Given that the livelihoods of millions of pensioners depend on getting this right, we think we need to recognise this uncertainty – by deducting a bit more from what can be counted as capital up-front to allow for it. I should be clear that this isn’t just the view of a prudential regulator – any sensible financial market participant will demand some buffer of safety (or ‘credit risk premium’) when potential losses are uncertain, and it is odd that the EU’s MA construct does not explicitly address this. [5] Second: wrong asset, wrong risk. Under the rules we have inherited from the EU, the amount of future losses firms are required to expect on their assets is based on the historical performance of corporate and government bonds. At the time the rules were negotiated these assets accounted  Page 6  for the very large bulk of insurers’ investments, so this made sense – but as insurers invest more in other sorts of assets, there is an obvious risk that those assets’ future performance will diverge from the benchmarks used in the rules. For example, it is reasonable to question whether the losses which might arise from investments in a commercial real estate loan today will be the same as those experienced on corporate bonds in the past – even if they have the same credit rating.
Some observers have therefore posed the following question: has the functioning of the economy changed so that higher demand does not necessarily translate into higher inflation, but instead results in growing financial imbalances? If so, a conflict may arise between achieving the inflation target in the short term and financial stability. There are several reasons why financial bubbles can develop in periods of low inflation. First, a highly credible monetary policy results in low inflation expectations. Explicit or implicit long-term price and wage contracts will become more common. It will take longer for higher demand to translate into higher inflation. Cyclical changes will have less impact on inflation. Moreover, periods of higher productivity growth may lay the basis for high corporate earnings, heightened optimism and reduced risk awareness. At the same time, with strong productivity growth, inflation remains low. Banks that record low losses and solid results can increase lending without eroding their capital adequacy level. Debt-financed investments may lead to a faster rise in house and property prices. A third factor is that strong international competition may contribute to curbing inflation during a period of strong economic expansion. China, because of its access to an abundance of cheap labour and its substantial production capacity, has contributed to a fall in prices for many manufactured goods. In Norway, we have not experienced situations where there has been a conflict between the objectives of financial stability and price stability.