Mr Gjedrem discusses various aspects of monetary policy,
financial markets and the welfare state in Norway
Annual address by Mr Svein Gjedrem, Governor of Norges Bank, the Norwegian central bank, at the
meeting of the Supervisory Council of Norges Bank, held in Oslo on 17 February 2000.
* * *
We have just marked the turn of the millennium. Norway can look back at a century of upheaval - the
dissolution of the union with Sweden in 1905, social conflict in the interwar period and the emergence
of the welfare state. At the beginning of a new century it is natural to examine some of the threads
running through our economic history. This may also shed light on the choices Norway is now facing.
We have experienced periods of inflation and periods of deflationary recession. Vast changes in the
world economy have led to shifts in monetary policy and financial markets. Technology has broken
down regulations. Patterns of funding and ownership are changing. This creates unrest and
uncertainty, but also offers new opportunities for growth and welfare. The welfare state is facing major
challenges as a result of the ageing of the population and tax competition among countries. In this
year's annual address I will discuss various aspects of monetary policy, financial markets and the
welfare state.
Historical perspective
One of the first endeavours of the Storting (Norwegian parliament) after its establishment in 1814 was
monetary reform. In 1816 Norges Bank was founded. The specie daler was Norway's first monetary
unit.
From the mid-1800s an increasing number of countries chose to link the value of money to gold. The
central banks were under the obligation to convert their currency at a fixed rate into gold on demand.
At the same time, there were no import or export restrictions on gold. This gradually resulted in the
establishment of an international fixed exchange rate system based on a gold standard.
Chart 1
Norway switched from the silver standard to the gold standard in 1874. The krone was introduced as a
currency unit and we formed a monetary union with Sweden and Denmark. The gold standard and the
monetary union were successful. The world economy and the Norwegian economy were expanding.
Price levels were stable. In the 1900s periods of nominal stability, i.e. price and exchange rate
stability, have also coincided with periods of steady and solid economic growth.
Chart 2
The experience of the last century shows that consumer price inflation is ultimately associated with
high growth in the money supply. However, the causal relationship between money supply and
inflation may be unclear.
Norway has experienced four episodes of high inflation in the last century: during and after the two
world wars and the Korean War, and a 15-year period from the first half of the 1970s to the second
half of the 1980s.
During the First World War inflation accelerated sharply. The British war effort was partly financed
by printing money. Price inflation accelerated in most countries, also in Norway. The gold standard
was suspended.
The krone's value against gold and pound sterling fell sharply in the boom during and after the First
World War. Price inflation soared, accompanied by a speculative bubble with rising asset prices.
When the bubble burst the boom came to an end, followed by deflationary recession and a banking
crisis. The recession was probably exacerbated by the so-called parity policy pursued at that time,
which aimed at returning the krone exchange rate to its pre-war value against gold.
Inflation also accelerated during the Second World War. But unlike the interwar period, the years after
1945 were not marked by recession. With the exception of a few years of high price inflation during
the Korean War, the postwar period featured low and stable inflation and buoyant economic growth.
Chart 3
Chart 4
Chart 5
The fourth period of high inflation was different from the three previous ones. In the 1970s and 1980s
inflation gradually increased. Although inflation rates were not as high as during the two world wars,
inflation remained high for a longer period.
The postwar fixed exchange rate system - the Bretton Woods System - collapsed in 1971. A few years
later, the Yom Kippur War broke out and OPEC countries suspended oil deliveries, triggering the first
oil crisis. The sharp rise in oil prices led to a recession in the western economies. Moreover, inflation
took root in most countries. In Europe, only Germany and Switzerland were able to keep inflation
more or less at bay.
In Norway, the welfare state and support schemes were rapidly expanded partly based on expectations
of large future oil revenues. Economic policy was oriented towards building a bridge over what was
expected to be a temporary downturn in the world economy. This led to a tug of war for real resources
between the business sector and the public sector - between the exposed and sheltered sector.
Chart 6
The cost level in manufacturing industry was driven upwards. At the same time, the slowdown in
growth proved to be permanent. The sheltered sector continued to expand, while industries exposed to
international competition experienced deteriorating profitability and a relative decline. The recession
at the end of the 1980s was followed by a period of low wage growth and gains in competitiveness.
This may help to explain why the decline in manufacturing employment came to a halt in the 1990s.
However, wage costs increased again in the late 1990s. The relative wage level in manufacturing
industry compared with trading partners is now back at the level in the 1970s.
Two forces were behind economic developments from the beginning of the 1970s. First, the
deterioration in competitiveness was caused by the expansion of the Norwegian welfare state and a
transfer of real resources from the exposed sector to the sheltered sector. Second, inflation
expectations took root as a result of low administered interest rates and competitive devaluations.
Nominal interest rates were kept low although price inflation and the value of tax-deductible interest
expenses rose. Frequent devaluations in the period from 1976 were ultimately ineffective with regard
to preventing a relative decline in manufacturing industry. On the contrary, the devaluations proved to
be self-reinforcing.
Chart 7
Over a period of 15 years from 1973 to 1988 consumer prices in Norway rose twice as much as in
Germany. In the same period, the value of the krone was virtually halved against the Mark. While we
paid around 2 kroner for one Mark in 1973, 15 years later we had to pay close to 4 kroner. Since then
the krone has remained relatively stable against the Deutsche Mark. Today the exchange rate is around
4 kroner and 10 øre.
The last devaluation came in 1986 after the fall in oil prices. Thereafter, the krone exchange rate was
fixed. The Norwegian economy had to go through a severe economic turnaround. Confidence in the
krone had to be restored in order to avoid persistent inflation. This required very high interest rates.
The Norwegian economy entered the worst recession experienced since the interwar period.
Unemployment rose from about 2% in 1987 to almost 6% in the winter of 1992/1993. Many
companies went broke and households were faced with debt problems. The financial sector was hit by
crisis.
The fixed exchange rate regime led to a gradual decline in price inflation, but not to deflation as was
the case in the 1920s. An improved wage-setting process, in conjunction with an active fiscal policy,
contributed to curbing the real economic costs. Hence, the experience of 1986 and the beginning of the
1990s probably provides a realistic picture of the minimal costs associated with stamping out high
inflation. At the same time, an active fiscal policy enhanced the credibility of monetary policy because
it led to lower unemployment than would have been the case otherwise.
In Norway, high inflation is a war phenomenon and phenomenon of the 1970s and 1980s. In the
aftermath of high inflation, we experienced substantial real economic losses and financial instability.
The cost of inflation has been high.
History shows that lower unemployment cannot be achieved in exchange for higher inflation in the
long run. A monetary policy that fuels inflation does not generate economic growth. On the contrary,
the result is booms and speculative bubbles, which are the precursors of recession and unemployment.
In the absence of nominal stability, employment and production will not show stability either. The
economy must be endowed with a nominal anchor. This is the task of monetary policy.
The Norwegian economy was lacking a nominal anchor during the period of low interest rates and
devaluations in the 1970s and 1980s. This led to rising inflation and instability. From 1986 the fixed
exchange rate regime restored confidence in monetary policy and subsequently laid a foundation for
more stable economic developments.
Chart 8
Through the 1990s, inflation has been on a par with or below inflation in Europe. While the average
annual rise in prices was a good 8% in Norway in the 1970s and 1980s, the annual rise in consumer
prices has been confined to 2 1/4% in the 1990s. The subdued rate of increase in consumer prices has
coincided with a strong expansion. In 1999, the number of employed was 200,000 higher than in 1990,
i.e. an increase of 10%.
We had to abandon our fixed exchange rate policy in December 1992, primarily as a result of the
system's inherent weaknesses in a world of free flows of capital and deep international financial
markets. When the fixed exchange rate policy was formally abandoned, there was a risk that the
Norwegian economy would again lose its nominal anchor. However, the krone exchange rate showed
little change and quickly found a new trading range.
Chart 9
In the first years the krone exchange rate was very stable, also on a daily basis. When we now look
back at developments in the Norwegian foreign exchange market in the 1990s, we see no significant
change in 1992. On the contrary, we witnessed a pronounced shift in January 1997. It was from this
point in time that daily quotations and month-to-month variations in the exchange rate show that the
krone is floating.
Wider fluctuations in the exchange rate have improved the functioning of the options market and
forward contracts in Norwegian kroner. At a premium, businesses can hedge against short-term
fluctuations in the krone exchange rate. The fluctuations are not greater than in other countries with a
floating exchange rate.
In 1996 and in the autumn of 1998, Norges Bank attempted to attenuate movements in the krone
exchange rate through exchange market interventions. On both occasions, interventions prompted a
game situation between the central bank and market participants, as was also the case during the
currency crisis in the autumn of 1992. When a central bank trades its own currency, market operators
make a play for profits on the premise that the exchange rate does not reflect market fundamentals. In
a world where capital flows freely, this game situation can quickly trigger large capital movements.
The experience of the 1990s shows that Norges Bank does not have the instruments to fine-tune the
krone exchange rate.
Today's monetary policy
The objective of monetary policy is exchange rate stability against European currencies, defined as the
euro from 1 January. Norges Bank's mandate - which is the Exchange Rate Regulation - takes into
account that the krone may remain outside its normal range. The Exchange Rate Regulation states that
"in the event of significant changes in the exchange rate, monetary policy instruments will be oriented
with a view to returning the exchange rate over time to its initial range". The concept "significant
changes" is not quantified and must be given an economic content. Norges Bank interprets a
"significant" change in the exchange rate as a change that fuels expectations of price and cost inflation
to the extent that the change in the exchange rate becomes self-reinforcing.
Monetary policy can counter such a self-reinforcing movement in the exchange rate by contributing to
low and stable inflation without recession. In its conduct of monetary policy, Norges Bank therefore
places emphasis on fulfilling the fundamental preconditions for exchange rate stability against the
euro: monetary policy instruments must be oriented towards bringing inflation down to the level aimed
at by the Eurosystem. At the same time, Norges Bank must prevent monetary policy from contributing
to a deflationary recession as this may weaken confidence in the krone.
The experience of the 1970s and 1980s shows that monetary policy cannot in the long run steer
competitiveness or the size of the exposed sector. If we attempt to do so, monetary policy only
contributes to instability. Such real economic fundamentals may on the other hand be influenced
through fiscal policy and cooperation between the social partners. Norges Bank cannot with open eyes
contribute to higher inflation or a deflationary recession. This would contribute to an unstable krone.
Hence, there is no conflict between gearing monetary policy instruments towards low and stable
inflation and the objective of a stable krone exchange rate over time.
Although monetary policy cannot be used to steer competitiveness, changes in the krone exchange rate
may provide an early warning of a weakening - or strengthening - of the exposed sector in the tug of
war for real resources. A successful fiscal policy and a well-functioning wage formation process
provide a sound basis for a stable krone exchange rate. The main difference between Norway and
countries that have adopted an inflation target for monetary policy lies in the interaction between
monetary policy and fiscal policy. The oil economy and capital exports through the Government
Petroleum Fund are also features that are specific to the Norwegian economy.
The most important factor that influences the krone exchange rate is confidence in nominal stability. If
such confidence exists, short-term fluctuations in the krone exchange rate may vary without
consequences for the exchange rate level over time. However, confidence depends on a number of
factors, such as the authorities' will to pursue nominal stability. Under the fixed exchange rate regime,
we tied ourselves to the mast by stipulating an exchange rate band for the krone. With a floating
exchange rate regime and wider scope for discretion, transparency concerning analyses and policy
response pattern can contribute to bolstering confidence in the nominal anchor. However, this
presupposed that the announced policy response pattern is actually followed.
Fluctuations in domestic activity may induce changes in the exchange rate. For instance, strong
demand for labour could push up wages and weaken competitiveness. If there is confidence in nominal
stability, the deterioration in competitiveness may result in an appreciation of the krone in the short
term. A lack of confidence in nominal stability may result in a depreciation of the krone. Both cases
may entail fluctuations in the exchange rate.
A shift in public expenditure growth - or one-sided tax cuts - will have an impact on domestic demand,
thus prompting movements in the exchange rate. When fiscal policy is used to smooth fluctuations in
domestic demand, it will contribute to a stable exchange rate.
International business cycles and financial market unrest may have an impact on the krone exchange
rate. Exchange rate variations among major currencies may influence the krone exchange rate
measured against individual currencies. Over the last year the euro has depreciated against the
US dollar, the yen and pound sterling. The krone has appreciated against the euro. The effective
exchange rate has been more stable.
A situation may arise with a significant shift in economic fundamentals in Norway. A shock of this
nature may be due to a permanent change in growth prospects. This may also imply a permanent
change in the krone exchange rate. Our experience suggests that this seldom occurs. A sharp and
sustained shift in oil prices, as witnessed in 1973 and 1986, may imply that the use of oil revenues will
have to change. This may in itself have an impact on the exchange rate.
Fiscal policy and the Government Petroleum Fund have proved to be effective in terms of sheltering
the mainland economy from more normal variations in oil revenues. A permanent change in the krone
exchange rate will occur only if there is an increase in the use of oil revenues through a shift in
expenditure growth. In this context, instruments other than those available to Norges Bank must be
used to return the krone to its initial range.
Interest rates influence the exchange rate through two channels. The interest rate differential against
other currencies has some effect on the exchange rate. The exchange rate is further influenced via the
impact of interest rates on domestic price and cost trends. The isolated effect of the interest rate
differential on the exchange rate may be of little consequence compared with other factors. According
to Norges Bank's calculations, the current interest rate differential against the euro area impacts the
krone exhange rate in the order of 20 øre against the euro in the short term. On the other hand, the
effect of the interest rate on the exchange rate through the channel of domestic demand and price and
wage inflation may in many situations be considerable.
The Norwegian economy may be exposed to shocks or disturbances that both reduce domestic activity
and weaken the Norwegian krone. In response, interest rates should not be increased. An increase in
interest rates will result in higher unemployment and mounting instability in the domestic economy
and the exchange rate. Our economy may also be exposed to disturbances that both increase domestic
activity and strengthen the krone. Interest rates should then not be lowered.
In response to the prospect of a downturn in the Norwegian economy, Norges Bank reduced interest
rates in the winter of 1999 when the krone was weak against the euro. This contributed to stabilising
the Norwegian economy and hence also the krone exchange rate. Along the same lines, a situation
may arise with growing pressures in the economy and signs of higher inflation where interest rates will
be increased when the krone is strong in relation to the euro.
Chart 10
Over the last 15 years, the business cycle in Norway has been desynchronised in relation to cyclical
developments in most European countries. The output gap provides a rough indication of capacity
utilisation in the economy. The chart shows a specifically Norwegian upturn in the mid-1980s and a
subsequent downturn. While the downturn bottomed out in Norway in 1990, other European
economies were booming. Subsequently, cyclical developments have remained desynchronised. The
cyclical fluctuations in Norway can to some extent be traced back to the disturbances in the
Norwegian economy in the 1980s and the economic shock in Europe in the wake of the fall of the
Berlin Wall.
The cyclical desynchronisation is the main reason behind the inflation differential between Norway
and euro area countries. The very low rate of inflation in Europe primarily reflects the downturn in the
1990s. A fundamental precondition for exchange rate stability against the euro is that the inflation rate
in Norway is brought down to the level aimed at by the Eurosystem. In recent years, the rate of
increase in prices has been higher in Norway than among euro area countries, which is reflected in the
interest rate differential between Norway and the euro area.
If we were to lower interest rates to the level prevailing in the euro area in the current environment,
inflation would rise rapidly in Norway accompanied by exchange rate volatility. Any movements in
the krone exchange rate will be thoroughly analysed by Norges Bank. A policy response pattern
involving automatic changes in interest rates in response to movements in the exchange rate, as a fixed
exchange rate regime would imply, is inappropriate.
A century of growth
Chart 11
At the turn of the last century GDP per capita was around NOK 20,000 in present-day value. Today
the average is around NOK 250,000, or about 10 times higher than 100 years ago. For purposes of
comparison, the increase was barely twofold between 1820 and 1900.
Economic growth in Norway was particularly strong in the first 30 years following the Second World
War, as a result of the introduction of new technology from the US and new products in Europe.
Europe has gradually caught up with the US thanks to the import of technology from the US, effective
restructuring and the expansion in global trade. This explains why welfare gains have been
substantially higher in Norway and other European countries than in the US in the postwar period.
Chart 12
Growth in productivity in mainland Norway was high in the 1960s and 1970s. Since 1980 productivity
growth has been more in line with growth in the US. By then we had reached a high level of income. It
follows that there was less to gain than earlier from the import of new technology.
Chart 13
In spite of the boost provided by Norway's oil resources, there is a difference in income between
Norway and the US. The income differential is probably to a large extent ascribable to differences in
working hours and employment. Labour participation is slightly higher in Norway than in the US,
while the average working time in Norway is almost 30% below the US average. Many people in
Norway work part time. But even a full person-year amounts to a good 10% fewer hours than the US
average. The income differential primarily reflects that Norwegians have preferred leisure to long
working hours.
However, the income level in Norway is high compared with other European countries, which is
attributable to Norway's petroleum revenues and high level of employment. The relatively high level
of income indicates that we have to a large extent closed the technological gap between Norway and
the US. This means that we cannot expect growth rates on a par with that of the 1950s and 1960s,
i.e. annual growth rates of up to 5%.
A new economy
New technology may be a driving force behind structural changes in the economy and lead to high
growth rates.
Chart 14
The trend in the postwar period, with stronger growth in productivity in Norway than in the US, may
have been reversed. Productivity growth has tended to move on a weaker trend in Norway, while
rising in the US. Both Norway and the US have enjoyed a long period of sustained expansion in the
1990s. At this stage, productivity growth tends to be low. Signs of higher growth in the US may thus
suggest a new trend.
It is probably too early to draw any definite conclusions. We also know that there may be considerable
statistical sources of error. However, the new growth trend is supported by evidence of a more
anecdotal nature. Major changes are taking place in the US business sector through processes such as
mergers and acquisitions. There is an exceptionally rich supply of capital in the stock market. The new
technology companies dominate stock exchange developments. In Europe, Sweden and Finland are
leaders in developing new technology environments. Norwegian companies may also be at the
forefront of developments in some areas.
Securities markets have been a vital force behind these changes. In the course of the last 20 years, a
revolution has taken place in global financial markets. Capital restrictions have been removed.
Companies around the world are experiencing a wave of mergers, acquisitions and demergers. These
transactions reflect a higher required rate of return among all companies and all areas of a business. At
the same time, there is an increased willingness to take risk, with a soaring number of start-up
companies. This trend has been particularly evident in the US, but European countries are also part of
this process.
Increased possibilities for using information improves financial markets' ability to act as a catalyst for
profitable restructuring and growth. Companies financed through equities, bonds and commercial
paper are continuously monitored through a transparent process. Owners and potential investors
follow company performance closely. There are ever-stricter requirements concerning information. A
poorly performing enterprise can be acquired by others who feel they can either run it more profitably
or use its resources more effectively elsewhere.
One may be sceptical with regard to these developments, which seem to have created a situation where
a few keyboard operations can lead to wealth and losses. Financial markets are driven by forces and
psychological mechanisms that may result in extreme volatility. Financial bubbles fuelled by
unrealistic optimism may lead to the darkest pessimism and fears. The so-called new economy may be
a bubble. The concept "new economy" was first introduced prior to the stock market crash in 1929.
The authorities carry a particular responsibility for monitoring financial stability and ensuring that the
rules of the game are followed.
The alternative to open securities funding is bank credit. This type of financing is traditionally based
on a close relationship between banks and borrowers. Banks gain access to extensive information
concerning the borrower and often exert influence over business decisions.
This type of arrangement has long been preferred in many European countries as it was very difficult
to obtain adequate information about individual companies and time-consuming to analyse the
information that was available.
This situation has changed with the advent of new information technology. Financial markets are now
more effective in terms of channelling capital to investments that yield the highest returns.
Germany is the country in Europe where banks and borrowers have been the most dependent on each
other. In addition to providing loans, banks have large shareholdings in companies and big companies
have a large stake in private banks. The tax system has locked in this cross-ownership. Owners have
had to pay about 50% in taxes on capital gains on share transactions. The German government has
announced that this tax will be eliminated from 2001. This is expected to prompt a restructuring, first
in the ownership of German banks and enterprises and subsequently in production.
The business sector is dependent on both a smoothly functioning securities market and banks with a
close relationship to borrowers. Small and medium-sized enterprises are particularly dependent on the
expertise and guidance offered by banks. Funding in securities markets is too expensive for the
smallest enterprises.
The securities market plays less of a role in Norway compared with other European countries and the
US. The market for equity capital is particularly small in Norway. Norwegian companies often rely on
foreign funding for new projects. The thin market for securities capital in Norway may be an obstacle
to the development of the business sector.
This means that it is essential that the banking system function smoothly.
When they function, the strength of financial markets lies in their transparency and adaptability.
Capital which is tied up in unprofitable activity can be freed up for other activities. Competition for
capital contributes to creative destruction.
Chart 15
Structural changes also take place within individual companies. One example is NOKIA. Thirty years
ago, the forerunners of the world's leading producer of cellular telephones were primarily producing
telephone cables, rubber boots and tyres. At that time, the electronics division accounted for 3% of
NOKIA's turnover and employed 460 persons. However, research and product development led to a
wider range of products. In 1988 NOKIA was the third largest producer of television sets in Europe
and the largest producer of cellular telephone equipment in the Nordic area.
NOKIA experienced a deep crisis in the beginning of the 1990s, as did many Finnish companies.
NOKIA decided to concentrate on telecommunications. The split-up of the group was initiated from
within the company. Non-core activities were spun off and sold. This allowed NOKIA to free up
capital for the most profitable activities of the company. Today the company has more than
50,000 employees. At the end of last year, the market value of NOKIA was about NOK 1,700 billion,
which is four times the market value of all the companies listed on the Oslo Stock Exchange.
The economy needs creative destruction to develop. The tendency may have been for the Norwegian
authorities to provide various types of support to businesses and industries that have existed for some
time. When the government intervenes, the authorities tread a fine line between business development
and conservation. It is thus important to tread carefully, so that capital and labour are not tied up in
less profitable activity.
The required rate of return and the need for restructuring in the business sector often conflict with the
need for stability and security for the individual employee. Local communities may suffer. The answer
is not to oppose restructuring. The best solution is to develop and take advantage of skills and
expertise. This also requires extensive adaptability and labour mobility.
The welfare state
The restructuring that we are facing in the Norwegian public sector is hardly of less significance than
the changes in the business sector. During the last decades the Norwegian welfare state has expanded
rapidly. Household income and consumption have also shown steady and strong growth. We have also
witnessed a sharp expansion in the production of services in both the public and private sector.
Chart 16
Employment growth in the service industries increased while declining in primary industries and
manufacturing, with a redistribution of real resources between sectors. The transfer is the result of a
steeper increase in demand for services than for goods when income rises.
Taxes were increased to finance the expansion of the welfare state. Excluding the petroleum sector, the
tax level has increased from 41% of mainland GDP in 1970 to around 48% today.
Chart 17
The tax burden in mainland Norway is among the highest in the OECD countries. Only Sweden and
Denmark have a higher tax burden. There are many reasons why further tax increases would put the
Norwegian welfare state in jeopardy. Tax competition among countries is intensifying. Several
countries have attracted new business by reducing taxes. Enterprises, capital and labour choose their
location based on tax considerations.
In principle, it is conceivable that higher taxes only affect the household sector, so that the business
sector is not exposed to a heavy tax burden. However, it is difficult to find direct or indirect taxes that
do not also affect the business sector. Higher direct and indirect taxes may lead to demands for higher
income, which will be easier to achieve the tighter the labour market is. However, companies exposed
to strong international competition have limited scope for passing on higher costs to households.
A high tax level is particularly dependent on an efficient tax system. High tax rates promote tax
planning and hamper the growth capacity of an economy. Low, broad-based tax rates are preferable to
high tax rates with a narrow base. Norway made headway with the tax reform of 1992. There is still
room for considerable improvement in the Norwegian system.
Many public services are of considerable economic importance. Infrastructure, education, sound
legislation and a solid judicial system are necessary for the economy to function and grow. Public
services may be important in order to secure equality and security. At the same time, the public sector
is so large that it affects the economy at large. This means that requirements concerning efficiency and
adaptability must also apply to the public sector.
Chart 18
Over a twenty year period, the number of employed in the health, care and education sectors increased
by 240,000, which account for about 60% of the increase in overall employment in Norway. The
number of employed in the health and care sector has more than doubled in 20 years. More people are
now working in this sector than in the whole of manufacturing.
Nevertheless, every day we receive reports of personnel shortages at hospitals, in elderly care or at
schools. The authorities constantly signal increases in appropriations in order to remedy these
problems. Norway imports labour from other countries t