12 August 2015

Scandinavian Unexceptionalism #8: The third-way model – a collosal failure


“Sweden is often used in my country as an argument for why socialism works”. This is roughly what many people abroad have told me after reading Scandinavian Unexceptionalism. In a previous columns for CapX, I have argued for why Sweden and other Nordic countries are not exception from the laws of economics, wherein high taxes hinder economic development. However socialism is something different than the current economic policy in the Nordics – based on combining free markets with high taxes and large welfare states. Socialism is about giving government control over the economy as a whole. It´s worth knowing that Sweden has indeed experimented with socialism. However, it proved such a colossal failure that few even in the left today view the memory as something positive.

A common notion is that particularly Sweden, and to some extent other Nordic nations, have embarked on a unique economic route: the third way. Third way politics refers to an alternative to free‑markets on the one hand and communism on the other. Indeed, policies did steer sharply to the left during the late 1960s in Sweden. Not only did the overall tax burden rise, but the new system also discriminated heavily against individuals who owned businesses. As politics radicalised the social democratic system began challenging the core of the free market model: entrepreneurship.

Swedish economist Magnus Henrekson has concluded that the effective marginal tax rate (marginal tax plus the effect of inflation) that was levied on Swedish businesses reached more than 100 per cent of the profits at times. In 1980 a private person who owned a business could pay an effective marginal tax of 137 per cent on the returns on the capital raised by new share issues. This means that the individual would actually lose money by making a profit once the effect of both taxes and the inflation of the original investment were taken into account. If the business had been financed by debt, the venture became profitable, albeit still facing a high tax rate. Tax exempt institutions and insurance companies could face negative effective taxation, due mainly to the effect of high rates of inflation. Henrekson draws the conclusion that the tax policies “developed according to the vision of a market economy without individual capitalists and entrepreneurs”.

Not surprisingly, this absurd situation that resulted from a sharp left turn in economic policy markedly affected entrepreneurship. Sten Axelsson, another Swedish economist, has shown that the period between the end of the 19th century and the beginning of the First World War was a golden age for the founding of successful entrepreneurial firms in Sweden. After 1970 however, the establishment of new firms dropped significantly.

The third way policies in Sweden were not merely about crowding out entrepreneurship by punishingly high taxes. They also culminated with the introduction of “employee funds” at the beginning of the 1980s. The idea was to confiscate parts of companies’ profits and use them to buy shares, which in turn would be part of the funds controlled by labour unions. In effect, the system was designed to gradually transform the ownership of private companies to the unions – a soft evolution towards socialism. Although the system was abolished before it could turn Sweden into a socialist economy, it did manage to drive the founders of IKEA, Tetra Pak, H&M and other highly successful firms away from the country.

Third way policies are often upheld as the normal state of Swedish policies. In reality, one can better understand these policies as a social experiment, with poor outcomes in terms of stagnating growth, which has with time been abandoned. Interestingly, even the leading Social democrats at the time seem to have been aware of the damage that third way policies could do.

The most striking example relates to the introduction of the employee funds. Kjell Olof Feldt, one of Sweden’s leading Social Democrats through history and at the time the finance minister, had to debate the benefits of the funds in Parliament. But the minister was uneasy. During the debate, he was scrambling on a piece of paper for himself. A Swedish reporter took a photograph of a poem that the minister wrote down. Remarkably, it turned out that the finance minister was anything but enthusiastic about the funds. In fact, he believed them to have a great negative impact for Sweden. Feldt went as far as describing them with profanity. A loose translation of the poem is:

“The employee funds are a [profanity],
but now we have dragged them all this way.
Then they will be filled with every bigwig,
who have supported us so much in our struggle.
Now we don’t have to go any more rounds,
until the whole of Sweden is full of funds.”

Kjell‑Olof Feldt had good reasons to be critical of the radical ideas championed and introduced by his own party. In October 1983, a few months before Feldt scribbled his famous poem, what is likely to have been the largest political demonstration in the country’s history was arranged. Upwards of 100,000 people marched against the employee funds. Although the social democratic leadership seems to have been aware that the funds were a bad idea, they had invested too much political prestige in the idea to back away from it. The funds were introduced in 1984, and later abolished following the election of a centre-right government in 1991. Not only was the confiscation of profits for the funds stopped, the money previously gathered in the funds was transferred into pensions savings and research foundations. Sweden chose to return to the path of market economics over that of socialism.

Nima 8.1

The employee funds were the tip of an iceberg of destructive policies introduced during the third-way period. Changes in regulation, taxation and increased state involvement had reduced the growth potential of the previously dynamic Swedish economy. As late as 1975 Sweden was ranked as the 4th richest nation in the world according to OECD measures. The policy shift that occurred dramatically slowed down the growth rate. Sweden dropped to 13th place in the mid‑1990s. In 2014, following a period of recovery from the country’s crisis and significant free market and tax reduction reforms that followed, Sweden had risen to 8th position.

The famous Swedish economist Assar Lindbeck concluded in the late 1990s: “If recent developments of the Swedish economic and social system continue, the ‘Swedish model’ […] will turn out to have been a brief historical episode – an interlude lasting no more than about three decades, from the mid-1960s to the early 1990s.” So far he has been proven right. The failure of third way policies is well known amongst both academics and politicians in the country, and can in turn explain the enthusiasm for market reform that the country has experienced since the early 1990s. It is perhaps surprising how the myth of Sweden’s successful socialist system lives on abroad, decades after state control over the economy was rejected in the country itself.

Dr. Nima Sanandaji is a research fellow at CPS, and the author of Scandinavian Unexceptionalism. The entire book is available through the Institute of Economic Affairs which has published it.