Lars Heikensten: Swedish economic policy in the EMU
Speech by Mr Lars Heikensten, First Deputy Governor of the Sveriges Riksbank, at the Swedish
Academy of Engineering Sciences, Stockholm, 23 January 2002.
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I should like to thank the Academy of Engineering Sciences for inviting me to talk about Swedish
economic policy in the event of full participation in the European Monetary Union. I am, of course,
particularly pleased to do so as a newly-elected member.
Those of you who have visited the Continent since the turn of the year will no doubt have come into
physical contact with the euro. Having previously existed only as an electronic means of payment in
financial markets, the euro is now also a reality in the purses and wallets of the citizens of twelve of
the European Union's fifteen member countries.
In Sweden this has revived the discussion about EMU, which makes it particularly stimulating to have
an opportunity to talk about some related issues. Over the years in my present job I have made ten or
so EMU speeches, generally in the light of what I have learnt and experienced by working on
economic policy in Sweden as well as in the framework of EU cooperation. Interest in the subject has
certainly varied but conditions now seem to be good again for a broad discussion about Sweden and
the monetary union. This is a discussion that everyone has reason to encourage before the time
comes to make the political decisions.
For clarity's sake I should perhaps add that I am speaking in a personal capacity, not expressing an
official position on behalf of the Riksbank.
Some new conditions for economic policy
If Sweden were to adopt the euro, responsibility for monetary policy would be transferred to the
European Central Bank (ECB), which acts, not in the interest of particular countries but for what is
appropriate for the euro area as a whole. Thus, Swedish economic policy would no longer have
recourse to the short-term interest rate and the exchange rate. Tendencies to overheating and inflation
just in Sweden could no longer be countered with the monetary alternative of raising the interest rate
here, just as the interest rate could not be lowered to mitigate a marked slowdown in our economy.
This is clearly a change in the conditions for economic policy that needs to be analysed and discussed
in advance of a decision to adopt the euro.
Having said that, the issue should not be seen too dramatically. The set-up for economic policy in a
monetary union is much the same as in a country with a fixed exchange rate. In Sweden that was
actually the case in 73 of the past 100 years, with results that were excellent in some periods and
considerably worse in others. It is important to learn from those experiences. What distinguishes a
monetary union is that the exchange rate is locked irrevocably. That means there is no room for the
type of misguided economic policy that characterised the 1970s and '80s, for example, when Sweden
used repeated devaluations in an attempt to rectify the situation. Such failures must be avoided at any
cost.
Against this background it is not remarkable that the discussion about economic policy with EMU has
focused on stabilisation policy. Even so, it is important to start from a broader perspective. The issues
to do with stabilisation policy have featured prominently in the Swedish debate. This has to do with a
strong Keynesian tradition and the ability of Lars Calmfors and his former colleagues to place the
so-called insurance argument in the centre of the whole discussion about a monetary union. The latter
naturally has to do with the fact that the very dramatic crisis which hit Sweden in the early 1990s was
so closely connected with stabilisation policy. It is hardly surprising that in many other countries the
discussion took a very different course before they adhered to the EMU.
It is extremely important that our discussion about economic policy - with or without the euro - does
not overlook or play down the supply side of the economy. Countries that create conditions for a
smooth adjustment of labour markets and a favourable development of productivity will almost
certainly do well as members of the monetary union. Measures to this end are naturally warranted in
any event - they promote prosperity. But they also alter the conditions for stabilisation policy and
reduce the need for 'insurance'.
In this context it may be worth recalling that the overheating that led up to the crisis in the early 1990s
was by no means primarily due to the growth of demand being notably strong, though demand was
certainly too high in relation to the economy's productive capacity. Annual GDP growth from 1985 to
1990 was actually no more than 2.4 per cent. What really mattered was poor conditions for growth;
productivity rose only 1.1 per cent and employment in hours only 1.3 per cent. If productivity growth in
the late 1980s and early 1990s had been half or one percentage point higher, things could have been
very different.
Our tendency to concentrate the EMU discussion on stabilisation policy means that a number of
important points about EMU cooperation are overlooked. They concern the longer run and aim
precisely at improving conditions for growth and employment in this horizon. EMU has an important
role here. Trade will be facilitated along with other cross-border activities such as investment.
Simplified price comparisons can led to stronger competition. We will also have a broader and deeper
capital market. Moreover, EMU implies better conditions for a stable development in the Union as a
whole. Good examples are the crises in Asia and Russia around 1998 and last year's abrupt
slowdown in the American economy; had it not been for EMU, Europe's financial markets would have
been more turbulent.
Policy frames in the European Union
Before discussing economic policy in Sweden in the event of a transition to the euro, something
should be said about the European frames which this policy would have to comply with. These frames
already affect the conditions for Sweden's policy and will presumably do so even more in the future.
Of the economic policy processes in the European Union, the most prominent are contingent on the
Stability and Growth Pact from 1997. The primary purpose of the Pact is to ensure that budget policy
in the member states is conducted so that no country encounters serious problems with debt because
that could lead to costs for the Union as a whole and, in the worst case, to other countries being forced
to bail out the 'sinner'. The Pact contains binding rules and in well-defined extreme cases could even
result in sanctions. In addition, there is a number of processes or rules whereby peer pressure and
benchmarking are used to speed up the EU's structural reforms. The central policy instrument is the
general economic policy guidelines, which can be likened to a budget statement. Other instruments
are, for example, the Luxembourg, Cardiff and Lisbon processes. All the above applies to Sweden,
whether or not we adopt the euro, though the terms of the Growth and Stability Pact do differ in this
respect; the rules for sanctions, for instance, do not apply as long as we are outside the euro area.
There is much to be said both about the actual construction of the processes and what they have
achieved to date. Moreover, knowledge of these matters is generally lacking in Sweden. Today,
however, I shall be very brief. As I see it, there is a tendency towards an increased coordination of
fiscal and structural policies. This takes many forms. The issues are discussed together, both at the
highest level and further down among civil servants and experts. It is partly a learning process, an
exchange of thoughts about good examples, a communication of ideas and so on. New, more specific
knowledge is also being generated. At present, for instance, common principles are being drawn up
for the measurement of budget outcomes and capacity utilisation. This is necessary for effective
surveillance of compliance with the Stability and Growth Pact. Similar work has begun in the field of
pensions. These quotidian efforts should not be underrated. They help to make many problems more
understandable and promote a consensus about how they should be handled.
Sweden has much to gain from this kind of international collaboration. To exemplify how international
discussions can influence matters I can mention that when we at the Ministry of Finance were aiming
to alter the economic policy agenda in the late 1980s, we were greatly inspired by the work that had
been done under the auspices of the OECD and others. In my opinion, the policy realignment owed at
least as much to our international contacts as to the successful opinion-forming work by, for example,
the Centre for Business & Policy Studies (SNS).
Many of the problems and measures that are being discussed are of a national nature; they vary
between countries and it is in each country's interest to solve them. Moreover, due to differences in
the initial situation, the solutions may have to differ, too. One should therefore be cautious about
imposing universal mandatory rules. Furthermore, solutions will presumably become more uniform as
a result of increased trade and competition. It is likely, however, that fiscal and budget polices will be
further coordinated, though this process will not necessarily be driven solely by principles and
intellectual arguments. I am more inclined to guess that circumstances will bring this about by degrees
as new problems, stemming from the member states sitting in the same boat, have to be tackled,
perhaps in some cases at rather short notice.
Fiscal policy in Sweden
The problems for stabilisation policy
So what about the problems for stabilisation policy that arise if the euro is adopted? We would clearly
have to do without an independent monetary policy. By itself, this may imply a risk of larger cyclical
fluctuations and it would also make a proper crisis more difficult to manage with measures of
economic policy. As was the case in the early 1990s, a crisis can arise mainly from an inappropriate
domestic policy; it can also result from an external shock that hits Sweden more strongly than the
average euro country; a third possibility is the failure of one or more Swedish companies of vital
importance for our economy.
There are other ways in which the conditions for economic policy can be affected. As a euro
participant, a country has somewhat more room for manoeuvre in fiscal policy. This is really only the
other side of the arguments behind the Stability and Growth Pact. Financial markets would have less
reason to follow developments in Sweden, with the attendant risk that fiscal and budget policies
become less sustainable. Another question concerns the effect on wage agreements. Views differ on
this. Some count on a more disciplined approach if Sweden adopts the euro; otherwise a failure could
then be very costly, with years of unduly weak competitiveness and growth. Others argue that as
things are, the connection between wage outcomes and the interest rate in Sweden is more direct.
They sometimes refer, for example, to the outcomes of the latest round of wage negotiations and the
effect on them of interest rate policy in autumn 1997.
This undoubtedly warrants a closer look at what the framework for stabilisation policy should consist
of. A major problem in this context is clearly that, for a number of familiar reasons, it is more difficult to
use fiscal than monetary policy for active economic stabilisation. A crucial problem in both cases is not
knowing in which direction the economy is moving. Here it will suffice to recall what most of us here
were saying about the economy two years ago. Another, related problem has to do with the time lag
before measures have an impact. In the case of monetary policy we usually allow for a lag of one to
two years. Arriving at decisions also takes time, particularly in fiscal policy. Moreover, decisions are
often swayed by other considerations than stabilisation policy, which is just why the implementation of
monetary policy has been assigned to an independent institution.
Firm principles for budget policy
This speaks for the importance of not exaggerating what can be achieved with fiscal fine-tuning. What
matters is that the fiscal policy framework is such that adequate reserves are built up. The combination
of a stable public sector financial surplus over the business cycle and low debt provides a margin for
the government finances to deteriorate in the normal way when activity is weakening and let the
automatic stabilisers work. If that functions properly, we will have made good progress.
Given adequate reserves, Sweden will be in an unusually good position in this respect because our
extensive public sector, high replacement levels in transfer systems and high taxes mean that the
budget balance fluctuates more than in other countries. At the same time, it should perhaps be
mentioned that an economy contains many other types of stabiliser, not all of which are necessarily
public. A system like ours, with high income taxes and transfers, naturally also influences the extent to
which private safety-nets or reserves are built up. This includes everything from saving by households
to contractual unemployment insurance.
For the automatic stabilisers to function in full during future downturns it is important to stick to the
current rules for fiscal policy and ensure strict compliance when times are bad as well as good. There
may also be grounds for being even more ambitious about the budget surplus and aim for a level of,
say, 3 per cent over the business cycle. Debt could then be repaid more quickly, giving us more room
for manoeuvre in the future. The spending ceiling has functioned well both by breaking what was
previously an almost automatic increase in government expenditure and by maintaining discipline in
the central government finances. The same applies to the requirement that the local government
finances are balanced; there is less talk of this requirement in contexts like the present but it has been
an essential part of the framework that has held back the expansion of public spending in recent
years. It is therefore important that these rule systems are not eroded. On top of all this there may be a
case for some changes in the arrangement of budget work. Some of the proposals put forward
recently by Svante Öberg can be considered as a way of strengthening the process still more. It is
important, for example, to ensure that the budgeting margins are in fact handled so they can be used
as intended.
Notable progress has unquestionably been made in this field in recent years. This may be a problem
in the ongoing discussion, which often seems to assume that consolidation is something that happens
almost by itself. I do not believe that is so. The reason why everything has gone so well just in recent
years seems to me to be that the crisis in the early 1990s is still in everyone's minds and therefore
makes a firm policy easier. Moreover, growth as well as inflation have been unexpectedly favourable
for three to four years and this has consolidated budgets much sooner than had been foreseen.
Looking ahead, the challenges are considerable. If the quality of publicly financed services such as
school education and the health service is to be maintained at an acceptable level in the longer run,
this will be rather costly. That is because productivity in activities of this type, be they produced
publicly or privately, will not rise as quickly as in the production of goods. Moreover, Sweden has an
ageing population. Together with any difficulties in sticking to a tax level that is internationally high, this
would severely test the public finances. Under these circumstances it will be exceedingly important to
make a thorough scrutiny of the social security system's design; this is a question that has been on
something of a back burner, what with the crisis for stabilisation policy in the 1990s and the
achievement of a more lasting solution to the issue of pensions. In such a discussion about social
security systems that are effective and sustainable in the long term there is a place for the issue of
cyclical stabilisation. Systems that are fully or partly funded, publicly or privately, can function well as
stabilisers. Thus, it is mainly in this context that I would like to place the discussion that has taken
place about various types of buffer fund. But the need to reform the social security system is primarily
connected, not with stabilisation policy but with being able to guarantee a high quality of publicly
financed services without raising the tax take.
Measures for influencing the business cycle
Finally there are the questions of whether a more active, discretionary fiscal policy would be advisable
and whether, to function better in the future, it may need to be supported by new institutional
arrangements. First, let me stress that, for reasons I mentioned earlier, I do not have much faith in fine
tuning. Of course that does not rule out trying not to accentuate fluctuations as far as possible when
measures are taken primarily for other reasons. The central issue, however, is how more pronounced
problems or crises for stabilisation policy are to be handled.
One approach to this is to relate once again to our own experiences. As I see it, we have had to face
problems of two types. One concerns a lack of knowledge about the direction in which the economy is
moving. A dramatic example of this is the crisis in 1990, when neither the problem that was looming
with the real interest rate nor the crisis in the financial system was identified in time by virtually any
Swedish observer. The other problem is political and has to do with the difficulties in keeping policy
sufficiently tight over the business cycle, particularly when demand exceeds long-term supply. A good
illustration of this problem is the late 1980s.
Perhaps one should mention a third problem, namely that automatic stabilisers affect demand
regardless of the nature of the preceding shock. If demand in general has weakened on account of,
say, a share price fall that has affected household wealth, all will be well; a part of the loss of demand
will be compensated automatically. Things will be different if the shock comes from the supply side, for
instance as an oil price rise or a change in productivity. There could then be grounds for a
discretionary policy move to adjust demand to the change in production capacity; this could be more
difficult in the absence of an independent monetary policy. As a euro participant, however, Sweden
would be in the same boat as other member states as regards many of what appear to be likely supply
shocks, for instance oil price fluctuations.
As regards the lack of knowledge, there are clearly no simple institutional solutions. But this does not
mean that the institutional frameworks for conducting policy do not affect the accumulation of
knowledge. As I mentioned earlier, the Stability and Growth Pact has led to a rapid development of EU
work to arrive at a better understanding of the interaction of public budgets and capacity utilisation. In
Sweden, the acquisition of knowledge about potential growth, the output gap and so on has been
stimulated in that the Riksbank has been made accountable for safeguarding the value of money and
we have placed this mandate in a clear intellectual framework that calls for deeper analyses. This in
turn has had consequences for how both the Ministry of Finance and the National Institute of
Economic Research are now working on these matters. Another reason why Swedish authorities have
reason to be more involved in a broad discussion and analysis of questions such as these is perhaps
that euro participation could lead to the financial markets becoming less interested in analysing
specifically Swedish conditions.
I consider that the importance of a high level of competence in such institutions as the Finance
Ministry, the Riksbank and the National Institute should be emphasised. Good links between these
institutions and the academic world are also desirable; in a European context I consider that in this
respect we are already in the forefront. It is likewise important that we participate in the international
work on these issues, primarily in the context of the European Union and the ECB but also in the
OECD and the IMF. And although we are doing relatively well internationally, a good deal is being
accomplished elsewhere that we can try out here in Sweden. As a member of the Governing Council
of the ECB, the Riksbank will have cause to go on working on these issues at the European level. I
also think it would be natural to continue to publish the Inflation Report twice a year; that would be a
way of presenting analyses of the interplay between cyclical activity, monetary policy and the
government finances and thereby contribute to the discussion of economic policy. A qualified ongoing
analysis is needed for a small country like Sweden to play a meaningful role in the international
cooperation. Besides the traditional issues of stabilisation policy, there are grounds for the Riksbank
continuing to be deeply engaged with developments in the financial sector, for instance with the
Stability Report. A conceivable evolution of the existing structure as regards the basis for fiscal policy
could be a more direct involvement of the Economic Council that is attached to development work in
the Ministry of Finance.
Handling the political problems to do with a consistent, long-term approach to stabilisation policy is
considerably more complicated. In practice it seems to be mainly a matter of ensuring that budget
policy sticks to the rules in upward phases, both in order to secure reserves for down-turns and to
avoid overheating, with its negative effects on wage formation, costs and so on. One possibility that
has featured in the public discussion would be to extend the function of the Economic Council, for
instance by formulating opinions about the formation of policy on behalf of the Riksdag (Sweden's
parliament). At a general level I can see no crucial objection to this; one more voice in the public
discussion can do no harm. But as soon as one goes further than that, difficult issues arise.
Time does not permit a long discussion of this question, which is not all that central. I just want to say
that it touches on aspects of democracy that are likely to become even more tangible in that, if
Sweden adopts the euro, monetary policy will be conducted well beyond our borders. The difficulties
are compounded in that in questions such as these - taxes, cyclical activity, the direction of fiscal
policy - the distinction between knowledge and values tends to be indistinct. To exemplify this I can
cite a discussion I had two years ago with representatives of the Ministry of Finance. At that time they
considered there was a case for cutting taxes and argued on the basis of estimated resource
utilisation that this was feasible without risking capacity restrictions. Our estimations suggested
otherwise, though the differences should not be exaggerated. We still do not know who was right. But
what we do know is that economic activity has declined far more than any of us foresaw and this has
been accompanied by higher inflation.
Concluding remarks
Now for a brief summary of what I have said.
Economic policy as a euro participant is not all that different from economic policy today. When
discussing stabilisation policy it should borne in mind that the best way for us to achieve a favourable
development - inside or outside the euro area - is to create conditions for a smooth adjustment to
various markets, primarily the labour market, and for a good productivity trend. In these respects there
are measures we ought to take in any event. But euro participation can help us to move in the right
direction.
By adopting the euro we would relinquish our national monetary policy. That would make the formation
of fiscal policy more crucial. There are risks here, as we know from our own experience in the 1970s
and '80s, when policy was neither consistent nor focused on the long term. As a result, cyclical
fluctuations were accentuated and the government finances gradually weakened. That limited the
room for action when Sweden entered the 1990s.
The main thing to do to prevent new crises for stabilisation policy is to develop and possibly reinforce
the framework for budget policy that has applied in recent years. Government debt can then be run
down more quickly and reserves can be built up so that the automatic stabilisers can be left to do their
work. An important issue in this context is the construction of the social security system. Changes will
be needed and there may well be reasons for increasing the element of funding.
It may be asked whether some institutional changes are also needed to facilitate a discretionary fiscal
policy. This is certainly not a minor question but it has taken up too much of the discussion about
economic policy. The possibility of implementing a discretionary fiscal policy in a meaningful way is
limited. The discussion should therefore concentrate on what can be done to manage situations when
more serious shocks are likely to occur.
The problem here has been a lack of knowledge, plus the difficulties in mobilising sufficient support for
a restrictive policy when the economy is overheating. There are presumably some things that can be
done to improve our knowledge, though it is mostly a matter of trimming an existing structure. But that
must be done in the light of the limited competence for empirical economic analysis in Sweden and the
numerous challenges that lie ahead in other respects than stabilisation policy.
Perhaps a sharper analysis and discussion could also be a help with the political problems. In this
context, an economic council along the lines put forward in the public debate might possibly play a
part.