A Fistful of Kronor - By Peter Wolodarski

Europe's economic turbulence has been raging for more than two years, fueled by political leaders' continuing failure to come up with real solutions to the euro crisis. Time and again, they claim to have solved it, only to see bond prices tick up and growth projections tick downward. Don't be fooled by the August calm. When the continent returns from its collective Mediterranean vacation next month, the crisis will rear its head once again.

European leaders might learn a thing or two from the recent experience of my country, Sweden. In the beginning of the 1990s, Sweden was struck by a severe financial crisis, much like what Spain and Ireland are experiencing today. After almost a decade of strong economic growth, fueled by cheap credit and rapidly rising housing prices, the market suddenly collapsed, which caused severe problems in the Swedish banking system.

Before the crisis broke out, in 1990, Sweden boasted a budget surplus of 4 percent of GDP. Then something unexpected happened. In just three years, the country's public finances took a dramatic nosedive, resulting in a record deficit of 13 percent of GDP in 1993.

At the time, many, such as the Social Democratic economist Bo Södersten, heralded the mess as a sign that Sweden's welfare state had collapsed. People needed to work more, it was said, and be less dependent on handouts from the government. The IMF urged Sweden and Finland, a country in a similar situation, to clean up their budgets.

Structural reforms were arguably needed. High marginal taxes rates were hampering economic growth, and the labor market was not flexible enough, which pushed the unemployment rate up. Generous welfare benefits also decreased the incentives to work. But problems with Sweden's welfare state could hardly explain why a seemingly thriving economy descended into a full-blown crisis, with rapidly rising unemployment, falling GDP, and an exploding budget deficit.

So what happened?

In the 1980s, a huge bubble was created in Sweden's real estate market, coupled with a rapid increase in construction. Financial deregulation led to an explosion of credit, and the private sector became heavily indebted. The economy also overheated because the government devalued the Swedish krona without trying to slow down the economy in the go-go years. People started to buy homes on speculation, and banks easily provided new loans, not only for homes but also for cars, boats, and art. Sound familiar?

In Sweden's case, the boom and speculation ended with a terrible crash and a banking crisis in 1991. As a consequence, private investment and consumption collapsed, and the economy slowed sharply. Instead of borrowing money, companies and households started to save. It was Sweden's severest economic slowdown since the Depression of the 1930s.

Thanks to a rereading of Irving Fisher's classic essay on debt deflation, economists like Hans Tson Söderström, president of the influential SNS think tank, realized what had happened. Households and businesses -- not the government -- were overly indebted. The huge budget deficit of 13 percent of GDP was a result of the depression, not a cause of it. Tax revenues declined as a consequence of the fall in GDP, creating the government's fiscal problem.