Katzenstein’s compensation hypothesis and the Scandinavian welfare states.

According to the compensation hypothesis, the large welfare states of Scandinavian countries is a response to the economic volatility these countries suffer as a result of being exposed to international markets.

The standard reference is Katzenstein (1985), though the idea can be traced back at least to Cameron (1978) and Lindbeck (1975).

These days, another idea regarding compensation, welfare states and economic openess, is gaining ground. The idea is that welfare states are compensating for the problems caused by high taxes using economic openess and otherwise market friendly policies (references provided below).

The original compensation hypothesis rests on two empirical claims:

First, that countries with with larger public sectors tend to be more open.

Second, that countries that are more open are more exposed to risk.

While Katzenstein is often cited by political scientists, the first claim was made popular among economists by Rodrik (1998), who joined Katzenstein and Lindbeck in interpreting the correlation as a causality running from ‘‘exposure to external risk to government spending” (Rodrik, p. 988).

Interestingly, the second claim remained untested for a long time. When it evetually was put to empirical test, it was found to be wrong.

In 2001, Iversen’s (2001) noted that , in the post-war period, the more open OECD economies appear to have experienced lower output volatility than did more closed economies. Later, Down (2007) noted that according to economic theory, expansion of international trade that entails integration into larger markets should give rise to risk diversification, and thus should promote rather than reduce economic stability. The openness-volatility link was questioned on similar theoretical grounds also by Kim (2007), who also noted that a statistical analysis of a panel data set from 175 countries (1950–2002) finds no significant effect of openness on volatility.

In other words, the idea that exposure to international markets causes volatility for small countries, and that these countries develop welfare states to compensate for this volatility, was shown to be empirically wrong: more open economies are not necessarily more volatile externally or internally.

The new version of the compenation hypothesis probably starts with Iversen (2005), who noted that economic openness may be instrumentally important for countries with generous welfare states:

Labor-intensive, low-productivity jobs do not thrive in the context of high social protection and intensive labor-market regulation, and without international trade countries cannot specialize in high value-added services. Lack of international trade and competition, therefore, not the growth of these, is the cause of current employment problems in high-protection countries. (p- 74)

Iversen is given empiricval support by Epifani and Gancia (2009), who show that countries with high taxes benefit from globalisation via a terms of trade mechanism. Essentially, higher production costs are passed on to consumers globally because exporters in high tax countries have market power and can increase prices to levels well above marginal costs.

In 2006, I suggested (Bergh 2006) that welfare states compensate not only through economic openess, but by applying market friendly policies in all areas other than government size. This paper tended to constantly annoy at least one referee, and never got published. The idea appears later in Bergh and Henrekson (2011):

Welfare states with high taxes can compensate negative growth effects from large government by applying other growth-promoting policies. (p. 887)

The idea is perhaps most easily illustrated using the Economic Freedom Index, as shown by the table below (taken from Bergh and Henrekson 2011).


The table shows that the Scandinavian countries do exhibit growth rates similar to (or even higher than) Anglo-Saxon countries, but they also have similar levels of economic freedom – once you control for their large public sectors.

In conclusion: To explain why some countries have developed larger welfare states than others, we can no longer say that they are compensating for volatility induced by international markets. Rather, economic openess is an important way for high tax countries to keep their economies competitive.

To explain variation is welfare state size, other factors are needed (such as variations in historical trust levels, as suggested by Bergh and Bjørnskov 2011).


Bergh, Andreas, Explaining Welfare State Survival: The Role of Economic Freedom and Globalization (April 19, 2006). Available at SSRN: http://ssrn.com/abstract=897746

Bergh, A., and Bjørnskov, C. (2011). Historical trust levels predict the current size of the welfare state. Kyklos, 64, 1-19.

Bergh, A., and Henrekson, M. (2011). Government Size and Growth: A Survey and Interpretation of the Evidence. Journal of Economic Surveys, 25, 872–897.

Cameron, David R. 1978. “The Expansion of the Public Economy: A Comparative Analysis.” American Political Science Review 72:1243-61.

Down, Ian (2007) “Trade Openness, Country Size and Economic Volatility: The Compensation Hypothesis Revisited” Business and Politics, Volume 9, Issue 2, Article 3: 1-20

Epifani, Paolo, and Gancia G Gino. 2009. “Openness, Government Size and the Terms of Trade.” Review of Economics Studies 76 (2):629–68.

Iversen, T. (2001). The new politics of the welfare state: Oxford University Press.

Iversen, Torben. 2005. Capitalism, Democracy and Welfare. USA: Cambridge University Press.

Katzenstein, Peter. 1985. Small States in World Markets: Industrial Policy in Europe. Ithaca, N.Y.: Cornell University Press.

Kim, So Young. 2007. “Openness, External Risk, and Volatility: Implications for the Compensation Hypothesis.” International Organization 61:181-181.

Lindbeck, Assar. 1975. “Business Cycles, Politics, and International Economic Dependence.” Skandinaviska Enskilden Bank Quarterly Review 2:53-68.

Rodrik, D. (1998). Why do more open economies have bigger governments? The Journal of Political Economy, 106, 997-1032.

Finally, here’s a recent blog-post by Dan Mitchell showing that the new version of the compensation hypothesis has reached the blogosphere.

The book is out – hardback and ebook

The book is out now! Buy it at google play, or at ebooks.com or get the hardback at amazon.

The book already has a really nice customer review at amazon:

The same author wrote a very similar book a few years back (I would guess this is an translation with updates). I have only read the Swedish version, but I have waited for this English version for a LONG time. Every time someone have asked me why my native Sweden is successful (in terms of GDP, HDI, competitiveness index, happiness index) I always wanted to refer to this book because no other piece spell it out as well.

Read the full review here!


Fred Bergsten in the Washington Post

C. Fred Bergsten in the Washington Post on Sweden:

The Swedish model for economic recovery

[…] Sweden remains a social welfare society, and government spending still accounts for half of its economy; it finances all education and health care, as is common throughout Europe. Sweden did not dismantle the social system but, in addition to drastically reducing its costs, adopted macroeconomic and structural reforms to make it sustainable and greatly enhanced its efficiency by privatizing the delivery of many educational and medical services. […]


Paper forthcoming in New Political Economy

My working paper “The Rise, Fall and Revival of a Capitalist Welfare State: What are the Policy Lessons from Sweden?” has now been accepted by the journal New Political Economy (which was my first choice, although it took a while)

During the review process I was asked to add and explain a number of things that I initially intended to spare the reader, so the accepted version is longer than the working paper that has been available for some time now.

The (not proof read) forthcoming version accepted can be downloaded here, and the working paper can (still) be found here.


On Sweden in The Economist

The are two good texts on Sweden and the nordic countries in The Economist, feb 2nd:

The Next Supermodel and The secret of their success (where I am actually cited – wohoo!)

Scandinavia freeriding?

A new paper by Acemoglu, Robsinsson and Verdier has an interesting idea…

under plausible assumptions, the world equilibrium is asymmetric: some countries will opt for a type of “cutthroat” capitalism that generates greater inequality and more innovation and will become the technology leaders, while others will free-ride on the cutthroat incentives of the leaders and choose a more cuddly form of capitalism. Paradoxically, those with cuddly reward structures, though poorer, may have higher welfare than cutthroat capitalists; but in the world equilibrium, it is not a best response for the cutthroat capitalists to switch to a more cuddly form of capitalism

Krugman vs Coburn on what to learn from Sweden

The lessons from Sweden’s success are debated once again.

From the Washington Post:

TC [Tom Coburn]: Go look at Sweden. Here’s what Sweden did. They cut their spending and their taxes. They have the best growth rate in Europe. They had a surplus this year. They had growth at six-plus percent. They actually did a Reagan style approach to their problem by cutting spending and cutting taxes. And they’re the fastest growing with a decline in their debt-to-GDP ratio.

EK: But correct me if I’m wrong, but if I recall, Sweden’s monetary policy went towards a very sharp devaluation, they’ve been driven by export growth, and alongside Israel, they’ve been more aggressive than any other central bank in the world. They’ve done stuff that if we did it here, people would lose their minds.

TC: I think there are monetary parts to that. But their finance minister put in place tough stuff. They had people who left Sweden because of the tax ratio. Now they’ve moved back. And it’s not a perfect example, but it’s an exception to the Krugman story.

Krugman comments:

But Ezra didn’t challenge Coburn on the claim about spending cuts; why don’t we look at what Sweden has actually done, as opposed to the official right-wing line? Look, in particular, at actual government consumption — purchases of stuff.

So, who is right?

In terms of the facts, they are both right: Sweden did lower taxes and expenditure and did increase economic freedom a lot, especially from the late 1980s to the mid 1990s. Importantly, budget rules were reformed.

As a result of these reforms, Sweden ran a large budget surplus and had low public debt when the financial crisis came in 2008. Because of this, Sweden could afford a more expansionary policy during the crisis (as indicated by the graph in Krugman’s post).

Does the expansionary policy during the crisis also explain why Sweden did reasonably well? Maybe. It is hard to know.

The important (and politically more tricky) part, however, was to implement the reforms before the crisis.

The welfare state’s reckoning?

Robert J Samuelson in the Washington Post is not very optimistic about the welfare state:

The modern welfare state has reached a historic reckoning. As a political institution, it hasn’t adapted to change … The paradox is that the welfare state, designed to improve security and dampen social conflict, now looms as an engine for insecurity, conflict and disappointment.

For sure, this does not apply to the nordic welfare states. On reform and adaptation of the welfare state, see for example

Bergh, A., and Erlingsson, G.Ó. (2009). Liberalization without Retrenchment: Understanding the Consensus on Swedish Welfare State Reforms. Scandinavian Political Studies, 32, 71-94. Link.


Bergh, A. (2008). Explaining the Survival of the Swedish Welfare State: Maintaining Political Support through Incremental Change. Financial Theory and Practice, 32, 233-254. Link.

Andrew Brown on Sweden in the Guardian

In the Guardian, Andrew Brown summarizes many of the latest political discussions in Sweden:

Social democracy spent decades smashing up the old authority structures, among them God and the traditional family, in order to take over their authority. From the 1980s onwards the neoliberals spent decades smashing up Social Democratic beliefs. And at the end of this process, the future has let both sides down.

What follows…

The idea of society as a place of mutual service has disappeared or at least attenuated to an ideal.

is somewhat of a stretch.

More here.

Southern Economics Association

This weekend, the paper “The rise, fall and revival of a capitalist welfare state: What are the policy lessons from Sweden?” will be presented at the meetings of the Southern Economics Association in Washington. The session is 25J for those attending the conference.