Sweden and Germany pave the way for Europe

Europe is once again on the edge of the cliff. Spain is out of money to finance itself and its banks; Greece, even though the pro-bailout coalition was formed, remains Europe’s weakest link; Italy is extremely vulnerable to a Spanish default; and yet the blame again falls on Germany. Even among the Germans themselves, notable economists are arguing over whether or not Germany should offer more bailouts and consequentially bear more risk (see here and here).

But Chancellor Merkel stands strong against her critics, domestic and foreign. From her perspective all this hardly looks immoral or threatening to the survival of the Union and its currency. More than a decade ago Germany had very similar problems of an inefficient and protected labour market, falling productivity, and a congested business sector. But it overcame them successfully and turned into Europe’s genuine economic powerhouse. While it is true that the German current account surplus grew rapidly during the past decade, the huge difference between Germany and the rest of Europe can hardly be explained by exports and benefits from the exchange rate. The difference was much more systemic.

Agenda 2010 in Germany 

Even after the adjustment and convergence of East Germany, the most important long-run structural reform was rather recent. It started in 2003 under the name ‘Agenda 2010’and its plan was to reform the business environment in Germany. It reformed the social security system by incentivising more people to work, not live off the welfare state (this included cutting unemployment benefits, income taxes and medical treatment benefits). It was also aimed at restoring businesses growth and reducing the regulatory burden. But the main point was decreasing the blocking power of unions and guilds, thereby making it easier for employers to hire and fire, and easier for low-skilled youth to enter the job market. Surprisingly or not, the programme was initiated by a social democrat government, under the Chancellor Gerhard Schroder.

The full effects of the reform weren’t visible until 2005 when unemployment started falling and businesses started growing. This is best shown in Germany’s business freedom index which went up by almost 20 points as a result of the reforms.

Naturally the measures were unpopular at first, causing Schroder to lose the 2005 elections. But this is an expected cost of unpopular measures hitting interest groups and the welfare state mentality. So far, all the pro-reform governments in the periphery won the elections (or were appointed, e. g. Monti). The broad democratic majority accepted that reforms are a must, so there is no excuse for the peripheral governments to postpone them.

Swedish reforms in the 1990s

Sweden is an even better story of how to reform a system hit by resilient unions,high taxes, high government spending and high inflation. These pressures culminated in the 1991 crisis, following a housing bubble burst and a credit crunch. The systemic instabilities accumulated over the years became obvious and reforms needed to be implemented. After engaging in a policy reform similar to the German ‘Agenda 2010’, Sweden became a state with relatively high levels of both individual and economic freedom. In fact, one reason Sweden weathered the current crisis so well is the structural reforms in the 1990s which made it much more resilient to future demand shocks. Current Swedish Finance Minister Anders Borg had a lot to say on this in his recent lecture at the Peterson Institute in New York.

Sweden’s starting point was an economic situation as challenging as that facing the peripheral Eurozone now: lagging growth, low productivity, highly regulated markets, huge barriers to entry for entrepreneurs, high marginal tax rates, political battles between unions and businesses, inflation-driven wages set by the public sector (which was a big deal with 10% average inflation), entrepreneurs leaving the country, and finally large deficits and rising debt levels. But Sweden was determined to reform.

It started with a consolidation close to 15% of GDP that was based mostly on cutting taxes and cutting expenditures (the real austerity programme). Taxes on income were cut and the composition of taxes changed by broadening its base. Large-scale deregulation resulted in Sweden having a lower regulatory burden than both UK and the USA. EU membership in 1995 resulted in lower tariffs and opened the Swedish economy even further, leading to a growth in exports (devaluation in 1992 helped ease the reforms but overall the exchange rate system was very flexible and the krona was left to float). The pension system was reformed by increasing the retirement age and lowering the indexation of pensions. A balanced budget requirement was introduced in health care, together with greater competition, particularly in the primary care sector. The power of the unions was curtailed by changing the wage setting system so that the competitive sector starts first and the public sector adjusts. All the reforms supported each other and made the overall change irreversible.

The biggest success was that Sweden switched from an equal and non-dynamic society, to a society that is both equal and dynamic. But it had the courage to reform no matter how painful it initially was. The United States, not only Europe, should learn from this.

So what does Germany really want from Europe? It wants it to go through its own supply- side revolution. Just likeGermany and Sweden did in the 1990s and the 2000s, which created a basis upon which they built their export-led growth in the later part of the 2000s. No one ever said it was going to be easy, but the periphery has postponed it long enough.

2 thoughts on “Sweden and Germany pave the way for Europe”

  1. Posted 23/07/2012 at 21:34 | Permalink

    Germany has a specific Mittelstand model of small and medium size business clustering. Thanks to their collaboration they create their own economies of scale and help each other in manufacturing and exports. The model also gives workers a stronger say in managing the company which makes the business being run on trust and stronger ethical values. This made it much harder for managers to fire people which is why they made the workers work in shifts. A temporary solution to fight the crisis but it worked since it didn’t depress the German aggregate demand, as there is a big difference in holding to a job with a temporarily lower wage than losing a job altogether. There is also the question of the apprenticeship system in Germany that works very well in solving the youth unemployment.
    My point is that Agenda 2010 didn’t help at all in the recent recession. It was the old model Germany had before which clearly works.

  2. Posted 25/07/2012 at 09:06 | Permalink

    The cultural differences of which you speak of certainly made it easier to implement the reforms. The same argument can be applied to Sweden and its relatively higher equality before their 1992 shock and recovery. However, the structural reforms are the ones that made the system more robust to outside shocks, which is exactly the reason why Germany and Sweden experienced only a mild shock compared to the rest of Europe (see this paper: http://ftp.iza.org/dp6250.pdf and this text: http://www.voxeu.org/article/should-we-believe-german-labour-market-miracle). The specifics of the German model only made the reforms easier to implement, and I believe the causal relationship between the reforms and increasing German business freedom and export-led growth is strong and significant. There is no one solution applicable to every country, but increasing business freedom, reducing bureaucratic burdens, lowering marginal tax rates, and reforming the labour market are certainly among the most successful solutions.

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