III Financial Market Turmoil and Economic Policies in Industrial Countries

International Monetary Fund. Research Dept.
Published Date:
October 1995
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Bond yields and exchange rates have posted relatively large movements over the past year and a half. During 1994. long-term interest rates rose between 175 and 500 basis points across the industrial countries. They then tumbled in 1995. largely reversing the 1994 run-up in many cases. Although such swings are not unusual by the standards of the 1970s and 1980s. They were nevertheless surprisingly large in view of the high degree of price stability that has been reestablished in most countries (Chart 15). There have also been wide shifts in exchange rates. By mid-1995, for example, the effective exchange rate of the yen had appreciated by almost 25 percent from its already high level at the end of 1993. Then between mid-1995 and early fall, the yen depreciated sharply, roughly reverting to its late 1993 value. Movements in other currencies have been less dramatic but have nevertheless contributed to widespread concerns that exchange rate movements may have been restraining growth in countries with strong currencies, while adding to inflationary pressures in countries with depreciated currencies.

Chart 15.Major Industrial Countries: Long-Term Interest Rates and Consumer Price Inflation

Recent swings in long-term interest rates contrast with generally subdued inflation

1GDP-weighted average Of ten-year (or nearest maturity) government bond rates for the United States, Japan, Germany, France, Italy. United Kingdom, and Canada. Excluding Japan prior to 1967.

2Percent change from four quarters earlier.

It is difficult to find complete explanations based on economic fundamentals for these movements in asset prices that are applicable to all countries. The sharp appreciation of the yen and then its subsequent decline is particularly difficult to explain in terms of fundamental economic factors. On the other hand, recent adverse swings in market sentiment have affected financial market prices in a number of countries with relatively weak policy fundamentals. Throughout 1994. Countries with large budget deficits tended to experience the biggest increases in long-term interest rates.9 Sweden and Italy, for instance, had among the highest ratios of budget deficits to GDP over the 1990–94 period and suffered some of the largest interest rate hikes. Despite partial reversals in 1995, these countries continue to experience exceptionally wide interest rate differentials relative to Germany. And over the first half of 1995. Countries with persistently large external deficits saw their currencies depreciate relative to countries with stronger external positions, perhaps reflecting increased market concerns about the sustainability of external imbalances in the wake of the Mexican crisis.

Countries with depreciating currencies in the first half of 1995 also generally had a less successful track record in controlling inflation (Chart 16). It seems clear that fundamentals do influence market sentiment, and that international investors recognize actual or potential policy weaknesses and adjust their portfolios accordingly, albeit sometimes with a lag. It is also clear that financial markets can serve to discipline and reinforce policy decisions in a helpful way.

Chart 16.Selected Industrial Countries: Inflation and Changes in Effective Exchange Rates1

Countries with historically higher inflation saw their currencies depreciate the most in the first halt of 1995.

1 The effective exchange rates take account of relative importance of a country’s trading partners, of competitive relations with “third countries,” of differences in the importance of the foreign sector, of the commodity composition of trade, and of estimated trade elasticities.

At the same time, there are valid concerns that shifts in market sentiment may exacerbate problems in countries with weak fundamentals, create new problems in other countries, and generally complicate policymaking. In Sweden and Italy, for example, high interest rates have led to mounting interest payments on their public debt, making attempts at fiscal consolidation even more difficult, while sharply depreciated exchange rates have increased inflationary pressures. In addition, the appreciation of some European currencies that had been the counterpart to the weakness of the lira, the krona, and the peseta dampened business confidence in some countries and led to downward revisions of growth expectations. The sharp appreciation of the yen until mid-1995 clearly worked in the opposite direction from what was needed to foster economic recovery. The strong yen meant lower net exports and hence reduced aggregate demand in an economy that is still struggling to break out of a protracted downturn. The yen’s appreciation also contributed to declining price levels in Japan and heavy losses in the yen value of Japan’s foreign assets denominated in foreign currency.

Market Volatility Versus Fundamental Misalignment

A certain amount of financial sector volatility is natural and reflects the healthy flow of information among market participants. Normal week-to-week or month-to-month fluctuations in financial prices do not necessarily hurt overall economic performance.10 Occasionally, fundamental misalignments do occur, however, when markets push prices decidedly away from their long-run equilibrium values for long periods. In this case, the costs can be much more significant. It is admittedly difficult to judge when a misalignment has occurred, because a temporary overshooting of financial market prices may simply reflect different speeds of adjustment in financial and goods markets in response to changes in economic policies or other shocks.11 The possibility of misalignments was acknowledged in the Interim Committee’s communiqué of April 1995. which said that recent exchange rate movements for some major currencies had gone farther man warranted by fundamentals. Subsequent currency reversals strengthen the argument that the early 1995 movements did represent a misalignment. The sharp drops in world long-term interest rates in 1993, the spiking of rates in 1994, and the subsequent decline again in 1995, also suggest the possibility of overshooting in bond markets in some countries.

Misalignments of exchange rates may be due to inappropriate policies, incorrect views about future policies, or anomalies in market behavior unrelated to fundamentals. While a policy-related imbalance may justify a large movement in an exchange rate based on short-term fundamentals, the currency may still be misaligned from a longer-term perspective. One clear case in recent history of significant misalignment of a major currency was the surge of the U.S. dollar during the early 1980s, which at least partly reflected the combination of a highly stimulative fiscal policy and a restrictive monetary policy in the United States. During the later stages of that episode, especially by late 1984 and early 1985. bandwagon or speculative bubble effects also appear to have played a role.

Currency misalignments have undesirable welfare consequences for both the country with the misaligned currency and its trading partners. First, misalignments give the wrong price signals to investors, labor market participants, producers, and consumers, so resources are not allocated efficiently. Resources are shifted into or out of tradable goods sectors to a greater extent than may be desirable or sustainable on a long-term basis. If there were no barriers to the migration of labor, if capital were perfectly fungible, and if there were no startup or shutdown costs, then such disruptions might not matter much. But there are many rigidities in the world’s investment and labor markets, and disruptions occur both when the misalignment builds up and when it is eventually unwound, leading to cumulative economic welfare losses that could be very large.

Misalignments can also worsen macroeconomic problems and complicate stabilization policy. A sharp depreciation of a currency below its fundamental equilibrium value, for example, would tend to boost inflation, and thereby contribute to escalating wage demands. While there would be a beneficial effect on inflation in the country with the overvalued currency, there could be negative welfare effects if the overvaluation leads to a decline in prices. Misalignments could also spill over to third parties whose currencies are linked to an overshooting currency, and such linkages will tend to amplify welfare losses across the world economy. Overvaluation can also lead to protectionist pressures and exacerbate trade frictions. Obviously economies need to adjust if an exchange rate movement is in line with fundamentals, and the sooner the better. But if the movement will eventually be reversed because markets have overshot, then the costs may be significant.

Since there are welfare losses from currency misalignments, what should governments do to avoid them? First and foremost, governments should correct macroeconomic imbalances as soon as they appear to reduce the risk of future market turmoil. As is generally the case when imbalances are allowed to persist and credibility suffers, stronger action may eventually become necessary, at potentially great cost, to focus market attention on a government’s resolve. There may also be a role for currency intervention, not as a substitute for correcting fundamental policy imbalances. but as a temporary prod to help guide markets to a better reading of the underlying fundamentals and the balance of risks. In some cases, publicly announced multilateral actions such as the Plaza Agreement of 1985 may be useful in correcting large and persistent currency misalignments. Even in this case, however, governments will need to adjust economic policies including through coordinated policy actions. Without such policy changes, it may be difficult to convince the currency markets that exchange rates are out of line with longer-term fundamentals.

Did Currencies Overshoot?

Before discussing whether exchange rates, as they stood in mid-1995, may have been misaligned, it is useful to recall that the exchange rate is a price that will inevitably change over time. The need for such changes arises from disturbances and policy changes that affect countries asymmetrically, from differences in cyclical developments across countries, from differences in productivity growth and inflation performance, and from changes in investment opportunities that affect the international flow of capital. Such changes in exchange rates may not always be welcomed by the countries concerned but are nonetheless necessary and desirable. With pegged exchange rates, this implies that occasional realignments may be necessary to avoid the buildup of unsustainable external imbalances and to alleviate the costs of having to compensate for the lack of exchange rate flexibility exclusively through demand management policies. An assessment of the appropriateness of movements in exchange rates needs to distinguish between economically justified and desirable exchange rate changes and fluctuations that appear to go beyond what seems to be warranted by fundamentals.

The lira and the Swedish krona depreciated sharply after the two currencies were floated during the 1992 crisis in the European Monetary System. These depreciations largely reflected the need to adjust for earlier losses of competitiveness as well as cyclical factors, particularly in Sweden where the recent recession was unusually severe, but there may have been an element of overshooting. The continued steep depreciation of these currencies in early 1995 may have been related to political uncertainties (in the case of Italy), and to continued doubts in financial markets about the prospects for reducing the large fiscal imbalances in the two countries. However, in view of strong export performance and the sizable swing into external surplus of both countries since 1992, as well as strengthened commitments to fiscal consolidation, the lira and the krona do appear to have been somewhat undervalued by the spring of 1995. The weakness of these currencies until recently also began to exert pressure on inflation, complicating macroeconomic stabilization efforts for both countries. As their budget consolidation efforts translate into lower actual budget deficits—which markets now may have begun to expect with greater confidence—there should be scope for some further exchange rate appreciation as well as for a significant reduction of the large premiums in their long-term interest rates. In Canada, where the weakness of the currency may have been exacerbated by political uncertainties, the dollar also appeared to be somewhat undervalued relative to the fundamentals. While the desirability of reducing Canada’s longstanding external deficit is an important consideration, the recent level of the exchange rate appears to be consistent with a substantial improvement in the external position.

The sharp appreciation of the yen against the dollar between early 1993 and mid-1995 is particularly difficult to reconcile with the changes in the fundamental determinants of exchange rates that occurred. Admittedly, during this period the inflation differential and the U.S. bilateral trade deficit with Japan would have suggested some yen appreciation. Over the nine quarters from the first quarter of 1993 to the second quarter of 1995, for example, the consumer price inflation differential would have indicated about a 4½ percent cumulative yen appreciation for the exchange rate to be kept unchanged in real terms. But other factors should have worked in the direction of a weaker yen relative to the dollar. Cyclical movements over this period more than explain the increase in the U.S. trade deficit with Japan and the underlying or cyclically adjusted external imbalances of both countries tended to decline as a result of earlier exchange rate changes. In addition, interest rates swung significantly in favor of the dollar over this period. The weakness of activity and low returns on many financial investments in Japan would normally also have been expected to increase the incentive for Japanese investors to invest in markets with stronger performance.12

Of course, it cannot be excluded that the appreciation of the yen over this period served to correct a previously undervalued exchange rate. However, a macroeconomic balance approach for assessing long-run equilibrium values for exchange rates supports the view that the yen was overvalued in mid-1995. Such an approach, although based upon important assumptions and therefore not very precise, calculates exchange rates that are consistent with internal and external balance, where internal balance means full employment with reasonable price stability and external balance means that the current account position is consistent with desired and sustainable levels of private saving and investment at full employment.13 As the private sector in Japan has a very high saving rate, and because population aging indicates a need for the Japanese fiscal balance to shift to surplus over the medium term, it is plausible that total national saving would continue to exceed total domestic investment at full employment. This excess of national saving over domestic investment would be reflected in a current account surplus and associated net capital outflows to the rest of the world. The staff’s analysis suggests that a moderate external surplus would be consistent with Japan’s saving-investment needs over the medium term. The very high value of the yen in the summer of 1995, however, would not have been consistent with the maintenance of such a moderate surplus. In this sense the yen can be said to have been overvalued.

What then accounted for the strength of the yen? Many factors were at work, but reduced recycling by Japanese investors of large current account surpluses may have been particularly important. Because of the secular rise in the value of the yen, the value of Japanese foreign assets measured in yen has been reduced by as much as $400 billion since 1980, implying a large-scale depreciation of Japanese overseas wealth. Many of these losses occurred between early 1993 and mid-1995, and may well have increased the aversion of Japanese investors to currency exposure. This may have led to a vicious circle, whereby reduced Japanese capital outflows led to yen appreciation, which increased yen-based losses on foreign assets. Which then caused more sales of foreign assets or fewer foreign purchases. Political or confidence factors may also have been important during this period. Policy considerations related to Japan’s difficult economic situation are discussed below.

While a reasonable case can be made that movements in the yen, the lira, the krona, and possibly the Canadian dollar through the middle of 1995 had overshot relative to the fundamentals, it is less clear that the U.S. dollar overshot significantly. The dollar’s weakness against other major currencies was partly compensated by its strength against the Canadian dollar, the Mexican peso, and several other currencies. As a result, the U.S. currency did not appear to be significantly undervalued relative to medium-term fundamentals on a real effective basis, although it certainly did depreciate to the lower end of its trading range of recent years. Of course, assessment of the appropriate value of the dollar also needs to take into account the desirability of reducing the external deficit. At the current level of the dollar. U.S. tradable goods industries still enjoy a high degree of international cost competitiveness; and a substantial improvement in the U.S. current account, which is desirable for both domestic and external reasons, would appear to be potentially achievable. Whether this desirable adjustment will materialize will depend on the degree to which macro-economic policy, especially fiscal policy, will restrain the growth of domestic absorption, thereby allowing resources to be shifted toward net exports.

The third major currency, the deutsche mark, appreciated significantly in early 1995 against the U.S. dollar and against several European currencies, including the lira and the krona, as already discussed, as well as against the pound sterling and the peseta. The appreciation came on top of earlier rises in the effective value of the deutsche mark, particularly in 1992, which had to a large extent been consistent with the deterioration in Germany’s external position necessary to finance the high level of investment in the eastern Lander, The early 1995 rise was, however, less easy to justify on fundamental grounds, and it has since fallen by a few percentage points. Fiscal consolidation in several European countries with highly depreciated exchange rates could help to reverse some of the deutsche mark’s appreciation in recent years.

Fiscal Consolidation and Currency Values

The Fund has often emphasized the need for fiscal consolidation for both domestic reasons and to help correct external imbalances. As part of the process of adjustment to a smaller current account deficit, for example, it has been widely recognized that a currency would generally need to depreciate to make a country’s exports more competitive, and domestic saving would have to increase relative to investment demand. That is, the exchange rate and fiscal consolidation would work together to correct a large external imbalance. How would these factors help to reduce persistent $150 billion a year U.S. current account deficits? The sharp decline in the value of the dollar since 1985 has greatly improved the U.S. competitive position in world markets, which has helped to reduce the external deficit from a peak of 3¾ percent of GDP in 1987 to a projected deficit of 2½ percent of GDP in 1995. However, the dollar’s depreciation might have produced a larger reduction of the external deficit if the adjustment process had not been tempered by high levels of domestic demand. In an economy close to full employment with a large external deficit such as the United States, reducing the external imbalance will require a decline in domestic demand relative to output, for example through fiscal tightening, if increased net exports are not to overheat the economy and erode the competitive position through higher inflation.

In the long run, a stronger equilibrium net foreign investment position should imply a stronger currency. As discussed in the Annex, lower budget deficits should lead to a higher level of national saving, an improved current account position, and less need to borrow from foreigners. Lower external deficits and lower net foreign liabilities would mean lower interest payments to foreigners, and this would reduce the trade surplus necessary to service the foreign liabilities. To induce a smaller trade surplus with the rest of the world, the real exchange rate must eventually appreciate. This result is intuitively plausible in that a country that saves more than its trading partners will accumulate more foreign assets and ultimately its currency will strengthen relative to other currencies.

In the short run, the effects of fiscal tightening on the exchange rate are more ambiguous. Fiscal consolidation would normally cause a country’s aggregate demand to decline and its real interest rate to fall, and this would tend to cause the real exchange rate to depreciate, according to the standard Mundell-Fleming model of an open economy. In this model, changes in the real interest rate and the real exchange rate are the mechanisms that equilibrate aggregate demand and aggregate supply in the various regions of the world. But risk premium factors might work in the opposite direction of the interest rate effects. From a portfolio balance perspective. International investors allocate their portfolios on the basis of total expected returns available from assets denominated in different currencies. If the supply of a country’s securities is relatively large, then risk-averse investors may require a larger total return to induce them to hold a higher share of those securities in their investment portfolios. The total expected return in domestic currency on a security denominated in foreign currency is equal to the interest rate plus the expected change in the value of the currency in which the security is denominated. The higher total return required by investors could be provided either through a higher interest rate or through a temporary decline in the value of the currency that would imply an expected appreciation (or a smaller expected further depreciation). Thus, following a fiscal tightening, a lower supply of securities would tend to reduce the total risk-adjusted return that financial markets would demand. As a result the exchange rate might appreciate and risk premiums in interest rates might decline.14

For Sweden and Italy, and perhaps also Canada, the size of the premiums in long-term interest rates and the persistent weakness of exchange rates suggest that confidence effects may well dominate, and that these currencies could appreciate as credible progress is made with fiscal consolidation, even in the short run. For the United States, where confidence effects seem much smaller and only appear to affect the exchange rate, the initial effects of fiscal consolidation, especially a heavily front-loaded package in the face of a weak economy, would probably be a depreciation, in accordance with the standard Mundell-Fleming result. However, with a more gradual fiscal consolidation package and a sustained expansion of economic activity, confidence effects should provide a substantial offset to the Mundell-Fleming interest rate effect. On balance, taking into account the recent depreciation of the dollar against the other major currencies, the dollar might well tend to strengthen relatively quickly, at least relative to what otherwise might transpire, if the fiscal deficit were progressively eliminated over the medium term.

Priorities for Policy Action

The Madrid Declaration and the April 1995 communique by the Interim Committee spelled out a set of policy commitments to promote sustained global economic expansion and to reduce foreign exchange and financial market tensions. These commitments included continued trade and capital account liberalization, strengthened fiscal consolidation efforts, and a readiness to use monetary policy to tight incipient inflationary pressures. The Declaration specifically advocated fiscal tightening in 1995 and over the medium term, and noted that countries with serious fiscal problems should not delay corrective actions, because financial markets would be unsympathetic and would demand ever larger real interest premiums.

How have the industrial countries done by these criteria? Although there have been few new measures since the adoption of the Madrid Declaration, there does appear to have been some progress in recent years in reducing underlying or structural budget deficits over and above the normal improvements that have come with the recent economic recoveries (Table 7). These underlying improvements, including expected progress this year under current legislation, have been quite significant in Germany, the United States, Italy, the United Kingdom, and Canada. Among the smaller industrial countries, there has been significant progress in reducing structural deficits in Spain, the Netherlands, and, more recently, Sweden. There also appears to be strong, and in some cases increased, commitments to step up efforts at fiscal consolidation over the medium term. Many countries have established strengthened medium-term targets for deficit reduction, including in countries such as Italy and Sweden, that have been struggling with particularly large fiscal imbalances.

Table 7.Industrial Countries: General Government Fiscal Balances and Debt1(In percent of GDP)
Major industrial countries
Actual balance-2.9-2.6-3.7-4.1-3.5-3.3-3.0-1.9
Output gap-0.10.2-0.8-2.2-1.6-1.5-1.5
Structural balance-2.8-2.9-3.3-3.0-2.6-2.5-2.2-1.9
United States
Actual balance-2.5-3.2-4.3-3.4-2.0-1.9-2.0-1.4
Output gap-0.4-1.3-1.5-
Structural balance-2.4-2.8-3.6-2.9-2.0-2.1-2.1-1.4
Net debt36.749.853.856.257.657.657.755.3
Gross debt50.563.766.868.868.968.969.066.2
Actual balance-
Output gap0.33.00.6-2.4-4.1-5.7-5.8
Structural balance-
Net debt20.
Gross debt66.767.771.276.683.290.695.9103.6
Actual balance excluding social security-4.0-0.7-2.0-4.9-6.5-7.0-7.0-5.6
Structural balance excluding social security-4.1-1.7-2.2-4.0-5.0-5.0-5.0-5.6
Actual balance-2.1-3.3-2.9-3.3-2.5-2.5-2.11.2
Output gap-
Structural balance-1.5-5.2-3.9-2.2-1.2-1.2-1.0-1.2
Net debt20.621.427.735.
Gross debt39.841.143.747.849.857.858.557.4
Actual balance-2.0-2.2-4.0-6.1-6.0-5.2-4.5-2.7
Output gap0.10.5-0.5-3.9-3.1-2.2-1.70.1
Structural balance-2.1-2.4-3.6-3.6-3.8-3.6-3.2-2.8
Net debt322.
Gross debt29.635.539.645.348.451.153.155.5
Actual balance-10.9-10.2-9.5-9.6-9.0-7.7-6.5-2.8
Output gap2.11.8-3.4-3.3-2.5-1.9-0.1
Structural balance-11.8-11.2-9.6-7.9-7.3-6.5-5.6-2.7
Net debt73.396.2103.0112.0117.2114.9113.0101.9
Gross debt80.7105.9113.4123.2129.0126.5124.3112.1
United Kingdom
Actual balance-2.0-2.6-6.1-7.8-6.8-4.9-3.2-0.7
Output gap-0.6-2.3-4.4-1.5-2.9-2.1-1.2
Structural balance-1.3-2.7-3.7-4.4-4.1-3.1-2.0-0.6
Net debt40.326.728.132.537.742.443.138.9
Gross debt48.033.634.940.445.949.049.645.4
Actual balance-4.5-6.6-7.4-7.3-5.3-4.6-3.4-1.3
Output gap0.1-2.6-3.7-4.0-2.1-2.2-2.1-0.2
Structural balance-4.4-4.9-4.8-4.6-3.8-3.3-2.3-1.2
Net debt30.149.756.961.964.467.268.465.0
Gross debt60.979.987.392.195.498.098.792.7
Other industrial countries5
Actual balance-2.3-3.5-4.5-5.94.9-3.9-3.1-2.1
Output gap0.1-0.2-1.5-3.4-2.6-1.8-1.3-0.1
Structural balance-2.9-3.7-3.7-3.4-2.8-2.6-2.2-2.1

Despite the generally positive trends in fiscal positions, it is apparent from the still-large fiscal deficits that much remains to be done to restore an adequate degree of fiscal balance and to put ratios of public debt to GDP on a clearly declining trend in all countries, there by alleviating pressures on global real interest rates. In many cases, the planned medium-term objectives may not take fully into account the need to build up assets in public pension systems in view of aging populations. In most countries, hoped-for deficit reductions are yet to be spelled out in legislation. And many countries are only making slow progress, missing the opportunity posed by the generally favorable global economic situation to achieve more significant deficit cuts.

In Japan, the fiscal position has weakened considerably in recent years as the authorities have appropriately supported activity through a series of expansionary fiscal measures. As the recovery eventually picks up, the fiscal position should improve. Under current policies, however, the underlying position would worsen substantially in the future as the aging population increases public spending and as a result of the high levels of public investment envisaged in the authorities’ ten-year investment plan. While there is a need for continuing fiscal support in the near term, significant new measures will be needed over the medium term to contain the fiscal deficit at a sustainable level.

Achieving the needed additional reduction in fiscal deficits will not be an easy task, suggesting considerable risks of policy slippages. In some countries, tax revenues may need to be increased, which could be done by eliminating economically or socially unjustified tax breaks. In most cases, however, the emphasis needs to be on expenditure cuts. As the scope for achieving minor cuts in existing expenditure programs is exhausted, governments will increasingly need to reform major programs. Among the issues that need to be addressed are unsustainable pension plans, the sharply rising costs of health care, distortionary and costly subsidies, and the modification of overly generous and unsustainable indexing schemes and formulas. In this context, the recent declarations of intent by both the U.S. Congress and the administration to balance the budget over the next seven or ten years are constructive because they have shown that policymakers are willing to consider reforming a range of social programs. Bui the intended pace of implementation seems very slow. In Sweden, sustained implementation of the recently announced medium-term consolidation program is essential to the restoration of credibility. Italy also is reducing its large deficit and debt problems, but further measures to achieve the targets of the three-year fiscal plan remain to be specified and financial markets still appear to have doubts about the ability of Italy’s political system to deliver these measures. In Greece, uncertainties about the fiscal outlook continue to be reflected in large premiums on long-term interest rates. And in Spain, where interest-rate premiums are also substantial, it is critical that measures be adopted to achieve the objectives in the government’s convergence plan.

In contrast to the significant further progress that is still needed in the fiscal area, the maintenance of inflation levels closer to price stability than seen in close lo thirty years in many industrial countries is a major policy achievement. Monetary authorities in the United Kingdom, the United States, New Zealand, and Australia have demonstrated their readiness to tighten policy to prevent inflation from increasing. Because of this, inflation remains low in many countries that are relatively far along the expansion path. In those countries where inflation has picked up lately, it is mainly because of currency depreciations. Higher import prices have contributed to inflationary pressures in Italy and Australia, and to a smaller extent in Sweden, Canada, and the United Kingdom. Nevertheless, the domestic inflation effects of the large depreciations experienced in recent years appear to have been smaller than past experience would have suggested. Import price inflation is also higher than domestic inflation in the United States for the first time in half a decade, but the relatively small weight of imports in GDP tends to mute the impact on inflation. Most of the rest of the industrial countries are not yet close to full employment, and it is too early to tell how quickly and vigorously their policymakers will respond when inflation signals do appear. But commitments to safeguard progress toward price stability appear strong everywhere. Meanwhile in Japan, the strength of the yen and persistently weak demand have combined to produce a special problem, declining price levels.

Rebalancing Policies for More Sustainable Growth

Further progress in fiscal consolidation would help to foster sustainable economic expansions by reducing the risk of financial market turbulence and through generally lower long-term interest rates. Countries that take determined steps toward fiscal consolidation may also be candidates for some monetary easing. Such rebalancing of policies would have the effect of switching expenditure away from government spending and toward interest-sensitive components of demand, especially private investment, which in turn should raise productivity and real incomes.

With inflation generally under control in most of the major industrial countries, a gradual easing of money market conditions in the context of fiscal consolidation and potential declines in long-term interest rates need not compromise hard-earned anti-inflationary credentials. The behavior of exchange rates is an important consideration in many countries, especially European countries working toward monetary union by the end of the decade. For these countries, the risks of precipitating an unwanted depreciation must be weighed against the benefits of stronger macroeconomic performance and a consequently improved fiscal situation. However, stronger efforts at fiscal consolidation and stronger growth prospects should help to alleviate some of the principal causes of tension in European currency markets.

The medium-term baseline projections foresee a soft landing with moderate growth on the basis of policies currently in place.15 Even better results would be expected with the implementation of bolder policies to eliminate budget deficits and make labor markets more flexible. This is illustrated in a scenario that assumes that all of the industrial countries tighten fiscal policy to reduce demands on world saving and implement labor market reforms to reduce structural unemployment rates (Table 8).16 Budgets are assumed to be balanced by 2000, and it is assumed that budgets remain in balance until about half of the 30 percentage point increase in the industrial country aggregate debt-to-GDP ratio—built up between 1980 and 1995—is unwound. Spending cuts comprise the bulk of the deficit reductions. It is assumed that payroll taxes and unemployment compensation benefits are cut and that other labor market rigidities are reduced so that structural unemployment rates fall by about 1 percentage point on average.

Table 8.Industrial Countries: Balanced Government Deficits in Five Years and Reduced Structural Unemployment Rates Scenario(Percentage deviation from baseline unless otherwise noted)
1996–971998–992000–01Long Run
Industrial countries
Real GDP-
Capital stock0.
inflation (GDP deflator)10.5-0.5-1.0
Unemployment rate0.2-0.6-0.9-1.0
Short-term interest rate1-0.3-1.2-2.2-0.4
Long-term interest rate1-0.1-1.9-1.9-0.4
Real long-term interest rate1-0.1-1.5-2.0-0.4
General government balance/GDP10.
Government debt/GDP1-1.7-4.5-9.3-17.9
Contribution to real GDP
Real government spending1-0.6-1.4-2.2
Real consumption11.51.41.3
Real investment10.
Real net exports10.10.1
Note: The simulation assumes that a gradual reduction in public debt stocks is achieved through cuts in real spending and nondistortionary transfers. The fiscal consolidation is enough to achieve fiscal balance by 2000 but is not credibly viewed as permanent until 1998. In addition, it is assumed that revenue-neutral cuts in unemployment compensation and labor taxes reduce the natural rate of unemployment by approximately 1½ percent in Europe, over 2 percent in Canada, and 1 percent in the United States.

Assuming that it takes bond markets a few years to view the deficit reduction actions as fully credible, the simulation suggests that long-term interest rates would thereafter be between 100 and 200 basis points lower than otherwise. Short-term interest rates would also decline as monetary policies reflected the improved fiscal environment. Investment would respond to the lower interest rates, resulting in a faster growing capital stock. This would boost productivity and tend to reduce inflation. This tendency toward lower inflation, even with higher output, would be reinforced by more flexible labor markets, and the unemployment rate would be lower, which would improve fiscal positions. Real GDP would be permanently higher. If financial markets view the policy change as credible from the start, long-term interest rates would fall faster and growth would be even higher.

The simulation exercise underscores several key lessons. First, falling interest rates should come to the aid of governments that undertake fiscal consolidation. Second, labor market reform is critical for achieving long-run fiscal consolidation and for raising real incomes in the long run—of the 2½ percent increase in real output in the long run, 1 percent is due to the assumed reduction in structural unemployment. Finally, there may well be some moderate up-front costs during the early phase of the consolidation process, implying that the best time to start would be when inflation fundamentals are favorable and growth is strong. With industrial countries currently enjoying some of the best inflation fundamentals in decades, and with generally solid growth prospects, the next few years offer an excellent window of opportunity to put fiscal houses in order. The short-term costs of the necessary fiscal belt-tightening would be small and the long-term gains would be substantial and durable.

Costs of Policy Slippage

The favorable scenario can be put in perspective by comparing it with a less attractive outcome. The future may not unfold so smoothly as in the soft-landing baseline projection. In particular, it cannot be excluded that policymakers will overreact to the current softening of growth and inappropriately relax both monetary and fiscal policies. Signs of sluggish growth have already led to some monetary easing in several countries. With tax reductions publicly debated or in the pipeline in the United States, the United Kingdom, and Germany, and possibly insufficient expenditure restraint in many other countries, there is also a risk of fiscal backsliding.

As noted in Chapter II, the risks of an undesirable and persistent economic slowdown in countries such as the United States, the United Kingdom, Canada, France, and Germany seem to be rather low, and there are few signs of the inflationary pressures that traditionally appear near business cycle peaks. Wage demands for the most part remain moderate, there is no heavy overhang of inventories or new construction, bank lending is adequate, stock markets are reasonably strong, and the bond market rally of 1995 has reduced long-term interest rates so that housing activity and investment should rebound with a normal three or four quarter lag. Clearly, policymakers must carefully monitor inflation signals and make sure that they do not overstimulate economies today, only to suffer a much harder landing in 1997 or 1998 and possibly earlier financial market reactions.

A “hard-landing” scenario illustrates the dangers of such mistakenly procyclical policies, and shows that the benefits would be fleeting and the costs high (Table 9). The simulation assumes that governments increase spending and cut tax rates, while at the same time the monetary authorities reduce short-term interest rates. Although real GDP might be boosted over the first year, inflation would soon spike upward, requiring a severe monetary clamp down. Budget deficits and debt-to-GDP ratios would be higher than the baseline, boosting long-term real interest rates. This would dampen investment spending, cause the capital-income ratio to decline, and reduce long-term productivity growth and potential output. In addition to a possible recession in 1997 or 1998, real GDP in the industrial countries would be permanently reduced relative to the baseline projections.

Table 9.Industrial Countries: Hard-Landing Scenario(Percentage deviation from baseline unless otherwise noted)
1996–971998–992000–01Long Run
Industrial countries
Real GDP0.8-0.5-1.0-1.7
Capital stock-0.2-0.8-1.5-5.3
Inflation (GDP deflator)11.90.9-0.1
Unemployment rate-0.6-0.20.4
Short-term interest rate11.21.40.3
Long-term interest rate10.
Real long-term interest rate10.
General government balance/GDP11.4-2.5-2.1-0.5
Government deht/GDP10.
Contribution to real GDP
Real government spending10.
Real consumption10.4-0.5-0.9-1.6
Real investment1-0.3-1.0-1.1-1.0
Real net exports1-0.1
Note: The simulation assumes that the growth rate of money increases by approximately 2 percent a year in 1996 arid 1997 before returning to its baseline rate of growth. It is also assumed that fiscal policy is eased so as to increase debt stocks by around 10 percent of GDP, phased in gradually over five years. It is assumed that these policy changes are known in 1996 and consequently are relief led in expectations. The estimates for the long run represent the permanent effects of the shocks.

Labor Market Policies

Labor markets are a key priority policy area for the industrial countries. The lack of progress is most apparent in Europe, where structural unemployment has risen dramatically during the past twenty-five years. The level of structural unemployment in Europe may now be on the order of 8-9 percent. This compares with broadly stable levels of structural unemployment of about 6 percent in the United States and 2½ percent in Japan. Structural unemployment has also increased substantially in Canada and Australia, over the past two decades, although not to the levels now prevailing in Europe.17

In economic terms, the largest cost of unemployment is the forgone output that could have been produced by the unemployed. The temporary output losses from the typical postwar recession are trivial compared with, for example, the yearly loss of about 3 percent of GDP that would result from a structural unemployment rate of 9 percent rather than 6 percent.18 Other costs of sustained levels of high unemployment are also important. These include the social exclusion and loss of social cohesion that come with long-duration unemployment, a distinguishing feature of European labor markets; the budgetary costs to governments of labor market programs, which averaged more than 3 percent of GDP in Europe in 1993–94, two thirds of which were on passive income support to the unemployed;19 and the leaching of economic dynamism from the economic system that, together with the labor market rigidities that contribute to high unemployment, makes economies less able to respond to adverse shocks or to take advantage of new opportunities in an increasingly competitive global market.20

Given the high levels of unemployment, it is not surprising that this issue has been near the top of the political agenda recently. Many countries have in fact taken steps to reduce distortions that contribute to high unemployment. The policy actions that have been taken include measures to reduce employers’ social insurance contributions for the young, low-skilled, or unemployed; to exempt, or to lessen the impact of, minimum wages for young workers; to increase wage flexibility by reducing or eliminating indexation provisions and by increasing the importance of local conditions in the wage formation process; to increase the flexibility of working time; to improve education and training; to encourage job search by reforming unemployment benefits and related welfare payments; and to improve the effectiveness of active labor market policies.21 While these policies should help to lower unemployment, other recent policies, such as increases in minimum wages and restrictions on fixed-term contracts, are likely to raise unemployment.

It is too early to tell if, on balance, the policies that have been recently adopted will be sufficient to lower structural unemployment significantly. Thus far, unemployment remains at or near its cyclical peaks in most continental European countries, and projections by most private and official analysts suggest little further decline as expansions mature. This points to the need for more fundamental, broad-based reforms to address the root causes of high unemployment. There is evidence that efforts to make labor markets more flexible in countries such as the United Kingdom and New Zealand may have lowered the level of structural unemployment. In New Zealand, for example, the unemployment rate has fallen by a remarkable 4 percentage points during the current expansion with little evidence of higher wage pressures, suggesting a fall in the equilibrium level of unemployment.22 In the absence of more fundamental labor market reforms in continental Europe, current cyclical unemployment may be transformed into another step increase in structural unemployment.

Progress in this area will require that governments address sensitive issues of equity and fairness. Structural reforms to reduce unemployment may sometimes have unfavorable distributional consequences in the short run. To address these concerns, labor market reforms should be accompanied by appropriately designed, well-targeted transfer programs. Labor market reforms may adversely affect some insiders already employed, implying that reforms will be politically difficult to implement. Policies that mainly protect the interests of the employed are often justified by the need to foster social cohesion and to prevent social exclusion, which is paradoxical because these same policies often contribute to high levels of structural unemployment. In the long run, the only durable solution to social exclusion and low wages of the low skilled is improved training and education to raise labor productivity and incomes.

Special Policy Challenges in Japan

After four years of protracted weakness, and with no immediate signs of recovery, Japan faces a unique policy challenge. Labor market slack is high by Japanese standards, there is a threat of spreading price declines, and the continued weakness of asset prices hurts business and consumer confidence.23 The declines in land prices, stock prices, and in the yen value of foreign assets, all down by roughly one half, have had widespread negative wealth effects. Additional obstacles have included the pressure that the strong yen placed on the economy until very recently, and the financial sector disruptions caused by some high-profile insolvencies. The result is that even with the recent sharp depreciation of the yen, the recently upgraded Fund forecast for economic growth in 1996 implies no narrowing of the wide output gap.

Policy responses have gone a long way to mitigate the effects of repeated shocks to the Japanese economy. On the monetary policy side, the recent series of reductions of market interest rates and the official discount rate have been useful. With consumer prices stable or falling, and with significant price declines at the producer level, real short-term interest rates had not been particularly low, and the decline in short-term interest rates in late summer have provided a welcome measure of monetary easing (Chart 17). Given the overall tepid economic environment, however, it is important for the authorities to keep the supply of liquidity ample, especially since the risks of inflation remain low. Lower interest rates tend lo ameliorate problems in the financial sector, and with land prices and asset prices still falling, there should be plenty of time for monetary authorities to remove monetary stimulus to prevent any risk of a future speculative bubble when economic conditions begin to show improvement. In the area of fiscal policy, the recent ¥14 trillion stimulus package should help to place the economy firmly on a path of sustained economic recovery. Some observers have raised concerns that the stimulatory effects of the package may be partly offset by adverse reactions in financial markets. Although the fiscal deficit has widened sharply during the economic slowdown, it is important to view the deficit as providing necessary support during an exceptionally difficult period. Of course, once the recovery is firmly established, Japan will need to undertake fiscal consolidation.

Chart 17.Japan: Real Prime Interest Rate1

Recent moves by the Japanese monetary authorities have lowered real short-term interest rates to their lowest levels since the late 1980s.

1 Three-month centered moving average of the nominal interest rate deflated by the percent change of the consumer price index from 12 months earlier.

Actions by the authorities also have been helpful in correcting the previous overvaluation of the yen. These actions included measures to promote Japanese overseas investments and loans, the reductions in short-term interest rates, and persistent intervention to drive down the value of the yen. The large Josses on foreign assets that Japanese investors suffered in yen terms may have contributed to a relative shift of portfolio preferences in favor of yen-based assets—a vicious circle that further strengthened the yen. Guided in part by government actions, this pattern appeared to have run its course by mid-1995, and renewed willingness of Japanese investors to acquire foreign currency-denominated assets has probably been an important factor behind the recent depreciation of the yen.

Other problems need to be addressed to reinvigorate the Japanese economy. Regulation of the Japanese economy imposes deadweight costs because resources are not used as efficiently as they could be. It also slowed the economy’s pace of macroeconomic adjustment to the yen’s appreciation over 1994 and the first half of 1995. Even though currency appreciation is painful, it partially sows the seeds for adjustment if an economy responds strongly to price signals. A strong currency, for example, would tend to cause import prices to decline, which would boost real disposable incomes and spur real consumption. But some analysts have found that the Japanese economy suffers from rigidities in market practices that have slowed the corrective macroeconomic adjustment. Although declines in import prices are generally found to feed through to retail prices, studies have concluded that only part of the rise of the yen appears to have been passed on to import prices.24 Overregulation also reduces the number of sectors of the economy that undertake the adjustment to a sharp currency appreciation. This means that the adjustment is concentrated on sectors that face international competition, and this can lead to painful industry and regional effects.

Finally, financial sector problems remain significant, contribute to the lack of confidence in the financial system, and might continue to slow the pace of recovery. The recent successfully managed closure of some insolvent financial institutions was an important step toward the resolution of the bad loan problem, and illustrated that prompt and comprehensive action by the authorities can contain the spillover effects to other institutions. Still, other financial institutions might need restructuring. The government needs to facilitate loan write-offs, encourage the use of loan securitization, make more flexible the use of deposit insurance funds, and decisively address the problems of housing loan companies. When confidence is questioned, small or incremental steps to deal with a problem often have the opposite effect from what policymakers desire. In such circumstances, a broad-based policy response may be necessary to convince markets that policymakers appreciate the full extent of the problem and are ready to deal with it.

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