Norway, Sweden, and Finland had been known for their extensive welfare states after World War II. Economies were growing, unemployment was low, and welfare benefits were generous. This changed beginning in the 1970s as the oil crises struck. Sweden used countercyclical fiscal policies to address the economic slowdown, but built up public deficits as a result. Unemployment rose in Finland, remaining above 5 percent for most of the 1980s. Still, the welfare state persisted even as financial liberalization arose.

The three largest Nordic countries experienced a large boom-and-bust period in the 1980s and early 1990s. Norway, Sweden, and Finland had relatively tight control of their banking systems until the 1980s. These included capital controls, quantitative banking restrictions, and interest rate regulations (Drees and Pazarbagioglu 1998). Bank profitability was stable and price competition was non-existent. The banking system was conservative and lending was relationship based. Government-owned banks originated a large percentage of loans in Norway and a significant percentage of loans in Finland.

The system, however, was shielded from market forces and in many ways inefficient, as lenders found ways to circumvent interest rate restrictions (Drees and Pazarbagioglu 1998). Rising inflation and nominal interest rate restrictions put further constraints on the financial system. Circumvention of the rules became increasingly popular, and did not correct distortions. Regulators therefore decided to deregulate the financial market to increase efficiency in preparation for the development of a European-wide financial market.

Deregulation began with the removal of interest rate restrictions, and ended, in Norway and Sweden, with the opening up of the financial market to foreign competition. Finland took a more radical path and started with opening to foreign banks and liberalizing the capital account even to the extent that private households were allowed to raise foreign currency-denominated loans. Credit demand climbed in step with liberalization, which coincided with economic growth. Some of this was due to pent-up credit demand, while additional demand resulted from procyclical forces that gave rise to higher asset, particularly real estate, values.

Household and corporate borrowers were willing to incur debt to purchase assets because they were unable to foresee the new downside risks introduced by liberalization. Borrowing in foreign currency increased greatly, especially in Finland. Whereas lenders might have controlled the inflating bubble, they were uncertain in the new competitive environment, and responded by competing for loans. Government involvement in banking, particularly in Norway, declined dramatically. Hence no party was sure how to respond to deregulation, and each acted in their own self-interest to maximize perceived profitability.

Housing and equity prices increased in the late 1980s, and expansionary fiscal policy in Sweden and Norway exacerbated the situation. House price volatility was highest in Sweden and Finland (Jaffee 1994). These rapid expansions of credit, with riskier engagements, were doomed at the downside of the business cycle. When the business cycle turned and asset prices leveled out, it became clear that the boom was in fact a bubble, which subsequently burst in the late 1980s and early 1990s (Mai 2008). Tightening of monetary policy in all three countries in response to inflationary pressures from Germany through the ERM, and of fiscal policy in Sweden and Norway, led to a decline in asset prices and a credit crunch (Mai 2008). Monetary policy was tied to keeping exchange rates stable, while fiscal policy was overly lax (Sandal 2004). In response to the crises, capital was injected into banks on a growing scale, and government takeovers of banks soon occurred (Mai 2008). Creditor guarantees were issued in both Sweden and Finland.

Unlike other crises, the Nordic crisis was relatively straightforward in its problem and resolution. A combination of financial deregulation without sufficient risk provision, along with external shocks, affected Norway, Sweden, and Finland. The problem did not stem from problems embedded in the past, nor were they, particularly in Norway and Sweden, real economic structural problems. The resolution was swift, as the government was able to inject sufficient liquidity into the banking system to suffocate the flames.

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