Mr. Bäckström discusses monetary policy and unemployment in Sweden
Speech by the Governor of the Bank of Sweden, Mr. Urban Bäckström, before the Swedish
Economics Association on 6/3/97.
First a word of thanks for the invitation to this evening's discussion. This is the
third year in succession that your Association's agenda has featured monetary policy. My first
introductory talk, in 1995, was about the importance of low inflation and the background to and
implications of focusing on price stability. Last year I took up matters to do with monetary
policy's construction and effects, as well as the considerations behind the monetary policy
decisions in recent years. This evening I shall be elaborating on those discussions and then deal
with monetary policy in the context of Sweden's high unemployment.
Economic developments in Sweden
Following the deep recession in the Swedish economy in the early 1990s, we are
now in the fourth year of economic expansion. Since 1994 production's annual growth rate has
averaged 2.8 per cent, which is considerably above the trend to which we have been accustomed
in recent decades.
In 1994 and 1995 the GDP growth rate averaged as much as 3.5 per cent. This
increase was concentrated on the internationally oriented sector and industrial activity registered
the fastest upswing in a long time. This led to capacity problems despite relatively high
investment growth. The strong expansion was therefore not sustainable. Moreover, the
credibility of economic policy was impaired by weak central government finance and an
unfavourable history of inflation. There was a lack of confidence that the expansionary trend
could continue without generating higher inflation. Inflation expectations moved up--more and
more people began to count on rising inflation. All this was manifested in, for example, rising
long-term interest rates, a weak exchange rate, rising producer prices and accelerating wage
increases.
The Riksbank therefore tightened interest rate policy, beginning in August 1994.
The restrictive turn was criticised in some quarters because inflation had not yet started to
accelerate. But our intention was precisely that. If monetary policy measures are taken in time,
the inflationary process can be checked before it has taken off. Once inflation has got going,
more pronounced monetary policy measures are needed for a return to low inflation.
Vigorous efforts have also been made over these years to tackle the central
government financial deficit. With its six-monthly control stations, the convergence programme
enables people to keep an eye on the political system's determination to complete the
consolidation of the budget and fulfil the goal of balance in 1998. Government representatives
have also expressed an ambition to achieve a surplus after that. With the improvement in central
government finance, confidence in economic policy grew appreciably and inflation expectations
fell back notably in the autumn of 1995 and during 1996. This in turn is a fundamental
prerequisite for lastingly stable growth. During 1996 the Riksbank was in a position to reduce
the repo rate by degrees to the lowest level for more than thirty years.
Towards the end of 1995 the growth of production slackened and the increase
during 1996 probably stopped at between 1 and 1.5 per cent. However, the slowdown seems to
have been relatively gentle. The demand situation appears to be good, particularly when one
considers that the growth of private sector production was held back by marked destocking in
1996. Stock adjustments are not uncommon after some years of rising output and they do not
seem to have had negative effects on private consumption. In the second half of 1996 private
consumption picked up and export demand went on rising. As the destocking comes to an end,
domestic and international demand should therefore be able to generate an accelerating growth
of production this year and in 1988.
Considering the economy's unutilised resources, I do not expect inflationary
capacity restrictions to arise in the coming years. If inflation expectations also remain low and
confidence in economic policy in general is stable, this, too, will contribute to a subdued
development of future inflation.
Since the autumn there have been some months in which the level of consumer
prices was lower than a year earlier. In a price analysis, however, it is important to distinguish
transitory effects on inflation from the underlying inflationary process. In January this year the
level of consumer prices was 0.1 per cent lower than a year earlier. Strictly speaking, however,
what Sweden is experiencing is not deflation. The falling price level has to do with transitory
effects, above all the Riksbank's marked reduction of the repo rate during 1996. Excluding
house mortgage interest costs, the rate of inflation in January 1997 was about 1.5 per cent.
The outlook for inflation points to room for a fall in bond rates. Moreover,
underlying economic factors suggest that, after the depreciation in recent months, the krona is
undervalued and should be capable of appreciating.
The present monetary stance appears to be well balanced. After the major changes
in the past year, for example in the repo rate, time is needed to assess their effects. Another
matter to consider is the recent months' developments in financial markets. They, too, call for a
cautious line in monetary policy.
I note that the Swedish economy seems to have made good progress in adjusting
to a low inflation regime, with stable, sustained growth. What gives cause for concern, however,
is that the recovery of employment appears to be much more sluggish and that unemployment is
persistently high.
High cost of unemployment
As shown in Diagram 1, registered unemployment in Sweden rose sharply in the
early 1990s; from a level between 2 and 3 per cent, it shot up to around 8 per cent. This was
accompanied by increased participation in labour market programmes. Total unemployment
accordingly reached around 13 per cent, an increase of almost 10 percentage points or up to half
a million people. This is the highest level since the 1930s. It is primarily among youth that
unemployment is high, as shown in Diagram 2. Sweden seems to have landed in much the same
situation as many other countries in Europe.
High unemployment is associated with grave social problems and large economic
costs. Unemployment's long-run economic costs in terms of GDP can be said to be of
- 3 -
Diagram 1
Diagram 1
Unem ploym ent 1965-96
Unem ploym ent 1965-96
per per cent cent
14 14 14 14
12 12 12 12
10 10 10 10
T otal
8 8
6 6
4 4
R e gistere d
2 2
0 0
65 65 70 70 75 75 80 80 85 85 90 90 95 95
S ource s: S ta tistics S we de n a nd Na tiona l La bour M a rke t Board
D iagram 2
D iagram 2
A ge-related unem ploym ent
A ge-related unem ploym ent
rates
rates
P P er er cent cent
2 2 0 0 2 2 0 0
1 1 8 8 1 1 8 8
1 1 6 6 1 1 6 6
16-24 y rs.
1 1 4 4 1 1 4 4
1 1 2 2 1 1 2 2
25-34 y rs.
1 1 0 0 1 1 0 0
8 8
6 6
16-64 y rs.
4 4
2 2
0 0
7 6 7 7 7 8 7 9 8 0 8 1 8 2 8 3 8 4 8 5 8 6 8 7 8 8 8 9 9 0 9 1 9 2 9 3 9 4 9 5 9 6
S ou rce : S ta tistics S w e de n
approximately the same magnitude as the unemployment rate.1 Sweden's increase in
unemployment can in this way be estimated to cost around 10 per cent of GDP a year, which is
equivalent to SKr 150 billion. Considering the sensitivity of general government finance to
variations in unemployment and production, the cost to the public sector, in the form of lower
tax revenue and increased expenditure on unemployment support, for example, may actually be
as high as 9 per cent of GDP or SKr 135 billion.2
Conversely, an appreciable reduction of unemployment implies decreased social
tensions as well as substantial economic gains. Calculated in the same way, halving registered
unemployment from 8 to 4 per cent, for example, would confer an estimated long-term gain in
production of 4 per cent of GDP and strengthen government finance by as much as over
SKr 50 billion a year.
Simple calculations of this type are obviously uncertain but they do serve to
illustrate the sort of economic benefits that may be reaped from an appreciable fall in
unemployment.
What can the Riksbank and monetary policy do?
There was a time when many people believed that the problem of very high
unemployment could be tackled with a generally expansionary economic policy. Lower interest
rates, devaluations or fiscal stimuli were seen as instruments for boosting demand, raising
production, improving employment and thereby lowering unemployment. Even today, advocates
of similar views are not uncommon. As the consolidation of the budget places constraints on
fiscal policy, attention concentrates on monetary policy. Representatives of this line argue that
the problem of unemployment could be solved if only the Riksbank had a wider objective than
combating inflation. Some say that the Riksbank ought therefore also to have explicit goals for
growth, employment and unemployment, goals that should be as important as keeping inflation
under control.
You will hardly be surprised to hear that I do not share such opinions. The current
situation in the labour market is more complicated than that.
An expansionary economic policy, aimed at boosting demand above the
economy's long-term production potential, would actually be liable to worsen the labour market
situation in the longer run. Inflation would move up and the economy would function less well.
Neither is it the case that higher inflation would generate permanently higher employment and
lastingly lower unemployment. Let me give you an example.
Suppose inflation is 2 per cent initially and monetary policy is given an
expansionary turn that disregards the sustainable level of output. If wage agreements have been
concluded for a considerable period, an upward shift in inflation to, say, 5 per cent could in the
best case contribute to a short-run increase in employment because firms' real wage costs are
reduced. In time, however, 5 per cent inflation will be perceived as normal and wage demands
will be pitched accordingly. With higher nominal wage increases, real wage costs will rise again
and unemployment will tend to return to its initial level. A renewed attempt to stimulate
employment and reduce unemployment would then entail a further acceleration of inflation from
5 to, say, 8 per cent and the procedure would be repeated. Ultimately, all that is achieved is
higher average inflation and an economy than functions less efficiently; unemployment stays at
its initial level.
The level of unemployment to which an economy returns when inflation
expectations have been adjusted to actual inflation is usually referred to as equilibrium
unemployment. It is immune to monetary policy and determined primarily by structural factors
such as demographic changes, technology and the institutional conditions in the labour market.
What I have just described is the textbook model for the long-term Phillips curve.
The message is that an economy has a path for long-term growth that is
determined by underlying, structural factors. Under certain circumstances, fiscal and monetary
policy are capable of influencing fluctuations in activity around this trend, though one should
not expect to be able to fine-tune demand. A basic idea behind a monetary policy focused on
price stability is that the economy is capable of sustained growth along this long-term path. If
this path accommodates a rapid increase in production, growth will be high; but if potential
output rises slowly, actual growth will be weak even if monetary policy were to be very
expansionary and possibly affect the situation temporarily.
A very important conclusion from this is that permanently low unemployment
cannot be achieved by accepting permanently high inflation. In other words, sustained
employment cannot be generated by implementing an expansionary monetary policy and
disregarding unemployment's equilibrium level or the potential level of output. The narrower
the gap between actual production and the capacity ceiling and the lower unemployment
happens to be in relation to its equilibrium level, the greater will be the risk of higher inflation.
From this also follows a need to know whether the equilibrium level of
unemployment has risen. If that is the case, measures should be taken specifically to lower the
equilibrium level, a task that is outside the scope of monetary policy.
Where is unemployment's equilibrium level?
What is unemployment's current equilibrium level in Sweden? As always when
one goes from a theoretical analysis to practical economics, everything becomes much more
complex. Unemployment's equilibrium level is not an observable quantity. One has to make do
with estimates and their inevitable uncertainty means that interpretations have to be cautious.
The available estimates suggest that equilibrium unemployment in Sweden moved
up in the early 1990s and, in terms of registered unemployment, is now somewhere in the
interval between 4.5 and 7.5 per cent.3 The OECD also counts on a marked increase in the
1990s; in the latest report on Sweden the current level is put at between 6 and 7 per cent.4
There is not, in fact, complete agreement that equilibrium unemployment has
moved up sharply.5 But what suggests that it has, even though we cannot be sure of its exact
level, is that otherwise the high unemployment should have acted as a strong restraint on wage
formation. The actual development of wages does not indicate this.
It therefore has to be concluded that unemployment cannot be lowered
appreciably by monetary policy alone. Most economic observers also consider that even with
decent growth in the coming years, unemployment will remain high. A lasting return just to
something resembling the unemployment figures we have been accustomed to in Sweden
therefore requires a proper discussion of which measures are needed to bring equilibrium
unemployment down.
The picture in the USA, Western Europe and Sweden
It is not just in Sweden that unemployment is high. This is something which is
leaving its mark on virtually the whole of the EU area. Moreover, the level of European
unemployment has been high during most of the 1980s. In the United States, on the other hand,
unemployment has fluctuated around 6 per cent for the past quarter century without any upward
trend.
The direct explanation for the difference between the EU area and the United
States is the appreciably faster growth of employment over there. In the past quarter century and
more, employment in the United States has risen over 60 per cent as against only 15 per cent in
the EU area. The number of new jobs certainly grew by some one per cent in Europe when
activity was recovering but almost as many jobs disappeared in the downturns. In the United
States, on the other hand, over the business cycle there have been net increases.
Economists differ as to the underlying causes. For some economists, equilibrium
unemployment has moved up on account of underlying structural factors. One hypothesis, put
forward by, among others, the American economist Paul Krugman, is that certain categories of
labour (low educated, for example) are having increasing difficulty in competing in the labour
market.6 This is mainly bound up with a technology that replaces manual labour with machines
but presumably it also has to do with increased competition from countries where wage levels
are considerably lower. It is often pointed out that the effects of this are countered by a wider
wage spread that in turn has stimulated an expansion of the private services sector. Employment
has therefore risen rapidly in the United States. In Europe, on the other hand, the result has been
increased unemployment; the labour market and wage formation here have not permitted the
same development as in the United States.
A similar effect, leading to a stronger employment trend, may have come from a
lower average real wage rise in the United States compared with Europe. The steep real wage
increase in the EU area has favoured capital-intensive sectors and stimulated the use of
capital-intensive technology. At the same time, low-productivity enterprises have shrunk or
closed down. This has shown up in increased productivity and weakly rising employment. The
opposite has occurred in the United States: sluggish real wages have limited the need to
rationalise labour and invest in capital-intensive equipment and this has resulted in rapidly rising
employment.7
- 7 -
Diagram 3a
Diagram 3a
Real wages and employed persons,
Real wages and employed persons,
EU and USA, 1970-97
EU and USA, 1970-97
Index 1970=100
Index 1970=100
170 170 170 170 170 170
EU USA
160 160 160 160 160 160
Real wages
150 150 150 150 150 150
140 140 140 140 140 140
E mployment
130 130 130 130 130 130
120 120 120 120 120 120
E mployment
110 110 110 110 110 110
Real wages
100 100 100 100 100 100
90 90 90 90 90 90
80 80 80 80 80 80
70 70 72 72 74 74 76 76 78 78 80 80 82 82 84 84 86 86 88 88 90 90 92 92 94 94 96 96 98 98 70 72 74 76 78 80 82 84 86 88 90 92 94 96 98
Source: O E CD
As shown in Diagram 3a, since 1970 the average real wage in the United States
has risen by a total of 15 per cent but by as much as 60 per cent in the EU area. The change in
employment, as I mentioned earlier, has been the opposite.
D D iagram iagram 3b 3b
Real wages and em ployed persons,
Real wages and em ployed persons,
Netherlands and Sweden, 1970-96
Netherlands and Sweden, 1970-96
Index 1970=100
Index 1970=100
Netherlands
Sweden
170 170 170 170 170 170
160 160 160 160 160 160
150 150 150 150 150 150
R e a l wa ge s
140 140 140 140 140 140
R e a l wa ge s
130 130 130 130 130 130
120 120 120 120 120 120
110 110 110
110 110 110
100 100 100 100 100 100
E m ploym e n t
E m ploym e n t
90 90 90 90 90 90
80 80 80 80 80 80
70 70 72 72 74 74 76 76 78 78 80 80 82 82 84 84 86 86 88 88 90 90 92 92 94 94 96 96 98 98 70 72 74 76 78 80 82 84 86 88 90 92 94 96 98
S ource : O E C D
Europe, however, does have some positive examples. One of the few countries
here that has managed to turn the employment curve upwards from the mid-1980s is the
Netherlands, as shown in Diagram 3b. In the course of a decade unemployment has been
virtually halved, from 12 to just over 6 per cent. One factor behind this is a very moderate real
wage rise, so that employment has risen on this account. The labour market has probably
become more adaptable. Another phenomenon in the Netherlands is an increase in part-time
employment; this probably reflects a change in labour demand but also a shift in supply. The
case of the Netherlands shows that the employment trend can be turned.
This indicates, in my opinion, that in the current discussion in Sweden about a
new model for wage formation, the prototype ought not to be Europe as a whole. If the average
real wage rise in Sweden were to match the rate observed in Europe in the past quarter-century,
it might make a reduction of unemployment more difficult. The model should rather be the
Netherlands.
The pattern in Sweden resembles that for the EU area. In the period as a whole
employment has hardly changed. As in Europe in general, real wages have risen relatively
strongly, though the trend has been held back by a series of devaluations that pushed inflation
up, presumably with a negative effect on production.
Diagram 4
Diagram 4
Cumulative change in
Cumulative change in
employment 1960-96
employment 1960-96
Thousands
10 1000
Public
80 800
employment
60 600
Total
employment
40 400
20 200
0
-200 00
Private
employment
-400 00
60 60 65 65 70 70 75 75 80 80 85 85 90 90 95 95
Source: Statistics Sweden
The great challenge Sweden faces in the future development of employment is
evident from Diagram 4, which shows that for a long time there has been no net increase in
private sector jobs. This is the trend that must be broken. While there has certainly been some
increase in employment in boom years, in the subsequent downturns virtually as many jobs have
disappeared. The overall increase in employment has come from an expansion of public sector
jobs; one million jobs were created in this sector between 1960 and 1990. Now that, for various
reasons, the political system has been obliged to arrest the public sector's expansion,
employment has also fallen.
Diagram 5
Diagram 5
GDP 1970-96
GDP 1970-96
USA, EU, Netherlands and Sweden
USA, EU, Netherlands and Sweden
Index 1970=100 1970=100
Index
220 220
200 200
U SA
E U
180 180
Netherlands
S weden
160 160
140 140
120 120
100 100
80 80
70 71 72 73 74 75 76 77 78 79 80 81 82 83 84 85 86 87 88 89 90 91 92 93 94 95 96 97 98
1996-97 O E CD forecast S ource: E UR O STAT
It is important, I think, to underscore that, notwithstanding the marked differences
in employment, GDP growth does not differ substantially between the United States, the EU
area, the Netherlands and Sweden. Therefore it is not high demand generated by a more
expansionary monetary and fiscal policy that can account for the creation of so many new jobs
in the United States or, in the past decade, in the Netherlands. This is an indication that
structural factors lie behind the development in Western Europe as a whole. An important part
seems to be played, not least, by wage formation.
The weak growth in Sweden is also evident from Diagram 5. This is another
interesting observation in the present context. When potential output rises slowly for structural
reasons, growth will be weak even if economic policy is expansionary. In spite of devaluations
and fiscal expansion with a view to boosting demand, growth has remained lower than in many
other industrialised countries. This is an important lesson to bear in mind when discussing
monetary policy's functions and tasks.
Other economists have been less interested in why employment has been slack
and unemployment has risen and more concerned with unemployment's tendency to remain at a
high level. The observation that unemployment, having risen, tends to stick at a high level or
falls back to normal levels only gradually is usually described in terms of hysteresis and
persistence.8 An explanation for the occurrence of persistence tendencies is provided by the
insider-outsider model. Briefly, an increase in unemployment does not lead to wage restraint
because those who have lost the jobs--the outsiders--exercise no influence on wage setting.
Instead of a restrained wage rise, with lower labour costs and a possibility of taking on
additional labour, the wage increases remain high and the outsiders remain out of work.9 Strictly
speaking, this does not constitute an increase in equilibrium unemployment but it still amounts
to unemployment that is more or less permanent.
In Sweden, wage increases tended to accelerate in the 1995 round of settlements
even though unemployment was high. Statements by representatives of labour market
organisations are indicative of a propensity to give real wage increases priority over increased
employment. Allow me to cite (from Finanstidningen, 14th October 1996): "There is no direct
link between our coming wage claims and the number who are unemployed". This is an
illustration of the theories about insiders and outsiders in the labour market.
The costs of hiring and firing labour are one source of insiders' influence over
wage formation, which can affect the possibility of bringing unemployment down. During the
latest economic upswing in Sweden the number of hours worked rose by the equivalent of
130,000 new jobs but the increase in the number of persons in employment stopped at 85,000.
The direct explanation is that average working time lengthened, which naturally may have
reflected a rising propensity to go from part-time to full-time work and to do overtime in order
to ease a strained personal economy. But it is also conceivable that employers have become less
inclined to hire additional labour and more prone to make greater use of the existing labour force
to cope with rising demand. An indication of this could be employers' willingness to introduce
working hours related to the activity in the economy.
The differences between the explanatory models should not be exaggerated. They
have several features in common and this makes them difficult to separate clearly in practice.
Most of the evidence suggests that the high equilibrium unemployment in Western Europe as
well as in Sweden has several causes. As the structures and institutions in the Swedish labour
market resemble those in the rest of Western Europe in many respects, it is reasonable to
suppose that the same forces have been at work in our country but that their impact and
importance were concealed for a long time by an expansionary economic policy that was
ultimately unsustainable.
High and more or less permanent unemployment, or high equilibrium
unemployment, is a sign that the labour market is functioning poorly. These problems are rooted
in turn in wage developments because it is price formation which is the central market
mechanism.
Conclusion
The best way in which monetary policy can contribute to an economy that
functions better economy with employment and growth is by keeping inflation low and stable.
The economy can then expand along its long-term growth trend. If this path, which is
determined by structural factors, permits a rapid increase in output, growth will then be high. If
potential output rises slowly, on the other hand, economic growth will be weak even if monetary
policy were to be very expansionary.
Most things suggest that traditional demand policy is not capable of lowering
unemployment appreciably. Most economic observers also expect that even with decent growth,
unemployment will remain high in the coming years.
Whatever the causes of the high unemployment, an important key to turning this
tendency lies in the functioning of the labour market. I have not considered conceivable specific
measures, such as stimulating private sector employment, contributing to efficient wage
formation and encouraging individuals to look for and accept jobs and maintain and develop
their competence. I believe that, as Assar Lindbeck pointed out recently,10 the problem of
unemployment in Sweden and, indeed, in the whole of Western Europe has to do with a great
many factors connected with how the labour market functions.
Although the most effective measures cannot be identified for certain in advance,
the central concern is the workings of the labour market and thereby also the labour market
organisations. This applies to employer and employee representatives alike. The climate in the
labour market will be of significance for the possibility of bringing the high unemployment
down.
One issue is whether a mood of mutual understanding can be created so that
employment has priority in wage setting. An important lesson seems to be that Sweden ought
not to opt for a standard in wage formation that matches the average level in Western Europe;
such a relatively high level could impede a reduction of unemployment. The model should rather
be the Netherlands.
Another issue is whether a mood of mutual understanding can be created about
the reform and construction of labour market rules and other measures that can help to reduce
unemployment.
My intention this evening has not been to present a deeper analysis of the labour
market problems, nor to answer questions about what needs to be done. But perhaps I have
contributed by raising some of the questions that need to be answered and by defining the
function of monetary policy and what it can do. If we are to achieve a lasting return just to
something resembling the unemployment figures we have been accustomed to in Sweden, there
will have to be a proper discussion of which measures are needed to bring unemployment down.