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The following OECD assessment and recommendations summarise chapter 1 of the Economic Survey of Denmark published on 5 November 2009.
Denmark is enduring a major recession
The Danish economy has not escaped the global financial and economic crisis. The deterioration in financial conditions and collapse of world trade, along with the ending of the property boom, have all hit Denmark hard, although GDP has not fallen as much as in some neighbouring countries. Unemployment is now on the rise, providing the first hard test of the “flexicurity” model, which to date has operated primarily in better times. With labour utilisation already high, though needing to improve further, the key here is boosting productivity, the Achilles heel of the Danish economy over the recent past. This will require maintaining the traditional strengths in the economy, described below, as well as pursuing an agenda focussed on productivity-enhancing reforms in education and the business sector.
Denmark has achieved high levels of income and low inequality
Growth in Danish living standards has been underpinned by flexible labour and product markets, a strong social safety net and active policies to help the unemployed back into work. These measures have promoted gains in labour utilisation that have driven economic growth. Following the deep downturn of the early 1990s, structural unemployment has fallen, and labour force participation and average hours worked have risen. The employment rate is now amongst the highest in the OECD, although average hours worked are still relatively low. However, while labour utilisation has been growing, productivity has slowed. As a result, national income per capita has lost ground vis-à-vis the leading OECD economies.
High living standards have been achieved alongside a very equitable distribution of income, both within and between generations. A high degree of social mobility, measured by the extent to which parents’ educational attainment influences that of their children, is supported by a generally sound education system. Ongoing focus on improving educational attainment and outcomes can help maintain equity as well as boost the contribution of human capital to productivity growth, the current weak link in the economy.
The financial sector has been under pressure and the real economy is feeling the effects
In the short term, the Danish economy is in the midst of a challenging period. Danish financial markets have been under severe pressure, although they are returning to greater normality. The unique mortgage bond market has continued to function and while it has experienced some stress it has been much less affected by the sub-prime crisis than mortgage bond markets elsewhere. Banks’ earnings have deteriorated and loan losses have surged. Some 18 smaller institutions have been taken over or wound up. Sharp falls in equity prices, along with the downturn in the housing market, have led to a substantial deterioration in household wealth, although the net wealth-to-income ratio remains fairly high in a longer-term perspective. Tightening lending standards coupled with weakening demand for credit have led to slower growth in lending by financial institutions. If the measures already implemented to improve solvency and confidence in the financial sector turn out to be insufficient, credit conditions might become even tighter and act as a brake on economic activity. Interest rates spiked late in 2008 but have retreated significantly since, in line with an easier monetary stance and improvement in financial markets.
Against this backdrop, the real economy is set to shrink in 2009 before recovering modestly in 2010. Private consumption will be restrained by diminished household wealth and rising unemployment, but supported by tax cuts, withdrawal of Special Pension scheme savings and lower interest rates. Business investment will be held back by the scale of economic slack. While the drop in interest rates since last autumn may help stem the fall in house prices, residential investment is on course to decline further, a process that could be compounded by rising forced sales due to higher unemployment. With Denmark’s export markets undergoing a major contraction, exports will be very weak. The recovery might also be slowed by the sizeable loss in competitiveness accumulated over the past few years due to strong wage growth and effective exchange rate appreciation. With the output gap widening considerably, inflationary pressure will diminish but unit labour costs and consumer prices may continue to rise more than in the euro area, further hurting competitiveness. Another risk relates to the mortgage debt taken on in recent years by some households, the burden of which might hold back consumption growth in the future.
Potential output may be durably affected
The depth of the recession is likely to have adverse medium-term consequences for the Danish economy. Higher actual unemployment could lead to higher structural unemployment for quite some time, although less so than in many other OECD countries due to low long-term unemployment and strong active labour market programmes. Also, the depth of the downturn in investment means that the contribution to GDP growth from additions to the capital stock will be lower than normal for a few years. Furthermore, there could be effects from reduced investment in R&D. Since growth in potential employment is expected to be weak due to a reduction in the working-age population, this means that the growth potential of the economy will be subdued for a number of years. Taking into account these various effects, potential output growth is expected to decline from 1.7% on average over 2006-08 to 0.5% in 2009-10 and 1.1% in 2011-17.
Financial sector policy measures have been effective
Financial sector policy measures to deal with the crisis have been extensive. A key measure was the creation of a bailout fund by the government and the Danish banking sector that serves to guarantee all claims of unsecured creditors on participating banks. Only if the total loss were to exceed DKK 35 billion would this guarantee entail government payments. The government also established a new process for dealing with institutions whose capital falls below statutory minimum levels and offered capital injections to boost capital-adequacy ratios. In addition, the central bank has taken a number of initiatives to improve financial system liquidity. These measures are likely to significantly reduce the risk of widespread insolvency even under scenarios of great stress. However, if used to their fullest extent, they imply that the government could end up as a significant owner of equity in some banks. Furthermore, the measures will probably only stem the slowdown in lending to some extent since demand for financing will be curtailed by the drop in investment and lower house prices while lending policies in any case becomes more cautious when growth prospects are weak. Detailed “bottom-up” stress tests, involving the financial institutions themselves, would help establish whether financial institutions are sufficiently capitalised to absorb the losses arising from impaired loans.
In the medium term, significant changes are likely to stem from international efforts to bolster financial system regulation. A specific issue for Denmark will be how to reduce the pro-cyclical capital requirements for the new type of mortgage bonds, which require extra capital when house prices are falling. The regulatory resources to supervise medium- and smaller-sized institutions have been increased and it will be important to ensure that they are adequate.
Fiscal policy is boosting disposable incomes and demand
Denmark entered the recession with a strong fiscal position and a sound fiscal policy framework. Large budget surpluses in recent years have reduced debt – indeed, the government had a positive net asset position of about 5% of GDP in 2008. Fiscal targets are set according to a medium-term framework based on fiscal sustainability assessments. Therefore, discretionary policy measures are likely to be credible in the eyes of financial markets. Danish automatic stabilisers are the largest in the OECD, implying a smaller need for discretionary policy measures. Nevertheless, given the depth of the recession, significant discretionary measures have been taken. Tax cuts, which were decided well before the crisis, took effect in 2009. Public consumption will increase quite sharply. Government investment spending has been brought forward. A major tax reform package was legislated in early 2009, aimed at raising labour supply and reducing the government financing gap in the long run but providing demand stimulus in the short run. And release of funds from the compulsory private Special Pension scheme has significantly eased households’ liquidity constraints. Signs of improvement in the economy and the substantial deterioration in the fiscal position already expected suggest that there is no need for additional fiscal stimulus, although with a highly uncertain environment it should not be completely ruled out. Looking ahead, discretionary measures will be required to bring the structural budget balance back in line with the government’s 2015 fiscal targets. Spelling out targets for the intervening years and identifying some specific consolidation measures would help.
The Danish economy has been hard hit by the global crisis
1. From same period of previous year.
2. For the United States, the unemployment rate is from the monthly Current Population Survey of persons aged 16 and over. For the euro area, it is derived from aggregating labour force data for individual countries. For Denmark, it is calculated using the Eurostat harmonised labour force survey level of unemployment and the level of employment from the national accounts.
3. Harmonised index of consumer prices for the euro area.
Source: OECD Analytical Database.
Labour market policies must adapt to weak demand, but still focus on boosting labour supply in the long term
With unemployment on the rise, the short-term focus of employment policies will need to be on maintaining job search efforts and keeping people attached to the labour market to prevent a rise in structural unemployment. With weak labour demand, unemployment spells will lengthen, so a larger proportion of the unemployed will end up participating in activation programmes. It is important that public sector job centres have sufficient resources to deal with the rise in unemployment. The decentralisation of all functions of the public sector job centres to local governments should be carefully monitored to ensure that effective services are delivered to an increasing pool of clients. At the same time, there is less risk of unemployed people missing out on a job because they reduce search effort due to the time commitments of participating in activation programmes. This calls for careful targeting of training programmes and job placements to steer the unemployed to those programmes that are most likely to be effective.
For the longer term, the recommendations of the Labour Market Commission will be more important now than ever – if structural unemployment rises in response to the crisis, the government’s long-term goals for fiscal sustainability will be even more difficult to achieve. As unemployment rises, it will be important to avoid policies that restrain labour supply, such as job-sharing measures that may be hard to reverse once labour demand picks up again.
How to obtain this publication
The complete edition of the Economic Survey of Denmark is available from:
The Policy Brief (pdf format) can be downloaded in English. It contains the OECD assessment and recommendations.
For further information please contact the Denmark Desk at the OECD Economics Department at email@example.com.
The OECD Secretariat's report was prepared by Stéphanie Jamet, Peter Welz and Niels-Jakob Harbo Hansen under the supervision of Vincent Koen. Research assistance was provided by Lutécia Daniel.