PCI

The Sweden Solution

In every emergency, it's human nature to seek out someone who has been through a similar crisis and survived.

So, it's no wonder that in the current banking crisis, economists talk a lot about the experience of Sweden a decade-and-a-half ago. That's when the Swedish banking sector was on the point of collapse but was rescued by tough-minded government action. Are there lessons in that for other countries today?

If you closed your eyes and listened to the news from Sweden in the early 1990's, it would sound familiar. A frenzy of lending to homebuyers, made possible by financial deregulation a decade earlier, set off frenzied buying and selling of homes at ever increasing prices. Then as prices went too high, demand slowed, and panic set in. People sold houses all at once, prices plummeted and, by mid-1994, the real estate market lost 60% of its value.

Sweden's economy spiraled downward. Banks, shocked by the massive drop in the value of their assets (the drop in the value of the houses they held as collateral against mortgage loans) stopped lending, even to businesses. Companies shed jobs. And unemployment, which been at 3% in 1990, quadrupled in three years.

But if all of this sounds like another bad news story of the kind one hears too frequently today, there is a difference: The Swedish story had a happy ending.

By the mid-90s, Sweden contained its banking crisis through an extraordinary level of government intervention. And the strategy worked so well that today economists are looking at it as a possible way out of the current emergency.

The Swedish approach combined all the various steps currently being discussed on both sides of the Atlantic. It included the government injecting new money into weak banks, setting up "bad banks" to buy up other banks' devalued assets, and nationalizing banks that were insolvent.

And in a particularly tough-minded move, Stockholm decided to protect ordinary citizens with deposits in banks but not to protect the owners -- the shareholders -- of the banks themselves.

"They decided both to guarantee all the liabilities and the depositors while at the same time, in those banks where there was no value left, they would let the shareholders be wiped out through nationalization.

The government guarantees calmed creditors and depositors who feared that they would lose money in the crisis.

And the decision to not protect the banks' owners mobilized public support for using massive amounts of taxpayer money for rescuing the banking sector.

Briefly, here is what the Swedish government did:

• Before giving any bank new capital, it reviewed the banks' records to see if the banks were still solvent;
• It recapitalized the solvent banks in exchange for government equity, and fully nationalized two banks that were not solvent -- in both cases allowing officials to oversee bank policies;
• It restored investor confidence in the two nationalized banks by isolating their devalued assets in a Bad Bank;
• And, by intervening so forcefully, it spurred banks that did not want to be partly government-owned to scramble to fix their own problems by raising new private capital.

Overall, Sweden spent 4% of its GDP to rescue its ailing banks. At one point in 1995, the government controlled more than one-fifth of the entire banking system.

But the government also later recovered about half of its investment. It sold off its holding of devalued assets after the housing market recovered. And it sold its equity shares in the banks after they were healthy enough to go ahead alone.

Will we see any governments in today's crisis adopt as interventionist an approach as the Swedish one? Who knows?

Officials in W-DC are looking for more comprehensive strategies after seeing their earlier single-track solutions -- like bailouts and lower interest rates -- fail to ease the banking crisis. They are talking about the aggregator bank ("bad bank"), and about the need for bank recapitalization.