Speech by Minister of Finance Siv Jensen at "Valutaseminaret 2017".
On March 10th 1976, a fairy-tale was published in the Swedish evening tabloid Expressen. The story was about Pomperipossa, a children’s book author who lived in Monismania, a country far, far away. Monismania was a good place to live, but now and then the Government made some strange decisions. One time the Government decided that Pomperipossa had to pay 102 percent in tax. She was left wondering what wrong she had done to children to deserve such a high tax rate. Would she need to quit her beloved job to afford to live?
The fairy-tale, of course, was based on a true story, and written by Astrid Lindgren in response to the 102% marginal tax rate incurred in 1976. It illustrates that economic policy, the economic interference with people’s lives, can indeed be destabilising: In this case to a single person, but more generally to the whole economy. The lessons learned from Sweden in the 1970s, and also from our own country at the time, is that economic policy matters – it has the power to undermine economic growth, but it also has the power to support it, if crafted wisely.
My talk today will emphasize the roles of monetary, fiscal and macroprudential policies in stabilising the economy.
Today, monetary policy is the first line of defence against economic shocks. Fiscal policy is the second, and should also help stabilise the economy when necessary, but generally has a more medium term view. The newcomer in this policy mix, macroprudential regulation, aims to ensure financial stability.
This allocation of responsibilities is quite new. In the decades prior to the introduction of the inflation target and the fiscal rule in 2001, fiscal policy was expected to do the job of stabilisation, while many of the macroprudential measures were yet to be introduced. In the aftermath of the financial crisis, important revisions have been made to economic policies across the world. Today, the role that prudential tools can play has become evident. Furthermore, the limited room for more expansionary monetary policy in many OECD countries has motivated a renewed call for countercyclical fiscal policy.
I will argue that there needs to be a well-designed division of labour between fiscal, monetary and prudential policies when seeking to stabilise economic developments.
Let us first have a brief look at how the division of labour between monetary and fiscal policy has changed over time, and why the discussion on discretionary fiscal policy now is back on the agenda. Then, I will turn to the latest contribution to our toolbox and describe the need for and setup of macroprudential measures.
Before 1936 and Keynes’ famous book, «General Theory of Employment, Interest and Money», there was a consensus that recessions were to be accepted in market economies. They were not being actively fought, neither with monetary nor fiscal policy, and interest rates and government budgets were generally not seen as tools for stabilising the business cycle.
Monetary policy was centred on money supply, and in most countries geared at keeping the exchange rate at a given parity. The approach proved to have some serious shortcomings. Norwegians earned the experience in the 1920s, when Norges Bank set the goal of parity for the krone above other goals, such as high employment. In the US, economists were unable to act on the 1930s’ depression. Even though interest rates eventually reached a very low level, aggregate demand was weak.
Such hard-earned lessons of the 1920s and -30s sparked fresh thinking on the role of fiscal policy, especially on its potential for handling crises and recessions. Keynes’ General Theory, which emphasized potential welfare gains from fiscal measures in dire circumstances, is often seen as the starting point of decades of active fiscal policy in developed countries.
In Norway, Keynes’ ideas exerted significant influence over fiscal policy after the Second World War. The following decades were characterized by great optimism regarding the effect of fiscal stimulus and detailed economic steering. The Ministry of Finance was carefully controlling economic policy with all its bells and whistles. By and large, this optimism lasted until the late 1970s. From this decade on, Keynesian ideas came under attack from a range of academic economists as well as conservative and liberal politicians.
The idea that high growth and low unemployment could be achieved at the price of high inflation increasingly became the subject of criticism by economists like Milton Friedman. Furthermore, the Lucas critique, namely that agents in the economy take policy changes into account when shaping their expectations, was popularised in the late 70s. A third major topic from this period is that of rules versus discretion in economic policymaking, introduced by the Norwegian Nobel Prize laureate, Finn Kydland, and his co-author Edward Prescott in 1977. Combined, these critiques were powerful in arguing that activist fiscal and monetary policy could end up doing more harm than good.
It is important to remember that monetary policy at the time was conducted by elected politicians. Only in the second half of the 1980s was Norges Bank handed the right to set the key interest rate independently. Like many small open economies, Norway kept its exchange rate pegged until the 1990s, when it was gradually given up. This was a necessary reaction to international trends; first and foremost the liberalization of credit markets, including international capital movements.
The inflation target was formally introduced almost a decade later, in 2001. By then, we had recognized that monetary policy should play a more prominent role as a defence against economic shocks, as stated at the outset. And, gradually, the Copernican revolution was fulfilled: Monetary policy was assigned the first line of defence, whereas fiscal policy would be applied according to medium-term considerations, in line with the fiscal rule.
The guideline for fiscal policy – our fiscal rule – today is at the core of our economic policy framework. The State’s net cash flow from the petroleum industry is transferred to the Government Pension Fund Global in its entirety and invested abroad. The transfers back from the Fund to the central government budget shall, over time, reflect the expected real return from the Fund. In a given year, the use of oil money shall be adapted to the economic situation. This rule not only ensures a gradual and sustainable use of oil revenues in the Norwegian economy. It also has the important function of anchoring expectations about how fiscal policy will adapt to shifts in the economic environment, and expectations of sustainable public finances in the long run.
The years after the regime shift in economic policy in 2001 have been characterized by low and stable inflation in Norway. Both at home and internationally, there is now widespread agreement that an inflation target, or related concepts, is the state of the art in conducting monetary policy.
In the same period, high production and prices of oil and gas have contributed to a rapid accumulation of capital in the Government Pension Fund Global. Few other countries have succeeded to the same extent in saving resource revenues. Meanwhile, the fund and the fiscal rule shields the budget from short-term fluctuations in oil revenues, and gives us fiscal space to counteract economic downturns. These results have granted our fiscal framework international recognition.
As you are aware, the term «fiscal policy» is not only referring to discretionary policies, such as tax changes or «packages» of public expenditure designed to boost demand. A main ingredient of fiscal policy is automatic stabilisers. When economic activity and employment weaken, causing lower tax income and higher welfare and unemployment expenditures, the budget deficit is allowed to increase. Over the past decades, many economists and policymakers have viewed these stabilisers as the most important part of fiscal policy.
In Norway, as well as in other countries with a wide-reaching welfare state, the automatic stabilisers are large.
And in the case of Norway, it is fair to say that during the crisis of 2008/2009, and since the oil price shock of 2014, automatic stabilisers have played an important a role in counteracting the downturn, maybe even more important than the discretionary measures that were taken. At the same time, discretionary fiscal policy was never absent from the economic discussion, in part reflecting Norway’s healthy government finances. In many other OECD countries, fiscal policy had been too lax in the run up to the financial crisis, based on growth forecasts that later turned out to be too optimistic. Automatic stabilizers were definitely the main ingredient of fiscal policy, but proved insufficient to avoid years of high unemployment and low growth in the aftermath of the crisis, as did monetary policy. In some countries, due to high public debt, the room for manoeuvre in fiscal policy was too limited when it was needed.
Why fiscal policy was left out
One of the reasons why fiscal policy has been considered inferior to monetary policy in stabilising the economy, is that it is subject to political debate and parliament rule. This could mean that desired fiscal stimulus cannot be delivered in time, reducing the potential welfare gain of these policies. When a shock hits the economy, monetary policy is able to adapt quicker than discretionary fiscal policy.
A second much-discussed point regarding discretionary fiscal policy is that it may crowd out private investment and exports by raising interest rates. This claim has some empirical support. Several academics, as well as researchers at the IMF and the OECD, have argued, however, that this effect is likely to be less of a problem in a situation when monetary policy is constrained by the effective lower bound, and thereby strengthening the case for discretionary fiscal policy under such circumstances.
Further, there is the argument that if the government accumulates debt when conducting expansionary fiscal policy, it may reduce the space for action later on. This argument is a relevant part of the discussion for many indebted countries, but also to a lesser extent in today’s low rate environment.
Many countries have experienced that it is difficult to pursue fiscal policy in a symmetric way – it is easier to stimulate than to tighten. Excessive use of expansionary measures may translate into the accumulation of debt over time, gradually undermining the ability to respond properly to new shocks.
Finally, there is the discussion of whether foresighted agents will anticipate that an expansionary fiscal policy sooner rather than later will have to be undone, potentially reducing its impact. However, there seems to be a consensus that fiscal stimulus does have an effect on demand, also when the stimulus is temporary.
Monetary policy is characterized by its scarcity of instruments as well as its wide-ranging effects – it gets into all the cracks. Fiscal policy, on the other hand, is a common term for a multitude of policy instruments and can, at least in principle, be altered on a very detailed level in order to achieve the desired effect on economic activity. However, estimates on fiscal multipliers vary greatly depending on timing and choice of instrument, making it hard to assess the effect of discretionary fiscal stimulus.
These objections, as well as the success of monetary policy in stabilising the economy in the 90s and early 2000s, are the reasons why fiscal policy was gradually put on the back-burner in the stabilisation policy textbook, albeit to a lesser degree in Norway than in other countries. In 2002, Robert Solow remarked that «Serious discussion of fiscal policy has almost disappeared».
Today, 15 years later, such serious discussion has reappeared and has been on the agenda for some time.
Policy combination in a low-rate environment
In the aftermath of the Great Recession, a number of countries have reduced their key policy rates to record lows. This has opened the door for unconventional monetary policy measures. Quantitative easing has been applied by a number of central banks, aiming to spur growth when policy rates have reached the effective lower bound. Despite these measures, economic activity has been slow to pick up in many countries, except, perhaps, in the US and the UK. It is this situation, often described as a low-growth trap, which has brought fiscal policy back into the warmth of countercyclical economic policymaking. After decades of relying on monetary policy to accommodate the dual target of stable economic development and low and stable inflation, there is now a call for more active use of fiscal policy measures. The OECD argue in their latest Economic Outlook that fiscal space has increased as a result of low policy rates, and that fiscal initiatives would support long-term growth (OECD, 2016). I am sure that the chief economist of the OECD, Catherine Mann, will elaborate on that later today. Their message is that the fiscal stance should be reconsidered, taking consequences for growth into account, instead of focusing solely on the budget balance.
Others support this view. As the former Chairman of The Council of Economic Advisors, Jason Furman, stated last year: “When monetary policy is constrained, fiscal policy may be effective because monetary policy will not partially offset fiscal policy through interest-rate or exchange-rate channels.” (Furman, 2016, page x)
Furthermore, Furman argues that discretionary fiscal stimulus can be very effective and may in some circumstances even crowd in private investment, if conducted in an appropriate way. That is, if the policy measures are economically profitable.
This has also been the Norwegian Government’s approach in recent years, facing the oil price drop from the summer of 2014 – a significant negative demand shock for Norway. And just to be clear: The challenge Norway now faces, with lower growth-contributions from the oil industry to the mainland economy, is first and foremost a lasting, structural change in the Norwegian economy. We have therefore prioritized measures to support necessary structural adjustments. That is, measures that seek to increase potential growth, such as investments in infrastructure and education, and a new tax reform that encourages business investment and employment in Norway.
At the same time, there has been a need for short-term stabilisation policy to cushion the impact on the economy. A crucial question in this situation is what role monetary and fiscal policy can and should play. So far, the downturn seems to have been weathered off quite well, with joint efforts from monetary and fiscal policy.
The key policy rate has been reduced to a record low, while still keeping some space for future easing if needed. The exchange rate has weakened, and thereby improved competitiveness in Norwegian businesses that are exposed to international competition. At the same time, fiscal policy has been expansionary, and recent budgets have included extraordinary measures directed towards regions and sectors especially exposed to the oil price drop. Monetary policy is unable to attain such directed measures. Readily available projects have been quickly executed, and we have avoided the implementation lags often associated with fiscal policy. We have invested in infrastructure projects, implying a strong fiscal multiplier. According to the OECD, the stimulus from Norwegian fiscal policy and the way it is conducted is in line with their recommendations.
When institutions such as the OECD now call for fiscal policy to play a more important role in the context of business cycle management, I don’t consider it a desire to return to the years of fine-tuning the economy. Rather, it is about acknowledging that certain forms of discretionary fiscal policy may have a positive effect when the economy faces serious problems related to weak aggregate demand.
Indeed, we need to combine monetary and fiscal policy when striving to achieve economic stabilisation. Still, the two have been proven not to be sufficient.
The financial crisis in 2008 was a painful reminder that financial imbalances can build up and cause major crises in the real economy. Such systemic risks in financial markets may be present even when inflation and production growth seem stable and individual financial institutions seem effectively regulated.
Financial cycles – driven especially by the development in credit and house prises – typically last longer than business cycles. Financial imbalances can continue to build up long after the business cycle has peaked, even when economic performance is relatively weak. When financial imbalances eventually unravel, a downward spiral could easily occur, where instability in financial markets and weak economic growth mutually reinforce each other. Recessions that follow financial instability tend to be deeper and longer lasting than other recessions. We have learned this both from our own banking crisis in the early 1990s, and from the experiences of other countries.
Because business cycles and financial cycles do not always correlate, we need to supplement traditional monetary policy and banking regulation. Alternative tools are necessary to achieve both economic and financial stability through the cycles. Effective alternative tools may also reduce the need for monetary policy to lean against the wind when real and financial cycles are pointing to different policy actions.
In the aftermath of the international financial crisis, much effort has been made to address systemic risk in financial markets. New policy measures have been introduced under the common term “macro-prudential policies”. The objective of these policies is two-fold:
- Firstly – to increase the resilience of the financial system by building buffers that can be drawn on to mitigate the effects of disturbances and downturns. Building buffers in good times may also constrain financial booms, but this effect is uncertain and probably small.
- Secondly – the policies aim to identify and manage contagion effects in the financial system, resulting from, for instance, similar activities in banks, risk concentration and interconnectedness.
Norwegian authorities have implemented a number of new instruments, and given renewed attention to existing policy measures that can be characterized as macro-prudential tools. Together with Sweden and Switzerland, we were among the first countries to introduce such tools to address systemic risks associated with high growth in house prices and household debt.
In line with stricter capital requirements, Norwegian banks have substantially improved their capital ratios and become more resilient to losses. A countercyclical capital buffer has been implemented on top of other buffer requirements.
Other measures are aimed at improving the resilience of the heavily indebted Norwegian households.
Norwegian households’ debt is at a historical high, at 2.5 times their disposable income, and even higher for young households. This is indeed also high compared to other countries.
The heavy debt burden has built up over decades, fuelled by rapid growth in house prices. Since the banking crisis in the early 1990s house prices in Norway have risen almost continuously, and increased particularly fast last year.
Following this development, a regulation from the Ministry of Finance on prudent residential mortgage lending was tightened last year. The purpose of the regulation is to strengthen the resilience of households and improve lending practices. Today, the regulation caps the loan-to-value ratio on residential mortgage loans at 85 per cent and requires amortisation when the loan-to-value ratio exceeds 60 per cent. In addition, lenders must make allowance for an interest rate increase of 5 percentage points when assessing a borrower’s debt-servicing ability. An additional element is a cap on borrowers’ total debt at five times the gross annual income when taking up new mortgage loans.
It is important to provide banks with some flexibility in parallel with the caps and limits of the regulation. Creditworthy customers should have a chance to be granted mortgage loans even if they fall short on one or two of the requirements. A flexibility quota – a speed-limit –allows for 10 percent of the loans granted each quarter to deviate from the requirements in one way or another.
House prices in Oslo have increased by more than 20 per cent over the last 12 months, significantly higher than the 13 per cent price growth nationally. This is not sustainable over time and may give rise to particular vulnerabilities. We have therefore introduced special provisions for lending in Oslo in the mortgage lending regulation. These include a much stricter loan-to-value cap at 60 per cent for secondary homes and a smaller flexibility quota for banks.
Policymakers need to juggle at least three balls at the same time, ensuring that monetary and fiscal policy are wisely conducted and combined with a steady use of macro-prudential tools.
Monetary, financial and prudential policies represent possibilities for economic stabilisation. But the tools must be handled with care. The fact that they are available does not mean we should use them too much. On the contrary, as with many nice things in life, they must be used in a healthy way to be good for us. Their presence should not encourage politicians, like myself, to develop unfounded optimism on fine-tuning the economy. Our main job is to accommodate well-functioning economic mechanisms, to ensure that market participants make good choices for themselves – choices that result in the stable economic growth we want.
Astrid Lindgren’s saga about Pomperipossa was a reminder that economic policy is not just a desktop exercise at the Ministry of Finance, but indeed affects the way our economy works. The saga caused a stormy debate in Sweden when the finance minister of the day patronized Lindgren for not being good with numbers. She responded that he was even better than her in telling fairy-tales and suggested they switch jobs. The debate ended in the defeat of the Social Democrats later that year, after 40 years in power, and the tax level was eventually brought down.
Always, the combination of policies has to be well designed – both in upturns and downturns – and with a view for the long run. This is what we aim for in our policymaking.
Furman, Jason (2016): The New View of Fiscal Policy and Its Application, Remarks to the Conference: Global Implications of Europe’s Redesign, New York, 5 October.
OECD (2016): Chapter 2: Using fiscal levers to escape the low growth trap, OECD Economic Outlook, Vol. 2016/2, OECD.
Keynes, John Maynard (1936): The General Theory of Employment, Interest and Money. Palgrave Macmillan.