Long term challenges for fiscal policy

Ladies and gentlemen,

Thank you for inviting me, and congratulations with your three year anniversary. These three years have coincided with a very special period in the world economy – although I do not believe there is a causal connection between your establishment and the financial crisis. More likely, the course of events has posed challenges to you too, in this initial phase.

I am also very grateful for the opportunity to meet Mr. Kofi Annan here today and share in his deep insights into the geopolitical consequences of the financial crisis.

(As Mr. Annan pointed out,) the roots of the financial crisis are many and complex. High saving in China and other Asian countries pushed global long-term interest rates down. Low inflation and low growth after the millennium turn paved the way for a long period with expansionary monetary policy with low short-term rates. And American politicians had a strong wish to secure everybody their own house.

Nevertheless it is difficult to avoid the conclusion that also extensive speculation and imprudence have played an important part. Many in the banking and finance system have been imaginative and created innovations which may have been lucrative for them, but which have caused considerable damage to the society. The interplay of these various factors led to large imbalances and increased risk, and finally the most encompassing financial crisis since the Second World War. Those who have to pay the most are the millions of people all over the world who have lost their homes and their jobs. It is a moral paradox that several countries have spent billions on repairing the damage from the financial crisis.
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Even if we gradually will learn more about the mechanics of the crisis as experiences are gathered and analysis conducted, an important lesson seems to be that markets cannot be left to themselves. A market economy can underpin creativity and wealth creation. But if the activities don’t take place within appropriate rules and regulations, the market players may become too creative – serving their own benefits, but not the society’s. This creates inequality and unfairness. It is therefore a matter of duty that the authorities regulate the markets to safeguard the interests of the community. We do not want a society where conscientious workers must pay for the gains of the speculators. And neither do we want our children and grandchildren to pay for an imprudence committed by their ancestors.
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The Norwegian economy was also hit by the financial crisis. Even though Norwegian financial institutions were financially sound, the stress in international markets and economies also affected Norwegian banks and the economy but to a lesser extent than many other economies.  A good macroeconomic situation, sound financial market regulation and extensive policy measures have been the key factors contributing to the stabilization of the financial markets and the economy in Norway. 

In the period 1988 to 1993 Norway suffered a banking crisis, which started with problems in smaller banks, but ended up as a failure of the major part of the Norwegian banking system. The Norwegian crisis had domestic roots, and there are huge differences between that crisis and the recent international financial crisis. But there are also some strikingly similar elements. Let me mention deregulation of markets, excess liquidity, a lack of responsibility in the financial institutions, exotic financial innovation, a housing bubble, and lack of prudent control mechanisms.

A key lesson from the latest international financial crisis is that efficient and consistent regulation is an important precondition for financial stability, and that loss of financial stability may entail high macroeconomic costs. We have, in the 20 years since our banking crisis, developed our financial regulation and supervision, and we find the following elements to be fundamental:

• Financial regulation should be comprehensive and cover the whole financial sector.
• Financial regulation should be consistent – the same risk must be regulated in the same way whoever holds it.
• There should be one single supervisor for the whole financial market, which combines supervision of individual firms with macro surveillance.

A good Norwegian deposit guarantee scheme, where currently approximately 250 000 Euro per customer per bank is guaranteed, and the guarantee is backed by a pre-paid fund, has also served us well. The global financial crisis has showed the need for better financial market regulation and supervision both nationally and internationally. Some of the roots of the crisis may be found in strong growth in financial products and financial institutions, which was not subject to adequate regulation and supervision.  With closely connected global financial markets, we need sufficient international regulatory standards.

All relevant financial actors and all types of financial instruments should be subject to appropriate regulation and oversight. We need to close existing gaps and loopholes and achieve stronger capital requirements and better risk management. Regulation should be based on the principle of same risk, same regulation.

Substantial work has been laid down in this area in forums such as the Basle Committee, the IMF, the G20 and the EU. But important work still remains. The situation calls for a spirit of cooperation and a willingness to pull together. If we are unable to agree on better standards internationally, we risk ending up with a financial system that do not serve the global economy any better than the one we had before. Norway is a strong supporter of the efforts to improve regulation and supervision of banks and other financial institutions. We have taken due note of the initiatives from the G20 and the Basel Committee, and, participate in the working groups under the Commission on financial market issues.

New legislation on compensation schemes in firms in the financial sector was recently enacted. The Government is now in the process of implementing the new EU directive on remuneration policies, with regulations that inter alia curtail bonuses to senior staff in banks and other financial institutions. The purpose is to avoid excesses and promote financial stability.
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Even though Norway was relatively mildly hit by the recent financial crisis, we were not unaffected – and to some extent, the effects linger on. Certain industries exposed to international competition still face substantial challenges, with lower demand and prices on important products. When the crisis hit, the Government carried out several measures to keep the financial sector going. We set up a swap arrangement to improve bank liquidity, established a Fund to supply banks with core capital, and another Fund to improve demand in the market for private sector bonds. But our main goal, as stated so clearly by the Prime Minister, was to keep unemployment at the lowest level in Europe throughout the crisis. And we managed to reach this goal. This owes in part to our active labor market policies and flexible regulations on temporary lay-offs. But it was also important that the Norwegian central bank significantly reduced interest rates to a low of 1¼ per cent – and, not least, that there was a record high fiscal expansion. The use of petroleum revenues  rose by more than NOK 40 bn. from 2008 to 2009, ending up at NOK 110 bn. Together with the impact of automatic stabilizers this made a noticeable notch in the Governmental Petroleum Fund Global.

Other countries have had less favorable points of departure. For some, the financial crisis and international economic downturn have developed into severe domestic economic problems and major budgetary challenges, most notable in Iceland, Latvia and Greece. For the OECD as a whole, it is estimated that the average general government financial deficit as a share of GDP will more than double from 2008 to 2011 . Also the average debt to GDP ratio is set to increase, to approximately 100 pct. in 2011. Increased unemployment is one of the other consequences of the crisis. What worries me the most is the very high level of youth unemployment – now, 20% of  youths are unemployed in the EU [EU-15]. In several countries, like Spain, Ireland and Greece one talks of a lost generation, where a much too large share of youths never gain a foothold in the labor market. (Spania: 40,3 pst, Italia: 27,7 pst) This is obviously terrible for the youths in question, but also their societies, having to cope with increased social turbulence – and the public budgets.

And this at a time when comprehensive fiscal consolidation is needed. IMF has estimated that lowering the gross general government debt to GDP ratio back to the pre-crisis median of 60 pct. for advanced countries  by 2030, would require improving the underlying primary balance  by 8.7 percentage points by 2020 and maintaining this level for the following decade. OECD has presented calculations very much in line with this.

The challenges related to the building up of debt are particularly worrying as they come on top of what I still believe is the main long term challenge for economic sustainability – that of an ageing population. This challenge has been known for a long time. It is also shared by most developed countries – and some emerging markets – although some are harder hit than others. Japan is the classic example, where the old age dependency ratio  is projected to increase from 36 pct. in 2010 to 82 pct. in 2050. Germany is another, with an estimated growth from 34 to 61 pct. But even if the 2060 levels may be lower, the increase and thus the shock to sustainability, is even more pronounced in other countries, like Poland, Mexico, and China. Whichever way you see it, Norway is comparably fortunate, with an increase from 25 to 43 pct.
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Even though the ageing process in Norway is comparably modest, the long term challenges to fiscal sustainability turn out to be more severe than for many other countries. This owes partly to a higher growth in health care spending, but also to the expected developments in old age and disability pensions. In line with this, EU Ageing Working Group has estimated the rise in public expenditures as share of GDP to be stronger in Norway than in the EU15.

This illustrates the fiscal importance of the welfare system. A rising number of elderly means more welfare demand. Thus, boasting a generous and universal system of pensions, benefits and services does come with a cost.

While expenditures will rise, the petroleum revenues channeled into the public budgets are projected to fall. We have designed our fiscal policy framework to ensure a sound long-term management of the petroleum wealth. This is important for me as a Minister of Finance – to ensure that also the next generation and the generations after that can benefit from the petroleum wealth. Our framework implies that all petroleum revenues are channeled into the Fund, while the fiscal rule regulates the outflow. However, the petroleum production has already passed its peak. And although the Fund is projected to increase also on a medium term basis, the return will constitute a steadily smaller share of GDP already from about 15-20 years from now. The result is a gradually increasing gap between public expenditures and public revenues.
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Projections of fiscal sustainability are inherently uncertain. They depend on a host of assumptions about the oil price, the return on the Fund, demographics and so forth – factors which are largely beneath our control. But other factors we can definitely influence, and fortunately one of these is the most important of them all: Labor. High labor supply is paramount to ensuring fiscal sustainability, as it boosts tax revenues and may decrease the welfare expenditures. – And of course, labor is also beneficial for the laborer and the society at large. 

But how can we achieve higher labor supply? Again, Norway is in a slightly different position from many other countries. The labor force participation rate is already high among women and the elderly in an international perspective, while the structural unemployment rate is low. These sources of potential labor supply are all highly relevant in other countries, but in Norway this potential is to a large extent already exhausted.

But what we can do, is mobilizing some of those who are currently outside the labor market. This challenge is complex. Our pension reform is one important step in the right direction. Put into effect in 2011, this reform aims to increase the actual retirement age and also the labor supply from the working population by making work more economically worthwhile.

More broadly, increasing the labor supply is also about the education system – preparing and caring; the health system – healing and preventing; and the whole welfare state – providing safety and motivation. Changing circumstances calls for development – to keep what is valuable but to acknowledge that sustainability might require adaptation. And this reasoning goes far beyond fiscal sustainability.

After all, sustainability is not only about keeping the budgets. It is also about burden sharing, both between people nationally and globally, and between generations. One thing we have learned the past couple of years is that this can only be reached through a clever interplay between the authorities and the markets. We need economic growth which is sustainable both socially and environmentally, which again requires a fair distribution of the income.

Thank you.