A Fistful of Kronor

Europe’s economic turbulence has been raging for more than two years, fueled by political leaders’ continuing failure to come up with real solutions to the euro crisis. Time and again, they claim to have solved it, only to see bond prices tick up and growth projections tick downward. Don’t be fooled by the August calm. When the continent returns from its collective Mediterranean vacation next month, the crisis will rear its head once again.

European leaders might learn a thing or two from the recent experience of my country, Sweden. In the beginning of the 1990s, Sweden was struck by a severe financial crisis, much like what Spain and Ireland are experiencing today. After almost a decade of strong economic growth, fueled by cheap credit and rapidly rising housing prices, the market suddenly collapsed, which caused severe problems in the Swedish banking system.

Before the crisis broke out, in 1990, Sweden boasted a budget surplus of 4 percent of GDP. Then something unexpected happened. In just three years, the country’s public finances took a dramatic nosedive, resulting in a record deficit of 13 percent of GDP in 1993.

At the time, many, such as the Social Democratic economist Bo Södersten, heralded the mess as a sign that Sweden’s welfare state had collapsed. People needed to work more, it was said, and be less dependent on handouts from the government. The IMF urged Sweden and Finland, a country in a similar situation, to clean up their budgets.

Structural reforms were arguably needed. High marginal taxes rates were hampering economic growth, and the labor market was not flexible enough, which pushed the unemployment rate up. Generous welfare benefits also decreased the incentives to work. But problems with Sweden’s welfare state could hardly explain why a seemingly thriving economy descended into a full-blown crisis, with rapidly rising unemployment, falling GDP, and an exploding budget deficit.

So what happened?

In the 1980s, a huge bubble was created in Sweden’s real estate market, coupled with a rapid increase in construction. Financial deregulation led to an explosion of credit, and the private sector became heavily indebted. The economy also overheated because the government devalued the Swedish krona without trying to slow down the economy in the go-go years. People started to buy homes on speculation, and banks easily provided new loans, not only for homes but also for cars, boats, and art. Sound familiar?

In Sweden’s case, the boom and speculation ended with a terrible crash and a banking crisis in 1991. As a consequence, private investment and consumption collapsed, and the economy slowed sharply. Instead of borrowing money, companies and households started to save. It was Sweden’s severest economic slowdown since the Depression of the 1930s.

Thanks to a rereading of Irving Fisher’s classic essay on debt deflation, economists like Hans Tson Söderström, president of the influential SNS think tank, realized what had happened. Households and businesses — not the government — were overly indebted. The huge budget deficit of 13 percent of GDP was a result of the depression, not a cause of it. Tax revenues declined as a consequence of the fall in GDP, creating the government’s fiscal problem.

When the real estate bubble burst, the private sector was forced to consolidate its balance sheets. It took several years to deleverage. Households and companies substantially and simultaneously reduced their level of debt, which immediately caused aggregate demand in the economy to fall.

It is this kind of painful adjustment that several eurozone countries are now experiencing. As with Sweden in the 1990s, Spain and Ireland ran budget surpluses amid real estate bubbles during the boom years. Their public debt was low, well below the eurozone average. However, problems became acute because the private sector was heavily indebted. In the common currency’s first decade, Germany in particular exported cheap credit to Southern Europe, and interest rates were at historic lows. As in Sweden — and more recently the United States — cheap credit fueled housing booms and an unsustainable economic path. Put another way, the current budget woes of countries like Ireland and Spain aren’t mainly a result of political incompetence; they are an automatic reflection of the private sector’s debt reduction.

Public debt spiked in Sweden during the 1990s, but this phenomenon was only a transfer from the private to the public sector. For the economy as a whole, this collectivization of debt was necessary to avoid a further deepening of the crisis. If you want to avoid a complete collapse in employment and production, everyone cannot simultaneously save — so the Swedish government tolerated big deficits for a number of years. Then, when the economy started to pick up in the middle of the decade, mainly thanks to a large deprecation of the krona, the Social Democratic government launched an austerity program. But — and this is important — the harsh measures were introduced only once the economy had started to rebound after several years of negative GDP growth. Good years, not bad, were the right time to cut back.

The strange thing about Sweden’s 1990s experience is how little today’s government appears to have learned from it. Instead of being a voice of reason on the euro crisis, Finance Minister Anders Borg — ranked by the Financial Times as No. 1 in Europe, among his colleagues — has joined his conservative friends in Germany in promoting policies that further depress the troubled economies.

And it’s not just Sweden. Many Northern European politicians speak as if the crisis were created by budget deficits, and not the other way around. In Finland, a member of the eurozone, the leader of the popular True Finns has raged against crisis countries being "spendthrift." This despite the fact that Spain and Ireland (though admittedly not Greece, and hardly Portugal) had orderly public finances before the Lehman Brothers crash in 2008.

Of course, the fly in the ointment is that, unlike Sweden, eurozone members don’t have the luxury of being able to devalue or depreciate their currency. They are stuck with the euro and have to follow the European Central Bank’s one-size-fits-all policy. And they lack a proper lender of last resort, a fact that has driven interest rates on Spanish and Italians bonds to dangerous levels.

In the 1990s, the Swedish government also had the capacity to temporarily swallow losses in the banking system. A "bad bank" was created, which later became liquidated without any loss for the taxpayer. Today, the problem has become too big for any single country to tackle alone. Therefore, Europe needs common solutions to restore stability in the banking system.

But the first step is to make a correct diagnosis of the disease.