(FORTUNE Magazine) – Until recently, when people asked me what kind of a society I wanted to see, I had a stock answer: "Sweden in the summer of 1980." Why Sweden? Because I am a soggy liberal, and Sweden has traditionally been the exemplar of what used to be called the "middle way," a market economy with the rough edges smoothed by generous government programs. Why summer? Because Stockholm, arguably the world's most beautiful city on a sunny day in June, has precious little daylight in winter. And why 1980? Because by the early '90s the Swedish model was falling apart. The one-time model society had contracted Euro-sclerosis, with sagging growth and an unemployment rate of more than 8%. And the Swedish welfare state seemed to be going broke: In 1993 the budget deficit reached an absurd 12% of GDP.

The collapse of the Swedish model brought joy to conservatives. As a 1991 Cato Institute report gleefully declared, "Sweden seemed to present an intellectual challenge to those who argued that high tax rates and extensive state intervention would hamper economic growth.... Few would now consider the Swedish system worthy of emulation."

But have they looked at Sweden lately? On a recent visit to Stockholm, I was stunned as usual by the city's beauty but also startled by the unmistakable buzz of prosperity. First impressions are confirmed by the statistics: Since 1993 the economy has grown vigorously; most predictions are for growth of almost 4% this year. Unemployment has fallen steadily, with many predicting that it will drop below 5% next year--an achievement even more impressive given very high labor force participation rates (in Sweden, as in the U.S., about three-fourths of working-age adults are employed, compared with less than two-thirds in Continental Europe). And the budget is in surplus.

How did the Swedes manage this turnaround? Did they Reaganize their economy, adopting an American-style regime of low taxes and winner-take-all markets? In a word, nej. Oh, Sweden has scaled back its welfare state a bit and eliminated some of the truly crazy disincentives in the tax system (supposedly there used to be cases in which marginal rates really were in excess of 100%). But last year Sweden collected an awesome 63% of GDP in taxes. The Swedish welfare state remains extremely generous, its safety net remarkably far above the ground. If you believe the people who think that America's comparatively trivial tax burden--a mere 34% of GDP!--is an oppressive drag on the economy, you would expect to see the Swedish economy imploding instead of booming. (For another European turnaround story, see "The Luck of the Irish.")

The Swedes themselves are not entirely sure what they have done right. But a good guess is that the formula for Sweden's "New Economy" is similar to that of America's: a culture that is receptive to modern information technology combined with a monetary policy that has let the economy take advantage of higher growth potential.

Start with the technology. Nobody is sure why Scandinavians and digital technology go together like herring and boiled potatoes, but the affinity is undeniable. Americans think they own the Net; but by most measures Finland (not technically Scandinavian but close enough), the home of Linux and Nokia, is the world's most wired nation, and Norway and Sweden aren't far behind. Some say it's the combination of highly educated, highly Anglophonic populations and low telephone charges; others, that there isn't much else to do during those long, dark winters.

But higher productivity isn't enough: There also has to be enough demand to make use of the economy's higher potential. And that's where the Swedes had a great stroke of luck. Back in the dark days of 1992, Swedish officials believed that to restore prosperity they had to be part of Europe's drive toward a unified currency. Although Sweden was not a formal member of the European Monetary System, it behaved as though it was, pegging the krona to the German mark even in the face of soaring unemployment. After all, any devaluation would be a disaster, leading to spiraling inflation, right? Then, in the aftermath of Britain's devaluation in September 1992, speculators attacked, eventually forcing Sweden to accept a devaluation of its own--just what the economy needed.

Of course, Sweden's future is by no means guaranteed. Responding both to globalization and high tax rates, some Swedish companies have moved their headquarters abroad--Ericsson, for example, now has its head office in London. But the Swedish story should prove that nice societies sometimes finish first.

PAUL KRUGMAN is a professor of economics at the Massachusetts Institute of Technology and the author of The Return of Depression Economics.