Ifo Viewpoint No. 80: Scandinavia’s Accounting Trick

Hans-Werner Sinn
Munich, 10 November 2006

While most of the world’s developed countries face increasing difficulties in coping with the forces of globalisation and competition from low-wage countries, the Scandinavian countries – Denmark, Finland, Norway, and Sweden – seem to have managed these challenges quite well so far. With an average yearly GDP growth of 2.8% from 1995 to 2005, the Nordics outshone the non-Scandinavian countries of the EU-15, which averaged just 2.2%. In 2005, the Scandinavians’ average GDP per capita was 39% above that of the other EU-15 countries, while their average unemployment rate stood at 6.7%, compared to 8% elsewhere in the old EU. What is the secret behind Scandinavia’s success?

One explanation of Scandinavia’s strong performance is Sweden’s courageous product market liberalisation, a less generous wage replacement system in Denmark, the Nokia miracle in Finland and, last but not least, the massive devaluations of 1992, which resulted in comparatively low wages for Finns and Swedes. However, while these factors have an undeniable explanatory power, the low unemployment and the high per capita GDP levels also have a much more straightforward explanation: the high share of government employment in the labour force. When private jobs are no longer competitive, government jobs seem the easy solution to keep people employed.

Indeed, it is surprising how large the share of government employment in Scandinavia is. In Sweden, it amounts to 33.5% of dependent employment, and to 32.9% in Denmark. On average, the share of state employment in total dependent employment across Scandinavia is 32.7%, compared to only 18.5% in the non-Scandinavian countries of the EU-15. In Germany, Europe’s largest economy, the government’s share in dependent employment is only 12.2%.

The high share of government employment naturally contributes to the region’s low unemployment rate. But that’s not all: it also explains to a large degree the high per capita GDP figures. The simple reason for this is that the value-added created by these government jobs is part of GDP, even if it could never have been produced in the market economy and given that it encompasses activities of private households that would otherwise not have been considered in the national accounts. According to the rules of national income accounting, in the absence of market prices, the contribution of the government sector to GDP is measured by the wage incomes paid out by the government, regardless of how productive or useful the government jobs are, and regardless of the question of whether such activities would have been undertaken at all by private businesses had the government not stepped in. Thus, the performance difference relative to Germany, say, could be caricatured as follows: while Germans collect part of the private value-added as taxes, which they then spend on unemployment benefits, Scandinavians give their unemployed a desk and count the unemployment benefits as value-added of the government sector and, therefore, a contribution to GDP. Furthermore, they encourage women to look after each other’s children, thereby putting them in a position to enter child rearing as a contribution to GDP.

Apart from the accounting trick implicit in Scandinavia’s success, the high share of government in employment may also make a real contribution to solving one of the most fundamental problems western economies now face. Prompted by capital flows to low-wage countries, specialisation, outsourcing, and even immigration, the equilibrium price of unskilled labour has fallen throughout the western countries. Yet, for obvious social reasons, these countries hesitate to let actual wages fall accordingly.

If they want to defend the incomes of the unskilled (or the less motivated), they have four options. The best is to educate the unskilled better, but this is a cumbersome and time-consuming process that offers no short-term solution. Thus, only the three following options remain in the short and medium term to cope with the awkward distributional trends brought about by globalisation.

The first of these three options is to defend the wages of the low-skilled by way of minimum-wage laws or by paying social replacement incomes, which imply minimum wage demands against the private economy. This is the strategy that most EU countries, Germany in particular, have chosen. It results in mass unemployment that is inefficient in itself and financially unsustainable. The second option is to pay wage subsidies instead of wage-replacement incomes, thus allowing for the wage dispersion necessary for full employment without letting the incomes of the unskilled fall. This is the strategy chosen by the United States with its earned-income tax credit and which, in a similar form, Edmund Phelps, this year’s Nobel laureate in economics, has long advocated. The third option is the Scandinavian way described above, in which the government demand for labour keeps minimum wages high.

While many economists judge Germany’s strategy the worst and America’s the best, the Scandinavian strategy can be considered a second-best. Indeed, it is better to let people clean public parks, nurse children, and take care of the old in government facilities than have them, as in Germany, do nothing. Even though GDP is artificially inflated, some useful activities are carried out.

Nevertheless, it might be better to let the market decide what kinds of products and services the low-skilled and less-motivated part of the workforce should and could reasonably turn out, which speaks for the American way of subsidising wages. The Scandinavian way is more than a mere accounting trick, but it is also less than a truly recommendable strategy for coping with the challenges of globalisation.

Hans-Werner Sinn
Professor of Economics and Finance, University of Munich
President of the Ifo Institute

Revised version. Earlier published as "Skandinavischer Schwindel", Die Welt, No. 261, November 8, 2006, p. 9; also published in Il Sole - 24 Ore (Italy), L´Echo (Belgium), Aripaev (Estonia), Vilaggazdasag (Hungary), The Australian Financial Review (Australia), The Straits Times (Singapore), Taipei Times (Taiwan), The Nation (Thailand), L´Avenir (Congo), Les Echos (Mali).