Saturday, April 28, 2012

The Swedish lessons for Europe

Fiscal austerity is the current buzzword in macroeconomic policymaking. Across Europe, despite very strong domestic political opposition, governments have embraced wildly ambitious fiscal adjustment targets in an attempt to rein in soaring public debts, restore market confidence, and thereby engineer economic recovery. 

However, evidence from nearly three years of such experimentation across Britain and the Eurozone economies has been dismal. Bond markets have remained unimpressed and sovereign bond yields continue to rise. Not only have the expected recovery not materialized, but these economies have slipped further down the abyss. And this has been the fate of economies within and outside the Eurozone. The latest casualty is Britain, which has officially slipped into a double-dip recession, its second recession in three years. It joins Belgium, the Czech Republic, Greece, Italy, the Netherlands and Spain who are already in recession.

As with Greece, Ireland, and Portugal earlier, Spain too is now experiencing the wages of the same austerity medicine. Amidst a contracting economy, its sovereign debt rating has been downgraded and cost of borrowing has been rising. One-in-four Spaniards are unemployed and half all Spanish youth are out of work, both the highest among advanced economies. Even with all the belt-tightening, Spain is expected to easily miss its target of lowering budget deficit from 8.5% of GDP to 5.3% in 2012 and do no better than 6.2% .   

As could have been anticipated, the blind embrace of austerity has had the effect of accepting the worst of all worlds. As economic growth has contracted, public debt-to-GDP ratios have gone up even higher and tax revenues have dipped sharply. In the absence of either the private sector or external sector stepping in top stanch the space vacated by public expenditures, it was natural that the economy would contract.

All this has raised unemployment rates and inflicted untold suffering on citizens across Europe. Economic hardship have triggered off pent-up social tensions. Political rebellions and protests have become commonplace in these countries. Many governments have lost power in the face of street protests and failures to push through the tough fiscal adjustment measures required to secure external funds. At last count governments in Greece, Ireland, Italy, Portugal, Spain, Netherlands, and now Romania have lost power due to the pains caused by spending cuts.     

In this context, it has become important that these economies abandon their dogmatic ideological embrace of austerity and fall back on policies that can get their economies growing. Robert Samuelson has a nice article which highlights the less-discussed economic turnaround of Sweden since its banking crisis induced economic recession in early nineties. In recent years, Sweden has emerged, along with Germany, as among the best performing developed economies.

Instead of being wedded to ideology-driven policies, Sweden embraced prudent policies that combined both the conservative and liberal social and economic agendas. For a start, it did not bail out its banks but forced them to take massive losses and virtually nationalized its banking sector. The real estate bubble that was inflated by the financial deregulation of the 1980s deflated in 1991-92. As pressure mounted on the krona, overnight interest rates spiked to 500%, and the Swedish economy contracted steeply and unemployment quadrupled in three years to 12%. After a series of bank failures, the government moved in swiftly with a series of measures,

In September 1992... the government announced that the Swedish state would guarantee all bank deposits and creditors of the nation’s 114 banks. Sweden formed a new agency to supervise institutions that needed recapitalization, and another that sold off the assets, mainly real estate, that the banks held as collateral. Sweden told its banks to write down their losses promptly before coming to the state for recapitalization. Facing its own problem later in the decade, Japan made the mistake of dragging this process out, delaying a solution for years...

By the end of the crisis, the Swedish government had seized a vast portion of the banking sector, and the agency had mostly fulfilled its hard-nosed mandate to drain share capital before injecting cash. When markets stabilized, the Swedish state then reaped the benefits by taking the banks public again.
This was followed with several far-reaching structural reforms that turned the largely statist economy into one of the world's most dynamic economies, without compromising on its social-democratic principles. The reforms drew from both the conservative and liberal playbooks,  

Sweden’s income tax base was broadened and tax rates were sharply reduced (marginal tax rates fell from 46% in 1996 to 33% in 2010). Spending was cut on old-age pensions, child allowances, unemployment benefits and housing subsidies. Union power over wages was reduced. Many markets (banking, air travel, telecommunications, electricity production) were deregulated. Low inflation and balanced budgets became broadly embraced popular goals...

Although Sweden trimmed social benefits, it hardly abandoned the welfare state. Overall government spending is still about 50 percent of the GDP, much higher than in the United States... To reduce income tax rates, the government raised other taxes. Gasoline and cigarette taxes were increased; so were taxes on dividends and capital gains, hitting the rich. Altogether, deficit reduction totaled a huge 12 percent of GDP from 1991 to 1998. Slightly more than a third of that came from higher taxes...
The aims were clear: to reward work by cutting income tax rates; to push people back into the labor market by reducing some government benefits; and to promote productivity by increasing competition. Productivity and “real” (after-inflation) wage gains improved markedly. Still, Sweden has less economic inequality than most advanced countries.

Sweden also benefited from favorable external economic conditions. Its recession coincided with a sustained period of economic strength across much of the world. Sweden could therefore export its way out of recession. A 25% devaluation of the krona boosted exports. Unfortunately, none of the peripheral European economices today can afford this luxury. None of the Eurozone economies have the freedom to undertake this policy route. See also this excellent presentation by Swedish Finance Minister Anders Borg.

The choices facing Eurozone governments are stark. Currently the austerity policies are merely pushing their economies down the hill, with no hope of finding an anchor that can drive economic recovery in the foreseeable future. It is necessary for all the Eurozone economies to start regaining their economic competitiveness for any sustained recovery to take hold. This can happen only with either a Eurozone exit and/or fiscal transfers from the Eurozone's center. There has to be some period of fiscal accommodation in the periphery and consumption increase in the center.

This is an opportunity to push through the tough labour market liberalization and industry dergulation policies that have for long contributed to sclerosis in Europe. More than that it is an opportunity for the Europen monetary union to become a loose political union, a necessary requirement for the continent to stave off similar situations in future, leave alone escape the current mess.   

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