Economic perspectives.

• Position: Norway's economic history and its future - Statistical Data Included - Transcript

Annual address by Governor Svein Gjedrem at the meeting of the Supervisory Council of Norges Bank on Thursday 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.

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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, ie price and exchange rate stability, have also coincided with periods of steady and solid economic growth.

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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 primarily financed by printing money. Price inflation accelerated in most countries, also in Norway. The gold standard was suspended.

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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 a 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.

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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 post-war period featured low and stable inflation and buoyant economic growth.

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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 post-war 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 due to 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 sector and the sheltered sector.

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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.

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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 ore.

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 per cent in 1987 to almost 6 per cent 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 a 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...