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The Rise, Fall and Revival of the Swedish Welfare State: What Are the Policy Lessons from Sweden?

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The Rise, Fall and Revival of the Swedish Welfare State: What Are the Policy Lessons from Sweden? IFN Working Paper No. 873, 2011 The Rise, Fall and Revival of the Swedish Welfare State: What are the Policy Lessons from Sweden? Andreas Bergh Research Institute of Industrial Economics P.O. Box 55665 SE-102 15 Stockholm, Sweden [email protected] www.ifn.se The rise, fall and revival of a capitalist welfare state: what are the policy lessons from Sweden?* Andreas Bergh1,2 Abstract: This paper discusses a number of questions with regard to Sweden’s economic and political development: • How did Sweden become rich? • What explains Sweden’s high level of income equality? • What were the causes of Sweden’s problems from 1970 to 1995? • How is it possible that Sweden, since the crisis of the early 1990s, is growing faster than most EU countries despite its high taxes and generous welfare state? These questions are analyzed using recent insights from institutional economics, as well as studies of inequality and economic growth. The main conclusion is that there is little, if any, Swedish exceptionalism: Sweden became rich because of well-functioning capitalist institutions, and inequality was low before the expansion of the welfare state. The recent favorable growth record of Sweden, including the period of financial stress (2008– 2010), is a likely outcome of a number of far-reaching structural reforms implemented in the 1980s and 90s. JEL classification: O43; O52; H50; I38. Keywords: Sweden, welfare state, equality, growth, institutions, capitalism 1Research Institute of Industrial 2Department of Economics Economics (IFN) Lund University Box 55665 P.O. Box 7082 SE-102 15 Stockholm SE-220 07 Lund Phone: +46-8-665 45 00 Fax: +46-8-665 45 99 e-mail: [email protected] e-mail: [email protected] * Financial support from the Jan Wallander and Tom Hedelius Research Foundation is gratefully acknowledged. The paper has benefitted from comments from seminar participants at the Ratio institute, the Research institute of industrial economics, Lund university and the annual meeting of the European and American Public Choice Society. Special thanks to Assar Lindbeck, Magnus Henrekson, Nils Karlson and Daniel Waldenström. 1. Why care about Sweden? ―The Swedes themselves are not entirely sure what they have done right.‖ – Paul Krugman1 ―Is there a certain ‗Nordic experience‘ from which we might learn?‖ – Klas Eklund2 For some, Sweden is proof that a generous welfare state and big government is fully compatible with a growing competitive economy. For others, Sweden is a frightening example of what big government can do to a thriving economy. This paper departs from the fact that for about 140 of the 160 years that have elapsed since 1850, Sweden has done well—often remarkably well—in combining high levels of economic growth with increasing equality. From being one of the poorest countries in Europe, the 100-year period from 1870 to 1970 turned Sweden into the fourth richest country in the world. Remarkably, as will be shown below, in more or less the same period Sweden also turned into a country with one of the world’s most compressed income distributions. There are standard explanations of both achievements: Sweden’s prosperity is usually attributed to the presence of natural resources (such as forest and iron ore) and to the absence of war. Sweden’s high level of income equality is typically assumed to be caused by high and progressive taxes, a regulated labor market and progressive social policies. As will be shown, these standard explanations of Sweden’s success are insufficient and sometimes wrong. Just like most countries, Sweden grew rich because of well-functioning capitalist institutions, and its egalitarianism is much older than the policies that today make Sweden stand out in international welfare state comparisons. These conclusions are reached by applying recent advances in institutional economics and inequality research to Sweden’s economic history. More specifically, this paper synthesizes existing research to find compelling answers to the following questions: How did Sweden become rich? What explains Sweden’s high level of income equality? Why did Sweden run into problems from 1970 and onwards? Why has Sweden, after the crisis of the early 90s, grown faster than most EU countries despite its high taxes and generous welfare state? Taken together, the answers to these questions tell a story of the rise, fall and revival of a capitalist welfare state. This paper is not the first case study of Sweden from an economic perspective. For example, Lindbeck (1997) argues that Swedish politics in the 1970s and 80s can be understood as a social science experiment with a devastating outcome. For at least two reasons, however, Lindbeck’s story needs updating. First, since 1995, the last year covered by Lindbeck, Sweden has done remarkably well in terms of economic growth, and the economic crisis of 2008 has only strengthened this impression. Second, the economic consequences of institutional quality, economic freedom and 1 Who knew? The Swedish model is working, October 1999. Available at www.pkarchive.org. 2 Cited from ―The Nordic Way‖ (Eklund et al., 2011) presented at the World Economic Forum in Davos, 2011. globalization have been a thriving research field, shedding new light on the case of Sweden, from the institutional reforms of the 1800s to the solid economic development today. The paper proceeds as follows. Section 2 describes the rise of the Swedish economy, from the 1800s to 1970, and discusses how it can be understood from an institutional economics perspective. Section 3 discusses the when and why of Swedish income equality, while Section 4 describes the problematic period of 1970 to 1995. Finally, Section 5 delves into the most recent period of intense reform and high economic growth, and Section 6 concludes. 2. Prosperity The period between 1870 and 1970 in Sweden has been referred to as the golden years. Figure 1 explains why. Swedish productivity grew to 17 times its size during this period—a figure only to be remotely matched by Japan and Finland. As a result, Sweden went from having a per capita income equivalent to 40–50 percent of the United Kingdom’s per capita income during the first half of the 19th century to being the fourth richest country in the world by 1970 (after Switzerland, the US and Luxembourg).3 Figure 1. How much higher was GDP per hour worked in 1970 compared to 1870? (factor)4 20 17 16 15 14 12 11 10 10 9 7 5 5 4 0 A typical account explains the growth of the golden years with the export of natural resources. When industrialism gained momentum in the UK, the demand for Swedish timber and ore increased. Another explanation often mentioned is that Sweden benefitted from staying out of the two world wars. Myhrman (1994) was one of the first to scrutinize these standard explanations, and surprisingly few have followed. Myhrman asks: if British economic growth caused growth in Sweden, why was the Swedish economy so weak in its development between 1780 and 1860? And why was there an 3 In earlier versions of the OECD statistics, Sweden actually placed third. However, Luxembourg has now revised its GDP figures. 4 Source: Maddison (1982). increase in Swedish economic growth around the turn of the last century, when the British economy had slowed down? According to Myhrman, the standard explanations cannot provide sufficient answers to these questions, but the pattern can be explained by institutional factors. In fact, research clearly suggests that Sweden is no different from most other rich countries: prosperity was caused by well-functioning, capitalist institutions. As will be shown, focusing on the importance of stable capitalist institutions also makes it easier to explain why Sweden started trailing behind other countries in the 1970s. 2.1 Explaining growth The importance of institutions is now more or less mainstream economics, but that was not always the case. Neoclassical growth models predict that growth per person increases when savings and investments increase, but they say nothing about what influences technological development and thereby the long-term growth rate. The more recent, new (or endogenous) growth theory of Lucas (1988) and Romer (1990) takes education and human capital into account as well, but it still lacks an in-depth analysis of what promotes innovation and the creation of knowledge, and the crucial role of institutions in the growth process. Following works like North (1987; 1990), studies on economic growth (Knack and Keefer, 1995) appeared during the 1990s, which explicitly took into account the role of institutions, for example Knack and Keefer (1995). Institutions rule claim Rodrik et al., (2004), in a famous paper, arguing that certain types of institutional quality, especially property rights, trumps geography and trade as determinants of growth. Abdiweli (2003) has reviewed existing evidence and provided further evidence that judicial efficiency, low levels of corruption, well-organized public bureaucracy, and well-defined private ownership co-varies with high levels of growth. Another important survey by Doucouliagos and Ulubasoglu (2006) carried out a meta-analysis of 52 other studies, which examined the link between institutions characterized by economic freedom (measured in several different ways) and growth. They conclude that economic freedom has a robust positive effect on economic growth regardless of how it is measured. Research in this area is very much in progress, but many findings support the view that there seems to be a causal link from institutions to growth. This holds, for example, when using instrumental variables to handle the problem of reverse causality from growth or income to institutions. Well- known instruments used include legal origin (Acemoglu and Johnson, 2005), latitude (Easterly and Levine, 2003), and settler mortality (Acemoglu et al., 2001).5 Furthermore, Granger causality tests by Heckelman (2000) and Dawson (2003) suggest that the level of economic freedom Granger causes economic growth.
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