Growth in a Time of Austerity: Looking beyond Germany at the Nordic Model

Adrian Wooldridge is the Management Editor and ‘Schumpeter’ Columnist for The Economist. He recently published a detailed Special Report on the Nordic Model for The Economist entitled “Northern Lights.” He wrote the following essay based on the remarks he made at AGI’s recent roundtable on “Growth in Times of Austerity: Looking beyond Germany at the Scandinavian Model.”

AGI normally focuses on a big country at the heart of Europe. Today I want to focus on four countries—Sweden, Denmark, Finland and Norway—that have a collective population of 25 million and shiver on the far North of Europe. Germany is the engine of the euro. Sweden and Denmark are outside the euro zone and Norway has refused to join the euro. Yet the Nordic model has some important lessons for the rest of the world: lessons that the rest of the world might be willing to learn precisely because the Nordic countries are much smaller and more peripheral than the German giant.

One is about the relationship between austerity and growth. The debate between the proponents of austerity and the proponents of growth is at the centre of the current global political debate. The austerity camp argues that retrenchment and reform are preconditions for healthy growth. The growth camp argues that retrenchment and reform can be self-defeating if too many countries retrench and reform at once.

The Nordic model powerfully reinforces the austerity camp. All four countries faced near disaster in the early 1990s and responded by cutting their debt and introducing far reaching reforms. They are now some of the best performing economies in the rich world. Sweden’s GDP grew by an average of 2.7% a year and productivity 2.1% a year in 1993-2010, compared with 1.9% and 1% respectively for the main 15 EU countries. But this observation comes with a big caveat: the Nordics introduced their reforms in the 1990s when the rest of the world economy was growing healthily.

The second lesson is that the Nordic model tells us something interesting about productivity growth in the public sector. The rich world is entering a prolonged period of austerity in the public sector as demand runs ahead of supply and the population ages. But the Nordic countries have been very successful at boosting productivity in the public sector. In order to draw the right lessons from the Nordic model, we have to start off by deciding what the Nordic model is. Most people continue to think that the Nordic world is stuck in the 1970s: ruled by Social Democrats who believe in super sizing the state, milking business and entrepreneurs for ever higher taxes and driving the economy to the left. However, that particular Nordic model hit the buffers in the 1980s: Sweden was demoted from being the world’s fourth-richest in 1970 to 14th-richest in 1993, when the average Swede was poorer than the average Briton or Italian. The Nordic countries—led by Sweden, which has been the regional pace setter over these years—completely overhauled their model and replaced it by a new one.

The old model depended on the idea that the state could keep on getting bigger. The answer to every problem was more state—and more state inevitably meant more taxes and more regulation. But in the 1990s the Nordic countries realized that they had reached the limits of big government. The new model focused on restraining the growth of the state and getting more productivity from taxes. It also focused on putting long-term finances on a sound footing.

Sweden reduced public spending as a proportion of GDP from 67% in 1993 to 49% today. It could soon have a smaller state than Britain. It also cut the top marginal tax rate by 27 percentage points since 1983, to 57%, and scrapped a mare’s nest of taxes on property, gifts, wealth, and inheritance. In 2013 it cut the corporate-tax rate from 26.3% to 22%. Sweden also donned the golden straitjacket of fiscal orthodoxy with its pledge to produce a fiscal surplus over the economic cycle. Its public debt fell from 70% of GDP in 1993 to 37% in 2010, and its budget moved from an 11% deficit to a surplus of 0.3% over the same period. Sweden also put its pension system on a sound foundation, replacing a defined-benefit system with a defined-contribution one and making automatic adjustments for longer life expectancy.

The old model depended on a very homogeneous and deferential society. The state made the big decisions about people’s lives—even drawing up complicated rules about the size and layout of kitchens—and the people accepted them because they were ethnically homogeneous, socially equal and culturally deferential: they believed in the wisdom of bureaucrats. But society is much less homogeneous than it was—14% of Swedes were born abroad—and much less equal. There has been an explosion in the number of new rich driven by the private equity boom in Sweden, the oil boom in Norway and the Nokia boom in Finland. The Nordic countries have all redesigned their welfare states to put individual choice (and to a lesser extent individual responsibility) as their hearts.

The old model depended on big globalized companies such as Sweden’s Volvo and Denmark’s Novo Nordisc producing a generous surplus that could be taxed by the state and redistributed to the rest of society. But globalization is changing this. Traditional champions are expanding abroad and competing head-to-head with low cost rivals. And foreign companies are entering Nordic markets: China’s Geely has bought Volvo for example.

The new model preserves some of the features of the old: 30% of the population is employed in the public sector and the unfortunate can rely on long-term care. But the basic features have been rejigged. The new Nordic model begins with the individual rather than the state. It begins with fiscal responsibility rather than pump-priming: all four Nordic countries have AAA ratings and debt loads significantly below the euro-zone average. It begins with choice and competition rather than paternalism and planning. The economic-freedom index of the Fraser Institute, a Canadian think-tank, shows Sweden and Finland catching up with the United States. The leftward lurch has been reversed: rather than extending the state into the market, the Nordics are extending the market into the state.

The Nordic countries have two big lessons for the classic austerity debate. The first is that you need to combine short-term crisis management with long-term entitlement reform. The Nordics seized on the crisis of the early 1990s to deal with pension obligations as well as short-term imbalances. This allowed them to earn the long-term confidence of the markets. All four countries recovered from the 2007-08 financial crisis relatively unscathed despite being small, open economies.

The second is that you need to lay the foundations of long-term growth by unleashing the private sector’s animal spirits. The Nordic countries realized that they had reached the limits of relying on a handful of global champions. They did what they could—by lowering taxes, reforming regulations and changing the culture—to encourage high-growth entrepreneurial firms. The region is now producing a striking number of successful new companies, such as Skype and Spotify in Sweden and Rovio (maker of Angry Birds) and Supercell (maker of Clash of Clans) in Finland. It is also enjoying a cultural renaissance with the Nordic noire boom and the Nordic culinary boom. Who would have guessed twenty years ago that Denmark would produce Europe’s best restaurant (Noma) and its best TV drama (The Killing)?

The most interesting lessons are about improving the productivity of the public sector. All four countries have pioneered bold experiments with introducing markets into the public sector. And all four have pioneered post-ideological politics that combines the best ideas from different political traditions.

Sweden has introduced school vouchers and allowed private equity companies to run chains of schools. Almost half the country’s schoolchildren choose not to go to their local schools. More than 10% of students under 16 and more than 20% of those over 16 attend “free” schools, two-thirds of which are run by private companies.

Denmark has introduced vouchers and private schools, but with the proviso that you can top up with private funds. Denmark has also introduced “flexisecurity” (protecting workers, not jobs, by making it easier to sack people). Finland has created one of the world’s most successful school systems by devolving power teachers. It has also created an eco-system of entrepreneurial companies by providing venture capital for start-ups and providing mentorship for fledgling entrepreneurs.

All this comes with lots of caveats. It is hard to imitate other people’s success. The Nordic model is rooted in Nordic culture, which puts a high premium on trusting institutions and demanding transparency and honesty.

But the Nordic model nevertheless points to two big conclusions. One is that all countries will eventually reach the limits of big government: the point whereby you can no longer offer more government without overburdening the economy and producing diminishing returns. The Nordics have dealt with this by introducing a post-ideological and pragmatic politics. But other countries might do so by engaging in pointless squabbles and slash-and-burn politics.

The second is closely related: the importance of good government in promoting long-term growth. We spent the 1980s rediscovering the value of the market. I suspect that we will spend the next decade rediscovering the value of government. Good government can square the circle and ensure that we have a competitive economy and a generous welfare state. Bad government can do the opposite and turn economic crises into calamities and political dysfunction into long-term economic decline.