Svein Gjedrem: Monetary policy from a historical perspective
Speech by Mr Svein Gjedrem, Governor of Norges Bank (Central Bank of Norway), at the
conference to mark the 100th anniversary of the Association of Norwegian Economists, Oslo,
16 September 2008.
The text may differ slightly from the actual presentation.
* * *
Introduction
Let me begin by offering my congratulations to the Association of Norwegian Economists on
its 100th anniversary. One hundred is a respectable age. In Norway, the introduction of a
university degree in economics was certainly an important stimulus in the first part of the last
century. In the period since the Second World War, major changes in society have increased
the demand for expertise in the field of economics.
And economists are constantly gaining new insights. This also applies to the field of central
banking, even though one of the fundamental central bank responsibilities - to safeguard the
value of money - was as important 100 years ago as it is today. Monetary policy in Norway
has changed considerably over the past 100 years. The government, with the support of the
Storting, has now defined an objective for monetary policy of low and stable inflation. Norges
Bank sets its interest rate with a view to achieving price stability. This has not always been
the case.
Monetary policy in Norway
Norges Bank was established in 1816 and was placed directly under the Storting (Norwegian
parliament). The government had no control or influence. The Bank was authorised to issue
banknotes that were to serve as legal tender. To ensure stability in the value of money, the
banknotes were to be redeemable in silver, although this was not achieved until 1842. Later
- in 1874 - the basis for the monetary system was changed from silver to gold. One year
later, in 1875, Norway entered the Scandinavian Currency Union with Sweden and Denmark.
Norway was a member of the currency union until around the mid-1920s, but after 1914 the
union lost its practical significance.1
The latter half of the 1800s was generally marked by stable prices. Hence, when the first
students completed their degree in economics in 1908, price stability was perhaps not the
main concern of economists.
When the First World War broke out in 1914, confidence in the monetary system faltered.
The obligation to convert banknotes into gold was suspended. The money supply was out of
control and inflation rose sharply. It reached 40 per cent in 1918. When Nicolai Rygg took
office as chairman of the board of Norges Bank in 1920, he regarded it as an obligation to
restore the gold value of the krone to previous values, i.e. parity policy.2 This was considered
a pre-condition for restoring confidence in the monetary system and in money as a means of
payment and saving vehicle.3
The crisis in the 1930s, which severely affected the Norwegian economy, led to changes in
views regarding economic policy. The parity policy experience was probably an important
reason for this change. As a result, there were few objections when after liberation in 1945,
the government with the Storting's support made decisions that under the law were the
responsibilities of the central bank. This was the start of a new era of reduced independence
for the central bank. The discount rate, for example, was reduced to 2.5 per cent on the
recommendation of the government in January 1946. The Bank's task was to implement the
government's decisions. Norges Bank nonetheless played an important role in shaping
monetary policy, for example serving as an interface with international financial community
and acting as adviser and facilitator.4
In the first decades after the Second World War, it was firmly believed that the economy
could be fine-tuned in the desired direction by coordinating instruments established by the
central authorities. In Norway, this resulted in a period of low nominal interest rates set by the
government authorities, direct regulation of credit through quotas set out in a separate credit
budget, channelling of loans for special purposes via state banks, regulation of cross-border
capital movements, a fixed but adjustable krone and occasionally the use of price and wage
regulation. For a period, regulation and fine-tuning seemed to be having the intended effect.
But in the 1970s, inflation got out of control in Norway and in a number of other countries.
The Norwegian economy experienced a price/wage spiral. Although the krone was devalued
several times in the 10-year period from 1976 to 1986 in pace with high price and wage
inflation, this was nonetheless not sufficient to prevent a decline in the manufacturing sector.
In 1980, Odd Aukrust, Head of Research in Statistics Norway, stated the following with
regard to developments in the Norwegian economy: "Unfortunately there is even less reason
for optimism this time. It seems that competitiveness in Norwegian manufacturing will
deteriorate in the year ahead. The main problem is that no one can control price
developments. With annual inflation at approximately 10 per cent, no one dares to invest in
measures that could stop this price carousel."5
High inflation showed that the economic policy framework was not functioning as intended,
and the importance of providing the economy with a nominal anchor became evident. In the
light of experience, it became clear that unemployment could not be permanently reduced by
merely accepting higher inflation.6
One of the first to formulate this clearly in the debate in Norway was then Director General at
the Ministry of Finance Per Schreiner, who wrote in 1982 that:7
"It has long been a commonly held view in the Nordic countries that a policy choice can be
made between price stability and full employment. There are strong indications that this
choice does not exist [...] Personally, I am no longer in doubt that controlling inflation is
essential to achieving other social objectives."
In line with developments in other countries, a shift in monetary policy also took place in
Norway. In 1985, legislation was adopted which gave Norges Bank greater independence.
After the last devaluation in 1986, monetary policy was oriented towards a fixed exchange
rate. The fixed exchange rate was to be our nominal anchor.
The fixed exchange rate regime was abandoned in December 1992 in the wake of the crisis
in the European Monetary System (EMS). The UK withdrew from the EMS and our
neighbours Sweden and Finland also had to accept a floating exchange rate. The crisis
revealed the built-in weaknesses of a fixed exchange rate regime in a world of free capital
flows and deep financial markets. And it did indeed finally spread to the Norwegian krone.
When the fixed exchange rate policy was abandoned, there was a risk that the Norwegian
economy might again lose its nominal anchor. But the krone exchange rate showed little
change, and rapidly found a new range.
From 1996 the conditions necessary for exchange-rate stability deteriorated. With a
strengthening of central government finances, the minority government was not able to
contribute sufficiently to restraining growth in government spending. Wage growth was
substantially higher than in other countries. Moreover, petroleum revenues fluctuated widely
from year to year and turbulence in international financial markets spilled over to our
currency. The krone exchange rate fluctuated in spite of the active use of Norges Bank's
instruments. Volatility increased further in 1998. The Norwegian krone fell in value. In
response to this the interest rate was raised on several occasions through 1998.
The years between 1996 and 1998 showed that it was difficult to use the interest rate to
finetune the exchange rate. Norges Bank Governor Kjell Storvik discussed the situation in a
speech he gave in August 1998: "Let us be mindful of the well known fact that a lower
exchange-rate can amplify inflation expectations and that these expectations can in turn
contribute to expectations of a weaker exchange rate, and in themselves amplify the
depreciation tendency. Price expectations would then be self-fulfilling. The interest-rate level
that has now been established should, in addition to directly contributing to stabilising the
krone exchange rate, also curb price expectations."8
In recognition of this fact, Norges Bank gradually gave greater weight to influencing inflation
developments as a prerequisite for a more stable krone exchange rate over time. As stated
in an article in the Norwegian daily newspaper Aftenposten in May 19999: "In the
discretionary assessments on which monetary policy is based, Norges Bank gives weight to
fundamental preconditions for exchange-rate stability over time. Price and cost inflation must
be brought down towards the level aimed for by the euro area countries. At the same time
the situation must be avoided whereby monetary policy in itself contributes to a downturn
with deflation."
The division of responsibility in economic policy was even more clearly defined when the
government presented new economic policy guidelines in March 2001. An inflation target for
monetary policy was introduced, with an operational target for annual consumer price
inflation of close to 2.5 per cent over time. The fiscal policy rule was also introduced.
According to this rule, the cyclically adjusted non-oil government budget deficit shall
correspond to the long-term real return on the Government Pension Fund - Global. The
division of responsibility in economic policy has since been the following:
•
Monetary policy steers inflation in the medium and long term and can also contribute
to smoothing swings in output and employment.
•
The central government budget - growth in public spending - affects the real krone
exchange rate and the size of the internationally exposed business sector in the
long term. At the same time, developments in government expenditure and
revenues must ensure a reasonable distribution across generations.
•
Wage formation, the structure of the economy and incentives determine how well
and how efficiently we utilise labour and other real economic resources.
It is the government that defines the inflation target. Norges Bank sets the interest rate with
the aim of reaching the inflation target. The Bank must account for its decisions. It does so
through an annual report on the conduct of monetary policy. The report is submitted to the
Ministry of Finance to be presented to the King and communicated to the Storting. The
government's assessment is presented in the annual credit reports. The governor of Norges
Bank is also required once a year - first in 2003 - to appear at an open hearing on monetary
policy of the Standing Committee on Finance and Economic Affairs.
What can we learn from history?
We can learn from history. The experience of the 1970s and 1980s was a costly one. After
the last devaluation in 1986, a fixed exchange rate policy was introduced and the economy
went through a period of extensive restructuring. Confidence in the krone had to be restored
to prevent persistently high inflation. This required very high interest rates. The Norwegian
economy entered into the deepest recession since the interwar period. Unemployment rose
from around 2 per cent in 1987 to 6 per cent in the winter of 1992/1993. Many companies
went bankrupt and households faced debt problems. There was a crisis in the banking
sector. Inflation only decreased to 2-3 per cent in the early 1990s. The years between 1986
and the beginning of the 1990s provide a realistic picture of the cost of bringing down
inflation from a high level.
Inflation has been low and stable since the mid-1990s because the objective of monetary
policy has been to provide the economy with a nominal anchor. Economic agents should be
able to rely on the value of money remaining stable over time. High inflation and inflation that
varies considerably over time result in random changes in the real value of assets and debt.
This leads to unintended transfers between creditors and debtors. When inflation is high and
variable over time, the function of prices as an information vehicle is also impaired. When
inflation is low and stable, changes in relative prices are more easily discernible, and it is
easier for households and businesses to make decisions about consumption and investment.
Low and stable inflation is the best contribution monetary policy can make over time to
employment, economic growth and welfare.
The central banks in the first industrialised countries have attained a more independent
status over the past 20 years. This is partly because Germany and its firm Bundesbank fared
better during the period of high inflation in the 1970s and 1980s than many other countries.
Arguments in favour of an independent central bank are also found in economic theory.
Studies by Finn Kydland of Norway and Edward Prescott of the US at the end of the 1970s
on economic policy rules were groundbreaking.10 The insights gained from these studies
provide arguments for ensuring central bank independence and deriving monetary policy
objectives.
History and theoretical studies have taught us that adverse effects may occur if the
authorities do not take into account that households and enterprises are forward-looking
when making decisions about consumption, investment, wages and prices. They base these
decisions their expectations of economic policy in the future, not only on today's policy. It is
therefore important that the authorities do not sow doubt, but on the contrary pursue a
longterm and predictable policy. The authorities must be credible and inspire confidence. There
must be consistency between the stated objectives of economic policy and what is actually
done to achieve these objectives. This is the most important reason why the conduct of
monetary policy has been delegated to the central bank in Norway, as is the case in other
comparable countries.
The question of central bank independence is not new. When Norges Bank was established
almost 200 years ago, there was much discussion about where to locate the head office.
Trondheim was chosen and one of the arguments in the debate was that locating the central
bank far from the seat of government would prevent the central bank from coming under
political pressure. It was not until 1896 that the Storting decided that the central bank should
be moved to Kristiania (now Oslo). The strongest objection to relocating the central bank
from Trondheim to Kristiania was expressed by Director Karl Gether Bomhoff, who was in
fact also a friend of Henrik Ibsen from his Dresden period.11 Bomhoff was a member of the
Bank's board for 35 years, from 1885 to 1920. In 1893, he became the first permanently
employed chairman of the board and the first director for the entire central bank. He
emphasised that Norges Bank had to be independent and free of pressure from the political
authorities and civil servants He stated at the time:12
"As I have said before, I believe that the Bank can be managed just as well from Trondheim
as from Kristiania, and I believe, better, because in the capital city it will be subject to
pressure that it is impossible to know how long the board will be able to resist, since there
are those in Kristiania, and perhaps also in the government, that may seek to change the
Bank's objectives. Norges Bank should be maintained as an independent institution under
the control of the Storting."
Geographical distance to markets and government has no significance today, but it may well
be said that Bomhoff expressed thoughts that were articulated in more modern terms by
Kydland and Prescott 70-80 years later.
History has also taught us that fiscal policy has considerable bearing on the role monetary
policy can play. If the government's debt is too high, the political authorities have an incentive
to increase inflation in order to reduce the real value of the debt. It is then difficult to anchor
inflation expectations. No monetary policy can secure the nominal anchor if government
spending spins out of control. Monetary policy and fiscal policy must therefore have a
common platform.
The interaction between the political authorities and the central bank can be effective if the
authorities take the role of "leader", and the central bank the role of "follower". Inflation
targeting provides a clear indication as to how the central bank should respond in different
situations. The political authorities are the "leader" in this interaction. They can internalise the
central bank's - the "follower's" - pattern of response in their actions.13 Government
spending growth can then be decided knowing the effect it will have on interest rates.
We have also learned from history that financial bubbles and crises occur from time to time.
Even though financial crises may seem to be very different, they usually have a common
feature. The US economist Hyman P. Minsky was of the view that this could be summed up
in five stages: First a shock, often triggered by a technological breakthrough or changes in
legislation and regulation of the business sector, followed by a period of growth - a boom -
where new technology and opportunities are applied. This turns into euphoria - people get
carried away. At some point some people wake up and take out their profits by selling. This
triggers a fall in asset prices and equity prices and ultimately leads to panic and a crash.14
This is referred to as the Minsky moment.
We are now in the midst of a global financial crisis, which originated in the US housing
market. Combined with new financial instruments that were intended to spread risk - but that
did not prove to be viable - the US housing crisis has spread to many parts of the world and
whose outcome is still unknown. Seven or eight years ago, we experienced a similar
situation, although not as severe, when the dotcom bubble burst. Many also recall the crises
in the emerging market economies in Asia, Central Europe and South America ten years ago
and the downturn in the Japanese economy in the 1990s. Nor will we forget the banking
crises in the Scandinavian countries in the early 1990s. However, financial crises are nothing
new. We also find parallels to today's crisis if we go back to the Great Depression in the
1930s. If we go much further back in history, to the 1600s, the same phenomenon occurred
with speculation in the tulip trade. In Holland, they discovered at an early stage that a virus
could give tulips stripes and beautiful colour. A forward market for bulbs developed in the
1630s. In 1636 market prices rose sharply and in a short time that winter bulb prices
increased 25-fold. This did not last. The market collapsed in February 1637 and prices fell to
5 per cent of earlier levels in the course of few days. Auction lists a hundred years after the
crisis show prices from one per cent to 0.005 per cent of the level before the collapse.15
Moving depictions of financial crises and their effect on people can also be found in
imaginative literature. The Norwegian author Alexander Kielland depicts the local financial
bubble in Stavanger in the 1880s in his book Fortuna. There was a surge in credit growth
and speculation in commercial bills that did not represent actual values. Speculation formed
the basis for quick gains and it all ended in bankruptcies and banks that failed. One of the
climaxes in the book is a scene where Taraldsen - the old messenger from Norges Bank -
realises that the financial bubble is about to burst:
... in breathless surprise Taraldsen asked again: "Aren't your bills of
exchange to be redeemed today?"
"No."
"Mr. Marcussen! People say that you are a jocular man; but this -" "I'm not
joking - damn it!"
Old Taraldsen straightened up; everyone was hunched over their work;
only young Rasmus' eyes met his. The boy was white as a sheet; he began
to understand. It also started to become clear for old Taraldsen; but
immediately afterwards, he became very confused again; because he
understood the entire scope of this; he had the entire town's bills of
exchange in his head; and of course he had seen a lot of this kind of thing
during his long life but all of those were trifles compared to what would
happen now.
His voice shook as he almost ceremoniously asked:
"Will Carsten Løvdahl's papers be protested?"
"Yes," replied Marcussen without looking up.
Old Taraldsen trotted out of the offices; but on the steps he met the
messenger from Aktiebanken: "Is it true? - Taraldsen!"
"Now the entire town is going to collapse," answered the old man, throwing
up his arms in despair.
Kielland's description of a financial crisis and its consequences was realistic. There was
speculation then and there is speculation today, but in other kinds of financial instruments
than at that time. We might find employees at Lehman Brothers today who have expressed
themselves in the same way as old Taraldsen.
It seems to be an inherent property in financial markets that financial bubbles and crises
occur from time to time. A monetary policy that is oriented towards stabilising inflation and
inflation expectations will reduce the impact. We have seen that when the interest rate is
raised to restrain the rise in prices for goods and services, it also has the effect of stabilising
house and property prices. In some areas, however, regulations and frameworks - cf. the
substantial tax subsidy benefiting homeowners - amplify fluctuations in asset prices and
lending.
Conclusion
The monetary system has changed through history. If we go far enough back in time, money
consisted of coins with a certain quantity of silver or gold. The quantity of silver and gold
therefore limited the volume of money that could be produced. This ensured that coins were
attractive as a means of exchange and as a means of storing value. On the other hand,
paper money cost almost nothing to produce and can be therefore be printed in unlimited
quantities. Over the past 100 years, there have been several periods when paper money
could be redeemed for silver or gold. For example, this was for a long period the case in the
Scandinavian Currency Union. In the period after the Second World War and up to the
beginning of the 1970s, the US dollar had a fixed price against gold while other currencies
had a fixed exchange rate against the US dollar. This was the basis for what was known as
the Bretton Woods monetary system. Paper money had a value because the central bank
was obligated to redeem it for gold.
A system whereby paper money can be redeemed for gold is nevertheless more fragile than
a system whereby coins must contain a certain quantity of the precious metal. A central bank
can quickly cease to redeem paper money for gold, or redeem notes at a lower gold price
than prevailing earlier. This is what happened when the Bretton Woods system collapsed
after the Federal Reserve was no longer obligated to redeem dollars for gold.
Today's monetary system may even be more fragile. Gold and silver belong to the past.
Today it is deposit money and paper money that prevail. People must be confident that
deposit money can be converted into paper money. The central bank must promise that the
value of paper money is maintained. If people do not believe that the central bank will keep
its promise, they will want neither deposit money nor paper money. Money will then lose its
value. Other currencies or goods with direct utility value will take over as a means of
exchange and a means for storing value. This reduces the effectiveness of the economic
system.
We are of the view that it is an important but demanding task to safeguard the value of
money. It is our own economic policy that determines the value of our money in the long
term. It is therefore important to remember that price stability does not come about on its
own.
Thank you for your attention.
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•
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•
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•
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