Michael de Laine

By Michael de Laine, The Copenhagen Voice, 22 October 2009

The Danish economy will recover slowly from the ongoing financial crisis over time, but from a very low starting point, the independent chairmen of the Economic Council (the ‘wise men’) say in their latest report on the Danish economy, published today. But it will take years before the Danish production is at the same level as before the crisis. Denmark needs a new plan to ensure long-run fiscal sustainability.

Like the rest of the world, Denmark was in 2008 hit by the most severe economic downturn since the Second World War, but the fall in Danish gross domestic product (GDP) started in the beginning of 2008, and thus earlier than in most other countries, the economic ‘wise men’ say.

The GDP decrease has also been greater in Denmark, partly because the capacity pressure was considerable in the Danish economy in 2007 and 2008, and therefore there were low Danish growth rates in prospect, even before the crisis.

GDP fell sharply in the second half of 2008, and the fall continued with increased strength in the first half of 2009. Second-quarter GDP is 7% lower than a year ago.

However, the ‘wise men’ say, there are indicators implying that the bottom will soon be reached. The decrease in industrial production has ended, and the fall in private consumption has slowed. Also the business and consumer expectations of the future have moved upward, and the more optimistic mood is reflected in the stock prices, which have increased by 50% since March. The signs of recovery are even more pronounced abroad, and some countries (including Germany) actually experienced positive growth rates in the second quarter of 2009.

Therefore, a recovery of the Danish economy is in prospect, but from a very low starting point. However, there are several reasons to expect a slow recovery, and that it will take years before the Danish production is at the same level as before the crisis.

An important reason to expect a relatively weak recovery in Denmark is that households have suffered considerable wealth losses, in particular due to lower house prices. The lower wealth and the prospect of increasing unemployment will tend to keep private consumption at a low level, in spite of increases in disposable income.

Another reason to expect a weak recovery is that public finances have deteriorated in both Denmark and abroad, which implies a need for fiscal consolidation. It is expected that public finances abroad will be tightened along with the improvement of the economies, and this will contribute to lower growth on the Danish export markets the following years.

A third reason for expecting a weak recovery is that, even though the conditions in the financial sector have been partly normalised, there is still a considerable need for consolidation in response to the large losses the sector has suffered during the crisis. This will restrain the growth in lending and thereby the increase in economic activity. Restrained lending will probably be complemented by tighter regulation of the financial sector, e.g. through more restrictive international capital requirements for banks.

Finally, the economic ‘wide men’ expect that monetary policy will return to more normal conditions as the state of countries’ economies improves. This will, within a few years, imply higher interest rates and more restrictive opportunities for banks to acquire liquid funds in the central banks.

GDP is expected to fall by around 4.75% from 2008 to 2009. The downturn is reflected in all of the private demand components. Private consumption is expected to fall by 5% percent, exports by 10% and investments by 15%.

Private consumption falls in spite of a considerable increase in disposable income, among others due to tax cuts and the release of the Special Pension Savings, which is a compulsory pension payment that all employees paid in the period 1997 to 2004. Tax cuts will also increase disposable income in 2010, and thereby tend to stimulate private consumption.

However it is expected that the ratio of private consumption to income will fall, because of higher unemployment and lower house prices. Based on this, private consumption is only expected to increase by around 1.75 in 2010.

The ‘wise men’ say the Danish housing market is characterised by falling prices, longer selling periods and a marked fall in construction activity. Housing prices were at an unsustainable high level under the preceding boom, and housing prices have already fallen by almost 20% compared to the peak in 2007. With the increasing unemployment in mind it is expected that housing prices will fall by around 5% from 2009 to 2010. Starting from 2011, housing prices are expected to rise again.

Fixed business investments have already fallen markedly due to the lower demand, and they are expected also to fall in 2010.

Both imports and exports have fallen heavily as a response to the economic crisis in Denmark and abroad. Imports are expected to fall by around 12% in 2009, and exports by around 10%, but the decline in exports is expected to turn into an increase in the second half of 2009.

Several international institutions have revised their estimates of the global economic growth upward; growth in countries buying Danish exports will turn from -4% in 2009 to around 1.75% percent in 2010, and increasing to around 3.5% in 2012.

The noticeable fall in production has not yet been reflected in a corresponding decrease in employment, because the productivity has continued to fall, the economic ‘wise men’ say. This large productivity gap implies a potential for large increases in productivity in the following years, but it also implies a reduction in the number in employment toward 2011. The total fall in employment from 2008 to 2011 is estimated to be around 160,000 persons.

The fall in employment is not expected to be fully reflected in the number of registered unemployed, due to a cyclical fall in the total workforce. It is estimated that the number of unemployed will increase to around 170,000 persons in 2011, which is 125,000 higher than the historical low level in the summer of 2008.

The higher unemployment has also lowered the rate of wage increases, which is expected to remain at around 2.5% in the following years. This development implies a further deterioration of the Danish wage competitiveness, even though the domestic wage increases are at a historical low.

According to the economic ‘wise men’, the state of the economy has contributed to a sharp deterioration of public finances. It is expected that a surplus of DKK 60 billion in 2008 will be turned into a deficit at around DKK 90 billion in 2010. This is primarily due to a cyclical fall in tax revenues and an increase in unemployment expenditures. This, however, is supplemented by a discretionary fiscal easing, through tax cuts and increased expenditures, of around DKK 45 billion.

In 2009, the government’s fiscal policy will stimulate economic growth and reduce unemployment. This is due to increased public consumption and investment and also tax cuts. The general government budget for next year is not yet final, but fiscal easing of about DKK 20 billion has already been planned for 2010. The easing in 2010 is mainly due to the tax cuts as part of a tax reform that is underfinanced in the short run, but which the ‘wise men’ believe will have a neutral impact on the general government budget balance when it is fully implemented.

Because the current economic downturn is expected to be deep and long-lasting, chairmen of the Economic Council recommend further fiscal easing next year through additional public investments of about DKK 10 billion, but the recommended effect can also be achieved through other policy measures.

The fiscal policy recommended will not bring unemployment below its estimated natural rate, even if economic growth becomes somewhat stronger than forecasted. If, on the other hand, growth becomes somewhat weaker than forecasted, there is a risk that high unemployment will lead to an increase in the natural rate of unemployment.

The ‘wise men’ say it is important that expansive fiscal policy during downturns is countered by contractive fiscal policy during upturns, and it is therefore important that new expansive policies do not lead to a permanent increase in public spending. Starting an already planned investment project is by definition a temporary measure, as the fiscal tightening begins when the project is finished and spending stops. Thus public investment is a preferred measure in the current situation.

The general government debt under the Economic and Monetary Union (EMU) is estimated to reach DKK 700 billion by the end of 2010. This is about DKK 200 billion more than estimated in the central government’s latest Convergence Programme prepared in accordance with the rules in the EU’s Stability and Growth Pact. The increase in debt is primarily due to weak growth and a high degree of automatic fiscal stabilizers, which weakens the general government budget balance, but the Government‘s discretionary fiscal measures are also enhancing debt.

The economic ‘wise men’ say their new outlook makes it clear that Denmark needs a new plan to ensure long-run fiscal sustainability. The sustainability challenge must be recalculated with regard to the latest information and the calculations should take the increasing health expenses into account.

A new sustainability plan should include concrete measures for:

• Labour market reforms, including reforms of the early retirement scheme and the unemployment benefit system.
• Postponing the retirement age.
• Dropping the tax freeze on property and other nominal fixed non-inflation-adjusted taxes. The ‘wise men’ recommend adoption of a capital gains tax on the sales value of owner-occupied dwellings.
• Fulfilling the government’s objectives for education and greenhouse gas emissions.
• A public investment plan as an important part of both the short-term stabilization policy and longer-term structural policy as e.g. investments in infrastructure can increase productivity.

The economic ‘wise men’ say the necessary economic reforms should be carried through the parliament as soon as possible, while the reforms could be implemented later and over several years when economic growth has recovered.

The high growth in economic activity and employment in recent years have led to an increase in jobs for many low-skilled workers with difficulties in getting a foothold on the labour market. It is important that these people do not lose this foothold as employment falls. In a few years, the Danish economy will once again lack labour, and active labour market policy measures should therefore target this group.