The causes and consequences of the financial crisis

2.1 Economic policies prior to financial liberalization⁴

Sweden became a member of the Bretton Woods system in 1951, when its exchange rate was pegged to the United States dollar (US$). The Swedish krona (hereafter krona) was set at 5.17 Swedish kronor to the US$, and was kept constant by the Riksbank for 20 years. A pegged or fixed rate for the krona remained a major goal until the financial crisis of the 1990s.

World War II unleashed broad-ranging regulations of the Swedish economy. Capital account (foreign exchange) controls were introduced early during the war and remained in force until 1989. They were complemented in the 1950s by instruments such as liquidity ratios that allowed the Riksbank to set the interest rate and steer credit flows according to political priorities. The external and internal regulations of the financial system facilitated a policy of low interest rates, keeping interest rates below the levels that would have prevailed if there had been no regulatory system in place.

The capital account controls were the basis for post-war stabilization policies. They isolated Sweden financially from the rest of the world, in this way allowing for selective monetary and fiscal policies domestically. Commercial banking was turned into an almost risk-free business. Since nominal interest rates were kept low and the tax system allowed large deductions for the cost of borrowing, private sector demand for credit outstripped the available supply. The private sector remained in a permanent state of liquidity rationing.

In the early 1970s, the Bretton Woods system broke down. Still, after its demise, capital account controls remained in force in Sweden until the end of the 1980s. In the 1970s, full employment emerged as a major policy goal, one reason being the strong political position of the labor unions. This goal contributed to accommodative fiscal and monetary policies. This policy mix led to low rates of unemployment, high rates of inflation and several devaluations during the period 1976–82. The discretionary exchange rate flexibility allowed the necessary adjustment of real wages required for maintaining full employment and external balance.

The policy of devaluation peaked during the second oil crisis (OPEC II). The center-right government devalued the krona by 10% in September 1981. Immediately after the 1982 election, when the Social Democrats returned to power, an “offensive” devaluation of 16% was carried out to gain a competitive advantage for a few years. The devaluations of 1981–82 contributed to a rapid recovery after OPEC II.

Prior to the crisis of the 1990s, Sweden was known as a rich welfare state, immune to the high unemployment that plagued many Western European economies since the 1970s.⁵ Few understood that the macroeconomic policy regime rested on a system of strong capital account regulations which isolated the country from the rest of the world.

2.2 The boom of 1985–90

The financial regulations were gradually softened in the 1970s and 1980s. Shortly after the 1985 election, the Governing Board of the Riksbank abolished the quantitative controls on lending by commercial banks. This measure, later dubbed the "November revolution", had a significant, although unexpected and unintended, effect over the next 10 years. It was originally considered as a minor technical measure without any significant economic consequences. It turned out that the 1985 deregulation was an important first move in the build up towards the crisis of the 1990s.

The deregulation should be evaluated against the imbalances that characterized private sector portfolios prior to the November 1985 decision. Companies and households had been restricted in their choice of portfolios due to the regulations introduced in the 1950s. High inflation and, as a consequence, the expectation of further high inflation, together with a tax system that favored borrowing, compounded these portfolio imbalances.

The financial deregulation of 1985 gave strong incentives for companies and households to expand their borrowing at prevailing interest rates. It changed the incentives confronting commercial banks. Suddenly they were facing more open and aggressive competition for market share. They adjusted to the new situation by expanding credit, when borrowers tried to take on new debt.

The outcome of the new incentives was that between 1986 and 1988 debt grew rapidly (Figure 1 [ PDF 58.9KB | 1 page ]). A large part of the expanding volume of credit was channeled into property and share markets. House prices increased rapidly (Figure 2 [ PDF 63.2KB | 1 page ]). The private sector utilized the rising value of real assets as collateral for additional borrowing. The process was fuelled by a rising rate of inflation, which peaked in 1990 (Figure 3 [ PDF 63.2KB | 1 page ]). Inflation expectations followed the rise in the inflation rate. The real after-tax interest rate was negative for many investors due to the combination of high actual inflation, high inflation expectations and the rules of the tax system (Figure 4 [ PDF 74KB | 1 page ]).

The low and commonly negative real interest rates made it tempting to take on additional loans for investments and consumption. The result was the creation of a financial bubble in the Swedish economy, built on excessive indebtedness within the private sector, and a corresponding overlending within the financial system.

The credit boom was reflected within the real sector as well. Consumption became the driving force behind the overheating of the economy (Table 1 [ PDF 74KB | 1 page ]). During the most intense part of the boom, households consumed more than their disposable income. Real income grew rapidly (Figure 5 [ PDF 61KB | 1 page ]). Government finances improved during the overheating, since the sharp growth in consumption and income resulted in growing tax revenues from value added taxes (Figure 6 [ PDF 61KB | 1 page ]). The budget showed a small surplus in the late 1980s, leading to a decline in the debt-to-GDP ratio.

The labor market was driven by strong demand from the domestic (non-tradable) sector, in particular from the construction sector. Construction benefited from the rise in the price of real assets. It was also subsidized through the government's housing policy. The labor market became overheated when unemployment was under 2% at the end of the 1980s (Figure 7 [ PDF 59.2KB | 1 page ]).

As a consequence of rapid domestic expansion, the export sector (the tradable sector) was squeezed. Exports declined while imports soared. The current account worsened toward the end of the 1980s after the recovery in the wake of the 1981–82 devaluations.

Other factors supported the economic upturn. The fall in oil prices in 1985 gave a positive impetus to the world economy. The long period of international economic growth that began in 1982–83 peaked in 1989–90, when all indicators pointed to an overheating of the Swedish economy, undermining the credibility of the pegged exchange rate for the krona.⁶

The expansionary impulse set off by financial liberalization was not countered by any contractionary policy measures until 1989–91. Monetary policy had been founded on the pegged exchange rate of the krona since 1982. The devaluation in 1982 was declared the last of its kind. As the Riksbank did not counter the overheating by revaluing the krona, responsibility for stabilization fell solely on the Ministry of Finance. After the 1988 election, a series of restrictive measures were adopted. In February 1990, the government proposed a freeze on all wages, prices and dividends for two years and a limitation of the right to strike. This package triggered a government crisis. The Social-Democratic government resigned, but returned shortly afterwards with a new Minister of Finance, taking over an economy that was moving into a deep crisis.

In October 1990, as a consequence of a speculative attack on the krona, a new austerity package was introduced. At the same time, the government announced that Sweden would apply for European Union membership, an attempt to shore up the credibility of the krona. In May 1991, the Riksbank strengthened the credibility of the krona by pegging the krona to the common European currency unit, the ECU. In September 1991, a major financial institution, Nyckeln, faced severe problems. This event is commonly regarded as the start of the bust phase.⁷ The very same month, the Social Democratic government lost the parliamentary elections. A four-party coalition formed the new government, with Carl Bildt from the Conservative Party as prime minister. The new government took over an economy in rapid decline.

2.3 The bust and crisis of 1991–93

The bust was driven by a strong and unexpected upturn in the real rate of interest adjusted for taxes (Figure 4). The Swedish rate of inflation declined sharply after a peak of about 10% in 1990 (Figure 3). Inflationary expectations, which followed actual inflation with a small time lag, started to decrease around 1991. A major tax reform introduced in 1990–91, heralded as "the tax reform of the century" in public debate, made the conditions for loan-financed investments worse and favored savings. In addition, the remaining capital account controls were abolished in 1989, prompting an outflow of capital from Sweden.

Swedish real interest rates were forced upwards by international factors, in particular the reunification of Germany, which led the Bundesbank to raise German, and thus European, interest rates. The krona was subject to several speculative attacks due to the falling credibility of the policy of a pegged krona rate. The Riksbank had to defend the krona rate by raising interest rates in Sweden by more than rates in the rest of Europe.

When the real rate of interest rose, the price of assets declined in a downward spiral. The fall in asset prices meant a reduction in wealth, since these had been financed through loans whose nominal value remained unchanged (Figure 2). The downturn was fuelled by expectations that asset prices would continue to fall.⁸ The number of bankruptcies increased dramatically.

The massive loss in the balance sheet of the private sector created by the increase in the real rate of interest can be calculated in various ways. Söderström (1996: 174–79) estimated that the value of tangible assets in Sweden declined by about 30%. He also showed that the private sector tried to counteract this loss of wealth by increasing its financial savings by making repayments on its loans and thereby trying to rebuild its equity.⁹

Households adjusted their portfolios by increasing savings and by reducing consumption, primarily of durable consumer goods. The savings ratio rose from a negative level at the end of the 1980s to about 8% in 1993.¹⁰ This change in private savings was a significant feature of the crisis.

At this point, it became apparent that the many years of regulated low interest rates had resulted in considerable overinvestment. The rise in the real rate of interest revealed excessive holdings of assets, mainly in the form of housing, at the beginning of the 1990s. Then this asset bubble burst. The revaluation of property and other assets brought with it an abrupt freeze in investment within the housing sector—a sector that had previously been considered a major engine of the Swedish economy.

The shock of high real interest rates created a sharp fall in aggregate demand. Unemployment increased from around 2% to close to the Organisation of Economic Co-operation and Development (OECD) average of over 8%. Employment fell sharply. The number of bankruptcies skyrocketed. In 1990 inflation was 10% per annum; in the mid-1990s it was down to 2%. Available indices for asset prices show deep deflation during the years 1990–93.

The weakening of the current account that had begun in the late 1980s continued throughout the crisis. It culminated in a deficit amounting to 3.5% of GDP in 1992. This reflected the cost crisis that had afflicted Sweden's export industry as a result of the overheating at the end of the 1980s.¹¹

As a consequence of the decline in economic activity, the rise in unemployment and government support to the financial sector, the budget deficit increased alarmingly. The national debt in relation to GDP reached the highest figure recorded since World War II, considerably higher than during OPEC II (Figure 6). The expansion of the national debt was not the result of discretionary decisions, but rather the result of the workings of automatic stabilizers.

The center-right government that came to power after the election in 1991 was firmly set to continue the pegged krona rate policy. From the start it chose to focus on supply-side policies to increase the growth potential of the Swedish economy. However, the new government soon faced catastrophic developments.

The rapid increase in real interest rates undermined the financial system, triggering a banking crisis. In September 1992, the government intervened to prevent a major financial collapse by announcing a blanket guarantee for the liabilities of the banking system. A bank support authority was set up a few months later, and two banks, Nordbanken and Gotabanken, ended up under government control.

Domestic developments—a growing financial crisis, falling industrial output and rising unemployment—undermined the credibility of the pegged krona rate. The authorities were trapped in a situation where external conditions (the currency crisis) required contractionary measures, while domestic considerations (the banking crisis) demanded an expansionary policy. The more the Riksbank tried to defend the pegged krona rate by raising interest rates, the deeper the domestic crisis became.

With the European currency markets facing unrest in September 1992, the Riksbank defended the krona by significantly raising its overnight rates. For a very short period, the marginal interest rate—the overnight rate—was 500%. The government and the opposition party, the Social Democrats, agreed in September to jointly back two austerity packages to avoid a devaluation of the krona. However, the defense of the krona broke down in November 1992 when it came under massive speculative attack. A floating exchange rate was introduced on 19 November 1992, amounting to a considerable depreciation of the Swedish currency (Figure 8 [ PDF 62.9KB | 1 page ]).

2.4 The recovery

The depreciation of the krona in November 1992 marked the culmination of the crisis and the beginning of the recovery in Sweden. Because the krona was floating, interest rates were gradually lowered. The turnaround and the recovery started in 1993. Economic growth turned positive in 1993 and remained strong throughout the rest of the 1990s, apart from a short downturn in 1996/97 (Figure 5). Almost all indicators of economic activity showed positive numbers after 1993–94.

Exports were the major driving force behind the recovery, increasing as a share of GDP. Exports for 1992 amounted to 28% of GDP. By the end of the decade the number was over 45% (Figure 9 [ PDF 62.9KB | 1 page ])—a remarkable development within less than a decade. There is no other similar case in Swedish economic history.

Several factors contributed to this sharp expansion in exports. First, the large and persistent depreciation of the krona after November 1992 increased the competitiveness of Swedish goods. Wage moderation and improvements in productivity facilitated the growth of exports. Exports were also favorably affected by Sweden's entry into the European Union in 1995, which fostered trade both directly and indirectly by promoting foreign direct investment, not least in the rapidly growing information communication technology sector.

The rise in domestic demand during the recovery phase was markedly lower. Both private and public consumption grew more slowly than GDP in the years following the crisis. At the same time, the household savings rate remained at a higher level than before the crisis, indicating a continued improvement of the balance sheets of the private sector.

The effects of the crisis on employment were more prolonged. Unemployment rates in the 1990s never dropped back to the level that prevailed during the 1980s. Open unemployment began to decline from the high level of around 8–10% by the end of 1997 (Figure 7). The high and persistent rate of unemployment contributed to wage moderation in the 1990s and well into the new century.

The move from the pegged exchange rate regime to inflation targeting in 1992-93 had a profound impact on the behavior of the labor market participants. The new monetary policy regime of low inflation contributed to non-indexed, two-year collective wage agreements in 1993 and to three-year contracts from 1995 until 2008. Judging from the emergence of three-year collective wage agreements, confidence in the new regime of inflation targeting was quick to flourish. To that extent, it stands out as a successful regime, at least so far. Of course, there is no guarantee that the inflation targeting regime will remain associated with long-term contracts in the future.¹²

The fall of the krona in November 1992, which allowed the Riksbank to move to lower interest rates, meant the end of the pegged exchange rate for the krona. Policymakers were not ready to return to a fixed krona rate after the events in the autumn of 1992. Instead the Riksbank unilaterally announced a policy of inflation targeting in January 1993. The target rate of inflation was set at a 2% yearly increase within a range of plus or minus 1%. The Riksbank declared that the new target range was to be binding from January 1995. Initially there was some uncertainty about the Riksbank's new policy regime. However, the rate of inflation and inflationary expectation declined surprisingly quickly toward the level set by the Riksbank, suggesting that the new monetary policy regime had gained credibility.

The center-right government lost the election in the autumn of 1994 immediately after the crisis, ceding power to the Social-Democratic opposition. There was initially some uncertainty about the economic policies of the new government. Was it going to contract or expand fiscal policy? The uncertainty was dispelled, however, when the new government launched a program of fiscal austerity. As the crisis had caused huge budget deficits, the new government decided that large cuts in government expenditures and tax increases were necessary.¹³ As the economy was recovering after the floating of the krona, the deficit as a share of GDP decreased rapidly, and the government debt to GDP ratio was brought down significantly during the latter part of the 1990s (Figure 6).

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