Budget deficits, public sector solvency and political biases in fiscal policy : a case study of Finland

The Finnish fiscal balances severely deteriorated during the deep recession of the early 1990s with large fiscal deficits and significant increases in the public debt to GDP ratio. On the external side, current account deficits led to a large accumulation of external debt. While part of the fiscal imbalance can be attributed to the cyclical conditions of the Finnish economy, this paper considers whether the size of the deficit can be explained exclusively by stabilization and/or taxsmoothing policies. The paper then highlights political and institutional factors which have increased public debt beyond what would be desirable from the vantage point of traditional economic theory. The argument for fiscal rules against discretion is re-assessed within a simple model of political bias towards deficit spending, allowing for tax-smoothing considerations as well as for international trade in goods and assets. The analysis of the Finnish data shows that political and institutional biases contribute to explain the significant internal and external deficits during the 1990s depression. A substantial fiscal retrenchment will soon be required in order to avoid the insolvency of the public sector.