By Anders Åslund/Stockholm

Europeans should remember that perceptions of strength and weakness change fast. In the 1980’s, Scandinavian countries stood for chronic budget deficits, high inflation, and repeated devaluations. In 1999, The Economist labelled Germany “the sick man of the euro” – a monument of European sclerosis, with low growth and high unemployment.

Now, however, the specter of devaluation has disappeared from northern European countries. Budgets are close to balance, with less public expenditure and lower tax rates, while economic growth has recovered. The transformation of the old European welfare state started in northern Europe, and it is proceeding to most of the rest of the continent.

Today, it is difficult to imagine the mindset that prevailed before Margaret Thatcher came to power in the United Kingdom in 1979 and Ronald Reagan in the United States in 1981. Thatcher’s greatest achievement was the liberalisation of the over-regulated British labour market, while Reagan turned the tide with his inaugural address: “In this present crisis, government is not the solution to our problem; government is the problem.” The moral superiority of high marginal income taxes suddenly waned. Free-market ideas took hold.

In northern Europe, the transformation of the welfare state started in Denmark in 1982. In deep financial crisis, traditionally social-democratic Denmark elected a conservative prime minister, Poul Schlüter, a jovial man with a bow tie. One of his first decisions was to peg the Danish krone to the Deutschmark to stop the inflation-devaluation cycle. The Danish peg – now to the euro – still holds.

Schlüter’s second big decision was to deregulate the Danish economy, which now has the world’s largest number of enterprises per citizen. But he left the country’s high taxes and welfare state in place.

In the early 1990’s, Norway, Sweden, and Finland experienced a horrendous real-estate, banking, and currency crisis. Output fell and unemployment skyrocketed. In 1991, Swedish voters broke the reign of the Social Democrats, electing a coalition government under conservative Prime Minister Carl Bildt, who called his programme “the only way.” Bildt tried to follow Schlüter’s lead, but, in 1992, Sweden was forced to devalue – though his deregulation of markets did work well.

Sweden’s greatest achievement was a gradual cut of public spending by no less than one-fifth of GDP from 1993 to 2007. Meanwhile, Sweden’s public debt was reduced from 73% of GDP to 39% of GDP, while taxes have been cut repeatedly. The Social Democrats returned to power in 1994, but they accepted Bildt’s new fiscal policies, and even carried out a revolutionary pension reform in 1998 that properly tied benefits to payments.

In parallel with the Scandinavian crisis, communism collapsed in Eastern Europe in 1989 and in 1991 in the Baltic states. Poland’s first post-communist finance minister, Leszek Balcerowicz, showed an amazed world how communism could be abolished and a market economy built almost instantly. The rest of Central Europe and the Baltic states followed his lead.

Former Estonian Prime Minister Mart Laar was the most radical European reformer. Indeed, his ideas about taxation have revolutionised Europe. In 1994, he introduced a flat personal-income tax, a policy that most Eastern European countries have since adopted. In 1999, when Laar became Prime Minister again, he abolished the tax on corporate profit, which was harming entrepreneurship. As a consequence of the ensuing tax competition, corporate-tax rates have fallen to 15-25% in most European countries.

More broadly, Estonia has revolutionised public finances. Since 1992, it has maintained a more or less balanced budget, with hardly any public debt. It slashed public expenditure and capped spending at 35% of GDP – the same level as in the United States.

As free-market thinking has taken hold and similar reforms have proliferated, the social-welfare state is being transformed into a social-welfare society. Government spending remains large enough to guarantee reasonable public services and a social safety net. Reformers have exposed the public sector to competition, not least from private providers, rendering it more efficient.

The systematic reforms in the United Kingdom, Denmark, Sweden, Poland, and Estonia have much in common. First, all were caused by a profound crisis of the social-welfare state: falling output, rising unemployment, large budget deficits, inflation, and devaluation. Without severe crisis, no significant reform was likely.

Second, a change of government through elections prompted reforms and gave them democratic legitimacy. Reform does not require a state of emergency, as is often argued.

Third, reforms require a strong leader. No major reform has been undertaken through consensus, though successful reforms usually generate a broad consensus a few years later. At that point, reforms can be carried forward by those who had initially opposed them, as happened in Denmark and Sweden.

Finally, fundamental reform of the social-welfare state requires leaders who embrace free-market ideas. Rethinking requires a new ideology, and, after one country has shown the right direction, neighbors often follow.

Europe has now reached the point at which most of its laggards are prepared to accept the social-welfare society. This humane European capitalism is now hastening toward crisis-ridden southern Europe. - Project Syndicate

♦ Anders Åslund is a senior fellow at the Peterson Institute for International Economics in Washington, DC, and author of How Capitalism Was Built.