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E c o n o m i c B u l l e t i n 1 02

A p r i l

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The Norges Bank web site (www.norges-bank.no) features the Bank's publications, statistics, announcements, press releases, speeches and other information in Norwegian and English.

The following English-language publications may be subscribed to from the Norges Bank web site: Annual Report, Economic Bulletin, Financial Stability, Government Petroleum Fund Annual Report, Government Petroleum Fund Quarterly Reports, Inflation Report, Occasional Papers, Annual Report on Payment Systems, Reprints and Working The Economic Bulletin is published quarterly by Norges Bank

Editor: Svein Gjedrem

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ISSN 0029-1676

E c o n o m i c B u l l e t i n A p r i l 2 0 0 2

Vo l u m e L X X I I I N o . 1

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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 2½ 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 2½ per cent, the interest rate will be increased. If it appears that inflation, with unchanged interest rates, will be lower than 2½ 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 implica- tions 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 (Chart 1). 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

E c o n o m i c p e r s p e c t i v e s

Annual address by Governor Svein Gjedrem at the meeting of the Supervisory Council of Norges Bank on Thursday, 14 February 2002

The figures for "euro" are for the German mark up to and including 1998 and for the euro as from 1999.

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raw materials tend to experience considerable volatility in their exchange rate (Chart 3). 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 pre- pared 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 (Chart 4). In spite of this, consumer price inflation has been close to 2½per 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 2

The vertical axis shows the standard deviation of annual changes in nominal effective exchange rates. The horizontal axis shows the standard deviation of annual changes in the terms of trade. The terms of trade is the ratio of export prices to import prices.

The chart shows the 12-month rate of increase in consumer prices, in prices for imported consumer goods and for goods and service produced in Norway. All the series are adjusted for the direct effects of real taxes and energy prices.

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increase in nominal labour costs of around 4-4½per 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 sta- bilise 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 Fund¹⁾. This guideline implies that fiscal policy will contribute to stimulat- ing 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 econ-

omy would have been more pronounced. It is therefore an advantage that fiscal policy is now predictable and anchored in a long-term 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 3¹/²per 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 accel- erate 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

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1) Storting proposition no 1. Supplement no. 4 (2001-2002)

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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 (Chart 5). The sharpest declines were observed in the years between 1977 and 1984 and from 1987 to 1992. The declines were preced- ed 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 (Chart 6). 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.

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The bars in the chart illustrate the scaling back of manufacturing in waves, particularly in the periods 1977-1984 and 1987-1992.

"Continental Europe" includes Switzerland and the EU countries except Sweden, Finland and the UK.

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The US economy also features considerable wage and income differentials. In Europe, the differentials are smaller, particularly in the Nordic countries (Chart 7).

Coordinated wage determination in Norway has probably raised the income level of those workers who would otherwise have fared poorly in the wage settlements.

Unemployment benefits, sick pay and pension schemes 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 (Chart 8). 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 (Chart 9).

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 system- atic 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.²⁾

As in Norway, labour markets in continental Europe are marked by extensive employment protection legislation, which implies substantial restructuring costs for companies (Chart 10). 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 determina-

5 Earnings dispersion is measured as the ratio between the lowest

income of the highest income decile, and the highest income of the lowest income decile.

The figures are from the "OECD Earnings Database".

The left-hand scale shows registered changes of residence from Sweden to Norway less the number of registered changes of residence from Norway to Sweden.The right-hand axis shows the unemployment rate in Sweden less the unemployment rate in Norway.

The figures show inflation and the unemployment rate, measured as the average in the period 1990-2000.

2)See for example Scarpetta, S. (1996). “Assessing the role of labour market policies and institutional settings on umemployment: A cross-country study”, OECD Economic Studies no. 26, 1996/1.

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tion 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 (Chart 11).

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 6

The chart shows the level of employment protection measured by the OECD’s indicator and the average unemployment rate, measured as averages for the period 1990-2000.

The rings denote countries with decentralised wage determination according to the classification of Calmfors/Driffil in the OECD Employment Outlook 1997.

The OECD’s indicator for employment protection is a weighted average of 22 subindices for the degree of employment protection. The subindices are measures of various features of employment protection, such as notice period, number of months with income after notice of dismissal etc. Information on the indicator can be found in the OECD Employment Outlook, June 1999.

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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 foun- dation 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 universi- ties 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 (Chart 12). This reflects both high labour force participation and low unemployment.

The picture becomes more mixed when average working hours are taken into account (Chart 13). 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 (Chart 14).

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 (Chart 15).

7 The chart shows the average number of hours worked per

employee in 2000.

The chart shows the number of employed as a percentage of the working age population (aged 15-64).

The chart shows the average number of hours worked per person in the working age population in 2000.

The chart shows the average number of hours worked per employee.

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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 (Chart 16).

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 58.³⁾

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.

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9 However, I believe that it will be possible to find solu-

tions 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 2½per cent. Over time, the inflation target and labour productivity set the standard for wage growth.

Thank you for your attention.

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Background

The payment system is an important part of a country’s economic and financial infrastructure. Smoothly functioning payment systems make it possible to execute safe and timely payment transactions. The payment system handles different kinds of payment transactions - for the settlement of goods and services purchases, capital transfers, securities and foreign exchange trading, etc., and these transactions are made by private customers, banks, enterprises and government agencies. These transactions result in claims between the payers’ and payees’ banks, and these claims are settled through the banks’ accounts in Norges Bank. Banks and the central bank are thus the core of the payment system. Banks’

accounts in Norges Bank provide the link between the payment system and monetary policy since the central bank’s key interest rates are the sight deposit and overnight lending rates in Norges Bank.

The payment system is also essential to financial stability. Banks’ participation in the payment system exposes them to different kinds of settlement risk:

credit risk is the risk of losses due to the failure of an- other bank to meet its obligations, while liquidity risk is the risk of losses due to the failure of a counterparty to meet obligations in part or in full at the agreed time.

Legal risk arises when the legal framework is unclear and payment transfers are not executed as expected, resulting in unexpected exposure to other market participants and thus potential losses. Operational risk is tied to inadequate procedures, malfunctions in computer systems, breach of rules, etc.

One bank’s risk may be the source of more compre- hensive systemic risk if the payment system is organised in such a way that problems at one bank spread to an- other bank, thus threatening financial stability. Systemic risk is the reason that central banks are concerned about how the payment system is organised. A significant precondition for financial stability is that payment and settlement systems are designed and function in such a way that participating banks can handle settlement risk and that one bank’s problems do not spread to other

banks. International efforts to reduce payment system risk have been in process for more than fifteen years.

The Norwegian authorities and the financial services industry have followed these developments closely with a view to ensuring that the Norwegian payment system is robust and efficient compared with systems in other countries.

Norges Bank’s responsibilities with regard to the payment system

Norges Bank is responsible for promoting robust and efficient payment systems and financial markets, thereby contributing to financial stability. Oversight of the payment system is based on the Bank’s formal responsibility as laid down in the Norges Bank Act. According to the first paragraph of Section 1, Norges Bank shall

"…promote an efficient payment system domestically as well as vis-à-vis other countries." Based on this, Norges Bank worked with the banks for many years to develop a common payment system infrastructure in Norway in order to reduce overall costs. This, combined with the introduction of prices for payment services that have encouraged customers to use the least expensive services when appropriate, has led to substantial efficiency gains. Today, this work is being continued by the banking industry’s own organisations with less direct participation from Norges Bank. For more than fifteen years, however, Norges Bank has followed developments in the Norwegian payment system by means of its Annual Report on Payment Systems. Today, this publication is the primary source of information about this important aspect of the financial infrastructure. Norges Bank will continue this work in order to provide a key reference for market participants, consumers and government agencies, both in Norway and abroad.

The efforts to establish a coordinated infrastructure have resulted in extensive advantages for its users, although technological developments may gradually

N o r g e s B a n k ’ s o v e r s i g h t a n d s u p e r v i s i o n o f t h e p a y m e n t s y s t e m

The Norges Bank Act from 1985 gave Norges Bank responsibility for promoting an efficient payment system.

In keeping with the increased focus on risk in the payment system, both nationally and internationally, Norges Bank’s work on payment system issues has also changed. The Payment Systems Act of 1999, which gives Norges Bank responsibility for authorisation and supervision of interbank systems, is important for the cen- tral bank’s work in this area. The recommendations concerning payment systems from the Bank for International Settlements (BIS) also state that central banks should publicly disclose their role and their most important policies with respect to payment systems. In order to explicitly define our objectives for and roles in the payment system and in line with the recommendations from the BIS, Norges Bank makes public the basis for its oversight and supervision of the payment system.

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11 permit small-scale solutions to give the same cost

advantages, thus facilitating more extensive competition. When new payment solutions are introduced and new participants enter the market, Norges Bank will place emphasis on the systems’ ability to communicate with each other in order to maintain the efficiency of the payment system as a whole. Norges Bank is also of the opinion that banks should play a key role in developing new payment solutions even though other market participants may offer some niche products. Cross-border payments normally take longer to complete and cost considerably more than domestic payments. Norges Bank will try to ensure that Norway complies with the EU Commission’s recommendations and regulations in a flexible and expedient manner.

The Payment Systems Act of 1999 gives Norges Bank responsibility for authorisation and supervision of interbank systems which comprise systems for interbank clearing and settlement. The Act reflects the increasing recognition in the 1980s and 1990s of the payment systems’ significance for financial stability. The Act under- pins the banking industry’s responsibility to design stable, robust systems in close cooperation with Norges Bank as the ultimate settlement agent in the Norwegian clearing and settlement system. However, as a last resort the Act also authorises direct intervention by Norges Bank in systemically important interbank systems.

Norwegian interbank systems’ size and function vary considerably. Therefore, Norges Bank may grant exemptions to the authorisation requirement for systems that have no significant effect on financial stability.

According to the Act, responsibility for the payment system is divided between Norges Bank and the Banking, Insurance and Securities Commission, which is responsible for customer-related aspects of the payment system (systems for payment services). The two institutions have identified their "target groups" and clarified the division of responsibility and work. It is often difficult to make a clear distinction between the two parts of the payment system, and the two institutions exchange information regularly about their ongoing activities. Norges Bank’s primary focus will be on monitoring the efficiency of the payment system as a whole, including the customer-related parts. It must be stressed that malfunctions in the customer-related parts of the payment system may also have considerable systemic consequences and spillover effects, which sub- stantiate the need for continuous oversight. The Banking, Insurance and Securities Commission is also responsible for approving securities settlement systems.

As settlement bank for the cash leg of securities settlements, Norges Bank will regularly evaluate the significance of these transactions for financial stability.

The Payment Systems Act is based on international recommendations, primarily from the Bank for International Settlements (BIS) and the European

Central Bank (ECB). The Act is in line with the BIS recommendations, Core Principles for Systemically Important Payment Systems, which currently provides the international standard for payment systems. The BIS report from the Committee on Payment and Settlement Systems presents ten core principles with which systemically important payment systems should comply. The principles focus on limiting legal, credit, liquidity and operational risk, as well as on the system’s cost effectiveness and access criteria. The BIS has also made four recommendations about how central banks should exercise their responsibility in this area, with regard to both overriding objectives and the application of the ten core principles throughout the payment system. The EEA Directive on Settlement Finality has been incorporated into Norwegian law with the passage of the Payment Systems Act. Thus, legal protection may be established for payments that are part of the assets of a bank that has initiated insolvency proceedings.

The purpose of the Payment Systems Act is to help ensure that the systems are organised in such a way that they promote financial stability. However, Norges Bank shall not control in detail the systems nor take over the operator’s responsibility for system operations. As long as the Payment Systems Act’s requirements are satis- fied, operators themselves determine how the system shall be developed and operated. The general background material for the Payment Systems Act makes it clear that the Act is a supplement to and not a replace- ment of the industry’s own regulation of the systems. In exercising its supervisory authority, Norges Bank emphasises that it is the banks’ responsibility to give due consideration to both risk and efficiency when they operate interbank systems. Norges Bank’s ongoing supervision of the interbank systems that are subject to authorisation will take the form of meetings with the licensees, where such factors are discussed in more detail, and will also include an annual report about system participation and turnover. In addition, all significant changes with regard to ownership, organisation and operating conditions shall be reported to Norges Bank before the changes are made.

In line with the BIS recommendations, Norges Bank, by virtue of its role as the ultimate settlement bank, contributes to ensuring the execution of payment settlements: banks’ accounts in Norges Bank ensure them settlement without underlying credit risk, and Norges Bank provides liquidity to banks through collateralised loans, thus ensuring prompt settlement of payment transactions.

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Risk in the Norwegian payment system

After the Payment Systems Act entered into force and adjustments were made to satisfy the authorisation requirements, the legal risk associated with the Norwegian Payment System is regarded as very limited.

Norges Bank’s analyses show that overall credit and liquidity risk is also relatively limited after several years of cooperation between banks and Norges Bank on various measures to reduce the risk in the Norwegian payment system. In Norges Bank’s opinion, the key interbank systems in Norway satisfy the BIS recommendations. Therefore, in the future the focus will large- ly be on risk associated with Norwegian banks’ participation in international foreign exchange trading (foreign exchange settlement risk) and operational risk.

The remaining settlement risk is primarily tied to banks’ high exposures in connection with foreign exchange trading. This is because settlement in different currencies is executed in different settlement systems, normally at different times. Participants are thus exposed to the risk of an unforeseen loss if foreign currency is paid out before receipt of an incoming payment.

The establishment of an international multi-currency settlement bank, CLS – Continuous Linked Settlement, will substantially reduce the settlement risk associated with such transactions. According to plan, Norwegian banks will be able to connect to the system in the third quarter of 2002, and Norwegian krone will be one of the settlement currencies within a year after the system becomes operational. The banking industry and Norges Bank have cooperated closely since 1999 on establish- ing this solution.

Norges Bank places considerable emphasis on reducing the operational risk in the private clearing and settlement systems. Operational disturbances at banks have demonstrated that there may be considerable vulnerabil- ity in this area. It is the responsibility of the system operators to ensure that routines, back-up solutions, exper- tise and contingency plans are in place to effectively deal with operational risk. The banking industry has commenced work to determine what measures are nec- essary to reduce this risk. This demonstrates that the banking industry is focusing on the problem and that operational risk is being taken seriously. However, the individual system operators are also expected to evaluate their routines and solutions to find ways to reduce risk. Norges Bank regularly assesses the need for measures in relation to systems that do not focus sufficiently on operational risk, and works closely with the Banking, Insurance and Securities Commission to this end.

Norges Bank’s operations in the area of payment systems

Developing and managing Norges Bank’s Settlement System (NBO) has allowed Norges Bank to influence the organisation of the payment system, and hence risk and efficiency. Due to the authorisation requirements in the Payment Systems Act, Norges Bank can also establish requirements for and monitor efficiency and risk, also in the bank-operated part of the clearing and settlement system. One consequence of this is that Norges Bank has initiated work to evaluate the organisation of the Norwegian payment system. In connection with this, a fundamental review concerning the central bank’s responsibilities and tasks in the payment system has been carried out.

The central bank’s primary functions include offering banks settlement in risk-free payment instruments, ie claims on Norges Bank, and ensuring sufficient liquidity in the interbank market to avoid disruptions in clearing and settlement. This is accomplished primarily by pro- viding banks access to loans in Norges Bank with securities holdings as collateral. These fundamentals can be maintained, however, without extensive involvement by Norges Bank in the operations and development of the settlement system. Based on this, Norges Bank has invited the banking industry to participate in a project to analyse alternatives to the present division of responsibility in the Norwegian clearing and settlement system.

The aim is to establish an appropriate division of responsibility between the banking sector and Norges Bank that allows Norges Bank to concentrate on its core activities (authorisation and oversight of the interbank systems, provision of liquidity for settlements as well as monetary policy issues connected with the payment system). It is assumed that such a review will reveal coordination gains that over time will reduce overall costs in the clearing and settlement system.

For further reading, we recommend:

Enge, Asbjørn and Bjørn Bakke (2001): "Risk in the Norwegian settlement system 1995-2000"

Economic Bulletin 1/2001 pp 20-27

Watne, Kjetil (2001): "Do Norwegian payment systems satisfy the new BIS recommendations?" Economic Bulletin 3/2001 pp 91-98

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The projections for 2000 published in 1998

The projections published at the end of 1998 were in- fluenced by the Asian crisis in 1997, the crisis in Russia in August 1998 and the crisis in Brazil in October/November the same year. Consequently, in the autumn of 1998 the projections for global economic developments were relatively pessimistic. At the same time, the Norwegian economy had experienced a turbulent year. Oil prices had fallen to almost USD 10 per barrel, and the wage settlement had resulted in considerably higher wage growth than expected. In conjunction with financial market unrest, this led to a weakening of the krone.

Money market rates rose from 3.5 per cent to 8 per cent in the course of 1998. In the December 1998 Inflation Report, Norges Bank projected a period of relatively weak growth in the Norwegian economy, a fall in employment and higher unemployment. The downturn would come as a result of weaker competitiveness, lower growth in the world economy and a fall in fixed investment.

However, the outcome showed that Norges Bank and other forecasters underestimated global growth in both 1999 and 2000. Monetary policy stimulus in the US and Europe, a swift recovery in Asia and renewed stability in financial markets led to a faster-than-expected rebound in growth. Norges Bank’s projections for GDP growth for trading partners published in December 1998 were consistent with OECD forecasts (see Chart 1). We underestimated growth in the US by a considerable margin.

The growth projections for the Norwegian economy were also off the mark. Table 1 shows projections and actual figures from the national accounts published in February this year. In 2000, economic growth was sig-

nificantly higher than projected in December 1998.

Mainland demand increased by 1.9 per cent in 2000, while our estimate was ¼per cent. The demand estimate for 1999 was off the mark by the same margin. In par- ticular, private consumption was underestimated for these two years, but fixed investment was also significantly higher than projected. For both 1999 and 2000, private consumption was projected to show slower growth, partly reflecting our projections of slower growth in disposable income and a fall in house prices.

The outcome was a further rise of 12 and 14 per cent in house prices in these two years. A faster-than-anticipat- ed upturn in the global economy and a sharp rise in oil prices probably boosted household expectations. The

E v a l u a t i o n o f N o r g e s B a n k ’ s p r o j e c t i o n s f o r 2 0 0 0

Marianne Sturød, economist in the Department for Macroeconomic Analysis*

Norges Bank’s projections for developments in the Norwegian and international economy form an important basis for monetary policy decisions. Norges Bank places emphasis on the importance of evaluating the pro- jections in the Inflation Report and on the transparency of our forecasting work. This is why the Bank reports regularly on the evaluation of its projections and examines the sources of forecast errors. Analyses of Norges Bank’s projections for the years 1996-1999 have been published earlier1). In this article, we analyse the pro- jections for 2000 as presented in the December 1998 and December 1999 Inflation Reports.

In December 1998 it was assumed that the Norwegian economy would show a relatively pronounced downturn through 1999 and 2000. It turned out that the downturn was far less pronounced than expected, and that the two-years-ahead projections were therefore not very accurate. The projections for 2000 pub- lished in the December 1999 Inflation Report were closer to the outcome.

Norges Bank’s projections are also compared with those of other institutions. The projections for con- sumer price inflation published by the Ministry of Finance, Statistics Norway and market participants have shown approximately the same degree of accuracy.

* With thanks to colleagues for their useful comments

1)See previous articles (Madsen 1996, Jore 1997, Jore 1999 and Jore 2000)

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main reason behind the forecast error for private consumption was probably that the interest rate decline in 1999 had a faster and stronger impact on the Norwegian economy than we had expected (see section on sources of forecast errors).

Because demand picked up faster than expected, employment and production also rose more than projected. Mainland GDP was also pushed up by higher- than-expected electricity production in 2000. The number of employed increased by 0.5 per cent, while we expected a comparable fall. Instead of edging up towards 4½ per cent, LFS unemployment remained at 3.4 per cent in 2000.

With a tighter-than-expected labour market, growth in wage costs in 2000 was higher than projected. In 1999, the social partners adhered to the wage restraint recom- mended. The following year, however, growth in wage costs was pushed up as a result of the two additional vacations days in 2001 and 2002, which were negotiat- ed at the same time. Taking into account the associated costs for enterprises in 2000, actual growth in wage costs turned out to be higher than projected in December 1998.

Consumer price inflation was also higher than projected. An unexpected surge in oil prices and global producer prices, in conjunction with a depreciation of the trade-weighted krone exchange rate, pushed up prices for traditional merchandise imports by 6 per cent in 2000. Consumer price inflation among trading partners also turned out to be higher than estimated (see Chart 2).

The feed-through from international producer prices to Norwegian consumer prices did not materialise, however. Prices for imported consumer goods, which are

directly incorporated in the CPI, fell by 0.9 per cent in 2000. However, the sharp increase in oil prices had an impact on Norwegian consumer prices via higher petrol prices. At the same time, electricity taxes were increased.

Price inflation adjusted for tax changes and excluding electricity products was 2.1 per cent in 2000, ie about the same rate of increase projected in December 1998.

Chart 3 provides a comparison of Norges Bank’s projections for a number of key variables for 2000 and Statistics Norway’s projections. Statistics Norway projected a less pronounced downturn in the Norwegian economy, but also underestimated GDP growth and overestimated unemployment. Both Statistics Norway and Norges Bank underestimated price inflation. In spite of having the highest unemployment estimate, Norges Bank also had the highest projection for wage growth, while Statistics Norway had the most accurate projection for price inflation. Statistics Norway had a somewhat higher estimate for import prices, but also empha- 14

Table 1 Projections for 2000 published in December 1998, and actual figures for 2000 (as at February 2002). Percentage rise on previous year unless otherwise indicated

2000 Projection Actual Forecast

error¹⁾

Mainland demand 1¼ 1.9 -1¾

Private consumption 1¼ 2.9 -1¼

Public consumption 2¼ 1.4 ¾

Fixed investment -5¾ 1.4 -7¼

Petroleum investment -15 -17.1 2

Exports 5½ 2.7 2¾

Crude oil and natural gas 9¼ 6.4 2¾

Traditional goods 3¾ 2.1 1¾

Imports 1¾ 2.5 -¾

Traditional goods 3 1.7 1¼

GDP 1 2.3 -1¼

Mainland GDP -¼ 1.8 -2

Employment -½ 0.5 -1

LFS unemployment, level 4½ 3.4 1

Annual wages (incl. costs

of additional vacation days) 4¼ 5.1 -¾ Import prices, traditional

goods ¼ 6.0 -5¾

Consumer prices 2¼ 3.1 -¾

1)Positive figures indicate that projections are too high

Sources: Statistics Norway (Economic Survey 1/2002) and Norges Bank (Economic Bulletin 1998/4)

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15 sised that the sharp rise in labour costs in 1998 would

translate into higher price inflation in 1999 and 2000.

Sources of forecast errors

Forecast errors can in retrospect be attributed to erroneous assumptions, model deficiencies or assessment errors. There is also uncertainty attached to current statistics. Even the February accounts from Statistics Norway, which are the preliminary accounts for the previous year, are associated with a considerable margin of error. On average, the difference between the preliminary figures and the final national accounts figures for mainland GDP was close to 1 percentage point in the period 1979-1997.

Our projections are based on assumptions concerning the money market rate, the exchange rate, fiscal policy, petroleum investment and developments in the world economy. Some of the forecast errors for 2000 can be explained by considerable differences between developments in key parameters and our assumptions:

• The exchange rate turned out to be somewhat stronger than assumed in 1999, but depreciated thereafter by 2.5 per cent between 1999 and 2000, as measured by the trade-weighted krone exchange rate. The projections were based on the assumption that the krone would appreciate by ¾ per cent in both 1999 and 2000.

• Oil prices increased sharply through 1999 and most of 2000. On average, the oil price per barrel hovered around NOK 142 in 1999 and NOK 252 in 2000. As a technical assumption, we had put the real price at around NOK 90 per barrel for the period.

• International producer prices fell by 3.5 per cent in 1999 and rose by 6.8 per cent in 2000. We had assumed a fall of ½per cent in 1999 and an increase of 1 per cent in 2000.

• Short-term interest rates were assumed to move in line with market expectations, as reflected in for- ward rates. This implied a gradual fall in interest rates to 5 per cent in 2000. Actual developments in 1999 were fairly closely in line with market expectations in December 1998, but short rates remained considerably higher in 2000 than implied by expectations. The average money market rate was 6.8 per cent in 2000, or 1¹/²per cent higher than assumed in the December 1998 Inflation Report.

The purpose of Norges Bank’s projections is to achieve an optimal decision-making basis for setting interest rates. When the projections result in an interest rate level that is different from the underlying technical assumption, the task of evaluating the projections becomes even more demanding. In such cases, it is particularly important to break down the sources of error behind the deviations between forecasts and the out-

come. The RIMINI model, which has been the main tool in Norges Bank’s forecasting work, has been used for this purpose. The Bank’s Research Department has been responsible for the econometric basis for the model, and the model is regularly developed thanks to the concert- ed efforts of several departments in the Bank. Around 70 of the model’s 350 equations are estimated on the basis of historical data, while the remaining equations are def- initional relationships.

The model’s description of economic relationships is itself a source of error. For example, changes in the functioning of the economy may occur without these being captured by the model. Economic relationships for some areas may not be sufficiently incorporated in the model. The projections for 2000 were based on an interest rate path that was significantly lower than the outturn. In spite of this, we underestimated both private consumption and fixed investment in both years.

Interest rate changes have probably had a faster and stronger impact on the Norwegian economy than we had assumed. The reasons for this may be that the key interest rate was previously changed in response to developments in the foreign exchange market. In addition, lending rates were regulated up to 1985. Today interest rates probably reflect household expectations to a greater extent. In the 1980s, when interest rates were regulated, house prices may have had this function. New estimates show that short-term interest rates have had a significant explanatory power since the end of the 1980s. A consumption equation with such an interest rate effect was first used in the model in the spring of 2000.²⁾

We exercise some degree of judgement in evaluating the model-based projections. In practice, this means that we adjust the model’s residual variables, which often enhances the accuracy of the projections. On the other hand, erroneous assumptions may be a source of forecast error. Our analysis is limited here to the effects of an erroneous esti- mation of the exogenous variables on our projections. This is illustrated by replacing our exogenous assumptions with actual values, and showing the outcome for some key variables (see Table 2). This does not mean that we necessarily obtain the projections we would then have presented. If we had known the effects of the actual values on the exogenous variables, it is likely that our assessment of the economic picture would have been different.

In the first line of Table 2 we have selected forecast errors for some of the main key variables. The next line shows the residual forecast error after incorporating the actual values for fiscal policy, money market rates and the exchange rate. The result is less accurate projections for private consumption, fixed investment and GDP growth, primarily because a higher interest rate is now incorporated. The projection for employment remains unchanged, partly as a result of the estimates for public consumption in both 1999 and 2000. Public consumption was significantly underestimated in 1999, but somewhat overestimated in 2000. This resulted in high-

2)See box in the June 2000 Inflation Report.