Address by the Governor of
Mr. Bäckstöm remarks on the Swedish economy
the Bank of Sweden, Mr. Urban Bäckström, at Svenska Handelsbanken's seminar in New York
on 7/10/98.
First of all I should like to thank Svenska Handelsbanken for the invitation to
meet with you today here in New York. I arrived late yesterday from the 1998 Annual Meeting of
the International Monetary Fund in Washington D.C. The discussions in Washington over the
weekend focused on the current problems in the world economy. At the centre was of course the
crises in emerging markets that began in Thailand last year, which spread to other economies in
East Asia and Russia and which most recently have been pressuring economies in Latin America.
Lately, we have also seen some contagion effects spreading to the industrial countries.
Stockmarkets have been falling and there have also been some problems in connection with the
Long-Term Capital hedge fund.
However, today I will talk about the Swedish economy. I shall be using a fairly
broad brush to paint you a picture of how our economy has developed in recent years and I will
conclude by saying a few words about the present situation in my country.
Positive trend in recent years
The Swedish economy is now entering its sixth consecutive year of favourable
growth. The average annual GDP growth rate since the summer of 1993 is almost 3 per cent.
This is an improvement compared to the average that has characterised our economy in the past
twenty-five years. It has been accompanied by external surpluses that are larger than for many
years, making it possible to repay foreign debt. Government finances, moreover, now show a
surplus instead of the earlier deficits, which means that government debt is already being reduced
in relation to GDP.
The latest figures show that prices in Sweden's economy are virtually stationary.
The falling trend in market interest rates in recent years has been a major factor here in that it has
reduced house mortgage interest expenditure and thereby temporarily exerted a downward effect
on inflation. The underlying price trend is not, in fact, as low as the CPI figures might suggest
but that does not alter the conclusion that in the years ahead, inflation will continue to be low.
If Sweden sticks to disciplined fiscal and monetary policies, together with other
ways of enhancing economic policy's credibility, we have a real opportunity of reinstating the
tradition of price stability that existed in Sweden prior to the 1970s and 80s. Let me give you a
short historical background to our current economic policy strategy.
Tradition of price stability
In the period from 1830 to the late 1960s, the annual rate of inflation in Sweden
averaged around 2 per cent. So if one disregards the 1970s and 80s, low inflation has been the
norm for almost a century and a half. There are indeed grounds for saying that price stability is a
long Swedish tradition.
The tradition of price stability did not obstruct the economy's development. This
is shown by the fact that from the mid 19th century up to the late 1960s growth in Sweden was
among the highest in the world. It is rather the case that the favourable outcome was promoted by
low inflation and the stability this represents.
The decades immediately after World War Two were particularly notable for high
growth, low inflation, external balance and an optimistic mood that resulted in the Swedish
economy's successive expansion. That was a prosperous period with a good, stable economic
trend, a rising standard of living and high employment.
After the collapse of the Bretton Woods system in the early 1970s it proved
difficult to establish an equally robust fixed exchange rate regime. A firm anchor no longer
existed for economic policy in general and wage formation in particular. Sweden experienced a
series of devaluation cycles, with an expansionary fiscal policy, inefficient wage formation and
growing structural problems. With the deregulation of the financial sector the problems became
all too evident.
During the 1970s and 80s economic growth in Sweden became weaker than in
other countries. But the economy still became overheated and this, together with an expansion of
public sector activities, meant that unemployment was restrained for the time being.
The situation was of course unsustainable. An inflationary, speculative bubble
cannot grow indefinitely; sooner or later it is bound to burst. There was also a limit to the public
resources for financing employment.
New direction in economic policy
In the late 1980s there was a growing awareness that something would have to be
done. The structural problems, high inflation and relatively low growth called for an economic
policy realignment.
This realignment involved a variety of measures. The tax system was reformed
and so were certain components of transfers. Sweden, moreover, applied for membership of the
European Union. Sweden's currency was linked to the ecu and in the autumn of 1992, during the
wave of currency speculation, the exchange rate was defended. Short term interest rates were
raised to high levels. The idea was to demonstrate the determination to re-establish low inflation.
However, Sweden's economic policy realignment coincided with a profound
economic crisis. Output fell around 5 per cent over a three-year period, open unemployment shot
up to over 9 per cent and total unemployment to around 13 per cent, figures that had been
completely unknown in modern Sweden. The government finances deteriorated sharply and
budget deficit reached a high of more than 12 per cent of GDP, which was almost without
precedent in the industrialised countries. In the middle of this crisis, moreover, virtually the
whole of the banking system was threatening to collapse. In the light of the crisis in the East
Asian economies, all this sounds very familiar.
Researchers will no doubt be studying whether this dramatic setback in the
Swedish economy could have been managed differently. Some things could definitely have been
arranged in another way both in the late 1980s and once the crisis was over us in the early
nineties.
But the vital conclusion is, I believe, that the roots of the profound crisis stretched
a long way into the past. An economic policy realignment was essential; a credible stability
oriented policy had been lacking ever since the collapse of the Bretton Woods system in the early
1970s. It was high time to put this right.
Making the new regime credible
After the long period of high inflation, together with extensive economic
problems and massive government deficits, the task of inspiring confidence in economic policy's
new direction proved difficult at first. Economic agents listened to the new approach with doubts
and hesitation.
As we know from other countries, however, creating confidence in a new regime
with low inflation is a rather long process that takes time. Moreover, if the work of keeping
inflation low and government finances in order is to be combined with low interest rates and
stable growth, it is a task that never ends.
In recent years the low-inflation regime has gained increased credibility. Besides a
disciplined monetary policy for price stability, a major contribution to this has come from the
consolidation of government finances. In just a few years a budget deficit at 12 per cent of GDP
has been turned into today's surplus.
In order to underscore its ambitions for public finances, the Government has a
long-term objective: as the average level over a business cycle, government finances are to
generate a surplus at 2 per cent of GDP. A surplus will make it possible to reduce public debt so
that future challenges which the Swedish economy may encounter can be accepted without
leading to problems for government finances.
Considering the public debt that has accumulated in the 1990s and the fact that
government finances in Sweden are relatively sensitive to cyclical factors, I find this objective
reasonable.
Besides the increased awareness of the importance of stable finances, the
conditions for achieving Sweden's budget target have been improved by institutional changes in
the budget process. Sweden now has a budget process that is inherently more disciplined and can
thereby contribute to maintaining sound finances.
Further steps are being taken to consolidate economic policy's focus on stability.
The independence which the Riksbank already has in practice is to have a formal legal status as
of next year. The monetary policy objective of price stability will be enshrined in law and the
Riksbank will be accountable for fulfilling it.
This new Riksbank legislation has already been approved once by the Riksdag
(Sweden's parliament) and the final decision is due this autumn. The reform is backed by five
political parties, whose combined representation in the newly elected Riksdag is over 80 per cent.
According to the timetable for the new legislation, the Riksdag's final decision
will be made sometime in the middle of November. It will be followed by the appointment of the
Riksbank's new Governing Board, which will consist of eleven Delegates. One of its major tasks
will be to appoint the Riksbank's new Executive Board. This Board will consist of six full-time
members who will direct the Riksbank and decide monetary policy as of January 1999.
The present situation
Sweden's monetary policy is conducted in a flexible exchange rate regime and has
an explicit inflation target. We sometimes use the following simple rule of thumb to describe
what governs our actions: if the overall assessment of inflation indicates that in one to two years
time the rate of inflation will deviate from the 2 per cent target, then the repo rate should be
adjusted accordingly. Our approach is symmetrical, which means that it is equally important to
avoid undershooting the target, as it is to avoid overshooting it.
The Riksbank's appraisal of inflation up to the autumn of 2000 and the monetary
policy conclusions that can be drawn from this are presented in the Inflation Report we published
last week. In order to visualise the consequences for the future path of monetary policy, the
report is based on the working assumption of an unchanged repo rate. As the Swedish krona is
judged to be undervalued at present, we also assume that the exchange rate follows a path that
represents a gradual appreciation.
The technical assumption of an unchanged repo rate and the presumed path for the
exchange rate are then incorporated in the main scenario for inflation. As inflation's future
course is not a straightforward matter, we also include assessments of uncertainties. The overall
picture of inflation prospects amounts in practice to an estimate of probabilities.
The assessments in the main scenario imply favourable economic fundamentals: a
growth rate between 2.5 and 3 per cent between 1998 and 2000, low inflation and a rising
government surplus. Domestic demand in the main scenario is expected to generate a relatively
limited increase in inflation's underlying rate, from 1.1 per cent at present to 1.6 per cent at the
end of next year and 2 per cent in the autumn of 2000.
The 12-month change in CPI inflation is expected to be somewhat below the
inflation target in one to two years time but the figure at the end of the period is judged to be
approximately 2 per cent. All this means that at the end of the period under review, inflation is
relatively well in line with the Riksbank's target.
It should be underscored, however, that the assessment of inflation prospects is
more difficult than usual on account of the financial turbulence. This naturally reflects the
international unrest but the political situation after the general election in Sweden has also left its
mark on price setting, above all in the currency market.
Inflation prospects and the future path of monetary policy accordingly depend on
two - contrary - factors: on the one hand, the international economic trend could be weaker than
we have counted on and thereby lead to lower inflation; on the other, a sustained weak exchange
rate that has no counterpart in a weaker real economy could generate increased inflationary
pressure.
Our monetary policy conclusion is that we will go on analysing the course of
events and appraise monetary policy continuously in the light of new information. Hopefully, the
analysis in the Inflation Report should give an indication of our line of reasoning about the
inflation outlook in Sweden and the future path of monetary policy that is as clear as possible in
the global economy's present state of uncertainty.
The unsettled situation in international financial markets has meant that investors
are shifting to currencies which are historically secure. As a result, other currencies, particularly
those of smaller economies, have weakened. This tendency has been evident for the Swedish
krona in recent weeks and very clear in the last few days. The recent path of the Swedish krona is
not consistent with the development of our economy's fundamentals. Under these circumstances
the Riksbank has chosen to use currency interventions to underscore that the movements in the
krona's exchange rate have been unduly abrupt and exaggerated.