Sweden's economy has made a powerful comeback after decades of steady decline, when it slipped from the ranks of the world's most prosperous nations. Since 1995, the year McKinsey last reported on the country's economic performance, GDP growth has averaged 2.7 percent a year, which is stronger than that of most comparable EU countries. (The full report, Sweden's Economic Performance: Recent Developments, Current Priorities, is available free of charge online.) Per capita GDP has risen to 112 percent of the Organisation for Economic Co-operation and Development (OECD) average, from 104 percent—a notable contrast to the continuing stagnation in France, Germany, and Italy (Exhibit 1).

Yet any sense of satisfaction for a job well done must be tempered by an acknowledgment of the difficulties that Sweden faces as it looks ahead. Its population is aging, job creation remains anemic, and the public sector—one of the world's largest—shows few signs of the productivity growth that has revitalized the country's private-sector corporations.

Further market reforms are necessary. If Sweden is to generate sustained economic growth and to preserve the social safety net its people hold dear, it must find ways to increase productivity in the public sector. The country must also lower the economy's total cost of labor, which currently holds back demand and thus the creation of new jobs. What's more, it must increase the flexibility of its workforce to hasten the pace of structural change in the economy, to raise the present low level of entrepreneurship, and to generate positive effects from the inevitable offshoring of jobs during the next decade. Unless Sweden can create new jobs more dynamically to replace those that go abroad, offshoring's net effect for the country will remain negative.

Fortunately, conditions in Sweden are favorable for such reforms. It has many productive industries—some of them world class—as well as macroeconomic stability and relatively good relations among politicians, companies, and unions. It will need to make the most of these advantages.

Looking back: Productivity turned the tide

Our 1995 study of the Swedish economy showed that low levels of competitive intensity in a range of industries and comprehensive regulation of product markets were hobbling productivity and job creation in Sweden's industries. In a number of them productivity was more than 20 percent lower than it was in the top-ranking countries. The result: lower growth in the economy as a whole.

From 1992 to 2004, however, overall productivity in Sweden rose by 2.4 percent a year, in line with the OECD average. Disaggregating the two components of GDP growth—productivity growth (changes in the value of output per hour worked) and adjustments in labor inputs (changes in the total number of hours worked)—makes it clear that Sweden's recovery has come about primarily through a strong increase in the productivity of the private sector, which employs about 70 percent of the workforce. Private-sector productivity has risen by 3.3 percent a year, the fourth-strongest private-sector growth rate in the OECD and 1.5 times higher than the average.

At the sector level, automotive manufacturing, retailing, retail banking, and food processing have all raised their productivity substantially, both absolutely and in comparison with the same sectors elsewhere. In 1995, for instance, the Swedish retailing sector's productivity was 16 percent lower than that of the leading country, and productivity was 20 percent lower in retail banking and 42 percent lower in food processing. Since then, however, productivity has increased more quickly in each of these four Swedish sectors than in those of any of our study's benchmark countries—by 8 percent a year in automotive manufacturing, 4.6 percent in both retailing and retail banking, and 3.1 percent in food processing.

The sole sector we studied that failed to improve was construction, where productivity has been growing by just 0.7 percent a year. Other countries also had low growth rates in the sector, but in Sweden it had a particularly poor starting point: in 1995, it was 25 percent less productive than its US counterpart, and its relative position has barely improved since then.

Crucial market reforms

Clearly, the reason for the productivity gains (outside of construction) is that Sweden has embraced market reforms over the past 10 to 15 years. After a deep economic crisis in the early 1990s, it gradually restored its public finances (partly by implementing a cap on spending) and introduced a restrictive monetary policy. These measures created macroeconomic stability, which has been the bedrock of the economy's development ever since. At the same time, extensive deregulation and regulatory reform, both in the country as a whole and in its individual sectors, have intensified competition within each industry and strongly lifted productivity in the private sector in general—a result that is consistent with the McKinsey Global Institute's studies of economies around the world.¹

Three changes have been critical. The first was Sweden's entry into the European Union, in 1995. The consequent lowering of trade barriers increased competition from abroad, prompting Swedish companies to boost their efficiency. Imports of processed food, for example, increased by 8 percent a year from 1993 to 2002, prodding Swedish food processors to respond: food exports from Sweden rose by 15 percent a year over the same period. Second, stricter laws have promoted fair competition. Earlier legislation along these lines had been fairly toothless; for instance, it allowed whole industries to adopt common pricing, a practice that is no longer permitted. Third, significant deregulation and regulatory reform have taken place at the sector level. Changes in zoning laws, for example, introduced greater competition in the retailing sector: since 1992, local policy makers have had to consider the positive effect of competition when would-be new entrants submit applications for retail licenses. Deregulation in retail banking too has helped new entrants to obtain licenses, with the result that competition has become more intense.

The automotive sector provides a good example of how the absence of regulatory product market barriers can stimulate efficiency. Swedish automakers, with no barriers to protect them from fierce overseas competition, have constantly been forced to improve their productivity. Sweden's truck-manufacturing industry, for instance, was already the most productive in the benchmark countries when we studied it in 1995. By 2003, its overall automotive industry (trucks and cars) ranked as the world's most productive, boasted the highest level of productivity growth, and was creating the largest number of new jobs (Exhibit 2). One explanation for these ongoing advances is the entry of Japanese automakers into the premium segment, where Swedish-made cars compete, and the increased competitive pressure they brought. Another key factor was the cooperation and mutual understanding between Swedish employers and labor unions. Both have recognized that constant improvement is necessary for survival, so efforts to enhance production methods have been much more effective than they were in, for example, construction.

Sweden's construction sector shows how inappropriate regulation holds back productivity. In fact, it was the only one of the five sectors we analyzed that has remained comprehensively regulated, with few changes to its rules during the period covered by our study. Rigid zoning laws, a bureaucratic planning process, and overly detailed building codes continue to limit innovation and to make the industry inefficient. The sector's productivity hasn't improved significantly in recent years, and employment has been falling (Exhibit 3)—a fact of great importance because the construction industry employs 3.5 percent of Sweden's labor force and generates 4.4 percent of GDP.² Inefficiencies in construction also have ripple effects in downstream industries by raising the cost of offices, factories, and housing.

Weaker public-sector productivity

The discrepancy between Sweden's annual private-sector productivity growth—3.3 percent—and the 2.4 percent increase in overall productivity during the past decade is caused by the country's large public sector, which employs some 30 percent of the workforce (compared, for instance, with 10 percent in Germany). Exact productivity numbers for the public sector aren't available, partly because quantifying its many outputs (such as national defense, environmental protection, health care, and education) is hard. Nonetheless, it is clear that the public sector's productivity—like that of the rest of the economy—is closely linked to the prevailing degree of competitive intensity and to the regulatory framework.³ Since government services in Sweden face little competition and are heavily regulated, it is reasonable to assume that productivity has improved much more slowly there than in the private sector. Attempts to measure Sweden's public-sector productivity in the 1980s and early 1990s support this assumption.

A failure to create new jobs

Despite recent strong growth, Sweden's economy is still significantly weaker than others in creating new jobs. From 1992 to 2003, employment among people of working age actually declined by 0.4 percent a year; employment in France, Norway, and the United Kingdom, for instance, increased by 0.5 percent annually during the same period. Had Sweden, with its nine million people, achieved the same growth rate, it would have created 400,000 to 500,000 new jobs.

Sweden's failure in this respect is most apparent in the private service sector, where the country had the poorest record of the 11 we chose for comparison. From 1992 to 2003, its private service sector created a number of new jobs equal to only 4 percent of the size of the working-age population, compared with 6.9 percent in Finland, 9.2 percent in France, and 13.5 percent in the Netherlands. Sweden's relative weakness has added to the country's high real unemployment rate, which now stands at more than 15 percent; the official rate is only 5 percent, but counting all those who want to work or could do so adds at least 10 percent (Exhibit 4). This failing is especially significant given the long-term trend, in all industrialized countries, for employment to shift from manufacturing to services.

Labor market barriers are the main reason for the private service sector's failure to create new jobs. High taxes on employment raise the cost of labor for all employers and make low-value-added services—undertaken, for instance, by restaurants, retailers, cleaning firms, and builders—very expensive. To give an example, a consumer earning a salary moderately higher than that of a home decorator would have to work for three or four hours to buy one hour of the latter's time. Not surprisingly, many Swedes choose to serve themselves as much as possible or purchase services on the gray market. It is illustrative that low-service furniture and fashion retail chains are among Sweden's most successful global companies and that Swedes spend less of their disposable income at restaurants than do the inhabitants of any other OECD country.

In addition, sector-specific regulations limit the creation of new jobs in a number of business segments. In retailing, for example, high statutory overtime payments make it much more expensive than it is elsewhere for stores to stay open at the times most convenient for customers. (Costs for retail labor rise by 70 percent on late weekday evenings and by 100 percent on weekends.) These increases curtail open hours, thereby reducing both the level of service provided to consumers and retail employment. Overall employment in retailing is much lower than it is in the United Kingdom, for example, where retail overtime rates are lower.

Rigid labor market regulations reduce productivity in construction as well, and that drives up costs and lowers demand, thus restraining employment. Surveys show, for instance, that the industry's complex piecework system for calculating wages drives up labor costs without increasing efficiency. Laws intended to protect employees also obstruct the creation of new jobs by slowing down structural change in the economy. For example, Sweden's "last in, first out" rule—which forces public- and private-sector employers to dismiss the most recently hired workers first when cutting staff—makes Swedes reluctant to move to new jobs, even at more productive companies with better growth prospects.

Challenges ahead

Sweden cannot rely on strong productivity growth in the private sector alone to drive economic growth, for three reasons. First, the improvements made since the early 1990s have been generated largely by deregulation, which enabled several sectors to catch up with and sometimes overtake their more productive foreign counterparts. However, the catch-up effect of these reforms will drop over time.

Second, demographic change will put Sweden's public sector under intolerable pressure unless its productivity improves. An aging population will require more welfare services—paid for by taxes levied on working-age people, whose share of the population is falling—and technical developments in health care constantly increase the demand for it. If nothing else changes, the resulting increase in welfare costs would become too large to finance through the current tax system in only 10 to 20 years. Even our base case scenario indicates that the municipal income tax rate would rise to roughly 50 percent over the coming 20 to 30 years, from about 30 percent today, unless productivity rises. Since the taxpayers are hardly likely to accept such an increase, the quality of public welfare and health care services would have to decline.

Third, Sweden's real unemployment rate—15 percent—is not only serious in itself but also even more troubling in the light of accelerating globalization. As it becomes increasingly feasible to produce goods and provide services in lower-cost countries and Swedish companies feel more pressure to raise their productivity, we believe that they will move 100,000 to 200,000 jobs offshore in the next ten years. That prospect makes it imperative for Sweden's economy to become more dynamic and to create new jobs to replace those that go abroad. If the country stagnates, the cost benefits of offshoring will accrue only to companies that move jobs abroad—not to the economy as a whole.

At present, Sweden's low rate of reemployment means that the economy is a net loser each time a service job moves abroad. In contrast, the US economy derives a net gain—and improves its overall prosperity—largely because it reemploys displaced workers much more quickly. Denmark also manages to reemploy displaced workers faster than Sweden does and is consequently very close to the breakeven point in the offshoring of service jobs.

Sweden must reform now

Sweden needs to move quickly to introduce reforms that would create favorable conditions for sustained productivity growth in the private sector, better performance in the public sector, and the creation of jobs in the private service sector.

The country's policy makers need to stimulate competition in the private sector by further deregulating the economy and adopting EU standards. In the poorly performing construction industry, for instance, Sweden should simplify its zoning laws, adopt common EU standards for materials, and reduce the sector's sizable informal component, which distorts competition by allowing certain companies to evade taxes and regulations. Moreover, the Swedish Competition Authority, which enforces antitrust laws and proposes regulatory changes to enhance competition, must continue its present work and possibly expand it. In particular, the agency should focus on the structure of many industries, including the value chains in dairy and meat production, construction materials, and food distribution, where oligopolies restrain competition.

Sweden's politicians should learn from the private sector's experience by creating similar mechanisms to improve the public sector's productivity, which must be measured to formulate growth targets and to track performance against them. Managerial responsibility for meeting these targets must be established at all levels of the public sector and competition within it intensified. One way of doing so—in education and health care, for instance—would be to let more private schools and hospitals compete with government-run institutions for publicly financed pupils and patients. Another would be to make it easier for patients to receive treatment in any public hospital they choose.

The politicians must also find ways to cut the total cost of labor, which limits demand and thereby the number of jobs created in Sweden. An obvious way would be to lower Sweden's tax wedges⁴ on labor, which at 44 percent rank among the world's highest. To limit the effects on public finance, such reforms might focus on private service sectors with the highest potential demand for labor.

Moreover, policy makers should consider ways of tackling the Swedish labor market's relative inflexibility, which not only limits the pace of structural change in the economy but also contributes to low levels of entrepreneurship. Neighboring Denmark's "flexicurity" model has demonstrated that it is possible to combine Anglo-Saxon labor market flexibility with Scandinavian-style unemployment benefits and active support for the efforts of the unemployed to find new jobs. Denmark's labor rules offer much less job protection than do their Swedish counterparts, but Denmark provides generous unemployment benefits and spends even more on training and other measures to improve each jobless person's employment prospects. The result has been a level of labor market turnover that is significantly higher than Sweden's.

Policy makers can't achieve the necessary outcomes on their own. Given the challenges the Swedish economy faces, politicians, companies, and labor unions must all communicate the need for reform to their respective constituencies and collaborate with one another to make reform work. The experience of Sweden's automotive industry shows that effective change comes about when all three parties understand what they must do to push ahead.

Sweden's economy has reached a critical juncture. If nothing is done, the problems will become much more serious. Quick and successful action, by contrast, would significantly increase the country's prosperity. If the private sector's productivity continues to improve at a rate one percentage point above the OECD average and the economy creates 500,000 new jobs, in ten years' time Sweden could regain fifth place in the OECD's welfare ranking,⁵ which it held in 1970.