Why saving fell in the Nordic countries.

The rate of private saving-that is, the ratio of net private saving to net disposable income-declined in all the Nordic countries during 1984-87, following the recent liberalization of financial markets. Saving developments in these countries also reflect the effects of high personal tax rates

and the favorable tax deductibility rules regarding interest payments on both mortgage and consumer loans. This decline, largely traceable to the sharp drop in the household saving rate (see chart), forced the Nordic countries to finance domestic investment through foreign borrowing. Although foreign borrowing has not posed any difficulties for these countries so far, persistent current account deficits could eventually require changes in economic policies. This would induce substantial adjustment costs by undermining market confidence in the fixed exchange rate policies pursued in these countries. (The external values of national currencies in Finland, Norway, and Sweden are pegged to a basket of currencies, which reflect their most important trading partners, while Denmark participates in the European Monetary System.)

The decline in the saving rates and the associated increase in the payments deficits has led policymakers to examine the factors that influenced household saving behavior in the Nordic countries. Rapid structural changes in the economic environment made it difficult for national authorities to predict consumption behavior when formulating economic policy. Easy access to credit and tax rules that discouraged saving led, in part, to over investment in housing and excessive consumption of consumer durables. this article reviews the financial and tax reforms carried out in the Nordic countries in the 1980s and discusses their impact on domestic saving rates.

Financial reforms

In the past decade, financial markets in the Nordic countries have undergone considerable reforms. These reforms include: elimination of ceilings on interest rates; the opening of money and capital markets to households; relaxation of foreign exchange controls; expansion of a range of activities permissible to banks and other financial institutions; and opening of domestic financial markets.

Until recently, Finland, Norway, and Sweden had far-reaching credit controls combined with low interest rate policies; only Denmark allowed domestic interest rates to rise to relatively high levels. The financial markets in Finland were tightly controlled, with rigid lending rates and an extensive use of foreign exchange controls. This resulted in credit rationing and led to a growing gray market unofficial market) in the late 1970s and early 1980s, reducing the effectiveness of monetary and credit restrictions. The Bank of Finland gradually deregulated the domestic banking system in the early 1980s.

Perhaps the most important elements in the Finnish financial reform were the elimination of interest rate ceilings and the creation of a short-term money market. In May 1983, the control of average bank lending rates was partially relaxed, allowing the banks to pass on part of the cost of their unregulated funding to their customers through higher lending rates. This was done to encourage banks to move their deposit talking and lending activities in the unregulated gray market operations back into their balance sheets. In 1986, the ceilings on average lending rates were abolished. Manufacturing companies were also allowed to raise foreign loans with maturities of at least five years for the financing of their operations. Moreover, the Bank of Finland and the commercial banks worked together to develop a domestic market for certificates of deposits (CDs), which expanded rapidly during 1987. The deregulation of foreign exchange controls in Finland proceeded gradually, lagging behind other Nordic countries. In September 1989, however, rules governing capital outflows were liberalized considerably by permitting residents to freely acquire foreign securities and real estate.

In Norway, most interest rates were regulated and credit growth wasifillited through lending ceilings prior to 1984, with credit rationing based on a credit budget covering all sectors of the economy. Ceilings on bank lending were, however, repealed in 1984 and regulation of bank interest rates was discontinued in September 1985. Since then, monetary policy has been largely implemented through market-oriented instruments that indirectly influence interest rates in the money and capital markets. Norway's exchange controls have been markedly relaxed since mid-1984 by allowing enterprises to borrow abroad long term, with maturities exceeding five years and permitting residents to buy foreign shares.

Interest rate regulation on banks' household deposits in Sweden was abolished in 1978, although in practice these rates remained linked to the central bank's discount rate. The regulation of bank lending rates was repealed in May 1985, and quantitative restrictions on lending were removed in November 1985. Unlike Finland, however, an efficient money market had already developed in Sweden by 1982-83. Treasury discount notes for financing the Government borrowing requirement were introduced in 1982, and a market for business and local government certificates was developed in 1983. Moreover, Government coupon bonds were introduced in 1983 and contributed to diversification of the term structure of market interest rates. Along with the domestic liberalization, foreign exchange controls were substantially relaxed, and in July 1989 virtually all the remaining foreign exchange regulations were repealed.

In Demnark, credit controls have traditionally been less restrictive than in the other Nordic countries. In the 1970s, the main instruments used by the monetary authorities to manage domestic liquidity were direct controls on bank lending and regulation of the terms of bank borrowing at the national bank. In March 1979, bank lending rates were deregulated and, in 1980, the ceilings on bank lending were abolished and replaced by a system of overall guidelines, which were dropped in 1985, when it became apparent that they were being circumvented by the banks.

The removal of exchange controls in Denmark was perhaps the most important institutional factor affecting financial decision making in the early 1980s. In 1983, Danes were allowed to freely acquire bonds listed on foreign exchanges with a maturity exceeding two years. In addition, the restrictions that linked a firm's foreign borrowing to fixed investment were removed in 1983, while the required minimum maturity of such loans was reduced from five years to one year in 1985. Further, in 1984, Danish residents were allowed to buy shares listed on foreign exchanges and Danish bonds denominated in foreign currency. In October 1988, they were allowed to deposit money and borrow abroad in foreign currency. Tax systems

In all the Nordic countries, the increase in household borrowing was facilitated by the generous rules governing the tax deductibility of interest payments coupled with high marginal personal income tax rates. Tax deductions were not only allowed on mortgage payments but also on most consumer loans. In recent years, concerns about low household saving rates have led the national authorities to reduce tax exemptions for interest payments; however, the tax rules in these countries still remain strongly biased against saving. The Darish tax reform in 1985 reduced the after-tax value of interest deductions to 51-57 percent, while other measures introduced in 1986, further reduced the tax value of interest payments on consumer loans to 31-37 percent. Similarly in Finland, the real value of deductions for interest payments on mortgage and consumer loans have gradually been reduced by not changing the nominal value of the maximum deduction. Norway's tax reform reduced the tax value of deductions by lowering the top marginal tax rate for interest deductions from over 66 percent in 1986 to some 45 percent in 1988. The tax reform of 1983-85 in Sweden reduced the tax value of interest payments to 50 percent for many households. Moreover, in the fall of 1989, the Swedish Parliament approved a major reform of the tax system, which included substantial cuts in marginal tax rates from January 1990 and affiliate on the maximum deduction for interest payments of SKr 100, 000 from January 1991.

Problems emerge

The deregulation of financial markets increased the efficiency of the use of credit and improved the transparency of the functioning of the markets in the Nordic countries. But at the same time, serious problems emerged because the monetary authorities could not sufficiently increase interest rates to quell a surge in the growth of money and credit, partly because domestic interest rates became increasingly tied to global interest rates. The surge in credit was mainly facilitated by the release in pent-up household credit demand, primarily for durable goods and real and financial assets, brought about by the end of rationing. Also, as discussed above, the generous tax deductibility of interest payments and the rapid increase in household wealth boosted households' ability and willingness to incur more debt. In all the Nordic countries, real after-tax interest rates were considerably lower than nominal rates.

In Finland, the annual growth of credit to households, which started to pick up in late 1986, increased by nearly 30 percent in late 1988. The removal of capital controls in Denmark-particularly on capital inflow, coupled with a high positive interest differential and increasing confidence in the firm exchange rate policy, resulted in strong capital inflows in 1984. These inflows contributed to a sharp growth in credit, with nonbusiness loans rising by 20 and 25 percent during 1984 and 1985, respectively. Household bank credit advanced by about 35 percent annually in 1985 in Norway and continued to grow by 25 percent in 1986 and 1987, while in Sweden, credit expansion accelerated from roughly zero in 1985 to 17 percent in 1986 and 23 percent in 1988.

The rise in borrowing contributed, among other things, to the increase in demand for equities. In Norway, industrial share prices increased by 32 percent in 1985, and in Fund and Sweden, share prices rose by more than 50 percent in 1986. In addition, the financial deregulation eased the requirement for saving in advance of housing purchases, hence increasing the demand for housing. This caused a rapid increase in house prices, particularly in Finland Norway, where the pent-up demand was strongest. For instance, urban housing prices in Norway increased by some 80 percent from the first quarter of 1984 to the first quarter of 1987; thus, freer access to credit increased consumption expenditure not only directly, but also through the wealth effects of higher asset and collateral values.

Impact on saving behavior

National authorities must make predictions for household saving behavior when formulating policy. This task was made difficult in the 1980s as a result of the rapid changes in the economic environment. Although the long-run characteristics of saving behavior may have remained unchanged, sudden structural changes seem to have had unpredictable consequences on national saving and the external balance. Since the developments in real disposable income cannot explain the sharp drop in saving, some other factors, such as changes in the value of real wealth, real after-tax interest rates, demographic factors, or inflation, appear to have played an important role.

A complete empirical assessment of the effects of financial liberalization on consumption and saving decisions in the Nordic countries is difficult, partly because of the lack of data since financial deregulation took place. Nevertheless, the study on which this article is based (see box) suggests that consumption patterns changed after financial deregulation. The empirical findings support the argument that it has been difficult, a priori, to assess the effects of the financial reforms on saving in the Nordic countries. In Denmark and Finland, and to some extent in Norway, significant changes in economic relationships appear to have taken place. Only in the case of Sweden is no evidence of structural change found; this may perhaps be explained by the fact that the gray market had already developed in the second half of the 1970s. In Finland, Norway, and Denmark, the effect on consumption of changes in real wealth appears to have increased. In the case of Sweden, the empirical results suggest that the relationship of changes in consumption to changes in wealth remained roughly the same after deregulation, although the increase in real wealth contributed to a rise in household consumption.

The findings tend to confirm the view that perceptions of changes in household wealth played a major role in household consumption-saving decisions in recent years in the Nordic countries. In fact, households' response to changes in wealth appear to have become stronger since financial markets were deregulated. This is also consistent with the view that freer access to credit increased consumption expenditure not only directly, but also indirectly, through higher asset values.

After deregulation, the sudden boost in household credit demand could not be fully countered by a rise in nominal domestic interest rates, since the fixed exchange rate policy implied that domestic interest rates were largely determined by foreign rates. With little autonomy in interest rate policy, a logical alternative would be to curtail or abolish the deductibility of interest payments and reduce marginal tax rates. Thus, it would appear that some of the gains associated with the financial deregulation in the Nordic countries appear to have been partially offset by the distortions in the tax codes. Given the present tax rules, it is unlikely that the household saving rate would return to its level prior to financial deregulation. There is, therefore, a case for removing the remaining tax distortions to improve household saving and provide better balance in the external accounts.