In 1990, the Swedish economy was working like a charm, with a budget surplus that amounted to 4% of GDP. Then events took an unexpected turn. In just three years, the state’s finances ran aground. By 1993, the spending deficit had ballooned to 13% — a level unheard-of in the current eurozone crisis in which none of the countries has such a huge hole in its accounts.

An understanding of the Swedish crisis is a good starting point for the analysis of the turmoil that is now affecting Europe. At the time, many specialists concluded that the welfare state was responsible for the state going bust. They were wrong, although it is true that a number of state systems had to be upgraded and opened to competition.

The fact is that Sweden, like all of the countries of the eurozone that are now in trouble, had experienced a serious financial crisis. Starting in the mid-1980s, the banks went on a lending spree which resulted in the formation of a bubble in the property market. After a few years, this bubble burst and the lenders were suddenly in serious trouble.

Debt not increased but collectivised

Before the crisis, economist Hans Tson Söderström was one of the people who criticised the weaknesses of the welfare state and argued for rigourous regulation of the economy, tight control of inflation, balanced budgets and fixed exchange rates. But the turmoil of the 1990s led him to switch sides in the debate. At the time, Hans Tson Söderström was conducting a study for the central bank of Finland, a country which was in a similar financial situation to Sweden.

The more he studied the situation in Sweden and Finland, the more Hans Tson Söderström realised that traditional analysis was no longer relevant. Notably in the light of his rereading of Irving Fisher’s major work on the subject, The Debt-Deflation Theory of Great Depressions

[1933], Söderström understood that the debacle was the result of the property crash and the banking crisis it had engendered.

The cause of the over-indebtedness was not the state, but households and companies. When the bubble burst, they were forced to put their finances in order, which they did by saving massively for several years. This in turn resulted in a slump in investment and consumption which brought about a major decline in demand. And it is precisely this type of painful debt reduction that lies in store for several Eurozone countries.

Hans Tson Söderström understood that the Swedish budget deficit was not the result of political irresponsibility, but of the austerity cure in the private sector. The country’s debt had not increased; it had simply been transferred from the private sector to the public sector – in a word, it had been collectivised.

It followed that the explosion of the public debt was not the cause of the depression, but one of its symptoms. If the country had not run a high deficit during a transition period, the crisis would have been much more serious with a much more severe slump in employment and production.

Crazy austerity measures

As it turned out, this is exactly what happened in Finland. The country’s leaders, whose initiative was regularly praised by the IMF, were in a much bigger hurry to balance the books than their Swedish colleagues. As a result, the country sank deeper into depression. In contrast, the Swedes postponed the clean-up of public finances until the mid 1990s.

By then, the problem of the indebtedness of the private sector had already been resolved and the economy was on its way to a recovery spurred by a significant devaluation of the krona, which boosted exporting industries.

The public finances of countries like Spain and Ireland were in order before the crisis. It is clear that these countries ought to follow the example of Sweden in the 1990s and temporarily suspend the drive to deal with spending deficits, instead of imposing crazy austerity measures whose only impact will be to accelerate economic decline.

Their situation is all the more complicated, because they do not have the option of devaluing their currency and it is difficult for them to borrow from financial markets. A European or internationally supported plan will be essential if they are to obtain further cash to restore stability in their banking systems (guarantee deposits and recapitalise institutions).

But even more importantly, as a first step they will have to correctly diagnose the causes of the economic ailments that have led to their current situation.