Follow the Model

And this is after I depreciated

Who wouldn’t like to adopt a Swedish model? ( I would.) They seem to do all the right things to look appetising, to be just the thing you’d like to call your own. And now the Swedish model is more coveted than ever. Everyone wants to bring it home.

We are of course talking about the Swedish economic model. What on earth did you think? After a bruising financial breakdown in the early 1990s, its national pride somewhat battered, Sweden sat down to develop a model that would make sure that such a debacle could not recur. Boy, did it succeed. Not only the current crisis passed it by; it has been growing at an enviable clip, with a balanced budget, low interest rates and negligible inflation. No wonder everyone seems to be gazing northwards nowadays.

How did they do it? And, most crucially, can the model be replicated by the Eurozone’s crisis-stricken countries? The European Economic Advisory Group at CESifo (EEAG) took a close look at the Swedish wonder and published its findings in its latest EEAG Report on the European Economy. They distilled the following lessons:

• A deep fiscal crisis can create a consensus on fiscal discipline

Sweden had its Greece-moment in 1991-1993. Its GDP plummeted for three consecutive years, its fiscal deficit climbed to 11 per cent of GDP by 1993, and government gross debt rose from 41 per cent of GDP in 1990 to 73 per cent in 1996. The fright was enough to goad politicians into forging a broad consensus that Sweden should never again end up in a similar situation.

With Viking steeliness, they adopted a tough, unconditional fiscal consolidation programme: the path to fiscal virtue would take no heed of macroeconomic developments. And it worked: by 2000 it could show a fiscal surplus of 3.6 per cent of GDP. Iron budget discipline reduced government debt to below the pre-crisis level, boasting merely 37 per cent of GDP in 2011. As a result, Sweden’s long-term government bond interest rates are even now lower than those for Germany’s.

What makes these developments remarkable is that they did not budge in the face of minority or coalition governments, strong political polarisation regarding the size of the public sector, and high employment as a political priority, all factors that tend to increase not reduce deficits.

• Comprehensive fiscal reforms increase the chances of success

Lest the consensus should crack, its budget-discipline principles have been translated into a strict, comprehensive fiscal framework based on five pillars:

1. A top-down budget process. Once overall government expenditure and its allocation between 27 areas are determined, decisions are taken on individual expenditure items in such a way that one type of expenditure cannot be raised unless another type of expenditure in the same area is correspondingly reduced.
2. A fiscal surplus target of one per cent of GDP but over a business cycle, not a single year. This is crucial to preserve flexibility for fiscal policy as a stabilisation tool.
3. A ceiling for central government expenditure set three years in advance.
4. A balanced budget requirement for local governments.
5. A reform of the pension system to define contributions, not benefits, in order to guarantee its long-term sustainability.

• Fiscal transparency may be more important than formal enforcement

Unlike the Swiss and German debt brakes and to what is envisaged in the European compact, the Swedish system does not include automatic correction mechanisms in the case of breaches: there are no formal enforcement or sanction procedures. Yet, remarkably, the rules have on the whole been respected. What’s the trick? Apparently, the reliance on a high degree of fiscal transparency raises the reputation costs for the government of deviating from its targets. Sweden is well-known for its high scores in transparency.

Furthermore, the attainment of the fiscal targets is continuously monitored. In order to make sure that the budget surplus target can be met, before the work on setting the budget starts, the Ministry of Finance must provide an evaluation of the scope for reforms, ie the sum of discretionary tax cuts and government expenditure increases that the government can adopt and that are consistent with meeting the surplus target. Astonishingly (when thinking of the epic budget battles in the US), even the opposition parties have accepted this calculation in recent years.

But, as someone said, trust is good but control is better. A number of government agencies, acting with a high degree of independence, regularly peruse the budget and the underlying forecasts and analyses. Among them is the Fiscal Policy Council, established in 2007 to provide further scrutiny. Its independence is considered paramount: the council itself proposes its members to the government. It monitors the sustainability of the public finances, the adherence to the surplus target and to the expenditure ceiling as well as fiscal policy’s cyclical stance.

• Output growth is crucial

Sweden combined its fiscal consolidation in the 1990s with high output growth, aided by a large real exchange rate depreciation: in 1991-1993 relative unit labour costs fell by 20 per cent. Due mainly to a depreciation of the nominal exchange rate, its result was a boost to net exports. The ensuing stimulus effects allowed aggregate demand to grow in 1994-2000 despite the fiscal consolidation. In fact, the depreciation greatly facilitated fiscal consolidation.

A number of growth-enhancing reforms contributed as well, such as a comprehensive tax reform in 1991, product-market deregulations in the first half of the 1990s, and reforms of the wage bargaining system in the late 1990s. The results were palpable: the average annual GDP growth rate in 1995-2011 the was 0.8 percentage points higher than the 1970-1994 average.

Higher long-term growth, in turn, helped to reduce the government debt-to-GDP ratio by about 10 percentage points and provided more ample room for tax cuts and expenditure increases without deteriorating the fiscal balance.

What can the rest of the Eurozone and the rest of the EU learn from Sweden’s experience? First, that a deep fiscal crisis can, and should, forge a political consensus on the need for budget discipline and trigger comprehensive reforms of the fiscal framework. Second, transparency and a high-quality policy debate may be more important for fiscal discipline than the German-type binding rules, debt brakes and automatic correction mechanisms that the Eurozone is now keen on introducing. Less heartening, however, is Sweden’s lesson that swift real exchange rate depreciation facilitates fiscal consolidation enormously. In its absence, the consolidation process will be long and painful, and fiscal retrenchment is bound to hurt growth. With the common currency, the Eurozone’s countries in distress have no instrument for a fast real exchange rate depreciation. The only way is to deflate. And that hurts.

• 2012 EEAG Report on the European Economy
• The Swedish Model chapter of the EEAG Report (download, 1.7MB)
• CESifo Working Papers published in the past three months