Valerie Cerra

The Swedish authorities responded to the lessons of the exchange rate mechanism (ERM) and banking crises of the early 1990s by introducing well-designed frameworks for monetary and fiscal policy, and by strengthening banking regulation and supervision. An economic boom in the 1990s helped restore financial sector soundness and contributed to the buildup of fiscal surpluses. Nevertheless, the Swedish welfare state faces challenges from longer-term pressures stemming from globalization, demographic transition, and integration with the rest of Europe, as well as from the threat of lower potential growth. This article summarizes recent IMF research on the key features of Sweden’s policy framework and economic developments.

Sweden has long been regarded as the epitome of the modern welfare state, which is characterized by large income transfers, centralized institutions, and an activist government with a political mandate for extensive intervention in market processes. The question of whether the welfare state has had an adverse impact on growth and other aspects of economic performance remains controversial. A new book by Thakur and others (see sidebar on p. 3) analyzes the main features of the Swedish economic model and its key achievements. It also asks whether the Swedish model can survive the challenges arising from the forces of globalization, European integration, and demographics.

Sweden introduced comprehensive fiscal reforms over the decade following the banking crisis. A comprehensive tax reform in 1991 significantly broadened the tax base, markedly lowered the highest marginal income tax rates, and established a dual income tax system that separates the flat tax on capital from progressive labor taxes. A far-reaching pension reform was undertaken in recent years to address the fiscal impact of the prospective aging of the population and decline in labor participation rates in the coming decades (Arnason, 1998; Thomas, 1999b). The new pension scheme includes a public pay-as-you-go (PAYG) component with large associated buffer funds, a fully funded defined-contribution component, and an automatic balancing mechanism that ensures that the system remains able to meet its obligations with fixed contribution rates. The authorities also introduced a medium-term fiscal framework consisting of three fiscal rules: a surplus target of 2 percent of GDP for the general government over the economic cycle, nominal central government expenditure ceilings set three years in advance, and a balanced budget requirement for local governments.

The fiscal framework has contributed to outcomes that have been among the best in Europe in recent years. Its design has been the subject of much recent IMF research and policy advice. The flexibility of the rules for engaging in stabilization policy has been hotly debated in Sweden in the run-up to a referendum on membership in the European Monetary Union (EMU). Schimmelpfennig (2002) concludes that the current surplus target is set at a level consistent with sustainable public debt dynamics and offers considerable room for stabilization policy in the event that Sweden joins the euro area. Annett (2003) finds that even though the government has managed to respect the system of fiscal rules, it rook advantage of favorable cyclical conditions in the late 1990s to ratchet up expenditure, partly in an attempt to restore social services that were cut back in the fiscal consolidation effort that followed the banking crisis. Most notably, a rapid rise in local government consumption was financed by a revenue boom and was thus consistent with the balanced budget rule. Subsequently, the recent downturn has begun to put the framework under strain. Schimmelpfennig (2002) and Annett (2003) argue that there is also scope for improving the design of the central government expenditure ceilings; in particular, it would be important to ensure that the margins under the ceiling are used for cyclical spending rather than for discretionary measures, and that the ceilings are explicitly linked to the surplus target. The ceilings have recently come under intense pressure because of a surge in sickness absenteeism, which is generously compensated by the government after the first couple of weeks. Mehrez (2002) documents the sharp rise in sickness leave and attributes it to the increased generosity of sickness benefits, a fall in unemployment, and other cyclical and structural factors.

The monetary policy strategy and its institutional framework were also reformed to improve monetary policy credibility, and financial sector supervision and regulation were strengthened to reduce the likelihood of any further financial crises. Swinburne (1999) discusses the design of the inflation targeting framework adopted in 1993 as the Riksbank’s policy anchor, the monetary policy implications of a decision to join the EMU, and legislative changes to enhance central bank independence. He also reviews measures taken to strengthen the supervision and regulation of the financial sector and shows that indicators of financial sector soundness had improved by the late 1990s. The Swedish financial sector is dominated by large and complex financial institutions that operate across jurisdictions in the Nordic area and beyond (Johnston and others, 2003). The size, complexity, and cross-border linkages of these institutions present challenges for supervisory oversight by increasing the risks of contagion and possibly exacerbating moral hazard problems associated with policies toward institutions that are too big to fail. These challenges underscore the importance of active coordination by the affected Nordic supervisory agencies, including for consolidated surveillance, and emergency liquidity and crisis-management arrangements.

Estimates of the output gap and the growth of potential output are required for determining structural fiscal balances and also constitute important inputs for inflation targeting. Cerra and Saxena (2000) survey alternative estimation methods and provide estimates for Sweden, explaining why some methods are more plausible than others. Although the range of point estimates at the end of the sample spans several percentage points, the methods indicate qualitatively similar trends in the 1990s. In particular, the banking crisis opened up a large negative output gap, which had not completely closed by 1998. In addition, the banking crisis resulted in a permanent loss in the level of potential output. Thomas (1999a) finds that the fiscal consolidation program of the 1990s temporarily raised the rate of potential output growth by reducing the ratio of government spending to GDP.

Sweden has effective tax rates on capital income that are competitive with other countries, but tax rates on labor income rank among the highest in the OECD (Thakur and others, 2003). Thomas (1998a) estimates that tax wedges have had adverse effects on the labor market. He finds that increases in payroll and total labor taxes reduce hours worked and raise unemployment by 0.5 percent and 0.3 percent, respectively. Growing tax wedges in the 1980s are estimated to have contributed to a rise in latent unemployment, which was masked by increasing public sector employment until the deep recession of the early 1990s. Thomas (1998b) suggests that the switch from a centralized wage bargaining system to industry-level bargaining in the late 1980s may have also contributed to a steep rise in unemployment after the crisis by reducing the sensitivity of real wage growth to cyclical conditions.