Irma Rosenberg: Monetary policy and the conditions for growth
Speech by Ms Irma Rosenberg, Deputy Governor of the Sveriges Riksbank, at an economics
conference, Klippan (in the south of Sweden), 1 November 2004.
* * *
Let me begin by thanking you for the invitation to come here and speak.
The subject for this year's conference is growth. This is a subject close to the hearts of economists
and one that often crops up in debate. What factors determine economic growth in the long term, and
what can be done to increase it? I intend to approach this question from a central bank perspective. Is
it possible, for instance, for the Riksbank to use monetary policy to raise the level of long-term growth?
Are there means of affecting growth? Long-term, or potential, growth is a many-faceted concept and I
intend to begin by speaking about the prevailing theory with regard to links to monetary policy. I shall
then go into more detail on the underlying determining factors behind the long-term growth rate and
briefly describe trends in recent years. I shall also speculate on possible future developments and
what can be done to improve long-term growth prospects.
Long-term growth and monetary policy
Let us start with Figure 1, where the blue line shows developments in real GDP in Sweden during the
period 1950 to 2003. One can see that there has been a clear trend increase during these years. In
1950, the total output value was just over SEK 500 billion, measured at current prices, and in 2003 it
was around SEK 2,300 billion. However, one can also see that this has not been an even
development. GDP growth has been more rapid during certain periods than others and during some
episodes, such as the 1990s crisis, the level of output even fell. But seen over a longer period, the
increase in GDP has been relatively stable. On average, output rose by 2.7 per cent during these
years.
The orange line in the figure shows how a measure of trend, or potential, output has developed over
the same period. Potential output in principle reflects the capacity limits put on production of goods
and services at a given point in time. One type of limit is the access to resources for production -
factors of production - in the economy. This normally covers two main factors: labour force and
physical capital, i.e. factories, machinery, etc. Another limitation is how productive these factors of
production are, that is to say, how much that can be produced in, for example, one hour of work or use
of the machinery.
It is important to emphasise that potential output is not an estimate of a ceiling for production. It is
therefore not a measure of the level of output that would apply if the entire labour force were employed
and all physical capital was used to the maximum. By potential output and potential growth we mean
instead the output and growth that is possible without serious imbalances arising in the economy; the
level of output at which supply and demand correspond and actual and expected inflation are in line
with the central bank's inflation target (assuming that there is one). The potential output level is not
constant over time; it usually shows a growth trend, which is illustrated in Figure 1. This is mainly
because technological developments mean that higher output can be achieved with the same amount
of factors of production. Another reason could be long-term changes in the factors of production. The
change in potential output from year to year is equal to the potential growth of the economy, which
thus is the growth rate that is sustainable in the long term. Figure 1 shows the potential output level
according to a simple statistical method where the trend, and thereby also the potential growth rate, is
allowed to vary over time.
The difference between actual and potential output is known as the output gap, and this reflects the
cyclical variations in the economy. A negative output gap, that is to say, when actual output is lower
than potential output, is usually connected with a recession. The demand pressure for goods, services
and the factors of production is then small and there are ample unutilised resources in the economy.
Price and wage increases are small and inflation is usually below the central bank's target level. When
there is a positive output gap, the circumstances are normally the reverse. Then, actual output is
higher than potential output, resources are strained, unemployment is lower than normal and inflation
is higher than the target level. When the economy is in balance, the output gap is closed, that is to
say, equal to zero.
In practice, both actual and potential output is affected by various shocks which mean that the output
gap is rarely zero. If there is a situation with a negative output to begin with, the economy can grow
more rapidly than its potential output rate for a short period. The fact is that this is necessary in such a
situation in order to close the gap and bring the economy back into balance. However, problems arise
if the economy grows at a more rapid rate than that allowed by potential growth over a longer period of
time. Then production resources become strained, bottlenecks arise and tendencies appear towards
overheating. In this way, potential growth for the economy can be likened to a recommended speed
from which it is important not to deviate for too long a period.
It is in this short-term perspective that monetary policy can play a role in influencing growth. As the
output gap reflects the demand pressure in the economy and the demand pressure in turn affects
inflation, monetary policy is largely about choosing an interest rate that will make the output gap as
small as possible. If actual and potential output coincide so that the output gap is closed, inflation is in
line with the Riksbank's target of 2 per cent, assuming that there is confidence in the policy conducted.
This means at the same time that the size of potential growth affects the scope for conducting
monetary policy. The higher the long-term sustainable growth rate, the higher the actual growth rate
can be without resource utilisation becoming so high that inflation takes off and the Riksbank is forced
to intervene to subdue demand.
This reasoning is of necessity somewhat simplified. In actual fact, temporary shocks to inflation can
occur that lead to inflation not being on target, despite the fact that actual and potential output are at
the same level. However, in this case, inflation is in practice probably close to the target, so a more
realistic description is therefore that the target on average is met when the output gap is closed.
Moreover, monetary policy affects demand with some lag. Consequently, the Riksbank adjusts the
interest rate in accordance with forecasts of inflation a couple of years ahead. During this period
shocks can of course occur in the economy that couldn't be foreseen at the time of the forecast. We
therefore attempt to avoid excessive fluctuations in the economy by gradually bringing inflation back
towards the target.
Thus, in the short term, the Riksbank can affect output and employment by adjusting the interest rate,
thereby stimulating or cooling down economic activity. But in the long run, attempts, for example, to
make the economy grow faster than its long-term sustainable rate would only result in higher inflation
without any change in output or employment. As I mentioned, the economy's long-term capacity is
limited by the size of the factors of production and their productivity. These factors cannot be governed
by monetary policy. By changing the interest rate, the Riksbank can affect actual output growth in the
short term but not the potential, long-term growth rate. Monetary policy can possibly indirectly lay the
foundation for good growth in the long term by ensuring that our payment and price-setting system
functions in an efficient and confidence-inspiring manner.
What determines long-term growth?
As you understand from what I have said this far, it is important for the Riksbank to make a good
assessment of the Swedish economy's potential growth capacity in order to conduct successful
monetary policy. We therefore return to this issue fairly often in, for instance, our Inflation Reports.
One difficulty is that potential output and potential growth cannot be observed directly in the same way
as actual GDP and employment. Instead, the measure must be estimated using statistical methods
and there are a number of these, each with its own advantages and disadvantages. In other words,
there are several different ways of drawing the orange line in Figure 1, and the different methods have
demonstrated fairly differing results. The Riksbank therefore uses several different methods of
calculating the output gap. We also supplement our analysis with a number of other indicators of
resource utilisation in the economy.
As I mentioned earlier, long-term sustainable growth in the economy is determined partly by
technological developments in society. This means that production per hour worked shows an
increasing trend over time and thus is one of the more important contributions to long-term growth. But
long-term changes in the factors of production can also affect potential growth. If we measure the
labour force's contribution to production in the number of hours worked, one can express it simply as
our long-term growth potential depending on how much we work and how productive we are.
However, it is important to point out that it is the more long-term developments in productivity growth
and the change in labour contributions that are significant in this context.
I mentioned earlier that different methods of estimating potential growth can give quite different results.
One of the reasons is that it is difficult to distinguish the more long-term sustainable trend from
temporary developments. It is of course no easy task to determine whether a change is permanent
when we receive new statistics on economic developments. However, it appears that this can even be
difficult to determine afterwards, when studying the historical trend. As I intend to illustrate, this applies
to both productivity and labour supply. So, allow me to proceed to look more closely at the determining
factors behind long-term growth and see how they have developed historically and what can be said
about future developments. I shall begin with labour productivity.
Productivity growth
Figure 2 shows the annual change in labour productivity, measured as GDP per hour worked, together
with an estimate of the long-term trend. At the bottom of the figure is the average rate of change
during different periods of time. We can see that productivity growth is nearly always positive and
varies considerably from year to year, but also that it has had a tendency to increase over time,
particularly during the 1990s. This is a clear difference compared with the previous decade. On
average, the increase in productivity was 1.2 per cent during the 1980s. During the 1990s, there was a
rapid increase and productivity growth reached an average level of above 2 per cent. This average
subsequently remained at that level for the remainder of the period.
What is the reason for this more favourable development? We do not have any certain answers, but
there are still some factors that have most probably contributed to this development. To begin with, we
must remember that the Swedish economy underwent a severe crisis at the beginning of the 1990s
and this probably contributed to raising productivity growth during the first half of the decade. Many
companies went out of business during the crisis; companies with relatively low profitability. Although
this led to an increase in the productivity growth measured during a transitional period, this was at
substantial cost to those who lost their jobs and the economy as a whole, as a large part of the
economy's available resources were not utilised.
During and directly after the crisis there were also a number of structural changes in the economy that
are likely to have affected developments. Fiscal policy was tightened, with an expenditure ceiling and
surplus target, while monetary policy was targeted at achieving a low, stable inflation rate. Such a
stabilisation of the macroeconomy means that uncertainty about issues such as future tax rates and
price developments decrease, which in turn makes it easier for households and firms to plan.
Comparative studies of different countries have shown that this can have longer-term effects, partly
through a rise in productivity. Furthermore, several markets were opened to both domestic and
international competition through deregulation. Greater competition increases the pressure on
profitability, which raises motivation for making production and organisations more efficient, for
instance with the aid of more modern technology.
There were also other types of structural changes in the Swedish economy during the 1990s. Up to
the beginning of the 1990s, the number of people employed in the public sector increased, with a
corresponding decline in the private sector. After the crisis there was a turnaround, and the private
sector's share began to increase again. A shift from the public sector to the private sector most
probably entails an increase in productivity throughout the economy. One complication in this context
is that, for technical reasons, it is difficult to measure productivity growth in the public sector in the
National Accounts. The studies that have been carried out indicate that it is lower in the public sector
than in the private sector.1 So far, the statistics are quite simply based on the assumption that there is
no productivity increase in the public sector at all.
Another important change in the significance of different sectors in the economy was the rapid
expansion in the information and communications technology sector, particularly during the second
half of the 1990s. There has been lively discussion of the actual significance of information technology
for productivity growth in this period. What we can see, is that a large part of the productivity growth
during the latter part of the 1990s originated from the sectors producing information and telecom
products. Compared with this IT-producing sector, developments in the IT-using sectors was not at all
as impressive, despite large investments in IT during the period.
What does all this mean for future long-term productivity growth? The very high growth figures for
productivity during the latter part of the 1990s reflected both the macroeconomic stabilisation, an
expansion in the private sector relative to the public sector, and in particular the IT expansion. It is
unlikely that the development will continue in the same way in the future. However, we know that
productivity growth has been surprisingly high in recent years. Many economists are busy working on
the question of which factors lie behind this development. It is clear that, unlike the 1990s, it is not a
question of high productivity growth in the IT sector and major investment in IT. One theory that has
been put forward is that it may perhaps be explained by delayed effects in other sectors of earlier IT
investment; that it has quite simply taken time for companies to adjust and to take advantage of the
new technology.
It is thus difficult to say anything about the durability of the most recent development. However, there
are many indications that the long-term increase in productivity now is higher than it was during the
1980s. The widespread structural changes that took place during the 1990s are also an indication of
this. Nor should it be forgotten, that the labour force is better educated today than it was ten years
ago, particularly with regard to the percentage of those with a university education. There are studies
indicating that the improvement in qualifications has also contributed to the growth in productivity.
The possibility to improve productivity using economic policy, in addition to the basic contribution
made by price stability and healthy government finances, is probably fairly small, as it is difficult, for
instance, to govern how and when technological breakthroughs will occur. On the other hand, one can
try to affect the conditions for good productivity growth, for instance by ensuring that competitive
pressure is maintained in the economy and by conducting a good research and education policy.
Labour supply growth
Let us now leave productivity growth and move on to the other important component, the labour
supply. Figure 3 shows the annual growth in the number of hours worked throughout the economy
from 1981 onwards. As before, I have included an estimate of the long-term development. As can be
seen, it is only weakly positive for the period as a whole. During the 1980s, the labour market was
strong and we can see that the number of hours worked essentially grew during the whole period, up
to the crisis at the beginning of the 1990s. The fact that the crisis had a dramatic effect on the labour
input in the economy is also clear. On average, developments then improved during the second half of
the 1990s, but the positive trend has been broken in recent years. What lies behind this and what
conclusions can be drawn with regard to the future development of the labour supply?
One way of examining what has driven developments is to divide up the number of hours worked into
different sub-components. The number of hours worked in the economy is determined partly by how
many people actually work and partly by how many hours each person works. The number of people
in work is determined first and foremost by how large a percentage of the population are of working
age, defined here as 20-64 years of age. For various reasons, not all of these people are available for
work, so the labour supply is also affected by the percentage of people of working age that are
included in the labour force. Of the people in the labour force, some are unemployed and some are
employed. Finally, owing to various types of absence from work, only a certain percentage of the
employed actually contribute hours worked in production. If one totals the changes in all of these
components and also takes into account how much each works in a given year, one obtains the
change in the number of hours worked that year.
By studying the relative development of the components over time, it is possible to see how the
significance of different factors has varied, and also to speculate about the long-term trend in the
future labour supply. In this context there are many interesting relationships to observe. Let me point
out some aspects that illustrate some of the problems the Swedish economy is currently facing and
will be struggling with in future.
Figure 4 shows the population growth and the change in the number of people of working age. The
part of the curves shown as a broken line represents Statistics Sweden's forecasts. As you can see,
developments have varied quite a lot during this period, and unlike what many people may believe, the
demographical development during the 1990s was relatively favourable from the perspective of the
labour force. The growth in the working age population has been higher than the total population
growth, so the percentage of people of working age has increased during the period. As can be seen,
this development will deteriorate dramatically towards the end of this decade. It is quite simply an
illustration of the problem of having an ageing population, which means that the dependency burden
for those of working age will increase dramatically.
Another important observation refers to the percentage of the population of working age who are
included in the labour force and the percentage of people in the labour force who are employed.
Figure 5 shows that both the percentage of the labour force and the percentage of those employed
vary according to the economic cycle. When economic activity slows down, and it is difficult to get a
job, there is a decline not only in employment but also in the number of people who say they are
actively seeking work.
On the other hand, economic activity cannot explain why the level of both the percentage of the labour
force and the degree of employment appear to have fallen after the 1990s crisis. The degree of
employment fell considerably in connection with the crisis years and has only partially recovered since
then. Moreover, since the 1990s crisis, many of those who lost their jobs have not returned to the
labour market at all. This is ominous, given that economic growth in the past decade has nevertheless
been relatively high in a historical perspective. To some extent, the drop in the labour force percentage
can be explained by education factors. In connection with the 1990s crisis there was a significant
decline in labour force participation among younger age groups, which was connected to tougher
competition for jobs and many young people choosing to improve their qualifications instead of
entering the labour market. Since then, there have been changes aimed at raising the level of
education in society in general, for instance by lengthening upper-secondary school programmes and
expanding university colleges. These education initiatives are highly justifiable in themselves, but they
also entail a lower participation in the labour force and thereby an increased dependency burden for
the active part of the population.
Although some of the decline in labour force participation can be attributed to education factors, this is
not the full explanation. Calculations for 2003 show that close to 30 per cent of the group remaining
outside the labour force were studying. The others remained outside the labour force for other
reasons, with early retirement for health reasons, now known as sickness benefit, as one of the most
common causes. The number of newly-granted early retirements rose sharply from 1997 onwards. In
recent years, this increase has been particularly large with regard to people under the age of 50.2 The
percentage of those participating in the labour force has fallen from around 88 per cent at its highest
point in 1990 to about 82 per cent today. The fact that such a high percentage of people of working
age are outside the labour force will limit growth in the future and will contribute to further exacerbating
the problem of an ageing population.
Figure 6 shows both the percentage of employed actually working and the mean working time for
people in work.3 As you can see from the Figure, developments in these factors also vary according to
the economic cycle. During the boom at the end of the 1980s, the number of hours per person
rocketed while the percentage of people in work declined, partly due to a growth in sick leave. Many
studies have indicated that there is a link between total absence due to sickness and the situation in
the labour market. When the situation in the labour market improves, absence due to sickness
increases, and vice versa. However, this relationship does not seem to apply to long-term sick leave,
which is the type of sick leave that has increased most in recent years. How to resolve this is another
subject much debated at present.
In recent years, both the percentage of people at work and the hours worked per person have fallen
and thus provided a negative contribution to the change in the total number of hours worked in the
economy. The fact that mean working time has fallen is partly due to a decline in overtime and normal
working hours. The reason behind this development is not entirely clear. Cyclical effects as well as the
effects of taxes and benefits are possible explanations. Seen in a longer-term perspective ahead, it is
likely that households will tend to want to reduce the mean working time per person so as to use some
of their increased prosperity in the form of more leisure time.
So what conclusions can we draw regarding developments in the total number of hours worked in the
economy on the basis of this review of the various components? Unfortunately, the prospects are not
so bright if no measures are taken to improve the situation. In a long-term perspective, the
demographic development is very unfavourable because the percentage of the population of working
age is decreasing. The problems will be exacerbated if the rise in early retirement and long-term sick
leave together cannot be broken. Labour force participation and the degree of employment seem to
have attained a lower level following the 1990s crisis. Unemployment also varies considerably
between occupational categories and different parts of the country. This indicates that there are
structural problems and that the functioning of the labour market and the social insurance system must
be improved.
The conclusion that can be drawn is that the weak growth in employment is not mainly due to low
demand in the economy - although economic activity has not been favourable recently. There is thus
no point in seeking the answer to these problems in stabilisation policy. It is structural policy measures
that are needed to improve the functioning of the labour market. There are a number of projects there
that could contribute to raising the labour supply, at least in the medium term. As I understand it, these
include both general measures to increase the labour supply among all groups in the economy and
specific measures to increase the supply among certain groups where there may be a greater
potential for increases.
What can be done to increase the labour supply?
Economic incentives can affect individuals' participation in the work force, but economic theory alone
cannot always determine which effects they will have. Take the example of reduced marginal tax.
While reducing this tax will increase real wages, it does not automatically mean that people want to
work more. This is because the wage increase has two effects. Firstly, it makes work more profitable
relative to leisure and thus contributes to wanting to exchange leisure for work. On the other hand, an
increased real wage means that one receives a larger income for the same amount of work and this
means one can afford more leisure. There are thus two counteracting effects. Purely theoretically, it is
impossible to say what the net effect will be; empirical research must attempt to answer this question.
Many empirical studies have been made in this field, for instance, at the time of the large tax reform in
the beginning of the 1990s. The result of the studies is not unequivocal, but a common conclusion
appears to be that the labour supply calculated in hours increased after the tax reform, although the
size of the effect is much debated. Comparing different groups, the effect seems to have been
relatively larger among women and relatively smaller among those with a low income and/or that work
part-time. One complication with this kind of study is that the labour provided by many people is
probably determined at household level rather than individual level. The labour force participation for
an individual may also be affected by changes in their husband's/wife's/partner's income.
Recently, the focus has moved partly away from pure studies of the effects of the income tax system
to the combined effects on the labour supply of taxes and various benefit and social insurance
systems. The focus has often been on people that work to a smaller extent, that are on sick leave or
that are outside the labour force. We know from economic research that different types of
compensation and benefit affect the individual's reservation wage, that is to say, the wage level that
primarily influences the individual's decision to participate in the work force.
The reservation wage varies from person to person and if the wage level offered on the market is
lower than the reservation wage, the person chooses not to work. One can say that the individual
values his or her time more highly than the market does. The relationship between the wages for work
offered on the market and the individual reservation wage is thus a decisive factor in the decision on
whether or not to work. It is easy to understand that the reservation wage will be affected by taxes,
compensation levels in the unemployment and social insurance systems, rules for early retirement,
etc. Surveys of individuals' choices with regard to labour supply, which take into account both taxes
and various types of benefit, indicate that the forming of the benefit system may have a greater effect
on labour supply than changes in the taxation system.4
Is it possible to say anything about the size of the present driving forces for increasing the labour
supply? The most recent report of the Long-term Planning Commission and the National Institute of
Economic Research's most recent report on the Swedish economy both contain attempts to calculate
the economic driving forces that can make individuals change their decisions regarding labour force
participation. They are studying the driving forces that make people go between unemployment or sick
leave and work, as well as the driving forces that make people work slightly longer hours. Economic
driving forces refers in principle to the effect on disposable income entailed in the change in labour
supply, if one takes into account the effect of different types of tax, benefit and charge, in addition to
direct wage effects. The starting point is that the driving forces are lower the smaller the difference in
income is from changing status, or alternatively the less income one can keep after the increase in the
labour supply.
The Long-term Planning Commission has made calculations that indicate that the economic driving
forces for returning to work are generally low with regard to unemployment and usually even lower
with regard to sick leave. These calculations show that almost four out of ten wage-earners retain
90 per cent or more of their income when they go on sick leave. Approximately one out of ten retains
less than 70 per cent. The survey also shows that the driving forces for working slightly more have
increased since the 1990s, but also that they are relatively low among the lower income groups.5
While a high level of compensation means increased security for the individual in the case of loss of
income, if the negative effects on labour supply are large, they will also entail substantial costs to
society as a whole.
It is important to remember that what I have taken up here is the effects on the labour market's supply
side. But the total effect on the labour market is determined by the interaction between the supply side
and the demand side. If one wishes to affect the functioning of the labour market more radically, it is
probably necessary to implement structural policy measures that will influence both sides. Economic
driving forces are certainly not the only method of influencing the labour supply. Nor is it useful to
focus solely on the size of the compensation levels. The challenge will be to ensure that the various
insurance and benefit systems provide the necessary basic safety net but still maintain a strong
impetus for people to begin work again. It will probably be necessary to make both general changes in
insurance and benefit systems and selective measures to raise labour force participation in groups
where the potential to increase the work input is considered relatively large. Examples of these groups
are younger people, older people and people born abroad.
Conclusion
Let me finally return to my starting point and the discussion of long-term growth. I have mainly
concentrated on the relationship between potential growth and monetary policy. However, we must not
forget that long-term growth has significance for all parts of the economy and one of the most
important goals for economic policy in general is to promote a high level of long-term growth. Growth
is not the same thing as increased wealth, but growth creates a foundation for increased wealth. It
creates greater scope not just for households' private consumption, but also for financing, for instance,
education systems of high quality and a good level of care and welfare and provides better
opportunities to achieve other political goals.
Potential growth sets the framework for monetary policy. Simplified, one can say that the Riksbank's
task is to keep actual output as close to potential output as possible. The higher the long-term
sustainable growth rate, the higher the actual growth rate can be without resource utilisation becoming
so high that inflation takes off and the Riksbank is forced to intervene to subdue demand. Howeve