THE STRUCTURAL problems behind Sweden’s current economic dilemma can be traced to key institutional features of its labor market. Centralized bargaining and equalizing wages may no longer be appropriate.
The Swedish economy has been experiencing its worst crisis in the postwar period.
Real GDP declined by about 8 percent between the peak in the first quarter of 1990 and the trough of the recession in the second quarter of 1993.
The unemployment rate increased from about 3½ percent of the labor force in 1990 (including the 1 percent in state-sponsored labor market programs for that year) to almost 13 percent in 1993 (including about 4½ percent in labor market programs)—ending Sweden’s record of maintaining one of the lowest rates of unemployment among the industrial countries.
The central government’s overall borrowing requirement rose to over 18 percent of GDP in 1993-94, a symptom of the dramatic deterioration in Sweden’s public finances in recent years.
The current recession was precipitated by the big credit-led expansion of both consumption and investment that followed the financial liberalization of the mid-1980s. When the boom ended in early 1990, property values and asset prices fell sharply, triggering a sharp contraction in domestic demand. However, in addition to these immediate factors, the crisis also has its roots in the underlying structural problems of the Swedish economy—in particular, the long-term productivity slowdown and high wage inflation that have characterized its recent history. These structural problems, in turn, are linked to specific institutional features of the Swedish economy, such as its tax and benefit systems and, more important, the labor market institutions.
To gain a sense of how deep Sweden’s structural problems are, it is useful to look at several key indicators (see chart). First, the growth of labor productivity in manufacturing has been, in general, slower than the average for the European Union (EU)—formerly the European Community (EC)—since 1976. This has resulted in an increasing productivity gap with respect to the EU and a relative decline in Swedish living standards. While Sweden’s per capita private consumption had ranked fifth among the Organization for Economic Cooperation and Development (OECD) countries in 1970, it slipped to twelfth position by 1990. The Swedish economy also suffered from problems of declining external competitiveness in the 1980s. Because of the rapid growth of nominal wages and the slow growth of productivity, Sweden’s labor costs have been rising faster than those of its competitors—despite large devaluations in 1981-82, which led only to a transient improvement in competitiveness in the early 1980s.
What are the factors behind the long-term problems of slow productivity growth and high wage inflation? Although the answer is complex and multifaceted, it may well be strongly linked to specific features of the Swedish labor market. This article takes a look at the Swedish labor model and examines how Swedish labor market institutions over time have become a retarding influence on economic performance.
Swedish labor model
The “Swedish model,” usually identified as an advanced form of the welfare state, has attracted attention from many quarters for its apparent earlier success. One of its components—the Rehn-Meidner model—is aimed at promoting structural change and growth by combining centralized wage bargaining with an explicit policy of attempting to narrow wage differentials drastically across both firms and industries. The other component—the EFO model—is concerned with preserving the competitiveness of the Swedish economy by controlling the rate of growth of wages.
Sweden’s key indicators lag behind
Sources: World Economic Outlook database, and IMF staff calculations, IMF.
Although some form of centralized wage bargaining is common to all the Nordic countries, the Swedish trade unions have been unique in pursuing an explicit policy of wage equalization (“solidaristic wages”) as a key objective. Since the late 1930s, wage negotiations have been conducted between centralized trade unions and a centralized employers’ organization (Swedish Employers’ Confederation). One union represents all blue-collar workers and the other, all white-collar workers. Because almost 80 percent of the workers are unionized, these unions are truly all-encompassing. While wage negotiations are conducted at the central level, the system also allows for “wage drift,” whereby central wages are topped up at the local level.
Rehn-Meidner model. This model derives its name from the two economists of the Swedish trade union organization, Gösta Rehn and Rudolf Meidner, who were instrumental in outlining the economic arguments for the Swedish model in the early 1960s. It is based on the theory that wage equalization has two distinct effects.
First, it imposes a high wage cost on low-technology sectors and inefficient firms by not giving them the freedom to set a relatively low wage. This means that low-productivity enterprises will have to either rationalize operations and become more efficient or go out of business. At the same time, workers in high-technology sectors are not given the freedom to negotiate a relatively higher wage despite their higher productivity. This makes it possible for these enterprises to generate relatively higher rates of profit that can be invested for faster growth. Workers who are displaced from the low-technology sectors would provide the labor supply for the fast-growing high-technology sectors, aided by centralized retraining schemes.
Over time, this policy of implicitly penalizing low-productivity sectors and providing incentives for high-productivity sectors increased the share of dynamic, high-technology enterprises in total production. Since Sweden has traditionally been an economy with high average wages and labor shortages, the wage equalization policy was conceived as being advantageous for rapidly transforming the technological basis of the economy and promoting high growth without running into serious labor shortages. A crucial assumption behind this model was that the forcible retrenchment and retraining of workers ensures that structural change and growth are faster than in a system where workers spontaneously respond to wage differentials.
EFO model. The second model derives its name from the initials of the three chief economists of the white-collar trade union, the employers’ organization, and the blue-collar trade union in the early 1960s—Edgren, Faxen, and Odhner—who were instrumental in outlining the consensus view on wage bargaining between Swedish employers and workers.
The main objective of the EFO model was to maintain the international competitiveness of Swedish industry. Hence, in the competitive sector, or the sector open to foreign trade, the wage increase was to be restricted to the sum of international price inflation and the rate of growth of labor productivity in this sector. This would maintain Swedish tradable goods prices on a par with those of competitors. However, at the same time, the policy of wage equalization adopted by the trade unions dictated an equal wage increase for workers in the nontraded sector. Since productivity growth in the nontraded goods sector is relatively low, this policy imparted an inflationary thrust to the nontraded goods sector.
Swedish model problems
While the Swedish economy performed relatively well until the mid-1970s, serious problems emerged thereafter. Productivity growth slowed down and wage inflation averaged more than 8 percent a year in the 1980s. Sweden managed to avoid high unemployment through large devaluations (about 26 percent cumulatively) in 1981-82 and then a substantial expansion of the public sector, but its external competitiveness gradually declined and per capita GNP dropped to the OECD average in 1990 after being 10 percent above average in 1970.
High wage inflation. Sweden’s problems with high wage inflation can be traced largely to the way in which negotiations have come to be conducted. In theory, a centralized trade union is expected to be more moderate in its wage demands, as its actions have a much greater impact on macroeconomic performance than the actions of an isolated decentralized union. For example, if the centralized union pushes for too high a wage, there is likely to be an increase in the overall rate of unemployment, and the membership of the union will ultimately have to pay more taxes to fund additional unemployment benefits. In contrast, a decentralized union, operating in isolation, does not have to bear directly the adverse effects of its actions, because part of these costs are passed on to others.
“These structural problems suggest the need for far-reaching institutional changes in the Swedish labor market…”
However, Sweden has been unable to tap these potential benefits, especially since the early 1980s, for three main reasons.
(1) The multilevel bargaining structure in which wage drift accounted for a significant part of the overall settlements. Because of the subsequent wage drift, the central union usually decides on the initial nominal wage increase that is compatible with a given final real wage target. The real wage target is usually set with a view to maintaining a low rate of unemployment—a critical objective for the central union. This system works fairly well in an environment of high price inflation, as was the case in the 1970s.
However, multilevel bargaining does not work well in the context of low productivity growth and low price inflation, as was the case during much of the 1980s. To achieve the real wage target in this environment requires the centralized union to negotiate a negligible nominal wage increase because of the anticipated wage drift that is likely to follow. If the central union persists with its real wage target and desists from procuring any nominal wage increases at the central level, it is likely to have severe legitimacy problems with the membership, especially in light of the fact that the Swedes had become used to living in an inflationary environment. Hence, the central union is forced into bargaining for a nominal wage increase that is not warranted by the productivity performance or employment target. This seems to have happened especially during the mid-1980s, when the increase in real wages was higher than that warranted by productivity considerations. In the last two years, given the severity of the current recession, inflationary expectations have subsided and wage demands have become more moderate.
(2) The breakdown of the EFO model in the 1980s. The EFO model—based on the leading role of the traded goods sector—failed to provide the basis for wage negotiations in 1983, when the engineering workers broke off from centralized negotiations and concluded a separate wage pact. At the same time, workers in the nontraded goods sector (mainly services) started negotiating their wages without regard for the implications for the competitiveness of the traded goods sector. This was particularly true of public sector workers.
Because the nontraded goods sector is not fully subject to market discipline, the wages negotiated in this sector turned out to be far too high for maintaining the competitiveness of the traded goods sector. With the breakdown of the discipline provided by the EFO model, uncoordinated, competitive wage increases took place in all sectors. In addition, with a weakening of centralized bargaining, there was a significant increase in the degree of wage drift, which accounted for over 40 percent of total wage increases by the end of the 1980s, compared with about 25-30 percent in the 1970s.
(3) The impact of labor market programs in situations of very low unemployment. There are reasons to believe that, contrary to conventional wisdom, certain types of labor market programs may at times actually tend to raise wages. These programs, which are aimed at discouraging dependency on unemployment benefits, encompass centrally provided training schemes, relief work (which consists of temporary state-sponsored jobs), subsidized employment, and youth training.
The main argument for the wage-reducing impact of labor market programs is based on the fact that training programs and relief work, by helping to avoid problems of long-term unemployment and loss of skills of the labor force, promote more effective competition for jobs and consequently reduce upward pressure on wages.
However, at very low rates of unemployment (as happened in Sweden between 1974-77 and 1987-90, when the open unemployment rate averaged less than 1 ½ percent), the wage-reducing impact of labor market programs—particularly relief work—may cease to operate. This is because such programs effectively provide employed workers, or “insiders,” the guarantee of avoiding open unemployment—rather than enabling the unemployed “outsiders” to compete effectively for jobs. There is, therefore, an argument for making relief work contingent on the cyclical position of the economy.
Slow productivity growth. The analysis of long-term trends in productivity is a complex issue. A number of different factors, such as savings-investment behavior, educational attainment, and incentive mechanisms available for innovativeness, influence productivity. For Sweden, other factors, including the large public sector and the generous welfare state, also play a role. However, it is not easy to identify the exact empirical importance of each of these factors in explaining the country’s productivity performance.
In analyzing Sweden’s relatively poor productivity performance after the mid-1970s, this article focuses mainly on the impact that the incentive mechanisms operating in the labor market, particularly solidaristic wages, had on productivity. Other explanations are not taken up, not because they are unimportant but because there has so far been no systematic examination of this link between labor markets and productivity. The analysis provided is basically qualitative, suggesting possible causation mechanisms rather than providing an exhaustive, empirically testable explanation for the productivity slowdown.
The Rehn-Meidner model’s strategy of combining centralized bargaining with wage equalization seemed appropriate in the 1960s and early 1970s when the goal was to shift workers from the low-technology to high-technology industries, where they could take advantage of the rapid international transmission of technical knowledge. This strategy enhanced both the average levels of productivity and living standards. However, Sweden’s successful period of “catching up” implied that by the mid-1970s, a substantial part of Swedish industry was already technologically advanced. Hence, further productivity growth could be obtained only by increasing the efficiency with which existing enterprises operated. This required the creation of appropriate incentive mechanisms that would allow firms to increase productivity by restructuring their enterprises and motivating workers to enhance their human capital.
New developments in the organization of work—notably, a shift from standardized assembly line production (“Fordism”) to flexible work practices (“post-Fordism”)—also warranted a change in the wage regime. In the post-Fordist environment, there is a much greater diversity between individual firms, meaning a lot of variation in the level of effort, diligence, and skills that firms expect of their workers. Individual employers need the freedom to substantially vary their remuneration schemes, but a labor market with drastically compressed wage differentials makes this extremely difficult.
Although the concept of solidaristic wages was initially conceived as equal pay for equal work, in the 1970s, the unions pursued an aggressive policy of across-the-board wage equalization with little consideration for the nature of the work performed. As a result, by the early 1980s, Swedish wage differentials were substantially lower than in other OECD countries. The wage spread for industrial workers, calculated as the difference between the highest and lowest deciles in 1984, was an estimated 34 percent for Sweden, far narrower than the 210 percent for the United Kingdom and 490 percent for the United States. Furthermore, not only were pre-tax wages “equalized,” but progressive taxes in the 1980s reduced even further the differences in disposable incomes. By 1990, however, Sweden’s wage spread had inched up to 45 percent due to a weakening of centralized bargaining.
Finally, Sweden’s centralized training schemes proved inappropriate in the post Fordist environment. These schemes, by their very nature, impart mainly general skills, whereas the new technology required a much greater emphasis on firm-specific skills. But in order to find it optimal to offer in-house training, firms required the freedom to devise their own internal wage differentials and promotion schemes to motivate workers to enhance their human capital and stay on in the firm after acquiring the training. For example, firms needed the flexibility to offer a low wage initially and increase it steeply later in the career stream, so that workers would not have an incentive to move to another firm once they finished receiving the training. However, the rigidity imposed by the system of centralized bargaining and solidaristic wages precluded firms from tailoring their own remuneration schemes to enhance productivity.
Implications for Sweden
Thus, Sweden’s current economic crisis cannot be overcome solely by tackling the cyclical factors that have contributed to the current high levels of unemployment. Policymakers should also address the underlying structural problems—notably those in the labor market. High wage inflation in the 1980s can be traced to the combined impact of multilevel bargaining, the breakdown of the leading role of the traded goods sector in wage determination, and the operation of certain types of labor market programs in conditions of extremely low unemployment. Slow growth of productivity, in turn, can be attributed to the inappropriate-ness of the policy of wage equalization in an environment in which flexible working practices have become more prevalent and there is less scope for technological “catching up.”
These structural problems suggest the need for far-reaching institutional changes in the Swedish labor market—particularly for increasing wage differentials and dispensing with multilevel bargaining. However, in moving toward a greater market determination of wages, it is important to avoid the problem of long-term unemployment, which has become the defining feature of European labor markets. This calls for reforms to the labor market programs to make them more appropriate for the changed circumstances rather than abandoning them altogether. It is also vital to avoid the marginalization of sections of the labor force due to very high wage differentials, as in the United States. That is easier said than done.
For more details, see “The Structural Crisis in the Swedish Economy: Role of Labor Markets,” by the author, IMF Staff Papers, June 1994.