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Monday, August 20, 2018

Sweden: An Escalating Crisis

Yesterday I explained that Sweden, once a pinnacle of stability in northern Europe, is bound for an economic and political crisis of disturbing proportions. As reputable investor Erik Penser put it in an interview with Bloomberg, this is a good time to move money out of Sweden, secure it in U.S. dollars and shield whatever is left in Sweden from a macroeconomic calamity (my words, not Penser's).

As I pointed out in yesterday's article, this is a crisis that spans across both the economy and politics. This is always the case in welfare states; financial and other economic forecasters often disregard the role that government plays in the economy. This leads to confusion and misinterpretation of especially structural changes in an economy. In a mature egalitarian welfare state such as the Swedish, a misunderstanding of the role of government can lead to a significant misunderstanding of what an economic crisis will look like.

What is often overlooked, namely, is that a government responds to a crisis based primarily on political preferences, and only secondarily on economic analysis. Those preferences, in turn, are determined by the ideological commitment to the welfare state among leading political parties. This was the case in Europe during the Great Recession when the EU, the ECB and the IMF together forced several countries - Greece being the most notorious among them - into extended periods of harsh, unforgiving austerity. The goal was not to tear down the welfare state, as some ignorami suggest, but to save it and make it fit inside a smaller macroeconomic footprint.

Similar policies were forced upon the Swedish economy during the crisis in the early 1990s. My book Industrial Poverty has an entire chapter devoted to the Swedish crisis and what the austerity policies did to the country's economy. It was ugly, especially since two thirds of the austerity policies consisted of tax hikes.

Before the Greek crisis, the Swedish austerity episode was the toughest one forced upon a European economy since the 1920s. Since then, the Swedish economy has suffered the long-term consequences of austerity and the welfare state; it is important to understand the price tag from the last austerity episode in order to get a good idea what lies ahead for that country.

Austerity aimed at saving the welfare state has two major macroeconomic consequences. First, it recalibrates the welfare state in terms of its place in the economy: taxes go up permanently, and spending is cut permanently. The net effect is an increased, long-term drain on the private sector, which shows up in slower economic growth and a weaker domestic economy. The only way for European economies to conceal this drain is to do everything they can to increase exports, a point we will get back to in a later article.

The second macroeconomic consequence is a reinforcement of the private sector's dependency on government, especially the household sector. As growth slows down, more people see stagnant earnings over time. When earnings stall, more people become eligible for some or all of the welfare state's entitlement perks. This, in turn, makes the private sector more vulnerable to even small shifts in government spending; the negative multiplier from consumer spending can strike more quickly, so to speak.

Both of these consequences are relevant for understanding how serious the next Swedish economic and political crisis will be. Understanding this will, in turn, tell us just how serious the spillover effects are going to be from Sweden into neighboring countries, and possibly other parts of Europe.

Let us take this in three step.

1. The political reaction to a crisis. 

It does not matter what the political composition of the Swedish parliament will be after the September 9 election; it does not matter whether the majority will be of the current left-leaning kind or the previous center-right alliance - or a coalition between social democrats and the formerly right-leaning moderates. The policy response to an economic crisis will be the same. 

When the economy goes into a recession, the first order of business for the government is to close the growing budget gap. This requires spending cuts and tax increases - just as in the early 1990s, and just like in Greece, Spain, Italy, Portugal, France, Ireland and other countries around Europe during the Great Recession.

When you raise taxes and cut government spending in a recession, especially during the downturn, you accelerate and aggravate the recession. This, however, is not relevant in Swedish fiscal policy, where the health fo the economy is measured by the status of government finances. Therefore, the political focus will be on containing the budget deficit.

Macroeconomic consequences aside, the main problem with austerity is that when a government has already made major cuts to its services - as the Swedish government has since the early 1990s - there is not much to cut before it has serious repercussions for the private sector. Another wave of austerity in the Swedish economy could lead to shutdown of government services, such as closing entire hospitals or switching welfare programs to minimum-compensation levels (as opposed to today's system where compensation is proportionate to earnings).

The negative impact on the private sector will be larger per krona of spending cuts, causing - as mentioned - negative multiplier effects to spread through the economy much more rapidly than they otherwise would do. This in turn accelerates the downturn further, causing yet more losses of tax revenue.

It is, of course, illogical for government to focus on the budget balance in times of economic crisis. However, when their policy preferences are guided by a desire to save the welfare state, then that is what they are going to do. In order to understand politics and politicians, one has to part with analytical methods and logic at their level, and apply it at a higher level where it can help explain the consequences of irrational behavior.

2. Economic repercussions of austerity

Since the Swedish government is going to accelerate the crisis with austerity, we can expect significant suppression of domestic spending. Private consumption will fall rapidly, business investments will likely grind to a virtual halt and foreign direct investment could quickly turn negative. This means, in plain English, a crisis on all fronts, much like in Greece and certainly a repetition of what Sweden went through a quarter century ago.

Of immediate concern will be a collapse of the real estate market, and this is not only tied to the acute risk for an interest rate hike that I discussed yesterday. Swedish labor laws can actually aggravate the real estate crisis. The standard setting on the Swedish labor market is that changes to wages and employment protect older workers according to a last-hired-first-fired rule. Since last-hired workers tend to be younger and therefore make less than their older colleagues, they also carry heavier mortgages than older workers.

In a situation with major layoffs across the economy, a disproportionate amount of those losing their jobs will be young workers with small margins for honoring their mortgage obligations. This, in turn, will have disproportionately negative consequences for the real estate market and could actually accelerate mortgage defaults. Furthermore, if government panic-raises taxes, as is normal during an austerity episode, one of the first they will turn to is the value added tax (VAT). In EU member states the top rate can be 25 percent, and that can apply to everything you buy, from food to your apartment lease. However, it is common practice to have different VAT rates depending on how "essential" a product is, or if government wants to pick winners and losers by giving, say, the hospitality industry. The favored industry can then operate under a lower VAT.

In a situation with a rapidly growing budget deficit, increasing the VAT is a fast route to more tax revenue. If the tax goes up on products where the demand curve is price-insensitive - people are willing to buy it at almost any price - that new revenue stream is fairly predictable. Therefore, industries that have been favored by a lower VAT are probably the first to be hit by big tax hikes once government goes into fiscal panic mode.

Hospitality is a favored industry in Sweden. Since, for example, restaurants employ a lot of young people, a sharp rise in the VAT on food services would send yet more young people out in unemployment. 

Which brings us back to the banks and their exposure to mortgages. During the 1992 crisis the Swedish government saved its banks by intervening with enormous subsidies to cover loan defaults. That is not an option today: there is not enough margin in the government finances to allow a bank bailout. 

The only option is that the central bank, the Riksbank, starts printing money to save government finances, which in turn will save the banks. That, however, would crash the currency altogether and open the - however remote - risk for hyperinflation. 

3. Long-term political consequences

There is really only one way the Swedish government can manage a new economic crisis, and that is by forming a coalition between the two traditionally largest parties in parliament. Before we get to the details, here are the parties currently represented in the Riksdag:

Social democrats - precisely what it sounds like. This is the original egalitarian welfare-state party. They have gone from striving for long-term, gradual, reformist socialization of the country to simply being a caretaker of the existing welfare state. They used to be a 40-50 percent party; this election they are expected to get somewhere between 20 and 25 percent of the votes.
Moderates - a formerly conservative party. Today, this party's political practice is a "diet" version of the social democrats. They want to preserve big government, but do it "smarter" with slightly lower taxes on low incomes. Expected vote share in the upper teens.
Swedish democrats - formerly a nationalist party. Although this party calls itself "conservative" their political practice is essentially a copy of the social democrats as they were half a century ago. They fluctuate in the opinion polls but could capture as much as 25 percent of the votes in the September election. 

These three centrist parties poll anywhere between three and 12 percent:

Center party - has no distinct ideological profile other than that they are for abolishment of any restrictions in immigration.
Liberals - formerly a classical European liberal party, these days basically opportunist mainstream. Their only profile issue is that they are adamantly pro-EU.
Christian democrats - no longer a Christian party, but a mainstream social-democrat clone. 

Two small parties on the left:

The Left Party - formerly "Communists", now social democrats with higher taxes.
Green Party - commonly referred to as Khmer Verts, proposing extreme taxation and extremely generous immigration policies. Generally setting the bottom standard for intelligence in Swedish politics.

From 2006 to 2014 the moderates and the three centrist parties governed as the Alliance. Since 2014 the social democrats has been in coalition with the Khmer Verts with parliamentary backup from the The Left. However, for two reasons the upcoming election may result in the social democrats and the moderates forming a crisis coalition. 

First, ever since the Swedish democrats got into parliament in 2010 they have been excluded from parliamentary cooperation and the target of vicious attacks from the seven other parties. The reason is their criticism of what they saw as overly generous immigration policies. Gradually, the other parties have adopted their immigration policy platform. They still shun the SD, though for reasons that have no bearing in the political reality. Since the SD is now likely going to become the largest party, the two runners-up, the social democrats and the moderates, will probably form a coalition government. 

Secondly, in a serious economic crisis Swedish politicians tend to get together behind the incumbent prime minister. If the leaders of the social democrats and the moderates see an economic crisis on the horizon, they will form a coalition government for that very reason. No such formal coalition has existed in modern history, but with both these parties and their extended support in parliament having been diminished, the political landscape has changed. 

If a coalition is formed between the social democrats and the moderates, there will be enough parliamentary support for basically any kind of policy initiatives. This opens the door for very tough austerity policies, as well as for other extreme measures such as price and currency controls. 

Regardless of exactly how a crisis unfolds, it will be practically impossible for the Swedish government to stabilize it unless they resort to extreme policy measures. Next time, we will look at what that would mean for the other Nordic countries, and what the ramifications may be for Europe beyond the North.

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