Equality, growth and sustainability – an impossible combination?

Ladies and Gentlemen,

The Times They Are A-Changin’, Bob Dylan told us some 45 years ago. That may have been before most of you were born. Yet we still live in an age of turbulence, and circumstances are certainly changing rapidly.

Three years ago the financial crisis triggered the most serious economic recession since World War II. While its impact is still being felt, new challenges are emerging, spurred by weakened public finances. In addition, developments in the Middle East and North Africa have provoked political upheavals and energy price hikes. Droughts and inundations in important food-producing countries have contributed to large-scale crop failures, translating into rising world market prices on food. And in mid-March Japan was hit by the strongest earthquake ever registered in the country.

These developments are rather different in nature. Yet, they highlight the fact that we live in an interconnected world. What happens in one part of the world affects the lives of people in other parts.

Few places reflect the global aspect of our world better than the London School of Economics. With students from all over the world, you constitute a fairly global society. In an increasingly interconnected world, studying in such an environment has substantial value in itself. In addition, LSE ranks high among the world’s universities, and as students graduating from this institution you will provide us all with skills and expertise. It is a great honour to be here today and speak to such a distinguished audience.

Indeed, recent years’ turbulence in global markets has shaken our thinking about market efficiency and how economies work. Although some ideas have been seriously questioned, others have gained renewed foothold. In my lecture here today I will look into some aspects of this discussion from a Norwegian perspective. While the global recession indeed was felt also in Norway, its impact was more limited than elsewhere. The financial sector was only mildly affected. Also, unemployment stayed low, public finances remained sound and the recovery now seems to be gaining a solid footing. The large petroleum sector has protected the Norwegian economy from the worst effects of the crisis, but this is only part of the story. Indeed, also our neighbouring Nordic countries have managed fairly well. Although there are substantial differences between our countries, I believe that some common features in the way the Nordic societies are organized have contributed to this achievement.

One truth that in my opinion has not been challenged in the course of the past years is the significance of trust. Data from a number of countries reveal the positive correlation between the degree of inter-human trust and material well-being. Indeed, trust is crucial for specialization and trade – and for the smooth operation of markets. Without trust many advantageous transactions will not be executed. This was clearly illustrated when financial markets collapsed in 2008.  One important feature of the Nordic society model is, as I see it, that it incorporates qualities contributing to the building of trust among citizens.

I will organize my discussion around three pillars:

• I will start out with a recent event, the financial crisis. One major lesson from the breakdown of financial markets in the autumn of 2008 was how important trust among market participants is for markets to function. Trust again rests on the marketplace being sufficiently transparent so that participants are confident of the substance of their transactions. This was not the case in financial markets in the time leading up to the crisis of 2008.
• The second pillar I will talk about is the importance of sustainable fiscal policies, a lesson learnt by many resource-rich countries, but of relevance also to others.
• Finally I will discuss social equality, an essential part of the so called Nordic model. In my view, equality may strengthen trust and enhance growth and a good economic performance.

I will deal with each issue in some detail and bring in perspectives from my years as a politician. I leave it to you to judge whether our experience also can be of some relevance for others.

As I mentioned, an illustration of the importance of transparency was provided to us during the autumn almost three years ago when the world’s financial markets were on the verge of a total breakdown. While warnings against widening imbalances and credit-driven booms in housing markets were voiced, very few predicted the full extent of harmful consequences arising from the complexity of financial markets. Both financial institutions and investors, and even municipalities, invested in risky objects they didn’t fully understand.

Asymmetric information between lenders and borrowers, and between market participants and regulators, is a general characteristic of financial markets. Borrowers know more about their own ability to service debt, and banks have more information about their own risk exposure than regulators. This information problem is therefore something that regulators and supervisors always have to take into account in the design and implementation of financial market policies. However, prior to the crisis, it seemed that the seriousness of the information problem had been growing, and in 2008 asymmetric information had turned into a serious transparency deficit. When the crisis started it was almost impossible to separate the solid from the less solid banks in globally integrated markets, and confidence evaporated. The consequence was close to full stop in access to credit for banks, households and businesses.

Moreover, when looking for the roots of the global recessions, it is difficult to avoid the conclusion that also extensive speculation and imprudence played an important part. Imaginative individuals and institutions came up with innovations which may have been lucrative for the originators, but very costly to the society. Those who carry the cost are the millions of people who have lost their jobs and in some cases also their homes. In my view it is a moral paradox that countries have spent billions on repairing the damage from the financial crisis. Speculators and imprudent institutions should face the consequences and be made accountable. Making them accountable will in turn discourage unnecessary high risk taking and reduce the likelihood of future financial crises.

The recession has been the concern of the advanced countries of the world. The very same advanced countries, when advising developing countries on economic policy issues always stresses the importance of transparency and accountability. We should not advance so far that we forget to follow these principles ourselves. On several accounts, that might be seen as exactly what happened.

In Norway, the banking system performed relatively well during the financial crisis. One reason why Norwegian banks were less affected this time is, I believe, that we could lean on experiences from our own banking crisis some 20 years ago. What started out as problems in smaller banks in the late 1980s, ended up as failure of the major part of the Norwegian banking system. As the finance minister also at that time, I learned that making banks accountable and protecting the tax payer is crucial. I also learned that government recapitalisation of banks does not have to be costly for the taxpayer.

During the Norwegian banking crisis in the early 90s the government injected equity capital into banks, while private share capital was written down on the basis of a realistic assessment of loan losses. This ensured that the equity capital injected by the government also could benefit from upside opportunities. The Norwegian government assumed 100 per cent ownership of the three largest banks. The board of directors and senior management in each bank were replaced. Then, in the years following the crisis, the government gradually sold its shares in the nationalised banks – at a profit.

Moreover, in the 20 years since Norway suffered its banking crisis we refined our financial regulation and supervision, and we find the following three elements to be fundamental:

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

This system has served us well. However, financial markets worldwide have become both more complex and more integrated in the last 20 years. I therefore agree with the urgent need to improve international standards for financial market regulation, and I welcome the important role the Basel committee, the IMF, the EU and the G20 has taken in moving this issue forward. Concerted action is of great importance, and I am looking forward to further co-operation on the development of international financial regulation.

Deficiencies in financial markets were not the only weakness revealed during the global recession. This brings me to the second pillar in the concept of trust: The importance of sustainable fiscal policies. As the role of government interventions became more pressing, the strength of public finances was put on a test. What started as a financial crisis soon posed great challenges to public finances in a number of countries, with large deficits and rapidly increasing sovereign debt burdens. For some countries risk premiums have sky rocketed. However, not only financial markets may become nervous. Lack of confidence can also spread among taxpayers in these countries. Those are the ones who eventually will carry the burden.

When governments implement policies that are unsustainable, citizens may make arrangements to secure themselves. And Governments’ policies become less effective. In economic literature one often makes references to Ricardian equivalence.

Some 40 years ago Norway discovered oil on its continental shelf. This new resource has given us a privileged position. Today, the petroleum sector makes up more than 20 pct. of Norwegian GDP and almost 50 pct. of exports. The sector has given rise to a thriving supply sector and spurred technological innovation in a number of highly advanced niche industries, which are also finding their ways into new markets. As the world’s ninth largest exporter of crude oil and second largest exporter of natural gas, Norway is also an important participant in international energy markets.
 
However, many countries have experienced that transforming rich resource endowments into a lasting provision of welfare is indeed complicated. Expressions like “paradox of plenty”, “resource curse” or “Dutch Disease” are sometimes used to describe the development in countries that failed to do so. Clearly, excessive spending of high, although temporary, revenues is tempting, but will lead to levels of expenditures that are impossible to sustain in the longer term. Moreover, sectors of potentially high importance when resources are exhausted will be crowded out. Or one might get a situation where productive resources are wasted on rent-seeking behaviour, with decreasing economic efficiency as a result. Consequently, little wealth is left for generations to come.

Contrary to many other petroleum-rich countries, Norway had already developed a well-functioning democracy and fairly good economic institutions when we struck oil. From the very start considerable attention could therefore be given to designing an appropriate macroeconomic framework. It was early recognized that the main challenge was to transform a high and temporary revenue stream into an annuity. It took some time, however, and some hard learning, before we managed to settle on the present combination of a sovereign wealth fund and a prudent fiscal policy rule. 

According to our framework, the Government’s net cash flow from petroleum activities is set aside in a sovereign wealth fund and invested abroad. While the fund first and foremost is a saving vehicle, the expected real return on the fund is phased into the government’s budget every year, allowing for a more generous expenditure side than would otherwise have been the case. While fund capital can be spent only once, the real return can hopefully be spent forever. In this way, we gradually increase the spending of petroleum revenues at the same time as we shelter the mainland industries from large and fluctuating currency flows stemming from the petroleum sector. Moreover, we won’t use more of the oil revenues than what is sustainable in the long run. Hopefully, our children and grandchildren will inherit their share of the spending capacity generated by the resources with which my generation was endowed.

Without doubt, the petroleum resources and our macroeconomic framework gave us a favourable starting point when the financial crisis hit. Public finances were good and allowed us the necessary room of manoeuvring - of which full use was made. In 2009 we increased the spending of petroleum revenue well above the expected return of the fund, but it now seems that we will be well back on track again this year.

The need for sustainability is not confined to resource-rich countries, however, and present experience has shown that excessive public borrowing can lead to many of the same symptoms as excessive spending of petroleum revenues. Moreover, borrowed money must be repaid.

Public support for a prudent management framework of the petroleum revenue rests on revenue being spent to the benefit of the broad public, not only the few. This brings me to my third pillar, namely social equality. The legitimacy of a government that spends common resources, whether raised through taxation or collected as an economic rent on natural resources, rests on its ability to provide its citizens with adequate welfare distributed by principles considered to be fair. As we all know, fairness is a question of some controversy and the exact content may vary among countries, social groups and individuals. Nevertheless, in Norway there seem to be a fairly broad consensus on the benefits of an extensive social security net and equal access to education, health and care.

Economic theory sometimes presents us with a trade-off between economic efficiency and equality. Pursuing equality will lead to a loss of efficiency, which translates into lower output and meagre prospects of growth. However, looking at data, we see a quite clear trend suggesting that countries with a high degree of equality grow faster than countries characterized by inequality. Still, as is often the case in empirical studies, causality is harder to establish. Without entering too far into this academic discussion, I do think it is safe to say that the experience of the Nordic countries is an example of substantial harmony rather than conflict between growth and distribution.

So, what are the main features of the so called “Nordic model”? While both political and systemic differences among the Nordic countries are many, the term intends to capture some similarities in the institutional setup of these neighbouring countries. Among these are large public sectors and generous welfare schemes, strong unions, and to a large extent also fairly centralized wage bargaining and routine consultations between government and the social partners.

The model tends to produce a high degree of income and social equality. Key here is low wage differentials, high rates of work participation, an accordingly broad tax base and a public sector delivering basic goods and services to those the private sector fails to serve with equal ease.

In all societies the most valuable resource is labour. Historically, the broad coverage of strong labour unions in the Nordic countries pushed full employment onto the labour movement agenda. Full employment has often been traded against wage moderation, as union leaders have recognized the importance of full employment for a satisfactory wage growth over time. Accordingly, when achieved, full employment has allowed the economy to produce at or close to its production-possibility frontier. In addition, full employment has ensured a broad tax base, allowing the tax burden that supports the welfare state to be shared by the many.

Still, full employment is no guarantee for an efficient allocation of resources. As we know, productivity differs between jobs, and high productivity is crucial for growth to be sustainable. Yet, what we have seen is that a comprehensive income insurance scheme in combination with ambitious and active labour market policies has facilitated a reallocation of labour from declining low-productivity industries to rising high-productivity industries.

Further, high-productive firms employing highly educated workers face favourable conditions. A suppressed wage structure lifts the wage of low-paid workers, while decreasing the wage of the highly educated. As a result, high-productive firms may stay in business at the expense of the less productive ones. While difficult to measure, it is argued that innovative activity raise accordingly.

Our welfare scheme provides equal opportunities and free education for all children and youth, a social security net that takes care of people losing their job, the right to health care for those who needs it and care for elderly to ensure a worthy old age. Knowing this enhances trust. I also believe it may spur clever people to taking on the risk of starting new businesses and embark on innovative projects that will gain the country in the future. Income insurance transfers the risk of industrial readjustments from the individual to the state, allowing the individual worker to be more flexible in the process of modernization.

Even though the welfare scheme might be costly, I do believe the gains are even bigger. Clearly this is conditioned on the scheme and the financing of the scheme being designed in a sound way. Work must pay, and the security net and pension schemes must provide sufficient incentives to work. Certainly, this way of organizing the society requires relatively high taxes, which again increases the importance of designing a tax system that minimises efficiency losses.

My impression is that the willingness to pay taxes is high in Norway, in an acknowledgement of what we get in return. One example may be the gasoline tax rate, which is high by international standards. Even though Norway is one of the biggest petroleum exporters in the world, there is almost no discussion of this tax. This is by the way also one of the most sensible taxes, due to the environmental distortions stemming from CO2-emissions.

I will stress that the Nordic model is not a result of grand design. Rather, today’s features are the outcome of a long evolutionary process. Consensus-based policies and the cumulative implementation of reforms have produced its current version. Moreover, the model is not identical among the Nordic countries. However, I believe our way of organizing the society does reflect some important common values.

While the global recession spurred renewed interest in the Nordic model and its ability to create a society in which trust is widespread, it can be no more than an example. Each society has its own path of developments. Yet, economic thinking after the global recession would probably gain from looking at a broad range of experiences. I hope my speech here today can be one of many contributions in our search for sustainability in the economic system.  

We live in a knowledge society. Books, papers, television and the internet enable us to get information about almost anything at high speed. At the same time, societies have become more complex and specialized, making information less accessible for many of us. The accumulation of knowledge is endless and learning takes place within an increasingly technical and mathematical frame, accessible only for experts. Indeed, in a growing number of areas we have to trust what experts tell us.

You are now gaining knowledge within fields in which you will be the experts. Yet wisdom requires more than knowledge gained from studying. One has to learn from the successes and the mistakes of earlier generations. And you must listen to your hearts. A wise man, Nelson Mandela, once said: “A good head and a good heart are always a formidable combination.” Deploy your skills and knowledge wisely, and you will contribute to the creation of trust in your society.

I started out today by quoting one of my favourite songwriters Mr. Bob Dylan. Mr. Dylan also told us that there are answers out there. Capture them and use them for the best of yourself, your children and for society.

Good luck and thanks for listening