Svein Gjedrem: Economic perspectives
Annual address by Mr Svein Gjedrem, Governor of Norges Bank, at the meeting of the Supervisory
Council of Norges Bank, Oslo, 14 February 2002.
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Introduction
The world economy is experiencing a slowdown. Growth in the US economy came to a halt last spring.
Overinvestment, particularly in IT and telecom equipment, led to low returns on real capital and
reduced corporate earnings. Stock markets declined when growth prospects were revised. Terrorism
and war added to the uncertainty. These developments had contagion effects on European and Asian
economies. Japan is in a deflationary recession.
The US economy is flexible and seldom remains in recession for a long period. There are some signs
of an early recovery. However, there is a risk of a longer period of stagnation. Companies are highly
leveraged and vulnerable. Household saving is at a low level. There is uncertainty associated with
household wealth as it is invested in stocks and the housing market.
Oil prices have plunged by about 40 per cent since autumn 2000. Prices for other Norwegian export
goods have declined since spring 2001. Exports fell in autumn of last year. The global economic
downturn and the prospect of low import price inflation induced Norges Bank to reduce its key interest
rate in December.
In spite of this, the effects of the global downturn on the activity level in Norway have been limited.
Private and public consumption and housing investment continue to show strong growth. The fall in oil
prices has not deterred oil companies from investing eagerly. Both the central government budget and
the current account are in surplus. The Norwegian economy may weather the downturn without any
substantial impact on the level of activity or employment, but with a continued risk of high growth in
labour costs in the business and public sectors.
Economic policy
The guidelines for economic policy were revised last year. Henceforth, the real return on the
Government Petroleum Fund shall be used over the central government budget. Central government
petroleum revenues shall continue to be transferred to the Government Petroleum Fund and invested
abroad.
Monetary policy shall be oriented towards low and stable inflation. The inflation target is 21⁄2 per cent.
When monetary policy is oriented towards stabilising inflation, it also contributes to stabilising
aggregate demand and output. The inflation target is the nominal anchor for the Norwegian economy.
Low inflation is the objective and the interest rate is the instrument. If it appears that inflation, with
unchanged interest rates, will be higher than 21⁄2 per cent, the interest rate will be increased. If it
appears that inflation, with unchanged interest rates, will be lower than 21⁄2 per cent, the interest rate
will be lowered. Low and stable inflation will be a fixed feature of economic developments. This is
something that the social partners, businesses, borrowers and investors in property and securities can
take as a given.
From 1986, changes in the exchange rate or the prospect of changes in the exchange rate had
implications for interest rates. A stable krone exchange rate was the nominal anchor. In Norway, this
has been reflected in wage determination because labour cost developments among trading partner
countries have been an important reference.
Exchange rates between major international currencies fluctuate widely. The US dollar has
appreciated by more than 30 per cent since 1995. The German mark - the euro since January 1999 -
has depreciated by about the same between 1995 and autumn 2000. The Japanese yen has been
particularly volatile.
Smaller countries have also experienced fairly wide exchange rate fluctuations. The Swedish krona
has depreciated by more than 10 per cent since summer 2000. The Australian dollar has weakened by
over 30 per cent since spring 1997. The UK, Canada and New Zealand have also experienced wide
exchange rate fluctuations. The Norwegian krone exchange rate, on the other hand, has been
relatively stable.
Countries whose exports include a large component of raw materials tend to experience considerable
volatility in their exchange rate. Australia is one example. Fluctuations in commodity prices entail
changes in countries' terms of trade, which measures the ratio of export to import prices. Changes in
the terms of trade have an impact on the exchange rate, which in turn curbs the effects of changes in
commodity prices on profitability in the business sector. The exchange rate therefore serves as a
buffer against changes in the terms of trade.
Norway's terms of trade also fluctuate considerably, primarily reflecting changes in oil prices.
However, a substantial portion of petroleum revenues is invested in foreign equities and bonds
through the Government Petroleum Fund. Changes in oil prices influence the size of the Fund, but
have little effect on the use of petroleum revenues at home. The Government Petroleum Fund thus
serves as a buffer against swings in the oil price, and thereby stabilises the krone exchange rate.
The Norwegian economy may nevertheless be exposed to disturbances of a type that cannot be
absorbed by the Petroleum Fund. We have to be prepared for fluctuations in the value of our currency
that are more in line with the fluctuations observed in other countries. The exchange rate will vary.
This means that economic agents cannot assume that the krone will be stable against the euro, the
US dollar or a weighted average of foreign currencies. It is the inflation target that is the economy's
nominal anchor.
The increase in labour costs is important when Norges Bank's assesses the outlook for price inflation
and sets interest rates. High wage growth, both in manufacturing and other sectors, will affect the
internationally exposed sector through two channels. First, high wage growth will weaken earnings and
employment. Second, the interest rate will be increased. Normally, this will lead to an appreciation of
the krone, with a further weakening of earnings and employment. Manufacturing will, therefore, feel
the effects of high wage growth to an even greater extent than earlier.
Since 1997, labour costs have increased annually by between 5 and 7 per cent. In spite of this,
consumer price inflation has been close to 21⁄2 per cent over the past few years. The krone exchange
rate has appreciated as a result of a wider interest rate differential between Norway and other
countries. Combined with low growth abroad and increased trade with low-cost countries such as
China, this led to a slower rise in import prices. As the world economy recovers, import price inflation
will edge up. A rise in labour costs of more than 5 per cent will then only be consistent with the inflation
target if the krone continues to appreciate.
In the long run, wages must be compatible with the value added that is generated by workers, i.e.
labour productivity. Over time, the increase in real wages is therefore determined by developments in
labour productivity. In Norway, productivity growth has averaged 11⁄2-2 per cent over the last 20 years.
If this continues to be the case, an increase in nominal labour costs of around 4-41⁄2 per cent in the
long term will be consistent with the inflation target.
In general, an unexpected upward shift in labour costs will prompt an increase in interest rates in order
to avoid higher inflation. With a floating exchange rate and unchanged interest rates, an increase in
wage growth of one percentage point will eventually translate into a comparable increase in price
inflation, unless this increase is based on higher productivity. The interest rate increase must be
adjusted accordingly. First, the nominal interest rate must be increased to maintain the real interest
rate. Second, the real interest rate must also be increased in order to prevent inflation from
accelerating.
When wage growth reaches a level that is inconsistent with the inflation target, the result will be higher
interest rates, lower employment and higher unemployment. Similarly, when wage growth is lower
than the level consistent with the inflation target, the result will normally be lower interest rates, higher
employment and lower unemployment. The sharp growth in labour costs in recent years is a source of
higher unemployment. When real wage growth is higher than productivity growth, corporate
profitability declines. As a result, businesses will recruit less and shed more labour. In the public
sector, we will see a growing conflict between budget limits and service production requirements.
A monetary policy that is oriented towards low and stable inflation will contribute to stabilising
aggregate demand and output. As a result, the central government budget will not normally have to be
used actively to stabilise the economy. An increase in unemployment that is due to a higher rate of
increase in labour costs than implied by productivity growth cannot be offset by low interest rates or
higher public spending and tax cuts, but requires changes in the functioning of the labour market.
There is an important interaction between monetary policy and fiscal policy. According to the new
guidelines for fiscal policy, petroleum revenues are to be phased in approximately in pace with the
expected real return on the Government Petroleum Fund. This guideline implies that fiscal policy will
contribute to stimulating aggregate demand in the Norwegian economy every year for many years
ahead. The guideline also implies that the use of petroleum revenues will increase as long as the
Petroleum Fund is expanding.
Variations in oil prices are accompanied by considerable fluctuations in government petroleum
revenues from one year to the next. It is important to prevent these fluctuations from spilling over to
the mainland economy. Public expenditure and taxes that vary in relation to oil prices would result in
an unstable economic environment. Financial markets would be marked by uncertainty and
turbulence, with an increase in the risk premium on Norwegian securities. This would have resulted in
higher and more variable interest rates. The risk of financial crises in Norway would also have
increased because the cyclical fluctuations in the Norwegian economy would have been more
pronounced. It is therefore an advantage that fiscal policy is now predictable and anchored in a
longterm strategy.
The future size of the Petroleum Fund depends on oil price developments. The guideline ensures that
we only use the return on wealth that has already been accumulated. This makes policy robust to
changes in oil prices and ensures that petroleum wealth will be of benefit both today and in the future.
The guideline provides a framework that contributes to making the central government budget an
appropriate tool for setting political priorities. It sets a limit on the share of petroleum revenues that the
government can use each year and does not distinguish between domestic and foreign spending. This
eliminates the waste of resources that two separate budgets would necessarily entail.
The government invests petroleum wealth in foreign securities through the Petroleum Fund.
Government wealth is thereby more diversified. These investments have no impact on the Norwegian
capital market. Both mainland private saving and business fixed investment have been high in recent
years. In Norway, credit and capital markets nevertheless feature some weaknesses, with thin
securities markets and a narrow investor and ownership base compared with other countries. The
reasons, and hence the solutions, can probably be found in the structure of the taxation of dwellings,
property and financial assets, in a high level of state ownership of enterprises and in the organisation
of pension saving in Norway. Investing even more government capital in Norway would reduce the
return on investments in the Norwegian business sector and prompt other investors to invest
elsewhere. Allocating even more capital to the Norwegian economy would probably lead to a rapid
relocation of jobs to other countries, as the krone would tend to appreciate.
Effect on industry structure
The planned use of petroleum revenues will increase demand for public and private services. The
guidelines imply an increase in the use of petroleum revenues over the central government budget of
around 31⁄2 per cent of mainland GDP by 2010. This may entail an additional 60 000 person-years in
the service sector. As long as there are labour shortages in Norway, a comparable decline in
manufacturing employment is likely to occur.
Although the phasing in of petroleum revenues is a gradual process, the contest for labour resources
will intensify. As a result, monetary policy is likely to remain fairly tight in the years ahead. A high
interest rate level may in periods result in a strong krone. This may accelerate the scaling back of
manufacturing industry. However, in the long run monetary policy cannot influence overall employment
or its distribution across industries. A lower interest rate would have resulted in higher price and cost
inflation, which would also have weakened profitability in the manufacturing sector. The end result
would have been the same for employment and production, but in addition we would have had to face
the costs of high inflation.
Even if employment and production in manufacturing are affected, the situation for Norwegian
enterprises will not necessarily be negative. Some enterprises could be at the forefront of
technological developments and increase efficiency in pace with the relatively high rate of growth in
real wages in Norway. In recent years, we have also seen that many enterprises have moved large
portions of their production abroad, particularly the most labour-intensive production. Norwegian
manufacturing companies could therefore remain profitable even if the size of the manufacturing
sector in the Norwegian economy is reduced. However, the scaling back of manufacturing also
involves a risk. It makes the economy more vulnerable. The growth potential of the economy - the
basis for learning, innovation and development - may be impaired when less of the business sector is
exposed to intense foreign competition.
Over the last thirty years, manufacturing industry has been scaled back in waves. The sharpest
declines were observed in the years between 1977 and 1984 and from 1987 to 1992. The declines
were preceded by a deterioration in profitability in this industry. It may take time for a weakening to
spill over to output and employment, but when the turnaround first occurs it takes place rapidly and on
a large scale. Primary industries, in contrast, are scaled back gradually. These developments will take
place in addition to the effects associated with the increased spending of petroleum revenues. All in
all, employment in manufacturing and agriculture may fall by some 50 000-100 000 person-years in
the period to 2010. Employment in the manufacturing sector may drop to below 250 000. In the
agricultural sector, the number employed may be less than 50 000 person-years. Changes in industry
structure, with an increase in the number employed in services and a decrease in manufacturing, will
probably reduce the role of pay increases in manufacturing as a benchmark for wage determination.
Wage formation and the labour market
The structure of wage and income formation, the laws and rules governing the labour market and the
social safety net are the main determinants of business costs and employment.
If the cost level is too high, the business sector will find it unprofitable to employ everyone who wants
to work. The business sector must restructure rapidly when real wages increase sharply. Many
activities will no longer be profitable and will be shut down. This could lead to higher unemployment.
However, lower employment will not necessarily be reflected in unemployment figures. We may
instead see a flow of discouraged workers into, for example, disability pensions, early retirement
schemes or different types of adjustment packages. The extent to which these schemes are used will
depend on financial incentives and entitlement thresholds.
In many European countries unemployment has remained relatively high. By contrast, the US
managed to reduce unemployment rapidly following the period of high unemployment early in the
1980s. The labour market in the US is decentralised, with local wage agreements and
market-determined wages. Fluctuations in the economy rapidly spill over to employment and
unemployment, as reflected in developments over the last year. Labour costs are adjusted, so that
periods of high unemployment seldom last long. Because employment is easily adjusted, the business
sector can quickly reap the gains of new technology. This makes investments more profitable and the
economy more dynamic.
The US economy also features considerable wage and income differentials. In Europe, the
differentials are smaller, particularly in the Nordic countries. Coordinated wage determination in
Norway has probably raised the income level of those workers who would otherwise have fared poorly
in wage settlements. Unemployment benefits, sick pay and pensions provide a shield against income
losses.
Differences exist in qualifications and work capacity. A compressed wage structure can lead to an
exclusion of those with the lowest work performance from the labour market, with increased numbers
moving into social security. Labour markets in continental Europe are experiencing this, as is Norway
to an increasing extent. Small wage differentials can also lead to a shortage of labour - bottlenecks - in
some sectors and occupations.
The Nordic labour market has made a significant contribution to eliminating the bottlenecks observed
in Norway in the 1990s. The import of labour from other Nordic countries has been considerable,
particularly to hospitals, hotels, restaurants and construction. When unemployment in Sweden was
high in the mid-1990s, migration to Norway was also substantial. As unemployment in Sweden has
gradually declined, the migration to Norway has come to a halt.
Norway emerged from the crisis at the end of the 1980s and the beginning of the 1990s without a
persistent fall in employment. This is because wage formation functioned well. Wage determination
was coordinated, with substantial emphasis on overall employment. Wage discipline provided the
authorities with the leeway to stimulate the economy, with limited risk of higher inflation. This policy
yielded positive results. As regards unemployment and inflation in Europe in the 1990s, Norway is
among the top performers.
There may be many explanations for the wide differences in labour market performance across
countries. Historical and cultural factors may play a significant role. On the other hand, certain
common features and systematic differences should be duly noted. Among other things, the
effectiveness of labour market programmes, the degree of coordination in wage formation,
employment protection legislation (EPL), social security schemes and the education system may be
important factors.
As in Norway, labour markets in continental Europe are marked by extensive employment protection
legislation, which implies substantial restructuring costs for companies. The higher the level of
employment protection, the more an employee is perceived as a long-term investment and the more
cautious the employer must be with regard to hiring. On the other hand, a high level of employment
protection can motivate employers to develop skills among their employees.
With a centralised and coordinated wage formation process, the social partners can take account of
overall employment in wage negotiations. The Scandinavian countries and Austria have organised
wage determination in this way. Generally speaking, unemployment in these countries remained low in
the 1990s and employment is high.
Many countries with decentralised wage determination and a low level of employment protection have
also experienced high employment and low unemployment. Wages are determined on the basis of
each company's profitability and the supply of labour. This system can be found in countries like the
US, Canada, the UK and Switzerland.
By contrast, a decentralised wage formation system that is combined with a strong bargaining position
at the local level and extensive employment protection can produce unfavourable results. Countries
with this type of structure include France, Italy and Spain. In these countries unemployment is high,
with substantial flows out of the labour market into various pension and social security schemes. Nor
have countries such as Germany, Belgium and Finland, where employment protection is relatively
extensive and wage determination only partly decentralised, achieved particularly favourable results
even though the results are somewhat more mixed.
Extensive employment protection and a tightly knit social safety net reinforce the perception that the
risk of an income loss is limited. Employees can take advantage of the bargaining power these rights
afford to obtain high wages without taking into account the effects on overall employment. For their
part, employers may have incentives to promote exclusion through government-financed social
security schemes. Those who are not employed will be interested in finding employment, even at a
lower wage level. However, it is not the unemployed who negotiate local wage agreements. This gives
rise to a conflict of interests between the employed and the unemployed.
However, local wage settlements also feature a number of positive aspects. Wages are adapted to
companies' capacity to pay, which enhances the flow of labour between industries, regions and
occupations. Labour market bottlenecks are eliminated.
Coordinated wage determination in Norway had many advantages, but also limited the scope for
eliminating bottlenecks or remedying imbalances across occupational groups, regions and industries.
Groups that were not included in the coordination, such as liberal professions and salaried employees,
were able to exploit companies' capacity to pay. The system of coordination came under pressure. It
now appears that wages will increasingly be determined at the local level on the basis of each
company's profitability, its need for labour and the supply of various types of labour.
The wage formation process functioned well for a long period because of the strong emphasis that
was placed on overall employment. A precondition for this has been that employees do not fully use
the bargaining power provided by employment protection and the social safety net. Coordinated wage
determination requires discipline. With a more locally based and less coordinated wage formation
structure, the profitability of the individual enterprise and labour market conditions will be the main
source of discipline. Extensive employment protection and a tightly knit social safety net may then lead
to high unemployment and a substantial rise in flows of discouraged workers into social security
schemes.
In the public sector, there are no absolute requirements as to profitability and efficiency. Public
enterprises do not go bankrupt, and in many cases the authorities cannot allow a public enterprise to
discontinue operations. This is a demanding starting point for a shift to more locally determined wages.
The possibility of granting local pay increases might, however, increase efficiency if there are binding
nominal budget limits for these entities and clear production requirements.
When a higher share of wages is determined at the local level and coordination is reduced, it will be
even more important to promote flexibility in the labour market and the labour supply. Otherwise, an
increasing number of workers may be excluded from working life and unemployment may rise on a
permanent basis, while the foundation for production is weakened. Effective labour market
programmes, supported by a sound system for education and infrastructure, can facilitate these
adjustments. It is also important to assess working environment and labour market legislation with a
view to fostering greater flexibility. Hiring costs may be reduced and flexibility enhanced through
greater scope for temporary employment and labour contracting. The throughput in universities and
colleges can be improved. The financial incentives and entitlement thresholds in our social security
system are also of substantial importance to employment.
Pensions
In Norway, the employment rate is among the highest in the OECD area. This reflects both high labour
force participation and low unemployment.
The picture becomes more mixed when average working hours are taken into account. The average is
lower in Norway than in other countries. The sickness absence rate is high. Part-time employment is
widespread.
The average number of person-hours worked in the working-age population is relatively low, despite
high labour force participation and low unemployment. Among OECD countries, the only countries with
lower figures than Norway are those with very high unemployment.
In Norway, average working hours have fallen by more than 20 per cent in the last thirty years. This
can be partly explained by the way working life and child care are organised, but similar trends also
exist in many other countries, especially in Scandinavia.
We cannot simply assume that people want to work more, even if an increased labour input will result
in higher income and greater prosperity. It is natural to use some of the increase in prosperity for
leisure. The considerable share of part-time employment may reflect choices that individuals do not
necessarily want to change.
On the other hand, if we increase our labour input to the level in Sweden, without reducing
productivity, our future income would increase by more than the wealth increase resulting from a
doubling of our petroleum wealth.
The structure of the tax and pension system influences the choice between work and leisure. Lower
tax rates on employment income could boost labour input. The pension system is also of significance
to labour input, as it influences employers' labour investment decisions.
The expansion of the labour force is coming to a halt. At the same time, the number of old-age and
disability pensioners is rising rapidly. Twenty years ago, there were nearly three persons in the labour
force for every pensioner, whereas in 20 years, there will be fewer than two.
Although life expectancy is high, the average retirement age in Norway is steadily falling. For men over
50, the average retirement age fell from nearly 67 in 1970 to a little more than 63 at the end of the
1990s. For the entire labour force, including all age groups, the average pension age in the National
Insurance Scheme was down to 58.
Flexibility in working hours and in the retirement age gives each worker the opportunity to choose
between work and leisure. This freedom to choose is a benefit in itself. However, the terms - wages,
working hours and pension schemes - should reflect the value added of labour. Pension benefits
should therefore depend on how long each individual chooses to remain in employment.
When the National Insurance Scheme was introduced in 1967, the scheme called for a clear link
between labour input and future pensions. Supplementary pensions depended on earned pension
points. However, supplementary pensions have gradually been reduced in relation to labour income.
For most employees who are approaching the age of retirement, additional work effort results in little
or no change in their future pensions. The relationship between labour input and future pensions has
weakened.
The link is especially weak in the contractual early retirement scheme (AFP). For most workers, the
annual pension does not depend on when they choose to retire, as long as they are between 62 and
67 years of age. Nor does the age of retirement affect the size of the national insurance benefits after
the age of 67. Hence, the earlier an employee retires, the higher the total pension benefit will be.
A clearer link between labour input and future pensions may be achieved in a defined-contribution
pension scheme. The total pension for individual employees will then be determined by the
employee's contributions and the return on these contributions. The annual pension is determined by
the individual's age of retirement and the total contribution. For every extra year of employment, the
employee increases his pension wealth. In addition, the total pension wealth will be spread over a
shorter retirement period. This means the longer a person remains in employment, the higher the
annual pension will be.
The main principle is that there should be a clear link between labour input and pensions. Such a link
may also be established in a system where the individual receives an annual pension that is stipulated
in advance.
Sweden has recently implemented a pension reform that ensures that annual pension benefits
increase in relation to the number of years the individual has worked. At the same time, an increase in
life expectancy for each cohort will reduce the annual pension. This motivates the individual to remain
in employment and to ensure that the system is sustainable.
The National Insurance Scheme's expenditure is financed directly over the central government budget.
Decisions about national insurance benefits have a substantial influence on future taxpayers. These
costs are not transparent when the budget is decided. Developments since 1967 show that such a
pay-as-you-go system is not robust. Benefits change over time and costs can easily be pushed into
the future.
The alternative is a system where pension expenditure is covered by accumulated capital, i.e. a
funded system. In a funded system, a decision to increase pensions or reduce the age of retirement
will require the allocation of capital today to cover future expenditure. Such a fund provides a measure
of the cost of increasing pension expenditure.
Our pension system is complicated. In addition to the National Insurance Scheme, many other
operators, including the central government, have established additional pension schemes. There are
different rules for coordination and entitlement. Any shift to a fund-based system for the National
Insurance Scheme will probably require transitional rules for many years ahead. However, I believe
that it will be possible to find solutions to these practical problems.
Distributional and practical considerations imply that minimum benefits in the pension scheme cannot
depend on earlier employment, but should apply to everyone. On the other hand, supplementary
pensions may be financed by a fund where the pension is determined by the individual's contribution
to the pension fund and the return on the fund's investments.
Labour is our most important resource. The decline in average hours worked cannot continue if we are
to have a sustainable pension system. The current evaluation of our public pension system must focus
on the incentives to work and the effects on the average retirement age. A fund-based system may be
an appropriate approach and at the same time make pension savings transparent for each individual.
This may in itself provide an incentive to increase working hours.
Conclusion
The Norwegian economy is changing. Even a gradual increase in the use of petroleum revenues will
change the industry structure substantially in the next decade. It appears that we may see an increase
in locally determined wages. This will generate considerable gains, but in the absence of reforms in
the labour market and in the social security and pension system, the growth potential and
sustainability of our economy may weaken, labour may be displaced and unemployment may rise.
Monetary policy provides the economy with a nominal anchor. The guidelines hold the promise of a
fiscal policy that is anchored in a long-term strategy. When fiscal policy is predictable, monetary policy
can also contribute to stability in aggregate demand and output. The social partners, businesses,
borrowers and investors can act on the assumption that the inflation rate will be 21⁄2 per cent. Over
time, the inflation target and labour productivity set the standard for wage growth.
Thank you for your attention.