III Policy Considerations
- International Monetary Fund. Research Dept.
- Published Date:
- January 1992
The continued sluggishness of economic activity in the industrial world has given rise to concerns that the medium-term strategy pursued since the early 1980s is not living up to its promises and that a different approach is warranted. As pointed out in past issues of the World Economic Outlook, however, it is inappropriate to conclude that the strategy has failed. The problem, rather, is that key aspects of the strategy have not been implemented. In the fiscal area, the missed opportunity to consolidate budgetary positions in North America and many European countries during the long expansion of the 1980s stands out as a particularly striking policy failure. Progress in the structural area has also been far from adequate. This is especially evident in Europe, where continued high levels of unemployment point to the urgent need for labor market reforms. For many countries there remains a need to change the structure of incentives (especially tax preferences) that may discourage saving and encourage excessive indebtedness by the private sector. There has been far-reaching liberalization of financial markets, but failure to adjust macroeconomic policies and the lack of adequate prudential oversight contributed to asset price inflation and the subsequent, unavoidable process of balance sheet adjustment. Finally, there have been important setbacks in the area of trade, mainly in the form of quantitative restrictions and other nontariff distortions. The unfinished agenda of the 1980s remains a valuable guide for tackling both systemic problems and the challenges facing individual countries.
Since 1990, in addition to the adverse consequences that large structural budget deficits have had for financial conditions and confidence, the industrial countries have been affected by two major economic forces that have led to protracted sluggishness of activity in most countries and have contributed to the recent turbulence in foreign exchange markets. The first and most important is the adjustments made necessary by increases in private sector indebtedness in some countries during the 1980s and by the erosion of balance sheets stemming from the correction of inflated asset prices. The second is the tensions caused by divergences in policies and performances across Europe, which have been exacerbated by the fiscal expansion that accompanied German unification. The policy measures that have been adopted to deal with the resulting difficulties have had some, albeit limited, success in containing adverse domestic repercussions. The lack of coordination of the appropriate policy responses, however, has resulted in a serious mismatch of macroeconomic policies across countries, especially in Europe.
It is difficult to judge how much adjustment is still required to reduce private sector indebtedness to sustainable levels and to overcome the associated financial sector problems. IMF—and most other—analysts have so far underestimated the extent of this problem, and the risk remains that even the revised growth projections for the countries most affected may prove optimistic. Moreover, in those countries where the balance sheet adjustment problems have been less acute, there are increasing signs of economic weakness; in particular, there are now signs of a significant slowdown of growth in Germany. Only North America seems poised for recovery, even though economic slack there may be absorbed only slowly.
The weak short-term prospects for many industrial countries raise the question of which measures, if any, might be taken to strengthen economic performance. Very few countries have room to provide discretionary fiscal stimulus. The persistence of relatively large structural budget deficits in North America and in Europe militates strongly against expansionary fiscal action because of the danger that this would put additional pressure on long-term interest rates, destabilize financial markets, and exacerbate medium-term budgetary adjustment difficulties. Higher interest rates would complicate the private sector’s adjustment efforts and further erode confidence. Rather than short-term fiscal stimulus, there is an urgent need in many countries to reduce uncertainty through the adoption of credible budget-consolidation programs to eliminate unsustainable structural deficits over the medium term.
In contrast to the constraints facing fiscal policy, there appears to be a stronger case for further reductions in official interest rates in many of the industrial countries—particularly in Europe, where the tightness of monetary conditions is an important restraining influence. In addition to facilitating the adjustment process in the private sector by easing cash flow problems associated with large debt burdens, a coordinated reduction of interest rates in countries where this is warranted would undoubtedly help to strengthen confidence by demonstrating the continued commitment to international policy cooperation. A lowering of official interest rates would have the added advantage over fiscal measures of being more easily reversible as activity recovers or if inflationary pressures threaten to re-emerge.
In view of the reduction of short-term interest rates that has already occurred in some countries and the concerns about inflation in Germany, it is important to determine whether a further easing of monetary conditions would be compatible with the goal of sustained noninflationary growth underlying the medium-term strategy. A relatively easy stance of monetary policy under current circumstances of sluggish growth and receding inflationary pressures does appear to be fully consistent with the medium-term objective of price stability. Interest rates have already been reduced significantly in the United States and Japan, but there is no evidence to suggest that this has given rise to increasing inflationary pressures (see the Annex). In Germany, although current inflation is still too high, the restrictive stance of monetary policy that has been pursued for some time is clearly beginning to show its effectiveness. Thus, together with the impact of the recent appreciation of the deutsche mark within the ERM, the weakening of the economy that is now under way can be expected to result in a significant easing of cost pressures and inflation during 1993. In the United Kingdom, the recent reductions in interest rates have improved the outlook for growth somewhat, but the high level of indebtedness remains a restraining influence, and the large margin of slack should continue to contribute to a further reduction of underlying inflation. For most other European countries, there is no doubt that monetary conditions are extremely tight at present, in view of the current and projected weakness of activity and the decline in inflation. Nevertheless, to safeguard the considerable decline in inflation during the past decade and to ensure further progress where prices are still rising too rapidly, the scope for lower interest rates in many countries depends on efforts to reduce excessive fiscal deficits. Moreover, it will be essential to remain vigilant for any indications that inflationary pressures may again be building.
In the EC, in addition to any policy changes that may be appropriate in light of the current economic difficulties, the EMS will need to be strengthened to reduce the risk of a recurrence of the recent tensions. There is also a need for a cooperative effort to re-establish conditions that will permit the return of the pound sterling and the lira to the ERM. The exchange rate adjustments that took place in connection with the September and November crises have reduced tensions for now, but the underlying problems are far from being fully resolved. A key objective is to ensure greater progress toward economic convergence. Despite substantial progress, however, it is unlikely that convergence will be achieved immediately for all EC member countries, and currencies may therefore again become misaligned. This suggests that it may be necessary to undertake small adjustments of parities on a timely basis to avoid the buildup of the pressures seen recently.
More fundamentally, it is important for EC members to consider adaptations of the EMS to changing circumstances and to prepare for the transition to a single currency. The recent experience has demonstrated the crucial importance, for exchange rate stability, of close coordination of fiscal and monetary policies, and of convergence in economic performance. In current circumstances, effective coordination of monetary policy to establish monetary conditions that are appropriate for most if not all of the participating countries would, of course, require greater reliance on fiscal consolidation to control inflationary pressures in Germany, in accordance with the successful experience of other ERM countries that have already achieved a high degree of inflation convergence. In addition to a strengthening of policy coordination, there is also a need to reinforce mechanisms to defend the ERM when the fundamentals do not warrant parity changes—for example, through greater use of partially symmetric, nonsterilized intervention, such as was applied by the Bundesbank and the Banque de France to combat the recent speculation against the French franc. To promote greater monetary cooperation, it would be useful to complement national indicators of monetary conditions and inflationary pressures with ERM-wide indicators in order to ensure that currency substitution effects are correctly interpreted and that monetary conditions are compatible with sustained noninflationary growth in the area as a whole.
Greater efforts are also required in the structural area to increase the benefits from economic and monetary integration in Europe and to promote adjustment without parity changes, in preparation for the introduction of a single currency, which would eliminate the exchange rate as a policy instrument. The completion of the “single market” program of structural reforms constitutes a major step in this direction. Progress in enhancing the flexibility of European labor markets has been disappointing, however, and structural unemployment remains at record levels throughout Europe. A failure to tackle Europe’s labor market problems would substantially erode the benefits of economic and monetary union (EMU); it would also increase the need for government subsidies and transfers to economically weaker regions, which could jeopardize fiscal consolidation efforts.21
Among the many risks in the outlook, the recent escalation of trade tensions between the United States and the EC is a sobering reminder of the fragility of the global economy. What is at stake is not only the success of the Uruguay Round of multilateral trade negotiations—the failure of which would in itself be a serious setback—but the cooperative trading environment that has underpinned world growth over the past forty years. It is clear that appreciation of the possible consequences of a contraction of trade helped to forge the compromises reached in late November. Although only a small share of trade would have been directly affected, the threat of a spiral of retaliation and counterretaliation would have increased tensions worldwide, thereby harming business confidence and undermining prospects for growth. With some progress in the resolution of the difficulties between the world’s major trading partners, decisive further efforts are now needed to complete the global package and bring the Uruguay Round to a successful conclusion.
Policy Requirements in Individual Countries
In the United States, notwithstanding a pickup in growth to about 3½ percent (annual rate) in the third quarter of 1992 and other positive signs, including improved business and consumer confidence, the possibility of a relatively hesitant recovery remains. In particular, it is not yet clear that the process of balance sheet adjustment has come to an end, and export growth seems likely to slow as a result of the weakness of activity in other industrial countries. The substantial easing of monetary conditions that has taken place should ensure moderate growth of about 3 percent in 1993, but the pace at which economic slack is likely to be absorbed may still be unsatisfactory. The new administration taking office in January could therefore be under strong pressure to stimulate economic activity.
The room to maneuver is extremely limited, however. In view of the large fiscal imbalance and high level of real long-term interest rates, early action to ensure substantial budgetary consolidation over the medium term is an overriding priority. A credible medium-term deficit-reduction program would strengthen confidence and ease pressures on long-term interest rates, even in the near term, and would substantially enhance medium-term growth prospects.22 Fiscal stimulus could provide short-term support for aggregate demand, but it might also jeopardize the achievement of medium-term budgetary objectives. Indeed, to the extent that a fiscal expansion might push up long-term interest rates and increase uncertainty about future policies, there is a considerable risk that it would be counterproductive. Because of this danger, advocates of fiscal stimulus emphasize that any short-term fiscal stimulus should be accompanied by legislation to ensure a rapid return to a path of medium-term consolidation as economic activity picks up. Since repeated attempts during the past several years to legislate deficit control have failed, however, the credibility of any new consolidation plan will be difficult to establish, especially if the large structural budget deficit is allowed to widen further in the near term.
For U.S. monetary policy, a cautious attitude toward further reduction in official interest rates has been appropriate because of the substantial monetary stimulus already in the pipeline and because of the risk of adverse effects on exchange markets. Recent data suggest that the decline in short-term interest rates is beginning to contribute to more robust growth. If the recovery proves stronger than currently expected, appropriate adjustments of monetary conditions will be essential to prevent an increase in inflationary expectations.
In Canada, the deep and prolonged recession has reduced price increases to the point where there can be substantial confidence that the official inflation reduction target will be achieved. A return to a progressive relaxation of money market conditions is therefore appropriate, although pressures on exchange markets could be a constraint. Fiscal policy has remained tight, given the recession, but the structural deficit (despite some progress in tackling this long-standing problem) should again be addressed as soon as economic activity begins to pick up.
In Japan, the stimulative policy actions already announced should help to reverse the recent weakness in economic activity and to revitalize growth during 1993. However, there is reason for concern that the pattern of weak recovery experienced by other countries that have been affected by asset price deflation and associated financial problems may also hold for Japan. If the expected recovery does not materialize, there would be scope for an additional easing of short-term interest rates. Following the implementation of the announced stimulus package in the latter part of 1992 and in early 1993, fiscal policy should be adjusted in light of actual and expected economic developments, and the budget position should converge gradually toward its desired medium-term path so as to avoid a sudden large withdrawal of stimulus before economic recovery is firmly established. Nevertheless, further fiscal consolidation will be necessary over the longer term.
In Germany, there is continued concern about the rapid growth of M3 and an inflation rate that is still in excess of the authorities’ objective. Indicators of future inflation suggest, however, that conditions for a progressive easing of monetary conditions may soon be in place. Indeed, recent declines in short-term market interest rates have been appropriate in light of the weakness of activity, the appreciation of the deutsche mark within the ERM, and the squeeze on profits, all of which should help to ensure a moderate wage round in 1993. As wage and demand pressures abate, further declines in interest rates will be appropriate; this would facilitate growth across Europe and reduce the risk of a further deepening of the recession in Germany. An early, moderate cut in official German interest rates in line with the recent decline in market rates would send a signal that would boost confidence throughout Europe and in the rest of the world.
To permit more significant and sustainable reductions in German interest rates, fiscal policy will need to play a greater role in controlling inflationary pressures. It clearly would have been preferable if stronger steps to contain the budget deficit had already been taken. Although the speed of implementation may now need to take account of the weakness of the economy, there is an urgent need for effective measures to contain the aggregate fiscal imbalance at all levels of government (and for off-budget agencies) through reductions in public expenditure, particularly subsidies. However, if sufficient progress cannot be achieved on the expenditure side, tax increases may also be required. Efforts are also needed to ensure wage moderation in west Germany—for example, by containing public sector wage awards—and to ensure that wages in east Germany develop more closely in line with productivity, since the large divergences that have emerged will delay restructuring of the east German economy and increase demands for public transfers.
In France, although the calming of exchange market tensions in October allowed interest rates to fall again close to German levels, the pressures experienced in November and early December led to a renewed widening of the interest differentials vis-à-vis Germany. Despite a low inflation rate and a strong external position, it is likely to remain difficult—at least for some time—for French monetary policy to push interest rates below those in Germany without threatening the exchange rate. Thus, a significant decline of interest rates to promote more vigorous growth depends on parallel interest rate reductions in Germany. As regards fiscal policy, it has been appropriate to allow the automatic stabilizers to operate on revenue while containing the growth of public expenditure. This policy will need to be implemented symmetrically when activity picks up.
In Italy, there is no alternative to comprehensive and credible measures to reinforce the process of budgetary consolidation, with the goal of reducing the deficit by at least 2 percent of GDP annually during the next three to four years. Despite recent progress, further measures should be identified as a matter of urgency to offset any shortfalls in 1993; additional major adjustments will be required to meet the government’s 1994–95 targets. Large-scale privatization of state enterprises could make a valuable contribution to reducing the level of government indebtedness and would enhance economic efficiency. Also of special importance in Italy is an incomes policy that will appropriately restrain nominal wages; the existing agreement for 1993 must be maintained, and agreement should be reached for subsequent years. Limits on public sector wages and on pensions, together with effective measures to combat tax evasion, are essential features of both fiscal and incomes policy. Meanwhile, monetary policy needs to maintain a firm stance in order to contain domestic inflationary pressures and to limit the depreciation of the lira. The high risk premiums on Italian interest rates relative to those prevailing elsewhere in Europe are unlikely to fall until further deficit-reduction measures have been adopted and their effects have become visible. Further reductions in Italian interest rates, which would directly reduce the cost of servicing the huge Italian public debt, would then be contingent on reductions in the general level of European interest rates.
Italy intends to rejoin the ERM at the earliest feasible date. This requires—in addition to external support, adequate reserves, and the maintenance of a monetary policy geared to inflation restraint—that the fiscal situation begins to improve and that cost and price developments are consistent with conditions in the ERM countries. Markets must have confidence that a sustainable budgetary and debt position will be achieved and that competitiveness will be improved on a durable basis. With its reserves depleted, its credibility impaired, and its maneuverability constrained by a large public debt, Italy cannot afford to let the lira rejoin the ERM at an exchange rate that is likely soon to be challenged in the market, or that is held up only by a substantial and ultimately unsustainable interest rate premium.
In the United Kingdom, there are as yet no convincing signs of recovery, but the recent depreciation of sterling and reductions in interest rates should stimulate both export growth and domestic demand. Recent gains in international competitiveness from the depreciation of the pound will prove ephemeral, however, unless inflationary pressures are contained. The easing of monetary conditions since the exit of the pound from the ERM has been appropriate in light of domestic conditions, but further declines in interest rates should probably await evidence over the coming months of the economy’s response to the easing of policies that has already occurred. A possible further reduction of interest rates will also depend on a lowering of interest rates in the ERM countries in order to prevent an excessive depreciation of the exchange rate. For fiscal policy, the deterioration in the budget balance since 1989 has exhausted any scope there may have been for supporting activity through fiscal action. Although there clearly are limits to the pace of fiscal consolidation in the midst of a relatively deep recession, it will be necessary to begin the process of consolidation in 1993 in order to contain potential inflationary pressures following the depreciation of the pound and the easier stance of monetary policy. Success in containing the inflationary impact of the depreciation will be essential for rejoining the ERM and for choosing the appropriate re-entry exchange rate and its margin of fluctuation within the mechanism.
In Spain, the recent two-step devaluation of the central rate has offset much of the real appreciation of the peseta since Spain joined the EMS in 1989 and provides a needed boost to exports and growth over the medium term. Notwithstanding increasing concerns about the near-term outlook, there is little scope to stimulate the economy, and the priority should be to reduce inflation in order to stabilize the peseta within the ERM. This will require a tightening of fiscal and monetary policy to defend the new central rate. The 1993 budget sets appropriately ambitious targets, but achieving them will be difficult because of rising social security payments, increases in transfers to lower levels of government, and the cyclical slowdown of economic activity, which will increase outlays and reduce the growth of revenue. Monetary conditions, meanwhile, will need to remain tight until there are clear signs that inflation is abating. Inadequate progress in tackling the rigidities in the labor market has been a prime factor behind the persistence of inflation. Hence, intensification of labor market reform is indispensable to rebuilding Spain’s competitiveness through wage moderation and an improvement in profit margins. The situation is similar in Portugal, where the inflation rate remains too high to prevent further losses in competitiveness. Since monetary conditions are already quite tight, the burden of macroeconomic restraint should fall on fiscal policy. The fiscal retrenchment planned for 1993—the deficit-GDP ratio is expected to fall by 1 percentage point, to just over 4½ percent—is probably the minimum that is required.
The different strategies of the Finnish and Swedish authorities in response to the buildup of tensions in foreign exchange markets in September illustrate the importance both of cyclical conditions and of the relationship between exchange rate objectives and fundamental policy changes. In Finland, which has been experiencing a protracted slump stemming from the collapse of exports to the former Soviet Union and from a severe financial crisis, the authorities decided in September to float the markka following a depreciation vis-à-vis the ECU in November 1991. This was an appropriate decision given the high economic costs that would likely have been associated with defending the peg to the ECU. Nevertheless, the Finnish authorities will still need to take vigorous measures to reduce the fiscal deficit (estimated at almost 9 percent of GDP in 1992) to a sustainable level. Clear evidence that the adjustment efforts are successful will also be necessary to permit the currency again to be pegged against ERM currencies.
In Sweden, during the September crisis the authorities decided to defend the krona by sharply increasing the rate on overdraft facilities with the central bank. The decision met with broad political approval and helped to forge an essential compromise on fiscal policy. Notwithstanding the successful defense of the krona in September, the prospect of a sharp deterioration in the budgetary position, a likely further increase in unemployment, and severe difficulties in the financial sector led to renewed pressures against the krona in November. In view of the subsequent failure to achieve a consensus on additional comprehensive measures to reduce the budget deficit, on November 19 the authorities decided to float the currency until solutions can be found to the country’s economic and financial crisis.
In contrast to the markka and the krona, there was little speculative pressure against the Norwegian krone in September, perhaps because of the relatively strong external position of the Norwegian economy, largely due to strong oil revenues. However, following Sweden’s decision to float on November 19, the Norwegian central bank was forced to take strong measures to defend the currency, and nearly a month later, on December 10, it was decided to allow the krone to float, resulting in a depreciation against the deutsche mark of about 5 percent. Although oil revenues have bolstered both the current account and government revenues and financial assets, the mainland economy (that is, excluding oil and shipping) is still characterized by high costs and structural impediments, including a weak financial sector.
Economic Confidence and the Need to Strengthen International Cooperation
For all of the industrial countries, restoration of confidence is a critical requirement for returning to the path of sustainable, noninflationary growth. Everywhere in the industrial world, confidence has been undermined not only by the slowdown of activity or recession, but also by the disarray in financial markets and by the apparent collapse of cooperative efforts to address common problems by the governments of leading nations. As previously discussed, individual efforts by national governments will be required to correct the imbalances in national economies and thereby contribute to the restoration of confidence that is essential for a renewal of growth. But the potential for enhancing confidence directly through demonstrations of a new spirit of economic coordination and cooperation among the industrial countries should not be neglected.
It will take time to unwind the financial imbalances that have impaired growth and undermined confidence in many countries, and it will take time to establish the credibility of efforts to correct the large fiscal deficits of a number of countries with poor records of fiscal prudence. In contrast, a successful conclusion to the Uruguay Round—with its prospective longer-term benefits for world trade and its shorter-term benefits for confidence—can be achieved almost immediately. All that is required is the political will to reach a mutually beneficial agreement that is now within the grasp of the negotiating parties.
Similarly, it should be possible—and would be highly desirable—for the industrial nations to demonstrate a new spirit of cooperation in efforts to coordinate their macroeconomic and exchange rate policies for the common good. If, as now expected, the economies of North America begin to show more robust growth without resort to large-scale fiscal stimulus, this positive development for the world economy should be recognized and applauded. Along the same lines, Japan’s notable efforts to stimulate activity by exploiting the flexibility in fiscal policy it possesses deserve endorsement as an important element of the global strategy to enhance prospects for growth. This support should not be muted if, despite the government’s best efforts, growth turns out to be somewhat weaker than is now expected.
For Germany, in accordance with recent market developments, the authorities could implement an early, moderate reduction of short-term interest rates. This would no doubt contribute to strengthening confidence (and thus growth) in Germany and in the rest of Europe. The German authorities could also recognize that the present recessionary tendencies throughout Europe call for larger interest rate reductions during the period ahead, and that fiscal policy adjustments together with wage moderation will be needed to permit such interest rate reductions without jeopardizing the outlook for inflation. Symmetrically, for other European governments, it is relevant to recognize both the special challenge that German unification continues to present for German economic policy and the importance, for all of Europe, of a convincing reversal of the recent upsurge of inflationary pressures in Germany. Moreover, in the future, greater realism about the need for timely adjustments of exchange rate parities to correct accumulating disequilibria, as well as more cooperative efforts to defend mutually agreed parities, could avoid some of the damage to confidence that inevitably accompanies the disarray and turbulence associated with sharp, market-induced changes in exchange rate policies.
Finally, the challenge of supporting the economic transformation of the former centrally planned economies, while continuing to assist the successful development of many of the world’s poorer nations, remains a vital area for cooperative endeavors by the industrial nations. Of course, for such support to be effective, it must be complemented by determined adjustment efforts and bold and sustained reform initiatives in these countries. The maintenance of open and expanding markets for the exports of all countries is clearly critical to meeting this challenge, and it is essential that the industrial nations jointly undertake the burden of resisting domestic protectionist pressures. Provision of adequate financial assistance, including debt relief for the poorest nations, is another key element of this challenge. In this context it needs to be widely understood that the industrial nations have a common interest in this regard, with each nation playing its fair and appropriate role. Successful transformation of the former centrally planned economies to market-oriented economies will clearly pay enormous dividends for the entire world economy, and for many important reasons beyond purely economic ones. At the present time, there is probably no public sector investment for which the prospective rate of return is as high as in well-structured, coordinated financial and technical assistance to countries facing the truly daunting tasks of economic stabilization and adjustment.
The high rates of structural unemployment now prevailing in many European countries can best be addressed by measures that increase incentives to find and keep employment and that promote better matching between workers and jobs. Reducing minimum wages (especially for young, inexperienced workers), lowering firms’ costs of hiring and retaining workers, and limiting the generosity and duration of unemployment benefits would encourage the unemployed to seek work, and firms to hire them. Active labor market policies that promote training and participation in the job market would increase opportunities for employment. In some countries, the structure of collective bargaining may have to be modified to raise the responsiveness of wages to macroeconomic conditions, particularly where institutional arrangements have excessively limited the market influence of outsiders. The next issue of the World Economic Outlook will discuss in more detail the importance of labor market policies for the success of EMU.
In its Article IV consultations with the U.S. authorities, the IMF has noted that meaningful fiscal adjustment will involve action on a broad front and has formulated a set of options to illustrate the range and type of measures that would be required. The growth in mandatory expenditures has been particularly rapid, especially outlays on Medicare and Medicaid, suggesting the need for fundamental reform of the system of health-care financing. In addition, a further compression of discretionary expenditures in the areas of defense outlays and subsidies could also contribute significantly to deficit reduction. Options for revenue enhancement include an energy tax (for example, a gasoline tax), the introduction of a federal consumption tax (such as a value-added tax), the elimination of tax deductibility of mortgage interest payments, and the inclusion of employer-provided health insurance benefits in taxable income. In addition to contributing to deficit control, such measures would support an improvement in overall allocative efficiency and growth prospects.