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Wednesday, September 19, 2018

Do Not Invest in Sweden

Sweden is Europe's most reputable welfare state, or notorious, depending on how you view it. For decades the country has built an image of itself as the successful combination of egalitarianism and capitalism.

That image has been crumbling for some time now, as I explained already in 2014. Others have added to the picture - though some contributions have been more ham fisted than helpful - and the overall image of the country is slowly changing in a more accurate direction.

Today, the economic and political situation is serious, so serious, in fact, that it is time to warn investors from committing to Sweden. There are a number of reasons for this warning, though the four listed below should suffice as a deterrent.

1 - Exchange rate and interest rates.

The Swedish central bank, the Riksbank, is stubbornly holding on to a negative deposit rate. It dropped the rate below zero in July 2014 and has gradually dug itself deeper on the negative side; the current rate is -1.25 percent.

A negative deposit rate serves two purposes. The first is to leave more cash in the financial institutions, encouraging them to continue to lend to the general public. This expansionary monetary policy has flooded the Swedish housing market with cheap loans, which in turn has led to a dangerous debt burden on the shoulders of the household sector, and the world's most over-inflated housing market.

The second purpose is to keep down the costs of government debt. By depressing the cost of debt in general, the Riksbank makes it cheaper for the national government to roll over its debt, and for local governments to maintain and even grow their debt. Since the early 1980s, it has been the express goal of the Swedish government to concentrate all fiscal policy measures to the funding of the welfare state; despite formal independence, the Riksbank has gradually accommodated its monetary policy to this goal.

It is wise to not under-estimate the significance of this goal with the depressed interest rates, especially with regard to the outlook of the Swedish economy. More on that in a moment.

Economic theory says that low interest rates have a negative effect on the exchange rate. In practice, it is difficult to establish this causality. It is true that a country cannot maintain too big of an interest rate disparity vs. other countries and currencies, but the disparity depends on investment-related factors such as the performance of the stock market (short term) and GDP growth (long-term). Here, Sweden has done fairly well, but its stock market is comparatively slanted, depending increasingly on old manufacturing companies and the financial industry.

Low interest rates benefit both industries - at least insofar as manufacturers sell a large share of their production abroad - but when profits in both industries start to taper off, the stock market will react negatively. If the exchange rate is weak in the first place, an outflow of international capital will quickly have a negative impact on the krona.

Since January, the krona has been declining steadily against the U.S. dollar, touching 11 cents per krona in August. It has fallen steadily vs. the euro as well, which is remarkable given that the ECB has run its own version of Quantitative Easing since the bottom of the Great Recession.

To make matters even worse, Swedish banks, which invest heavily in the country's mortgage market, have borrowed significantly abroad. With debt denominated in foreign currency and equity dependent on one of the world's most over-valued housing markets (see below), Swedish banks are in deep trouble. Even if they secure their debt with term contracts to minimize the impact of exchange-rate depreciation, there is only so much such contracts can do to prevent a rapid erosion of their balance sheets.

In other words, depressed interest rates and a weak currency can quickly turn into a reversed pendulum: rather than stabilizing a crisis, they can serve as cumulative destabilizers.

2 - Household debt bias.

Financial markets are not very good at considering long-term policy intentions in their understanding of trends in individual countries. Unfortunately, this can lead to misinterpretation and missed opportunities, especially when it comes to protecting money from a crisis.

Sweden serves a good example. A key variable to understanding how a crisis would unfold is to understand the political priorities behind Swedish fiscal policy. To understand these priorities, in turn, let us have a look at Figure 1. The blue function reports household debt as share of household disposable income; the grey function reports government debt as share of GDP.

Figure 1: Swedish debt
Source of raw dataStatistics Sweden

This figure explains a fundamental shift in fiscal policy priorities, a shift that will explain how the Swedish government will handle its next economic crisis. The policy priority shift has to do entirely with the welfare state and the ideological and fiscal commitment that government has made to it.

During the early-to-mid 1970s (1), the welfare state had not yet overwhelmed the Swedish economy. The cost of the welfare state had just about exceeded 40 percent of GDP in terms of taxation, but the structural effects of this burden had not yet taken a serious toll on economic growth and the tax base. Therefore, there was no explicit ambition behind fiscal policy to prioritize government at every turn; the social-democrat government had raised taxes quite a bit during the 1960s, but in the early 1970s the taxes they had were considered "sufficient.

On the spending side, government was still growing, thus returning tax revenue to the economy.

In the late 1970s (2) the Swedish government experienced the same rise in deficits as many other welfare states. It took until the early 1980s for a change in fiscal policy (3). However, unlike, e.g., the Reagan administration, the Swedish government did not go for growth-oriented tax cuts. Their idea was instead to inch taxes upward, hold back domestic demand by suppressing wages (through the social-democrat union arm that negotiated national union contracts) and stimulating exports by means of devaluations to the fixed exchange rate. 

This period marked the beginning of an era where fiscal policy was focused on providing all the revenue that the welfare state needed. Government even instituted a permanent goal of a budget surplus equal to two percent of GDP. Since then, this has been the definition of a "balanced budget".

Tough fiscal policy, primarily through the pursuit of higher tax revenue, turned the trend in government debt. When the crisis of the early '90s came along, the private sector had been structurally beaten by a harmful tax reform designed by the same government-first mindset. As a result, the private sector collapsed and government debt skyrocketed (4). By 1994 the Social Democrat party launched a barrage of harsh austerity measures (see the chapter on Sweden in my book Industrial Poverty) that lasted through the rest of the '90s (5). 

Since then, fiscal policy has been focused relentlessly on providing enough tax revenue to pay for the world's most ambitious welfare state (6). While this has brought down the government-to-GDP ratio, it has left the private sector, especially households, gasping for air. 

The only way that Swedish households have been able to maintain a comparatively high standard of living is by increasing their debt. It is striking to note how the household debt-to-disposable-income ratio has mirrored the government debt-to-GDP ratio; this is not the result of some version of the Ricardian equivalence (as some of my fellow macroeconomics nerds would suggest), but simply the reaction among households as their finances suffer under government-first fiscal policy.

Based on this overview of trends in Swedish fiscal policy, we can draw two conclusions for a coming economic crisis. First, every reaction by government will be aimed at preventing the debt-to-GDP ratio from rising. Technically, this means they will strive to balance the budget at every turn. They did this in the 5th period in Figure 1, and they will do it again. As a result, fiscal policy will be predisposed to accelerate the recession.

Secondly, the dangerously high household debt ratio will continue to rise, even if banks stop lending and start calling back loans. The reason is that under fiscal austerity, disposable income declines and the ability of indebted households to pay principals and even interest will accordingly weaken. As a result, fiscal austerity will transmit straight into bank balance sheets.

3 - Unusual revision of national accounts.

On September 13, Statistics Sweden issued a news bulletin announcing revisions of GDP as far back as 2016. The revision lowered GDP by 0.5 percentage points for 2016, down from 3.2 percent to 2.7 percent, and by 0.2 percentage points, to 2.1 percent, for 2017. 

I have worked with macroeconomics, national accounts and fiscal policy for 30 years and I cannot remember a revision of the same substance in an otherwise developed country. Quarterly revisions happen all the time, and even end-of-year adjustments, and there are even sloppy news bulletins that mislead the public regarding current growth, but to go back two years is highly irregular. 

This is not to say that there is anything untoward with this recalculation, as it is probably just made necessary by carelessness in keeping track of GDP. However, to let national accounts decay to this extent is definitely irresponsible, and the consequences for investors are not to be ignored. 

No investor uses macroeconomic data as his main indicator when deciding how to invest. However, a revision of macroeconomic data of this magnitude does have consequences that could have more than a marginal effect on the forecast of business investments. The cumulative effect of these recalculations of Swedish GDP is equivalent to $200 billion in the U.S. economy, of which $140 billion would be consumer spending and $30 billion gross fixed capital formation. If American consumers spent $140 billion in the past year than we thought they did, it would require at least a revision of the outlook for a lot of businesses. 

The downgrade of Swedish GDP growth means that the country is going into a future crisis less well prepared - the plunge to rock bottom will be shorter and faster - than otherwise believed. While, again, the difference is not considerable by any stretch of imagination, it is big enough to make a difference on the margin. This is especially the case in terms of the timing of relevant decisions. A one-percent lower GDP may shorten the period of time an investor has to consider whether or not the economy is bound for, or already in, a recession. 

4 - The uncertain parliamentary situation.

The September 9 election resulted in a parliamentary stalemate, with the left-wing coalition at 144 seats, the center-right alliance at 143 and the nationalist party at 62. With 175 seats to win majority, either side will have to cooperate with the nationalists, abbreviated SD, in order to govern. However, both sides have pledged not to do so, leaving an across-the-aisle coalition as the only alternative. So far, a week and a half out of the election, there are no signs of such a coalition emerging. 

For now, the social democrats and the green party continue their pre-election government, in defiance of the constitutional mandate for a prime minister to resign when there is no apparent support for him in a newly elected parliament. Technically, the new parliament does not meet until next week, leaving the incumbent prime minister in a constitutional vacuum, but there is a fair chance he will be voted out next week. 

If, next week, there is no new government ready to take the place of the old, an open crisis in government will put the country in a unique situation. Not since universal suffrage began has Sweden suffered a government crisis of this kind. It remains to be seen if it actually happens, but given opinions expressed by in particular leading representatives of the center-right alliance, there is no apparent majority-supported candidate for prime minister to be elected next week. 

Given this situation, it is entirely possible that Sweden will suffer a crisis in government for an extended period of time. If, during that time, an economic crisis opens up, the lack of a firm government would be immediately interpreted as lack of economic leadership. This would seriously aggravate any crisis, and especially one where there is a combined implosion of the real estate market and a solvency crisis in the banking system. 

At that point, Swedish politicians will form a crisis coalition across the ideological dividing line, but it will be formed under a Damoclean Sword, allowing it to only execute very short-term, entirely reactive policy measures. The result will likely be a Greek-style decline, though from a weaker starting point. 

Do not invest in Sweden

All in all, the situation in Sweden as of today is such that any investments in the country would be associated with high risk. The best advice for those interested in the country is, short term, to await the parliamentary votes next week on speaker and prime minister, and, long term, to watch the price trends on the housing market for the rest of the year. January would be a good time to review the situation in the country again.

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