Svein Gjedrem: Norwegian experiences in balancing economic development
with macroeconomic stability - a historical perspective
Speech by Mr Svein Gjedrem, Governor of Norges Bank (Central Bank of Norway), at the Norwegian
Embassy, New Dehli, 21 March 2006.
The Charts in pdf-format can be found on the Norges Bank's website.
The speech does not contain assessments of the economic situation or the monetary stance. Please note that the text below
may differ slightly from the actual presentation.
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Excellencies, Ladies and Gentlemen,
It is a great honour to address you today on behalf of Norges Bank. The ties between Norway and
India seem to be growing stronger, in spite of the geographical distance and vast differences between
our two countries. Over the last few years, a number of Norwegian companies have entered the Indian
market or strengthened their involvement in India. For example, the Norwegian oil and gas company
Norsk Hydro reports that almost 300 000 hours of engineering services for the natural gas field Ormen
Lange were supplied by Indian engineers, located in India. Last year, the Government Pension Fund
made its first investments in the Indian stock market. By the end of 2005, the Fund had holdings in
more than 70 Indian companies. There are also numerous cultural ties. This year, Norway is
commemorating our most famous playwright Henrik Ibsen. A wide range of events is being arranged
both in Norway and abroad. Of particular interest is that Indian actors are providing fresh
interpretations of Ibsen's work, both in India and in Norway.
The topic of my speech today is Norwegian experiences in balancing economic development with
macroeconomic stability from a historical perspective. As a background for the subject, let me start
with a brief characteristic of Norway today from an economic perspective.
First, Norway is a small, mountainous country with a population of only 41⁄2 million people scattered
across a land area that is one tenth of the size of India. Second, Norway's economic growth has been
favourable for many years, and the per capita income is among the highest in the world. An
abundance of natural resources, not least oil and gas, and openness to trade and capital movements
are important reasons for this. The petroleum sector's share of GDP was approximately 24 per cent in
2005. Over the last 10 years, the government has earned higher petroleum revenues than it has
spent. Today we have a sizeable Government Pension Fund, which invests all its funds globally.
Globalisation and cyclical developments have been kind to the Norwegian economy. 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-of-trade
gains for the mainland economy have also been high. One aspect of this is that trade in services with
India is increasing.
Petroleum and luck is, however, not the whole story behind the high per capita income in Norway. We
have also been successful in seizing the opportunities that have been offered by changing
international environments. The foundations for the Norwegian welfare state were established some
two hundred years back in history.
Long-term economic developments
The Napoleonic Wars, which tormented Europe in the early 19th century, brought some great changes
to the face of Europe. Norway took this opportunity to adopt a constitution and establish a number of
central governmental institutions, including a central bank.
Norway was severely hit by the economic crisis that followed the war, and around 1820 Norway's GDP
per capita was lower than in many comparable countries. In the second half of the 1820s, a new
period of economic expansion started. The upturn gathered momentum from the middle of the century.
An event which had a considerable impact on Norwegian shipping and economic history took place in
1849 when England repealed all navigation acts regulating the right to transport goods to and from
England and its colonies.
This new and more competition-friendly trade environment spurred a rapid build-up of the Norwegian
commercial fleet. Norway suddenly became a major exporter of services. As the chart shows, the
tonnage of the Norwegian commercial fleet increased almost six-fold from 1850 to 1880. By 1880,
Norway had built up the world's third largest commercial fleet.
In the latter part of the 1800s, Norway benefited greatly from free trade and free capital movements
and became a relatively prosperous country. Access to international technology, competence and
capital were important when the first industrial base was established in the late 19th century. The
banking sector also expanded rapidly in this period.
As this chart shows, value added in manufacturing and services became more important and
increased as a share of total GDP. Employment and value added in agriculture, fisheries etc., on the
other hand, declined markedly. By the beginning of the 20th century, the standard of living in Norway
did not lag behind that of other European countries. This change in industry structure is necessary and
lies at the heart of economic development.
The second half of the 19th century also represents a golden age for Norwegian cultural development,
with the literature of Henrik Ibsen, the music of Edvard Grieg and later the paintings of Edvard Munch.
In the period preceding the First World War, the world experienced a period of strong growth in trade
and cross-border capital flows. There were few political barriers and major technological advances
fostered growth in trade. Prosperity increased. But this period was interrupted, and in the interwar
period protectionism gained ground, with trade barriers and a contraction in international trade. This
was combined with deep economic recessions.
Economic policy after the Second World War
After the Second World War, a strong belief evolved in Norway that the economy could be controlled
and steered in the desired direction. The support for a market economy lost ground after the
recessions and financial instability in the interwar period. Economic policy was marked by
coordination, control and regulation. At the same time, Norway took part in international organisations.
International organisations made an effort to promote economic cooperation and increased integration
of international trade and fixed investment. Trade barriers were gradually scaled back and trade
picked up already in the 1950s. Capital movements remained strongly regulated, however.
Maintenance of a high level of fixed capital formation in inter alia infrastructure and private and public
industrial companies was an important part of economic policy after the war. The fixed
investment-toGDP ratio stayed at a historically high level until the late 1970s. On the other hand, low or negative
real interest rates, combined with credit regulation, contributed to a low return to capital and an
inefficient use of resources. Since the late 1970s, the investment ratio has declined in Norway as in
many other European countries. India, on the other hand, is in the process of catching up. High
investment growth in infrastructure as well as in businesses is probably important to maintain high
economic growth in India.
The government sector in Norway increased in importance until the beginning of the 1990s. Taxes
were raised to support increased use of resources in the public service sector and to support a rising
level of transfers between households and industries.
The regulatory economic policy in the post-war period was, however, not sustainable. This policy was
at the root of many of the problems that followed in the 1970s and 1980s. Today's formulation of
economic policy reflects the experience gained and the lessons learned in these two decades.
The economic policy contributed to wide fluctuations in the Norwegian economy. Inflation became high
and variable. This was largely due to a perception in the 1960s and 1970s 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 there was no such trade-off.
The absence of a nominal anchor was one of the main reasons behind the pronounced swings in the
Norwegian economy. With a policy of low interest rates and devaluations, inflation took root. Nominal
interest rates were kept at a low level even though inflation rose. Frequent devaluations from 1976
were unable in the long term to prevent a decline in the manufacturing sector. On the contrary, they
proved to be self-reinforcing. The wide fluctuations culminated in a credit boom in the mid-1980s.
The fluctuations were reinforced by oil price shocks and the use of expected revenues from oil
production. The government began already in the 1970s to budget on the basis of future strong growth
in petroleum revenues. The result was that we spent a large share of our petroleum wealth in the
1970s and 1980s. Welfare schemes were expanded significantly. Manufacturing industry was scaled
back. The recession after the credit bubble burst and oil prices fell in 1986 was deep. The recession
was deeper than would have been the case if we had maintained a larger and competitive
manufacturing sector. Norwegian industry lost export market shares in the late 1980s in spite of the
booming conditions abroad and substantial capacity slack at home.
It was recognised that a substantial revision of economic policy would be necessary and that the
problems created by inflation had to be taken seriously. The exchange rate was chosen as the
nominal anchor in 1986. A fixed exchange rate was an intermediate target for achieving low and stable
inflation. Inflation fell gradually to 2-3 per cent in 1991-1992.
We had to abandon the fixed exchange rate policy in 1992. An important reason was the weakness
inherent in the fixed exchange rate regime in a world with free capital flows and deep financial
markets. The krone exchange rate showed, however, little change to begin with and rapidly found a
new range.
A formal inflation target for monetary policy was introduced in the spring of 2001. The operational
target of monetary policy as defined by the government is inflation of close to 2.5 per cent over time.
Many countries had already gained many years' experience in operating such a system. New Zealand
was the first in line towards the end of the 1980s. Canada followed shortly thereafter.
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. Through
the 1990s, inflation generally remained in the interval 11⁄2 - 31⁄2 per cent.
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. In order to make forecasts for
inflation and output, we must also judge how interest rates will develop in the future. If inflation
deviates substantially from the target for a period, the interest rate will be set with a view to returning it
gradually to the target, so that we avoid substantial variations in output and employment. This chart
Inflation
illustrates the judgement as published in the latest Report.
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 take into account particularly
unfavourable developments.
In a period of increased cross-border labour flows, substantial technological advances, changes in
competitive conditions and new trading patterns, Norway may, with our very open economy, have to
accept somewhat greater variation in inflation and deviations from the target, as we have witnessed
over the past two to three years.
Challenges in an oil economy
Petroleum revenues pose as mentioned special challenges to stabilisation policy. The experience of
other countries that had received large, unexpected income from natural resources was not
encouraging. The classic example is Spain's substantial revenues from the colonisation of America in
the 1600s. The historian David Landes1 summarised the Spanish experience as follows:
Landes stated that easy money is bad for a country. It is very tempting to live comfortably on this
income and be less concerned about safeguarding other revenue sources. In that case, the country is
poorly poised to cope with an end to easy money.
The oil age in Norway has spanned 30 years and it appears that it will continue for many years ahead.
Petroleum activities give Norway an economic base that is not available to many other countries. But it
also presents us with many challenges.
First, petroleum wealth is part of Norway's national wealth. 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. By doing so, we diversify risk. We must also strive for
an equitable distribution of this wealth across generations.
The Norwegian authorities have been successful in ensuring that the bulk of petroleum wealth benefits
society as a whole. Both the state's ownership interests through the State's Direct Financial Interest in
petroleum activities (SDFI) and the tax system have contributed. The companies that extract oil earn a
reasonable return on their investments and have incentives to invest, but the economic rent has
essentially accrued to the general public.
Second, the size of the cash flow from petroleum activities also varies. If petroleum revenues were to
be used as they accrue, this would lead to wide fluctuations in demand in the Norwegian economy.
Third, the use of petroleum revenues has an impact on competitiveness in Norwegian business and
industry. A high level and substantial variations in the use of petroleum revenues would have a
negative impact on internationally exposed industries.
The establishment of the Government Pension Fund and the spending guidelines for petroleum
revenues are intended to meet these challenges.
The government earns large net cash flows deriving from the oil companies' sale of petroleum
products in foreign markets. The Pension Fund serves as a buffer between current petroleum
revenues and spending these revenues in the Norwegian economy. All central government revenues
from petroleum operations shall be transferred to the Fund.
According to the fiscal rule that has been approved by the Norwegian parliament, petroleum revenue
spending shall be limited to 4 per cent or the expected annual real return on the Pension Fund over
time. This partly insulates the economy from fluctuations in oil prices and extraction rates in the
petroleum sector - and when followed it ensures that revenue spending in the Norwegian economy is
at a level that can be sustained over time. The difference between the net cash flow and spending is
reinvested in foreign financial markets.
The Petroleum Fund also functions as a buffer and dampens the wide fluctuations in the krone
exchange rate that petroleum revenues might otherwise have generated. Operators in the foreign
exchange market may at times have a tendency to underestimate the Fund's function as a stabilisation
mechanism. The capital outflows through the Fund contribute to both curbing the appreciation of the
krone and maintaining its stability.
At the end of 2005, the market value of the Pension Fund's portfolio was roughly 73 per cent of GDP.
As shown in the chart, the value of the 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.
On the other hand, Norway, like many other countries, is facing substantial fiscal challenges.
Financing the large pension payments that will have to be disbursed in the coming years will be very
demanding.
Final remarks
To sum up, Norway has a market economy and a large government sector. The way in which
economic policy is oriented today reflects the knowledge gained and the lessons learned.
We know from experience that fiscal policy alone cannot ensure a high level of employment. The
structure of the labour market and wage formation are probably of greater importance. The direct
regulation of credit, interest rates and capital movements collapsed and was phased out in the 1980s.
Price regulation no longer plays a role as a macroeconomic instrument. The scope of business policy
has become more general.
The most important contribution monetary policy can make to sound economic developments in the
long term is low and stable inflation. Low and stable inflation has contributed to solid growth in the
global economy in recent years.
Thank you for your attention.