The Finnish Great Depression of the 1990s: reconciling theory and evidence

This paper reconciles quantitative macroeconomic theory of the Finnish Great Depression and the empirical evidence. The main controversy is that the existing theoretical work assigns a larger role for the collapse of the trade with the Soviet Union than the empirical evidence would suggest. This paper argues that explaining the Finnish crisis warrants a model with involuntary unemployment, and that the collapse resulted mainly from increased financial constraints, not the Soviet trade collapse. While it has been argued and that a large Soviet-trade contribution would result from costly reallocation of resources away from the Soviet sector, and trade-induced income effects that hit the consumption in the domestic sector, this paper finds it hard to reconcile them with the actual evidence. The economic collapse was wide-spread, and the domestic sector collapse reflects decline in investment rather than consumption.