Sweden's economic recovery and the theory of comparative institutional advantage.

Author:Schneider, Geoffrey E.

Think of a bumblebee. With its overly heavy body and little wings, supposedly it should not be able to fly--but it does.... This is how so-called analysts view the Swedish economy. We 'defy gravity.' We have high taxes and a large public sector, and yet, Sweden reaches new heights. We are still flying, so well that many envy us for it today.

--Goran Persson, Swedish Prime Minister, March 10, 2000 (1)

Many mainstream economists have been predicting the demise of the Swedish model of social democratic capitalism for decades. But the Swedish welfare state, while slightly smaller in scope than it once was, is still largely intact. Furthermore, the Swedish economy has outperformed that of the United States and most OECD (Organization for Economic Co-operation and Development) countries for the past decade (see Table 1). So the question arises, why is the Swedish bumblebee still flying? Indeed, why is it soaring despite the opinions of so many observers that it is doomed to fail?

The argument that the Swedish model was doomed to failure rested on two ideological artifices. The first was a simplistic application of the theory of comparative advantage. This theory implies that exogenously determined resource endowments and factor costs are the primary determinants of trade flows and the location of production. Second, critics tended to assume that government intervention is inherently inefficient relative to the wonders of the market system, and in an era of globalization, countries must reduce the size and scope of government to compete internationally. The Swedish resurgence in the last decade indicates that there are serious flaws with this analysis.

A more sophisticated explanation of the forces determining the location of production can be provided by the theory of comparative institutional advantage. This theory seeks to go beyond standard analysis to consider the institutional factors that better explain trade patterns. Part of this explanation includes the fact that efficient government intervention and welfare state institutions can contribute to the attraction of particular industries to a specific location.

This paper lays out the key aspects of the theory of comparative institutional advantage as they apply to the resurgence of the Swedish economy. The dramatic reversal of fortunes of the Swedish economy demonstrates the extent to which countries can affect the location of production using non-market institutions, and the extent to which certain welfare state institutions can support high wage industries. The security and stability engendered by Sweden's extensive welfare state encouraged workers and entrepreneurs to take risks and provided a safe environment for long term investment. And, the Swedish national system of innovation, characterized by partnerships between industries, local governments, and universities, proved remarkably successful in generating profitable innovations. (2) The theory of comparative institutional advantage provides a better method of understanding the recent evolution of the Swedish economic system than is possible under mainstream theories.

The Theory of Comparative Institutional Advantage

As John Adams (1987) aptly observed, the theory of comparative advantage is mainly concerned with the location of production. Of course, the location of production matters: in contemporary capitalism, the attraction of sufficient amounts of production to a particular community is often the major determinant of the level of provisioning. But the theory of comparative advantage encounters significant problems when theorists try to apply it to modern trade patterns. Of particular importance to this current study, the theory of comparative advantage is unable to explain why some developed countries are able to attract particular industries when many developed countries possess similar factor endowments.

The theory of comparative institutional advantage is better able to capture the entire range of factors that can affect the location of production. Schneider (2006) has defined the Theory of Comparative Institutional Advantage as follows:

a country or region has a comparative institutional advantage when a particular combination of institutions causes economic actors to locate production facilities or operations of a certain type and character in a specific geographical location due to the advantages created by the matrix of local institutions. (3) Key institutions besides factor endowments that can influence the location of production include national and regional systems of innovation, infrastructure, education and training, skill-development, labor relations, workplace norms, flexibility and willingness to embrace innovation, technological learning capacity, legal systems, and tax structures.

In the Swedish case, government policies and programs played a key role in attracting high-wage industries. Many economists tend to assume that large amounts of government intervention compromise efficiency and provide disincentives for productive economic activity. Using this reasoning, a country with a large state sector such as Sweden must be an unattractive location. However, in a comprehensive study, Lindert (2004 v. 1, 17-18) demonstrated that large welfare states do not harm economic growth: "Nine decades of...

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