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NORDIC MODEL – A SUCCESS STORY?

Remarks by Ms. Sinikka Salo, Member of the Board,
in the seminar at the Banco de España, 27 March 2006

Key points of the presentation:

Introduction: equity and efficiency

• There is a strong political will in Europe to provide protection for the vagaries of
the labour market, as well as a more egalitarian income distribution. Social pro-
tection, in the form of pensions, health and long-term care, protection for the poor
and disabled, and policies to support people in the event of unemployment, fea-
tures in the Member States on average 27 % of GDP, in contrast to only 15 % in
the United States and 17 % in Japan. Developments in demography – ageing
population - technology and globalisation tend to increase the pressure to increase
spending for social protection even further in most Member States.
• There are in fact a wide variety of social models in the Member States, even if we
omit the new Member States. The comparison of different social models has
stimulated interest in interdependencies between competitiveness, employment
and social security and there has been increasing debate about the appropriate
trade-offs between economic and social outcomes. One key challenge is to draw
lessons from the examples of success within Europe in balancing the need for la-
bour market flexibility and effective social safety nets.
• One participant in this discussion has been Professor André Sapir, who in his
presentation for the informal Ecofin meeting in Manchester last year grouped so-
cial models in the EU-15 countries into four groups. In Sapir's analysis the "Con-
tinental" and "Mediterranean" models, which together account for 90 per cent of
the GDP of the euro area, are inefficient and must be reformed, probably by
adopting features of the two more efficient models. Of these, the "Nordic model"
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combines high employment and low probability of poverty and is thus more at-
tractive politically than the "Anglo-Saxon" model. (Chart 1)

1 – Poverty rate , %
92
”Continental” Luxemburg "Nordic"
”Nordic”
90
Sweden
Finland Netherlands
France
88 Denmark
Austria
86
Belgium
Germany
Germany
Belgium
84
”Mediterranean” ”Anglo-Saxon”
"Anglo-Saxon"
82 UK
Italy Spain
Portugal
80
Greece
Ireland
78
55 60 65 70 75 80
Source: Sapir 2005 Employment rate, %

Chart 1: Employment rates and probability of escaping poverty

• Professor Sapir argues that strict employment protection has rendered the econo-
mies of Continental and Mediterranean inefficient whereas the generosity of un-
employment and other social benefits in Nordic countries are less harmful and po-
tentially even useful for employment. Perhaps in the same vein, the European
Council recently invited Member States and social partners to pursue reforms in
labour market and social policies under an approach which combines in an inte-
grated manner flexibility and security, adequately adapted to specific institutional
environments.
• This presentation discusses strengths and weaknesses of the Nordic model. In
many cases, it takes Finland as an example, this being the country I know best.
While the Nordic countries are similar in terms of income distribution and em-
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ployment performances, their economic structures and social and labour market
policies vary considerably, and each country appears to provide its own combina-
tion of employment protection, unemployment benefits, and active labour market
policies. In many respects, Nordic countries - and Finland among them - have
been a success story, but it is not entirely clear what kind of conclusions one can
draw from them in the debate about reforming Europe's social systems.

Employment protection legislation and unemployment benefits

• There are many reasons why strict employment protection legislation may be an
unsatisfactory tool for employment protection. It protects only those who already
have a job, while it may have serious adverse effects, especially on the weakest
groups in the labour market, and the cost to firing workers entails disincentives to
hiring in the first place. The job prospects for those with relatively weak attach-
ment to the labour market, such as young workers, women and long-term unem-
ployed have been found to be compromised by strict employment protection leg-
islation. Moreover, if wages are not sufficiently flexible to allow high dismissal
costs to be reflected in lower wages, the job prospects of low-wage workers will
be adversely affected.
• On the other hand, there is also much evidence that the level and duration of un-
employment benefits correlate positively with unemployment. High unemploy-
ment benefits may reduce the job-search intensity of the unemployed and their
willingness to accept job offers, and by lowering the economic cost of unem-
ployment, they may put upward pressure on workers' wage claim and thereby re-
duce labour demand.
• Different countries have adopted different combinations of employment protec-
tion legislation and unemployment benefits. Professor Sapir’s characterization of
Nordic countries as having a low level of employment protection legislation but
generous and comprehensive unemployment benefits clearly applies to Denmark,
but less so to Sweden and Finland, where employment protection legislation and
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unemployment benefits are at about the average levels of industrialized countries.

Moreover, in Sweden and Finland comprehensive social contracts play a signifi-
cant role in employment protection. While strict employment protection legisla-
tion may be one reason for the low level of employment in Mediterranean and
Continental countries, its absence does not explain of the high level of employ-
ment in Nordic countries, at least not in Sweden and Finland. Nor do Sweden and
Finland provide strong evidence for the claim that generous unemployment bene-
fits are not harmful for employment, and even in the case of Denmark it should be
noted that unemployment benefits has decreased considerably from their very
high level in the early 1990s. (Chart 2; the data source is OECD) ("Assessing the
OECD jobs strategy: past developments and reforms" by Brant, Nicola, Burniaux,
Jean-Marc and Duval Romain, Economics department working papers no. 429,
2005).

OECD summary measure of benefit entitlements 2001, %

60

Denmark Netherlands
50

France Portugal
40 Belgium

Italy
Finland
30 Ireland Spain
Germany

Sweden
20
UK
USA
Greece

10
0 1 2 3 4 5
Employment protection legislation for
permanent contracts 2003

Chart 2: Employment entitlements and employment protection legislation

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Public employment

• Active labour market policies, for example in the form of public job creation and
wage subsidy programmes, are used extensively in Denmark, Norway and Swe-
den, as well as in the Netherlands. Also Finland has experimented with them, but
the outcomes have been not entirely encouraging, and the expenditure on active
labour market policies is in Finland on average European level only. Neverthe-
less, there is a substantial reserve of hidden unemployment in all Nordic coun-
tries, including Finland.
• If "active labour market policies" is defined so as to include public sector em-
ployment, it amounts to a significant share of total employment in all Nordic
countries. In Finland, almost one fourth of total employment is in the public sec-
tor. Welfare services such as health services, children's day-care, education and
care of elderly are provided largely by the local government, which employs
about three fourths of the public sector employees. After the decline in early
1990s in the aftermath of the recession and banking crisis, the employment in the
local government has increased substantially, by about 10 per cent.
• A high level of participation ratios and employment in Nordic countries is related
to a large extent to this type of “activism” by the public sector. By providing day-
care and care for elderly people both parents are able to participate in work force.
This is one corner-stone of the Nordic model – and the area where there may be
lessons to learn for ageing Europe. I come back to this in my conclusions at the
end of my presentation.
• High level of employment in the Nordic countries is a reflection of a high level of
female participation and employment rates. In Finland female employment is
higher than male employment and exceeds clearly the Lisbon goal of 60 per cent
for female employment in 2010. (Chart 3). From the economic point of view this
model has made possible to make efficient use of all resources (human capital of
highly educated women, economies of scale for child care and taking care of eld-
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erly). Family friendly policies have also resulted in birth rates which in Nordic
countries are among the highest in the EU.

Male Female Both genders

as percentage of working age population, 15-64 years old
80

75

70

65

60

55
1989 1991 1993 1995 1997 1999 2001 2003 2005

Source: Statistics Finland.

Chart 3: Male and female employment in Finland

• The provision of public welfare services has offered women an opportunity to

participate in the labour force, and at the same time created job opportunities for
them in the public sector. About 80 per cent of all employees in local government
are women.

Competitive open sector

• In spite of the large public sector, the open sector in Nordic countries is competi-
tive. In many branches of manufacturing industries, productivity has reached or
even exceeded the US level. In small and remote economies, exports have always
been a prerequisite for firm growth, and irrespective of their political colour, the
governments in Nordic countries have tried to keep business climate favourable.
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• In the 1990s the economies of Sweden and Finland became technology-intensive.

In the background was a long, self-strengthening and complex development proc-
ess that began in institutions, organisations and throughout the society already in
the early 1980s. Although measures by the public authorities created a solid
foundation for developing competitiveness, the high-tech industry did not emerge
as a product of old-fashioned industrial policies in the form of state subsidies or
protected monopoly positions in the markets.
• On the contrary, as a result of the early liberalisation of telecommunication,
heightened competition drove prices down and led to mass markets for wireless
communication, providing a test laboratory for the equipment industry. The liber-
alisation of capital markets and the following rapid increase in risk financing gave
a further stimulus to the growth, diversification and internationalisation of the
technology sector.
• In telecommunication, standardization among the Nordic countries and in par-
ticular the NMT standard gave an early start for the internationalization of the
mobile telecommunication industry. In the 1980s and early 1990s, the prospect of
EU membership was instrumental for the adoption of the GSM standard, which
opportunity the Swedish and Finnish mobile phone companies were able to ex-
ploit fully.
• In Finland, the cutting edge of the high-tech industry has been the mobile
communications company Nokia. It is an illustration of the fact that it is feasible
for a global enterprise to develop in a small country. Compared with the size of
the Finnish economy, Nokia is very large in many respects. At the height of the
IT boom in 2000, its market value was nearly double the value of the Finnish
GDP, reflecting of course high – even if in retrospect misplaced − expectations of
future growth of sales and profit opportunities.
• Research and development expenditure in Finland was in 2004 3.5 % of GDP,
slightly less than in Sweden but well above the 3 % of GDP Lisbon goal for the
EU in 2010. Research and development expenditure comes largely from the busi-
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ness sector, the R&D financed by the public sector being only about 1 % of GDP.
The role of Nokia is significant also in here. It has been estimated that Nokia ac-
counts almost 50 % of all R& D expenditure carried out by the business sector in
Finland and its share in total R& D expenditure is more than 30 %. These values
are only indicative, as Nokia does not publish R&D expenditures by country
breakdown. (Chart 4)

Industry Other sectors (since 1993)

% of GDP
4

0
1975 1980 1985 1990 1995 2000
Sources: Statistics Finland and survey data from Confederation of Finnish Industry
and Employers.

Chart 4: Research and development expenditure in Finland

• It should be also mentioned that Nokia has benefited from Finland's educational
system. The supply of high-skilled engineers has been abundant and consequently
the wages of engineers have remained moderate in spite of strong demand in
Nokia and the whole IT-cluster born out of Nokia's success. Free education may
have contributed to wage moderation.
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The Nordic model has performed well in many respects

• Large public sector reflects choices by the politicians and ultimately by the elec-
torate. Surveys of public opinion indicate that a large majority of citizens is satis-
fied with the welfare services and is willing to pay high taxes as the price of
them. There are many explanations for the legitimacy of welfare state in Nordic
countries:

(1) For geographic and historical reasons, populations in the Nordic countries are
small and homogeneous. This entails that public services can be easily tailored
for the "median voter". Perhaps the most homogenous of all Member States is
Finland, where not only the income distribution is even but also the proportion of
foreigners in total population is low, about 2 %, i.e. the lowest one among the EU
15 Member States.
(2) All Nordic countries have a tradition of strict budgetary discipline. This may
reflect intergenerational solidarity, but may also be important on its own. In par-
ticular, budgetary discipline has helped to curtail expenditure on public debt in-
terest, and thus providing room for socially more highly valued types of expendi-
ture. Budgetary discipline may also have fostered good governance at all levels of
government.
(3) The integrity of civil servants is not often questioned. According to the last
Transparency International survey, Finland, Denmark, Sweden and Norway are
all among the 10 least corrupt countries, whereas the world's least corrupt country
being seen to be Iceland. The index defines corruption as the abuse of public of-
fice for private gain, and measures the degree to which corruption is perceived to
exist among a country's public officials and politicians.
(4) Welfare services provided by the Nordic countries have performed well in in-
ternational comparisons. A case in point is educational system in Finland. Finland
has been among the top performers in OECD's Programme for International Stu-
dent Assessment (PISA). This assesses how far students near the end of compul-
sory education have acquired some of the knowledge and skills that are essential
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for full participation in society, covering the domains of reading, mathematical

and scientific literacy. The survey was implemented in more than 40 countries in
the first two assessments in 2000 and 2003. Finland has performed excellently in
both surveys. In 2003, it kept its lead in reading but was now in the top also in
sciences and second after Hong Kong in mathematics. PISA does not take into
account resources devoted to education. However, there is no evidence to suggest
that the Finnish educational system is more expensive than in other Member
States the expenditure on education being at the average level of industrial coun-
tries.
(5) Public sector employees form a powerful interest group, and of course are
interested in maintaining the welfare state.

• The educational level of public sector employees and the whole workforce is rela-
tively high in all Nordic countries and has increased rapidly in recent years. To
take again one example from Finland, the share of working age population who
have completed higher education is higher than in other Member States, with the
exception of Ireland, even though not as high as in the US. In 2000, 32 %, of total
workforce in Finland had achieved tertiary education, while the EU-15 average
was 24 % and the corresponding figure for the US 37 %.

• A certain degree of consensus in industrial relations has been a characteristic fea-

ture for labour markets in all Nordic countries. In Finland and Sweden the degree
of unionization in labour markets is albeit declining still high for both employees
and employers, and labour contracts have a relatively prominent role in shaping
the relationship between employee and employer, instead of employment protec-
tion legislation. Comprehensive income agreements have suppresses wage differ-
entials and contributed to relatively moderate wage increases and low inflation.

In recent years, the role of local agreements has been on increase, and working time
arrangements have been increasingly flexible at the local level, allowing firms to
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adopt working hours to the cycle. Harmonious labour market relations are illustrated
for example by the fact that recently a major pension reform was agreed and imple-
mented in Finland without a single demonstration. I mention only three main ele-
ments of the reform. First, this reform abolished two early-retirement schemes. Sec-
ond, there will be an automatic cut in pensions according to the increase in life expec-
tancy. Third, benefits will be calculated on the basis of the whole lifetime income and
not the last working years.

The challenges of the Nordic model are increasing

• Generous provision of welfare services require high taxes, with the revenues of
the public sector having been in recent years at the level of 58-59 % of GDP in
Sweden, 55 % in Denmark and 53 % in Finland. Direct labour tax rate for aver-
age production worker income is around 40 % in Sweden and Finland and some-
what lower, around 30 % in Denmark. Although there has not been strong pres-
sure from the electorate, policy makers have increasingly recognized heavy taxa-
tion to be a problem. In Denmark there has been a tax freeze in force since 2001,
entailing a gradual but over time substantial decline in tax burden, and also
Finland and to some extent even Sweden have eased especially wage taxation.
• A high level of wage taxation tends to suppress labour input, and similar consid-
erations may apply to employees' and employers' social security contributions and
value added taxes. Prescott (2004) and Ueberfelt (2004) have argued that taxes
play a determining role in shaping the dynamics of hours worked per capita.
Hours worked per worker are below the OECD average in Sweden and Denmark,
and clearly below in Norway, whereas in Finland average hours are at the average
OECD level, comparably to the United States or the UK. The negative effect of
taxation on employment may be weaker in the Nordic countries than in some
other countries, because of the link between taxation and public employment.
Moreover, compulsory pension contributions are more or less accurately actuari-
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ally linked to pensions, mitigating the effect of social security contributions on

labour supply.
• In all Nordic countries, large public sector employment has certainly crowded out
employment in the private sector, and may have distorted the allocation of labour
input in the economy.
• A large public sector is a drag for productivity growth. In aggregate terms, the
level of productivity in the public sector is lower than in the rest of the economy
and in particular in the open sector, and productivity grows more slowly in the
public sector than in the private sector. It is not surprising that in spite of the dy-
namism of the open sector, total factor productivity growth has been slower in the
Nordic countries than in the Anglo-Saxon countries or in the US.
• In national accounts the public sector output is defined on the basis of inputs, and
thus public sector's productivity and productivity growth are low almost by defi-
nition. There have been some attempts to measure public sector productivity by
comparing different performance indices with physical inputs. These productivity
indicators combine heterogeneous elements and give rise to difficult measure-
ment problems even within a single function and they usually do not take into ac-
count changes in the quality of public services. Nevertheless, they may give some
hint of true productivity trends in the public sector. Empirical estimates are rather
gloomy. For example, in Finland the productivity of local government appears to
have declined every year since 1998.
• Another indication of inefficiency are large and rather permanent differences in
productivity between different production units. It has been estimated that for ex-
ample in social and health services and in education, productivity could increase
by 10-20 per cent, if all units would function as effectively as the most effective
units. Even larger increases could be feasible by reforming structures and func-
tioning of the system or by using modern information technology.
• Because of low productivity growth, the long-run performance of the mature wel-
fare state Sweden was below the average of industrial countries for decenniums,
and in Finland the catching-up process practically stalled after the gradual adop-
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tion of the Nordic welfare state was more or less completed in mid-1980s. (Chart
5) Recently, the growth has picked up both in Sweden and in Finland, but this
may reflect at least in part exceptional factors. First, after the banking crises of
the early 1990s output has returned to normal level. Second, Sweden and Finland
have been lucky to enjoy from the boost of the ICT-sector which has temporarily
accelerated the growth of GDP. Nokia alone contributed 1.6 percentage points to
Finland's overall GDP growth in 2000. The growth of the ICT sector has deceler-
ated thereafter, but its contribution to the GDP growth has been substantial even
in recent years.

Finland Sweden United States Spain

per head at the price levels and PPPs of 2000 (US dollars)
40000

35000

30000

25000

20000

15000

10000

5000

0
1970 1975 1980 1985 1990 1995 2000
Source: OECD.

Chart 5: PPP output per capita

• Even though public finances are in good shape in all Nordic countries, problems
are already mounting on the horizon. The demand for welfare services increases
as the population grows older, and at the same time, the room for financing extra
expenditure by rising taxation is limited because of already high level of taxation
and increasing tax competition. Expenditure savings in central government are
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feasible, but they do not suffice to solve the problems at the local level. Indeed, it
is in the municipalities who provide most services and where most rationalisation
efforts are needed.
• A major challenge comes from globalization in the form of higher dispersion of
income and increased immigration, and in future means are needed to maintain
the solidarity and social cohesion needed to keep the Nordic model functional.
Conclusions

• Each Nordic country has its own version of the "Nordic model", depending on
geographical, historical and economical circumstances. This makes it difficult to
draw universally applicable policy conclusions from the success of the model.
• Homogeneous societies tend to provide more public goods than heterogeneous
societies, as public services can be more easily tailored for the needs of the "me-
dian voter". The Nordic countries are homogeneous, and it is thus be no surprise
that the public sector is large in all of them.
• There is some evidence that the public sector services are provided in Nordic
countries more effectively than in most countries - although there are room for
improvement in this field as discussed before. This may also be related to the
homogeneity of the society, but other factors such as the small size of the coun-
tries or a general tradition of the rule of law and lack of corruption may have con-
tributed to the success of the public sector.
• Employment is high mainly because of the high level of female participation. The
extensive provision of welfare services by the public sector has made it possible
for the women to participate in work force and at the same time created job op-
portunities for them. As I hinted before this aspect of the Nordic model could
perhaps be adopted also elsewhere in Europe. In a way this is implicitly included
in the Lisbon strategy where more participation of women in work force is called
for. This highlights, as a prerequisite, the importance of child care and care for
elderly. These services can be provided either by the public sector or by the pri-
vate sector. However, relying entirely on private sector may not produce these
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services to the extent needed to raise participation rate of women to the targeted
levels of Lisbon agenda. Therefore public money is needed. And there we come
close to the service providing aspects of the “Nordic model”.
• High level of employment is instrumental for the prevention of poverty and mar-
ginalization. And perhaps one could draw from the Nordic model the lesson that
universal and high-level education can reduce the risk of poverty by promoting
the accumulation of human capital in the society. Finland and other Nordic coun-
tries have been successful in providing education not only at the elementary but
also at the higher level.
• The importance of private sector competitiveness should be highlighted. In small
and remote economies, exports have always been a prerequisite for firm growth,
and irrespective of their political colour, the governments in Nordic countries
have tried to keep business climate favourable.
• Finally, I would stress again that the Nordic model, like any of the European
models, faces its challenges in an ageing society. The Nordic welfare state is
based on economic growth and thus the most basic challenge is how to streamline
the production of public services so that public finances can remain sustainable
without distorting growth prospects with excessive taxation.