policy can be used in what is in effect a "reverse-causation" scheme: instead of first producing and then creating the money in order to match this new production for exchange purposes, we first create the fiat money, that now functions as windfall-wealth, in order to increase demand and thus generate new production that will eventually match the money (that's what "demand side policy" is all about). If the economy is in a recession, and there is a large amount of unemployed factors of production, it has some good chances of succeeding (i.e. the increased demand will activate again factors of production rather than just create inflation). Note that the use of fiscal policy in such a situation essentially amounts to the same thing -but instead of strengthening the demand of the private sector towards the private sector, it is the government that directly, through fiscal policy, purposefully raises aggregate demand in order to induce supply.

If an asymmetric shock hits selectively only some parts of the SEA, then the government can use its tax revenues for (usually geographic, but also sectoral) redistributive purposes, channeling resources to the regions/sectors that are hit. Moreover, if factors of production are mobile enough, they will move towards the comparatively more economically healthy regions/sectors, alleviating the problem of production factors' unemployment, which if it persists, will create a social problem, and will threaten the SEA's cohesion.

Now consider the European Union: It has a currency alright, and a Central Bank -but the Central Bank is not permitted to act as a lender of last resort proper -the currently observed "quantitative easing" is a silently accepted bending (not breaking) of the official rules of the ECB. Why deprive the European Central Bank of such a fundamental function of a central bank? Because it was Germany's non-negotiable condition in order to create a common currency, originating from Germany's experience with hyperinflation. Germany did not impose this to others, having made an exception for itself: when there was still a Deutsche mark, Germany's central bank also was not permitted to act as a lender of last resort for the commercial banks (and Germany's economy proved strong enough to not ever come in need of such a safety valve).

The EU also has a "Government" (the European Commission) -but its fiscal budget is so small compared to the EU's economy, that it cannot adequately perform any redistributive function to the required degree, in the case of an asymmetric shock (redistribution happens alright -but it is slow and long-term). Also, members' national budgets are under scrutiny and hard-pressed at a political level in order not to go south.

Finally, due to history and culture, factors of production, especially human ones, have very low mobility.

So while a SEA-wide shock is not really likely for such a diverse area like the EU, asymmetric shocks are much more likely for the very same reasons -and it is for these asymmetric shocks that the EU is really lacking the tools to deal with, at least the tools that are currently known and used.

Therefore, it appears that we have to concede that the European Union, including monetary union, was a "premature" action, if judged by macroeconomic criteria: on the balance, the tangible economic benefits appear to be outweighed by the hardships introduced. Theoretically, we should have first wait for economic homogeneity and integration to happen or nearly-happen, and then strengthen it through the creation of the EU. And indeed, this was the original plan: the European Union started as partial (country-wise and sector-wise) economic semi-unions here and there, to slowly and gradually help economic integration -and then it accelerated, because the global geopolitical situation suddenly changed and (deep) uncertainty once more ruled the land...

...We should make a mental effort to imagine what the experience of two devastating World Wars (which are not that old, anyway), has imprinted on this continent. The forced/hurried economic unity/integration represented by the EU, was and still is in my opinion mainly an attempt to lay these continent-wide nightmares to rest. Since this is a "negative" motive, it is only natural that "positive" motives emerged in the process.

Especially after the crisis of 2008, one could argue with some strength that currently, the European Union is little more than "feeling asphyxiated, but sticking together, grinding our teeth"...

...So, perhaps "everyone should exit"?

The real issue as I see it is whether the alternative will be eventually along the lines of (economically and/or physically) "sharpening our teeth to each others' neck" -or not.

Answer 3

In the present legal environment it's not possible for a country to exit just the Eurozone voluntarily, by itself. The only sure way is the complicated scenario in which a country would leave the EU and rejoin it without rejoining the Eurozone; it is so far out there that I doubt you can find any serious economic analysis of it. A few other scenarios have been posited in which all the EU member countries would essentially have to agree to it... but since they have given no indication they would do that for Greece, it's even more doubtful they would do it for Finland.

I actually voted to close this question as primarily opinion-based, but retracted since that is unfair given that I do answer it, even though with a "not really answerable" answer in many (and actually in the least unplausible, IMO) scenarios. It also turn out there is one paper, albeit not a deep analysis attempting to estimate this for Finland in particular. And given that a somewhat similar question about the costs of Brexit, wasn't closed... and that I answered a specific-Brexit-scenario question myself... I will answering this in more depth, to the extent that is possible based on publications I found.

Regarding euro-exit, for starters, you can read opinions/proposals like

In 2018, Columbia University economics professor and Nobel laureate Joseph Stiglitz, in the context of arguing that Italy faces "a choice [the country] shouldn’t have to make: between membership in the Eurozone and economic prosperity," remarked that "the challenge [of exit] will be to find a way to leave the Eurozone that minimizes the economic and political costs. A massive debt restructuring, carefully done, with special attention to the consequences for domestic financial institutions, will be essential. Without such a restructuring," Stiglitz argued, "the burden of euro denominated debt would soar, offsetting possibly a large part of the potential gains." He claimed that from "an economic perspective, the easiest thing to do would be for [the exiting country's] entities (governments, corporations and individuals) to simply redenominate debts from Euros into the new [national currency]" and then "enact a super-Chapter 11 bankruptcy law, providing expeditious recourse to debt restructuring to any entity for whom the new national currency presents severe economic problems."

But that's not really an answer that quantifies anything, like what would the blowback be if a EU member unilaterally did this.

Likewise, there are some off-the-cuff estimates, such as:

At the American Economic Association's annual meeting of 2015, Berkeley University economic historian Barry Eichengreen predicted that the withdrawal of a member state, such as Greece, from the Eurozone, would "set off [a] devastating turmoil in financial markets."

Actually this one offered a sort of quantification calling it "Lehman Brothers squared", but offered no deep analysis behind that "number".

For Italy, it turns out there is more serious attempt to quantify something. There's a 2017 paper by Bagnai et al.. It finds that if Italy exited the euro,

the Italian economy would recover its pre-crisis GDP level by 2020 i.e. five years before the year currently assumed by the IMF.

However, some of the caveats are that they assume the worst the EU could do in return is to impose

a retaliatory tariff on Italian products by core countries, equal to 5% for the first two years of the simulation sample

And another limitations is that they basically assume a fixed exchange rate for the new currency

In conceptual terms, our simulation experiments therefore amount to analysing the effects of realignment within a system of fixed exchange rates.

Frankly this seems a big limitation given that somewhat similar analyses on Greece have suggested its new currency would face fairly rapid devaluation.

And as it turns out, one of the handful of papers citing Bagnai... is one about Finland, Malinen et al. (2018). Its abstract concludes:

Although there is a way out of the euro for Finland and other member countries, exit would not be easy, nor would its short-term costs be known beforehand with any clear margin. We find the lack of a domestic payments system and uncertainty concerning the redenomination costs to be the biggest risks associated with the cost of Finland’s exit. Still, the costs of Finland’s exit need not be very large, around 10 billion euros in the best-case scenario, but we also acknowledge a very costly scenario for the exit.

The authors favor a unilateral exit after secret preparations. But in the draft one can find on SSRN, on page 11 the authors acknowledge that

Probably the biggest single uncertainty concerning the euro exit is the role that the exiting country would have in the EU after an exit, especially in the case of a unilateral withdrawal from the Eurozone.

And on p. 23

What remains unclear is whether the Eurozone authorities are willing and legally entitled to impose EU-related rather than Eurozone-specific hardships on an exiting country. If a country exiting the Eurozone also faced exclusion from the European Single Market, for instance, disincentives could become prohibitive. The European Court of Justice should in such cases be asked to assess whether such practices are legally allowed. The problem is that it may take years for the ECJ to reach a decision on this issue. In any case, present initiatives to develop a multi-speed EU may, under ideal scenarios, affect both the acceptability of exit and the need for retaliation.

On p. 35 it is revealed that in the optimistic scenario (the $10B euros one)

we assume that both ECB and EBA will provide Finnish monetary authorities the support they need and that Finland will be allowed to continue as a member of the EU.

As for the more pessimistic one(s)... they don't advance a figure.

Euro area authorities may be less than helpful in supporting the exit process. In the worst case, the ECB would even immediately stop euro clearing payments from Finland. Finland could also be cut off from SEPA, forcing Finland to rely completely on makeshift measures to run its payments system (see Section 3.1). The commission could even try to oust Finland from the EU, leading to major uncertainty, possibly large legal costs and (probably) to a political crisis in Finland and/or in the EU itself. Unfavorable derivative positions for exit could lead to unexpectedly large-scale losses for firms and banks with, e.g., need for substantial temporary financial support in the case of heavy depreciation of the NM. Finnish authorities could also fail on their preparations and/or on their efforts to achieve the trust of markets. Possible make-shift measures applied in banks could lead to failures of the payment systems causing additional hardship to the economy. These could lead to serious detrimental developments in, for example, Finland’s forex markets, domestic markets, trade and/or the balance of payments. We will not try to estimate these costs or their probability, as they are highly uncertain, but just to note that a much more costly scenario for Finland to exit the euro also exists.

Frankly, for the optimistic scenario the assumption of secret preparations doesn't quite square off with the assumption of complete support from the EU authorities. They do discuss the possibility of leaks (during the preparations) in the paper, but again that is not translated in quantitative terms. They do mention that if secrecy of preparations is not maintained, Finland may have to impose capital controls.

They estimate that 33% of the debts would have to be redenominated. On the plus side (from a realism perspective) they do take into account a depreciation of the new Finnish currency (NM) of 5-15% even in the optimistic scenario. But I find it strange the only effect of a depreciation considered is to actually reduce the cost of the exit, but reducing the value of the debts. The effects of the new currency depreciation on other aspects of the economy is not considered as an exit cost.

(As an aside, the journal in which this latter paper was published, The Economists' Voice "is a publishing forum for professional economists that seeks to fill the gap between op-ed pages of newspapers and scholarly journal articles." Also, I'm somewhat unsurprised that Stiglitz turns out to be an editor of this journal. The journal might contain other similar [Euro-exit] articles, because the topic has been of a fair bit of interest to Stiglitz; he wrote a [Euro-skeptical] book about.)