Preparing for the next crisis
Lessons from the successful Swedish fiscal framework
Fredrik N G Andersson
Department of Economics, Lund University
Department of Economics and Knut Wicksell Centre for Financial Studies, Lund University
Prepared for the forthcoming volume: Using Fiscal and Monetary Rules to Solve the Debt Crisis
November 30, 2020
Abstract: This paper discusses the history and the post-corona future of the Swedish fiscal framework. First, we describe how the fiscal framework evolved domestically following a major fiscal crisis in the early 1990s, and how it contributed to a quarter of a century of stable public finances and declining public debt. We argue that the success of the framework is not only found in the formal rules, but also in the political environment that developed since the 1990s. The memory of the fiscal crisis contributed to a long lasting political consensus across the political spectrum of the importance of sustainable public finances.
Next, we focus on the future. We claim that the framework has some key weaknesses that may reduce its efficiency in the future. It focuses too much on a surplus target that is easy to break, and too much of its success is due to the memory of the fiscal crisis in the 1990s. We recommend one key change to strengthen the framework: a shift in attention from maintaining a budget surplus of 1/3 percent of GDP over the business cycle to sustaining a stable debt-to-GDP ratio of 25 percent of GDP +/- 5 percentage points. A debt anchor at this level would introduce a memory into the framework and provide sufficient fiscal space in case of a future major economic crisis judging from recent cross-country evidence as well as from the recent corona crisis.
The necessity to maintain stable public finances is increasingly questioned in the present debate. Historical evidence, however, demonstrate how stable public finances prior to a crisis provides the fiscal space needed to stabilize the economy during the crisis, and avoid the negative social and political effects that emanate from a fiscal crisis. In a world where populism and austerity fatigue are rampant, we stress the importance of a fiscal framework allowing successful consumption and tax smoothing in case of major negative shocks to the fiscal space. Our recommendations hold not only for Sweden but for other countries as well.
Key words: Fiscal policy, fiscal framework; fiscal policy council; financial crisis; debt crisis, corona crisis, consumption smoothing, Sweden.
JEL code: E61; E62; E63; G02; H12; H30; N14; O52.
Authors’ e-mail addresses email@example.com; Lars.Jonung@nek.lu.se
Prior to the outbreak of the corona pandemic in the spring of 2020, the Swedish public debt-to-GDP ratio, defined according to the Maastricht definition, had declined to 35 percent of GDP from a peak close to 75 percent in 1995, see Figure 1. The debt level is expected to rise to about 45 percent by 2021 (National Institute for Economic Research, 2020). Despite this increase, the level of public debt remains remarkably low by present international standards. The debt ratio in the euro area and the United States are expected to exceed 100 percent by the end of 2020. Even fiscally prudent Germany is expected to carry a debt of 75 percent of GDP.
Ever since the international financial crisis of 2007/08, Sweden stands out as a country with a prudent and sustainable national debt policy. Debt rises during recessions and crises only to fall back during times of growth. A low debt level before a major crisis allows Sweden to increase its public debt and support the economy during a crisis without risking a fiscal crisis. The strength of the Swedish public finances raises three questions: first, what are the determinants behind this strong performance; second, is the framework sustainable for the future; and third, are there any lessons for other countries?
|Percent of GDP|
|United States||Sweden forecast||Germany forecast|
|United States forecast||Euro area forecast|
- This paper builds upon and extends upon Andersson and Jonung (2019) and Jonung (2016). We have benefitted from comments from Lina Aldén, Niklas Frank, Oskar Grevesmühl och Pär Österholm.
Figure 1: The Maastricht debt-to-GDP ratio for Sweden, the euro area, and Germany; and the federal debt held by the public in the United States. Actual data 1995-2019 and forecast data 2020-2021.
Data source: Thompson Reuters Datastream (actual data). The European Commission Spring forecast 2020, and Congressional Budget Office (forecast data).
The purpose of this report is to provide answers these questions. The report consists of five parts. First, we give a brief account of the development of public debt in Sweden from 1750 to 2020. We show that Sweden has a long history of low and sustainable debt until the break-up of the Bretton Woods system in the early 1970s. The debt levels then rose more or less every year until the mid-1990s, when, following the economic crisis of the early 1990s, the government was forced to consolidate its finances. A new fiscal framework was introduced which contributed to a quarter of a century of budget surpluses and a declining debt level.
In the second part, we describe the present Swedish framework and how it has evolved over time. Presently it consists of four components: i) an expenditure ceiling set in advance to keep expenditures under control, ii) a surplus target to ensure that the budget, including those at sub-national level, is balanced over the business cycle and debt is reduced, iii) a fiscal policy council to check whether the government follows the fiscal rules, and iv) a debt anchor to ensure that the debt level does not grow too rapidly during major recessions when the framework allows the government to borrow.
We also discuss why the framework has been successful. In our view, there are four main reasons. First, leading politicians have had personal memory from the 1990s when public finances rapidly deteriorated, and from the subsequent period when fiscal discipline was restored through unpopular austerity measures. Second, the framework has evolved over time giving it a flexibility that has ensured that public support for the framework has remained high. Third, financial markets have responded eventually positively to the reduction in debt by reducing long-term government borrowing costs through lower interest rates. As interest rates fell, politicians were rewarded for fiscal discipline. The Swedish central bank did not bail out the government in the 1990s when debt was high and rising. Instead, interest rates were allowed to rise sharply. Fourth, the framework was designed domestically as an outcome of an internal political process, thus giving rise to public support behind the framework. It was not forced upon Sweden by outside forces. All major political parties concluded that sustainable public finances were essential for the well-being of the Swedish economy.
After this account of the past, we move, in the third part, to challenges to the framework. We identify two main weaknesses with it: the reliance on a surplus target and the strong role of the personal memory of leading politicians in maintaining the framework. We suggest potential reforms of the fiscal framework to address these shortcomings. Specifically, we argue that greater emphasis should be given to the debt anchor, i.e. to debt stabilization. The surplus target is too easy to abandon, and it has no memory: bygones are bygones. A too low surplus one year is not compensated for by a higher surplus in the future. This creates an incentive to ignore the surplus target, especially when the debt level is low. There is a high risk of a return of a deficit-bias in the public finances. The focus on a low and stable debt anchor removes this possibility. In addition, stressing the importance of achieving a low debt ratio prior to a crisis is one way to maintain the political support for a low debt as it allows fiscal policy to better support the economy in a crisis. Here we argue that the present debt anchor of 35 percent of GDP is set too high. It should be lowered to 25 percent to ensure that Sweden has sufficient fiscal space to meet a future crisis.
In the fourth part, we turn to the fiscal effects of the corona crisis. Here we stress the benefits of having sufficient fiscal space well in advance of a crisis like the present Covid-19 crisis. In the fifth and final part, we discuss the relevance of the Swedish experience for the fiscal governance of other countries. We are well aware that prevailing Swedish views on debt and fiscal prudence are different from those of many other countries. Still, this should not prevent us from considering how other countries may draw lessons from the Swedish fiscal record.
- Swedish public debt from 1750 to 2020
Swedish fiscal history shares many similarities with that of other European countries.2 Before the industrialization process, and before the creation of the modern welfare state, the public debt level was relatively low and stable. It increased during wartime and decreased during peacetime. Economic conditions had in general no effect on public debt. The Swedish debt-to-GDP ratio during the period 1750-2017 is displayed in Figure 2. The solid black line represents central government debt (Riksgäldsskulden) and the dotted black line shows the Maastricht debt. Data on the Maastricht debt is only available from 1980 and onwards. Most of the time, the two debt ratios are similar, except for the latter part of the 2010s when local
- See Eichengreen et al (2019) on the cross-country history of debt accumulation in a secular perspective.
governments rapidly increased their debt while the central government continued to reduce its debt ratio.
|Percent of GDP|
|Riksgald’s debt ratio||Maastricht debt ratio|
Figure 2: Swedish central government debt (Riksgäldsskulden) in relation to GDP 1750-2017 (solid black line) and Swedish Maastricht debt in relation to GDP 1980-2017 (dotted black line).
Data source: Swedish National Debt Office, Statistics Sweden, Fregert and Gustavsson (2013), and Thompson Reuters Financial Datastream.
In pre-industrial times, the Swedish government maintained a debt of roughly 10 percent of GDP from 1750 until the war against Russia in 1788-90 when the debt level increased to 30 percent of GDP. The debt ratio was then reduced to almost zero in the 1820s, a level that was maintained until the start of industrialization and public investments in railroads in the 1850s. During a 25-year period, the debt level increased to 20 percent of a GDP when the government invested heavily in infrastructure. For roughly a century, from the 1880s until 1970, the debt ratio fluctuated between 15 and 25 percent of GDP except during the Second World War when it reached 50 percent. The war effect was brief. The debt ratio was back to 20 percent already by 1950.
The fact that debt never exceeded 50 percent of GDP from 1750 to 1970 is partly explained by the long period of peace enjoyed by Sweden. The last war Sweden fought was in 1814 against Norway. Sweden stayed out of active combat during both the First and the Second World War. Although both world wars contributed to an increase in government borrowing,
the rise was limited. During the First World War, high inflation was key to hold down the debt-to- GDP level. Nominal debt increased by 155 percent between 1913 and 1918, but high inflation (47 percent in 1918) kept the increase in relation to GDP to almost zero.
The fiscal history after 1970 is a more volatile one following the demise of the Bretton Woods system and the fiscal discipline inferred by the implicit gold standard. From a low of 12.5 percent debt in 1970, it reached 62 percent in 1985 before briefly falling back to 40 percent by 1990, at the peak of the financial boom that followed the financial de-regulation that started in 1985. The ensuing financial crisis increased debt to 74 percent of GDP by 1995 (Figure 2). Three important factors contributed to the increase in debt: declining growth rates following the first oil price shock (OPEC I), the acceptance of a Keynesian view of the role of fiscal policy to ensure full employment, and expanding international financial markets.3
As in Western Europe, real GDP growth rates were high in Sweden following the Second World War, peaking in the mid-1960s before starting to decline gradually (Andersson, 2017). The post-World War II growth phase ended with OPEC I. Swedish stabilization policy was strongly influenced by the Keynesian views dominating the policy debate at the time (Jonung, 1999). Thus, the belief in the powers of discretionary fiscal policy in stabilizing the economy through economic fine-tuning was widespread among academics and politicians. The response to the decline in growth due to OPEC I was initially an expansionary fiscal program to prop up domestic demand and employment, which continued through OPEC II in 1979 and into the early 1980s. Consequently, government debt rose rapidly.
The acceptance of the Keynesian view was part of the expansion of the welfare state in Sweden in the post-World War II period. Public expenditures increased not just for health, education and infrastructure but also for social spending and transfers. More and more of the life-cycle consumption smoothing of households over the life cycle was performed by the Swedish state through a generous social security system funded through high taxation. As wages stagnated and unemployment rose after OPEC I and OPEC II, government expenses increased to counter the decline in income. A reduction in the financial responsibilities of the state was deemed politically impossible.
- See Persson (1996) for the development of Swedish debt from the 1970s to the first part of the 1990s.
Financial repression during the Bretton Woods period, including extensive controls on cross-border capital flows, restricted access to credit to largely domestic savings. Being less developed, international capital markets did not serve as a source of finance in the 1950s and 1960s. During the 1970s, following the first oil price shock (OPEC I), international capital markets began to expand, partially due to the recycling of the rapidly growing revenues of the oil-exporting countries.
Because of the negative chocks to the Swedish economy of OPEC I and OPEC II, large budget deficits emerged. The Swedish government chose to finance these deficits without draining the domestic credit market of funds by borrowing internationally. In 1974, 0.1 percent of the national debt consisted of external borrowing. By 1983, the share had increased to about 21 percent (Riksbank, 1984). The adoption of the Keynesian approach to stabilization policy-making, demands through a large welfare state coupled with a reduction in economic growth, and a new source of funding outside Sweden clearly left its mark on public finances and public debt.4
A minor consolidation of the public finances took place in the mid-1980s. However, most of the decline in the debt ratio occurred due to an economic boom fueled by cheap credit following the deregulation of the domestic financial markets. The resulting boom, which turned to bust and a large financial crisis in the early 1990s, partly masked the weak underlying standing of the public finances.5 While public debt fell to 40 percent in 1990, it rapidly shot up to 74 percent in 1995 in the wake of the financial crisis.
When the Swedish economy started to recover after the financial crisis of 1991-93, rapid fiscal consolidation took place between 1994 and 1999 when the budget was balanced. The government debt ratio continued to fall until the international financial crisis of 2008-09. The debt ratio increased briefly during the crisis before it began to fall again. Central government debt fell, while local governments benefitted from the low interest rates that followed the crisis to fund investments. By 2017, the central government debt (Riksgäldsskulden) was 29
- See Jonung (1999) on the shifting stabilization policy models used by Swedish governments 1970-99.
- See the analysis of boom-bust induced cycles in public finance in Sweden in chapter 6 in Jonung et al (2009).
percent of GDP compared to 74 percent in 1995 and 33 percent in 2008. The Maastricht debt was 41 percent compared to 74 percent in 1995 and 38 percent in 2008.
The fiscal consolidation in the late 1990s was part of a major overhaul of economic policy-making in Sweden. The framework for monetary and fiscal policy-making was changed in a most fundamental way. The fixed exchange rate of the krona was abolished in November 1992 in the midst of the financial crisis and replaced by a flexible exchange rate. Inflation targeting was adopted in early 1993 with a numerical target for consumer price inflation of 2 per cent to be valid from 1995. The Riksbank was made independent in 1999. The role of fiscal policy in stabilizing the economy was reduced to that of the workings of automatic stabilizers while the main responsibility for macroeconomic fine-tuning was given to the Riksbank. Several domestic markets were liberalized and tax rates reduced, especially on capital income. Combined with a depreciation of the krona exchange rate of around 25 percent following the unpegging of the exchange rate, growth picked up, which contributed positively to the fiscal consolidation. The reduction in domestic demand due to the fiscal consolidation was more than fully compensated for by higher external demand for Swedish exports through the depreciation of the Swedish krona. The fiscal consolidation was also successful partly because it coincided with a break with the perceived failed policies of the past.6 The fiscal policy framework that set clear rules for sustainable finances was one of several components of the package of new economic policies and new institutional set-ups for policy-making. Since the new consensus on economic policy was established, so far few have argued for a return to the past system.
- The evolution of the present Swedish fiscal framework
The current Swedish fiscal framework has evolved over time starting in the mid-1990s, with the most recent adjustments agreed to by the political parties in 2016. Although the framework has changed over time, the goals have remained the same: to keep public spending under control, and to ensure that the national debt ratio declines over time. Following the reforms in 2016, which came into effect in 2019, the fiscal framework consists of four major components: i) an expenditure ceiling, ii) a surplus target, iii) a fiscal policy council, and iv) a debt anchor. The surplus target is set at 1/3 percent of GDP over the business cycle for the general government (central and local government, and the public pension system). The debt
6 Andersson (2016) shows that major economic crises in general cause a change in policy across developed countries.
anchor, the latest addition to the framework emerging from the 2016 reform, is set at 35 percent of GDP +/- 5 percentage points.
2.1 The evolving framework
When the budget deficit reached as high as 15 percent of GDP in 1993, the risks to the sustainability of the public finances were apparent. Because public finances had been on an unsustainable track for almost 20 years, a review of the budget process was initiated.7 A report from the Ministry of Finance published already in 1992 was a first step, inspired by a study by Jürgen von Hagen (1992), arguing that the power of the executive was weak compared to that of the legislature in the Swedish system. The Riksdag (parliament) could easily add on expenditures beyond what was requested by the government. A string of more or less weak minority governments and a short three-year election period gave strong incentives for rising government spending without any restraining control on overall spending.8
To maintain control over government expenditures, the budget process was reorganized as a top-down procedure. First, the Riksdag votes on the overall spending volume for 27 expenditure areas before spending within each area is allocated. Spending beyond the amount allocated to each spending area is not possible. The Riksdag can no longer add on expenditures once the spending levels are decided upon as it could do in the past.
Second, to control the spending level for the medium term, the Riksdag votes on expenditure ceilings for total government spending less interest payments on government debt. These ceilings are set three years in advance. The Riksdag can change these ceilings. However, it has refrained from doing so with the exception for “technical adjustments”, or for the election of a new government with a new economic agenda. Thus, a new government is not bound by the expenditure ceilings set by the previous government.
The expenditure ceiling has two main purposes. First, it forces the government and the Riksdag to prioritize among expenditures. An increase in one spending area is weighed
7 The rise of the Swedish fiscal framework is described in detail in Calmfors (2013) and Jonung (2015, 2018).
- An extension of the terms of office from three to four years was introduced in 1994 as a response to the financial crisis of the early 1990s.
against a reduction in another area. Second, it prevents the temptation to add permanent expenditures to the budget due to a temporary increase in revenues during e.g. an economic boom. The reformed budget process and the expenditure ceilings tightened the government’s grip on spending. The expenditure ceiling has turned into a key policy instrument for the Ministry of Finance to control the spending of other departments.
The next step in the creation of the fiscal framework was the announcement in 1997 of a surplus target, which was subsequently phased in over four years. The target was set at 2 percent of GDP over the business cycle and covered general government balance, i.e. central government, regional and local government, and the pension system. Part of the savings in the pensions system was later defined as private savings rather than government savings. As a consequence, the surplus target was reduced from 2 to 1 percent in 2007 as a technical adjustment with no overall impact on government policy.
The surplus target was introduced to reduce the government debt ratio, in preparation for the expected future strain on public finances coming from an older population. In 2016, the surplus target was reduced to 1/3 of a percent of GDP over the business cycle. The main reason for this step was that the debt ratio had fallen to a relatively low level and that the Swedish population was growing older.
A balanced budget requirement for local governments was enacted in 2000 to prevent local governments from undermining fiscal sustainability. Local governments are required to balance their budgets every year. They can borrow to invest as long as their yearly revenues are sufficient to cover their running expenditures and the cost of servicing and repaying their loans.
Another important part of the fiscal framework was put in place in 2007 by the establishment of a Fiscal Policy Council to monitor the government’s adherence to the rules of the fiscal framework. The council was the brain-child of Anders Borg, the Minister of Finance at that time in a center-right government. It was initially met with resistance from the opposition
parties on the left. However, by now both sides of the political spectrum have come to accept the council.9
The Swedish council is an agency under the Ministry of Finance. Its budget is proposed by the Government and decided by parliament as a separate line in the annual national budget. The mandate of the Fiscal Policy Council is set out in a remit framed by the Government. The present one from 2011 with minor modifications from the beginning of 2017 is short, about one page long, stating that the main task of the Council is to review and evaluate the extent to which the fiscal and economic policy objectives proposed by the Government and decided by the Riksdag are being achieved, and thus to contribute to more transparency and clarity about the aims and effectiveness of economic policy.
The main tool of the Council for communicating its views and analysis is the annual report published in the spring. Soon after its publication, the annual report is presented at an open hearing before the Committee on Finance of the Riksdag (finansutskottet) where the Minister of Finance takes part as well. The report is then taken into consideration in the Committee’s evaluation of the economic policies of the government. The government responds in the Budget Bill to the report of the Council, usually in September the same year.
Although the Council has no formal powers, it is a force to be reckoned with in public debate and policy-making. Sweden has a long history of open debate on economic issues and the economics profession has a relatively strong standing in public opinion. Critique from the Council has thus a likely impact on public opinion and thus it indirectly affects the government.
The fourth and latest building block of the fiscal framework is the debt anchor introduced in the 2016 review. Coming into effect in 2019, the debt anchor stipulates that the Maastricht debt ratio should be 35 percent of GDP +/- 5 percentage points. In principle, a debt anchor is unnecessary given the surplus target, as the debt ratio would fall as long as the government runs a surplus. However, the surplus target is set as an average over the business cycle. In addition, there is no memory in the target in the sense that the government does not have to compensate in the future for failure to meet the target in the past. It does not have to run larger
9 See Jonung (2018) on the establishment of the Fiscal Policy Council in 2007. Wyplosz
(2002) contributed early to the arguments for a fiscal council in Sweden.
surpluses in the future just because the surpluses were too small in the past. A severe recession can thus cause government debt to increase. Consequently, a government that fails to adhere to the surplus target can drive debt higher. In contrast, the debt anchor ensures that debt is kept low.
The fiscal framework contains clear rules for the level of expenditures, the budget balance, government debt and supervision. However, the framework is also flexible. A new government can change the expenditure ceilings. The government can ignore both the surplus target and the debt anchor if the Riksdag is willing to adopt the government’s economic policy agenda. To further strengthen the framework, the revised budget law following the 2016 review stipulates that the government is forced to explain in public if its policies are in conflict with the surplus target and/or the debt anchor, and to present a plan for how the public finances are to be brought back in line with the rules of the framework. As long as public support for the fiscal framework remains high, these provisions are likely to induce governments to stick to the rules.
2.2. Lessons from the fiscal framework
No fiscal framework is perfect or “optimal” in its execution, not every budget since the late 1990s has been as fiscally responsible as it could have been. However, Swedish public finances have been on a sustainable path for a long time. The budget has on average been balanced with a small surplus since 2001 of 0.5 percent of GDP. No budget deficit has been higher than 1.6 percent of GDP in this period. As a result, the debt ratio has fallen. Economic growth has contributed to this decline as well. Central government debt is presently the lowest since 1978.
On the negative side, we note a growing volume of local government debt. As the borrowing costs have approached zero, local government debt has increased.10 Higher interest rate costs may put the sustainability of local finances into question. Nevertheless, the framework has successfully reduced the Swedish debt ratio to one of the lowest in Europe. Politicians have followed the rules for more than 20 years and the present framework was agreed to by seven out of the eight political parties represented in the parliament. The exception was the Sweden Democrats, who objected to changing the rules and wished to maintain the old rules.
- The average interest rate in 2017 was 0.57 percent (Kommuninvest, 2017).
Why has the framework been such a success? There are several possible explanations,
mutually enforcing each other. First, the framework has emerged through a domestic process.
It was not imposed by demands or requirements from external authorities. Most likely, such
reforms are more likely to succeed. They face less political resistance, they are credible, and they suit the country’s circumstances better.11 Politicians stick to the rules because they have
designed the rules.
Second, the severity of the financial crisis in the early 1990s and the policy measures needed
to stabilize the fiscal outlook have remained fresh in the memory of the public and of
politicians in power. Few wish to revert to the fiscal deficits of the past. As the memory of the
crisis of the 1990s fades, public support for the fiscal framework may also diminish. So far,
leading members of the present government as well as of past governments have personal
memories from the fiscal woes either during the crisis (1991-94) or during the fiscal
consolidation period (1995-99). Table 1 shows the career position during the crisis and the
consolidation period for all prime ministers and ministers of finance that have served since
2000 (i.e. after the adoption of the fiscal framework). In all governments, the prime minister,
the minister of finance, or both, have private experience from the crisis and the consolidation
process. Some were in government at the time as leading ministers, other served as members
of parliament and some worked for the prime ministers serving at the time.
|Crisis phase 1991-94||Consolidation of public finances|
Göran Persson (1996-2006)
Fredrik Reinfeldt (2006-14) Stefan Löfven (2014-)
Minister of finance
Opposition, shadow finance minister (1993-94).
Member of parliament for ruling Moderate party. Board member Metall (labor union).
Minister of finance, (1994-96). Prime minister (1996-2006)
Member of parliament for the opposition.
Member of the Finance Committee.
Board member Metall (labour union).
International secretary Metall.
|Bosse Ringholm||Chairman||Country||Chairman National Labour Board|
|Committee (1994-97)||Minister of finance (1999-2004)|
- Manasse and Katsikas (2018) argue that domestically driven reforms in Southern Europe were more successful compared to externally imposed reforms. Andersson (2016) reaches a similar conclusion. Domestic reforms are more long lasting compared to reforms imposed by external organizations.
|Per Nuder||Member of||parliament||State Secretary Prime Minister’s office|
|Anders Borg||Political Advisor to Prime||Private sector|
|Magdalena Andersson||Part-time||lecturer||Political advisor Prime||minister’s||office|
|Stockholm||Schoolof||(1996-98). Director of||Planning||Prime|
|Economics||minister’s office (1998-2004)|
Table 1: Career positions of prime ministers and ministers of finance from 2000 to 2020 during the financial crisis of 1991-94, and the fiscal consolidation period 1995-99 in Sweden
The government’s reluctance to spend in times of low economic activity was criticized by the Fiscal Policy Council in 2009, 2010 and 2012. The Council advised the government to spend and borrow more than it did, thus proposing a more expansionary fiscal policy than the actual policy adopted by the government. In fact, the Minister of Finance criticized the Council for being too expansionary, warning that it might jeopardize fiscal sustainability in the long run.12 Third, the framework has so far proven flexible in the sense that there has been a broad consensus across the political spectrum concerning alterations of the rules. As the economic circumstances change, so has the fiscal framework. The surplus target has been modified and a debt anchor was introduced in 2016. A fiscal policy council to evaluate the government was established in 2007. The flexibility of the framework is likely an important reason behind its durability.
Fourth, the strong reputation of the Fiscal Policy Council forces the government in power to stick to the rules or risk public criticism from one of its own agencies. Media and the opposition parties can refer to the Council in its critique of the government, which enhances the credibility of the Council. In addition, the Fiscal Policy Council has enhanced the public’s awareness of the framework, and the budget rules represent a starting point for public debate on fiscal issues. Few parties dare to promise unfunded expenditure increases or tax cuts due to the critique they may encounter in a political environment that puts a premium on fiscal prudence.
Fifth, politicians were rewarded by the financial markets for fiscal responsibility in the sense that long term borrowing costs declined as the debt ratio was reduced. In 1995, the Swedish 10-year bond yield was 3.5 percentage points higher the German yield despite similar rates of
- It is tempting to suggest that Swedish governments have suffered from a surplus bias, not a deficit bias, a concept frequently adopted to explain fiscal profligacy.
inflation. In 2007, the year before the international financial crisis, Swedish bond yields were 0.1 percentage points lower than German yields. This reduction in borrowing costs became a major incentive to continue to lower the debt ratio as it increased the fiscal space allowing either increased spending or reduced taxation. The Swedish central bank did not act to influence long term bond rates when the public debt levels were high. Instead, bond yields became an important economic indicator of the state of the public finances, and politicians responded to these signals
To sum up, so far the fiscal framework has performed well during its first twenty years up to the corona crisis. It has been a source of fiscal prudence. It has received solid support from the political parties and from the public. Let us now turn to the post-corona future of the fiscal framework.
- The future of the Swedish fiscal framework
The success of the fiscal framework raises the question: why change it? Part of the success of the framework has been its adaptability. Future reforms of the framework are likely needed for it to continue to support sustainable public finances and to enjoy broad political support. In fact, the 2016 revisions of the fiscal framework included an automatic review to take place every eight years (every second parliament). The next review is thus due in 2025/26.
Despite its success, the framework suffers from two main weaknesses that may reduce its efficiency in the future. The first weakness is the strong emphasis on the surplus target. The target has no memory. It is an ambition to be achieved over the business cycle. However, there is no mechanism to compensate for too small surpluses in the past: bygones are bygones. This creates an incentive for policymakers to miss the target deliberately. Why has the framework worked as well as it has over the last 25 years? One possible answer is the personal memory of the leading politicians of the fiscal crisis in the 1990s. This is the second main weakness of the framework: its success may be too heavily dependent on the personal memory of the leading politicians. As the memory of the 1990s fades from the collective memory, the risk of weaker public finances in the future grows.
To improve the framework, we suggest strengthening the role of the debt anchor. A debt anchor introduces a memory into the framework, as too small surpluses will cause a too high debt level. It also contributes to a political narrative of the importance of prudent fiscal
policies during normal times to prepare for an inevitable future crisis. Thus, the question we should address concerns the proper size of a debt anchor for a country like Sweden.
3.1 Identifying a proper debt anchor for Sweden
Finding a proper level for the debt anchor is far from trivial. The large empirical and theoretical literature on the optimal debt level and on optimal fiscal policy reaches no firm policy recommendations on the size of the public debt-to-GDP ratio.13 One part of the literature studies the optimal size in relation to public investments and their growth enhancing effects, arriving at no clear recommendation concerning the debt ratio. Another part of the literature focuses on finding a threshold level when the debt becomes a drag on economic growth (see for example Reinhart and Rogoff, 2010), without any firm conclusions. Research on optimal government debt suggests that there is not one optimal level fixed over time and across countries. Instead, the results appear to be time and country specific, as well as depending on the methodological approach adopted.
We adopt an insurance approach: in case of a major crisis, the fiscal authorities should have sufficient fiscal space, serving as a fiscal buffer, to meet the crisis at a low cost to society. We use a broad concept of “cost” here – including loss in output and employment as well as the social and political costs of crises. The Swedish fiscal consolidation processes during the 1990s as well as the experience of some EU member countries during the euro crisis and the recent corona crisis illustrate the importance for society at large of having adequate fiscal space before any major crisis erupts in order to allow an expansionary fiscal response and thus to avoid unpopular consolidation measures when the economy is already depressed. In other words, having sufficient space facilitates a successful fiscal response to crises. Most likely, the size of the fiscal multipliers is larger when government debt is lower and trust in the government’s ability to sustain its debt is high. Government actions to limit the real economic effects of the crisis thus become more effective and the output cost of the crisis is reduced.14
Having ample fiscal space implies that drastic and large austerity measures, and the political effects that come with such measures, can be avoided. This is important in any country, not
- See for example the survey by Alesina and Passalacqua (2015).
- See for example Jordà et al (2016) and Romer and Romer (2019) for the international evidence. Romer and Romer (2019, p. 12) note a “tremendous variation in the severity and persistence of output declines following financial distress”. They explain this variation mainly by differences in fiscal space across countries.
least in a country like Sweden with a relatively large welfare state and public sector.15 Swedish households rely on the government for a large share of their consumption smoothing over the life-cycle and during unexpected spells of income losses (e.g. due to unemployment). Cutting back on public spending clearly hurts households financially. Households will struggle to compensate for the loss of public spending in the short to medium run. They will cut private consumption, thus making the downturn deeper during a recession or deep crisis.16 This was the case during the financial crisis in the early 1990s when Sweden entered a debt deflation process.17
Sharp austerity measures are likely to have substantial political consequences as well. As Swedish voters expect the government to fulfil its welfare promises, a disappointing economic performance will fuel populism and make it more difficult to form responsible governments. Typically, erosion of trust in government, in elected politicians and in the democratic process in general takes place during major economic crises.18 Trust in the Riksdag and the government fell from a net of +40 in the late 1980s before the fiscal consolidation to -40 during the fiscal consolidation in the mid 1990s on a scale from plus 100 to -100, (Martinsson and Andersson, 2018). It took many years to restore trust in the government among the public.
To derive a proper level for the debt anchor, we adopt a two-step approach. First, we rely on recent economic history to decide when the cost of servicing government debt begins to increase significantly due to a rising debt level. Here, we want to identify the size of the debt limit or debt threshold where the negative effects of additional debt outweigh the positive effects. Second, we examine the fiscal cost of recent economic crises. Based on these results, we arrive at an estimate of the fiscal space required before a crisis such that the government can handle the debt after the crisis without drastic austerity measures.
3.2 When does Swedish public debt become unsustainable?
15 Social spending in Sweden in relation to GDP was 26 percent in 2016 compared to the OECD average of 20 percent and 19 percent in the US (OECD, 2016).
16 Swedish households have a relatively small amount of financial assets compared to households in other OECD countries. Most of Swedish household wealth is in housing (OECD, 2015).
- See chapter 2 in Jonung et al (2009).
- See for example Eichengreen (2018).
One potential cost of high debt is that it may be a drag on economic growth. We find it difficult to establish exactly when public debt becomes too large in the sense that it hampers economic growth. Figure 3 shows the contemporaneous relationship for Sweden between the public debt ratio and GDP growth in the post-war era (1961-2019). There is no clear relationship between debt and growth. Economic growth has been high and low irrespective of the debt level. Average growth was slightly higher during the years when the debt ratio was between 10 and 20 percent. However, these observations are from the 1960s when growth was high in the entire developed world and thus likely not related to the Swedish debt level. Lagging the debt ratio does not change the results. We find no statistically significant correlation between the debt ratio and economic growth for Sweden. Having a high debt is not directly associated with lower economic growth, at least not at the debt levels observed historically in Sweden.
|GDP growth (%)|
|Debt (% of GDP)|
Figure 3: Economic growth and the public debt ratio in Sweden, 1961-2019.
Data source: Thompson Reuters Datastream.
Another potential cost of high debt is the cost of servicing government debt. This is possibly a large cost for a small open economy with its own currency such as Sweden with limited domestic financial markets. A larger domestic debt is likely to require external funding, where the government needs to pay higher rates to attract investors, including taking an exchange rate risk. The relationship between the debt ratio and the real rate of interest is plotted in Figure 4 for Sweden 1985-2019, starting with the liberalization of financial markets in the mid-1980s.
Figure 4 displays a clear positive correlation between the debt ratio and the real rate of interest, a relationship that we should expect. Rapidly increasing real rates during the mid-1990s was a key factor driving the government to balance the budget from a deficit from 15 percent of GDP in 1993 within five years. According to Figure 4, an increase in the debt ratio from 40 percent to 70 percent increased the real interest rate from 1.5 percent to 7 percent.
Real interest rates have declined globally since the 1990s as part of the process of secular stagnation. The relationship in Figure 4 is thus potentially a spurious one as a falling debt ratio and falling interest rates may coincide without being causally related. To control for globally falling interest rates, we plot the relationship between the Swedish debt ratio and the real interest rate difference between Sweden and the United States (Figure 5), and Sweden and Germany between 1985 and 2019 (Figure 6).
|Real 10 year yield (%)|
|Debt (% of GDP)|
Figure 4: Real interest rates and the public debt ratio in Sweden, 1985-2019.
Data source: Thompson Reuters Datastream.
|in real yeild between Sweden||United States (percentage||points)|
|Debt (% of GDP)|
Figure 5: The interest rate difference between Sweden and the United States, and the Swedish public debt ratio, 1985-2019.
Data source: Thompson Reuters Datastream.
|yeild between Sweden||(percentage points)|
|Difference in real||and Germany|
|Debt (% of GDP)|
Figure 6: The interest rate difference between Sweden and Germany, and the Swedish public debt ratio, 1985-2019.
Data source: Thompson Reuters Datastream.
Figures 5 and 6 confirm the positive relationship between the debt ratio and interest rates. The
result is especially strong when Swedish government bond rates are compared to German
bond rates: an increase in the debt ratio from 40 percent to 70 percent implies two percentage
points higher interest rates compared to German rates. In relation to the United States, the
difference in interest rates between 40 and 70 percent debt ratio is approximately three
The increases in interest rates have a relatively large effect on government finances. The rise in debt raises the cost of debt financing as well as bringing about a larger debt to service. The real interest rate in relation to Germany increases by two percentage points at a debt ratio of 70 percent. The additional cost due to the higher interest rate is 1.4 percent of GDP. Simply to balance the budget, the government would have to increase the primary budget surplus by 1.4 percent of GDP. The average Swedish primary budget balance between 2000 and 2019 was 1.1 percent. The increase in interest expenditure only stemming from higher interest rates would require a twice as high primary balance to finance. The cost is not impossible to cover but sufficiently large to be avoided unless in case of a major economic crisis forcing the government to rely heavily on debt financing.
Extrapolating the results suggests that the interest rate difference compared to Germany would increase to 4 percentage points if the debt ratio surges to 90 percent of GDP. The additional debt service cost would be 3.6 percent of GDP.
We conclude from the above calculations that the central government debt-to-GDP should be kept at least below 40 percent in normal times and preferably never exceed 70-75 percent. We suggest, based on the historical evidence, that a 70 percent debt level is a reasonable debt limit or debt threshold for Sweden.19
3.3 Economic crises and the public debt ratio
Debt levels fluctuate with the business cycle and with economic crises. To establish an appropriate debt anchor, our second and final step is to estimate the fiscal cost of major economic crises. Sweden has experienced seven major economic crises since 1870, see the listing in Chapter 6 in Jonung et al (2009): the crisis of 1877/78, the international financial crisis of 1907, the depression of the early 1920s, the Great Depression in the 1930s, OPEC I and II, and the financial crisis in the early 1990s. The international crisis of 2008/09, the Great Recession, should be added to this list although Sweden was only indirectly affected by the
- This level is consistent with the view of Fall et al (2015) proposing a debt threshold for high income countries in the range of 70-90 percent, close to our threshold of 70 percent. It is also roughly consistent with the finding of Barrett (2018) of a debt limit for the UK of 90 percent, although calculated by a methodology different from ours.
crisis and did not suffer from a domestic financial crisis as many EU member states. Still, the decline in the growth rate of GDP was sharp and sizeable.
These eight major crises were highlighted in Figure 2, which plots the Swedish public debt-to-GDP ratio. The effect on the debt ratio of those crises occurring before the Second World War was modest. The welfare state had not yet been created; the public sector was limited in size. Consequently, the automatic stabilizers were small. In addition, a balanced budget was the aim of the government before the 1930s. The debt ratio shows only a modest correlation with the cyclical position of the economy. Between 1930 and 1935, during the Great Depression, the debt ratio increased by only 6.2 percentage points. Although Sweden was an early adopter of expansionary fiscal policy in the early 1930s, the actual size of the fiscal measures was limited.
Following the Second World War and the expansion of the welfare state and the adoption of a Keynesian approach to fiscal policy, the correlation between the business cycle and the volume of government debt is stronger, in particular during economic crises. The largest debt increase took place following OPEC I and OPEC II when the government opted for an expansionary fiscal response. The debt increased by 50 percentage points. The financial crisis 1991-92 left its mark by an increase of 33 percentage points.
We are aware that these episodes of rising debt are time-specific. Today, the idea of a policy of “bridging over”, like the policy pursued in the wake of OPEC I, would hardly find political support. Policy-makers have learnt from the policy mistakes of the past. The policy experiments in the 1970s and 1980s do not serve as convincing evidence for our estimates of the appropriate debt anchor today.
Instead, we are of the opinion that financial crises constitute the most severe threat facing the global economy presently. The rapid growth of the financial system following the financial deregulation of the 1980s and 1990s has increased financial imbalances. The Great Recession of 2008 has not arrested this build-up. Most of the recent crises are primarily caused by financial developments. In the case of Sweden, financial imbalances have grown significantly since the mid-1990s, raising the risk of future corrections (Andersson and Jonung, 2016).
As we deem a financial crisis the most likely future menace to the fiscal stance of Sweden, we consider the fiscal cost of financial crises internationally in the post-1990 period. Table 2 illustrates these costs post-1990 among EU15, Norway, Japan and the United States according to Laeven and Valencia (2018). The first column of Table 2 shows the total increase of the debt level (in relation to GDP), the second column the fiscal cost of supporting the banking system, and the third column the income loss generated by the crises.
|Fiscal cost||Macroeconomic cost|
|Country||Crisis||Increase in public||Public support to||GDP-loss|
|years||debt (% GDP)||banks (% GDP)||(% GDP)|
|Top 5 most costly crises||48.8||19.8||64.4|
|Top 10 most costly crises||38.7||13.8||45.7|
Table 2: Fiscal costs of major financial crises in EU15, Norway, Japan and the United States.
Data source: Laeven and Valencia (2018).
Each crisis is different as illustrated by the large variation in the estimates of the costs of
crises. The least costly crisis was the Italian crisis in 2008-09 with a fiscal cost of 8.6 percent
of GDP. The most expensive one was the Irish 2008-12 crisis with a fiscal cost of 76.5
percent of GDP. Approximately half of the cost is due to the refinancing of the banking
system. The cost of the average crisis is 29.5 percent of GDP and of the median crisis 24.9
percent of GDP. The five most expensive crises have an average cost of 48.8 percent, the ten
most costly crises a cost of 38.7 percent of GDP on average; in general, the larger the cost for the support of commercial banks, the larger the total fiscal cost.
Recent changes in EU legislation have shifted the responsibility of re-financing failing banks from the taxpayers to the owners of banks. Whether this will be the case in the future remains to be seen. However, even if we exclude the re-financing costs, still we find that the fiscal cost of financial crises is high. The average re-financing costs is 9.5 percent of GDP and for the median crisis 6.2 percent. Hence, most of the increase in the debt ratio is due to lower economic growth resulting in lower tax revenues and increased costs for inter alia higher unemployment.
What conclusions should we draw from these numbers? We are of the opinion that it is reasonable that a country like Sweden should be able to meet an average crisis without running into debt problems. In other words, the government should be able to sustain an increase in the debt level of between 30 and 50 percent of GDP without facing rapidly increasing interest rates and/or having to seek support from the EU or the IMF. Given that Sweden should avoid debt ratios in excess of 70 to 75 percent of GDP, the debt ratio should be between 20 and 40 percent of GDP before the crisis. If we are to err on the side of caution, we should put the debt target in the lower part of this range.
Consequently, we view the pre-corona debt anchor in early 2020 of 35 percent of GDP as too high. Instead, Sweden should aim for a central point of no more than 25 percent with a tolerance band of +/- 5 percentage points around the central point to account for normal business cycle fluctuations.
Our proposed size of the new debt anchor prepares Sweden for the consequences of a future major economic crisis. We arrive at this recommendation based on a precautionary or prudent line of reasoning. We want to have a sufficient fiscal space as an insurance against future shocks. We do not claim that we have derived the optimal debt level for Sweden. Rather, we have doubts about the concept of an optimal debt level. For this reason, we discuss the proper, prudent or “safe” debt level from a crisis insurance perspective that would allow sufficient consumption and tax smoothing over time – ignoring any attempt of defining an optimal debt ratio for Sweden. Recent arguments by Blanchard (2019) and others suggest that the proper size of the national debt does not constitute a binding constraint for policy-makers as long as
the borrowing rate is below the growth rate of the economy. We find that approach risky as real yields varies substantially over time (Jorda et al, 2019). The risk of higher yields in the future is too high for the government to increase its present debt levels.
There are of course potential costs as well as benefits of a low public debt. One cost of a low debt is that the government drains the economy of economic resources, which reduces demand, or sets taxes too high. The Swedish evidence suggests these costs are non-existent or negligible. The Swedish economy out-performed most other comparable countries between 2000 and 2019 while the debt level declined. For example, GDP growth averaged 2.3 percent per year compared to 2.1 percent in the United States, 1.8 percent in the United Kingdom, and 1.4 percent in the euro area. The tax ratio fell from 49 to 42 percent of GDP and real public consumption grew by 29 percent. There is little evidence of the strong public finances having hurt society.
3.4 The new debt anchor
Our proposed new debt anchor has several advantages. It is a simple rule, easy to communicate with the public and the adherence to the rule can be monitored successfully by the fiscal policy council and thus by the public. Once the debt ratio has reached the 25 percent of GDP level, the surplus target becomes superfluous and should be abolished. A major disadvantage with the present surplus target is that it is relatively demanding to evaluate. Measuring the phase and size of the business cycle is notoriously difficult in real time. The task of estimating the structural budget deficit to quantify the surplus target involves measurement errors. Our debt anchor does not suffer from similar difficulties. It is easy to estimate in real time. We want to distinguish between a flow concept (the budget surplus) and a stock concept (the volume of debt). Of course, they are related but it is much easier to monitor the volume of debt than the structural stance of the budget.
The other building blocks of the fiscal framework should be kept in place: the expenditure ceiling, the Fiscal Policy Council and the debt anchor. The expenditure ceiling is an important element to keep government expenditures in line during good times under a debt anchor. In addition, once the surplus target has been abolished, the monitoring of the finances of regional and local authorities should be a prime task of the Fiscal Policy Council.
- The corona crisis and public debt
At the time of writing, the corona pandemic is causing a major economic downturn in the global economy. The fiscal situation has worsened dramatically: data from the IMF suggest an increase in the debt level for advanced countries from around 105 percent of GDP prior to the pandemic to more than 120 percent by April 2020, and it is expected to have increased by even more by the end of 2020.20 The Swedish general government debt is expected to increase from 35 percent to 43 percent, a smaller increase compared to many other countries, yet larger than during the international financial crisis of 2008-2009.
Although still early, we can already draw some conclusions. First, the corona crisis demonstrates the importance of having a sufficient fiscal space before any crisis. The Swedish government may now substantially increase its budget deficit without worrying about the future fiscal situation or about rising interest rates. Furthermore, there is great uncertainty how the economy will develop in the coming years. The strong fiscal space allows the Swedish government to withdraw economic support from the economy gradually over time and without risking the recovery. Countries with high debt levels may have to shift from expansionary to contractionary policies while the economy still is in a recession. Such a shift is likely to cause a political reaction with growing populism and extremism as a result, which will further deteriorate the fiscal position.
Second, the Swedish central bank, the Riksbank, does not have to bail out the government by monetizing the public debt. Quickly rising debt levels increases the risk of higher interest rates, which could trigger a sovereign debt crisis, similar to the European debt crisis in 2010-2015. Such a fiscal crisis would worsen the already severe economic effects of the pandemic. Although central banks may provide temporary relief for highly indebted countries, by buying government bonds, such a policy also carries future economic risks and costs. Quantitative easing and ultralow central bank policy rates contribute to growing financial imbalances and thus raises the risk of future financial crises (Andersson and Jonung, 2020).
Third, major increases in public spending during the corona crisis may be politically difficult to withdraw after the crisis. They may also lead to further calls for public spending on other areas. The large increases in spending and the use of quantitative easing following the
- See IMF (2020).
international financial crisis in 2008-09 gave rise to populist calls for the people’s QE and bailout for Main Street rather than for Wall Street. 21 Maintaining fiscal balance in the long run may prove difficult after the pandemic if governments spend too much during the crisis. Sustainable public finances are only achievable in a stable political environment. Crises threaten the stability of the political system. A strong fiscal framework with a low debt level prior to the crisis may help to reduce political pressures during the crisis.
5 Can and should Sweden serve as an example for other countries?
Sweden is in a fiscally envious position compared to many other countries. During the fall of 2019 and the early months of 2020, before the pandemic struck, the public debate on fiscal policy focused on whether the public debt was too low and whether or not to abandon the surplus target. Still, after the corona crisis, Swedish national debt remains at a low level in international comparisons. This raises two questions. First, is Sweden such a fiscal exception that other countries have not much to learn from the Swedish case? Second, should other countries follow the Swedish example?
5.1 Is Sweden an outlier?
The Swedish fiscal framework is embedded in a unique institutional setting. However, from a historical perspective, the strength of the Swedish public finances is relatively new. The period from 1973 until 1995 was marked by growing debts and rising interest rates. It was the financial and fiscal crisis of the 1990s that forced Sweden to change course. The collective memory of the crisis in the 1990s has since helped to to form a political consensus across the political spectrum concerning the importance of fiscal stability. Market signals through higher interest rates during the 1990s contributed to strengthening this consensus. Falling interest rates, once government debt began to decline, provided further incentives to continue to reduce the debt level. In the euro area, following the crisis of the late 2000s, the policy of the ECB reduced interest rates on public debt, in this way weakening political incentives to stabilize public finances. In Sweden, interest rates fell due to fiscal consolidation after the financial crisis of 1992, not due to the lack of fiscal consolidation as in the euro area after the crisis of 2008.
Countries that are struggling to get their fiscal house in order should view a fiscal framework that relies on a debt anchor as a useful instrument. The original fiscal framework for the EU as set out in the Maastricht treaty of 1992 and the Stability and Growth Pact of 1997 has proven insufficient. The Maastricht rules of a maximum debt level of 60 percent and a budget deficit of no more than 3 percent has not served as ceilings. Instead, in the best cases, they have become fiscal targets that too many governments have been aiming for. In the worst cases, the debt ceiling has become a floor rather than a ceiling – thus turning counterproductive. The Maastricht framework has clearly proven insufficient and given rise to a number of additional fiscal rules, pasted more or less ad hoc onto the initial treaty.22
Before the corona crisis, EU fiscal governance had turned into a very complicated affair with a wide set of rules and regulations that make the system difficult to monitor, to evaluate and to communicate to the public. In addition, the system is a constant source of tension between “Brussels” (the Commission) and the member states. Another concern is that equal treatment across member states does not seem to be a firm principle.
As Debrun and Jonung (2019) argued, the EU system of fiscal governance before the corona crisis lacked credibility and efficiency. According to Debrun and Jonung (2019, p 155): In practice, the focus on enforceable rules appears to have resulted in intractable complexity, to the point of putting rules-based fiscal policy at risk. The evolution of the EU fiscal framework illustrates this outcome and the related risk of de-anchoring fiscal expectations.” As an alternative, they recommended in their conclusions “simple, flexible but non-enforceable rules” that work through “reputational effects”. In fact, they proposed a system of fiscal governance similar to the Swedish one. Here the fiscal policy council has an important role to play due to its solid reputation. It serves as a guardian of the collective memory of the high cost of fiscal imbalances.
The corona crisis has further eroded the EU’s fiscal rules by effectively removing any binding obligations. This is the appropriate response during a crisis, but raises the question of what happens next? Debt levels in the euro area have the shape of a staircase. Debt levels grow rapidly during crises. They are flat or fall just slightly during normal times, only to grow
22 See Larch et al (2010).
again when the next crisis hits. The result is increased fiscal vulnerabilities over time. The average debt level in the euro area is today higher than 100 percent of GDP. This corresponds to the Greek and Italian debt levels in 2007 prior to the international financial crisis and the European debt crisis. The debt crisis was never fully resolved. The symptoms of higher bond yields were made milder through the ECB’s quantitative easing program, yet debt levels remained too high.
There is clearly a need for binding fiscal frameworks. The fiscal situation in the United States and Japan is similar. The US use of debt limits and pay-as-you-go rules set by Congress has proven inadequate. The present corona-induced expansion of federal debt following the rapid rise in federal debt in recent years reveals a major weakness in the US system similar to that of the EU.
One of the few frameworks that successfully have transformed the fiscal position of an advanced country during the last quarter of a century is the Swedish framework. A reformed Swedish system with a greater focus on the debt anchor is a model to be considered by other countries. Of course, we are aware that it is a far step for many EU members like Italy, Greece and France and countries like Japan and the United States to move to a prudent or “safe” debt level as low as 25 percent of GDP. However, achieving fiscal discipline in Sweden was once regarded as an impossible task but proved possible over time. The turning point was a combination of a deep economic crisis, market forces that punished Sweden through higher interest rates, and a growing awareness of the importance of sustainable public finances. If it was possible in Sweden to turn around weakening fiscal position, it should possible in other countries as well.23
5.2 Should other countries follow the Swedish example?
The Swedish fiscal framework was introduced in a different global economic environment than that reigning today. In the 1990s, Swedish long-term government yields were in excess of 5 percent. Interest rates have declined steadily since then. Lower rates have inspired economists like Blanchard (2019), Rachel and Summers (2019), among others, to argue for
- The Swedish experience shows that a country is not guaranteed a free fiscal lunch as suggested by Blanchard (2019). He assumes that the government can consistently borrow at low rates – a view that is clearly inconsistent with the historical evidence. This time is not different, in our view.
greater reliance on deficit financing, thus increased public borrowing and higher public debt ratios. The corona pandemic has reinforced this argument with the IMF calling for quality public investments to stimulate the economy among already heavily indebted developed countries (IMF, 2020).
The hypothesis of continuously low interest rates is a misleading one. Historically, real bond yields have varied substantially over time (Jorda et al, 2019). Figure 7 illustrates a trend estimate of the real 10 year government bond yield in Sweden, the United Kingdom and the United States from 1840 to 2016. There are sustained periods of low interest rates and sustained periods of high interest rates lasting several decades. Part of the decrease in yields during the 2010s are due to central bank asset purchase programs, so called quantitate easing, which have expanded the balance sheet of the Federal Reserve from close to 5 percent in relation to GDP in 2007 to close to 35 percent in 2020. The corresponding numbers for the balance sheet of the European Central Bank show a rise from 15 percent to 60 percent over the same period
Although possible, it is unlikely that interest rates will remain record low forever. The historical evidence clearly shows that periods of low yields are followed, eventually, by periods of high yields. Nor is a continuous expansion of central bank balance sheets possible while maintaining economic stability. In our view, betting on low interest rates is a gamble. Only a modest increase in interest rates may cause severe harm to fiscal and real economic stability. It is easy to increase the debt ratio, but history suggests that it is difficult to reduce it. The decline in the Swedish debt ratio from 75 percent of GDP to 35 percent of GDP took 25 years. When interest rates increase again in the future, heavily indebted countries will suffer. Resisting the temptation to increase the debt during periods of low rates is part of a sustainable fiscal policy.
|United States||United Kingdom||Sweden|
Figure 7: Trend estimate of the real 10-year government bond yield in the United States, the
United Kingdom and Sweden 1840-2015.
Source: Andersson (2017).
The Swedish fiscal policy framework has been a success – so far. In fact, it has been too successful in the sense that it was likely to lead eventually to a too low a level of government debt. From a debt level of 75 percent of GDP in 1995, the debt ratio was expected to fall to 30 percent by 2022 – before the pandemic occurred. It is now projected to peak at 45 percent in 2021.
Several factors have contributed to the secular decline of the debt ratio in Sweden. Widespread public support for the policy to first reduce debt and then to maintain it at a stable level has forced the political parties to compete in terms of fiscal responsibility. The experience of the crisis of the early 1990s of a rapid expansion of government debt and of ensuing large reductions in public spending is still in vivid memory. In addition, debt consolidation has rewarded governments with falling interest rates on government debt, giving the political system strong incentives to continue to reduce debt even in good times.
Although the fiscal framework has been a success until now, it does suffer from some weaknesses: One is the focus on a surplus target, another reliance on the personal memory of the crisis in the 1990s among leading policy makers. We argue that a possible reform to strengthen the framework for the future is to institutionalise the crisis memory by shifting the focus from the surplus target to the debt anchor.
As the history of government debt shows, fiscal crises are the most dangerous threat to the fiscal balance and to political stability. Thus, it is recommendable to design the fiscal framework so that it gives protection against future crises in the form sufficient fiscal space before the crisis. To derive the appropriate level of fiscal space and thus for the debt anchor for Sweden, we use a two-step approach. First, we estimate at which debt level the cost of servicing public debt begins to rise sharply. Second, starting from this debt threshold and using data from the fiscal costs of financial crises, we calculate that a debt-to-GDP ratio in the range of 20 to 30 percent would be a prudent level.
These calculations are strengthened by the recent experience during the pandemic. It demonstrates the importance of a low debt level before the crisis strike. Thanks to a public debt level of 35 per cent, the Swedish response to the corona crisis allowed for a rise in public debt by around 10 percent of GDP without causing concerns for an unsustainable future path of public debt. This episode demonstrates the value of having a fiscal framework that creates sufficient fiscal space to meet the next crisis. This is also the major lesson from Sweden for other countries, not least in Europe and the United States.
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