Sweden's economy has made a powerful comeback after decades of steady decline, when it slipped from the ranks of the world's most prosperous nations. Since 1995, the year McKinsey last reported on the country's economic performance, GDP growth has averaged 2.7 percent a year, which is stronger than that of most comparable EU countries. (The full report, Sweden's Economic Performance: Recent Developments, Current Priorities, is available free of charge online.) Per capita GDP has risen to 112 percent of the Organisation for Economic Co-operation and Development (OECD) average, from 104 percent—a notable contrast to the continuing stagnation in France, Germany, and Italy (Exhibit 1).

Yet any sense of satisfaction for a job well done must be tempered by an acknowledgment of the difficulties that Sweden faces as it looks ahead. Its population is aging, job creation remains anemic, and the public sector—one of the world's largest—shows few signs of the productivity growth that has revitalized the country's private-sector corporations.

Further market reforms are necessary. If Sweden is to generate sustained economic growth and to preserve the social safety net its people hold dear, it...