Jarle Bergo: Oil - economic policy challenges
Address by Mr Jarle Bergo, Deputy Governor of Norges Bank (Central Bank of Norway), at the 2003
Southern Norway Conference, Kristiansand, 11 March 2003.
The address is based on the assessments presented at Norges Bank's press conference following the Executive
Board's monetary policy meeting on 5 March and on previous speeches. Please note that the text below may
differ slightly from the actual presentation.
* * *
Oil is a major component of the Norwegian economy - with all the advantages and disadvantages this
entails. Oil gives us an economic base that is not available to many other countries. But it also
presents us with considerable challenges. How should we use our petroleum wealth wisely? This
question poses a number of economic policy challenges. In my discussion today, I will focus on three
points:
First, we must manage our petroleum resources recognising that they are part of our national wealth.
When oil is extracted and sold, natural assets are transformed into financial wealth. This is not income
in the ordinary sense. Norway's national wealth belongs not only to our generation, but also to future
generations. This means that our petroleum wealth must be equitably distributed between generations.
The authorities must therefore be disciplined and apply long-term considerations in their spending.
Moreover, the size of the cash flow from petroleum activities varies considerably. If it were to be used
as it accrues, this would have an enormous impact on demand impulses in the Norwegian economy,
and dramatically amplify cyclical fluctuations.
Third, the use of petroleum revenues will have an impact on competitiveness in Norwegian business
and industry. A high level of earnings and substantial fluctuations in the use of petroleum revenues
may have a considerable impact on the operating parameters for internationally exposed industries. It
is therefore important that we succeed in maintaining an industry structure that promotes learning,
innovation and development.
We are now in a phase where petroleum wealth is being converted from natural resources under the
seabed to financial assets abroad.
Both types of wealth involve large amounts of capital and are part of our national wealth, which
provides the basis for Norway's potential consumption over the long term. Consequently, it is crucial
that our national wealth is managed in a sound and prudent manner, so that the return will be high and
the risks acceptable.
Petroleum production generates a profit in excess of a normal return, i.e. economic rent. As economic
rent accrues to the state, this gives the central government a cash flow from petroleum activities.
Thus, the central government is now accumulating substantial capital.
Management of the Petroleum Fund poses challenges. At the same time, there is a demographic
challenge to be faced: the working population will decline sharply, and the proportion receiving income
from the public sector will rise.
The chart illustrates developments in the labour force and the number of pensioners in the period up
to 2050. The blue line shows that the labour force is projected to increase by about 150 000 from 2000
to 2030. Old-age and disability pensioners will increase by some 500 000, shown by the grey line. This
means that the number of persons in the labour force relative to the number of pensioners will fall from
2.6 to 1.8. These rough estimates are among other things based on the assumption that labour
immigration remains at the present level.
The increase in the number of pensioners will result in a sharp increase in the obligations of old-age
and disability pension funds. Expenditure on old-age and disability pensions is expected to more than
double as a share of total GDP in the course of the next 30 years. The increase in the number of
elderly, especially those over the age of 80, will in time require an increase in resources for nursing
and care services. Welfare reforms that have been adopted will also contribute to increasing the need
for resources in the public service sector in the years ahead.
With an ageing population and strong growth in expenditure on pensions and nursing and care
services, our petroleum wealth will be a welcome source of revenues. This is why it is particularly
important that it is managed in a sound manner.
Petroleum activities are a substantial component of the Norwegian economy. In the chart, petroleum
investment is shown by the blue line, while the red line shows the central government's net cash flow
from petroleum activities. Petroleum investment rose sharply in the 1970s and has subsequently
varied between 4 and 8 per cent of GDP. Petroleum investment fluctuates considerably and has a
substantial impact on cyclical developments in the Norwegian economy. The authorities can only
regulate petroleum investment to a limited extent. It is therefore difficult to prevent the impulses to the
Norwegian economy that are generated by these fluctuations. Consequently, it is all the more
important to prevent fluctuations in the cash flow to the central government from these activities from
having a direct impact on the economy.
Allow me to illustrate the consequences this might have:
Let us suppose that the oil price temporarily increased by NOK 20 per barrel, or a little less than
USD 3 per barrel. This is a small change, well within normal variations from one year to the next. The
central government's net cash flow from petroleum activities would then increase by around
NOK 16 billion the first year and NOK 20-22 billion the next. This corresponds to almost 2 per cent of
Norway's annual GDP.
If the increase in the cash flow is taken into the economy through higher expenditure or reduced taxes
in the central government budget, aggregate domestic demand will be affected. Higher expenditure
requires an increase in the public sector's use of real resources, primarily labour. Two per cent of GDP
is then a substantial figure. If the increase in petroleum revenues is used domestically, this would
correspond to almost all the annual growth in the mainland economy in a normal year. If the private
sector of the economy is also expanding, and the economy is already close to its capacity limit, this
policy would swiftly lead to strong pressures on economic resources. This would result in a rise in
wages and prices. This policy would also lead to unstable conditions in the foreign exchange market.
When oil prices then fell again and central government expenditure dropped, the economy would
experience a very strong contraction.
The Government Petroleum Fund was established in 1990 with a view to safeguarding long-term
considerations in the use of petroleum revenues. The idea behind the Petroleum Fund is that the cash
flow from an increase in the oil price should accrue to the Fund and be invested abroad and that the
increase in the oil price should not affect the wider budget. Thus, rather than affecting the domestic
economy, the increase in the cash flow would be invested abroad through the Petroleum Fund.
Similarly, a fall in the oil price would not affect the domestic economy, but would result in lower
accumulation of foreign assets. By building up the Fund, the aim of ensuring that several generations
will enjoy the benefits of our petroleum wealth is also taken into account.
In March 2001, the fiscal guideline and new guidelines for monetary policy were introduced. The
guideline for fiscal policy implies that the central government budget deficit shall be equivalent over
time to the expected real return on the Government Petroleum Fund. The new guidelines for economic
policy received broad support in the Storting.
The guideline specifying that only the real return on the Petroleum Fund is to be used means that the
capital in the Fund is not depleted. The capital in the Petroleum Fund will increase as long as there is
a positive cash flow (to the central government) from petroleum activities. When the conversion from
petroleum assets to financial wealth has been completed, the objective will still be to restrict
withdrawals so that the real value of the Fund's capital is maintained - in principle, indefinitely.
The guideline thereby provides a long-term anchor for fiscal policy. The guideline provides a stable
framework that contributes to curbing fluctuations in the Norwegian economy that are caused by
converting petroleum assets into investment at home and abroad. The guideline has been adhered to
in the past two years.
As mentioned, the largest conversion of our national wealth in the next thirty years will be from oil as
recoverable reserves to oil as financial wealth. The question might, of course, be raised as to whether
an alternative option would be to keep our wealth in the form of oil and extract what we needed.
Whether this would be profitable or not depends on oil price developments compared with the return
on financial assets.
If we look at the period from 1986 and compare developments in nominal oil prices with the return on a
fund managed according to the Petroleum Fund's investment strategy - a global portfolio containing
bonds and equities in a 60-40 distribution - we see that the fund would have yielded a far higher
annual return.
What about the risk? How is it affected by a conversion from oil to financial wealth? History provides
us with a clear, if somewhat surprising answer. A conversion from oil to financial wealth increases the
return and at the same time reduces the risk. This is because wealth under the seabed (somewhat
simplified) only consists of one asset, petroleum, while broadly invested financial wealth is highly
diversified in many instruments whose return fluctuates at different rates.
Today the distribution between financial wealth (the Petroleum Fund) and petroleum is about 20-80. If
we venture to base our assessment on historical relationships, it is fairly clear that we have, relatively
speaking, too much oil in our portfolio and that the current conversion to financial wealth is to our
advantage. We have no guarantee, of course, that history will repeat itself, but relying on the opposite
requires considerable courage.
The Petroleum Fund can be invested in two main types of instruments; bonds and equities. The
international bond market is about the same size as the equity market. Government bonds are a
relatively safe investment, but the return is low. Long-term rates in the US and Europe currently stand
at around 4 per cent. New investments will thus achieve an annual real rate of return of 11⁄2-2 per cent.
By way of comparison, the authorities have based their use of petroleum revenues over the central
government budget on the assumption that the Petroleum Fund can generate a long-term real return
of 4 per cent. It is unlikely that this rate of return will be achieved if we only invest in bonds.
Buying a bond means lending money to others. Buying equities is the same as investing in real assets.
Buying equities gives us direct ownership of the means of production in global business and industry.
On the one hand, these ownership rights provide high returns when companies are flourishing. On the
other, shareholders are the first to sustain losses when companies fail. Consequently, the return on
shares fluctuates far more than the return on bonds, reflecting the higher level of risk. Over the past
75 years, equity returns in the US market have been negative almost every third year.
An investor will only invest in high-risk vehicles if it is reasonable to expect compensation for the risk.
The compensation for high risk in the stock market is a far higher average return for equities compared
with bonds. Since 1926, the annual return on US equities has on average been 4.8 percentage points
higher than the return on bonds. Also in most ten-year periods, investing in US equities has been
profitable, with the exception of the depression in the 1930s and the last half of the 1970s. Equity
returns have been negative after ten years only in the years between 1928 and 1938, in other words
on equity investments made the year before the 1929 stock market crash.
It may also be worth noting that equities purchased during recessions - such as in the mid-1930s and
mid-1970s - brought solid returns ten years later. The picture is the same for most other countries.
Since short-term fluctuations in equity prices are difficult to predict, it may be a sound strategy to keep
the share of equities constant over time. This means buying a relatively large volume of equities when
prices are low, and buying a smaller volume - or selling - when prices are high. This is the strategy
applied by the Petroleum Fund.
Let us now revert to the Norwegian economy and Norwegian economic policy. The revision of
economic policy in March 2001 can to some extent be said to be a consequence of our oil economy.
The new guidelines have also changed the interaction between the different components of economic
policy. Fiscal policy will now have an expansionary effect. In order to prevent pressure from becoming
too strong, monetary policy has to be tighter than would otherwise have been the case. Monetary
policy has therefore been given a clearer role in stabilising economic developments.
A clear monetary policy target is a necessary complement to the fiscal guideline with a view to
ensuring reasonable macroeconomic stability. The operational target of monetary policy as defined by
the Government is inflation of close to 2.5 per cent over time. The inflation target provides economic
agents with an anchor for their decisions concerning saving, investment, budgets and wages.
Households, businesses, public entities, employees and employers can base decisions on the
assumption that inflation in Norway will be 21⁄2 per cent over time.
The rise in labour costs is an important factor underlying Norges Bank's assessment of the inflation
outlook and interest rate decisions. If wage growth is too high - both in manufacturing industry and
other industries - the internationally exposed sector will be affected in two ways. First, high wage
growth will itself reduce earnings and employment. Second, the interest rate will be raised. Normally,
this will lead to an appreciation of the krone, with a further reduction in earnings and employment. This
will amplify the impact of high wage growth on manufacturing industry. Since the new guidelines on
the use of petroleum revenues were introduced in a period when the labour market was tight, the
krone was expected to be strong in periods.
The interest rate differential between Norway and trading partners has resulted in a strong krone. The
wide interest rate differential is due to the historically low level of interest rates abroad. The slowdown
in global growth has been more pronounced and spanned a longer period than we had expected. The
Norwegian economy has also felt the effects of this. Norges Bank has therefore lowered the sight
deposit rate from 7 to 5.5 per cent since 11 December, most recently on 5 March. The interest rate
differential has narrowed. Since mid-January, the krone has depreciated, partly reflecting expectations
of lower interest rates. Monetary policy has been relaxed.
There is uncertainty associated with developments in many of the factors that will influence inflation
ahead, among others the exchange rate. This implies a gradual approach to the conduct of monetary
policy.
Increased spending of petroleum revenues will have implications for Norway's industry structure. High
demand for goods and services that require domestic resources, necessitates higher employment in
the sheltered sector. This labour has to be recruited from the exposed sector, or through the natural
increase in the labour force finding its way to the sheltered sector.
Even if employment and output in Norwegian manufacturing industry fall, developments for Norwegian
enterprises may not necessarily be only negative. Some enterprises may be at the cutting edge of
technology, and increase their efficiency in pace with the rise in costs in Norway.
Others may relocate labour-intensive activities abroad. The scaling back of manufacturing still involves
a risk. It makes the economy more vulnerable; the foundation for learning, innovation and
development may be undermined when a smaller share of the business sector is exposed to intense
international competition.
Even with a sustained extra currency income in the form of the return on the Petroleum Fund, the main
share of Norwegian imports must be financed using revenues deriving from exports of goods and
services from mainland Norway. This places demands on profitability in exposed industries. In the long
run, cost competitiveness must be adapted to the need for financing imports and securing balance in
the external economy.
Imports currently account for more than 30 per cent of GDP in Norway. The return on the
Petroleum Fund will range between 4-5 per cent of GDP when the bulk of our oil resources have been
extracted and converted into financial wealth. This means that no more than close to 1/5 of imports
can be financed on the basis of oil in the long run. In other words, if the share of imports is to remain at
the current level, a sizeable internationally exposed sector will be needed to finance imports.
Both our petroleum wealth and financial wealth are sizeable. However, it is the discounted value of our
own labour that is our predominant asset. Our livelihood essentially depends, and will continue to
depend in the future, on our ability to produce goods and services efficiently through our labour, and to
use our creativity and innovation to become ever more efficient.
This can be illustrated by the following example: If a perception that oil has made us so wealthy that
we can to some extent relax leads to a reduction in annual productivity growth of a quarter percentage
point, i.e. a reduction in trend GDP growth from the current level of about 2 per cent to 13⁄4 per cent,
the income base would be reduced by more than the entire return on petroleum wealth.
Societies that suddenly gain access to wealth deriving from natural resources have a tendency to
spend the money and then fall into decline. A very clear example of this can be found in Spain already
in the 1660s. The colonisation of South and Central America gave this country access to a wealth of
natural resources, and to gold. Spain chose to spend a large portion of the windfalls on luxury and
war. The attitude to working that this led to did not make it easy for these countries to get back on their
feet again when the gold came to an end.
Many countries have had similar experiences in more recent times. The expression "Dutch disease"
comes from the turn of events in the Dutch economy in the 1970s and 1980s after the revenues from
the large gas finds in the Groningen field were used to finance strong growth in public spending. When
the gas revenues declined, economic growth came to a halt and economy policy had to be tightened.
Several studies of the relationship between long-term economic growth and natural resources show
that countries with an abundant suppy of natural resources have tendency to experience lower
economic growth. Why? In principle, an abundance of natural resources is an advantage for a
country's economy.
One of the main findings of the studies on the relationship between long-term economic growth and
the supply of natural resources is illustrated in the chart. The chart was made by Jeffrey Sachs and
Andrew Warner, two of the most prominent researchers who have studied the phenomenon that has
come to be known as the "resource curse". They use the size of a country's exports of natural
resources in relation to GDP in 1970 to measure how rich the various countries are in terms of natural
resources. There is a negative correlation between the supply of natural resources and economic
growth in the period 1970-1989. The group of countries with the highest growth rates includes the
Asian tigers, which have had a very limited supply of natural resources. Several of the oil-rich
countries around the Persian Gulf fall into the group of countries with the lowest growth. This could
suggest that it is not necessarily an advantage to have an abundance of natural resources. There are
many factors that influence economic growth. Sachs and Warner only look at one of these factors in
their chart. The relationship has proved to be relatively robust, however. It is true that some
economists have argued that the negative relationship does not apply when institutional factors in the
countries included in the study are taken into account.
Venezuela is one of the poorest performing countries in the Sachs and Warner study. The country has
the largest known oil reserves in the world, and also has an abundance of other natural resources.
Venezuela has been among the largest oil producers since the 1920s. But as a result of an unsound
economic policy, the country has not been able to achieve solid and stable economic growth. After the
rise in oil prices in the 1970s, government spending increased sharply. In the 1980s, fiscal policy was
also highly expansionary. The result was high inflation and rising unemployment. Close to 85 per cent
of the country's population is living in poverty. Economic growth has been weak. Between 1970 and
2002, GDP per capita has fallen by about 20 per cent.
Why have many countries failed to make good use of windfalls? There may be a number of reasons.
In terms of economic policy, an explanation is that the wealth deriving from the resources leads to an
extreme focus on acquiring as much of this extra wealth by various groups. The contest for this profit
is often referred to as "rent-seeking behaviour". Countries with an abundance of natural resources may
be more vulnerable to extreme "rent-seeking behaviour" than economies with a limited supply of
natural resources. The competition between the various factions can lead to an inefficient tapping of
natural resources and an unsound use of revenues. The spirit of enterprise, talent and energy in both
business and political life are used to acquire a share of this income rather than to foster productive
activity in both the public and private sector. For an individual company or a group, this activity may
seem rational - a 10 per cent chance to win the jackpot could be better than investing in a business
that yields an ordinary return. This may have damaging consequences for a country.
A sociological explanation is that easily acquired wealth weakens the incentive for innovation and
work. We feel that we have become rich and want to live the good life. A possible economic
explanation is that a large and broad sector that is exposed to international competition fosters
learning and development. Without such a sector, the competitive intensity in the economy may
decline and the ability and willingness to be innovative may be impaired.
We must be cautious about drawing final conclusions based on historical comparisons. We would
prefer to assume that we are managing our wealth better. However, it may be of particular relevance
to highlight three critical pre-conditions for succeeding in this. First: Decision-making forms and
processes in the political and economic arena must provide effective protection against the acquisition
by interest groups of the right to use large shares of the petroleum wealth. Second: It is important for
the growth potential in the economy that we maintain a broad sector in the mainland economy that
works under intense competition so that we maintain and strengthen the incentive to acquire
knowledge and to be innovative. Third: It is important that we bear in mind the issue of distribution
across generations and that we manage the wealth as an asset.
1. From petroleum to financial wealth
Per cent of total wealth
8 Petroleum wealth
Financial wealth
7
6
5
4
3
2
1
0
1999 2030
Source: Long-term programme 2002-2005
2. A Demographic Challenge
1000 persons Ratio
3000 4
Number of persons in
labour force (left-hand axis)
2500
3
labour force / pensioners
2000
(left-hand axis)
1500 2
1000
1
500 Number of pensioners
(left-hand axis)
0 0
1970 1980 1990 2000 2010 2020 2030 2040 2050
Source: National Budget 2003
3. Petroleum activities and the Norwegian economy
Per cent of GDP
18 18
Net cash flow from
16 16
petroleum activities
14 14
12 12
10 10
Oil investment
8 8
6 6
4 4
2 2
0 0
1966 1969 1972 1975 1978 1981 1984 1987 1990 1993 1996 1999 2002
Source: National Budget 2003 and Norges Bank
1)
4. The Government Petroleum Fund
Per cent of GDP
150 150
125 125
100 100
75 75
50 50
25 25
0 0
2000 2010 2020 2030 2040 2050
1) When expected return is used.
Source: National Budget 2003, National Budget 2002 and Norges Bank
5. The fiscal policy rule prevents large unexpected
changes in the impulses from use of oil revenues
Per cent of GDP for Mainland Norway
10
8
6
Structural non-oil deficit
4
2
0
2000 2010 2020 2030 2040 2050
Source: National Budget 2003
6. Return on oil vs petroeleuml fund
Value index for oil price and Petroleum Fund in USD
(1.2.1986=100)
600
500
Petroleum Fund
400
300
Oil
200
100
0
feb.86 feb.87 feb.88 feb.89 feb.90 feb.91 feb.92 feb.93 feb.94 feb.95 feb.96 feb.97 feb.98 feb.99 feb.00 feb.01 feb.02 feb.03
Oil Petroleum Fund
Annual return 3.3 % 9.9 %
Standard deviation 40.5 % 8.9 %
7. Return and risk: oil vs Fund
- with the Fund's current equity portion (40 %)
Return and risk for combinations of oil and Fund
1 February 1986 - 1 February 2003.
Measured in USD. Per cent
14
12
Today (80 % oil)
10
100 % oil
8
0 % Fund
100 % Fund
6
0 % oil
(geom.annualised)
4
2
Return
0
0 10 20 30 40 50
Risk (standard deviation, annualised)
8. Annual return in the US
Per cent
60 60
40 40
20 20
0 0
Fixed income
-20 -20
Equities instruments
-40 -40
-60 -60
1925 1935 1945 1955 1965 1975 1985 1995
Source: Ibbotson Associates og Datastream
9. Average return in the US
Rolling 10-year periods. Per cent
25 25
20 20
Equities
15 15
10 10
Fixed income
instruments
5 5
0 0
-5 -5
1935 1945 1955 1965 1975 1985 1995 2005
Soruce: Ibbotson Associates og Datastream
10. Norway's national wealth
Per cent of total wealth
90
83 83
1999 2030
80
70
60
50
40
30
10
20
8
7
6
0
10 1
0
Petroleum wealth Real capital wealth Financial wealth Discounted value
of labour
Source: Long-Term Programme
11. "The resource curse"
Source: J.D. Sachs & A.M. Warner (2001)
12. The case of Venezuela
Per cent 1000 Bolivares
18 36
16 32
Real GDP per
capita (right-hand
14 28
axis)
12 24
10 20
Unemployment
8 16
(left-hand axis)
6 12
4 8
2 4
0 0