Sweden publishes IMF statement on the Swedish economy

A delegation from the International Monetary Fund (IMF) has been visiting Sweden in connection with the consultations that the IMF holds with member countries. In the course of the visit, which ends today, the delegation has met representatives from the Riksbank, the Ministry of Finance, the Ministry of Industry, Employment and Communications, the National Institute of Economic Research and the labour market organisations, for example.

The IMF’s appraisal of the Swedish economy is contained in the statement, which
is attached.

Mr James Boughton, who heads the delegation, will be available for questions
at 3 p.m. today, Wednesday, at the Riksbank. Admission by press card from
no. 7 Malmskillnadsgatan.

The IMF’s statement will also be accessible on the Riksbank’s website on the Internet: http://www.riksbank.se/eng.
For further information, please contact the International Department:
Maria Götherstam, telephone no. +46 8 787 04 95.

INTERNATIONAL MONETARY FUND

Sweden- – 1999 Article IV Consultation

Concluding Statement

May 26, 1999

Sweden is undertaking a remarkable transformation of its economy, and it already has much to show from it. Four successes stand out. First, the safety and profitability of the banking and financial structure have been restored after the crisis and recession of the early 1990s. Second, starting from a deficit of more than 12 percent of GDP early in this decade, the government accounts are now in surplus, and the prospect is for a continuing surplus and declining debt in the years to come. This improvement is all the more impressive in that it has been achieved without undermining the Swedish commitment to social welfare. Third, the Riksbank—armed with an effective inflation-targeting policy—has achieved price stability and has the tools to cope with any resurgence of inflationary pressures. The now-independent Riksbank has earned a measure of credibility that positions it well to maintain stable prices in the years to come.

Fourth, these strengthened policies have helped Sweden weather the international turbulence of the past year and have generated substantial economic growth. After a long period of slow growth and a wrenching recession, output growth in Sweden accelerated to a rate close to the industrial-country average in the second half of the 1990s and now is somewhat above. With a solid financial position and with economic policies that in most respects are not out of line with the rest of Europe, Sweden has reason to feel confident as it approaches a decision on whether to join the European Monetary Union (EMU).

The most obvious economic challenge for the government now is to persist with and build on these transformed policies. The second and even more important challenge is to broaden and intensify the structural changes that will enable Sweden to respond more fully and flexibly to developments in Europe and in the global economy. Even after the recently completed program of fiscal consolidation and the ongoing program to restructure state-owned enterprises, the economic role of the government (taxing, spending, and regulating) remains large in comparison with other industrial countries, and rigidities in the labor market remain an impediment to growth.

Despite the structural rigidities, strong economic growth is likely to continue over the next two years. It is very difficult to judge how quickly capacity constraints -will reappear, but the force of aggregate demand-—driven by consumption, exports, and a moderate shift toward fiscal expansion—will continue to drive up output in the short term. Within a few years, how-ever, a continuation of demand growth at this pace would likely bring new inflationary pressures that would stifle growth and reverse the gains that have been won through the efforts of the past several years. The potential rate of output growth in Sweden is estimated to be around 2 percent a year. To consistently grow faster requires not more stimulus but more reform.

The clearest distortions in the Swedish economy arise from the tax structure and the wage-bargaining process. One tax on labor income is piled on top of another until the cost of employing workers is a large multiple of take-home pay. Part of this tax burden finances an overly expensive system of unemploy-ment benefits that replaces too high a portion of lost wages and offers too many loopholes and too few incentives to get the unemployed quickly back to work. Part of it finances a generous system of pensions and other --transfers, the benefit of which is weakened by the consequent low level of private saving. In addition, although low take-home pay is cushioned by Sweden’s admirable system of social services and security, the present industry-level system of wage determination is inefficient and leads to low employment opportunities and excessive wage increases. Despite the moderating effect of reduced expectations of inflation, real wages rose by some 3 percent in 1998. That rate of increase is high in relation to estimated productivity growth and would be costly to sustain.

One result of these distortions is that economic growth is uneven. Entry-level and lower-skilled workers find employment especially difficult to obtain, wage differentiation is compressed and cannot respond flexibly to shifts in market conditions, and labor-intensive activities generally suffer. Another is that a high level of overall unemployment seems to have become entrenched, even in this cycle of renewed growth. As international competition becomes even more intense in the coming decade, the costs of maintaining this structure cannot help but rise unless bold action is taken soon.

Important steps have been taken in the right direction. Emphasis is being placed on raising the level of employment, not just on reducing unemployment relative to a possibly discouraged and shrinking labor force. An ambitious medium-term goal has been established, for 80 percent of the adult working-age population to be employed by 2004 (up from 76½ percent today). Special education programs have been established, with the aim of raising the skill levels of potential workers. It seems unlikely, however, that such measures alone can achieve the goal. A flexible and well balanced labor market will require a lighter regulatory touch, a comprehensive reform of labor taxation, and a greater commitment to compromise by both unions and employers. The recommendations of the 1998 wage commission provide a good framework for negotiation and should be implemented as fully as possible.

The central goal for fiscal policy—averaging a fiscal surplus of 2 percent of GDP over the business cycle—is appropriately challenging. If the government can continue to meet this objective, Sweden will enjoy strong public finances, will not have to adopt an overly tight monetary policy to control aggregate demand, and will probably exceed the Maastricht criteria for participation in European economic and monetary union. The goal obviously cannot be reached, however, unless the government is prepared to allow the surplus to rise above 2 percent when demand is particularly strong, as it may well be in the next few years. The ceilings on government spending that have been set since 1997 are crucial, both for maintaining fiscal discipline and for giving the private sector space in which to flourish. In view of the need to reduce the overall economic role of government in order to prepare for the next decade of challenges, adhering to the ceilings that have been announced for 1999 through 2002 and not raising them in real terms in later years are minimum requirements for fiscal policy. Earlier and more detailed contingency plans for specific spending cuts to counter overruns in entitlement spending, presented as part of a longer-term reform program, would improve the credibility of the ceilings.

On the tax side of the fiscal balance, the government has more room to move. If growth continues as expected, and if the spending ceilings are not breached, then some reduction in taxation will be welcome and will provide the opportunity to begin to tackle the distortions mentioned above. Care will have to be taken, however, to keep tax cuts from stimulating demand while the economy is very close to capacity, as it seems likely to be by 2001. Priority should be given to reducing those taxes that are causing the greatest dis-tortions, including those on wealth as well as labor and capital income. Cuts in government spending below the current ceilings should be considered as an adjunct to any major tax-cut package.

The recent agreement to link pension benefits more closely to contributions and to allow a portion of pension funds to be privately invested is welcome, both because these changes will help rationalize the pension system and because they should reduce the danger of fiscal pressures arising from future funding deficiencies. These benefits will be greatly enhanced if agreement is reached soon on a trigger mechanism to adjust indexation of pensions if the initial assumptions turn out to be overstated. For example, since the size of the working-age population is not expected to grow significantly during the next century, the assumption that real income will average 2 percent growth may be optimistic. Consideration should also be given to raising the portion of funds that can be invested in privately managed accounts.

Monetary policy also has a strong foundation and is appropriately balanced. Targeting a low inflation rate (2 percent) by controlling the level of short-term interest rates has been the centerpiece of Riksbank policy since 1993 and must be judged as a success. Short- and long-term interest rates in Sweden have fallen to levels close to the European average without endangering price stability. As long as the Riksbank and the European Central Bank are pursuing similar inflation targets and no large unexpected shocks occur, this strategy is likely to continue to produce a reasonably stable and competitive exchange rate as well as stable prices. A decision to join EMU would introduce new technical challenges but would not be expected to force a change in the broad policy strategy.

Inflation in the ”headline” CPI has been persistently below 1 percent for the past three years, but that does not imply that the Riksbank has been overzealous in pursuing its goal. Sharp cuts in interest rates since 1996 are still exerting downward pressure on interest costs for homeowners and consumers. The Riksbank must ignore this effect on the CPI if it is to run a sensible policy. Attempting to raise CPI inflation in the short run would require raising interest rates now. Cutting interest rates sharply might eventually bring measured inflation closer to the target, but it would put even more downward pressure on the CPI in the short run. As the Riksbank itself has stressed and has recently clarified, a balanced and stable strategy for adjusting interest rates must remain based on longer-term considerations.

To further improve the clarity and credibility of interest rate policy, the Riksbank would do better to place greater emphasis on the underlying rate of inflation by adopting a target that excludes the effects of changes in interest rates. The ”harmonized” index of consumer prices (HICP) that is now being refined by the European Union would be worth considering for this purpose. Other transitory influences on the level of prices such as shifts between indirect and direct taxes might also usefully be excluded, as in the ”underlying” inflation rate (UND1X) that is already used by the Riksbank. Both indexes are expected to evolve within the announced tolerance range of 1 to 3 percent in the next two years. The choice of index, however, is less important than the ability to forecast and explain both transitory and persistent inflationary pressures. In that difficult task, the Riksbank has performed reasonably well but cannot afford to relax its efforts.

The recent revision of the Riksbank Act has enhanced the central bank’s inde-pendence and formalized the central role of the inflation target. Those changes, reinforced by regular parliamentary monitoring, should help to promote the continued pursuit of price stability. In addition, an independent external review to assess performance, the policy process, and public accountability would be helpful.

In closing, we would like to thank the many officials of the Riksbank, the Ministry of Finance, and other government ministries and institutes for their openness, their hospitality, and the skill and thoroughness with which they have explained the nuances of Swedish economic policy and conditions to us. We also would like to thank the representatives of business, labor, and banking, and the researchers and economists we have met during our visit, for generously sharing their own views and experience. Our admiration for the way Sweden combines its social consciousness with insights and with seriousness of economic purpose has been confirmed and reinforced throughout our stay here.

One of the most difficult economic challenges for any democracy is to undertake needed structural reforms while the economy is performing well, because the cost of inaction will be seen clearly only in some unknown future. But world economic history leaves no doubt that waiting until the need is evident would only make those costs more difficult to bear.