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The Sweden Myth

Mises Daily: Monday, August 07, 2006 by

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Recently, the so-called Swedish model — that is, the Swedish economic system with high taxes and a big welfare state — has been celebrated again in the press.

The alleged recent success of the Swedish economy has allowed welfare statists both inside and outside of Sweden to argue that high taxes and an extensive welfare state are good for the economy. To fully understand this fallacy, we should review Sweden's economic history.

Until the second half of the 19th century, Sweden was fairly poor. But far-reaching free market reforms in the 1860s allowed Sweden to benefit from the spreading Industrial Revolution.

And so, during the late 19th and early 20th centuries, Sweden saw its economy rapidly industrializing, driven by the many Swedish inventors and entrepreneurs.

During that time, Sweden produced extraordinarily many inventions, given its small population, including: dynamite, invented by Alfred Nobel (who established the Nobel Prize); the self-aligning ball bearing, invented by Sven Wingquist (who used this to create the SKF company); the sun-valve, invented by Gustav Dahlén (who used it to found industrial gas company AGA); the gas absorption refrigerator, invented by Baltzar von Platen (which was later used by Electrolux).

In addition, there were countless non-inventing entrepreneurs during that period: car manufacturers Volvo and Saab, and telecommunications company Ericsson. Indeed, with just a few exceptions, nearly all large Swedish companies were started during the late 19th and early 20th centuries, which was not only a period of strong growth, but also the time when the foundation for later economic growth was laid.

Another factor which continued Swedish prosperity was the fact that Sweden was able to stay out of both World Wars, and indeed all other wars as well. Sweden is in fact the country with the longest consecutive period of peace, having fought no war since 1809, when Sweden was invaded by Russia, losing Finland to the invader.

Sweden has thus enjoyed 5 more years of peace than Switzerland, which participated in the Napoleonic wars in 1814. As a result of its free market policies, the resourcefulness of its people, and its successful avoidance of war, Sweden had the highest per-capita income growth in the world between 1870 and 1950, by which time Sweden had become one of the world's richest countries, behind only the United States and Switzerland, and Denmark (who have since also fallen behind because of high taxes).

But the foundation for future trouble had already been created. In 1932, the Social Democrats rose to power in the face of the Great Depression. And like FDR in America and Adolf Hitler in Germany, they started to expand government power over the economy. Until 1932, government spending had been kept below 10% of GDP in Sweden, but the Social Democrats, under their leader Per Albin Hansson, wanted to change this and remake Sweden into a "folkhem" ("people's home"), a term Swedish Social Democrats adopted from the Fascists in Italy.

Even in the early 1950s, Sweden was still one of the freest economies in the world, and government spending relative to GDP was in fact below the American level.

But between 1950 and 1976, Sweden experienced an expansion in government spending unprecedented during a period of peace, with government spending to GDP rising from about 20% in 1950 to more than 50% in 1975. Virtually every year, taxes were increased while the welfare state expanded relentlessly, both in the form of a sharp increase in the number of government employees and ever more transfer payment benefits.

During the first 20 years, this relentless government expansion took place seemingly without ill effect, as Sweden benefited from rapid global growth — although Sweden's growth had already started to slip in relative terms, from well above average to just average. This changed in the 1970s after Olof Palme, from the left wing of the Social Democratic party became Prime Minister. Palme stepped up the socialist transformation in Sweden, rapidly increasing anti-business regulations and sharply increased payroll taxes.

The payroll-tax increases, along with increasing wage demands from unions, made Swedish businesses highly uncompetitive on the global markets, something which Palme decided to solve by devaluing the Swedish krona. As a result, price inflation rose sharply, leading to repeated devaluations. Popular discontent from the economic woes created by the global economic downturn, the massive tax increases, the increased regulations, and the increasing inflation enabled the center right to come into power in 1976, breaking 44 years of uninterrupted Social Democratic rule.

But because the center-right parties were unwilling to push for more radical free-market reforms, the economic woes, including the inflation-devaluation cycle, continued. For this reason, and because the three coalition parties — the conservative Moderate Party, the Liberal Party, and the Center Party — were unable to get along, the Social Democrats returned to power in 1982.

They immediately implemented one "big bang" devaluation of 16%, which they claimed would be the last. They had claimed the same thing before all the previous devaluations, including the 10% devaluation that the center-right government had decided upon the year before. This time it appears that they actually meant it, but as with The Boy Who Cried Wolf, no one believed them.

Inflationary expectations and thus union wage demands remained very high. And in 1985, the government decided to deregulate bank lending. While this reform was necessary in order to improve capital allocation, it had disastrous side effects given the fact that at the time, real interest rates were way below zero after tax and inflation. This caused a massive credit expansion, which in turn helped further aggravate consumer price inflation while also creating a massive stock- and real estate bubble. As the exchange rate remained fixed, Swedish competitiveness was quickly undermined.

After Palme was killed by an unknown assassin in February 1986, pragmatist Ingvar Carlsson became prime minister. Worried that Swedish growth had trailed most other countries, Carlsson's government implemented a number of free-market reforms. Among these were the lifting of all currency controls in 1989 and a tax reform that dramatically reduced marginal tax rates (although they also reduced a number of deductions, including deductions for interest payments). Although these reforms have arguably contributed to improving the long-term economic performance of Sweden, they would contribute to precipitating the deep economic downturn in the early 1990s.

Meanwhile, as the economy started slowing significantly in 1990 after a series of tightening measures, consumer price inflation slowed. With the combination of continued high nominal interest rates, reduced capital gains taxation (and with that, reduced deductions for interest payments) and falling price inflation, real interest rates started rising significantly, helping to end the asset price bubbles. On top of all of this came the oil price shock following Saddam Hussein's invasion of Kuwait and an economic downturn in key trading partners such as the United States, the United Kingdom, and Finland. The end result was that Sweden slipped into a recession in late 1990.

As Sweden fell into a recession and its highly cyclical government budget balance started to deteriorate rapidly, investor confidence in the Swedish fixed-exchange-rate scheme started to deteriorate rapidly.

And with currency controls abolished a few years ago, the krona was fair game for currency speculators. Unlike in the past, the government was determined not to devalue, and they deemed a return to strict currency controls as unthinkable, so they had no choice but to defend the currency by raising interest rates. But as the currency speculators knew that these interest rate levels could not be sustained, they renewed their attacks, knowing that their gain from a collapsed currency regime would be far greater than the interest rate levels the Riksbank could offer. The end result was that real after-tax interest rates were pushed up into double digit levels — after having been negative just a few years earlier. That in turn deepened the recession further.

In the end, though, the fixed-exchange-rate scheme collapsed in November 1992. The dramatic increase in interest rates and the deep recession had at the same time created a large amount of bad loans, making almost all major banks in effect bankrupt. (The exception was Handelsbanken, known for its more cautious lending practices.) Only after the Swedish government pledged they would bail out the banks with whatever money they needed was a widespread banking collapse averted.

All told, the recession became Sweden's deepest by far since the Great Depression, with GDP in 1993 being 5% lower than in 1990, with employment falling more than 10%, and the budget deficit rising to more than 10% of GDP. By then Sweden had fallen to between 15th and 20th place in international income comparisons, a decline from which it has never
since recovered.

After this deep downturn, Sweden has performed much better for a number of reasons. The 20% decline in the value of the krona in late 1992 gave a strong boost to exports and together with the dramatic lowering of interest rates, this helped kick-start a cyclical recovery in late 1993. Moreover, a number of free market reforms implemented during Ingvar Carlsson and conservative Carl Bildt (who was Prime Minister between 1991 and 1994) had helped raise the structural growth potential of the Swedish economy.

Apart from the already mentioned reforms of reduced marginal tax rates and abolished currency controls, deregulated bank lending and significantly lower inflation, this included privatizations of several state-owned companies and deregulation of several key sectors, including the retail sector, the telecommunications sector and the airline industry. Also, when the massive budget deficit was eliminated, even the Social Democrats realized the need for deep spending cuts, which together with the typical cyclical decline in the burden of spending during booms helped reduce the extremely bloated burden of government spending somewhat.

All of this has helped Sweden recover in relative terms from the stagnation of the 1970s and 1980s and the deep economic downturn in the early 1990s. It is this relative recovery that is now seized upon by the Social Democrats and their sympathizers inside and outside of Sweden when they claim that the Swedish model of high taxes and a big welfare state is successful.

Yet as should be clear, the relative improvement of performance is due not to high taxes (lower now than previously), but to free-market reforms.

The reason Sweden no longer trails the rest of Europe is that these reforms, which have not been implemented in most continental European countires, have made the Swedish economy relatively freer.

And even with these reforms, Sweden has not, in fact, performed better than the rest of Europe. While headline GDP growth has been slightly higher, this advantage disappears when taking into account that Sweden's terms of trade have deteriorated significantly.

And if we exclude heavy-weight laggards Germany and Italy, Sweden has in fact continued to fall behind the Continent, event with Europe's dismal performance compared to most other parts of the world.

If we look beneath the aggregate production figures, we can see deep structural problems. The number of people employed is now 6% lower than in 1990, a weaker development than in any other western economy. By contrast, even with the weak job growth in recent years (by American standards), employment in the United States is 20% higher than in 1990.

And the number of people employed in Sweden is actually lower than in 1980, too. You have to go back to the mid-1970s to find employment numbers lower than the current ones. While total employment has been roughly unchanged since 1975, it masks a significant decline in male employment. And if you look only at the private sector, employment is now at a level lower than in 1950.

Social Democrats still often claim that Sweden has a comparatively high employment rate, but this claim is based on deceptive employment statistics that count as employed many who have been on long-term sick leave or in some other way on the receiving end of transfer payment programs, even though they don't actually work.

Moreover, the "stay at home mom" is very rare in Sweden. Because of the incentives created by the feminist construction of the Swedish welfare system, mothers mostly leave their children at government day care centers. Even if you believe that mothers who stay home to take care of their children are the victims of patriarchical oppression, you cannot deny the childcare takes a lot of work, but only those who take care of other people's children count as employed. By shifting childcare from the home to the public sector, the government further exaggerates Swedish employment figures.

The headline unemployment rate in Sweden is only 5–5.5%, but this number is extremely misleading as it only includes a small number of the people who the government pays not to work. Many unemployed are sent to so-called "labor market political activities" — activities whose only purpose is to reduce the official unemployment rate.

If we ignore this ruse, unemployment is 8%. And if you also include the enormous number of early retirees and people who live off sickness benefits, the real unemployment rate is more like 25%. The number of early retirees is 540,000, more than double the number of officially unemployed. Among non-Western immigrants, the real unemployment rate is higher than 50%.

All of this is exactly what we should expect from transfer payment benefits to people who don't work, from massive payroll taxes, income taxes, and value-added taxes. This has greatly inhibited the growth of a labor-intensive private-service sector that could have provided jobs for many of the unemployed immigrants.

During the most recent year, however, growth has picked up significantly in Sweden. To some extent, this reflects the global cyclical upswing, but there is also a domestic Swedish factor at work here, which has helped push Swedish growth higher than in most European countries. After the painful fiasco of the fixed-exchange-rate regime in 1992, Sweden instead adopted inflation targeting.

Sweden needs Mises: $25

This monetary policy regime seems so far to have been significantly more successful, but the policy is creating new problems. Because of deregulation and increased competition in a number of sectors in recent years, consumer price inflation has been fairly low, indeed below the 2% target most of the time. Food prices, for example, have been falling as fierce competition from low-price chains like Lidl, Netto, and Willys, have forced the major supermarket chains to cut prices in order to keep their customers.

Low prices are good for consumers, of course, but according to the inflation-targeting dogma, too low a rate of price inflation is itself a problem — a problem that must be counteracted with increased monetary inflation. Thus the Riksbank has been forced to push down interest rates dramatically in order to boost money supply enough to help achieve a 2% consumer price inflation rate.

As consumer price inflation is now starting to creep back up toward 2%, it appears that they will be successful, but this will have come at the cost of unleashing an asset price bubble and household debt levels similar to the levels experienced in the late 1980s.

Money supply rose 11.5% in Sweden in the year to May, even higher than the 8.9% seen in the Euro-zone. It is the dramatic acceleration of monetary inflation in 2005 which has temporarily boosted Swedish growth. The timing of this boom is, it should be noted, very convenient for the ruling Social Democrats and their parliamentary allies, the Green Party and the communist Left Party, given the fact that they face an election this year in September.

Ultimately, this artificial boom will have to come to an end, and although the ensuing crisis will likely not be as deep as in the early 1990s, the seemingly impressive Swedish boom will certainly be revealed as a fraud — just as the whole story of the success of the Swedish economic model is a fraud.


Stefan M.I. Karlsson is an economist currently working in Sweden. Read his blog. Send him mail. See his Mises articles. Comment on the Mises blog.

See also "How the Welfare State Corrupted Sweden."