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How Smart Fiscal Rules Keep Sweden’s Budget in Balance

Almost three decades ago, Herbert Stein, the former Chairman of Nixon’s Council of Economic Advisers, lamented that the United States had no long-run budget policy—no policy for the size of deficits and for the rate of growth of the public debt over a period of years. He pointed out that Congress makes annual budget decisions that are wholly inconsistent with professed long-term goals, hoping that something will happen before a point of crisis is reached. He might have added that when the crisis does arrive, it is resolved by a combination of hasty, one-off measures; the making of promises that are rarely kept; and the appointment of special commissions whose advice is rarely heeded.

What Stein said then remains true today. The rational way out of this destructive cycle of irresponsibility and crisis is to establish long-term fiscal policy rules and stick to them. There is at least a vague recognition among some members of Congress of the need to do so. The problem is that the rules they actually propose are primitive and counterproductive. The debt ceiling itself, which Congress routinely sets at levels that are inconsistent with its own spending and taxing decisions, is one such rule. The balanced budget amendment championed by many fiscal conservatives is also deeply flawed, for reasons detailed in this earlier post.

Instead of these “dumb” fiscal policy rules, we need to be looking at what can be learned from countries that have faced the same problems and introduced smarter rules to overcome them. Last week’s post examined how intelligent budget rules have helped Chile prosper. Today we look at the smart fiscal rules that have put Sweden’s budget on a sustainable path and made that country’s economy one of the strongest in Europe.

American conservatives still sometimes mock Sweden as failed experiment in socialism, but the reality, especially under that country’s current center-right government, is quite different. True, Sweden’s public sector is larger than that of the United States, although the gap is not as wide as some people imagine. When all levels of government are included, the share of government expenditures in GDP is 52 percent in Sweden compared to 41 percent in the United States. Somehow, though, the burden of government spending has not crushed Sweden’s economy as completely as might be thought.

According to OECD data, Sweden’s economy will grow 4.5 percent this year. Inflation is 2.9 percent and unemployment 7.5 percent, with both falling. The government budget has a surplus of 0.3 percent of GDP this year, projected to increase to 1.4 percent in 2012. Gross government debt is 45 percent of GDP and falling, compared to 101 percent and rising for the United States. In net terms, the Swedish government has financial assets that exceed its liabilities by 25 percent of GDP, compared to liabilities that exceed assets by 75 percent of GDP in the United States. In short, it looks like Sweden is doing something right.

Sweden has not always kept its fiscal house in order, however. In the early 1990s, it faced a severe budget crisis. Since that time, as the following chart shows, it has made a remarkable turnaround. The principles of fiscal policy that have underpinned Sweden’s fiscal consolidation have four main elements. Together, they represent a successful balance between discipline and flexibility.

The first element is a rule requiring a budget surplus equal to 1 percent of GDP on average over the business cycle. On the face of it, that sounds very much like Chile’s structural balance rule. It would, in fact, produce a similar trajectory for the deficit and debt over the long run. However, the Swedish rule is more flexible than the Chilean version in two respects. For one thing,  it allows more room for countercyclical policy, since the government can, if needed, run a structural deficit during a downturn provided it is offset by a correspondingly greater surplus during the next expansion. Also, under the Swedish rule, year-to-year budgeting is not as closely dependent on estimates of the output gap, a concept that is difficult to define and measure with precision.

The second element of Swedish fiscal policy is a system of annual expenditure limits. Those limits provide a measure of discipline to prevent abuse of the greater flexibility implied by a multi-year, cyclical target for the budget balance. Each year a spending target is set for the third year ahead, so that budgeting for each current year is constrained by the target set three years previously. The purpose of the spending cap is to counteract the universal tendency of democratic governments to spend extra tax revenue as it comes in during years of economic expansion, rather than running surpluses as required for proper countercyclical fiscal policy.

The third element of the Swedish system is a budget margin to prevent the spending cap from being too rigidly binding. The budget margin is not a formal rule, but rather, a general principle under which planned expenditures are not pushed right to the limit of the annual spending cap. That is especially important because the spending cap is set in nominal terms, so that faster than expected inflation, as well as unexpectedly high real expenditures, could lead to a breach of the cap.

The fourth element of the system, which was added in 2007, is a Fiscal Policy Council, six of whose eight members are academic economists. The FPC has several functions. The most important is to assess whether the government’s policies are in fact consistent with the fiscal policy targets, including the cyclical surplus requirement and the annual spending caps. In addition, the FPC has a role in evaluating the government’s models and forecasting methods, in promoting transparency in the whole budget process, and in reviewing policies and targets in the light of long-run goals of growth and stability. Sometimes it offers specific advice. For example, during the 2008 downturn, it recommended that the government make fuller use of its right, within the rules, to allow a temporary cyclical deficit.

Does this system work? It seems to, at least for Sweden. Are there lessons here for the United States? Yes, but with some qualifications.

The first lesson (to preempt any anyone who is getting ready to blast me for advocating a socialist welfare state), is that the Swedish fiscal model in no way depends on a specific level of government spending. Rather, it depends on maintaining a rational balance between revenue and expenditure over the business cycle. Whether that balance be achieved with government expenditures that average 52 percent of GDP or 18 percent, whether it be achieved with or without universal affordable health care, state-provided day care, and so on, is another matter altogether.

The second lesson is the need to strike a balance between flexibility and discipline. The appropriate balance may vary from one country to another. For example, as I have noted, Sweden’s approach has a bit more flexibility in allowing for countercyclical policy and a bit less year-to-year discipline than Chile’s. A set of rules for the United States might also need to be tilted more toward discipline.

There are two reasons the United States may need more fiscal discipline even at the expense of flexibility. One is the two-year U.S. election cycle, the shortest among the world’s major democracies. The short election cycle increases the pressure for government to spend increased revenues during an economic expansion rather than running the surplus needed for sustainable fiscal policy. It may be that the U.S. political system is not mature enough to think three years ahead.

Another reason the United States needs to tilt toward discipline is a lower level of political consensus. In Sweden, the major political parties agree on the importance of following the rules. Look again at the chart of Sweden’s debt and deficit since the fiscal reforms of the mid-1990s: The chart shows no sign of any disturbance when the government changed from Social Democratic to center-right in 2006. Compare that to the radical change change from the budget discipline of the Clinton years to the fiscal irresponsibility of the Bush years. A very strong set of chains indeed would have been needed to prevent euphoric Republicans from squandering the once-in-a-lifetime budget surpluses they inherited after the election of 2000.

The third lesson is that although the United States may need a stronger dose of fiscal discipline than Sweden does, discipline can also be too tight. An example is the procyclical annual balance requirement embodied in the balanced budget amendment that is so enthusiastically championed by House Republicans. By requiring severe budget cuts each time the country entered a recession, such a rule would make the troughs of the business cycle deeper and recoveries slower. Far from bolstering confidence and promoting long-run growth, the proposed amendment would be a recipe for chronic instability and stagnation.

Finally, the most important lesson to be drawn from the Swedish experience is a hopeful one: Fiscal consolidation is at least sometimes possible in a modern democracy. Sweden’s position in the early 1990s had some striking parallels with that of the United States today. It had experienced a sharp recession following the collapse of a housing bubble. Its banking system had nearly collapsed and required a costly government rescue. The deficit reached 11 percent of GDP and debt was around 70 percent, close to today’s U.S. numbers. Yet the country got back on track. It established a set of budget rules that all political parties could live with. It was shaken by the 2008 global crisis, but recovered more quickly than most. It could happen here.

Update: Recently Matt Andrews of Harvard’s Kennedy School has written a series of posts on Sweden’s system of fiscal policy. His posts go into much more historical detail on the development of the Swedish fiscal policy regime than I was able to in this post. Andrews argues, among other things, that “the lessons from Sweden are less about the mechanisms and systems and rules they have in place today, and more about the processes they went through to find and fit these mechanisms, systems and rules.”

Here are links to three of his posts:
Budget Reforms and Austerity: Lessons from Sweden
The past leads to the future in PFM reform: More on Sweden
Swedish lessons for dealing with the ‘fiscal cliff’ and beyond

19 Responses to “How Smart Fiscal Rules Keep Sweden’s Budget in Balance”

Craig_WestAugust 1st, 2011 at 7:28 am

I wonder if the current structure of federal government budgeting could fit within such a plan, with its tendency towards pork barrel appropriations and the lack of national focus among legislators. I don't know enough about Swedish politics to know whether similar tendencies exist there, but it seems that Swedish politicians have a better agreement on basics than do U.S. politicians. Could the parties agree on any set of chains?

By the way, Texas has a two year budget process that resembles somewhat your description of the Swedish longer term budget outlook. Texas politicians have become adept at pushing some expenditures into the next budget cycle by a month or so to meet the two year cycle restrictions.

burkbraunAugust 1st, 2011 at 8:53 am

The author forgets one important thing.. why Sweden doesn't face deflationary pressures from insufficient deficits. That is because it has a consistent trade surplus:
http://www.tradingeconomics.com/sweden/balance-of…

This surplus accommodates gradual economic growth while the government net contribution to growth is zero. But in the US, the situation is vastly different- persistent trade deficits, very high external demand for the currency, and thus a need for persistent government budget deficits. Thinking that gov. budget balance alone is some kind of universal motherhood and apple pie goodness, without appreciating its monetary and macro context is deeply mistaken, leading to all the right wing nostrums and misunderstandings.

EdDolanAugust 1st, 2011 at 3:42 pm

Craig– If you read some of the more conservative Swedish commentators on fiscal matters, they do worry about pork barrels and over spending. That is why the rules have been popular with the center-right alliance. From reports I've read, the Social Democrats were not too happy about some of the rules at first, especially the FPC, but after a few years, they have come around to supporting them, too.

Burkbraun– You are right that there is a relationship between budget deficits and the current account balance, but I don't think it is quite as simple as you make it out to be. The basic rule of accounting is (Ex-IM) = (T-G) + (S-I), that is, the external surplus of exports over imports has to equal the sum of the budget surplus and the surplus of domestic saving over domestic investment. If S=I, then the external deficit or surplus has to equal the government deficit or surplus (sometimes called the "twin deficit" phenomenon). But the causation of which deficit causes which is not so clear. For example, if the US decided to fix its deficit by a combination of tax increases and spending cuts, less need for Treasury borrowing would tend to lower interest rates, which in turn, would tend to cause the dollar to depreciate, which in turn, would cause imports to decrease and exports to increase. That is only one of several different causal paths that could operate.

The bottom line: If the US fixed its federal deficit problem, other things being equal, we would expect the current account to move toward surplus, with the reservation that part of the adjustment could also take place through domestic saving and investment.

burkbraunAugust 1st, 2011 at 2:04 pm

But one has to ask.. how much lower could interest rates be? The reality is that our trade balance position is not going to change appreciably in the near future, and certainly not due to a lowering of interest rates, even if that were the result of the policies you mention, which is rather doubtful.

The trade position arises from the power we have to export our currency to countries and individuals that want it rather than goods. China is an example, which prefers jobs and exports to consumption in dollars. This clearly doesn't have much to do with interest rates right now, but rather with our perceived safety and stability, which we are busily destroying, and our position as the reserve/global currency. If we are to plan for the real world in which we live, we can't and shouldn't rely on trade balancing up for the US.

EdDolanAugust 1st, 2011 at 2:53 pm

You're right, interest rates are not the most important adjustment path now. Yes, the fact that the dollar is a desired reserve currency works against US exports by keeping the currency higher than it otherwise would be. That is definitely a difference between the US and Sweden.

EdDolanAugust 2nd, 2011 at 6:54 am

A Swedish friend sends the following comment in a personal note that I take the liberty of reproducing in part:

"it seems very much like a success story (so far) and there seems to be more or less consensus on it. However, we will see what will happen with the Social Democras under their new leadership who were not involved in the economic policy making of the 1990s, whether they will stay committed or drift off in the populist direction.

"Finally, the economic reforms were accompanied by 'constitutional reform' extending the electoral cycle from 3 to 4 years. "

[I add] Hey, maybe a good idea: As long as the House Repubicans want to drag the country through the multi-stage agony of passing a constitutional amendment, why not add a clause extending House terms to 3 years and the President to 6, no reelection allowed?

tad_econAugust 5th, 2011 at 11:00 am

The merit of your proposals (Chilean and Swedish) is unquestionable. My question is whether the institutional differences make them unattainable. A common criticism is that the current congress cannot bind any future congress, e.g. why Republicans considered immediate tax increases in return for future spending cuts to be a Faustian deal. There does not appear to be a practical implementation. It really does depend upon the gentleman's agreement that you allude to in the Swedish legislature. It would seem to require a constitutional amendment rather than a simple law or rule, especially in light of your analysis that the US would require more rigidity than Sweden. Does anyone have a sense of the legal / constitutional hurdles required to implement some flavor of Prof. Dolan's suggestions?

Viktor TullgrenApril 14th, 2012 at 10:56 pm

As a Swede I would possibly want to note that the original opposition of the budget rules came from the liberals and conservatives. Interestingly the curent prime minister actually signed a bill opposing the rules when they were enacted. Especially calling the surplus rule "over taxation". The right wing parties have alter changed opinion.

Viktor TullgrenApril 14th, 2012 at 11:14 pm

I thought I should ad a point about the budget that is often overlooked but which is important in understanding why the rules work. And that is the change that were done in how a budget is voted upon.

In principle the rules demand that a budget is passed as a whole pacage. Meaning that amendments can't be added to the budget bill. Instead if changes to the suggested budget is wanted then this must be presented as a separate budget bill. The voting is then conducted so that the budget which most representatives of parlament support will be passed even if they are not a majority. A minority of parlament is thus able to pass a budget as long as the majority can not agre on another budget.

This part is often overlooked but actually one of the more important because it more or less eliminates the risk of dead looks. It also reduces the need for pork barrels to get a needed majority.

EdDolanApril 15th, 2012 at 10:04 am

Brilliant. The Swedes are so refreshingly honest. Our own deficit is so big because our own conservatives clearly regard raising enough taxes to cover the spending they vote for as "overtaxation," but they would never say so out loud. Maybe they, too, will change their views.

Viktor TullgrenApril 15th, 2012 at 6:33 pm

Well I Sweden would not have seen the need if it wasn't for the near state bankruptcy. But after that more or less the whole parlament agreed that it was better to have a rule that made certain that a budget passed then to have a situation were you risked ending up without one. Stopgap measurements is not a good way to run a government.

From my point of view I actually think this is the real problem in US. Of course some form of balanced budget amendment could be a good thing. But such an amendment is quite useless if congress is not able to pass a budget in the first place.

Unfortunately I don't know how such a rule would be work with the US bichamberal system. It would more or less require on of the chambers to be made superior to the other in such maters. And that seems to be against the US system.

Robert McMichaelDecember 31st, 2012 at 2:26 pm

Sweden is a very different country. Most Swedes are ethnically similar and Sweden has a relatively small immigrant population. Swedes have an affinity for one another and feel united. The USA is ethnically diverse and multicultural, with a huge population of immigrants and first and second generations born in the USA. Swedes with low and middle incomes pay high tax rates. In the USA half the voters are almost completely tax-free. The USA will remain divided due to its diversity and extreme class warfare at the ballot box.

EdDolanDecember 31st, 2012 at 3:54 pm

You are probably right about these things. However, they do not mean that we don't need better fiscal rules. They just explain why we don't have them.

AndrewFebruary 3rd, 2013 at 5:30 pm

What you don't explain, and I don't understand, is how Sweden could take so much money out of the private sector and not cause economic collapse. Certainly exports could explain part of it. The other possibility that comes to mind is that the government started taxing "correctly," which to me means taxing dollars that wouldn't otherwise get spent in the economy (in the US, we call this taxing the rich, and we think it unfair). Thoughts?

EdDolanFebruary 3rd, 2013 at 9:49 pm

Part of the answer is that the size of government is not as different from the US as many people might think. Sweden is highly centralized; when you compare Swedish total government to the total for federal, state and local government in the US, the difference for total expenditure is 51 to 40 percent (OECD, 2012 data). That is significant, but not massive.

Also, yes, Sweden has a somewhat more rational tax system. The US has about the worst tax code in the world. Sweden, for example, has a much lower corporate tax rate and fewer loopholes. That helps.

AndrewFebruary 5th, 2013 at 10:38 am

I don't understand what the size of the government has to do with anything.

If you are paying down debt, you are either not spending, or you are taxing money out of the private sector. Both are going to reduce GDP unless:

a) replaced with income from exports
b) you're taxing money that isn't contributing to GDP

When you're suggesting that the US follow Sweden's lead, it doesn't seem to be enough to say — look Sweden did these things and see how well it turned out for them. Instead, you have to show that it was the specific actions that Swedes took that helped their economy onto a better footing. One can argue about the right amount of government spending, but it seems pretty clear that changes in government spending are likely to have profound impacts on GDP if not offset.

Thanks for your thoughts,

EdDolanFebruary 5th, 2013 at 12:20 pm

OK, I'm sorry, I misunderstood your original question. I thought when you said "how Sweden could take so much money out of the private sector" you were suggesting (as many Americans believe) that the big-government Swedish "welfare state" model diverted too many resources out of the private sector. Now I see your question is quite different. You are asking why debt repayment does not tank the economy through its contractionary effect on aggregate demand.

The answer to that is that you can only safely pay down the government debt if you do so as part of a systematically countercyclical fiscal policy. If you pay down debt by taxing more or spending less when the economy is at the top of the cycle (positive output gap), then, rather than harming the economy, you are helping it by keeping the economy from overheating. Then, when you get another recession, you stop paying down the debt, and even run a deficit for a while. That is the Swedish concept.

At first, if you start with a big debt that you want to pay down, you policy is slightly asymmetrical. Your surpluses during booms are greater than your deficits during contractions. After you get the debt to a level you are happy with, you can make the policy more symmetrical.

The Swedish model is very different from the British "Austerian" approach of trying to pay down the debt when the economy is already weak. In the British case, your concerns would be fully justified.

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