-19 -

Fiscal policy remained expansionary in 1975, with public
final consumption rising by 5 percent in real terms. The central
government's deficit remained at about the same fraction (4 percent)
of GDP as in 1974 primarily because of automatic increases in tax
revenues associated with the 17-1/2 percent rise in nominal GDP.

In contrast to the fall in the previous year, fixed investment

rose by over 3 percent in 1975, in part as a result of the release

of funds from the investment fund accounts previously mentioned.
Ther2fore, despite the weak performance of exports, real GDP still
grew at a moderate pace and unemployment continued to shrink (Table 5).

In 1976, fiscal policy became less expansionary owing to
autonatic increases in tax revenues .22/ Real GNP growth began to slow,
with the second quarter being the only quarter of 1976 that showed
positive growth. The foreign sector accounted for much of this
slowdown. Real exports rose slowly (4-1/2 percent) despite a rapid
rate of economic growth (5.3 percent) in the OECD area, while imports
jumped by 10 percent. Much of this poor performance is attributable
to the decline in Swedish competitiveness which was alluded to above
and which continued in 1976.

By mid-1977 many observers -- both within and outside Sweden
-- were referring to the economic situation as a crisis: foreign debt
was rising, real GDP was declining, and the profits of companies listed
on the Stockholm stock exchange fell by 90 percent. The problem
industries, to which reference was made previously, were showing extensive
losses and were in danger of bankruptry. The aformentioned deterioration

in Sweden's international competitiveness helped to produce a 20 percent


- 36 -

Johnson, K. 1981. "The Impact of an Oil Price Increase on Aggregate
Supply," in process, March.

Lindbeck, A. 1974. Swedish Economic Policy. University of California
Press, Berkeley.

1979, "Imported and Structural Inflation and Aggregate
Demand," in A. Lindbeck, Inflation and Unemployment in Open
Economies, North Holland.

Lundberg, E. 1981. "The Rise and the Fall of the ‘Swedish Model,'"
Skandinaviska Enskilda Banken Quarterly Review, number 1-2,
pp. 12-20.

Martin, A., 1981. "Economic Stagnation and Social Stalemate in Sweden,"
in Monetary Policy, Selective Credit Policy and Industrial Policy
in France, Great Britain West Germany, and Sweden, A Staff Study

by the Joint Economic Committee, U.S. Government Printing Office,
Washington, D.C.

Meidner. R, et.al. 1963. E¢onomic Expansion and Structural Change:
A Trade Union Manifests, AlTen and Unwin, London.

OECD. 1981, 1974. Economic Outlook. Paris.
Economic Survey of Sweden, various issues. Paris.

Phelps, E. 1978. "Commodity-Supply Shock and Full Employment Monetary
Policy," Journal of Money, Credit and Banking, May.

Robinson, D., 1974. Solidaristic Wage Policy in Sweden. OECD, Paris.

Schmid, M, 1980. "Keynesian and Monetarist Analysis of Oil Price

Shocks," presented at the Konstanz Seminar on Monetary Theory
and Policy June 3-6.


-13-

IV. The Swedish Policy Response: 1974-77

Once an accommodative policy was decided upon, the Swedish
government acted quickly to maintain aggregate demand and, in accordance
with Mundell's assignment rule, used fiscal policy to maintain internal
balance while monetary policy was employed to maintain the value
of the krona within the snake. As can be seen in Table 3, in 1974
fiscal stimulus increased dramatically, as the combined impact of the
public sector rose to just over 3 percent of GDP from an approximately
neutral position in the previous year. Most of this expansionary
impetus cam from a temporary (6-month) decrease in the value-added
tax of 3 percentage points, as well as from increased transfer payments.
Real disposable income rose by about 6 percent, leading to a 4.1 percent
rise in real private consumption expenditures. Fixed investment was
weak as a result of the government-ordered freeze of part of companies'
profits in special investment funds 22/ However, because of government
subsidies for the accumulation of stocks of final goods, inventory
investment rose sharply from the reduced levels in the two previous
years. Also, despite a large decline in the rate of growth of economic
activity in Sweden's major trading partners (see Chart 1), export
growth held up fairly well in 1974.

Consequently, real GDP grew by over 4 percent in 1974 at
a tine when the growth rate in the EC fell from about 6 percent to
less than 2 percent. The success of Swedish policies was most evident
in the unemployment rate, which dropped markedly over the 1973-75
period (see Table 4) while unemployment was rising significantly in

other countries. However, the effects of this accommodation can also


- 23 -

The importance of the 1978 wage. settlement in the brief
Swedish turnaround cannot be overemphasized, Sweden's three major
uriions agreed to a 3 percent wage increase over the March-December
1978 period and a 2 percent rise during the next 10 months ending
on October 31, 1979, This settlement followed contractual increases
which had averaged about 7-1/2 percent per year during the previous
3 years and was particularly surprising since, at the time of its
announcement, the inflation rate was about 10-11 percent. An
important pre-condition, which was necessary to win union approval,
was the incorporation of a.price trigger clause, according to which
negotiations could be reopened if the consumer price index rose by
more than 7.25 percent during the March-December 1978 period or by
more than 5 percent in the first 10 months of 1979 ,29/ Additionally,
personal income tax rates were reduced somewhat and, as an added
incentive to secure labor's agreement to such a moderate package, direct
taxes were indexed for inflation.

Several factors facilitated the Swedish government's
attempt to achieve a fall in the real wage. First, the labor market
is highly centralized: there is one large employer's group (the SAF)
vhich is composed of 27,000 member firms employing about 1-1/2 million
people (one third of the labor force), one large union (the LO) which
covers over 90 percent of blue collar workers, two moderate-size
unions controlling about 80 percent of salaried.workers, and a handful of
small private and public employer groups. The collective wage
agreement is the most important. Indeed, it is rare for the smaller

employer and labor groups to deviate significantly from the LO-SAF


-4-

aggregate demand so as to restore output to its initial level (Y))-

If the supply curve has some positive slope, as in Figure 1, then

the resolution of this question depends on the society's preferences.

On the other hand, if the supply cirve is vertical, accommodative
policies will only result in higher prices, with no change in output

or employment. Consequently, most of the debate in the literature

has concentrated on the slope of the aggregate supply curve or,
equivalently, on the existence of a trade-off between inflation and
unemployment. The literature in this area is extensive and well known.
It is conceded by most economists that there is some short-run trade-off
-- even in a rational expectations model -~- if any price or wage

is sticky or fixed. As Blinder (1981) demonstrated, the setting of

the dollar price of oil by OPEC is sufficient to yield an upward sloping
supply curve.

However, even if we assume that the supply curve is upward
sloping, Figure 1 cannot be applied to the Swedish case without make two
amendments. First, the demand curve for Swedish output shifted downward
by more than the conventional theory admits because of the induced
recession in Sweden's major trading partners. Since the vast majority
of thse countries suffered a severe recession in 1974-75, aggregate
demand for Swedish output declined not only as a result of the
terms-of-trade effect alluded to above, but also because of this
foreign income effect. Most models that are used to analyze oil
shocks ignore the induced changes in income in other oi] importing
countries. Schmid (1980) is an exception to this statement, as he
employs a 3-country model which includes trade between of] importing

countries,


- 34 -

19/ The price standard was not breached until October 1979. Instead
~~ of renegotiating wages for 1979, the breaching of the price
standard was used as another argument for higher wages in 1980.

20/ As shown in Table 4, part of the increase in central government
net spending was offset by an increase in local government saving.

21/ See the Economic Outlook, 0.£.C.D. pp. 35-37, April 1980.

22/ Draft Economic Survey, OECD Table 7, May 1981. High tax rates
contributed to the growth of the underground economy, whose
size in relation to GNP may be among the largest in the OECD,
according to anecdotal and casual econometric evidence. Thus the
slower growth of real GDP in Sweden in the 1970s may have been
due to the faster than average growth of its underground economy.

23/ In addition to the evidence presented in section III concerning
the existence of economic shock prior to the oi] shock, it should
be mentioned that Branson and Myhrman (1976) did evidence of a
significant Phillips curve trade-off based on 1954-70 data.

24/ The OECD Economic Surve (1981) notes that industrial policy
measures, much of which went to shipbuilding, steel, and other
troubled industries, rose from 2-1/2 billion krona in 1975 to
kr. 10-1/2 billion in 1979. In 1981 these expenditures were-
estimated to about kr. 6 billion.

25/ Moreover, the impact of the shock on potential output was unknown
at the time of the shock and, in fact, is still being debated today.
Consequently, it is difficult to judge whether the Swedish authorities
accommodated or over-accommodated the oil shock. Swedish unemployment
fell to 1.6 percent by 1975-76, slightly above the 1963-69 average.
However, the oi] shock clearly raised the "non-accelerating
inflation rate of unemployment," so the Swedish authorities may
have over-accommodated.


- 20 -

decline in Sweden's share of OECD markets between 1975 and 1977.
Consequently, the current-account deficit widened, reaching 2 percent
of GDP in 1976 and was still larger in the first half of 1977.24/
Despite two small devaluations within the snake in October 1976

and April 1977, the downward pressure on the krona remained intense
through the summer of 1977 and ultimately led to the policy measures
of August 1977, to which we not turn our attention.

Vv. Corrective Measures and Backward Steps: 1977-79

Although much of the loss of international competitiveness
was due to domestic factors, Sweden's membership in the snake
exacerbated this trend. As shown in Chart 2, the weighted-average
krona appreciated by about 14 percent from early 1974 to late 1976,
leading to reduced price competitiveness vis-a-vis many of its
competitors 22/ Furthermore, the actual and expected inflation differentials
in mid-1977 between Sweden and several of the snake members, notably
Germany, implied the need for periodic exchange-rate realignments 26/
Consequently, as a first step in restoring international price
competitiveness, in August 1977 the Swedish government decided upori
a withdrawal from the snake and a 10 percent depreciation of the krona
against a basket of currencies representing Sweden's major trading
partners.

Additional measures in the August package included a
reduction in a special payroll tax on employers from 4 to 2 percent: --
and to zero in 1978 -- and a general price freeze until October 1977

followed by intense price surveillance. In fact, this price surveillance

program involved temporary price freezes on selected commodities through


~- 26 -

than is consistent with external and internal balance or progress
towards wage solidarity will be halted as firms bid against each other
for labor. Sweden has suffered somewhat more from the former problem
than from the latter.

The final bit of evidence of the seriousness of Sweden's
economic position at the end of the 1970's was the combination of strikes
and lockouts in the spring of 1980, which invoived one quarter of the
labor force. The result of this dispute was wage settlements which
led to unit labor cost increases approximately in line with other
OECD countries. However, in 1980 Sweden needed a better than average
cost performance in order to encourage export growth. Government
spending was 64 percent of GDP, the net borrowing requirement of the
central government was about 10-1/2 percent, and the current-account
deficit was over 4 percent of GDP. Thus, export growth was desired
so that the government sector (and the deficit) could be reduced without
incurring a rise in umemployment. The failure to secure lower relative
wage growth underlined the seriousness of Sweden's economic predicament
at the end of the 1970s.

VI. Lessons for the Accommodation Debate

During the 1970s Sweden's economic performance did not compare
favorably with that of other major industrial countries. Real GDP rose
by only 19-1/2 percent from 1970 to 1979, compared with gains during
the same period of 22 percent in the United Kingdom, 29 percent in
Denmark, 34 percent in Finland, and 30 percent in Germany .22/ Consumer
prices rose more rapidly in Sweden than in the QECD countries on average

in 7 of the 10 years of the 1970s. The government sector mushroomed,


- 22 -

1980. The government also stated its intention in August 1977 to
index taxes for inflation and to reduce the budget deficit.. A final
part of this austerity package was the increase in the value-acided
tax (VAT) in June 1977 from 17 to 21 percent.

Monetary policy measures were not part of the August package
since monetary policy was at that time perceived to be sufficiently
restrictive. As a result of exchange market pressures associated with
Swedish participation in the snake, restrictive monetary policy was
followed during the latter part of 1976 and most of 1977 .12/ The August
devaluation relieved exchange-market pressures and led to improvements
in the external balance. Consequently, it was possible for monetary
policy to become expansionary late in 1977 and in 1978 to accormodate
the growing government budget deficit.

The trade account responded quickly to devaluation and the
VAT increase, with a surplus in the fourth quarter of 1977 and in each
successive quarter through the middle of 1979 ,18/ In addition to the
devaluation, the. turnaround in the trade account was fostered by the
weak condition of domestic demand, the end of the stock subsidy scheme,
arid a low wage settlement in early 1978. Private consumption declined
in real terms by about 1 percent in 1977 and 1978, while gross fixed
capital formation fell in these years by 4 and 8-1/2 percent,
respectively. Thus resources were freed for the foreign sector, while
firms were encouraged by the weak domestic economy to look to foreign
markets. The existence of large stocks of goods also figured in the
rapidity of the turnaround, as sizable discounts are reported to
have been offered to reduce these stocks when the subsidy schene

ended in 1977.


~35-

Bibliography

Blinder, Alan S. 1980. "Supply Shock Inflation, in M.J, Flanders and
A. Razin, Development in an Inflationary World New York, Academic Press.

1981. "Monetary Accommodation of Supply Shocks under
Rational Expectations," Journal of Money, Credit, and Banking, vol.
12, no. 4, November.

Branson, W. H. and J. Myhrman. 1976. "Inflation in Open Economies:
Supply-determined versus demand-determined models," European Economic
Review, July.

Bruno, M. and Sachs, J. 1979. "Macroeconomic Adjustment with Import
Price Shocks: Real and Monetary Aspects," Working Paper No. 340,
N.B.E.R., April.

Buiter, W. 1978. "Short-run and Long-run Effects of External Disturbances
Under a Floating Exchange Rate," Economic, August.

Calmfors, L. 1977. "Inflation in Sweden" in L. B. Krause and W. S. Salant,
eds., Worldwide Inflation: Theory and Recent Experience. The
Brookings Institution, Washington, D.C.

1977a. "Swedish Stabilization Policy Experiences 1971-76:
RK Case Study of the International Dependence of a Small Open
Economy," University of Stockholm, Institute for the Study of
International Economics, processed.

Chow, Ya-lun. 1969. Statistical Analysis. Holt, Pinehart, and Winston,
New York.

Croxton, F. £., D. J. Crowden, and S. Klein. 1967. Applied General
Statistics, Printice-Hall, New York.

Edgren, G., K. 0. Faxen, and C. e. Odhner 1973. Wage Formation and the
Economy, London.

Freeman, R. F. 1981. "Macroeconomic Adjustment to an Oil Price Increase,"
in process, September

Gordon, R. J. 1975. "Alternative Responses of Policy to External Supply
Socks," Brookings Papers on Economic Activity, number 1.

Gramlich, E. M. 1979. "Macro Policy Responses to Price Shocks,"
Brookings Papers on Economic Activity, number 1, pp. 128-66.



Unit Labor Costs in Sweden and its Competitors—

-17-

Table 5

Vy

(percentage change, in domestic currency (in dollars))

1960-73
1974
1975
1976
1976/1974

Sweden

3.4 (4.8)
12.8 (10.8)
22.9 (31.5)
19.1 (13.3)
65.0 (65.0)

Eight Ten
European OECD
Countries Countries

4.3 (6.4) 3.8 (5.8)
13.7 (11.1) 16.6 (12.8)
17.1 (20.7) 15.9 (17.8)

5.7 (-3.5) 3.7 (-2.7)
40.7 (29.3) 40.2 (29.3)

1/ The eight European countries are:

France, Germany, Italy, the

United Kingdom, Belgium, Denmark, Netherlands and Sweden.
This group of countries plus Canada and Japan comprise the

10 OECD countries.

Figures in parenthesis represent the

percentage change in relative unit labor cost in dollars.

Source:

Labor Review, December 1980.

Arthur Neef and Patricia Capdevielle, “International
Comparisons of Productivity and Labor Costs", Monthly


-9-

decline in unemployment. The growth. of exports also helped to bring
about a large current-account surplus in 1973, which was equal to about
2-1/2 percent of GDP,

Thus at the time of the oil price shock, Sweden appeared
to be in a good position to take accommodative policies in response
to the expected decline in OECD growth in 1974-75. Although the
unemployment rate was declining in 1973, it was still high by historical
standards and full employment was the most import objective of
macroeconomic policy.2/ Price stability, also mentioned by the government
as a policy objective, seems to have been given less emphasis. The
inflation rate in 1973 of 6.7 percent, though high in comparison with
Swedish experience in the 1960s, was about 1 percent below the average
rate of inflation in the OECD. Finally, the record current-account
surplus of 1973 placed Sweden in a strong external position.

In the debate that rose among OECD governments shortly
after the oil price shock, it was agreed that the OECD countries as a
group would have to run a current-account deficit and that expansionary
policies were needed to offset the recessionary impact of the tranfer
to opec.9/ Sweden seemed te he in an excellent position to take such
expansionary policy measures. Given that this course of action
coincided with the desires of Swedish policy makers to lower the
unemployment rate, accommodative policies were adopted in 1974.

An additional and very important element in the Swedish
decision to accommodate the 1974-75 oil price shock was the expectation
that: the recessionary impact of the shock would be brief. This

expectation was not unique to Swedish policy makers. The OECD also


10/

- 32 -
Footnotes

International Finance Division, Federal Reserve Board. I have
benefited substantially from conversations with and comments
from Richard Freeman. I am also indebted to Peter Clark,

David Howard, and Karen Johnson and Raymond Lubitz for commentis
on an earlier draft of this paper. This paper represents the
views of the author and should not be interpreted as reflecting
the views of the Board of Governors of the Federal Reserve System
or other members of its staff.

A shock is said to be fully accommodated when macro policies

are altered so as to maintain the unemployment rate. Invariant
policy in the face of a shock is described as zero accommodation,
while partial accommodation refers to intermediate cases.

Bruno-Sachs (1979) argue, that for a.net importer of intermediate
goods, the demand curve is likely to shift to the left. However,
for a net exporter of these goods, the demand curve may shift

to the right.

By 1980, total public sector expenditures were 64 percent of GDP;
however, about one-half of this total represents transfer payments.

Until recent revisions of the national income accounts, the growth
rate of GDP in 1971 was recorded as -0.2 percent. Thus 1971 was
officially described as a recession until the revisions were made.

Calmfors (1977a) cites budget statements that emphasize the
primary importance of the full employment objective to Swedish
policy makers.

OECD Economic Outlook, July 1974, p. 7.

See Economic Expansion and Structural Change: A Trade Union Manifesto,
pp. 119-36.

Some selective job measures, such as labor retraining and subsidization,
were adopted by the government.

Both he and Meidner asserted that a more rapid reallocation of labor
would be achieved by, as Lindbeck puts it, pushing and pulling

labor (via contracting output in inefficient sectors and retraining
and subsidizing labor to shift to expanding sectors), rather than by
economic incentives operating through wage differentials.

See the OECD Economic Survey of Sweden (1981) pp. 41-44. Wage
dispersion was measured by the coefficient of yariation.


- 29 -

hard to ignore the possible consequences of accommodation for future
consumption. In the Swedish case, these costs were unexpectedly large
as 2 resuit of the underestimate of the magnitude and duration of

the recession in the OECD area and the apparent unrecognition of

the consequences of accommodation for relative unit labor costs ,
given solidaric wages and Swedish participation in the snake.

In addition to the foregone consumption of the. 1977
recession, Sweden paid (and is still paying) for the policy mix
which was adopted after the oi] price shock. with a mis-allocation
of resources. As argued previously, one consequence of the policy
mix was the hastening of the loss of comparative advantage on the
post of several key industries. Al though it is unclear at what rate
Sweden should have been reallocating its resources away from its
traditional industries, most observers agree that the long-term
trends favored such a switch. By concentrating the loss of competitiveness
in a short period of time, the government was compelled to bail-out
their troubled industries. Once begun, it is often difficult to
end such support measures, and Sweden has not been an exception
to this rule. 24/ The costs to the Swedish taxpayer might well have
been lower if at least one of the elements of the policy mix (wage,
exchange-rate, demand-management, and industrial policies) had been
altered.

This example brings out other aspects of the accommodation
decision. The simple approach to this issues seems to assume that
once an accommodative policy is decided on, politicians will opt
for the most efficient way to.attain the desired goal. -Although
uriderstandable from the viewpoint of a macro modelbuilder, such an

assumption is not supported by historical experience. Moreover, it


-6-

smai1.3/ The growth of the tax and transfer system coupled with
Sweden's wage policy (described below), led to a progressive narrowing
of the distribution of income.

At the time of the first oil price shock, Sweden was
just recovering from the 1971 slowdown of economic activity. Following
the boom of 1967-70, fiscal policy had been tightened to reduce ‘he
inflation rate and the current-account deficit, both of which were
much greater than the levels experienced during the 1960s. As shown
in Table 1, the rate of growth of real GDP declined sharply in 1971,
while unemployment, although low in comparison with other countries,
rose to the highest level in the post-war period.4/ Much of the decline
in the rate of growth was attributable to an 0.2 percent fall in
consumption, as disposable income declined as a result of increases
in value-added and municipal taxes. Investment expenditure also was
weak despite some favorable changes in taxes and various subsidies
for fixed and inventory investment.

On the other hand, exports held up well -- rising by
4.2 percent in 1971 -- despite a decline foreign growth from a very
high rate in 1970 (see Chart 1). Since imports fell with the decline
in disposable income, the trade and current accounts improved
significantly. When the inflation rate began to moderate in 1972,
fiscal policy became more stimulative in 1972 and 1973 in order to
lower the unemployment rate. Selective labor market measures --
incentives to improve labor mobility, re-training programs, and
relief works -- were important in this effort.

By 1973 the expansionary policies and rapid export growth
(14.1 percent) had produced a recovery of real GDP growth and a slight


-5-

Second, as will be emphasized below, the Swedish government
did not accurately estimate the size of the shifts of both supply and
demand, Although it might be relatively easly to calculate the impact
of cil prices unit costs, the combination of macroeconomic policies
and wage policy led to a jump in wages and prices, of which, had the
auttorities been cognizant, might have persuaded them to change
their mix of macro policies. Moreover, the Swedish authorities,
the OECD, and most reputable forecasters significantly underestimated
the recessionary impact of the shock, Hence, the Swedes were accommodating
an uncertain shock, in contrast to the percisely known shock in Figure 1.
In any event, the Swedes did accommodate the oi] price
shock of 1973-74 and the next three sections describe Swedish macroeconomic
developments and policies during the 1970s insofar as they related to
the oil price shock and the accommodation issue. Then, in the final
section, the Swedish experience will be used to evaluate critically
the simple approach to accommodation which was presented in this
section.

III, The Swedish Economy Prior to the Oi] Price Shock

Until the mid-1970s, the Swedish economic system was often
depicted as a model for other countries to emulate. During the 1950's
and 1960's, real GDP per capita advanced on average at an annual rate
of 4 percent, while unemployment and inflation remained low. These
developments occurred in the context of a socialist system peculiar
to Sweden. Although the government's share of GDP expanded rapidly,
most of this growth was associated with the expansion of Sweden's

social welfare system, while the state enterprise system remained


- 18 -

weak basis to explain relative unit labor cost differentials since

commodity prices rose for all countries, not just for Sweden. Moreover,

since many commodities are prices in dollars, and since the dollar

appreciated relative to most OECD currencies during the 1974-76 period

but remained essentially unchanged vis-a-vis the krona, it follows

that most of Sweden's competitors experienced a greater increase

in commodity prices measured in national currency than did Sweden.

Thus, in order to argue that the commodity price boom was the

principal factor behind the deterioration of relative unit labor

costs, one would have to show that production of the affected commodities

occupies a greater fraction of the labor force -- or accounts for a

greater portion of GDP -- in Sweden than in other OECD countries.
Instead, these differentials are more likely a result

of the difference in aggregate demand policies, which led to differences

in the degree of labor market slack in Sweden and in other OECD

countries, and especially the solidaric wage policy in Sweden.

As was noted above, wages in Sweden vary less among industries than

in other major OECD countries. Thus it is likely that the boost

in commodity prices coupled with tight labor markets led to sizable

wage increases in export industries. Then, owing to the unions

pursuit of (and the government's acquiescence to) wage solidarity,

large wage increases were rapidly transmitted to the rest of the

economy. Sizable wage increases, coupled with large boosts in payroll]

taxes, led to high unit labor cost increases relative to those in other

OECD economies.


-8.

GROWTH IN SWEDEN AND THE EUROPEAN COMMUNITY
(PERCENTAGE CHANGE IN REAL GDP, YEAR OVER YEAR)

Percent
—- 7
Sweden

a -- European Community

| ! | | | ! | | 1 it 3
1970 1972 1974 1976 1978 1980

Source: OECD Economic Outlook December 1980 and EEC Annual Report 1980.


~ 24 -

settlement. The absence of staggered contracts presumably facilitates
the similarity between the wage settlements of different unions.

Second, Swedish workers in 1978 seemed to have realized
that they had priced themselves out of too many markets. This
realization probably was strengthened by the extent of the decline
in the traditional export industries during the mid-1970s. Third,
Swedish income is distributed more evenly than in most countries and
this distribution narrowed in part as a result of the solidaric wage
policy. It is plausible that real wage decreases are easier to
impose the more equal the income distribution since income equality
would imply that everyone was bearing his or her share of the reduced
standard of living. Finally, at least until 1980, Swedish labor
relations were excellent, with the number of days lost to strikes
per thousand employed only 15 percent of the U.S. figure during the
1966-75 period.

As a result of the low wage settlement and the slack labor
market (which limited wage drift), labor costs per man hour decelerated
during 1978, attaining an annual rate of 8-1/2 percent in the fourth
quarter, one half of the rate during 1976. As 1978 proceeded, the
effect of the devaluation and wage settlement began to show up in
activity and prices. Led by foreign demand and government spending,
real GDP advanced by 1-1/2 percent in 1978 (and by almost 4 percent
on a Q4/Q4 basis), while inflation was preceeding at a rate of less
than 6 percent by the end of the year. However, the labor market remained
slack: officially, the unemployment rate rose to 2.2 percent, while

another 4 percent of the labor force was engaged in labor support schemes


International Finance Discussion Papers
Number 205

April 1982

THE SWEDISH ECONOMY IN THE 1970's:
THE LESSONS OF ACCOMMODATIVE POLICIES

by

Gerard Caprio

NOTE: International Finance Discussion Papers are preliminary materials
circulated to stimulate discussion and critical comment. References in
publications to International Finance Discussion Papers (other than an

acknowledgment by a writer that he has had access to unpublished material)
should be cleared with the author or authors.


-ll-

argued that when coupled with a labor mobility policy -- e.g.

retraining, payments for moving, etc. -- this would result in a

favorable allocation of resources. 2/
Given that the unions did adopt this policy and that

the degree of unionization in Sweden is the highest in the OECD

area, it is not surprising that some compression of wage differentials

has occurred .20/ Also, if solidaric wage policy has had any effect

on the dispersion of Swedish wages among industries, one would expect

that this phenomenon would show up in cross-country comparisons.

Table 2 presents data on labor compensation in about 30 industries

jin the G-10 countries. Sweden ranks third among these countries

in the level of average wages but , along with Italy and the

United Kingdom, has a relatively small standard deviation. The

low degree of wage dispersion in both of the latter two countries

is a result in part of incomes policies. Although it is possible

to use the standard deviation as a measure of dispersion when the

means differ by little, it is more appropriate to look at Kendall's

coefficient of variation (the standard deviation divided by the mean)

shown in column 3, when the means differ substantially 2/ According

to this measure wages in Sweden are less variable than in other G-10

countries and, given the absence of any formal incomes policy, it is

plausible that the solidaric wage policy accounts for at least part

of the lower dispersion of Swedish wages. Also, as I shall argue

below and as Rehn and Meidner accurately had foreseen, the interaction

of this wage policy with stimulative aggregate demand policies

lec to an explosion of wages.


-10-

predicted a short-lived recession: in the Economic Outlook of
July 1974, the OECD forecast that, after falling by 1-1/2 percent.
(s.a.a.r.) in the first half of 1974, real GNP/GDP in the major
seven industrial economies would grow by 2-3/4 percent in the
second half of 1974 and by 3-3/4 percent in the first half of 1975.
As is well known, the recession was both steeper and longer than
predicted, as GNP in these countries instead fell by 1.2 percent
in the second half of 1974 and by another 3-1/2 percent in the
first half of 1975. As we shall see below, the unanticipated lergth
and severity of the recession increased the costs to Sweden of its
accommodative policies.

Before proceeding with a description of the Swedish
policy response, it is necessary to comment on Sweden's solidaric
wage policy, since this policy pre-dates the shock and plays an
important role in subsequent developments. This policy, which is
fully espoused by the labor unions ,2/ has its origin in the early
postwar writing of Gosta Rehn and Rudolf Meidner. According to
Lindbeck (1974), Rehn argued that full employment should be achieved
with a generally restrictive macro policy coupled with selective
job-creating measures, rather than with a high level of aggregate:
demand .2/ He also argued that profits should be squeezed between
rising wages and weak output demand so as to force productivity
improvements. Thus Rehn proposed that unions try to set wages for
comparable work to achieye equality across industries regardless of
firm or industry profitability, He realized that such a policy

would lead weak firms and industries to contract or shut down, and


-31-

The main lesson of the Swedish experience during the
1970s, then, is that accommodative policy can be costlier than anticipated
and that the deleterious effects of such policies can persist for a
long time. Thus, any approach to the accommodation decision which
igrores future effects is necessarily limited and potentially
misleading. Unfortunately, this lesson is unlikely to be accepted
by politicians, who are often rewarded for having brief time horizons.
Although the Swedish experience does not argue against ever accommodating
a supply shock, it does suggest other alterations in existing policies
should be considered along with any decision to take accommodative

measures.


- 30-

is also assumed that policies can be reversed at any time -- e.g.,

if inflation becomes more costly than unemployment, a government

can switch policies at that point. Yet in the Swedish case, the
inability of the Swedes to reverse or halt existing programs account
for part of the automatic rise in the government deficit in the late
1970s. Programs like the labor market and industrial policy measures
build constituecies and thus are hard to stop. Of course, these
programs would have been more easily halted if the OECD countries
had recovered on schedule. Both of these additional aspects of the
accommodation issue -- the efficiency and the reversibility of policies
-- are easily omitted from consideration in the simple approach, which
only looks at the slope of the aggregate supply curve today. If
future consumption has some weight in the social welfare function,

it is at least possible that these additional aspects will be
considered,

Perhaps the most important lesson of the Swedish experience
is that the optimal policy response is contingent upon the exact
nature of the shock. In the Swedish case, such information was not
available. The vast majority of experts in early 1974 had little
idea of the magnitude and duration of the shock. Moreover, it was
unclear at the time -- especially in the problem industries -- how
much of the loss of markets was due to relative cost changes and
how much was due to cyclical factors abroad. The lack of such knowledge
weakens the case for accommodation by a small, open economy unless

it is accompanied by a similar policy response abroad .22/


Table 1

Selected Economic Indicators

1/

1963-69 1970 1971 1972 1973

Real GDP 4.4 5.0 1.0 2.1 3.8

Unemployment Rate 1.8 1.5 2.5 2.7 2.5

Consumer Prices 3.8 7.0 7.4 6.0 6.7

Hourly Compensation 9.6 13.0 12.3 14.8 9.4
Money Stock

M1 5.5 12.2 6.2 10.2 13.5

M3 nea. 3.7 8.7 11.8 12.5

Current Account -0.08 -0.3 0.2 0.2 1.2

(U.S. $ billions)

1/ Data are expressed as a percentage change over the previous year,
for the unemployment rate (which is expressed as a percent of the labor

force) and unless otherwise noted.

except

Source: IMF International Financial Statistics, OECD Economic Outlook,

Main Economic Indicators, and various national sources.



- 21 -

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BUOUY YSLPaMS aYyz JO azey abueyoxy

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STRUCTURE OF BANKING REGULATION-continued
IV. STRUCTURE OF SUPERVISION AND REGULATION
A. Why regulate banks?
B. Public confidence
C. Opinions
D. Benefits of bank regulation
COMMERCIAL REPORT OF EXAMINATION
A. Three sections.
B. Page 1 - Examiner's Comments
C. Regulatory Response
D. Purpose of Regulatory Action
C. Regulator's response

D. Purpose of regulatory action


~27-

as public sector employment rose from 20 to 30 percent of the labor
force, while the share of government spending in total GDP soared as
noted previously. At the end of the decade, Swedes were burdened by the
highest income and consumption taxes in the OECD region. The low wage
differentials -- both before and after taxes -- had produced a low
degree of labor mobility. Sweden's unemployment rate was far below
that of most OECD countries. However, much of this difference disappears
if the Swedish unemployment rate is adjsuted for that part of the labor
force participating in the various labor market programs mentioned
previously.

it is understandable, in view of the unexpected size and duration
of the oi] price shock, that these results were not predicted. However,
it is troublesome that the possibility of such results and, especially,
the inconsistency of accommodation with both wage and exchange-rate policies
do not seem to have received any attention. In fact, there does not
seem to have been much of a debate about Sweden's adoption of accommodation
policies. Instead, it appears to have been taken for granted by both
the Swedish government and the OECD Secretariat that, given the slack
in the Swedish economy on the eve of the oil price shock and a relatively
favorable balance of payments position, Sweden was well-suited for
acconmodative policies. In other words, in conformance with the simple
approach to accommodation, which was summarized in section II, policymakers
seem to have proceeded from the existence of economic slack to the
decision to accormodate.23/

The Swedish experience emphasizes that the simple approach

to the accommodation issue can only be a first step. That is, in


-3-

II. The Accommodation of Supply Shocks: Theoretical Issues

Although the issue of whether or not a government should
acconmodate a supply shock is a normative question, an evaluation
of the costs and benefits of accommodation is a topic for positive
economics and has been the subject of much research. Blinder (1980),
Gramlich (1979), Gordon (1975), and Phelps (1978), are some of the
better known studies on this subject. As shown in Figure 1, an
increase in the price of an imported input, such as oil, wil shift

the aggregate supply curve upwards, from Ss, to S}. Moreover, it is

likely that the demand curve. will also shift. As Freeman (1981)

FIGURE 1 |

Pt

tP1 Po
yy Yo Y.

demonstrates, an increase in the price of an imported input will
lead to a reduction in real domestic disposable income and therefore
produce a decline in aggregate demand .2/ As drawn in Figure 1, the
supply shift outweighs the demand shift, so that the price level is
higher at the new and lower level of output (Y)).

In this simple framework, the accommodation issue is

whether the government should take policies which will increase


-14-

Table 3

Effects of Fiscal Policy!’

(percentage of GDP)

1973, 1974 1975 1976 1977 1978 1979 1980

Central Government 0.2 1.5 0.4 1.1 2.2 3.4 2.5 -0.5
Direct 2/ (0.2) (0.0) (0.1) (0.2) (-0.2) (0.3) (0.3) (0.2)
Indirect 3/ (0.0) (1.5) (0.4) (0.9) (2.2) (3.1) (2.2) (-0.7)

Local Government 0.3 1.0 1.1 0.4 0.2 -1.0 1.0 1.1
Direct (0.3) (0.4) (0.5) (0.5) (0.9) (0.8) (0.8) (0.8)

* Indirect (0.0) (0.6) (0.6) (-1.0) (-0.7) (-1.8) (0.2) (0.3)

Social Security 70.2 0.7 0.4 -0.2 0.4 0.5 0.3 -0.2

Total 0.3 3.2 i) 1.3 2,8 2.9 3.3 0.4

T/ The data, which are estimates by the Swedish government, refer to the
contribution of the government to GNP growth. Although induced effects
of fiscal policy on income are included, only impact effects are
considered -- the lagged effects are ignored.

2/ Refers to the impact of government expenditure.
3/ Refers to the impact of tax and transfers on private demand.

Source: Revised National Budget, 1980.



- 1-

be seen (in Table 4) in the rise of wage and price inflation and the
deterioration of the current account.

If foreign economic activity had recovered as quickly as
had been forecast in early 1974, Swedish economic policy would have
been judged successful according to most social welfare functions.
Instead, real GNP in the OECD area again declined in 1975, leading
to a real decrease in Swedish exports of 11 percent. An additional
element behind the steep fall in exports was the stock subsidy
scheme, which provided an incentive to withhold goods from foreign
(and domestic) markets. Moreover, Sweden's exports were relatively
concentrated in investment goods, which lagged the recovery, and ‘in
certain problem industries, such as steel, textiles, and shipbuilding,
which lost their comparative advantage primarily to newly emerging
industrial countries. Finally, unit ‘abor costs rose sharply in
Sweden in comparison with other other industrial countries (see Table 5).
This performance was exacerbated by the effective appreciation of the
krona as a result of its membership in the snake, Consequently, unit
labor costs in Sweden relative to those of its main trading partners
deteriorated even more sharply after allowing for exchange rate changes.

The loss of competitiveness in the 1974-76 period was
crucial to Sweden's subsequent economic performance since the
resultant decline in market shares was not recaptured. Some observers,
notably Martin (1981), have suggested that this deterioration was
mainly a result of the jump in profits associated with the 1972-73
commodity price explosion. Although I agree that the commodity price

boom was an important factor in the rise in Swedish wages, it is a


-2-

Instead, it is argued that these difficulties resulted from the
interaction of accommodative policies with exchange-rate and wag?
policies, as well as from a misperception of the size and duration
of the shock.

A second and perhaps more interesting point of this paver
is to use the Swedish experience to suggest that the approach in the
literature to the question of whether or not a government should
accommodate a supply shock is too simple. According to this approach,
which is nicely set out by Blinder (1981) and Gramlich (1979),
accommodation is called for if there is a trade-off between inflation
and unemployment and if, given the terms of this trade-off, sociaty
is thought to value a'reduction in unemployment more highly than the
consequent increase in inflation. The Swedish case demonstrates that
there are a number of additional considerations which are neglected
by this approach.

In the next section I shall briefly summarize the trade-off
approach to the accommodation issue, withholding an evaluation of
it until later. Section III contains a description of the Swedish
economy prior to the shock, while section IV deals with the policies
adopted in response to the first oi] price shock and their effects
during the 1974-76 period. In section V I shall discuss the corrective
measures of 1977 and the explosion of public speinding over the
1978-80 period. Finally, section VI is devoted to a criticism of

the trade-off approach based on the Swedish experience.


Banking I School

STRUCTURE OF BANKING REGULATION

I. HISTORY OF U.S. BANK REGULATION
A. Commercial Banking
B. First BANK OF THE UNITED STATES
C. Second BANK OF THE UNITED STATES
D. Expansion of State Banks
E. Development of Dual Banking System
F. Development of Federal Reserve System
G. Banking Act of 1933 (Glass-Steagall Act)
I]. PRESENT STRUCTURE OF REGULATION IN THE U.S.
A. Regulators
B. Commercial banks
C. Federal Financial Institutions Examination Council (FFIEC)
1. Why?
2. How?
3. Task Forces
a. Bank Supervision
b. Consumer affairs
c. Education
D. Surveillance
I]I. FEDERAL RESERVE SYSTEM
A. Background
B. Board of Governors

C. Federal Open Market Committee

D. Federal Reserve Bank District Organization


- 25 -

and early retirement rose quickly. Moreover, as noted previously, real
private consumption had declined slightly in 1977 and 1978,

Thus, the Swedish government decided in 1978 to adopt a
more expansionary stance. Net transfers increased sharply in the
second half of 1978 and in 1979, leading to an increase in the net
borrowing requirement of the central government from 5.2 percent of
GDP in 1977 to 8.3 and 10.2 percent in 1978 and 1979, respectively.20/
Much of the increase was due to the increased cost of industrial policy
and labor market measures. Subsidies and other transfers to troubled
industries rose from about 2-1/2 billion krona in 1976 and 1977 to
10-1/2 billion in 1979, while the cost of various labor market programs
almost doubled to about 12 billion krona over the same time period .22/

The effects of this expansion quickly evinced itself in
activity and price data, Real GNP jumped by 4 percent in 1979, while
by the end of that year consumer prices were rising at a 12-13 percent
rate and the trade account had reverted to a deficit. The expansion
of aggregate demand by fiscal policy during 1978-79 was especially poorly —
timed, in that it increased inflationary pressure in Sweden at the time
of the oil price hikes of 1979-80. Moreover, this was the second instance
during the 1970s of a very expansionary fiscal policy, despite the
inconsistency of such a policy with solidaric wages. The Swedes also
demonstrated their unwillingness to permit the contraction of
uncompetitive fiyms and industries. However, as Rehn might have argued,
tight macro policy and a willingness to permit the contraction of
inefficient firms are prerequisites for a solidaric wage policy.

Without these prerequisites, either wages will rise together by more


I. Introduction

It is agreed among economists that, in the absence of any
policy response, an oi1 price shock in an of1-importing country will
produce a (presumably) temporary increase in both inflation and
unemployment. Freeman (1981), Johnson (1981), Blinder (1981),
Brunc-Sachs (1979), Buiter (1978), Gordon (1975), Phelps (1978), and
others have put forth models in which such a stagfTationary response
results from higher ofl] prices. Rather than a mere happenstance, the
Promulgation of these models was attributable to the macroeconomic
events which took place in most oil-importing countries following the
large oi] price hikes of the 1970s, Economists were quick to point
out that an oi] price shock presents policy makers with a choice, to
wit, whether to accommodate the shocks or to keep policy constant in
the face of the stagflationary response .2/ Those who endorsed the
existence of a short-run trade-off between inflation and unemployment
typically favored some type of accommodation, while those who denied
the existence of a stable, short-run trade-off argued against
accomnodation.

Economic developments in Sweden during the 1970's are
interesting in the present context because the Swedish authorities
clearly chose the option of fully accommodating the of] price shock of
1973-4. Opponents of accommodative pplicies -- either in general
or in response to the oi] shock in particular -- are quick to allude
to Sweden's subsequent economic difficulties as evidence against
accommodation. One purpose of this paper is to argue that accommodation

per sé was not necessarily the main source of later difficulties.


- 33 -

11/ See Chow (1969) pp. 106-8 and Croxton et.al. (1967) pp. 198-201
cn appropriate measures of dispersion. In the above case there
is little doubt. Imagine 2 countries identical in every respect
except that, owing to inflation, wages in country A are twice
as large in country B. In this case, the standard deviation
cf wages in A would be twice that of country B, while the coefficients
cf variation would be identical. Thus the latter measure conveys
the information that in terms of relative dispersion (i.e., relative
to each country's mean), A and B are identical.

12/ This policy was adopted to moderate demands for large wage
increases -- in other words, since businesses did not have large
profits, laborers should settle for moderate wage increases.
Thus the government was trying to repeal one of the assumptions
cf the EFO model, that labor's share in the export sector is
constant. Unfortunately, this strategy was not successful.

13/ The net borrowing requirement of the central government fell from
4 percent of GDP in 1974 to just over 2 percent in 1976.

14/ Until corrected in 1979, there was a substantial underreporting of
Sweden's service exports. The original balance of payments
statistics for 1975, 1976, and the first half of 1977 showed
deficits of 6.7, 10.5, and 7.7 billion kroner, respectively;
the corrected figures are 1.5, 7.1 and 5.3 billion. Although
the exaggerated current-account deficit may have contributed
somewhat to the downward pressure on the krona in foreign exchange
markets, it is clear that the krona was substantially overvalued
‘n 1977 and that a sizeable depreciation was warranted.

15/ “he exchange rate refered to in the text is the multilateral
trade-weighted average on a monthly basis.

16/ In the first half of 1977, Sweden's inflation rate was 7 percent
fa.r.) higher than Germany's, and the difference in policy stances
between the two countries indicated that this differential would
widen. In the second half of 1977, this differential did widen
substantially -- to 11 percent -- mainly because of the drop in
German inflation. Throughout the remainder of the decade, this
differential remained in excess of the 2-1/2 percent band of
exchange rate fluctuation permitted in the European Monetary
System.

17/ As shown in Table 5, the rate of growth of the broad money supply
~~ dropped from about jo percent in 1976 to about 6 percent in 1977.

18/ The surplus of $218 million in the fourth quarter of 1977 compared
with a cumulative deficit of $1 billion in the three preceeding
quarters.


- 28 -

considering the question of whether or not to accommodate a supply
shock it certainly is sensible to ascertain whether or not the
aggregate supply curve is vertical. However, the knowledge that there
is some elasticity of supply is not sufficient for accommodation to
be the optimal choice. One drawback of relying solely on the simple

approach to the accommodation issue is that it is at best a partial

equilibrium approach to the accommodation issue. The simple approach
ignores the interaction of the chosen accommodative policies with other
existing macroeconomic policies. However, in the Swedish case, both
exchange-rate and wage policies required tight demand management
policies; this interaction seems to have been ignored, at great expense
to the Swedish economy.

The omission of this interaction highlights the limited --
and theoretically ambiguous -- nature of a social welfare function defined
over inflation and unemployment. Instead, one can conceive of a social
welfare function which includes the present value of future consumption
and an income distribution parameter and which the authorities are
charged with maximizing subject to the production and trading possibilities
of the society. Besides being preferable from a welfare point of view,
such a formulation underlines the trade-off between growth and distribution
which often lies behind the accommodation decision. In the Swedish
case, this formulation might have focussed attention on the inconsistency
of the chosen policy mix.

The inclusion of the present value of future consumption as
an argument in the social welfare function introduces potential timing
questions. Even if it is granted that, in a given situation, accommodative

policies will raise present consumption, this formulation makes it


-12-

Table 2

Wage Dispersion in 1979 in G-10 countries!/

Standard Coefficient of
Country, Mean Wage Rate Deviation _Variation
Cin dol iars) (in percent)
Belgium 12.06 2.2508 18.7
Netherlands 11.27 1.5550 13.8
Sweden 11.22 0.9824 . 8.7
Germany 10.90 1.7214 15.2
United States 9.32 2.4986 26.8
France 8:20 1.2847 15.7
Canada 8.11 1.8136 22.4
Italy 7.67 0.9453 12.3
Japan 6.09 1.6643 27.3
United Kingdom 5.63 0.9023 16.0

1/ "Wages" are actually total compensation by industry for 30 industries in each
country. The data were converted into dollars using average exchange rates
for 1979.

Source: Bureau of Labor Statistics, unpublished data.


- 15-

Table 4

Selected Economic Indicators, 1973-80 y

1973, 1974 1975 1976 1977 1978 1979 1980

Real GDP 3.8 4.1 2.5 1.6 -2.4 1.4 4.0 1.4
Unemployment Rate 2.5 2.0 1.6 1.6 1.8 2.2 2.1 1.9
Consumer Prices 6.7 9.9 9.8 10.3 11.4 10.1 7.2 13.7
Hourly Compensation 9.4 16.6 21.2 19.9 12.2 12.5 7.9

Money Stock (M3) 12.5 12.3 9.9 9.9 5.8 14.2 14.3 12.3
Trade Account 1.5  -0.5 -0.4 -0.8 -0.9 1.2  -0.9 -0.8
($ billions)

Current Account 1.20 -0.8 -0.4 -1.6 -2.1 -0.2 -2.6 -5.2

($ billions)

J/ Data are expressed as a percentage change over the previous year unless
expressed otherwise.