Norway’s oil fund – officially, The Government Pension Fund Global – is the largest sovereign wealth fund in the world, topping 15 trillion Norwegian crowns (NOK) at the end of 2023 and owning 1.5 percent of all stocks worldwide.
One of the core values of the fund is to maintain wealth across generations, ensuring that the money amassed today serves as a foundation for the prosperity of Norwegians tomorrow.
To achieve this goal, successive Norwegian governments have followed a fiscal policy rule – known as "handlingsregelen" in Norwegian – that limits how much of the fund can be used each year.
Fredrik Wulfsberg is a professor of economics at the Oslo Business School at OsloMet and teaches courses on the Fiscal Policy Rule and the oil fund.
Through his research, he has shown that the rule is not only flawed – it is also a vehicle for additional economic uncertainty.
An oil-soaked economy
Norway is in a unique position thanks to its oil wealth and forward-thinking planning.
While other resource-rich countries spend lavishly on short-term projects or allow individuals and companies to grow exceedingly wealthy, Norway chose to mandate that the majority of the revenue from its oil profits go into a fund designed to provide for the future.
The country accomplishes this by reclaiming value at every stage of oil production and sale.
It collects environmental and land-use taxes, receives income through the state’s direct financial interest, enjoys dividends from oil investments, and owns 67 percent of Equinor – the state-owned oil company that manages Norway’s oil interests.
The result of this investment is the largest sovereign wealth fund in the world.
Nobody ever expected the fund to be this big.– Fredrik Wulfsberg
"Because the fund is now about four times Norway’s GDP, Norway could potentially spend an even larger portion of its wealth than it does today."
So, in order to prevent a spending spree and maintain the wealth for future generations, Norway implemented the Fiscal Policy Rule, which was designed to limit how governments can use the fund.
A "not-very-tight straight jacket"
Since 2001, the Fiscal Policy Rule has dictated that Norway can only use the expected real rate of return of the oil fund – in essence, the profits from the fund’s investments – and not the invested wealth.
This amount was originally set at four percent and later reduced to three percent in 2017. Wulfsberg describes the rule as "a not-very-tight straight jacket".
It constrains spending so the government does not go on a wild shopping binge, while still enabling governments to spend more on public expenditures than they would otherwise be able to.
The rule is also flexible and allows for more spending in a recession and less during a period of economic growth.
Crucially, the Fiscal Policy Rule has enjoyed broad political support since its inception. It serves as an example of rare unity cutting across the political spectrum, from the far-right Progress Party to the center-left Labor Party and parties further to the left.
The underlying idea behind the rule seems logical: the fund is expected to grow annually, and by spending only the growth part while safeguarding the principle, the fund should last forever.
The Fiscal Policy Rule is really important to the Norwegian economy and for Norwegians in general, both the living and future generations.– Fredrik Wulfsberg
The consequences of compound interest
The core flaw in the Fiscal Policy Rule’s logic is that it is based on the average or "expected" return on the investment.
If some years are a little better and others are a little worse, then it would seem like returns should average out and create a stable fund.
"It sounds like good intuition," says Wulfsberg.
"If you spend the average return each year, the actual return is sometimes a little less or a little more, leaving the principal investment’s value unchanged. That is the law of large numbers, but that does not apply here."
The problem is compound interest. The fund does not just go up or down by a percentage of the original amount; it changes by a percentage of the current year’s value.
When I started to simulate the changes in the fund, I was at first surprised when I saw its value decline. I believed that if you follow the Fiscal Policy Rule, the fund will last forever.– Fredrik Wulfsberg
As an example, Wulfsberg says to think of a starting amount of just 100 NOK.
If this year gives a good plus five percent return but next year has a bad minus five percent return, you might at first think that it would average out to zero percent and you would end up with your original 100 NOK back.
However, if you do the math you will find that you actually end up with 99.75 NOK, or slightly less than the original amount.
This might not be a big deal for our 100 NOK in the short run, but for a pot of money as big as the oil fund, over many years this can amount to a loss of billions.
An unbalanced problem
Wulfsberg has been simulating the effects of the Fiscal Policy Rule on the value of the oil fund over the next 100 years. He was initially inspired by the vision embodied by the rule to force governments to save for the future.
"When I started to simulate the changes in the fund, I was at first surprised when I saw its value decline," he says.
"I believed that if you follow the Fiscal Policy Rule, the fund will last forever."
Instead, he found that the fund will inevitably decline because of the compound interest rate effect.
In 100 years, the value of the fund will most likely be around two-thirds of its initial value if the Fiscal Policy Rule remains in place.
Wulfsberg acknowledges that he is not the first to realize this inherent flaw in the policy.
Some U.S. universities like Harvard boast endowments in the range of 500 billion NOK are governed by similar spending rules and have been struggling with this calculation since the 1980s.
As Wulfsberg explains, "it is a known result in economics, but it does not seem like policymakers in Norway have taken this into account."
As an example of this disconnect, he points to a recent opinion piece written by Norway’s finance minister (in Norwegian, regjeringen.no) and published in several major newspapers in which he reiterated the idea that if you just spend the expected return the fund will last forever.
Solving the equation
Wulfsberg speculates that the reason policymakers have not addressed the flaw in the Fiscal Policy Rule is rooted in the huge oil revenues that come into the fund every year.
"As long as more oil money is coming in, the oil fund grows and politicians can keep increasing spending each year."
Cutting short-term spending to preserve the fund for the future might not win many votes, but stabilizing financial policy is still a stated goal.
However, this method of divorcing the budget from volatile oil prices has had the consequences of tying it to volatile financial markets instead.
Wulfsberg says the focus should really be on making more sustainable and predictable fiscal policy.
One solution he suggests is to decouple fiscal policy entirely from financial markets by instead limiting the budget deficit to a percentage of GDP.
If the fund loses money, the budget would not necessarily have to change immediately.
This approach would provide stability in the policy, but would also ensure that the fund decreases faster with no direct connection to its financial performance.
It is a delicate balance between stable policy and a fund that would remain robust for generations.
The main takeaway is that if you stabilize policy, you destabilize the fund. You cannot have both!– Fredrik Wulfsberg
Saving for the future
Ultimately, it will be up to the politicians to determine how to handle the diminishing fund.
For his part, Wulfsberg has begun to question whether the goal of saving the fund will matter for future generations.
"Even if you want the fund to last forever, the current rule does not do that."
The only option for preserving the fund indefinitely, according to Wulfsberg, is to spend drastically less.
Even then, he wonders whether future generations will need the money. As Norway transitions away from oil and toward a greener economy, the money pouring into the fund will dry up.
Wulfsberg points out that productivity growth will mean that future generations will be much richer than we are, even without the fund.
Wulfsberg intends to continue studying the Fiscal Policy Rule and running simulations of financial volatility with different rules in place. His goal is to find solutions that will satisfy both fiscal stability and fund stability.
"The math is impossible to escape," he says.
The onus is on politicians to make the necessary decisions for the economic future of Norway.
"At the very least," he says "politicians should stop repeating that the fund will last forever."
