American Economic Review 2012, 102(4): 1619–1643
http://dx.doi.org/10.1257/aer.102.4.1619
1619
Understanding economic depressions has long been one of the central challenges in
macroeconomics. Their massive costs as well as disagreement over their causes and
propagationaresubjecttocontinuousdebate.WeexaminetheFinnishGreatDepression
of the early 1990s to shed new light on important transmission mechanisms that can
drive depressions through disruption of international trade relationships. Our analysis
of the Finnish Great Depression can also be useful for understanding the macroeconomic
implications of large structural shocks affecting trade arrangements and the
terms of trade in other countries, particularly in the case of the transition economies of
Eastern Europe in the aftermath of the collapse of the Soviet Union.
During the 1991–1993 period, Finland experienced the deepest economic contraction
in an industrialized country since the 1930s and the deepest recorded peacetime
recession in Finnish history. As illustrated in panel A of Figure 1, between
1990 and 1993, real GDP declined by 11 percent, real consumption declined by
10 percent, and investment fell to 55 percent of its 1990 level. The declines are even
more dramatic when measured as deviations from trend. Using this metric, value
added in the private sector fell about 20 percent below trend. Over the same period,
Finland experienced a quadrupling of unemployment, from 3.5 percent to a peak of
16.5 percent, and the stock market lost 60 percent of its value.
We argue that a major cause of the Finnish Great Depression was the costly
restructuring of the manufacturing sector and a sudden, sharp increase in energy
costs caused by the demise of the Soviet Union. The barter-type trade arrangement
between the Union of the Soviet Socialist Republics (USSR) and Finland skewed
Finnish manufacturing production and investment toward particular industries and
effectively allowed Finland to export noncompetitive products in exchange for energy
imports at an overvalued exchange rate. The collapse of the USSR provides a unique
natural experiment for which we know with precision the timing, nature, and size of
the exogenous shocks that hit the Finnish economy. Furthermore, unlike previous
The Finnish Great Depression: From Russia with Love†
By Yuriy Gorodnichenko, Enrique G. Mendoza, and Linda L. Tesar*
* Gorodnichenko: Department of Economics, 693 Evans Hall, University of California, Berkeley, CA 94720-
3880, and National Bureau of Economic Research (e-mail: ygorodni@econ.berkeley.edu); Mendoza: Department
of Economics, 3105 Tydings Hall, University of Maryland, College Park, MD 20742, and National Bureau of
Economic Research (e-mail: mendozae@econ.umd.edu); Tesar: Department of Economics, 358 Lorch Hall,
611 Tappan Street, University of Michigan,AnnArbor, MI 48109-1220, and National Bureau of Economic Research
(e-mail: ltesar@umich.edu). The authors would like to thank participants of seminars at the University of Michigan,
MIT, Cornell, UC Davis, UC Berkeley, UCLA, UC Santa Barbara, Western Michigan University, Wharton, NBER,
New York University, Rochester, FRB, Higher School of Economics, “Macroeconomics across Time and Space”
at the Federal Reserve Bank of Philadelphia, BREAD Conference on Development Economics and Society for
Economic Dynamics. We also gratefully acknowledge comments and suggestions from anonymous referees,
Olivier Coibion, Pierre-Olivier Gourinchas, Seppo Honkapohja, Wolfgang Keller, Peter Murrell, Pascal Michaillat,
Maurice Obstfeld, Lee Ohanian, Klara Sabirianova Peter, Christina Romer, Kim Ruhl, Jeff Smith, Kei-Mu Yi, and
Jing Zhang. The authors thank Anna Fedorova, Juhn Kim, and Lisa Xu for excellent research assistance.
†
To view additional materials, visit the article page at http://dx.doi.org/10.1257/aer.102.4.1619.
1620 THE AMERICAN ECONOMIC REVIEW june 2012
analyses of earlier depressions or downturns in developing economies, we have
access to high-quality economic data at different levels of aggregation and frequency.
We develop and calibrate a multisector dynamic general equilibrium model that
accounts for the key features of the Finnish Great Depression. The model captures the
economy’s response to the two shocks caused by the collapse of the Soviet Union: the
sudden loss of the market for specialized exports to the USSR and the surge in the relative
price of imported energy. The model generates large declines in aggregate output,
consumption, and employment, and replicates the dynamics of the sector devoted to
manufacturing goods for export to the USSR, the sector producing goods for the rest
of the world, and the nontradables sector. Our simulations suggest that downward
wage rigidity coinciding with a contraction in demand for nontraded goods observed
in Finland played a key role in the amplification of the downturn produced by these
shocks.
We validate our analysis in several ways. First, the model does well at reproducing
the dynamics of macroeconomic variables in a previous episode of a sudden
Panel A. Finnish GDP,
investment and consumption
Panel B. Output in Finland
and Eastern Europe
Panel D. Distribution of individual workers’
annual nominal growth by industry
Panel C. Employment and
exposure to Soviet trade
60
70
80
90
100
110
Levelrelativeto1990,1990=100
1985 1986 1987 1988 1989 1990 1991 1992 1993 1994 1995 1996 1997
GDP
Consumption
Investment
Employment
80
100
120
140
Levelrelativeto1990,1990=100
1990 1991 1992 1993 1994 1995 1996 1997
Czech Republic
Finland
Hungary
Bulgaria
Poland
Slovakia
Slovenia
Romania
Non-metallic mineral products
Shipbuilding
Other transport
Railroad equip.
Motor vehicles
Transport equip.
Pharmaceuticals
Instruments
Textile
Rubber
Electrical machinery
Elect. & optical
Machinery and equipment
Aircraft
Office equip.
OLS est. slope = -14.54
se = (6.04)
−50
−40
−30
−20
−10
Employment,percentdeviation
fromtrend,1993
0 0.2 0.4 0.6 0.8
Share of exports to USSR, 1988
0
0.2
0.4
0.6
0.8
−5 −4−3−2−10 1 2 3 4 5 6 7 8 9 101112 1314151617 1819 20
1992: Nonmanual workers, manufacturing
Figure 1. Macroeconomic Dynamics in Finland
Notes: Panel A: Data are from Organization for Economic Cooperation and Development (OECD 2010a). Panel B:
Data are from United Nations Statistics Division (2010). Panel C: Deviation from trend for employment (Source:
STAN OECD 2010b) is computed as the log difference between actual value of employment in 1993 and predicted
value for the trend estimated on 1980–1989 data. For shipbuilding and railroad equipment industries, the deviation
is computed as the difference between employment in 1993 and 1989 because these industries had volatile time
series. Panel D: Vertical axis measures fraction. Horizontal axis measures percent change in annual nominal wages.
The bar in blue indicates the level of inflation. Figures for additional industries, types of workers, and years are
reported in online Appendix D.
Source: Böckerman, Laaksonen, and Vainiomaki (2006).
1621Gorodnichenko et al.: the finnish great depressionVOL. 102 NO. 4
rise in energy costs, the oil price hike of the 1970s. In addition, we compare the
experience of Finland in the aftermath of the collapse of the Soviet Union with
that of Sweden. The Swedish economy is widely regarded as sharing many of
the same structural features that characterize the Finnish economy, and it went
through a similar economic downturn in the early 1990s (including currency and
banking crises). Sweden, however, had only a negligible trade relationship with
the Soviet Union. Hence, this comparison provides us with a natural experiment in
which one country (Finland) was hit by the two shocks triggered by the Soviet collapse
and the other (Sweden) was not. Our findings from this comparison support
the model’s quantitative predictions, because the downturn in Sweden was much
milder and of shorter duration than in Finland. Finally, we document that Finnish
manufacturing industries exposed to Soviet trade experienced a deeper contraction
than those that were not.
The impact of the shocks caused by the collapse of Soviet trade on Finland is
interesting in its own right, but it is especially compelling in light of the similar
experiences of the Eastern European transition economies (TEs). Panel B in
Figure 1 plots the dynamics of real GDP in the Czech Republic, Hungary, Poland,
Slovenia, Slovakia, Bulgaria, Romania, and Finland. The figure captures the familiar
“U-shaped” path for output characteristic for TEs (Blanchard and Kremer 1997,
Roland and Verdier 1999). The remarkable feature of the figure is that the adjustment
path for Finnish GDP in the post-1990 period is virtually identical to those
observed in TEs.1
Finland experienced the full force of the shocks induced by the
collapse of trade with the USSR, but as a western democracy with developed capital
markets and institutions, faced none of the institutional adjustments experienced
in TEs. Thus, by studying the Finnish experience we can isolate the effects due
solely to the shocks caused by the collapse of trade with the USSR from the other
burdens of adjustment borne by TEs. To the best of our knowledge, these results
provide the first quantitative assessment of the significance of these shocks for
explaining the downturn in these economies. To the extent that these shocks, combined
with standard macroeconomic reallocation costs and frictions, can account
for the depressions in TEs, the role of other factors such as institutional transformations
may be smaller than previously thought.
Other studies have offered alternative explanations of the Finnish crisis. One
view is that the origins of the Finnish depression were largely financial, working
through the banking sector and ultimately triggering a twin currency-banking
crisis (see, e.g., Honkapohja, Koskela, and Paunio 1996). There is little doubt that
financial factors played a role in the persistence and amplification of the crisis—
yet, Finland was already two years into the depression at the time of the banking
crisis and the large depreciation of the Finnish markka. Still, we do find that a
large and unexpected hike in the real interest rate, which we view as a proxy for
the financial shock that Finland suffered, enhances the ability of our model to
1 
In an early contribution, Rodrik (1994) explored the possible impact of trade on output in transition economies.
He estimated that the collapse of trade with the USSR could account for a 7 to 8 percent decline in GDP in
Hungary and Czechoslovakia and a 3.5 percent decline in Poland. At the time he wrote his article, it was too early
to characterize the transition path and U-shaped pattern of output resulting from the loss of trade. Thus, his analysis
was necessarily static while we emphasize the dynamic effects. Nonetheless, his work suggested that trade was an
important factor in understanding the dramatic decline in output in the early 1990s.
1622 THE AMERICAN ECONOMIC REVIEW june 2012
match important features of the macro time series, particularly the size of the
investment collapse. Another view of the Finnish depression argues that labor tax
hikes and negative productivity shocks may have been the culprit (Conesa, Kehoe,
and Ruhl 2007). It is difficult, however, to find evidence of large tax hikes in
available tax rate estimates and policy documents of the time. Also, as we argue
below, a decline in measured productivity may be a symptom rather than a cause
of contraction in a multisector economy.
In the next section, we lay out the key facts about the Soviet-Finnish trade relationship.
In Section II, we develop a dynamic model of the Finnish economy. In
Section III the model is calibrated using Finnish data before the collapse of Soviet
trade. Then we hit the model economy with the shocks caused by the collapse of the
Soviet Union, as once-and-for-all unanticipated shocks in a deterministic environment,
and compare the model’s dynamics with the dynamics observed in the data.
In Section IV, we evaluate alternative explanations of the depression. In Section V,
we discuss how our conclusion for Finland can be extended to transition economies.
We make concluding remarks in Section VI.
I.  Finnish-Soviet Trade
We argue that five factors—factors shared with other countries in the socialist
bloc—contributed to the deep economic contraction that occurred in Finland following
the cancellation of its trade arrangement with the Soviet Union in December
1990. First, the share of total exports to the USSR was large, and a number of manufacturing
sectors were particularly dependent on Soviet trade. Second, exports to the
USSR were produced to Soviet specifications. Once the Soviet market collapsed,
these goods had no alternative market. Third, the trading arrangement involved the
exchange of Finnish manufactures for Soviet oil at an overvalued exchange rate. This
meant that Finland simultaneously experienced both the collapse of a major export
market and an effective increase in the price of energy. Fourth, the loss of trade with
the USSR was largely unexpected. Finally, the rigidity of wages in Finland meant
that the adjustment to the trade shock resolved itself primarily through increased
unemployment, rather than an adjustment in wages.
A. Soviet Trade Share
The Soviet Union was Finland’s largest trading partner until the collapse of the
Soviet regime, accounting for roughly 20 percent of Finnish exports during the 1980s.
Among the sectors with heaviest Soviet-trade exposure were textiles, textile products,
leather, and footwear, with Soviet exports accounting for 29 percent of exports
and 34 percent of value added. Machinery and equipment also had significant Soviet
exposure at both the aggregate and disaggregated levels. The sector with the heaviest
exposure was transport equipment, and this exposure was further concentrated
in shipbuilding (85 percent of exports designated for the USSR and 225 percent of
value added) and railroad equipment (86 percent of exports to USSR and 103 percent
of value added). While some manufacturing sectors were particularly specialized in
goods destined for the Soviet market, no sector was fully isolated from the loss of
Soviet trade.
1623Gorodnichenko et al.: the finnish great depressionVOL. 102 NO. 4
B. Specialized Products for the Soviet Market
Finnish exports to the USSR were typically specialized for the Soviet market
and did not compete directly with products traded in western markets. To assess
the degree of specialization of the goods destined for the USSR, Kajaste (1992)
computes the share of Soviet exports at the four-digit level of CCCN classification
and finds strong concentration of trade. Conditional on exporting a good to the
East, more than 80 percent of all exports of this good went to socialist countries.
At the more detailed 7-digit level, Kajaste identifies 133 items with a Soviet export
share exceeding 90 percent. These items constituted approximately 40 percent of
exports to the USSR. Kajaste also reports that because of the highly specialized
nature of goods traded with countries in the Council of Mutual EconomicAssistance
(CMEA), the collapse of trade with the eastern markets was compensated only to
a very limited extent by redirecting trade to the West. The extent of specialization
was such that firms’ capacity developed for trading with the USSR became virtually
obsolete overnight.2, 3
For industries that sent a significant share of their exports to the USSR, the loss
of Soviet exports caused total exports to fall, suggesting that the goods were not
redirected to other counties. Panel C in Figure 1 illustrates that at the industry level
there is a strong negative correlation between export shares to the USSR in 1988 and
deviations of employment from trend in 1993. After the collapse of trade with the
USSR in December of 1990, entire industries had to be reorganized (see Sutela 1991
for case studies). Even for industries that had some export recovery (e.g., shipbuilding),
the loss of the Soviet market was painful as it involved major transformations in
product lines. The strategy of “icebreakers for the communists, luxury liners for the
capitalists” meant that production facilities specialized for Soviet production had to
be shut down.
C. Overvalued Terms of Trade
Trade between Finland and the USSR was governed by a series of five-year, highly
regulated trade agreements, similar to the agreements between the USSR and its
Eastern European allies. These agreements established the volume and composition
of trade between the two countries. By the late 1980s the trade arrangements had
evolved into a barter of Finnish manufactures for Soviet raw materials, principally
crude oil. Trade was to be balanced annually, though arrangements were periodically
made to allow for temporary imbalances.4
The five-year trade agreements established
explicit quotas for the export of manufactures to the USSR. While the volume of
2 
The fact that Finnish exports to the USSR would have little success in the West was clearly understood at the
time. Urho Kekkonen, President of the Republic and an active promoter of economic cooperation with the Soviet
Union, wrote on November 20, 1972: “We must of necessity maintain a relatively large trade with the West, but of
much importance is the fact that we are able to sell to the Soviet market in the main such goods that would be very
difficult to market into the West” (cited in Sutela 2005).
3 
Another important aspect of trade with the USSR was industry concentration. The five largest exporters
accounted for 39.9 percent of all exports, the 50 largest for 78.7 percent, and the 116 largest for 90 percent (Sutela
2005). This concentration of the Finnish-Soviet trade resembles trade within CMEA. Given this concentration,
economies of scale were often cited as an important source of profitability in the Finnish-Soviet trade.
4 
See Mottola, Bykov, and Korolev (1983), and Oblath and Pete (1990) for more details on the Soviet-Finnish trade.
1624 THE AMERICAN ECONOMIC REVIEW june 2012
exports was established by the bilateral trade agreement, the specific quantities and
unit prices of the items to be exported were established through direct negotiations.
Trade associations conducted the negotiations, applied for export licenses from the
Finnish government, and distributed the rights to export among their members. A key
condition of the export license was an 80 percent domestic content restriction.
More than 90 percent of imported oil and 100 percent of Finland’s imported natural
gas came from the USSR. In principle, the rate of exchange of Finnish goods
for Soviet energy was to take place at world prices. The value of crude oil was
easy to observe and was set at the dollar price of crude oil on the world market and
then converted to rubles using the official ruble­-to-dollar exchange rate. The market
value of Finnish exports to the USSR was less obvious. The evidence suggests that
over time the rate of exchange (goods per barrel of oil) tilted in Finland’s favor. For
example, interviews and surveys with managers and industry experts suggest that
exporting to the USSR was a lucrative business for Finnish firms (Kajaste 1992).
Precommitment to the five-year contracts eliminated exchange rate and business
cycle risk for firms. Kajaste (1992, p. 29) concludes that “[Soviet] exports seem to
have been exceptionally profitable.”
A more formal measure of the premium associated with exporting to the USSR is
the markup on Soviet exports relative to similar goods destined for western markets.
Using data from the 1980s, Kajaste (1992) estimates the markup using unit prices
of Soviet and non-Soviet exports and finds that the prices of exports to the Soviet
Union were at least 9.5 percent higher than those for exports to western markets.
We replicate this analysis using trade data at the five-digit level of standard international
trade classification disaggregation for 1990 and find an even larger markup
of 36 percent. This markup suggests that if a Finnish industry redirected its Soviet
trade to other countries, its goods would be competitive only if sold at a 10 to 36 percent
discount.5
Hence, the Finnish economy was subsidized by overvalued prices of
Finnish manufactures bartered for Soviet oil so that the effective price of Soviet oil
was at least 10 percent cheaper than its market price.
D. The Unanticipated Collapse of Trade
It seems remarkable ex post that Finnish firms, and indeed the world at large, were
caught short by the implosion of the USSR. To be sure, trade flows to the USSR had
fallen off in the late 1980s. Part of the decline was an endogenous contraction resulting
from falling oil prices. The decline was also a consequence of the reforms under
Perestroika, which attempted to decentralize Soviet decision-making but made it
difficult for Finnish firms to identify those with real authority on the Soviet end.
5 
There are several reasons why the USSR was willing to overpay for Finnish goods. First, neutral Finland
was the key source of modern Western know-how for the USSR. Other countries had much tighter export controls
against the Soviet bloc that were designed to block the transfer of technology. Second, the USSR used the
Finnish-Soviet trade as a lab for testing various forms of capitalist and socialist cooperation and as a guarantee of
peaceful coexistence. For example, Urho Kekkonen, the Finnish prime minister and president for three decades,
wrote in 1974, “ … our whole stable foreign policy course demands that we do keep the Soviet markets” (cited in
Sutela 2007, p. 139). Third, the Soviet subsidy was aimed at maintaining political status quo in Finland where left
parties played an important role. A former leader of Soviet intelligence in Finland once wrote, “One can go to any
lengths in thinking, if Kekkonen was a Soviet “agent of influence,” but hardly anybody denies that the Finns had
a president who pumped enormous amounts of economic benefit from Soviet leaders against short-term political
concessions … and thus Finnish standards of living increased” (cited in Sutela 2007, p. 160).
1625Gorodnichenko et al.: the finnish great depressionVOL. 102 NO. 4
The expressed belief that the trade arrangement with the USSR would persist,
however, appeared in government reports, interviews with policymakers, and corporate
forecasts. Even after the announcement that the trade contracts were to be canceled,
a representative of the central bank suggested that it was still possible that the
system would be reformed, and not fully dismantled. The private sector was equally
surprised by the collapse of the Soviet trade.6
The collapse was quick and deep. On December 6, 1990 the Soviet authorities
informed their Finnish counterparts that all trade arrangements were cancelled without
any transitional period. Imports of oil from the (former) USSR fell from 8.2 million
tons in 1989 to 1.3 million tons in 1992. Finnish exports to the (former) USSR
tumbled down by 84 percent over the same period.7
E. Rigidity of the Labor Market
To fully understand the reaction of the Finnish economy to the shocks caused by
the collapse of Soviet trade, it is important to examine the Finnish labor market,
which is notable for its high degree of unionization. In the early 1990s approximately
85 percent of workers belonged to unions and almost 95 percent of workers
were covered by collective agreements (Böckerman and Uusitalo 2006). Since most
employers are organized in federations, the wage bargaining normally starts at the
national level. If a federation or union rejects the nationwide agreement, it can negotiate
its own terms. Collective agreements stipulate the wages for different levels
of job complexity, education, etc. in a given industry. Typically, agreements allow
for upward wage drift if firms perform well. Although the government does not
have a formal role in the bargaining process, the government usually intermediates
negotiations.8
Not surprisingly, Finland is often classified as a country with highly
centralized wage setting (e.g., Botero et al. 2004).
Unions did not agree to cut nominal wages in 1992–1993, which were the peak
years of the depression. Instead, wages were frozen at the 1991 level (see online
Appendix D). Panel D in Figure 1 reports the distribution of wage changes in
1992 for individual nonmanual workers in manufacturing. Strikingly, the fraction
of workers with no wage change reached 75 percent. Thus, the national agreement
was binding for a broad array of firms and workers. Given that inflation was
quite moderate in the 1990s and there was a positive drift in the nominal wages
(which corresponds to the right tail of the distribution of wage growth in panel D
of Figure 1), real wages fell only to a limited extent. These findings are consistent
with Dickens et al. (2007), who cite Finland as a country with one of the greatest
downward wage rigidities.
6 
Nokia, a major exporter of telecommunications technology to the USSR, forecast strong sales to the Soviet
Union for 1991. Actual sales in January and February of 1991, however, came in at just 2 million markka
($469,000 US) instead of the projected 121 million markka ($28.1 million US), forcing the company to dramatically
change its business plan (Haikio 2001, p. 76).
7 
Allowing economic agents to learn in 1990:III or 1990:IV that the trade will collapse in one or two quarters
does not materially change our results.
8 
See Snellman (2005) for a more detailed description of the wage bargaining process in Finland.
1626 THE AMERICAN ECONOMIC REVIEW june 2012
II.  A Model of the Finnish Economy
In this section we develop a model of the Finnish economy that captures the key
features of its trading relationship with the Soviet Union and the Finnish labor market.
These features include the volume of trade, the composition of trade, overvalued
terms of trade, low elasticity of substitution between goods destined for the Soviet
market and western markets, and rigid labor markets.
We model the Finnish economy as a small open economy with three sectors.9
Sector 1 (non-Soviet sector) produces a traded good consumed at home and sold
abroad in western markets. Sector 2 (Soviet sector) produces a good that can be
consumed at home or sold exclusively to the USSR. Sector 3 (services) produces
nontradables. Our baseline functional forms and parameters produce equilibrium
allocations consistent with the Finnish economy prior to the Soviet trade collapse.10
A. Households
The representative household chooses a lifetime plan for consumption and labor
allocations to maximize utility, taking all goods and factor prices as given. The utility
function is U ≡ ​∑ t=0​ 
∞
 ​ ​β​ t
​​ U(​G​t​ , ​L​1t​ , ​L​ 2t​  , ​L​ 3t​), where G is a consumption aggregator
over four consumption goods and ​L​jt​for j = 1, 2, 3 is the labor supplied to each
sector. The consumption aggregator is given by ​G​t​  = ​C​ 1t​ ​ξ​1​
​ ​C​ 2t​ 
​ξ​2​
​ ​C​ 3t​ ​ξ​3​
​ ​C​ 4t​ (1−​ξ​1​−​ξ​2​−​ξ​3​)
​
where ​ξ​ j​are weights in the consumption aggregator, ​C​1t​is the consumption of the
non-Soviet traded good produced by sector 1, ​C​2t​is the consumption of the good
produced by the sector with Soviet exposure, ​C​3t​is the consumption of services, and​
C​4t​is the consumption of a good imported from the western markets.
We follow Greenwood, Hercowitz, and Huffman (1988) and assume a period utility
function U(​G​t​ , ​L​1t​ , ​L​ 2t​  , ​L​ 3t​) = ​  1
 _ 1 − σ
 ​ (​G​t​  − ​∑ j=1​ 
3
  ​ ​ 
​χ​j​
 _ 1 + η
 ​​ ​L​ jt​ 1+η
​​)​1−σ
​where 1/σ is the
elasticity of intertemporal substitution, 1/η is the Frisch elasticity of labor supply,
and ​χ​ j​is the scale of disutility from working in sector j. Note that under this assumption
households can adjust their labor input in each sector. The utility from each
type of leisure is not perfectly substitutable, however, so a decrease in labor input in
sector 2, which will occur in response to the collapse of export to the Soviet Union,
will not translate into a one-for-one increase in labor supply in the other, expanding
sectors. In this sense, labor is sector-specific and hence wages are not generally
equalized across sectors.11
Total employment is defined as ​L​t​  = ​L​1t​   +  ​L​ 2t​   + ​L​ 3t​ .
9 
The “small open economy” assumption means that Finnish exports faced a perfectly elastic demand curve in
foreign markets, which seems to be a reasonable approximation because Finnish goods had relatively small market
shares in their main foreign destinations.
10 
Online Appendix C shows that our results are robust to relaxing several assumptions of the baseline setup. In
particular, we introduce habit persistence in consumption, vary the elasticities of substitution between sectoral labor
supplies, allow for adjustment costs in investment and labor, allow for less-than-unitary elasticity of substitution
between capital and labor, and introduce imperfect substitutability of labor supply across sectors.
11 
Since we examine the behavior of the economy up to 1997, assuming sector-specific labor supply for seven
years is not generally appealing. We believe this assumption may be sensible for two reasons, however. First, in
online Appendix C, we show that if we allow imperfect substitution of labor across sectors, the results are similar to
the results in baseline specification. Second, Koskela and Uusitalo (2004), Ilmakunnas and Maliranta (2001), and
others document that the unemployment rate in Finland increased and stayed high because of changes in the sectoral
demand for workers, a dramatic rise in long-term unemployment, strong unions, generous unemployment/pension
benefits, increased share of elderly in the composition of unemployment, and considerably decreased rates of labor
flows (churning, job reallocation, etc.). Furthermore, the Beveridge curve for Finland strongly and persistently
1627Gorodnichenko et al.: the finnish great depressionVOL. 102 NO. 4
We assume that households are exclusive owners of domestic firms. Households
face the following budget constraint:
	​w​1t​ ​L​1t​  + ​w​2t​ ​L​ 2t​  + ​w​3t​ ​L​ 3t​  + (​q​1t​  + ​d​1t​) ​K​1, t−1​ 
	 + (​q​2t​  + ​d​2t​) ​K​2, t−1​  + (​q​3t​  + ​d​3t​) ​K​3, t−1​  + ​R​t​ ​B​t−1​ 
= ​B​t​  + ​q​1t​ ​K​1t​  + ​q​2t​ ​K​2t​  + ​q​3t​ ​K​3t​  + ​C​1t​  + ​p​2t​ ​C​2t​  + ​p​3t​ ​C​3t​  + ​p​4t​ ​C​4t​ ,
where ​w​jt​is the wage rate in sector j = 1, 2, 3, ​B​t​is a one-period bond denominated
in units of the world tradable good and traded in international markets at the gross
world interest rate of ​R​t​ , ​q​ jt​is the price of capital ​K​jt​in sector j, ​d​jt​is the dividend
rate on capital in sector j, and ​p​jt​is the relative price of goods in sector j (we take
good 1 as numeraire so ​p​1t​  = 1).
B. Firms
Firms in all three sectors use inputs of capital, labor, and energy (E) to produce
the final good in that sector. The problem faced by the representative firm in each
sector is to choose inputs to maximize profits taking factor prices as given. In sector
j = 1, 2, 3, the representative firm maximizes:
  ​∑ 
t=0
​ 
∞
 ​   ​  1 _ 
​Π​ s=0​ t
  ​ ​R​s​
 ​​ (​p​jt​ ​Q​jt​  − ​p​ t​ E
​ ​E​jt​  − ​w​ jt​ ​L​jt​ 
 	 − ​p​jt​ {​K​jt​  −  (1  −  δ) ​K​j, t−1​  + ​ 
ϕ
 _ 
2
 ​ [​ ​K​jt​
 _ 
​K​j, t−1​
 ​  − 1​]​
2
​ ​K​j, t−1​}),
where δ is the rate of depreciation of the capital stock, ϕ is a capital adjustment cost
coefficient, and ​p​ t​ E
​is the relative price of energy.
Production functions are given by ​Q​jt​  = min {​a​jE​ ​E​jt​, (​L​ jt​ ​α​Lj​
​ ​K​ j, t−1​ 1−​α​Lj​
​ )}, for j = 1, 2, 3,
where ​a​jE​is the energy requirement in sector j, and ​α​Lj​is the labor weight in the capital-labor
aggregator. We assume that energy and value added are perfect complements
because the ability of firms to substitute away from energy is very small in the
short run. At an optimum, no input is wasted, so ​Q​jt​  = ​a​jE​ ​E​jt​ . Value added is defined
as ​Y​ jt​  = ​p​jt​ ​Q​jt​  − ​p​ t​ E
​ ​E​jt​  = (​p​jt​  − ​p​ t​ E
​/​a​jE​)​Q​jt​and the corresponding value-added function
as ​Y​ jt​  ≡ ​F​ j​ (​L​jt​ , ​K​j, t−1​, ​p​jt​ , ​p​ t​ E
​ ). Note that for simplicity the three sectors do not
have direct linkages via input-output relationships.
shifted to the right in the early 1990s, which is often interpreted as a sign of increased mismatch between vacancies
and unemployed.
1628 THE AMERICAN ECONOMIC REVIEW june 2012
C. Market Clearing and Equilibrium
In sector 1, output is consumed, invested in that same sector (since investment I is
also sector-specific), or exported: ​Q​1t​ − ​C​1t​ − ​I​1t​ − ​X​1t​ = 0, where ​X​1t​measures
net exports of the non-Soviet good. These are exports of goods to western markets
in exchange for energy imports, ​M​t​  *​, purchased at a world relative price ​p​t​  *​, and for
imports of good ​C​4t​purchased at world relative price ​p​4t​ . Hence, the non-Soviet balance
of trade is T​B​t​ = ​X​1t​ − ​p​t​  *​ ​M​t​  *​ − ​p​4t​ ​C​4t​ = ​B​t​ − ​R​t​ ​B​t−1​.
In the Soviet sector, output is consumed by domestic consumers, invested in sec-
tor 2, or sold to the Soviet Union in exchange for energy: ​Q​2t​ − ​C​2t​ − ​I​2t​ − ​X​2t​ = 0,
where ​X​2t​measures export to the USSR. To capture the clearing system in the FinnishSoviet
trade, we assume that trade with the Soviet Union is balanced at all times:​
p​2t​ ​X​2t​ − ​p​t​ S
​ ​M​ t​ S
​ = 0, where ​p​t​ S
​is the barter price of energy contracted with the Soviet
union for a quantity ​M​ t​ S
​of energy imports. The values of ​p​t​ S
​and ​M​ t​ S
​are fixed, since
they were set by the five-year agreements between Finland and the USSR.
We assume that Finland produces no energy domestically and energy is not storable
so that imports of energy are equal to domestic consumption of energy: ​M​t​  * ​ + ​M​ t​ S
​ − 
(​E​1t​ + ​E​2t​ + ​E​3t​) = 0.
In sector 3 domestic production equals domestic absorption: ​Q​3t​ − ​C​3t​ − ​I​3t​ = 0.
We follow Shimer (2010) and model the rigidity of the labor market as a slow
adjustment of wages in each sector j = 1, 2, 3: ​w​jt​ = ​θ​j​ ​w​j, t−1​ + (1  − ​θ​ j​)​w​ jt​ D
​ , where
the parameter θ governs the degree of wage stickiness and ​w​ D
​is the reservation wage
given by the household labor supply. One interpretation of these wage dynamics is
that trade unions take the wage in the previous period as a starting point in bargaining
(“status quo” wages) and gradually change the wage to increase the employment
of union workers. Specifically θ = 1, corresponds to complete real wage rigidity,
while θ = 0 corresponds to complete real wage flexibility. Regardless of θ, we set​
w​ j​ D
​ = ​w​j​in the pre-Soviet-collapse steady state. Given the wage, clearing in the
labor market is demand-determined (i.e., by finding the labor allocation that satisfies
the labor demand condition and the settled wage).
An equilibrium of this economy is defined by sets of intertemporal sequences
of allocations ​{​L​1t​ , ​L​2t​ , ​L​3t​ , ​C​1t​ , ​C​2t​ , ​C​3t​ , ​C​4t​ , ​I​1t​ , ​I​2t​ , ​I​3t​ , ​Y​1t​ , ​Y​2t​ , ​Y​3t​ , ​E​1t​ , ​E​2t​ , ​E​3t​ , ​Q​1t​ , ​Q​2t​ ,
​Q​3t​ , ​X​1t​ , ​X​2t​ , ​B​t​}​ t=0​ ∞
 ​and prices ​{ ​p​2t​ , ​p​3t​ , ​w​1t​ , ​w​2t​ , ​w​3t​ , ​q​1t​ , ​q​2t​ , ​q​3t​}​ t=0​ ∞
 ​that solve the household’s
problem and the problem of each representative firm, and that satisfy the market
clearing conditions, for given initial conditions {K10, K20, K30, w10, w20, w30} and
sequences of exogenous variables ​{ ​p​t​ E
​, ​p​ t​ S
​, ​M​ t​ S
​, ​p​4t​ , ​R​t​}​t=0​ 
∞
 ​. In our quantitative analysis
we focus on equilibria that start from initial conditions calibrated to match the Finnish
economy at a stationary equilibrium just before the collapse of the Soviet Union, and
with the sequence of exogenous variables set to reflect the sudden increase in the
cost of energy and the collapse of the market for exports to the USSR. The precise
specification of these initial conditions and shocks is described in the next section.
III.  Quantitative Analysis
A. Detrending and Definition of the “Soviet” Sector
Since our study does not focus on either long-run growth or regular business
cycles, but rather on macro dynamics around the Great Depression episode, we filter
1629Gorodnichenko et al.: the finnish great depressionVOL. 102 NO. 4
the data in the following way. First, we express a data series in log first differences
and compute the average growth rate over 1975–1986. Then we use this estimate
of the growth rate to extrapolate actual series (in levels) for the post-1990 period
to construct a forecast, or counterfactual, of the macro dynamics that would have
been observed without the Finnish Great Depression during the 1990s (see online
Appendix B for more details). Deviations from the predicted trend are interpreted as
the dynamics resulting from the depression. We will compare these deviations with
the dynamics produced by the model.
One of the challenges in mapping the model to the data is that the pervasiveness
of Soviet exports throughout the manufacturing sector makes it difficult to separate
out a “Soviet” sector from a “non-Soviet” sector. The “Soviet-exposed” sector will
be defined in the data as a weighted index of industrial sectors. We define ​ω​ it​ X
​as the
share of exports of industry i at time t to the USSR in total exports of industry i.
Let ​Y​it​be, e.g., value added in industry i at time t. Then we compute value added
in the Soviet-exposed sector as ​Y​ t​ S
​ = ​∑ 
i
  ​ 
 
 ​​ω​ it​ X
​​​Y​it​and correspondingly the non-Sovietexposed
sector is ​Y​ t​ NS
​ = ​∑ 
i
  ​ 
 
 ​(​1  − ​ω​ it​ X
​ )​Y​it​ . We treat services as a separate sector producing
nontradable goods. We allow the weights ​ω​ it​ X
​to change over the 1989–1992
period. The relative size of the Soviet sector will therefore decline automatically as
trade with the USSR collapses. Since our model does not include the government
sector, which is governed by different objectives and did not experience any major
changes during the depression, we adjusted the data to exclude the public sector.
B. Calibration
We calibrate the model at quarterly frequency to match macroeconomic aggregates
in the year 1989. The discount factor is β = 0.99, which, given that output per
capita grew approximately two percent per year in Finland before 1991, implies an
annual real interest rate of six percent per year, consistent with the 6.1 percent per
year real lending rate in Finland before 1991. We choose an intertemporal elasticity
of substitution of ​σ​−1
​ = 0.5. Hall (2007) and Kimball and Shapiro (2010) provide
evidence indicating that the elasticity of labor supply at the macro level is about
one in the United States. In line with this evidence, we set η = 1. The results of the
model are not sensitive to reasonable variations in σ and η. Under our assumption
of Cobb-Douglas preferences over the four types of consumption goods, ​ξ​1​, ​ξ​2​, ​ξ​3​, ​
ξ​4​can be computed from data on consumption expenditures by sector. We find that​
ξ​1​ = 0.15, ​ξ​2​ = 0.04, ​ξ​3​ = 0.54, ​ξ​4​  ≡ 1 − ​ξ​2​ − ​ξ​3​ − ​ξ​4​ = 0.27.
Turning to the production side of the model, the parameters ​α​Lj​can be determined
from labor compensation in value added so that ​α​L1​ = 0.57, ​α​L2​ = 0.63, and​
α​L3​ = 0.63. The quarterly depreciation rate of capital, δ, is the same across sectors
and set to match an annual depreciation rate of ten percent. We assume small to
moderate adjustment costs in capital stock (ϕ = 1). Without loss of generality, we
define units of oil in such a way that the unit price of oil before the collapse of the
Soviet Union is equal to one (i.e., ​p​E
​ = 1). Because energy and value added are
Leontief complements, the energy requirement in the non-Soviet sector is given
by ​a​1E​ = ​p​1​​Q​1​/(​p​E
​​E​1​). Since we know the cost structure (specifically, expenditures
1630 THE AMERICAN ECONOMIC REVIEW june 2012
on energy), we can compute the energy requirement for the non-Soviet sector as
the ratio of cost (value added plus energy expenditures) to energy expenditures. For
the non-Soviet sector, this ratio is equal to 21.56. For other sectors, we cannot make
this calculation directly because it depends on prices determined at equilibrium. We
can impute the relative prices using cost shares for labor, capital labor ratios, and
relative wages, and then compute energy intensity for the Soviet and service sectors:​
a​2E​ = 37.84 and ​a​3E​ = 47.51. Since more than 90 percent of energy was imported
from the USSR, we assume that in the pre-Soviet-collapse period no energy was
imported from other countries. The disutility weights on labor χ are set to match the
sectoral share of employment (i.e., ​L​j​/L) in each sector.
These parameters pin down the ratios of macroeconomic variables relative to total
output and the allocation of factors across sectors (see Table 1). The model captures
the ratios of aggregate consumption, investment, and exports to output. At the sectoral
level, parameters are chosen to match consumption, labor, and energy allocations.
The model slightly overstates the size of the non-Soviet sector relative to the
size of the service sector.
The final parameter to be calibrated is the extent of wage rigidity, which affects
the transition dynamics, but not the steady-state allocations. As we have discussed
above, wages in Finland are downwardly rigid and wage adjustment in the early
1990s was very slow. Indeed, we do not observe large movements in real or nominal
wages in Finland over the 1990s. In light of these facts, we set ​θ​ j​ = 0.96, which is
just a notch higher than θ = 0.95 calibrated in Shimer (2010) for the United States.
This calibration is consistent with a variety of facts. For example, between 1991
and 1998, output and wages fell by 17.8 and 6.5 percent below trend, respectively.
If we exclude the recession of 1991–1993, employment and the labor force grew at
about one percent per year. Assuming that the economy was on the balanced growth
path before the start of the recession and after 1997, wages must have decreased by
17.8 percent − (7 years × 1 percent/year) = 10.8 percent to get on the balanced
growth path. Wages closed only 60 percent of the required fall (6.5/10.8 ≈ 0.60)
after 7 years. Hence, the implied speed of adjustment θ at the quarterly frequency
should be about 0.96–0.97. We also report results for alternative values of θ.
C. Simulating the Effects of the Soviet Shocks: Benchmark Results
We now use the calibrated version of our model to show that the shocks caused
by the loss of Soviet trade can result in a significant reduction of output, similar to
the decline observed in the data. We model these shocks as a once-and-for-all unanticipated
event at t = 0 in a deterministic environment. As we explained above, this
event produced two shocks for Finland. First, Finland lost one of its major export
markets. Because of the specialized nature of trade with the USSR, Finnish firms
could not redirect trade to other countries easily. We model this shock as a permanent
drop in Soviet oil imports ​M​ t​ S
​to zero for all t > 0, which implies that exports to
the USSR ​X​2t​also vanish for all t > 0. The second shock was the end of the Soviet
Union’s provision of subsidized energy for Finland. Evidence in Section II suggests
that this subsidy was at least ten percent of the world oil price. Thus, we assume
that the second shock was equivalent to an increase in the oil price from ​p​E
​ = 1 to​
p​E
​ = 1.1 for all t > 0. We hit our model economy with these shocks as of the initial
1631Gorodnichenko et al.: the finnish great depressionVOL. 102 NO. 4
date t = 0 and compute the transitional dynamics leading to the new post-Sovietcollapse
stationary equilibrium.12
Figure 2 plots actual and simulated responses for key macroeconomic variables
measured as percent deviations from the precollapse steady state.13
The baseline model
comes close to capturing the depth of the output drop: the peak-to-trough decline in
output is 17.2 percent in the model and 21 percent in the data. The model produces a
more sudden drop in output than observed in the data—the trough is reached in 1991
in the model versus 1993 in the data—and output in the model also recovers more
quickly. Seven years after the shock, output in the model settles at roughly 10 percent
below trend, while output in the data remains depressed at 20 percent below trend. A
similar result emerges for the dynamics of consumption and employment. The simulated
series both decline by about as much as in the data (about 20 percent below
trend), but both reach their troughs a year earlier than in the data. Similarly, after
seven years, both settle at a level that is below trend, but not as far below trend as the
actual data. Note that with very rigid wages (​θ​j​ = 0.99975), the model can generate
large, persistent declines in output, consumption, and employment similar to what is
observed in the data seven years after the shock.14
The model predicts a 26 percent decline in investment over 1991–1993 and a
recovery to about 12 percent below trend. The actual collapse in investment was more
severe in both the short and the long run. In the model, the recovery of ­investment
reflects the fact that given our functional form assumptions and calibrated parameter
12 
Following Mendoza and Tesar (1998), we address the dependency on initial conditions of the steady state
of net foreign assets by combining a shooting algorithm with log-linear approximations around the post-Sovietcollapse
steady state. We set the initial condition Bt = 0 because, in the Finnish national income and product
accounts, the 1980–1990 average net exports (or current account) to GDP ratio was close to zero.
13 
Model series are aggregated from quarterly frequency to annual frequency to compare with the dynamics in
the data.
14 
In our model, all prices (except real wages) are entirely flexible since our objective is to use the standard
international real business cycle framework. One can expect, however, that introducing sticky prices in the model
could reduce the degree of real wage stickiness required to generate persistent and large contraction as well as
comovement across sectors. Given that in our model prices are flexible, one can interpret our results as providing a
lower bound on how much the collapse of the trade shock can explain the depression. We thank one of the referees
for this observation.
Table 1—Descriptive Statistics for Soviet, Non-Soviet, and Service Sectors
Soviet sector Non-Soviet sector Service sector
Data Model Data Model Data Model
Panel A. Sectoral statistics
Labor cost share 0.630 0.630 0.570 0.570 0.630 0.630
Share of employment 0.055 0.065 0.233 0.259 0.712 0.676
Share of value added 0.056 0.083 0.269 0.456 0.675 0.507
Share of exports in total exports 0.175 0.151 0.815 0.849 — —
Ratio of energy cost to value added 0.049 0.029 0.052 0.049 0.035 0.025
Panel B. Aggregate statistics
Consumption to value-added ratio 0.705 0.719
Investment to value-added ratio 0.295 0.281
Export to value-added ratio 0.211 0.228
Energy cost to value-added ratio 0.042 0.034
Notes: The table reports moments of the data for sectors constructed as described in online Appendixes A and B.
Ratio of energy cost to value added computes the ratio of the cost of imported energy to value added in a given
industry. We use the input-output table for 1989 to allocate of the cost of imported energy across sectors.
1632 THE AMERICAN ECONOMIC REVIEW june 2012
values, the capital-to-output ratio (and hence the investment-to-output ratio) is fairly
insensitive to changes in the price of energy, relative prices, and wages.15
Hence, the
postshock steady-state level of aggregate investment is fairly invariant to the Soviet
shock. If utilization of capital required energy (as in e.g. Finn 2000), the relative
price of capital would be higher in the post-Soviet-collapse period and the decline
in investment larger and more persistent.
The model also captures well some of the features of the adjustment of net exports.
The ratio of net exports to gross output rises by about five percentage points shortly
after shocks hit the model economy, but this is a transitory surplus. The data show a
surplus of similar magnitude, but it builds up more gradually and is more persistent
than in the model.
15 
Specifically, in the steady state ​K​j​/​Q​j​ = [(1 − ​α​Lj​)β(1 − ​p​E
​/(​a​jE​​p​j​))]/(1 − β(1 − δ)), which follows from
the first-order condition for capital in sector j. Since ​a​jE​is relatively large, one needs large variation in ​p​E
​and ​p​j​to
change capital to output ratio significantly.
1989 1990 1991 1992 1993 1994 1995 1996 1997
−30
−20
−10
0
10
Value added
1989 1990 1991 1992 1993 1994 1995 1996 1997
−30
−20
−10
0
10
Employment
1989 1990 1991 1992 1993 1994 1995 1996 1997
−100
−80
−60
−40
−20
0
20
Investment
1989 1990 1991 1992 1993 1994 1995 1996 1997
−40
−30
−20
−10
0
10
Consumption
1989 1990 1991 1992 1993 1994 1995 1996 1997
−15
−10
−5
0
5
Wage
1989 1990 1991 1992 1993 1994 1995 1996 1997
−5
0
5
10
15
Net export/Total sales
90% confidence interval
Data
Baseline model
Fully flexible wage
Fully rigid wages
Adjustment costs included
Baseline + interest rate shock
Figure 2. Macroeconomic Aggregates: Data versus Simulated Responses, Percent Deviations from Trend
Notes: The figures plot percent deviations from trend in the data and simulated model series. Scenario “fully flexible
wages” sets θ1 = θ2 = θ3 = 0. Scenario “fully rigid wages” sets θ1 = θ2 = θ3 = 0.99975. Scenario “adjustment
costs included” presents the response of the economy when, in addition to capital adjustment costs, the following
is included: habit formation in consumption (h = 0.8), quadratic investment adjustment costs (ψ = 0.5), quadratic
labor adjustment costs (λ = 1) and wage adjustment is set to θ1 = θ2 = θ3 = 0.98. See online Appendix C for more
details on specification of these frictions. Scenario “baseline + interest rate shock” presents the response when the
model economy (with all adjustment costs included) is hit with the Soviet shock in 1991:I and two percent interest
rate shocks in 1991:IV and 1992:II. The shaded region shows 90 percent confidence interval (consistent with unit
root tests, each series is assumed to be a difference stationary process).
1633Gorodnichenko et al.: the finnish great depressionVOL. 102 NO. 4
Table 2 compares the model’s predictions for the output drop under different
scenarios. Each cell of the table shows the maximum output drop as well as the
output decline seven years after the initial shock. Reading down each column,
the table shows the results for different parameter values relative to the benchmark:
increasing the markup on Finnish exports to the USSR from 10 to 30 percent,
increasing the rigidity of wages, and adding other frictions to the model
(habit formation in consumption and quadratic labor and investment adjustment
costs; see online Appendix C for more details on specification of these frictions).
Reading across the table, each column shows i) the decomposition of output
contraction into contractions in main spending components (columns 2 through
4); and ii) the predictions for output resulting from different shocks to the model
economy. Column 5 shows the output drop when the shock is the loss of trade
but the energy subsidy is not removed. Column 6 performs the opposite experiment—the
only shock is a spike in the price of oil, with no loss in Soviet trade.
Column 7 examines the drop in output when the shock is assumed to have no
effect on the demand for services. Finally, column 8 shows the results in an economy
with fully flexible wages.
Beginning with the third row, we find that a higher markup on Finnish exports to
the USSR (effectively a bigger shock to the price of oil) deepens the output drop in
both the short and the long run. Imposing more rigid wages (fourth row) relative to
Table 2—Contraction of Output: Data versus Simulated Paths
Contributions of spending
components to output drop
Contribution of
shocks to output drop
Alternative
scenarios
Total Consumption Investment
Net
export
Loss
of trade
shock
only
Oil
price
shock
only
Hold
service
sector
fixed
No
wage
rigidity
(1) (2) (3) (4) (5) (6) (7) (8)
Data
  Output drop (peak to trough) −20.6 −11.2 −13.6 4.2
  Output drop after 7 years −17.0 −13.3 −8.3 4.6
Model
 Baseline
  Output drop (peak to trough) −17.2 −14.7 −5.5 3.1 −14.5 −2.7 −6.4 −8.3
   Output drop after 7 years −8.9 −6.1 −2.2 −0.6 −7.2 −1.7 −4.6 −7.9
  Higher markup, 30%
  Output drop (peak to trough) −22.8 −20.0 −7.5 4.7 −14.5 −8.3 −10.0 −11.8
   Output drop after 7 years −12.2 −8.9 −3.3 0.0 −7.2 −5.0 −8.3 −11.0
  More rigid wages, θ = 0.99
  Output drop (peak to trough) −20.5 −18.1 −7.2 4.6 −17.2 −3.3 −6.9 −8.3
   Output drop after 7 years −13.4 −10.0 −3.6 0.2 −11.0 −2.4 −6.0 −7.9
  All adjustment costs included
  Output drop (peak to trough) −17.0 −11.9 −6.5 1.4 −14.5 −2.5 −6.4 −8.2
   Output drop after 7 years −10.8 −8.6 −2.5 0.3 −9.0 −1.8 −5.2 −7.9
  Additional interest rate shock
  Output drop (peak to trough) −21.1 −13.9 −12.5 5.2 −18.5 −2.6 −9.2 −9.8
   Output drop after 7 years −12.4 −8.9 −2.8 −0.8 −10.5 −1.9 −8.1 −8.2
Notes: “Loss of trade shock only” scenario assumes that the price of oil is the same before and after the collapse of
the USSR. “Oil price shock only” scenario assumes that the volume of trade with the USSR does not change but
the price of oil increases. “Hold service sector fixed” scenario assumes that the service sector is fixed at precollapse
levels and does not respond to shocks. “No wage rigidity” scenario assumes that ​θ​ j​ = 0 for all j. The case “Higher
markup, 30%” sets the size of the oil price increase equal to 30 percent. The case “All adjustment costs included”
augments the baseline model with internal habit formation, quadratic labor, and investment adjustment costs (see
online Appendix C for more details on specification of these frictions). The case “Additional interest rate shock”
presents the response when the model economy (with all adjustment costs included) is hit with the Soviet shock in
1991:I and two percent interest rate shocks in 1991:IV and 1992:II.
1634 THE AMERICAN ECONOMIC REVIEW june 2012
the benchmark (second row) similarly produces a larger drop in both the short and
the long run. Adding further frictions to the model economy (the second to the last
row of the table) has minimal impact on the depth of the output drop, but slows the
recovery of output after the shock.
A comparison of columns 5 and 6 can be interpreted as a decomposition of the
Soviet trade shocks into the effects induced by the reallocation of factors away from
the Soviet goods industry and the effects of the loss of the energy subsidy. It is clear
that factor reallocation costs account for most of the drop in output. The bigger the
markup, however, the bigger the preshock subsidy to energy, and the more severe
the economic contraction when the subsidy is removed.
The results in column 7 illustrate the pivotal role played by the service (nontraded)
sector. When all goods are tradable, the collapse of Soviet trade puts pressure on factors
to shift from the Soviet to non-Soviet sector. This happens for two reasons: first,
because the relative price of the Soviet goods falls, and second, all of Finland’s energy
needs now have to be financed by exports of the non-Soviet good. Sector 2 contracts,
sector 1 expands, and aggregate output drops by 5 to 6 percent. A higher markup on
exports and more rigid wages contribute to the output drop, but the two-sector model
(i.e., when the service sector is held fixed) cannot come close to the data.
Another critical ingredient for generating a deep contraction is wage stickiness.
With flexible wages, the maximum contraction is less than half of that in the baseline
model (compare columns 1 and 8). It is the combination of imperfectly flexible wages
and a collapse in the demand for nontradables, however, that leads to a large amplification
of the Soviet trade shock. In effect, the nontraded goods sector is struck by two
negative shocks. First, the increase in the price of energy increases the cost of production.
Second, the income effect from the collapse of Soviet trade reduces the demand
for nontraded goods. These two effects together lead to a decline in the relative price
of nontraded goods and output. Both of these negative shocks are larger the more rigid
are wages because more rigid wages force firms to cut employment rather than adjust
the wage, the price of nontradables falls more, and the income effect is larger.
Figure 3 provides suggestive evidence that these sectoral dynamics were an
important part of the Finnish depression. Consistent with the data, the benchmark
model predicts a large contraction of output in the services sector (especially
with rigid wages). Likewise, the model predicts a 9.5 percent fall in the relative
price of the nontradables (the benchmark case), which is close to the 13 percent
decline in the data. The model does not, however, capture the full decline in the
non-Soviet sector.
In summary, there are two key determinants of a deep contraction: wage stickiness
and dynamics in the service sector. To the extent our results depend on adjustment
of real wages being sufficiently slow, which is supported by the evidence presented
in Section II, our findings echo the results in Cole and Ohanian (2004). Since habit
formation and labor/investment adjustment costs improve the fit of the model, our
subsequent analysis incorporates these additional frictions.
D. 1974 Oil Price Shock
A useful cross-check on the performance of the model in explaining the recession
in the 1990s is to ask how well this framework can reproduce dynamics in
1635Gorodnichenko et al.: the finnish great depressionVOL. 102 NO. 4
response to previous episodes of energy price shocks. We examine in particular how
the model fares in accounting for the macroeconomic dynamics in Finland after the
1974 oil price shock. Like the collapse of Soviet trade, this shock produced a large
increase in energy costs for Finland. Unlike the Soviet trade collapse, however, it
did not cause a major dislocation in Finland’s economic structure and sectoral factor
allocations. In particular, during this episode Finland continued to import subsidized
energy from the USSR in exchange for specialized exports. Thus, if in this 1974 oil
price shock experiment the model dynamics are still consistent with those observed
in the data, the conclusions derived in the previous subsection are more credible.
In this exercise, we keep the model calibrated as before. The only modification we
make is to energy intensity, which we set 25 percent higher than in the baseline calibration,
because the Finnish economy was more energy-intensive in the 1970s than
in the early 1990s.16
Since Finland was also less unionized in the early 1970s, we
also consider faster wage adjustment with ​θ​j​ = 0.9 for all j.
16 
The ratio of energy consumption (in millions of tonnes of oil equivalent) to GDP (in constant 2000 prices) in
1973 was 25 percent larger than the same ratio in 1989.
1989 1990 1991 1992 1993 1994 1995 1996 1997
−120
−100
−80
−60
−40
−20
0
Soviet sector
1989 1990 1991 1992 1993 1994 1995 1996 1997
−30
−25
−20
−15
−10
−5
0
5
10
Non-Soviet sector
1989 1990 1991 1992 1993 1994 1995 1996 1997
−30
−25
−20
−15
−10
−5
0
5
10
Service sector
90% confidence interval
Data
Baseline model
Fully flexible wage
Fully rigid wages
Adjustment costs included
Baseline + interest rate shock
Figure 3. Sectoral Dynamics: Data versus Simulated Responses of Value Added,
Percent Deviations from Trend
Notes: The figures plot percent deviations from trend in the data and simulated model series of value added in the
Soviet, non-Soviet, and service sectors. Scenario “fully flexible wages” sets θ1 = θ2 = θ3 = 0. Scenario “fully rigid
wages” sets θ1 = θ2 = θ3 = 0.99975. Scenario “adjustment costs included” presents the response of the economy
when, in addition to capital adjustment costs, the following is included: habit formation in consumption (h = 0.8),
quadratic investment adjustment costs (ψ = 0.5), quadratic labor adjustment costs (λ = 1), and wage adjustment
is set to θ1 = θ2 = θ3 = 0.98. See online Appendix C for more details on specification of these frictions.
Scenario “baseline + interest rate shock” presents the response when the model economy (with all adjustment
costs included) is hit with the Soviet shock in 1991:I and two percent interest rate shocks in 1991:IV and 1992:II.
The shaded region shows 90 percent confidence interval (consistent with unit root tests, each series is assumed to
be a difference stationary process).
1636 THE AMERICAN ECONOMIC REVIEW june 2012
Although most economies experienced the oil price shock early in 1974, the shock
to the Finnish economy was somewhat delayed because the oil price in the FinnishSoviet
trade was a moving average of the world price. Hence, we assume that the
shock to the world price occurs in the first quarter of 1974 and hits the Finnish
economy in the last quarter of 1974. To calibrate the size of the shock, we compute
the unit price of imported oil in 1973 and 1974 and find that the (log) change in the
price was 109 percent.
Figure 4 plots the model’s transitional dynamics in response to the oil price shock
and the dynamics of actual output, consumption, and investment. The model broadly
matches the response of the Finnish economy. The model also predicts that exports
to the USSR expanded in response to the oil price shock and output in the Soviet
sector expanded relative to output in the non-Soviet sector. These theoretical predictions
are consistent with anecdotal evidence (e.g., Sutela 2007) on sectoral dynamics
in Finland after the 1974 oil price shock.
IV.  Alternative Explanations of the Depression
A. Productivity and Tax Shocks
One theory of the Finnish Great Depression is the “tax and productivity” hypothesis
of Conesa, Kehoe, and Ruhl (2007), which argues that the depression was caused
1973 1974 1975 1976 1977 1978 1979 1980
−20
−15
−10
−5
0
5
Value added
1973 1974 1975 1976 1977 1978 1979 1980
−50
−40
−30
−20
−10
0
10
Investment
1973 1974 1975 1976 1977 1978 1979 1980
−15
−10
−5
0
Consumption
Data
Baseline model with all adj. costs, θ = 0.96
Baseline model with all adj. costs, θ = 0.90
Figure 4. Oil Price Shock in 1974, Percent Deviations from Trend
Notes: Solid line is the deviation of real GDP, real consumption, and real investment from the respective time trends
estimated on 1950–1973 data. Real GDP, real consumption, and real investment (in 2000 prices) series are taken
from Penn World Tables. The deviations are adjusted to be zero in 1973. The broken line and the solid line with circles
are the model impulse responses to 109 log points increase in the price of oil. Model parameters are calibrated
according to their baseline values. See text for further details.
1637Gorodnichenko et al.: the finnish great depressionVOL. 102 NO. 4
by adverse total factor productivity (TFP) and labor tax shocks. Note that, as argued
in Finn (2000), our oil price hike works like a technology shock since an increase in
the oil price reduces firms’ profit margins (provided there is a sufficiently small substitutability
of energy input). Although the effect of the oil price shock on measured
TFP is relatively small in our model, the trade shock leads to a significant decline
in measured TFP with dynamics that resemble the path of measured TFP in the
data (Figure 5, panel B). Intuitively, with sector-specific factors, changes in sectoral
demands drive a wedge in returns on inputs across sectors in the short run. In contrast,
the standard approach to TFP accounting assumes that returns are equalized
across sectors, which can overstate the contribution of inputs in relatively unproductive
sectors such as the Soviet sector in our model, and hence can show a decrease in
aggregate-measured TFP even when TFP at the sectoral level does not change. What
Conesa et al. interpret as a TFP shock could be partly capturing the energy price and
trade shocks in our model.
We can also reconcile Conesa et al.’s labor tax–like effects with our analysis by
interpreting those effects as taking the place of the wage rigidities in our model. In
an equilibrium without labor frictions, the wage received by workers is equal to their
reservation wage; i.e., ​w​jt​ = ​w​ jt​ D
​ . If wages are rigid, the reservation wage is not generally
equal to the wage actually received. Furthermore, in a downturn, workers are
willing to accept jobs at lower wages, but with inflexible wages there is a difference
between current market wages and the reservation wages, in particular ​w​jt​ > ​w​ jt​ D
​ .
Since firms stay on their labor demand curve, they cut employment. In light of these
arguments, we can reconcile decreased employment (as observed in the data) with
fully flexible wages (as assumed by Conesa, Kehoe, and Ruhl 2007), if we interpret
this situation as if there was a “labor tax” shock. In other words, one can interpret​
w​jt​ > ​w​ jt​ D
​as arising from a labor tax τ such that ​w​jt​ > (1 − τ)​w​jt​ = ​w​ jt​ D
​where the
after-tax wage is equal to the reservation wage.
While both labor tax hikes and wage rigidities can have similar theoretical
effects, we were unable to find actual evidence of significant changes in tax rates
in the Finnish press and legislation of the early 1990s. In addition, various measures
of the tax burden on labor earnings exhibit little variation over this period
(see Figure 5, panel A). If anything, marginal rates of the personal income tax
in Finland fell in the early 1990s. For example, the top bracket tax rate fell from
51 percent in 1988 to 43 percent in 1990 and further to 39 percent in 1991. By
contrast, we documented earlier strong evidence of labor rigidities, including wage
stickiness. Hence, the empirical evidence suggests that labor frictions may be
more relevant than tax shocks. Overall, we agree with the view of Conesa, Kehoe,
and Ruhl (2007) that productivity and wage-wedge movements are necessary to
explain the dynamics of macroeconomic aggregates. We interpret these movements
as symptoms rather than causes, however, and argue that the Soviet trade shock is
the fundamental force behind these movements.
B. Financial Shocks
Another competing explanation of the Finnish Great Depression is the “financial
view,” which attributes the depression to the major financial crisis experienced
in Finland in 1992. According to the financial view, financial liberalization during
1638 THE AMERICAN ECONOMIC REVIEW june 2012
the 1980s resulted in an overexpansion of credit, an overvalued stock market,
inflated real estate values, and a large stock of debt. A downturn in the economy
in the early 1990s due to the loss of the Soviet export market and a slowdown in
European growth triggered both a speculative attack on the currency and a credit
crunch. Clearly these factors played a role but they can also be interpreted as a
byproduct of the financial-sector effects of the Soviet trade shocks that first caused
a severe collapse of the real economy. Indeed, troubles in the Finnish financial sector
seem to have followed the collapse of the Soviet trade rather than preceded it.17
17 
Real domestic credit, which had increased at a steady pace since the late 1970s, began to fall in 1991:I and the
exchange rate experienced a first initial depreciation in 1991:IV, with a full currency collapse in 1992:IV. Real GDP
began contracting in the last quarter of 1990. In a comprehensive analysis of the banking crisis and credit crunch in
Finland, Vihriälä (1997) concludes that collapse of lending is better explained by a decline in firm and household
balance sheets and creditworthiness than by a contraction in supply of credit.
Figure 5. Alternative Theories
Notes: Panel A reports the tax burden on labor income. GDP pc means income equal to GDP per capita. Panel B
plots total factor productivity (TFP) measured according to standard growth accounting applied to aggregate series
in the data (taken from Conesa et al. 2007) and impulse responses of aggregate series in the model. The method is
described in Conesa et al. (2007). Data TFP series are normalized to zero in 1990. Panel C plots the path of nominal
interest rates (12 months) in the Finnish (HELIBOR) and German (FIBOR) interbank markets and the Finnish
consumer price index (CPI) inflation rate (year on year). Interest rates are monthly averages of daily rates. Panel D
reports percent deviations of output from time trend for Sweden and Finland. The trends are estimated separately
for each country on the 1975–1989 sample.
Sources: OECD (2010a, c); Peter, Buttrick, and Duncan (2010).
Panel A. Tax burden on labor income Panel B. Measured TFP in Finland, 1991–1997
Panel D. Sweden vs Finland, value added
Panel C. Interest rates and inflation,
monthly averages
0
10
20
30
40
50
60
1985 1986 1987 1988 1989 1990 1991 1992 1993 1994 1995 1996 1997
Year −8
−6
−4
−2
0
1989 1990 1991 1992 1993 1994 1995 1996 1997
Data
Model
0
5
10
15
Percentperyear
1990 1991 1992 1993 1994 1995 1996
German FIBOR, 12 months
Finnish HELIBOR, 12 months
Finnish CPI inflation, yoy
−20
−15
−10
−5
0
5
Percentdeviationfromtrend
1985 1986 1987 1988 1989 1990 1991 1992 1993 1994 1995 1996 1997
Sweden
Finland
PIT: Marg. tax rate @ GDP pc PIT: Avg. tax rate @ GDP pc
PIT: Top rate Labor tax revenue/labor compensation
▵
▵ ▵ ▵
▵
▵
▵
▵
▵
▵ ▵ ▵ ▵
1639Gorodnichenko et al.: the finnish great depressionVOL. 102 NO. 4
This interpretation of the ­financial sector as “following” the real economy can be
rationalized if we assume that financial variables responded to real developments
as in a classic cash-in-advance setup. Hence, the severe retrenchment in consumption
and investment expenditures due only to the Soviet trade collapse could have
caused a proportional collapse in demand for real balances, which, under a managed
exchange rate and a set level of foreign reserves, could have been large enough to
trigger a currency crash.18
If we consider also the possibility of financial amplification
via a working-capital or a financial accelerator channel, these developments
could have fed back into the real economy and enlarged the magnitude and duration
of the recession.
We can gather a sense of the extent to which a credit crunch can explain the
depression by introducing into our framework an exogenous, persistent increase in
the world interest rate that arrives as a large, unexpected shock. This is similar to
the approach followed in some of the literature using quantitative dynamic stochastic
general equilibrium models to examine the dynamics of financial crises (e.g.,
Gertler, Gilchrist, and Natalucci 2007). We focus, however, mainly on the effect of
interest rate shocks operating via the opportunity cost of capital and the intertemporal
cost of borrowing, abstracting from financial accelerator or Fisherian debtdeflation
mechanisms that the financial crises literature emphasizes.
Panel C in Figure 5 shows the path of the nominal interest rates in Finland
(HELIBOR) and Germany (FIBOR) as well as the Finnish CPI inflation rate. Note
that nominal and real interest rates in Finland were high well before the start of
the recession. These high rates were largely driven by increased interest rates in
Germany as the Bundesbank raised interest rates to fight inflationary expectations
fueled by the German reunification. The spread between the Finnish and German
interest rates, however, has two important spikes in 1991:IV and 1992:II. At these
times, the Bank of Finland raised the interest rate to defend the Finnish markka from
speculative attacks. These defensive measures increased quarterly averages of the
HELIBOR by about two percent.
We introduce the interest rate shock by assuming that, in addition to the Soviet
shock, the model economy is also hit with these two-percent increases in the world
interest rate in 1991:IV and 1992:II. The serial correlation of the interest rate shock
is set to 0.8, which is approximately the persistence of the interest rate in Finland.
Figure 2 contrasts the responses of the macroeconomic aggregates to the combination
of the Soviet and interest rate shock with the responses to only the Soviet
shock. The interest rate shock further amplifies the depth of the recession, which
helps the model to match the data. The effect of the interest rate shock is ­particularly
dramatic for investment, which falls by another 20 percent on the top of the 22 percent
drop in investment caused by the Soviet shock. This additional decrease in
investment helps the model to match the composition of the contraction in output.
18 
Our theoretical framework is formulated in terms of real variables and thus nominal devaluations are beyond
our model, but we can explore how an increase in the price of imported goods affects the dynamics of macroeconomic
aggregates. Specifically, we shock the price of the imported good (C4) by two devaluations: 12 percent in
1991:IV and 13 percent in 1992:IV (the timing and the magnitude of devaluations of the Finnish markka). Overall,
these shocks help to generate more prolonged deviations from trend (in part because shocks occur well after 1991:I,
when we hit the model economy with the Soviet trade shock) but our qualitative and largely quantitative results are
similar to the baseline set of results. More results are available upon request.
1640 THE AMERICAN ECONOMIC REVIEW june 2012
For example, decreases in consumption and investment contribute similar amounts
to the aggregate contraction of output, which is close to the contributions of consumption
and investment in the data. We conclude from these results that a credit
crunch indeed is a useful complement to our story, especially for matching the
dynamics of investment.
C. Sweden versus Finland
An alternative way to assess the importance of the collapse in the Soviet-Finnish
trade in accounting for the Finnish recession and to validate our baseline simulations
is to compare the output dynamics in Sweden and Finland. Both countries had
similar institutions (including regulated labor markets with high downward wage
rigidity; see Botero et al. 2004 and Dickens et al. 2007 for detailed comparisons)
and experienced a similar and almost simultaneous sequence of events (including
currency and financial crises) and policy responses in the late 1980s and early
1990s, with the only major difference being that Sweden had miniscule trade with
the USSR.19
We see Sweden as a counterfactual for what could have happened to
Finland if it did not trade so much with the USSR, and use this natural experiment
to evaluate the predictions from our model.
Panel D in Figure 5 plots the time series of percent deviations of output from time
trend for Finland and Sweden.At the trough of the recession the output drop in Finland
was about 21 percent from trend, while for Sweden it was 8 percent below trend. If
we take the difference as a measure of the contribution of the Soviet trade collapse to
the Finnish depression, then the magnitude of the contribution is broadly in line with
impulse responses in our model. Hence, the observed difference between output paths
in Sweden and Finland is consistent with our argument that the decline of the SovietFinnish
trade explains a significant fraction of the downturn in Finland.
V.  Extension to Transition Economies
There is ample evidence indicating that the trade and energy price shocks faced
by the TEs of Eastern Europe and the former Soviet Union were at least as severe
as those experienced by Finland. The practice of overpricing machines exported
from CMEA countries to the Soviet Union and underpricing raw materials (mainly
energy) exported from the Soviet Union to CMEA countries is well documented
(e.g., Marrese and Vanous 1983). Orlowski (1993), Krasnov and Brada (1997), and
others find the same pattern for intra-USSR trade. Rodrik (1994) and others document
that goods exported from CMEA countries to the USSR were tailored to Soviet
specifications and could be sold in the West only with large discounts. Finally, as
observed in Rodrik (1994), the sharp increase in unemployment rates across transition
countries is prima facie evidence that wages were inflexible. Given that the size
of distortions was greater in former CMEA countries than in Finland (e.g., greater
19 
Comparing the developments in Sweden and Finland between 1985 and 2000, Jonung, Kiander, and Vartia
(2009) observe that the two countries behaved as if they were “economic twins.” Jonung, Kiander, and Vartia (2009,
chapter 9) also discuss the connection between crises in Scandinavian countries in the early 1990s and Asian crises
in the late 1990s. Although there are some parallels with the Asian crises, the crisis in Finland is distinctive in having
an important trade shock.
1641Gorodnichenko et al.: the finnish great depressionVOL. 102 NO. 4
subsidy from USSR and greater specialization of trade with the USSR), one can
expect that standard macroeconomic factors can explain the bulk of downturn in
economic activity in transition countries even if wages in these countries were more
flexible than in Finland.20
In Gorodnichenko, Mendoza, and Tesar (2009), we replicate our quantitative analysis
for Poland and Hungary, which embody two different strategies of adjustment
in transition. Poland allowed a quick and deep adjustment of real wages, while in
Hungary real wages had gradual and modest adjustment. Given the Soviet trade shock,
our model can explain the bulk of the output contraction and the timing of the trough
for both economies. The magnitude of the decline in the model depends on the speed
of wage adjustment. In line with our model’s prediction that greater wage inflexibility
leads to deeper downturns, the model has a better fit to the data for Hungary when we
use a higher value of θ, which is consistent with the fact that Hungary had a slower
wage adjustment than Poland. Even for relatively flexible wages, the Soviet shock
accounts for at least 50 percent of the contraction in these countries.21
We also conjecture that misallocation of resources in the former Soviet Union
could have played an important role in the dramatic output decline in Russia and
other former Soviet republics in the early 1990s. Indeed, an enormous fraction of
the Soviet economy was militarized (15–20 percent of GNP according to various
estimates, e.g., Steinberg 1992) and had only limited ability to switch production
to nonmilitary goods. A tremendous shift in demand toward consumer goods meant
a gigantic transfer of resources, which was probably even more painful and costly
than in other countries in the socialist camp. In other words, the shock was internal
rather than external. In addition, many relatively energy-poor Soviet republics (e.g.,
Ukraine) had to buy oil and gas at higher prices that, when combined with the loss
of demand from other Soviet republics, resembles the shock experienced by other
Eastern European countries and Finland.
VI.  Concluding Remarks
We argue that the Finnish Great Depression can be explained to a large extent
by two exogenous shocks produced by the collapse of the Finnish-Soviet trade:
the surge in energy prices and the sudden redundancy of the Soviet-oriented manufacturing
industry. Since the identification of these shocks is particularly clear-cut,
this natural experiment clearly illustrates the behavior of a small open economy in
response to large exogenous shocks affecting energy costs and sectoral factor allocations.
We find that two important features of the Finnish economy contributed to
amplification of the initial shocks into a Great Depression: rigid real wages and the
collapse of demand for nontraded goods.
20 
Akerlof et al. (1991) also argue that high and inflexible real wages contributed to long and deep contraction in
East Germany after the German reunification.
21 
More generally, we find a strong negative relationship between real wages and employment in transition economies.
In other words, countries with smaller declines in real wages experienced a larger contraction of employment
between 1989 and 1995, which is consistent with our argument that incomplete adjustment of real wages could have
contributed to the depth of downturn in transition economies. See Gorodnichenko, Mendoza, and Tesar (2009) for
more details.
1642 THE AMERICAN ECONOMIC REVIEW june 2012
Our model can also be extended to account for the main features of the early 1990s
adjustment observed in Eastern European transition economies, which displayed output
dynamics and shocks to energy costs and sectoral factor allocation induced by the
collapse of trade with the USSR similar to those observed in Finland. This similarity
is particularly striking and calls for a reinterpretation of the sources of deep recessions
in transition economies since Finland, in contrast to transition economies, had a wellfunctioning
system of markets, courts, and other institutions. Although we cannot rule
out alternative explanations for contractions in transition economies, the quantitative
responses to the shocks triggered by the collapse of Soviet trade can account for a
large share of the contraction in transition countries and Finland. This important finding
suggests that alternative explanations such as institutional transformations could
have had a smaller effect than previously thought. The Finnish experience can also
shed new light on the post-WWII contractions after rapid changes in the composition
of aggregate demand (e.g., disarmament in the US after the Korean War).
The depression in Finland led to dramatic changes in the Finnish economy (e.g.,
increased export orientation, the rise of Nokia and the telecommunications industry,
a fall in unionization rates) and policy (e.g., adoption of inflation targeting, reduced
taxation, and more decentralized wage setting). Analyzing the effects of these
changes is beyond the scope of this paper. The depression of the 1990s, however, as
well as policy responses during the depression and its aftermath, have been highly
informative for policymakers and academics about how a country can turn around
after a deep contraction and how policy should be directed to prevent or minimize
the consequences of adverse shocks. Further analysis of the Finnish experience is a
fruitful avenue for future research.
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