Sweden's balancing lessons for Europe

McKinsey's Diana Farrell says the country is demonstrating that a competitive market need not conflict with social protection for its citizens.

Debate over the viability of Europe's social market model is hardly new, but the narrow electoral defeat of Sweden's Social Democrats after 12 unbroken years in power gives it a contemporary twist. At the heart of the dispute is a clash between those who have benefited from its generous welfare and labor–market protection and those who argue that the Continent will continue to suffer from slow growth unless it adopts Anglo–Saxon–style liberalization.

One country—Sweden—has always demonstrated that the two need not be mutually exclusive. The outgoing government of Goeran Persson maintained the country's social provision, while making great strides in deregulating and unleashing the dynamism of the economy. Prime Minister–elect Fredrik Reinfeldt has stated his intention to build on this record, intensifying efforts to enhance competition through liberalization.

If successful, Sweden will become an even more pertinent lesson to other European countries—France and Germany leap to mind—whose economies are saddled with low growth, high unemployment, and intensifying budget pressure, as aging populations place greater demands on welfare services.

At the beginning of the 1990s, Sweden went through its share of turbulence, which threatened to eat away at its generous welfare state and vibrant economy. By 1998, Sweden's per–capita income had fallen to 16th place among OECD (Organization for Economic Co–operation & Development) countries, down from 7th in 1980. Productivity was flagging and unemployment rising.

Increased Competition
But with a few changes it managed a remarkable turnaround. Between 1998 and 2004, income growth outstripped that of most comparable OECD countries. And over the past 12 years, productivity in Sweden's private corporate sector has risen by 3.3% a year—1.5 times higher than the OECD average.

The key to Sweden's revival? Widespread deregulation and regulatory reform that increased competition and boosted productivity while maintaining generous social provisions. First, entry into the European Union in 1995 lowered trade barriers, boosted competition from abroad, and encouraged efficiency. Sweden's imports of processed food, for instance, climbed by 8% annually between 1993 and 2002, but food exports almost doubled, to 15%.

Second, stricter antitrust and competition laws leveled industry playing fields. Whole industries could no longer adopt common prices. Third, Sweden started micro–level reform. In retail banking, for example, new entrants were given banking licenses, intensifying competition. Sweden's retail banks are now more productive than their peers in the US, Britain, France, and Germany.

Service Tangles
In retail, Sweden improved zoning laws, giving new entrants access to land. As a result, productivity improved rapidly and food prices fell by more than 25% compared with other European countries.

Service industries, from hairdressers to retailers to accountants, accounted for some 70% of Europe's GDP, and all of its net job creation over the past five years. But services continue to be hobbled by a thicket of regulation.

Germany, for instance, limits retailers' opening hours. Portuguese hotels must employ a set number of staff in each job category, depending on the hotel's size. And across the Continent, family–run corner shops with low productivity and relatively high prices are protected by tax and zoning laws. In some sectors, Sweden isn't much different. Its construction industry, for example, continues to suffer from over–regulation and has posted annual increases in productivity of just 0.7% since 1990.

Public Sector Drag
The McKinsey Global Institute (MGI) studied six major European countries and found that their low growth and high unemployment weren't caused by a lack of technology (as many European policy makers believe) but rather from too little competition. Boosting competition, through regulatory reforms similar to Sweden's, is the impetus Europe needs to improve its productivity.

Freeing up business is, of course, not the whole story for European economies committed to maintaining substantial public sectors, notably Sweden. Although it is hard to quantify, because it is not consistently measured, the productivity of Sweden's public sector has been growing far more slowly than that of the private sector, largely because it hasn't been exposed to significant competitive pressure.

Unless it improves, it will be a drag on Sweden's overall performance and compromise the efforts of the incoming government in the private sector.

Removing Barriers
Stimulating new employment, particularly as so many European service jobs are off–shored, is another daunting challenge. Sweden, hobbled by high employment taxes that make services such as restaurants and retailing prohibitively expensive, lags other countries. For instance, Swedish pay rates go up by about 70% for overtime on weekday evenings and 100% on weekends, raising the cost of opening stores at these times and limiting employment. Britain's retail sector, without such regulations, employs almost twice as many workers per capita as Sweden's does.

Removing unnecessary barriers to employment doesn't mean abandoning workers to the mercy of the market. It's quite possible to encourage people to move into, or return to, the workforce without removing their social safety net—a combination to which Prime Minister–elect Reinfeldt has long been committed.

Denmark's "flexicurity" hybrid, for instance, offers much lower job protection than Sweden, but provides equally generous unemployment benefits and spends even more on training and other measures to improve each jobless individual's employment prospects.

Spread It Around
As a result, Denmark has significantly higher labor turnover than Sweden, and markedly lower unemployment. Another model currently being examined in France and Germany encourages people to get off the dole and return to work by allowing employers to pay lower salaries, with the government making up the difference via a wage subsidy.

Sweden, along with Denmark, Ireland, Spain, and Britain, has already done much to promote economic dynamism by liberalizing key industries. Some of its European neighbors could examine its experience and emulate it. Now, Sweden's new government must build on the admirable work of its predecessors and continue thinking radically and imaginatively about how to promote employment and growth.

Diana Farrell is the director of the McKinsey Global Institute, McKinsey's economics think tank

This article originally ran in Businessweek.

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