Svein Gjedrem: Economic perspectives
Address by Mr Svein Gjedrem, Governor of Norges Bank (Central Bank of Norway), at the meeting of
the Supervisory Council of Norges Bank, Oslo, 16 February 2006.
The Charts in pdf-format can also be found on the website of the Norges Bank.
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1. Introduction
On the way into this building, we pass a statue of the nineteenth century Norwegian actor Johannes
Brun. He performed at Christiania Theatre, which once stood in the square in front of the main
entrance. Brun was an acquaintance of Henrik Ibsen, who also worked at the same theatre for a
period - part-time as dramatic consultant - when the theatre he had been directing closed. This was a
difficult time for our great dramatist, both personally and financially. He was struggling to overcome
writer's block and the public's preference for the mediocre and the trivial.1 Nineteenth-century
Christiania (now Oslo) was described as "O great and little city! What a cold and surly sky broods over
you!".2
A bleak time for Ibsen, perhaps. But the Norwegian economy was not faring all that badly. The
economic expansion that had begun in the 1820s gathered momentum from the middle of the century.
The British navigation acts were repealed in 1849 and the Norwegian fleet was permitted to transport
other countries' goods to and from England. Norway had suddenly become a major exporter of
services. The tonnage of the Norwegian commercial fleet increased almost six-fold from 1850 to 1880.
2. Changes in the international division of labour
We are now again in a period of considerable changes in the international division of labour. Global
trade is again growing at a markedly faster pace than production, thanks to technological advances
and a sharp reduction in the costs associated with trade in goods, services and information.
Trade barriers have been removed. In the early post-war years, tariff barriers between a few
industrialised countries were dismantled. The later rounds in GATT, now the WTO, embraced both a
far broader agenda and a greater number of countries. Today, almost all countries participate as
members or observers and the issues are far-ranging. In addition to dismantling tariff barriers,
antidumping measures have been introduced, subsidies have been removed and agreements have been
entered into for textiles and agricultural products. In the current round, issues related to health, the
environment and development are also being discussed.
Political changes have amplified this tendency. At the beginning of the 1990s, China changed course
and is now a member of the WTO. Its share of total exports is growing rapidly. India is at the
startingline.
These countries have large labour forces that offer their services at very low wages, and these labour
resources are available to companies that compete on world markets. The working-age population in
rural China is nearly the same as that of the entire OECD area. Many are underemployed and are
seeking work in urban areas.
Low labour costs and more efficient transport and communication attract labour-intensive production.
Production is being transferred to China or other emerging economies. There are many examples
showing that competition in selling highly skilled services is also intensifying. Myopia surgery is offered
in Turkey. Dental care and other medical services are also offered, at prices that are substantially
lower than in Norway. Norsk Hydro reports that almost 300 000 hours of engineering services for the
Ormen Lange project were supplied by Indian engineers, located in India.
Trade in services flows both ways. Norwegian architects are designing landmark buildings all around
the world. Det Norske Veritas sells its services worldwide. A company - Vik-Sandvik - that designs
ships that are built in Europe, Asia and the US has its head office in the rural community of Fitjar. An
ICT firm located in Ølen municipality - Omega - is developing and installing software for customers in
Baku and Dubai.
New markets in Asia are creating opportunities for industrialised countries. Resources are transferred
to enterprises producing goods and services that require specialised skills. Businesses that have been
sheltered and protected by national regulations are in a weak position when new technology or new
agreements expose them to external competition.
The shift in the division of labour is now influencing - and will continue to do so for a period - real
wage growth in industrialised countries. The risk that a business will have to wind up operations or
move abroad is dampening costs. In a number of European countries, wage growth is also being
influenced by labour inflows from the new EU member states.
Increased trade has engendered higher demand for shipping services and favourable freight rates.
This has in turn led to a boom in the shipbuilding industry. At the same time, high energy prices are
boosting investment in the petroleum and electricity sectors, with considerable impetus to the
engineering industry. Growth in Asia is having a favourable impact on aluminium prices.
Prices for our imported goods are falling in relation to prices for goods we export. Norway's terms of
trade are improving. The impact of the rise in oil and gas prices is particularly strong, but the
terms-oftrade gains for the mainland economy have also been high.
The situation in Norway differs from that of its Nordic neighbouring countries. Sales of Swedish and
Finnish high-tech products are growing strongly in volume terms, but prices are falling. Denmark has a
diversified business sector, which is overall moving on a steady path.
As consumers, we are benefiting from falling prices for many imported goods. Clothing prices are an
illustration of this. Prices rose by around 3 per cent annually for a long period, but since 1995 they
have been falling by about 6 per cent annually. This kink point coincides with the dismantling of the
restrictions on textile trade and it coincides with a period of rationalisation in retail trade in Norway.
China's membership of the WTO has subsequently pushed down prices further.
The Internet facilitates price comparison, and price margins in all sectors are under pressure.
World financial markets are also in flux. Technological advances, increased trade and liberalisation
have increased cross-border capital flows. Foreign ownership of businesses has increased
considerably. At the same time, savings are increasingly being invested in foreign countries. The
home bias for investment has diminished.
In recent years, long-term interest rates have declined. Low and stable inflation in many countries has
made a contribution. Investors have less of a need to hedge against high inflation. There is a strong
tendency to save among Asian and oil-exporting countries, while the willingness to invest is limited in
many industrialised countries. This is pushing down interest rates. Low long-term rates probably also
reflect low short-term interest rates and ample liquidity.
Interest rate developments and buoyant growth have led to a sharp rise in equity prices in the past few
years. At the same time, property prices are rising sharply in many countries.
Low interest rates, sharply rising equity and property prices, high commodity prices and high energy
prices are probably linked to cyclical developments and may therefore be transitory. Changes in the
international division of labour, integrated financial markets and increased competition in broad goods
and services markets are more permanent.
Globalisation and cyclical developments have been kind to the Norwegian economy. Few countries
are benefiting as much as Norway - and losing as little - in the current environment of freer trade in
goods and services and cross-border labour mobility.
3. Challenges to monetary policy
After almost two decades of high inflation, the rise in prices stabilised in many countries in the 1990s.
The year-on-year rise in prices in the industrial countries was about 13 per cent at the beginning of the
1980s. In the course of the following decade, it fell to below 2 per cent. Today, most central banks
orient monetary policy towards low and stable inflation.
The practical implementation of monetary policy can vary, but the common objective is price stability.
Low and stable inflation has contributed to solid growth in the global economy in recent years. Despite
rising oil prices, international conflicts that have led to uncertainty, and other disturbances, the impact
on inflation and output has been moderate.
The perception in Norway in the 1960s and 1970s, as in other countries, was that strong growth and
low unemployment could be achieved if we were only willing to accept somewhat higher inflation. But it
was gradually recognised that this was not the case. In 1980, Odd Aukrust, research director at
Statistics Norway said the following about economic developments in Norway: "Unfortunately, there is
even less reason for optimism this time. It appears that the competitive position of Norwegian
manufacturing will weaken in the coming year. The main problem is that no one controls price
developments. With an inflation rate of around 10 per cent a year, no one dares to make investments
that could stop this price carousel."3
From the second half of the 1980s, the authorities started using monetary policy to control inflation.
At the beginning of the 1990s, inflation had fallen, and since 1988, inflation has averaged 21⁄2 per cent.
Studies of price developments for all goods and services show that price formation underwent a
permanent shift around 1988.4 A transition occurred from a period of high and unstable inflation to the
current period of low and stable inflation.
Bringing the rate of inflation down had its costs. In the years from 1988 to 1992, the Norwegian
economy experienced the deepest recession of the post-war period. But growth picked up quickly, and
the 1990s as a whole were a golden decade. It also appears that the present decade will be
favourable. A foundation was laid when the Norwegian authorities took control of inflation.
Developments over the past 40 years illustrate that the most important contribution monetary policy
can make to sound economic developments in the long term is low and stable inflation. This provides
the economy with a nominal anchor.
Low and stable inflation makes it easier for economic agents to distinguish changes in relative prices
from changes in the general price level. Prices become a more accurate information vehicle. Alan
Greenspan has defined price stability as "a situation in which households and businesses in making
their saving and investment decisions can safely ignore the possibility of sustained, generalized price
increases or decreases".5 This is the aim of monetary policy in all countries.
When there is confidence in the inflation target, monetary policy can also contribute to stabilising
output and employment.
Norges Bank operates a flexible inflation targeting regime, so that weight is given to both variability in
inflation and variability in output and employment in interest-rate setting.
Past experience indicates that expectations as to future inflation remain stable even if inflation varies
somewhat as long as the interest rate is used actively to curb the effects. Monetary policy cannot
finetune economic developments, but it can prevent the largest effects from occurring when the economy
is exposed to disturbances. In some situations, it may be appropriate to hedge against particularly
unfavourable developments.
If inflation deviates substantially from the target for a period, the interest rate will be set with a view to
gradually returning it to the target, so that we avoid substantial variations in output and employment.
Through the 1990s, inflation remained on the whole in the interval 11⁄2 - 31⁄2 per cent. Inflation has
varied slightly more in the past few years. In a period of increased cross-border labour flows,
substantial technological advances, changes in competitive conditions and new trading patterns, we
may, with our very open economy, have to accept a somewhat greater variation in inflation and
deviations from the target, as we have witnessed over the past two to three years.
Even though economic growth has been strong over the past 15 years, economic cycles have varied.
A clear upturn in the years from 1993 to 1998 was followed by a period of more moderate growth and
a mild downturn in 2002 and into 2003. Since summer 2003, the Norwegian economy has again
experienced a marked upturn.
Wage developments reflect and influence business cycles. Strong employment growth in the 1990s
resulted in a rise in labour costs, which in turn had a dampening impact on growth. Moderate wage
growth in recent years is being accompanied by a strong cyclical upturn.
The Norwegian economy has continued to exhibit high growth this year. Low interest rates, higher
petroleum investment and strong global growth have been the most important driving forces. Low
interest rates contributed at the beginning of the upturn to high growth in private consumption and
housing investment. Last year, exports and corporate investment also showed solid growth. There is
now a broad upswing in demand for goods and services. It has taken time for employment to pick up,
but this is occurring now.
Inflation has increased somewhat, but is still very low, even 21⁄2 years after the cyclical change.
Inflation is still being restrained by the fall in prices for imported consumer goods, increased
competition in a number of markets and the current period of lower nominal pay increases.
The trend in prices for consumer goods over the past two or three years is a result of favourable
developments in the Norwegian and global economies. Low inflation is being accompanied by real
income growth and a rise in production. In other words, low inflation is not the result of declining
demand, activity or employment.
The labour supply and production equipment set a limit in the short term on the level of production in
Norwegian enterprises. When production approaches this limit, wage and price inflation will pick up.
For an open economy like Norway's, this limit can vary. We buy an increasingly wide range of goods
and services abroad. The production of goods for the domestic market can be moved abroad.
Services can also be provided by producers in other countries.
Norwegian companies are no longer looking to the domestic labour market only. Other Nordic
countries are an important source of labour. Last year, the number of work permits issued increased
by 30 per cent. A large share came from the new EU member states. The waiter from Sweden, the
Polish carpenter, the cherry-picker from Lithuania, the dentist from Iran and the physician from Sri
Lanka are altering the capacity limits of the Norwegian economy.
Nonetheless, many services are provided and must be delivered in Norway. Nor do we want to drive
internationally exposed businesses out of the mainland economy. Language and cultural differences
place limits on how quickly foreign labour can be absorbed, and the supply may diminish inasmuch as
the economies of Sweden and Poland are now growing strongly. Norway's skills requirements and
authorisation procedures are also curbing competition. Laws and resolutions on minimum pay
requirements may also restrict the flow of labour.
Current evidence suggests that capacity utilisation is increasing in some sectors of the Norwegian
economy.
Norwegian industrial leaders report that they are nearing capacity limits with regard to labour, plant
and equipment. Three of four enterprises in the construction industry report that they are operating at
capacity limits.6
The number of advertised vacancies is rising steadily. There are reports of shortages of craftsmen,
project managers and supervisors, engineers and skilled workers.
Even though capacity utilisation is rising, there are no visible signs of inflation. Intensified competition
is exerting downward pressure on margins. Wage growth is still at such a low level that it is
strengthening businesses and employment. However, we have experienced earlier that cost inflation
can rapidly accelerate. The settlements in 2004 and 2005 resulted in moderate wage growth. There
are now signs of higher local pay increases in some industries. Pay increments are probably rising in
occupations where pay is directly linked to performance. Municipalities and public entities have
recorded a sharp increase in revenues, and this may easily translate into higher labour costs.
Nevertheless, the labour market is not so tight that there is a pronounced risk of a marked increase in
wage growth in connection with the spring income settlement. Moreover, employee organisations have
gained acceptance for important changes in labour legislation and regulations. This probably reduces
the near-term risk of pay increases that weaken production.
A characteristic of the wage formation process in Norway has been that fairly long periods of moderate
nominal pay increases and rising employment have culminated in a sharp rise in cost inflation - often
as a result of working hour reforms - and a decline in employment. Developments in labour costs and
the wage settlements in 1974 and 1975, 1986 and 1987 and in the period between 1998 and 2002 laid
the basis for a subsequent decline in output and employment. In our interest-rate setting, we must
continuously assess how we should take account of the risk of another sharp rise in cost inflation
when the labour market tightens.
In the conduct of monetary policy, we assess the objective of stabilising inflation at close to 21⁄2 per
cent over time against the objective of stabilising output and employment. Given the low inflation rate,
we have decided to keep interest rates at a low level and at times considered an even lower interest
rate. However, against the background of solid growth in the Norwegian economy since summer 2003,
we have instead decided to use some time to bring inflation back to target.
Household debt has risen sharply since the mid-1990s. At the same time, house prices have shown a
marked increase. Debt developments through the 1990s can probably be viewed to some extent as a
delayed adaptation to the deregulation of the housing and credit markets in the 1980s, after many
households burned their fingers immediately after the deregulation. At the same time, the credit
market has deepened. New loan products have emerged, and it is easier to raise loans. Borrowers
can choose their repayment schedule. Credit and housing market liberalisation provides homebuyers
with the opportunity to establish a high housing standard early in their adult lives and draw on this
capital later in life. In recent years, household income growth has been solid, household confidence
regarding the future has been strong and households probably perceive higher income levels as
permanent. This may have resulted in a further rise in house prices and debt. In addition, low real
interest rates are currently contributing to this.
We have limited scope for restraining structural changes that take place when households increase
their debt over several years in order to invest in housing and other property and assets. An interest
rate level that effectively restrains this restructuring process would also have had adverse effects on
economic activity. However, households are more vulnerable when debt is high. Long periods of
sharply rising asset prices and debt may be a source of subsequent instability in production and
employment.
We believe that expectations regarding interest rate developments have a greater impact on
household and business borrowing and investment behaviour than actual interest rates.
Norges Bank communicates its analysis of the outlook for the Norwegian economy and the interest
rate. At this juncture, the outlook for output and inflation suggests that the interest rate should be
gradually - in small, not too frequent steps - brought up to a more normal level.7 The economic
outlook is uncertain. We illustrate interest rate uncertainty ahead with a fan chart, which is meant to
capture the outcome with a 70 per cent probability.
The consequences of higher interest rates for two households are illustrated in this chart. Both
households comprise two adults and two children. One household has a gross income of NOK
800 000 and NOK 2 million in debt. The other has an income of NOK 600 000 and NOK 1.5 million in
debt. The chart shows the two households' income after basic expenses and interest and principal
payments have been paid. The household with an income of NOK 800 000 can cope reasonably well
with a debt of NOK 2 million even after the interest rate has increased by 3 percentage points. The
household with the lowest income will have a tight margin. Principal payments will have to be deferred
and, even with a deferral of a few years, this household will have little leeway after basic expenses
have been paid. In order to increase its financial leeway, it will either have to increase its income, or
reduce housing consumption and dispose of its debt.
Both households will be vulnerable should one member lose income from employment and have to
rely on benefits. With an income loss of 10 per cent, even the household with the highest income level
would have to make considerable spending adjustments. Although these households have
higherthan-average debt, this debt level is not uncommon.
However, for most households, it will be relatively easy to cope with gradually higher interest
expenses.
The outlook for the Norwegian economy is favourable. Output has picked up, although so far not to
such a degree that there are visible signs of inflation. As long as the rise in prices is slow, it will be
appropriate to maintain a low interest rate. But when capacity utilisation increases, the interest rate will
have to be raised gradually towards a more normal level.
Even though price inflation has deviated from the target for a period, there are no indications that
economic agents have changed their view of future inflation. Expectations are stable. When
households and businesses make their saving and investment decisions and set prices, they can
safely ignore the possibility of sustained, marked increases or decreases in the general price level.
The business sector can base their decisions on the assumption that wage and cost inflation will not
revert to the level seen in the 1970s and 1980s. Employees also know that their pay increases will not
be eroded by inflation. Low and stable inflation is a credible objective.
4. Are we equipped for the future?
Norwegian enterprises have access to new markets and are encountering increasing competition.
New businesses are emerging while others are scaling back and closing down.
We have behind us 15-20 years of fairly sound macroeconomic management, which provides a good
basis for growth in the Norwegian economy. The banking system and securities markets are highly
developed. Generally, only unprofitable projects lack financing and capital. In a take-over, new owners
completely re-haul poorly run operations. In Norway, as in other industrialised countries, private
ownership is firmly protected. This is a competitive advantage and a fundamental precondition for a
market economy to function over time.
We like to believe that we have a highly educated labour force, and find some support for this in
OECD surveys. As a result of the tax reforms of 1992 and 2006, we are able to finance the welfare
state fairly effectively. Our infrastructure is being developed. The security provided by our welfare
system means that restructuring is easier than in many other countries. Like other Nordic countries,
we apply labour market rules that for the most part do not impede restructuring.
We learned a great deal about successful - and less successful - restructuring in the 1970s and
1980s. Two local communities that had to restructure are Kongsberg and Notodden.
The cornerstone enterprises in these two communities had to cut their workforces substantially.
Kongsberg fared well. When Kongsberg Våpenfabrikk declared bankruptcy in 1987, its defence
business was continued while all its civilian production was split up and sold. The new companies and
spin-off companies in Horten, Stjørdal and Egersund have posted solid growth and profitability.
Several of the companies have become leaders in their field. An adequate supply of state-of-the-art
technical expertise has been important for the companies' restructuring success.
Notodden did not fare as well. In the 1950s, Tinfoss Jernverk and Norsk Hydro employed more than
1500 manufacturing workers. Towards the end of the 1960s, they started shedding labour. The
processing industry has now been closed down. Many workers are now commuting to other
municipalities, including Kongsberg. The share of the population that is on disability benefits or
participating in various labour market programmes is above the national average. The basis for
establishing new businesses has not been as favourable as in Kongsberg, but there are now at last
signs that the situation is improving.
Kongsberg Våpenfabrikk was wholly state-owned. This was widely perceived as a guarantee for
continued operations. The company repeatedly required state capital injections following unfavourable
results. When the government allowed the company to fail, this also represented an important choice
with regard to state ownership policy. Profit requirements bolstered discipline in the fledgling
companies. At the same time, when the original company was split up, competencies and values
became visible.
The state still has extensive ownership interests in Norwegian business and industry, but it has
adopted a completely different approach to the management of its interests following the experience in
Kongsberg, Mo i Rana, Sulitjelma and Syd-Varanger. Corporate governance is now exercised through
resolutions in general meetings and according to recommendations from nominating committees, and
the board and management can run companies with the objective of increasing value. The state-
owned companies are subject to exactly the same market discipline as other operators, with a required
return and continuous adaptation and development. This is also the only way companies can avoid
stagnation.
Through the Government Pension Fund, the state owns equities worth more than NOK 500 billion,
spread across nearly 3 500 companies in over 30 countries. The holdings are minority interests. While
long-term interests in state-owned companies require ownership discipline and distance from
decisionmaking, the challenge to the Pension Fund is to assert its minority interests and contribute to
transparent corporate governance. Here we can apply internationally recognised principles drawn up
by the OECD and the UN.
Restructuring in state-owned enterprises and the wider business sector has enhanced the efficient use
of labour, capital and other resources.
International comparisons indicate that production in Norway is fairly efficient - also in sectors other
than oil and gas.8 A comparison shows that both Norway and Europe were catching up with the US for
a while. In Norway, productivity showed a particularly strong increase at the beginning of the 1970s.
Growth was weaker from the mid-1970s and up to the beginning of the 1990s, but has since picked up
somewhat again.
Productivity growth has been weaker in many European countries over the past decade. Restructuring
in retail trade and the financial industry in particular has progressed at a slower pace in Europe than in
the US. In this respect, developments in Norway are more similar to developments in the US. When
productivity growth picked up in Norway, it was primarily in retail trade and the postal, telecom and
banking industries.
Two factors seem to be important for growth:
First: In areas and enterprises in decline, adversity can trigger creativity when companies are split up
and new owners make their entry. Second: In order to reap the benefits of new technology, enterprises
must be able to make rapid changes in their workforces.9
However, at a more fundamental level, growth and restructuring capacity is closely linked to the level
of skills in a population. European surveys indicate that there is a high level of science and technology
skills among the adult population.10 Surveys among pupils and students do not provide an equally
positive picture. A report from the Norwegian Mathematics Council shows that the level of
mathematical skills among new university students has declined markedly in recent years.11 Even the
top performing students score considerably lower than earlier. This is illustrated here as the
percentage of correct answers in arithmetic and percent calculation, but we find similar scores for
other mathematical skills. Norway is taking an economic risk in allowing the skills level to decline.
But - to take a brighter view of this: We have after all experienced that negative trends can be
reversed in very important areas of society.
Our most important resource is our labour force. The employment rate is high in Norway. This is
because many wish to participate in working life, and the vast majority find a job.
However, the Norwegian labour market also has its weak points. The annual number of person-years
worked is lower in Norway than in the US and the rest of Europe. Both in Norway and the rest of
Europe, the fall in the number of working hours is ascribable to longer holidays and shorter working
days. The standard working year is short in Norway, but on the other hand Norway also has a higher
percentage of part-time employees than other countries. Access to these working hour arrangements
has made it easier for women and young workers to enter the labour market.
The income level in Norway has increased. Many may prefer to take advantage of this by increasing
their leisure time in the form of shorter working days or longer holidays. And this has in fact taken
place. Moreover, the retirement age is steadily declining. The expected retirement age is now below
60, when disability pensioners are taken into account. At the same time, life expectancy has
increased, and leisure time accounts for an increasing share of our lives.
The large post-war cohorts will only reach ordinary retirement age after 2012, but are now nearing the
age when they are eligible for early retirement. If they opt to retire under the scheme as it functions
today, the number of pensioners under the contractual early retirement scheme will increase by
16 000 in six years. Similarly, the ageing of the population will result in an additional 41 000 disability
pensioners.
The incentives embedded in pension rules, benefits and taxes encourage early retirement. The
pension rules make it costly for companies to recruit older workers. The wage trend perceived by a
wage-earner as appropriate over a lifetime may also deviate from the trend in work capacity expected
by the employer.
The basic problem seems to be that individuals are not sufficiently exposed to the social costs
associated with leisure and early retirement. Nor are the right incentives offered to individual
businesses.
5. Saving and returns in the Government Pension Fund
Our labour force is clearly our most important national resource, but Norway also has substantial
petroleum wealth. The state's share consists partly of the value of oil and gas under the seabed and
partly of the financial wealth accumulated in the Government Pension Fund - Global.
It is misleading to look upon the cash flow from petroleum activities as income. The appropriate
economic perspective is to see the transfer of the cash flow to the Government Pension Fund as a
way of transferring capital from one account to another - from petroleum to foreign securities.12 By
doing so, we diversify risk.
We are in a period marked by high oil and gas production and high prices. Substantial resources are
therefore transferred from the one account to the other. Combined with high returns, the result is that
the value of the Government Pension Fund is rising rapidly and may continue to do so in the years
ahead.
The Fund is now approaching the nominal value of one year's GDP and may reach two in the course
of the next decade. This is based on the assumption that oil prices remain high over the next few
years and then fall to about USD 30 per barrel. Experience has shown that forecasts for both oil
production and oil prices are highly uncertain.
The government bases its withdrawals from the Fund on an average real return of 4 per cent for
financing current expen