## _wp0529

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---

### I. INTRODUCTION
- Central question: appropriate role for government in economic activity and social safety nets; how fiscal policies and government involvement affect growth, development, and income distribution.
- Sweden exemplifies a Scandinavian model: private sector production with extensive redistribution and government intervention, particularly in labor markets.
- Notable feature: high average and marginal tax rates on labor income and savings.
- Main analytical claim:
  - Sharp negative shocks, such as Sweden’s banking crisis in the early 1990s, produced a permanent decline in the level of output at the time of the shock.
  - The sizable output loss from the financial crisis "dwarfs any decline associated with tax distortions and public interventions, which remain largely unnoticeable in the macroeconomic data."
- Methodology summary:
  - Combination of analytical arguments and formal econometric testing.
  - Use of time-series behavior of output and a common factor regime-switching model to distinguish permanent and temporary output loss.

### II. THE SWEDISH ECONOMIC MODEL
- Characterization:
  - Large, centralized institutions, extensive income transfers, and social safety nets targeting equal distribution of income and wealth.
  - Emphasis on universal benefits, generous social insurance, a relatively high share of public enterprises, regulatory intervention, and a large public sector providing social services.
- Key magnitudes:
  - General government income transfers were about 18½ percent of GDP in 2000, compared with the OECD average of about 13 percent.
  - According to OECD Revenue Statistics for 1998, Sweden’s personal income tax was 18.6 percent of GDP vs. the OECD average of 10.1 percent.
  - Employer’s social security contributions: 10 percent of GDP compared with the OECD average of 5.8 percent of GDP.
  - Payroll taxes: 3.9 percent of GDP compared with the OECD average of 0.4 percent of GDP.
  - Sweden’s tax wedge on labor was the second highest in the OECD in 1998 (after Germany).
  - At 52 percent of GDP, Sweden had the highest ratio of total tax revenues to GDP of any OECD country.
- Corporate taxation:
  - Sweden maintained relatively low statutory corporate income tax rates to minimize base mobility distortions.
  - In 2002, Sweden’s corporate income tax rate was 28 percent.
  - Marginal effective corporate tax rate estimates are described as "very low."
- Labor market institutions:
  - Centralized labor bargaining aiming for full employment and high participation.
  - Active labor market programs complement passive unemployment insurance to prevent long-term unemployment.

### III. EVIDENCE ON GROWTH AND REDISTRIBUTION
- Definition: "sclerosis" = ongoing sluggish growth caused by distortions from welfare state policies.
- Theoretical channels linking redistribution and growth:
  - Negative effects:
    - High average and marginal tax rates distort leisure-work choices and can generate welfare losses.
    - Progressive taxation may discourage human capital accumulation.
    - High corporate taxes may discourage capital accumulation.
    - High capital income tax may distort saving decisions.
    - Liberal unemployment, sickness, and early retirement programs may reduce labor supply.
  - Positive/offsetting effects:
    - Public expenditures on education, health, and infrastructure may enhance growth.
    - Redistribution can relax liquidity constraints, encourage productive risk-taking, and foster social and political stability, improving incentives to save and invest.
- Empirical and theoretical references:
  - Agell, Englund, and Södersten (1995) quantify marginal efficiency costs of Swedish tax system; Table 1 provides marginal excess burden per krona of tax revenue at various marginal tax wedges and compensated labor supply elasticities.
- Exact figures from Table 1. Marginal Excess Burden per Krona of Tax Revenue (in percent):
  - 0.05 0.11 0.25
  - Marginal tax wedge (percent):
    - 62 (average blue-collar worker, 1991) 8.2 19.0 54.7
    - 63 (average earned income, 1991) 8.6 20.1 59.0
    - 70.5 (average blue-collar worker, 1988) 12.7 31.6 121.8
    - 71.5 (average white-collar worker, 1991) 13.4 33.9 139.1
    - 73 (average earned income, 1988) 14.6 37.8 175.0
    - 79 (average white-collar worker, 1988) 22.0 65.3 2280.0
    - 85.5 (average senior white-collar worker, 1988) 41.0 192.5 ---
    - Tax rate that maximizes tax revenue 94.5 89.5 79.5
    - Source: Agell, Englund, and Södersten (1995)
    - supply elasticity Compensated labor
- Interpretation:
  - Even at low labor supply elasticities, sufficiently high marginal tax rates can produce large marginal welfare losses per krona of tax revenue.
  - There exists a region where efficiency costs increase rapidly and outstrip additional tax revenue.
- Empirical evidence on labor supply:
  - Studies indicate cuts in income tax rates would increase labor supply of primary and secondary earners, but growth effects of small marginal tax changes may be limited because the most elastic group (secondary earners) comprises a smaller share of the workforce.
- Evidence that public spending can enhance productivity:
  - Sweden scored highest in literacy skills in the OECD’s International Adult Literacy Survey published in 2000.
  - Sweden tops the list of 94 countries in the State of the World index covering women’s and children’s health, education and political stability (Thakur, Keen, Horváth and Cerra, 2003).
  - Berndt and Hansson (1992) find infrastructure investment had a significant impact on Swedish productivity.
- Theoretical synthesis (Barro, 1990):
  - Predicts a hump-shaped relationship between size of government and growth: at low taxation levels, increased taxation/spending can raise growth via public goods (crowding in); at very high taxation, distortions dominate and growth declines. Optimal tax rate is positive.
- Mixed empirical results across studies and countries:
  - Some OECD-sample studies find negative effects of social transfers on growth; others find positive effects or nonmonotonic relationships.
  - Causality between redistribution and growth remains difficult to establish.

### IV. THE DEBATE ON SWEDEN’S RANKING OF INCOME PER CAPITA
- Historical trajectory:
  - Sweden moved from among the poorest in Europe in the mid-19th century to among the richest by 1950, driven by industrialization, high labor productivity growth, and neutrality during world wars.
  - Sweden’s relative per capita income declined relative to the average of 12 European countries in the subsequent twenty years but retained a high ranking through (text truncated in source).
- Core dispute summarized:
  - Lindbeck et al. (1994) claim Sweden’s OECD ranking fell from number 3 in 1970 to number 14 in 1991.
  - Korpi (1996) argues measurement problems, sample period selection, and other factors give an appearance of relative decline; actual relative income may have been fairly stable.
  - Factors that could cause an apparent decline besides welfare-state policies: demography, catching up (convergence), and avoidable macroeconomic mistakes.
- Technical issues affecting cross-country GDP comparisons:
  - Use of current exchange rates or selection of an arbitrary year for measurement can produce misleading and volatile GDP comparisons.
  - Periods of deteriorating terms of trade and rampant inflation can erode exchange rates and relative income positions.
  - Developments in U.S. dollar-ECU/euro cross rates affected the Swedish krona (example: mid-1980s).
  - Example: Korpi (1996) used 1985 exchange rates when the U.S. dollar was strong relative to EMS currencies and the krona was tied to a basket with a disproportionate weight on the U.S. dollar, making Sweden’s income look favorable in that year.
  - Purchasing power parity (PPP) adjusted exchange rates are widely used to mitigate these exchange-rate distortions.
- Sensitivity to sample period selection and business cycle timing:
  - Lindbeck et al. (1994) comparison relies on end points 1970 and 1991:
    - Sweden’s high ranking in 1970 coincided with a peak year when growth was 5.6 percent.
    - Sweden does not drop to fourteenth place until 1991, which was the beginning of a major recession.
  - Korpi’s use of 1973 and 1989 shows Sweden more favorably: 1973 was a relatively deep recession year for Sweden; 1989 was an unsustainable boom.
  - Small differences in business cycle timing can materially change country rankings because many rich OECD countries have very close output levels.
- Convergence and initial income effects:
  - Countries with lower initial per capita incomes tend to have higher growth rates (“catching up”).
  - Convergence implies initially rich countries’ relative income levels should decline toward the mean even if rankings remain unchanged.
  - Dowrick and Nguyen (1989) estimate:
    - Sweden’s smaller scope for catching up reduced growth by 0.8 percentage points during 1950–73 compared with the OECD average.
    - Differential total factor productivity (TFP) growth: 0.79 percent per year in 1950–60, and -0.25 percent per year in 1973–85.
- Demographic timing and working-age population:
  - One factor in Sweden’s relative decline may be the demographic shock of an aging population hitting Sweden earlier than other countries, reflecting rapid post–World War II population expansion.
  - Figure evidence: ratio of working-age persons to total population in Sweden declined slightly over four decades while it rose on average in 24 OECD countries.
  - Alternative income measures that adjust for demographics:
    - Output per working-age person and output per employed person considered; output per working-age person preferred to adjust for demographic structure and avoid unemployment-rate distortions.
- Long-term empirical patterns (1960–2003, PPP-adjusted):
  - Using 1995 prices and PPP exchange rates:
    - Sweden was in the top half until the mid-1970s and had per capita income fairly close to many countries.
    - From mid-1970s through 1990, many countries slowed slightly; several took off again in the 1990s.
    - Sweden’s banking crisis and recession in the early 1990s appear to have produced a permanently lower level of output, allowing several countries to overtake Sweden in per capita GDP rankings.
  - Figure 3 comparison (1960 vs 2003) shows convergence: countries above the mean in 1960 tended to decline toward the mean by 2003; Sweden moved from above the mean in 1960 to near the mean by 2003.
  - Output per working-age person:
    - Both GDP per capita and GDP per working-age person show Sweden maintained a relative position above the OECD average until the early 1990s recession.
    - From early 1990s, Sweden’s relative GDP per capita fell to the average of the 24 countries; relative GDP per working-age person fell but remained above the average.
- Comparison with a lower tax-transfer comparator group:
  - Comparator group: Australia, Canada, New Zealand, United Kingdom, United States (smaller tax-transfer systems).
  - Sweden’s growth per capita broadly in line with the comparator group, with a fall during the banking crisis.
  - Sweden’s growth of output per working-age person:
    - Compares well with the United States and the comparator-group average.
    - Over the full sample, Swedish growth outpaced the comparator-group average for output per working-age person (moving from below the average in 1960 to above it in 2003).
  - Growth rates of output per working-age person strongly parallel U.S. and comparator-group developments, with some asynchronous timing early in the sample.

### V. LABOR MARKET INDICATORS
- Labor force participation rate (2002, measured relative to population aged 15-64):
  - Sweden: 79.0
  - Nordic average: 79.9
  - U.S.: 76.4
  - Other comparator group average: 76.1
  - Euro area average: 68.3
- Unemployment rate (2003):
  - Sweden: 4.9
  - Nordic average: 5.5
  - U.S.: 6.0
  - Other comparator group average: 5.8
  - Euro area average: 8.8
- Active labor market programs averaged 2½ percent of the labor force over the last five years, raising total unemployment in Sweden slightly above the U.S. rate.
- Swedish unemployment rates were considerably below U.S. levels until the banking crisis produced a sharp surge in unemployment.

### VI. BANKING CRISIS, MACROECONOMIC POLICY MISTAKES, AND THEIR EFFECTS
- Post-liberalization boom in the latter half of the 1980s:
  - Fixed exchange rate regime combined with high inflation and rapid credit expansion.
  - High inflation and tax policy interaction produced negative real interest rates and a surge in private consumption and investment.
- 1990–91 tax reform was implemented without suitable expenditure-side adjustment.
- Attempts to maintain the fixed exchange rate amid slowing external demand led to rapid disinflation, skyrocketing real interest rates and fiscal deficits, collapse of asset markets, and a surge in nonperforming loans.
- Consequences:
  - Personal saving rates rose for precautionary motives.
  - Unemployment rose to unprecedented levels.
  - Substantial costs of banking-sector recapitalization added to public debt and sustainability concerns.
- IMF/author figures document boom–bust:
  - Bank claims on private sector (percent of GDP), real investment (billions of kronor, 1991 prices), net household savings ratio (percent), real after-tax lending rate (percent per year), loan loss provisions and profits before taxes in banking sector indicators.

### VII. ECONOMETRIC ANALYSIS: MODEL AND RESULTS
- Objective: formalize whether Sweden’s banking crisis produced a permanent loss in output.
- Theory context:
  - Hamilton (1989) regime-switching stochastic trend model: regime switch in growth rate of permanent component implies permanent output loss if switch to negative growth state.
  - Friedman (1964, 1993) “pluck” model: recessions are temporary deviations followed by full recovery to original trend.
- Model features:
  - Dynamic two-factor model decomposing logs of series into deterministic component (DTi), permanent component (Pit), and transitory component (Tit).
  - Common permanent component n and common temporary component x; idiosyncratic permanent (ζ) and temporary (ω) components.
  - Growth rate of common permanent component approximated by AR(2) with state-dependent trend β that depends on permanent state S1t (state ∈ {0,1}).
  - Common temporary component is stationary approximated by AR(2) with regime switching in state S2t to capture Friedman-type “pluck” behavior.
  - Both state variables assumed independent first-order Markov switching processes with transition probabilities p and q specified.
  - Multivariate identification uses comovement across series rather than univariate analysis.
- Data: two quarterly OECD datasets used:
  - Dataset A: output, private consumption, private investment.
  - Dataset B: output, unemployment, inflation.
- Empirical results:
  - Both datasets identify switching in the permanent output component at the time of the banking crisis.
  - The probability of a switch to a recession regime in the permanent component rises essentially to one for several quarters from 1989 to early 1993 for both datasets.
  - Other identified permanent recessions (probability > 0.5) occurred in 1976-77 and 1980-82 (oil shock and worldwide recession related to U.S. disinflation).
  - Dataset including output, unemployment, inflation also shows probability of recession exceeding 0.5 in 1971 and tenuously in 1996.
  - The model’s fitted change in the permanent component matches log output movements: each episode of negative switch aligns with stagnant or deteriorating output.

### VIII. CONCLUSIONS AND POLICY IMPLICATIONS
- Main empirical finding:
  - There was a permanent output decline associated with Sweden’s banking crisis.
  - The permanent decline led to a drop in Sweden’s per capita GDP relative to other OECD countries and a sudden drop in ranking.
- Broader implications:
  - The result documents the costs of banking crises and underscores the importance of preventing them via appropriate financial sector supervision and regulation and sound macroeconomic policies.
  - Cerra and Saxena (2004 and 2005) corroborate that permanent output loss is a consequence of most financial crises; Sweden’s case is not unique and therefore not attributable solely to welfare-state features.
  - No evidence that welfare-state policies led to “sclerosis”: Sweden performed at least as well as the OECD average and the low tax-transfer comparator group on multiple macroeconomic criteria.
  - Sweden’s strong labor market metrics (pre-crisis) and growth similar to OECD average suggest macroeconomic policy mistakes—not welfare-state sclerosis—explained the abrupt relative slippage.
- Caution in cross-sectional growth inference:
  - Time-dimension analysis helps disentangle causes of growth declines from collinear variables in cross-sectional regressions (e.g., high tax rates vs. banking-crisis dummy).
  - Incorporating time series variation can better identify true determinants of growth declines.

*Source: _wp0529 — IMF Working Paper excerpt (References and selected content).*

### References .............................................................................................................

### _wp0529 - References

### I. INTRODUCTION
- Central question: appropriate role for government in economic activity and social safety nets; how fiscal policies and government involvement affect growth, development, and income distribution.
- Sweden exemplifies a Scandinavian model: private sector production with extensive redistribution and government intervention, particularly in labor markets.
- Notable feature: high average and marginal tax rates on labor income and savings.
- Main analytical claim:
  - Sharp negative shocks, such as Sweden’s banking crisis in the early 1990s, produced a permanent decline in the level of output at the time of the shock.
  - The sizable output loss from the financial crisis "dwarfs any decline associated with tax distortions and public interventions, which remain largely unnoticeable in the macroeconomic data."
- Methodology summary:
  - Combination of analytical arguments and formal econometric testing.
  - Use of times-series behavior of output and a common factor regime-switching model to distinguish permanent and temporary output loss.

### II. THE SWEDISH ECONOMIC MODEL
- Characterization:
  - Large, centralized institutions, extensive income transfers, and social safety nets targeting equal distribution of income and wealth.
  - Emphasis on universal benefits, generous social insurance, a relatively high share of public enterprises, regulatory intervention, and a large public sector providing social services.
- Key magnitudes (preserve exactly as in source):
  - General government income transfers were about 18½ percent of GDP in 2000, compared with the OECD average of about 13 percent.
  - According to OECD Revenue Statistics for 1998, Sweden’s personal income tax was 18.6 percent of GDP vs. the OECD average of 10.1 percent.
  - Employer’s social security contributions: 10 percent of GDP compared with the OECD average of 5.8 percent of GDP.
  - Payroll taxes: 3.9 percent of GDP compared with the OECD average of 0.4 percent of GDP.
  - Sweden’s tax wedge on labor was the second highest in the OECD in 1998 (after Germany).
  - At 52 percent of GDP, Sweden had the highest ratio of total tax revenues to GDP of any OECD country.
- Corporate taxation:
  - Sweden maintained relatively low statutory corporate income tax rates to minimize base mobility distortions.
  - In 2002, Sweden’s corporate income tax rate was 28 percent.
  - Marginal effective corporate tax rate estimates are described as "very low."
- Labor market institutions:
  - Centralized labor bargaining aiming for full employment and high participation.
  - Active labor market programs complement passive unemployment insurance to prevent long-term unemployment.

### III. EVIDENCE ON GROWTH AND REDISTRIBUTION
- Definition: "sclerosis" = ongoing sluggish growth caused by distortions from welfare state policies.
- Theoretical channels linking redistribution and growth:
  - Negative effects:
    - High average and marginal tax rates distort leisure-work choices and can generate welfare losses.
    - Progressive taxation may discourage human capital accumulation.
    - High corporate taxes may discourage capital accumulation.
    - High capital income tax may distort saving decisions.
    - Liberal unemployment, sickness, and early retirement programs may reduce labor supply.
  - Positive/offsetting effects:
    - Public expenditures on education, health, and infrastructure may enhance growth.
    - Redistribution can relax liquidity constraints, encourage productive risk-taking, and foster social and political stability, improving incentives to save and invest.
- Empirical and theoretical references:
  - Agell, Englund, and Södersten (1995) quantify marginal efficiency costs of Swedish tax system; Table 1 provides marginal excess burden per krona of tax revenue at various marginal tax wedges and compensated labor supply elasticities.
- Exact figures from Table 1 (preserve formatting of numbers and labels exactly as in source):
  - Table 1. Marginal Excess Burden per Krona of Tax Revenue (in percent)
    - 0.05 0.11 0.25
    - Marginal tax wedge (percent):
      - 62 (average blue-collar worker, 1991) 8.2 19.0 54.7
      - 63 (average earned income, 1991) 8.6 20.1 59.0
      - 70.5 (average blue-collar worker, 1988) 12.7 31.6 121.8
      - 71.5 (average white-collar worker, 1991) 13.4 33.9 139.1
      - 73 (average earned income, 1988) 14.6 37.8 175.0
      - 79 (average white-collar worker, 1988) 22.0 65.3 2280.0
      - 85.5 (average senior white-collar worker, 1988) 41.0 192.5 ---
    - Tax rate that maximizes tax revenue 94.5 89.5 79.5
    - Source: Agell, Englund, and Södersten (1995)
    - supply elasticity Compensated labor
- Interpretation of the table:
  - Even at low labor supply elasticities, sufficiently high marginal tax rates can produce large marginal welfare losses per krona of tax revenue.
  - There exists a region where efficiency costs increase rapidly and outstrip additional tax revenue.
- Empirical evidence on labor supply:
  - Studies indicate cuts in income tax rates would increase labor supply of primary and secondary earners, but growth effects of small marginal tax changes may be limited because the most elastic group (secondary earners) comprises a smaller share of the workforce.
- Evidence that public spending can enhance productivity:
  - Sweden scored highest in literacy skills in the OECD’s International Adult Literacy Survey published in 2000.
  - Sweden tops the list of 94 countries in the State of the World index covering women’s and children’s health, education and political stability (Thakur, Keen, Horváth and Cerra, 2003).
  - Berndt and Hansson (1992) find infrastructure investment had a significant impact on Swedish productivity.
- Theoretical synthesis (Barro, 1990):
  - Predicts a hump-shaped relationship between size of government and growth: at low taxation levels, increased taxation/spending can raise growth via public goods (crowding in); at very high taxation, distortions dominate and growth declines. Optimal tax rate is positive.
- Mixed empirical results across studies and countries:
  - Some OECD-sample studies find negative effects of social transfers on growth; others find positive effects or nonmonotonic relationships.
  - Causality between redistribution and growth remains difficult to establish.

### IV. THE DEBATE ON SWEDEN’S RANKING OF INCOME PER CAPITA
- Historical trajectory:
  - Sweden moved from among the poorest in Europe in the mid-19th century to among the richest by 1950, driven by industrialization, high labor productivity growth, and neutrality during world wars.
  - Sweden’s relative per capita income declined relative to the average of 12 European countries in the subsequent twenty years but retained a high ranking through (text truncated in source).
- Core dispute summarized:
  - Critics argued in the mid-1990s that welfare state policies undermined Sweden’s growth performance (e.g., Lindbeck et al., 1994).
  - Debate centers on whether Sweden suffered a relative decline in growth and living standards and whether that decline is attributable to the welfare state (high taxes and labor market interventions) or to other factors such as demography and policy mistakes.
- Authors’ recomposition of the debate:
  - Using extended data and time-series analysis, the paper finds Sweden’s ranking slipped suddenly around the early 1990s banking crisis rather than due to long-run effects of redistributive policies.
  - Emphasizes the advantage of time-dimension analyses over cross-country long-run growth regressions, which may be fragile or misspecified when permanent level shifts from shocks occur.

*Source: _wp0529 - References (excerpted content supplied).*

### 1970. Lindbeck et al. (1994) note that Sweden’s ranking among OECD countries fell from

### _wp0529 - 1970. Lindbeck et al. (1994) note that Sweden’s ranking among OECD countries fell from

### Debate over Sweden’s apparent relative decline
- Lindbeck et al. (1994) claim Sweden’s OECD ranking fell from number 3 in 1970 to number 14 in 1991.
- Korpi (1996) argues that measurement problems, sample period selection, and other factors give an appearance of relative decline; actual relative income may have been fairly stable.
- Factors that could cause an apparent decline besides welfare-state policies: demography, catching up (convergence), and avoidable macroeconomic mistakes.

### Technical issues affecting cross-country GDP comparisons
- Use of current exchange rates or selection of an arbitrary year for measurement can produce misleading and volatile GDP comparisons.
- Periods of deteriorating terms of trade and rampant inflation can erode exchange rates and relative income positions.
- Developments in U.S. dollar-ECU/euro cross rates affected the Swedish krona (example: mid-1980s).
- Example: Korpi (1996) used 1985 exchange rates when the U.S. dollar was strong relative to EMS currencies and the krona was tied to a basket with a disproportionate weight on the U.S. dollar, making Sweden’s income look favorable in that year.
- Purchasing power parity (PPP) adjusted exchange rates are widely used to mitigate these exchange-rate distortions.

### Sensitivity to sample period selection and business cycle timing
- Lindbeck et al. (1994) comparison relies on end points 1970 and 1991:
  - Sweden’s high ranking in 1970 coincided with a peak year when growth was 5.6 percent.
  - Sweden does not drop to fourteenth place until 1991, which was the beginning of a major recession.
  - Korpi’s use of 1973 and 1989 shows Sweden more favorably: 1973 was a relatively deep recession year for Sweden; 1989 was an unsustainable boom.
- Small differences in business cycle timing can materially change country rankings because many rich OECD countries have very close output levels.

### Convergence and initial income effects
- Countries with lower initial per capita incomes tend to have higher growth rates (“catching up”).
- Convergence implies initially rich countries’ relative income levels should decline toward the mean even if rankings remain unchanged.
- Dowrick and Nguyen (1989) estimate:
  - Sweden’s smaller scope for catching up reduced growth by 0.8 percentage points during 1950–73 compared with the OECD average.
  - Differential total factor productivity (TFP) growth: 0.79 percent per year in 1950–60, and -0.25 percent per year in 1973–85.

### Demographic timing and working-age population
- One factor in Sweden’s relative decline may be the demographic shock of an aging population hitting Sweden earlier than other countries, reflecting rapid post–World War II population expansion.
- Figure evidence: ratio of working-age persons to total population in Sweden declined slightly over four decades while it rose on average in 24 OECD countries.
- Alternative income measures that adjust for demographics:
  - Output per working-age person and output per employed person considered; output per working-age person preferred to adjust for demographic structure and avoid unemployment-rate distortions.

### Long-term empirical patterns (1960–2003, PPP-adjusted)
- Using 1995 prices and PPP exchange rates:
  - Sweden was in the top half until the mid-1970s and had per capita income fairly close to many countries.
  - From mid-1970s through 1990, many countries slowed slightly; several took off again in the 1990s.
  - Sweden’s banking crisis and recession in the early 1990s appear to have produced a permanently lower level of output, allowing several countries to overtake Sweden in per capita GDP rankings.
- Figure 3 comparison (1960 vs 2003) shows convergence: countries above the mean in 1960 tended to decline toward the mean by 2003; Sweden moved from above the mean in 1960 to near the mean by 2003.
- Output per working-age person:
  - Both GDP per capita and GDP per working-age person show Sweden maintained a relative position above the OECD average until the early 1990s recession.
  - From early 1990s, Sweden’s relative GDP per capita fell to the average of the 24 countries; relative GDP per working-age person fell but remained above the average.

### Comparison with a lower tax-transfer comparator group
- Comparator group: Australia, Canada, New Zealand, United Kingdom, United States (smaller tax-transfer systems).
- Sweden’s growth per capita broadly in line with the comparator group, with a fall during the banking crisis.
- Sweden’s growth of output per working-age person:
  - Compares well with the United States and the comparator-group average.
  - Over the full sample, Swedish growth outpaced the comparator-group average for output per working-age person (moving from below the average in 1960 to above it in 2003).
- Growth rates of output per working-age person strongly parallel U.S. and comparator-group developments, with some asynchronous timing early in the sample.

### Labor market indicators
- 2002 labor force participation rate (measured relative to population aged 15-64):
  - Sweden: 79.0
  - Nordic average: 79.9
  - U.S.: 76.4
  - Other comparator group average: 76.1
  - Euro area average: 68.3
- Unemployment rate, 2003:
  - Sweden: 4.9
  - Nordic average: 5.5
  - U.S.: 6.0
  - Other comparator group average: 5.8
  - Euro area average: 8.8
- Note: Active labor market programs averaged 2½ percent of the labor force over the last five years, raising total unemployment in Sweden slightly above the U.S. rate.
- Swedish unemployment rates were considerably below U.S. levels until the banking crisis produced a sharp surge in unemployment.

### Banking crisis, macroeconomic policy mistakes, and their effects
- Post-liberalization boom in the latter half of the 1980s:
  - Fixed exchange rate regime combined with high inflation and rapid credit expansion.
  - High inflation and tax policy interaction produced negative real interest rates and a surge in private consumption and investment.
- 1990–91 tax reform was implemented without suitable expenditure-side adjustment.
- Attempts to maintain the fixed exchange rate amid slowing external demand led to rapid disinflation, skyrocketing real interest rates and fiscal deficits, collapse of asset markets, and a surge in nonperforming loans.
- Consequences:
  - Personal saving rates rose for precautionary motives.
  - Unemployment rose to unprecedented levels.
  - Substantial costs of banking-sector recapitalization added to public debt and sustainability concerns.
- IMF/author figures document boom–bust:
  - Bank claims on private sector (percent of GDP), real investment (billions of kronor, 1991 prices), net household savings ratio (percent), real after-tax lending rate (percent per year), loan loss provisions and profits before taxes in banking sector indicators.

### Econometric analysis: model and results
- Objective: formalize whether Sweden’s banking crisis produced a permanent loss in output.
- Theory context:
  - Hamilton (1989) regime-switching stochastic trend model: regime switch in growth rate of permanent component implies permanent output loss if switch to negative growth state.
  - Friedman (1964, 1993) “pluck” model: recessions are temporary deviations followed by full recovery to original trend.
- Model features:
  - Dynamic two-factor model decomposing logs of series into deterministic component (DTi), permanent component (Pit), and transitory component (Tit).
  - Common permanent component n and common temporary component x; idiosyncratic permanent (ζ) and temporary (ω) components.
  - Growth rate of common permanent component approximated by AR(2) with state-dependent trend β that depends on permanent state S1t (state ∈ {0,1}).
  - Common temporary component is stationary approximated by AR(2) with regime switching in state S2t to capture Friedman-type “pluck” behavior.
  - Both state variables assumed independent first-order Markov switching processes with transition probabilities p and q specified.
  - Multivariate identification uses comovement across series rather than univariate analysis.
- Data: two quarterly OECD datasets used:
  - Dataset A: output, private consumption, private investment.
  - Dataset B: output, unemployment, inflation.
- Empirical results:
  - Both datasets identify switching in the permanent output component at the time of the banking crisis.
  - The probability of a switch to a recession regime in the permanent component rises essentially to one for several quarters from 1989 to early 1993 for both datasets.
  - Other identified permanent recessions (probability > 0.5) occurred in 1976-77 and 1980-82 (oil shock and worldwide recession related to U.S. disinflation).
  - Dataset including output, unemployment, inflation also shows probability of recession exceeding 0.5 in 1971 and tenuously in 1996.
  - The model’s fitted change in the permanent component matches log output movements: each episode of negative switch aligns with stagnant or deteriorating output.

### Conclusions and policy implications
- Main empirical finding:
  - There was a permanent output decline associated with Sweden’s banking crisis.
  - The permanent decline led to a drop in Sweden’s per capita GDP relative to other OECD countries and a sudden drop in ranking.
- Broader implications:
  - The result documents the costs of banking crises and underscores the importance of preventing them via appropriate financial sector supervision and regulation and sound macroeconomic policies.
  - Cerra and Saxena (2004 and 2005) corroborate that permanent output loss is a consequence of most financial crises; Sweden’s case is not unique and therefore not attributable solely to welfare-state features.
  - No evidence that welfare-state policies led to “sclerosis”: Sweden performed at least as well as the OECD average and the low tax-transfer comparator group on multiple macroeconomic criteria.
  - Sweden’s strong labor market metrics (pre-crisis) and growth similar to OECD average suggest macroeconomic policy mistakes—not welfare-state sclerosis—explained the abrupt relative slippage.
- Caution in cross-sectional growth inference:
  - Time-dimension analysis helps disentangle causes of growth declines from collinear variables in cross-sectional regressions (e.g., high tax rates vs. banking-crisis dummy).
  - Incorporating time series variation can better identify true determinants of growth declines.

*Source: IMF Working Paper content unit provided.*

### References

### _wp0529 - References

### Inequality, redistribution, and growth
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- Aghion, Philippe, Eva Caroli, and Cecilia García-Peñalosa, 1999, “Inequality and Economic Growth: The Perspective of the New Growth Theories,” Journal of Economic Literature, Vol. 37, pp. 1615–60.
- Alesina, Alberto, and Dani Rodrik, 1994, “Redistributive policies and economic growth,” The Quarterly Journal of Economics, 109(2), pp. 465–90.
- Benabou, Roland, 1996, “Inequality and growth,” in NBER Macroeconomic Annual, Vol. 11, ed. by B.S. Bernanke and J. Rotermberg (Cambridge, Massachusetts: MIT Press).
- Korpi, Walter, 1985, “Economic growth and the welfare system: Leaky bucket or irrigation system?” European Sociological Review, Vol. 1, pp. 97–118.
- Persson, Torsten, and Guido Tabellini, 1991, “Is inequality harmful for growth? Theory and evidence,” NBER Working Paper 3599 (Cambridge, Massachusetts: National Bureau of Economic Research).
- ———, 1994, “Is inequality harmful for growth?” American Economic Review, Vol. 84, pp. 600–21.
- Van Der Ploeg, Frederick, 2004, “The Welfare State Redistribution and the Economy: Reciprocal Altruism, Consumer Rivalry and Second Best,” CESifo Working Paper No. 1234 (Munich, Germany: Center for Economic Studies and Institute for Economic Research).

### Fiscal policy, government spending, and public capital
- Alesina, Alberto, and Roberto Perotti, 1996, “Income distribution, political instability and investment,” European Economic Review, Vol. 40, pp. 1203–28.
- Barro, Robert, 1989, “A cross-country study of growth, saving and government,” NBER Working Paper 2855 (Cambridge, Massachusetts: National Bureau of Economic Research).
- ———, 1990, “Government spending in a simple model of endogenous growth,” Journal of Political Economy, 98(5), pp. 103–17.
- Castles, Francis, and Steve Dowrick, 1990, “The impact of government spending levels on medium-term economic growth in the OECD, 1960-85,” Journal of Theoretical Politics, Vol. 2, pp. 173–204.
- Easterly, William, and Sergio Rebelo, 1993, “Fiscal policy and economic growth: An empirical investigation,” Journal of Monetary Economics, Vol. 32, pp. 417–58.
- Hansson, Par, and Magnus Henrekson, 1994, “A new framework for testing the effects of government spending on growth and productivity,” Public Choice, Vol. 81, pp. 381–401.
- Kneller, Richard, Michael Bleaney, and Normal Gemmell, 1999, “Fiscal Policy and Growth: Evidence from OECD Countries,” Journal of Public Economics, Vol. 74, pp. 171–90.
- Sala-i-Martin, Xavier, 1992, “Public Welfare and Growth,” Yale University Economic Growth Center Discussion Paper 666, New Haven, Yale University.
- Berndt, Ernst, and Bengt Hansson, 1992, “Measuring the contribution of public infrastructure capital in Sweden,” Scandinavian Journal of Economics, Vol. 94, pp. 151–68.

### Welfare state, Sweden, and Nordic studies
- Agell, Jonas, Peter Englund, and Jan Södersten, 1995, Swedish Tax Policy in Theory and Practice: The 1991 Tax Reform (Stockholm: Frizes).
- Lindbeck, Assar, 1997, “The Swedish Experiment,” Journal of Economic Literature, Vol. 35, pp. 1273–1319.
- Lindbeck, Assar, Per Molander, Torsten Persson, Olof Petersson, Agnar Sandmo, Birgitta Swedenborg, and Niels Thygesen, 1994, Turning Sweden Around (London: MIT Press).
- Thakur, Subhash, Michael Keen, Balazs Horváth, and Valerie Cerra, 2003, Sweden’s Welfare State: Can the Bumblebee Keep Flying? (Washington: International Monetary Fund).
- Du Rietz, Gunnar, 1994, “Välfärdsstatens finansiering,” Socialstatsprojektet 1994.1 (Stockholm: City University Press).
- Drees, Burkhard and Ceyla Pazarbaşioğlu, 1998, The Nordic Banking Crisis: Pitfalls in Financial Liberalization, IMF Occasional Paper No. 161 (Washington: International Monetary Fund).

### Growth theory, convergence, and determinants of long-run growth
- Dowrick, Steve, and Duc-Tho Nguyen, 1989, “OECD comparative economic growth 1950-85: Catch-Up and Convergence,” American Economic Review, Vol. 79, pp. 1010–30.
- Doppelhofer, Gernot, Ronald Miller, and Xavier Sala-i-Martin, 2000, “Determinants of Long-term Growth: A Bayesian Averaging of Classical Estimates (BAGE) Approach,” NBER Working Paper 7750 (Cambridge, Massachusetts: National Bureau of Economic Research).
- Maddison, Angus, 2001, “The world economy: A millennial perspective,” OECD Development Center Studies (Paris: Organization for Economic Cooperation and Development).
- McCallum, John, and Andre Blais, 1987, “Government, special interest groups and economic growth,” Public Choice, Vol. 54, pp. 3–18.
- Weede, Erich, 1986, “Sectoral reallocation, distributional coalitions and the welfare state as determinants of economic growth rates in industrialized democracies,” European Journal of Political Research, Vol. 14, pp. 501–19.
- ———, 1991, “The impact of state power on economic growth rates in OECD countries,” Quality and Quantity, Vol. 25, pp. 421–38.
- Korpi, Walter, 1996, “Eurosclerosis and the Sclerosis of Objectivity: On the role of values among economic policy experts,” Economic Journal, Vol. 106, pp. 1727–46.

### Time series, business cycles, and econometric methods
- Friedman, Milton, 1964, Monetary Studies of the National Bureau, the National Bureau Enters its 45th Year, 44th Annual Report, 7-25, NBER, New York; reprinted in Friedman, M., 1969, The Optimum Quantity of Money and Other Essays, Aldine, Chicago.
- ———, 1993, “The ‘Plucking Model’ of Business Fluctuations Revisited,” Economic Inquiry, Vol. 31 (April), pp. 171–77.
- Hamilton, James D., 1989, “A New Approach to the Economic Analysis of Nonstationary Times Series and the Business Cycle,” Econometrica, Vol. 57 (March), pp. 357–84.
- Nelson, Charles R., and Charles I. Plosser, 1982, “Trends and random walks in macroeconomic time series: some evidence and implications,” Journal of Monetary Economics, Vol. 10, pp. 139–62.
- Stock, James, and M.W. Watson, 1989, “New Indexes of Coincident and Leading Indicators,” in NBER Macroeconomics Annual 1989 Vol. 4, ed. by O. J. Blanchard and S. Fischer (Cambridge, Massachusetts: MIT Press).
- ———, 1991, “A Probability Model of the Coincident Economic Indicators,” in Leading Economic Indicators: New Approaches and Forecasting Records, ed. by K. Lahiri and G. H. Moore (New York, NY: Cambridge University Press).
- ———, 1993, “A Procedure for Predicting Recessions with Leading Indicators: Econometric Issues and Recent Experiences,” in Business Cycles, Indicators, and Forecasting, ed. by J. H. Stock and M. W. Watson (Chicago, Illinois: University of Chicago Press).
- Kim, Chang Jin, and Christian Murray, 2002, “Permanent and Transitory Components of Recessions,” Empirical Economics, Vol. 27, No. 2, pp. 163–83.
- Kim, Chang Jin, and Jeremy Piger, 2002, “Common Stochastic Trends, Common Cycles, and Asymmetry in Economic Fluctuations,” Journal of Monetary Economics, Vol. 49 (September), pp. 1189–1211.
- Cerra, Valerie, and Sweta Saxena, 2004, “Growth Dynamics: The Myth of Economic Recovery” (unpublished; Washington: International Monetary Fund).
- ———, 2005, “Did Ouput Recover from the Asian Crisis?” IMF Staff Papers (forthcoming; Washington: International Monetary Fund).

*References list from _wp0529 - References*

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