The Dutch Economy Over the Last Decade

Niels C. Beier, Economics

At the beginning of the 2000s the Netherlands encountered economic problems. Growth dived, public finances deteriorated strongly, and unemployment rose, cf. Chart 1. The problems arose after a strong boom in the 1990s, culminating with an overheated economy. The Dutch economy has only recently seemed to be recovering. This article seeks to answer two questions: 1) Why did it go wrong? and 2) What are the lessons to be learnt?

The Dutch experience is relevant to Denmark in view of the similarities between the two economies. Before the establishment of the euro area, the Netherlands for many years pursued a successful fixed-exchange-rate policy. Both the Netherlands and Denmark are small economies with substantial external trade and large public sectors. In addition, both countries have implemented reforms on an ongoing basis, especially to strengthen the labour markets. In the 1990s " the Dutch model" was known as a particularly efficient means of creating stable growth and high employment, while also ensuring social coherence. Today, the Danish economy is known for the same characteristics.

One of the most important lessons relates to fiscal policy. Contrary to all intentions, the fiscal policy amplified the boom-bust cycle. As the economy peaked, tax cuts were implemented because revenues exceeded expectations. When the economy reversed, the general-government balance subsequently deteriorated strongly. The EU Treaty's 3-per-cent limit was exceeded, and fiscal policy had to be tightened during the downturn. The underlying strength of the economy and public finances had been incorrectly assessed. The additional revenue should have been allocated to debt reduction in order to preserve a certain room for manoeuvre during the economic downturn.

This article has a chronological structure. A review of the boom period in the 1990s is followed by a review of the bust period in the 2000s. Fiscal policy is then discussed in more detail before the current situation is outlined, followed by the conclusion.

BOOM IN THE SECOND HALF OF THE 1990S

The sustained upswing was not only attributable to favourable short-term economic conditions. The Netherlands also reaped the fruits of a long, arduous reform period from 1982 onwards during which economic policy was restructured.

The long reform period from 1982 – " the Dutch model"
At the beginning of the 1980s the Dutch economy, like a number of others, suffered a crisis. Unemployment soared, competitiveness was extremely poor, while public finances and the balance of payments were in the red. The crisis called for restructuring of economic policy.

The pivotal elements of the restructured policy were stability, reform and wage restraint. From 1983 stability was inter alia reflected in a strengthening of the fixed-exchange-rate regime vis-à-vis the Netherlands' largest trading partner, Germany. The regime proved to be highly credible and sustainable. Reforms were implemented to create a more flexible labour market and restore public finances. This was achieved by tightening labour-market and welfare schemes in order to strengthen the incentives to work. Another objective was to downsize the public sector. Both government expenditure and government revenue were to be reduced, the latter via tax cuts and reduction of business enterprises' social contributions. This also contributed to acceptance of the wage moderation that was initially agreed by the social partners in 1982.^[1] The trade unions on the one hand agreed to increased use of part-time employees and wage restraint, while the employers on the other hand agreed to reduce working hours.

It should be emphasised that the reforms continued in the following years, and in the 1990s. In general, they were widely accepted in society.

The results soon began to show. Employment and labour participation rose as the labour market became more flexible and competitiveness was restored, cf. Chart 2. At the same time unemployment fell, so this policy was soon referred to as " the Dutch model" – not least in the 1990s when high growth seemed to go hand in hand with low inflation and unemployment, cf. e.g. Chart 1.

Virtually all short-term economic indicators were expansionary in 1995-2000
After moderate wage development for several years, competitiveness peaked in the mid-1990s. This was reinforced by a weakening of first the D-mark and then the euro against the US dollar, and Dutch business enterprises gained market shares against a backdrop of generally strong external demand. The US economy in particular enjoyed golden years, and was the locomotive of global economic growth. In 1999-2000 the euro area saw a short-lived upswing, which further strengthened the external demand for Dutch products.

The overall strong export growth in 1995-2000, among other factors, triggered a favourable snowball effect whereby business enterprises invested and increased employment, which in turn impacted on consumer incomes, consumer confidence – and ultimately consumer demand.

Even though exports took a favourable course the marked growth in investments and private consumption were the main factors underlying the sustained upswing. Private consumption was stimulated by extraordinarily high wealth gains as well as employment growth and sound increases in real disposable incomes.

The housing marked boomed, cf. Chart 3. Over a period of 7 years house prices rose by 100 per cent. Besides higher incomes, this reflected more expansionary financial conditions and innovation in the mortgage financing market. In a European context this market is well-functioning. The market offers a variety of products, including opportunities for mortgage equity withdrawal. During the 1990s, the product range was expanded, and the calculation basis was adjusted. Up through the 1990s, the second income of the household was gradually taken into account to a higher degree than before when only the primary income was taken as the basis. The result was a higher mortgage calculation basis. Favourable fundamentals led to strong price increases, reaching 20 per cent in 1999. Homeowners exploited the rising free mortgageable values, and consumption growth far exceeded growth in disposable incomes in this period.

The stock market more than trebled from 1995 to 2000, cf. Chart 3. Households' financial wealth (including pension savings) increased from 181 per cent of GDP in 1995 to 225 per cent in 1999. In addition to the direct wealth effect, high yields meant that the pension companies
lowered the savers' pension contributions. This fuelled growth in disposable incomes and amplified the cycle.

The financial conditions were expansionary. In view of the fixed exchange rate vis-à-vis the D-mark, interest-rate levels in 1995-98 to a higher degree reflected the subdued economic development in Germany after the reunification boom. During the upswing in the euro area in 1999-2000 the ECB raised the interest rate. Due to the normal monetary-policy lag the full effect of this did not emerge until the cyclical downturn, cf. below, while the direct effect of increased European demand was immediate. In the light of the expansionary financial conditions it was important that fiscal policy did not stimulate the economy. Subsequently, however, it became clear that fiscal policy had not been sufficiently tight. Its role is described separately below.

All in all, the upswing in the 1990s was very strong and protracted since virtually all economic indicators were expansionary at the same time. Especially private consumption rose, influenced by extraordinary wealth gains. Consumer confidence and business confidence were both riding high, cf. Chart 4, and unemployment fell to a low level. The upswing became self-fuelling until inflation finally began to rise and the global economy reversed.

DOWNTURN IN THE 2000S

After the golden years, the 2000s saw overheating and a hard landing. Virtually all of the factors that had driven the economy in the good times now exerted the opposite effect at one and the same time. The principal effect was the strong deterioration in competitiveness. The tight labour market caused wage and price developments to accelerate in 2001-02, cf. Charts 5 and 6. This was reinforced by the dollar's general weakening – and the euro's strengthening – in the wake of the economic slowdown in the USA in 2001-02. The slowdown was a global phenomenon which, together with the deterioration in competitiveness, had an adverse impact on exports and corporate earnings.

At the same time, the global stock markets plummeted, and house prices in the Netherlands flattened out, cf. Chart 3. Thus, a considerable driver of growth in private consumption disappeared. Households' financial wealth shrank from 225 per cent of GDP in 1999 to 167 per cent of GDP in 2003. The drop was cushioned by the soft landing in the housing market, no doubt helped by the decline in interest rates in 2002-04.

As a result of the falling interest rates and equity prices, the Dutch pension companies suffered solvency problems. They had to raise contributions, which had an adverse impact on households' disposable incomes and exacerbated the downturn.^[2]

The end result was a strong braking of private consumption and a decline in corporate investments. Confidence dropped, unemployment rose, and a vicious circle was activated.

The high inflation in 2001-02 was primarily attributable to accelerating wages, but one-off effects also contributed. In 2001 the VAT rate was raised from 17½ per cent to 19 per cent. According to the Dutch central bank, De Nederlandsche Bank, this caused inflation to increase by approximately three quarters of a per cent. Furthermore, the changeover to the euro took place in 2002. Dutch business enterprises took advantage of the changeover to raise the prices of a number of goods and services. The effect on inflation was approximately 0.6 per cent.^[3] As shown in Chart 5, wage and price developments were already clearly on the increase before the turn of the year 2000-01. This corroborates the well-known phenomenon that an inflationary pressure will appear with a lag if demand becomes strong enough. It can take a long time to eliminate it, as demonstrated by the persistence of the downturn.

FISCAL POLICY AMPLIFIED THE BOOM-BUST CYCLE

Fiscal policy played an unfortunate role in the boom-bust cycle. The upturn and the downturn were both amplified. In overall terms two errors were committed during the upturn. Firstly, the strength of public finances was overestimated. Secondly, the automatic stabilisers were not allowed to work freely. Subsequently, the general-government balance reversed dramatically, cf. Chart 7. In 2003 the deficit exceeded the 3-per-cent limit, and considerable tightening measures were required in the throes of the downturn.^[4]

In principle, the fiscal framework was prudent and stability-oriented. It was based on 4-year agreements concluded by the Dutch government after parliamentary elections. Consolidation of public finances was the objective of the medium-term framework. There was a clear distinction between revenue and spending to avoid expenditure drift in the event of high tax revenue in good times. The means to achieve consolidation included spending control. The 4-year period was subject to a spending ceiling. Finally, the budget was based on " prudent" economic growth assumptions.

A correct estimate of the economy's cyclical position is essential when assessing public finances. This makes it possible to distinguish how much of the development is solely attributable to cyclical factors and how much is attributable to underlying structural factors.

During the boom the underlying strength of the economy was incorrectly estimated. For example, in 2000 the OECD estimated the output gap in that year at approximately 1.5 per cent. The current estimate is 4 per cent, cf. Chart 8.^[5] This is why the strength of the underlying public finances was overestimated. This was reinforced by a number of temporary windfalls as a result of the extraordinarily high asset-price increases. Therefore, the subsequent reversal from a surplus to a deficit caught the authorities by surprise, cf. Chart 7. The force of the reversal clearly indicates that most of the budget improvements in the 1990s were a result of the boom.

The insufficiently tight fiscal-policy stance during the boom was due to the embedded procyclical mechanisms. On the revenue side, revenue in excess of the budget could be allocated evenly for tax cuts and debt reduction – in practice, three quarters went to debt reduction. On the spending side, savings – e.g. on unemployment benefits owing to declining unemployment – were also distributed on new expenses. In retrospect, it is clear that the automatic stabilisers should have been allowed to work freely. This could have created more room for manoeuvre during the downturn. Instead, tax cuts added even more steam to an economy that was already moving at full steam ahead.^[6]

THE DUTCH ECONOMY IN 2006 – ON THE ROAD TO RECOVERY

There are indications that the economy is recovering. The government deficit has been reduced considerably, and the imbalances in the pension companies are almost eliminated. In 2004-05 exports and the business enterprises benefited from the global upswing without any significant effect on domestic demand. Market shares are still being lost. Wage development is moderate, and competitiveness seems to be slowly regaining lost ground. The labour market is gradually improving, and consumer confidence is now clearly on the increase. The foundation for a recovery in private consumption and the economy overall seems to be in place. According to the European Commission's latest estimate, GDP growth is expected to be 2.6 per cent in 2006.

Although the last decade has been characterised by a boom-bust cycle, the reform strategy of the last 25 years was pursued continuously. The fiscal framework has been adjusted so that in future additional revenue will be allocated solely to debt reduction. On the spending side the fiscal framework has also been tightened. In addition, a number of welfare schemes have been adjusted in recent years, including reform of the health sector. The measures in the pipeline for 2006 include reform of the unemployment benefit system and job security. As in many other countries the current adjustments are being made in the light of the population's ageing and the need to increase the supply of labour. The ongoing reforms have to a great extent been successful. This is illustrated by the fact that despite the hard landing, unemployment was never much higher than 5 per cent^[7] – a level far below the euro area average.

CONCLUSION – RELEVANT LESSONS FOR DENMARK

Even though the Netherlands' economic structures are flexible compared to other European countries, the country did not escape an economic downturn in the 2000s after the golden years. A good structural policy is necessary, but is not sufficient to achieve stable economic development.

The Danish economy has followed a stable course for many years, but the economy is now booming with very low and declining unemployment. In this situation it is natural to learn from the Dutch experience. That is why Danmarks Nationalbank has on several previous occasions also referred to the development in the Netherlands, cf. Andersen (2003), Bernstein (2005) and Danmarks Nationalbank (2005, 2006).

The erosion of competitiveness was one of the main factors underlying the downturn in the Dutch economy. The tightening of the labour market was ultimately reflected in the wage development. This effect, however, emerged with a considerable time lag so that it was too late to respond. In retrospect the low unemployment should have led to an even more intensive effort to tap available resources in the economy. At the height of the boom there was still a large population group in the Netherlands passively receiving benefits outside the labour market.^[8] Furthermore, annual working hours were and are among the lowest in the OECD. The Netherlands failed to respond sufficiently and timely, and competitiveness is only slowly being regained.

Wealth effects amplified the cycle. There were special Dutch circumstances relating to the pension sector, but it should be noted that the economy experienced a sustained downturn despite the soft landing in the housing market. The consumers were well consolidated at the height of the boom, but a large share of the wealth gains was attributable to equity price increases, so these gains disappeared when prices reversed.

A special characteristic of the Dutch economy in the period from 1995 onwards was that practically all economic factors exerted the same kind of effect at the same time, i.e. an expansive effect followed by a contractive effect. Naturally, this was an unfortunate combination, but such are the terms for a small, open economy. It will always be affected by external global events in the financial markets and in the real economy. On such terms it is pivotal to apply a prudent approach to the part of economic policy that can be influenced. When monetary policy is dedicated to a fixed-exchange-rate policy, or when the country participates in a monetary union, it is the role of fiscal and structural policy to ensure stable development.

Perhaps the most important lesson concerns fiscal policy: The automatic stabilisers must be allowed to work freely. In particular, a public surplus achieved during a boom must not be channelled into unfinanced tax cuts. This will only amplify the cycle and create problems later. The largest scope and the greatest stability are sustained by reducing public debt. This consolidation strategy is the exact aim of Denmark's current fiscal policy.^[9]

LITERATURE

Andersen, Bodil Nyboe, 2003, Speech at the Annual Meeting of the
Danish Bankers Association on 3 December.

Andersen, Torben M. and Michael Svarer, 2006, Flexicurity – the Danish labour-market model (in Swedish), Ekonomisk Debatt 1, pp. 17-29.

Bernstein, Nils, 2005, Speech at the Annual Meeting of the Danish Bankers Association on 30 November.

Danmarks Nationalbank, 2005, Recent Economic and Monetary Trends, Monetary Review, 4th Quarter, pp. 1-22.

Danmarks Nationalbank, 2006, The Danish Economy, Report and
Accounts 2005, March, pp. 16-28.

De Nederlandsche Bank, 2001, Annual Report.

De Nederlandsche Bank, 2002a, Quarterly Bulletin, September.

De Nederlandsche Bank, 2002b, Annual Report.

De Nederlandsche Bank, 2003, Annual Report.

De Nederlandsche Bank, 2004, Annual Report.

De Nederlandsche Bank, 2005, Annual Report.

Ministry of Finance, 2004, Unemployment and Employment Policy in the EU, Chapter 5 in Financial Report 2004 (in Danish), June.

IMF, 2001a, Staff report for the 2001 Article IV consultation.

IMF, 2001b, Netherlands: Selected issues.

IMF, 2002a, Staff report for the 2002 Article IV consultation.

IMF, 2002b, Netherlands: Selected issues.

IMF, 2003a, Staff report for the 2003 Article IV consultation.

IMF, 2003b, Netherlands: Selected issues.

IMF, 2004a, Staff report for the 2004 Article IV consultation.

IMF, 2004b, Netherlands: Selected issues.

IMF, 2005a, Staff report for the 2005 Article IV consultation.

IMF, 2005b, Netherlands: Selected issues.

OECD, 1996, Netherlands, OECD Economic Surveys.

OECD, 1998, Netherlands, OECD Economic Surveys.

OECD, 2000, Netherlands, OECD Economic Surveys.

OECD, 2002, Netherlands, OECD Economic Surveys.

OECD, 2004, Netherlands, OECD Economic Surveys.

OECD, 2006, Netherlands, OECD Economic Surveys.

van Ours, Jan C., 2003, Has the Dutch miracle come to an end? CESIFO Working Paper No. 917.

The Welfare Commission, 2005, The Labour Market, Chapter 3 in Welfare of the Future – practice in other countries (in Danish), Analyserapport, March, pp. 75-172.

Watson C. M., B.B. Bakker, J.K. Martijn and I. Halikias, 1999, The Netherlands. Transforming a market economy, IMF Occasional Paper 181.

Ministry of Economic and Business Affairs, 2006, Capacity Pressures in Construction (in Danish), Økonomisk Tema No. 3, March.