- International Monetary Fund. Research Dept.
- Published Date:
- January 1985
The review just presented of short-term and medium-term prospects suggests that, despite the slowdown in activity in the first half of 1985, the overall outlook is not greatly changed from that envisaged in the April World Economic Outlook. In general, therefore, the stance of policies recommended at that time remains appropriate. In the first part of this section, the main features of these policies, and the interactions among them are recalled.
Nevertheless, new uncertainties about the future course of the world economy have undeniably emerged in the past six months. While some of these imply the possibility of a more favorable outcome than was foreseen in April, the new uncertainties have also increased the “downside risks,” or the likelihood of less favorable outcomes. The second part of this section reviews these uncertainties and risks.
Although the new uncertainties do not call for any change in basic policy stance, they do underline the need for dealing firmly with the imbalances that lie behind them. This is all the more important when international interactions are taken into account, since policy failures at one point in the system can adversely affect performance elsewhere, and may even lead to a cumulative deterioration in prospects. This is the theme of the third part of this section, which concludes with some brief observations about the role of the Fund in present circumstances.
Economic Policies in the Current Situation
The medium-term framework of policy that has been at the heart of the industrial countries’ economic strategy for the past several years remains, in the staffs view, broadly appropriate. This strategy has had several notable successes. There has been a marked reduction in inflation, output growth has picked up, and employment has begun to recover. Investment has revived (particularly in the United States and the United Kingdom), and productivity has grown more strongly than during much of the 1970s and early 1980s. The strategy has not always been implemented as intended, however, and a number of serious economic imbalances remain. In the United States, the federal fiscal deficit is again expected to exceed 5 percent of GNP in 1985, while the deficit in the current account of the balance of payments will rise to over 3 percent of GNP. In a number of countries, including the Federal Republic of Germany and Japan, the growth of output continues to be supported by foreign demand; and in many countries, including most of those in Europe, structural rigidities have impeded employment creation and slowed recovery.
Policy requirements in present circumstances flow naturally from the need to redress these imbalances. In the United States, there is now widespread agreement about the urgency of effective action to curb the federal deficit. This deficit has major international as well as domestic implications. It is associated, in varying degrees, with the high level of international interest rates, the still-high exchange rate of the U.S. dollar, and the growing size of the U.S. current account deficit. While the fiscal deficit contributed to the initial strength of the recovery in the United States, and helped spread its benefits to other countries, it also has had less desirable effects. Higher interest rates have retarded domestic demand growth in other industrial countries, while they have significantly increased the burden of debt service faced by heavily indebted countries. The appreciation of the U.S. dollar and associated trade developments have created uncertainties about the sustainability of the patterns of exchange rates and current account balances that may have negatively influenced investment decisions, even in countries whose measured competitiveness has increased. In addition, the large U.S. foreign trade deficit has contributed to a disturbing increase in protectionist pressures within that country.
The U.S. Administration is firmly of the view that the fiscal deficit should be reduced through expenditure cuts, and in general the staff supports this emphasis. In a macroeconomic context, however, it needs to be recognized that reducing government expenditure and reducing government deficits, although complementary, are policies with somewhat different objectives. If insurmountable obstacles to reducing particular categories of expenditure are encountered, this cannot be regarded as a sufficient reason for postponing attempts to bring the overall deficit back to more manageable levels. Recent moves to cut the deficit represent a welcome first step, but the process of restoring a sustainable fiscal position will require determined action over a number of years. Uncertainties about the medium-term evolution of fiscal policy could exert a potentially depressing effect on domestic investment in the United States, especially if these uncertainties were accompanied by significant delays in implementing tax reform proposals.
In contrast to the difficulties encountered in the implementation of fiscal policy, monetary policy in the United States has been more in accord with medium-term goals. As a result, market participants have come to have considerable confidence in the basic anti-inflationary thrust of policies. This has given the monetary authorities somewhat more room for maneuver in the short-term implementation of policies. It is important to recognize, however, that this room for maneuver is not unlimited. Spontaneous downward pressure on interest rates can be accommodated by judicious policy, and this was skilfully achieved in the first half of 1985. However, for the authorities to attempt to create or sustain such pressures in circumstances when market sentiment became less favorable would carry considerable risks. Indeed, the sensitivity of expectations is such that an actively expansionary monetary policy would very likely be counterproductive to its intended goals. Market participants are aware that, in past cycles, monetary accommodation to sustain expansion often contributed to a buildup of liquidity that later fueled inflationary pressures.
European countries have, by and large, exercised greater fiscal restraint than has the United States. Nevertheless, the fiscal consolidation has not always taken place as smoothly as could be hoped. In Italy and the United Kingdom, for example, there have been substantial swings in the fiscal impulse over the past four years, so that progress toward reducing deficits has encountered delays. In France, the budgeted deficit for the central government was exceeded in 1984, and may be exceeded again in 1985. The Federal Republic of Germany is the only major country in Europe where government expenditures have been brought sufficiently under control to permit significant tax cuts to be planned. As a result of these cuts, fiscal policy is expected to impart a slightly expansionary impulse to the German economy in 1986—a thrust that seems broadly appropriate in light of the relatively moderate growth of domestic demand and the recent improvements that have taken place in the underlying fiscal position.
Monetary policy in European countries has until recently been constrained by the weakness of their currencies against the U.S. dollar. Interest rates have thus been kept higher than might have been considered desirable from a domestic perspective. With the recent easing of monetary conditions in the United States, European countries have acquired some limited freedom to choose between lower interest rates and exchange rate appreciation. The fact that exchange rates initially moved more than interest rates does not in itself mean that monetary policy was deliberately kept tight. Indeed, in Germany, France, and the United Kingdom, monetary aggregates were in the top half of, or above, their target ranges. In some cases, however, these target ranges may have been set on the low side. It would seem appropriate that, if interest rates were to decline further in the United States, monetary policy in European countries should be such as to permit a significant decline there too.
In Japan, the key issue facing the authorities is not so much to stimulate the growth of GNP but to make it less dependent on foreign demand. The large foreign trade surplus is a problem both for Japan, because of the danger that its access to foreign markets will be restricted, and for the world at large because of the protectionist pressures it generates. The Japanese authorities have been very successful in stabilizing monetary growth and mastering inflation. At the same time the government has continued its program of fiscal consolidation that was made necessary by earlier rapid growth in public debt. By now, considerable progress in strengthening the underlying fiscal position has been achieved; in 1985 the general government fiscal deficit is expected to be 2 percent of GNP, lower than in any major country other than Germany and about two fifths the relative size of the deficit in 1978-80. However, the central government deficit, at over 5 percent of GNP, continues to be undesirably large, indicating that the Japanese authorities have some distance to go to achieve their structural fiscal objectives. Even so, the success achieved so far provides increased scope to pursue these objectives flexibly, taking account of the need to sustain Japan’s contribution to aggregate demand growth in the world economy. In this, consideration could be given to changes in the structure of revenues and expenditures that might help foster the growth of domestic demand. A strengthening of domestic demand growth would of course have to be managed in such a way as to prevent the emergence of excess pressure of demand on resources. This becomes less of a problem the more successful policies are in reducing the contribution of net exports to the growth of total demand. In this connection, the staff believes it would be appropriate for the Japanese authorities to continue to frame monetary policy in the light of exchange rate considerations, and thus to encourage a substantial appreciation of the yen. Continued efforts are also needed to improve the effective access of foreign suppliers to Japanese markets.
In the smaller industrial countries, as in the larger ones, policy requirements have to be differentiated according to the situation of individual countries. However, fiscal retrenchment remains an important objective in many of them. Monetary policy is constrained by the formal or informal links that many of the smaller industrial currencies have with the currencies of larger countries, and should continue to be conducted so as to maintain confidence in further progress toward better price stability.
Beyond these requirements for suitably differentiated financial policies, there is a continuing need to implement supply-side policies that enhance the structural functioning of industrial economies. This is particularly important for countries where structural rigidities, especially labor market rigidities, have impeded the restoration of satisfactory employment levels. The necessary measures have been discussed at length in earlier World Economic Outlook reports, and can therefore be summarized briefly here. They include: the reduction of distortions created by the impact of government regulations on price determination in private markets; the reform of wage-setting procedures that prevent the adjustment of real wages in line with changes in the marginal product of labor; the modification of minimum wages that limit incentives to hire unskilled workers or new entrants to the labor force; the reduction of subsidies or other mechanisms for preserving uneconomic industries; action by governments to enhance the ability of workers to move between industries and geographical locations; and firm resistance to protectionist pressures, which can only benefit one group of the population at the expense of others.
In present circumstances, it is appropriate to give special emphasis to this last point. Protectionism is not confined to the industrial countries; indeed many developing countries have even more restrictive trade systems, whose liberalization should be an important objective of policy. However, protectionism in industrial countries is of central concern because of the threat it poses to the fabric of international collaboration and to the satisfactory resolution of the international debt situation. Protectionist sentiments are exacerbated by weakness in economic activity and by imbalances in international trade, which give rise to shifts in employment and industrial structure that are perceived, generally erroneously, to be caused by “unfair” trade practices or inadequate “reciprocity” in trade. In dealing with protectionist sentiment, governments in industrial countries should not only resist demands for trade-distorting restrictions but also focus on actions that will help reduce the factors that give rise to such demands in the first place. Viewed in this light, effective action against protectionism involves effective action to deal with the whole range of economic and financial imbalances touched on above.
The staff’s medium-term scenario continues to show that, on plausible assumptions, developing countries could reduce their external debt ratios by one fourth to one third while achieving domestic economic growth of 4½-5 percent, over the period to 1990. The inevitable uncertainties in this scenario, however, leave no room for complacency, and underline the importance of an adjustment strategy geared to strengthening internal sources of growth in developing countries.
Over the past three years, developing countries have succeeded in reducing their combined current account deficit to a level that is financeable out of grants, long-term official assistance, direct investment, and import-related commercial financing. Less has been achieved, however, with the internal adjustments that are needed if domestic growth is to gain momentum without the external situation deteriorating dangerously and without impeding efforts to achieve greater price stability.
Given the external constraint faced by almost all developing countries, efforts to achieve sustainable higher growth need to have the twin focus of raising the rate of growth of foreign exchange earnings, and increasing the growth of domestic output that can be achieved with a given level of foreign exchange earnings. Examples of the first type of policy include ensuring that the exchange rate provides adequate incentives for the establishment and growth of export industries; adapting the tax structure to remove unintended fiscal impediments to export activities; and providing “start-up” assistance in developing foreign markets for nontraditional exports in which the country has a potential comparative advantage. Examples of the second include measures to raise the output of domestically consumed tradable goods—for instance, foodstuffs and import-substituting manufactures—through pricing reforms and a more efficient allocation of public investment expenditures. At the same time, policies to raise aggregate savings and investment, and to encourage greater efficiency in private investment, are fundamental to any long-term increase in the rate of economic growth.
Such an orientation of policies is often described as an “outward-looking” strategy, since it gives the price mechanism a central role in determining the allocation of resources, and makes the exploitation of comparative advantage an important element in the development process. In countries with such an outward-oriented policy stance, the centerpiece of the strategy has usually been the maintenance of an appropriate exchange rate, together with a reduction of taxes and direct restrictions on international trade. Maintaining adequate external competitiveness stimulates export growth, and thus permits a more rapid expansion of imports. Removing price distortions facilitates the direction of resources to those export activities with the greatest returns to the economy as a whole. Nonetheless, there are limits to the use of such a strategy. For instance, expanding output of certain primary products (especially if undertaken by a group of producing countries simultaneously) could have negative revenue effects. Furthermore, export prospects for some types of manufactured and agricultural products may be limited by protectionist measures in importing countries.
Because of the importance of the government in the investment process in most developing countries, choices with regard to the share of total government expenditure channeled toward public investment, and the-criteria by which public investment outlays are allocated among projects, are major determinants both of the level of aggregate investment and of its overall productivity. Nevertheless, efforts to raise saving and investment rates through the mobilization and investment of funds by the state have at times been associated with inefficient investments induced by a set of prices that has become distorted through widespread price controls, high import duties, inappropriate exchange rates, and very low or negative real rates of interest. Cutting back on subsidies to inefficiently run public enterprises can encourage more realistic pricing and more cost-effective operation, and can release scarce credit for financing more productive public investment, as well as capital formation in the private sector. Credit for private investment can be further increased by an interest rate policy that promotes domestic saving and encourages the channeling of savings through the financial system. Greater mobilization of savings through an efficiently functioning financial system can help increase the productivity of investment, which in many countries is even more fundamental to the success of the development effort than the level of investment.
In a number of developing countries, a particular impediment to domestic adjustment is the persistence and, in some cases, the intensification of inflation. Out of 131 developing countries for which data are available, there were 32 countries with at least 20 percent inflation in 1984 and 22 with at least 30 percent. In the seven largest borrowing countries, the weighted average inflation rate has increased in every year since 1978, and exceeded 100 percent in 1984. Little change is expected in this rate in 1985.
Views differ widely on the rate of price increases at which anti-inflation policies need to become the primary focus of economic management. There are large international contrasts in this respect: rates of inflation considered high in some countries might be considered quite moderate in others. For these latter countries, it is sometimes argued that attempting to reduce inflation below a critical minimum level (that may differ among countries) will only aggravate unemployment and retard the growth of output, because of structural rigidities and supply bottlenecks in the economy. In most member countries, however, once inflation rises beyond moderate rates, the need for greater price stability is clearly perceived. Even where some of the distributional effects of inflation are mitigated through indexation and various contracting and accounting devices, substantial inflation, particularly when it is highly variable, tends to affect domestic savings, investment, and growth adversely. It does so by increasing general uncertainty, and thus the required real return to saving and investment; by reducing the holding of financial assets; by distorting resource allocation toward assets yielding quick returns and to inflation hedges; and by diverting entrepreneurial resources from productive purposes into finding ways to cope with inflation.
A major issue arising in connection with anti-inflation policies in developing countries is how much reliance to place on financial policies (monetary and fiscal restraint) compared with other policy measures designed to increase the propensity to save, to reduce anticipated inflation, or to increase efficiency in the use of resources (and hence factor productivity and exports).
Reducing the rate of growth of monetary aggregates is, of course, central to bringing down inflation. However, in countries with relatively undeveloped capital markets, monetary growth is strongly influenced by the state of the budget deficit. For most developing countries that have succeeded in dampening inflation in the past few years, cutting the budget deficit has in fact been the keystone of the program, while most countries with a worsening inflation have also allowed their budget deficits to rise in relation to GDP.
While financial restraint is an unavoidable part of an anti-inflationary strategy, it has to be recognized that if such policies give rise to sharp initial declines in output and employment, this will tend to weaken the political support for fighting inflation. For this reason, anti-inflationary financial policies usually need to be supported by structural measures that help improve the trade-off between price declines and output declines as the growth of nominal demand is cut back. In countries with several decades of high inflation, general indexation of prices, wages, interest rates, the exchange rate, and taxes often becomes entrenched as a way of limiting the redistributive effects of inflation. Such indexation is typically backward-looking: this is notably the case for wage rates, which are adjusted at stated intervals in line with the inflation realized between adjustment dates in the past. If some degree of deindexation of wages is not carried out, real wages may tend to rise as inflation is lowered, thereby both hampering the disinflationary effort and tending to increase unemployment.
Some countries have also tried to attack inertial inflation by temporarily freezing prices and wages. Such an approach can be effective when used as a very short-term measure, and when the required monetary and fiscal policies are in place, so that it becomes obvious to workers and businesses that the authorities are taking steps to tackle the underlying causes of the inflation. But such a temporary freeze is not usually sufficient to change expectations in rapid inflations, unless it is accompanied by both currency reforms and fundamental changes in fiscal and credit policies.
In attempting to counteract inflationary pressures by increasing aggregate output, three types of supply-side policy measures have proved particularly useful. First, lower and more uniform import tariffs can both lower domestic prices directly and, through easing supply constraints, contribute to improved supply and lower price increases in the medium term. Second, the availability of imports can be increased and rationalized through the liberalization of exchange control; this tends to encourage domestic production dependent on imported inputs and to reinforce the effects of any accompanying import tariff reductions. It goes without saying, of course, that such measures can only be implemented when the external position has been restored to a situation of aggregate strength. Third, improving the performance of public enterprises is often an important means of augmenting aggregate production and reducing budgetary deficits.
Uncertainties in the Outlook
A number of developments in recent months have served to underline the uncertainties in the staffs projections. These uncertainties merit special attention because the balance of risks attached to alternative possible outcomes may not be symmetrical. Moreover, it may be appropriate to consider in advance the policy responses that would be required if economic conditions were different from those expected.
Questions of major concern to policymakers in present circumstances include the following: How serious is the risk that the economic slowdown of the first half of 1985 will prove more persistent than in the staff’s projections? How would the projections be affected by a different evolution of the U.S. fiscal position from that assumed? How will interest rates in the United States be affected by budgetary actions, and how will these interest rate developments be reflected in changes in exchange rates and interest rates more generally? Is a significant upsurge in protectionist measures a major danger, and what would be its consequences? How would the world economy be affected by a break in oil prices?
In the following, a perspective is offered on the nature of some of these uncertainties and their interconnections. The issue of how policies should respond is dealt with in the next part.
Risks of a Slowdown in Industrial Country Growth
Assessment of this issue is not easy. On the one hand, certain factors making for lower growth are not likely to disappear. The stimulus imparted to the U.S. economy by an expansionary fiscal policy has run its course, while the indirect consequences of past stimulus (for example, in continued high real interest rates) will limit the scope for future output increases. To the extent that fiscal policy in the major industrial countries, taken together, is likely to be more restrictive in 1986 than for some years, this could well have a dampening effect on demand growth. At the same time, structural rigidities continue to hamper the growth of output and employment in a number of countries, while protectionist pressures and the difficulties of indebted developing countries also cloud economic prospects.
On the other hand, it can be argued that the slowdown in industrial countries in the first half of 1985 reflected a number of special factors, which are unlikely to persist with the same intensity in the second half of the year and in 1986. In the United States, a large part of the weakness in GNP is attributable to inventory adjustments, and to a deterioration in the trade balance. Final domestic demand increased at 4¾ percent (annual rate) during the first two quarters of 1985. Since inventories are not likely to continue to be such a negative factor as in the first half of 1985, and since the further deterioration in the trade balance will probably be smaller than in the recent past, a resumption of output growth seems likely. In continental Europe, output in the early part of the year was adversely affected by the severe winter and, partly as a result, inventories were also run down. Another unusual feature of early 1985 was a sharp increase in the asymmetry on intra-industrial country trade, a statistical problem that may have depressed recorded output below actual.4
Looking ahead, the balance of forces acting on the world economy seems likely to sustain growth; inflation has been reduced considerably and is expected to remain subdued over the forecast period; monetary conditions have eased, especially in the United States; and the profit situation remains fairly satisfactory, providing a basis for continued growth of investment. The staff is therefore inclined to view the disappointing performance of the world economy in the first half of 1985 as an interruption in a trend that is likely to be resumed, rather than as a sign of a more protracted slowdown. Nevertheless, it goes without saying that forthcoming indicators need to be monitored carefully for the light they can throw on this judgment.
The U.S. Fiscal Deficit
The agreement reached recently in the U.S. Congress provides some guidance concerning the future evolution of the fiscal stance in the United States, but nevertheless leaves considerable uncertainties. The Congressional budget resolution would reduce the deficit (relative to the “current services” estimate) by $56 billion in the 1986 fiscal year, $90 billion in fiscal year (FY) 1987, and $132 billion in FY 1988. On this basis, and assuming output growth of 4 percent over the period 1986-88, the deficit would decline from around 5½ percent of GNP in 1985 to less than 2½ percent of GNP in 1988. However, most of the proposed cuts require additional legislation to take effect, and the prospects for passage of certain important measures are uncertain. Furthermore, if growth were to be lower than is anticipated by the Administration, as the staff is projecting, the deficit would be substantially larger. On the basis of slower growth and more limited deficit reduction measures—$40 billion in FY 1986 and relatively modest additional cuts in FY 1987 and FY 1988—the staff estimates that the deficit would be about 4¾ percent of GNP in FY 1988.
As noted earlier, the U.S. Administration’s tax reform proposal can be expected to improve resource allocation and to strengthen the medium-term growth prospects of the economy. Pending its enactment, however, this legislation does engender uncertainty in the minds of economic agents as regards both the date it will become effective and the precise nature of the provisions that will be enacted. The first uncertainty derives from the possibility of congressional delays in legislating tax reform. The second derives from the possibility that congressional review of the legislation may lead to significant changes in various aspects of the proposal.
Interest and Exchange Rates
The effect of budgetary actions on interest rates depends both on the extent to which such actions have already been discounted by market participants, and on the degree to which such actions are perceived to have consequences for other relevant variables, such as the stance of Federal Reserve policy. In present circumstances, however, budget cuts less than those expected by market opinion would be likely to bring about a rise in interest rates. If the Federal Reserve were to adopt a nonaccommodative stance for monetary policy, such a rise would occur through a tightening in credit market conditions. If, instead, market opinion feared that monetary policy was likely to become more accommodative, a rise would come about through a revival of inflationary expectations.
Exchange rate behavior is notoriously difficult to predict, but it seems reasonable to assume that exchange rates are influenced, among other factors, by current and anticipated changes in interest rate differentials. These differentials, in turn, are affected by shifts in relative savings-investment balances among countries. The relative stance of fiscal policies is important in this connection, but does not have an unambiguous impact, nor is it the only factor of importance. A higher fiscal deficit can lead to either upward or downward pressure on the exchange rate, depending on whether the direct effect on saving-investment balances (which would tend to push the exchange rate up in the short term) outweighs any indirect effect through a weakening of confidence in the sustainability of policy. Exchange rates will also be affected by the success of other policies in achieving satisfactory growth of output. If growth differentials among countries were to be significantly different from those envisaged by the staff, the real exchange rates of the faster-growing countries could well appreciate.
In the present state of the oil market, a decline in prices appears to be a significant possibility. Potential supply greatly exceeds demand at current prices, and many suppliers are in a difficult financial position. Thus far, a substantial decline in prices has been averted by the exercise of production restraint by major producers, particularly Saudi Arabia, and it cannot be ruled out that continued restraint would keep prices close to current levels. If prices were to fall, however, it is hard to estimate at what level prices might stabilize, given supply and demand conditions in the oil market. This in turn makes it difficult to assess the overall impact of an oil price drop, since large declines may have effects that are not simply a multiple of the effects of smaller declines. A relatively small decline in prices that could be accommodated without causing major financial difficulties to producers would have a number of beneficial effects. It would put downward pressure on inflation, which, with unchanged financial policies, could help support real demand in oil importing countries. Lower inflation would also tend to bring down nominal interest rates. Together, these effects would have positive consequences on the real incomes of oil importing countries that would probably be larger than the reductions in real incomes in oil exporting countries.
However, a large fall in energy prices within a relatively short period might well have rather different consequences. It might tend to weaken the financial position of some energy exporting countries to such an extent as to call in question the manageability of their external positions. This in turn could put more widespread strains on the financing arrangements that underpin adjustment efforts in developing countries. Furthermore, a large fall might create more uncertainty about the balance of supply and demand in the world energy market over the medium to long term, which could tend to inhibit the growth of fixed investment.
Uncertainties about protectionism loom large today and are linked with uncertainties concerning growth and exchange rates. A weakening of output growth would increase the incentive for producers to seek protection from foreign competition, while the persistence of the current pattern of exchange rates and current account balances could provide a superficially plausible rationale for such requests. A significant move toward more protection would not only entail the economic costs of a misallocation of resources, but also reduce global demand. Additional negative effects on output would arise from indebted countries adversely affected by market closures having to adapt their adjustment programs by cutting imports. This potential chain of consequences underlines the importance of resistance to protectionism to avert a cumulative contraction of world trade and output.
Uncertainties and Interactions
Each of these uncertainties is important not only in its own right, but also because of the repercussions it might provoke. A slowing of growth in industrial countries, for example, would retard the growth of developing countries’ exports, both directly and through the protectionist pressures it would encourage. A serious weakening of developing countries’ external positions would in turn call in question the manageability of the international debt situation. Absence of agreement on substantial cuts in the U.S. budget deficit could well have major implications for interest rates and exchange rates, but the magnitude (and in some cases even the direction) of these effects are difficult to foretell. Whether, in such circumstances, a rise in U.S. interest rates would lead to a renewed rise in the exchange rate of the dollar, or to a further decline, is hard to determine on a priori grounds. Expectations and confidence play a major role in foreign exchange and credit markets, and can for significant periods swamp more direct effects on supply and demand.
It also must be recognized that uncertainties have different implications for different groups of countries. Developments may be favorable for some countries and unfavorable for others. This is particularly evident in the case of a decline in oil prices, but here too there can be secondary repercussions. Difficulties faced by oil countries can be communicated to other countries if they cause financial uncertainties that impede continued credit flows. It is therefore important to consider the incidence, as well as the overall magnitude of possible alternative developments.
Policy Responses to Uncertainty
The existence of uncertainties poses a number of issues for policymakers, depending in part on the balance of risks involved. A first set of issues concerns whether any immediate policy changes are needed in the light of these uncertainties. For example, should increased concern about the possibility of a slowdown in industrial countries lead to offsetting policies, even though the forecasts do not envisage such a slowdown? A second set of issues concerns the question of whether contingency plans should be formulated against the possibility of unexpected adverse (or, for that matter, favorable) developments in the world economy. And a third set of issues concerns the consistency of policy responses across countries.
On the first issue, the staff does not believe that uncertainty justifies any immediate change in economic strategy. However, the increased risks that are perceived argue for firmer action to bring actual policies into line with the underlying strategy, and thus to reduce uncertainty. As has been noted above, policies in most member countries have been increasingly considered in the light of a medium-term strategy. This emphasis reflects a recognition of the fact that the lags with which policy changes affect economic conditions are uncertain. The medium-term approach is also based on the view that private markets will work more effectively, and will be better able to perform a stabilizing function, when the stance of official policy is not subject to sudden changes. While authorities must always retain a certain flexibility in the implementation of policies, present uncertainties argue for giving as clear a guidance as possible to private markets concerning the evolution of key economic variables in the medium term. In this connection, measures that would increase the confidence of market participants concerning the medium-term course of fiscal policy in the United States would be particularly helpful. It would also be desirable if several countries outside the United States were able to adhere more consistently than in the past to their medium-term financial and structural objectives.
Concerning the second issue noted above, the need for contingency plans, it would be impracticable to prepare detailed policy responses to deal with all possible eventualities. Experience suggests that the circumstances surrounding actual developments can vary in ways that significantly affect the policy response that is called for. This does not mean, however, that policy responses should not be discussed in a general sense. Indeed, the third issue mentioned, the need for consistency in policy responses across countries, adds to the case for considering possible responses in advance. The fact that policies have implications for trading partners makes it very important to ensure the mutual compatibility of policy actions. In what follows, possible responses to alternative developments in four key areas of uncertainty are briefly considered.
Growth in Industrial Countries
The recent weakness in economic activity in industrial countries naturally raises the question of how policies should respond if, contrary to the staff’s forecasts, growth remains sluggish in the period ahead. As far as fiscal policy is concerned, a weakening of activity would lead to a widening of recorded deficits, as tax revenues fell short of projections. In the staff’s view, such a widening of actual deficits should be accepted (provided, of course, that the thrust of fiscal policies is consistent with the pattern described in the first part of this section). This would constitute the working of “automatic stabilizers” which would limit the weakening of economic activity without increasing the underlying fiscal deficit. Additional discretionary fiscal action would, in general, have significant drawbacks. Discretionary (as opposed to automatic) fiscal changes would undermine confidence in stable financial policies and, given the already high level of deficits that have to be financed, might raise questions in the minds of market participants concerning whether debt could continue to be managed without recourse to inflationary finance.
As regards monetary policy, a weakening of activity with unchanged monetary growth rates would lead to an easing of monetary conditions and lower interest rates. Such a development should not be resisted, but there would be dangers, in a medium-term context, of trying to force the pace of monetary easing. The lags with which changes in monetary policy affect the real economy are in any event too uncertain for it to be used as an instrument of fine-tuning the economy.
It cannot, of course, be ruled out that growth might turn out to be higher than in the staff’s forecast. If this were the case, an argument could be made for taking advantage of such a favorable development to make somewhat more rapid progress in achieving medium-term fiscal objectives. This would apply also to structural objectives, since the removal of rigidities is likely to be easier in a situation of expanding output and employment. Stable monetary growth targets would remain appropriate, even though more rapid output growth would generate some upward pressure on interest rates. Keeping monetary policy on a steady course in such circumstances would reinforce the commitment to medium-term objectives, while not impeding progress toward a gradual further reduction in inflation.
Exchange Market Developments
As developments in the past year have shown, exchange rates can move by substantial amounts in a relatively short period, and this raises the question of whether and how monetary policies should adjust in the face of exchange market pressures. In this connection, it is important that actions undertaken in different countries should be mutually consistent. If, for example, the authorities in a country with a depreciating currency were to respond by tightening monetary policy in order to counter inflationary pressures, while those in a country with an appreciating currency lowered monetary growth to validate the prospective decline in inflation, there would be a systematically deflationary impact on the world economy.
The risk of inconsistent policy responses arises from the fact that different countries have different objectives in the management of monetary policy, and from the uncertainties that exist concerning how, in particular circumstances, exchange rate movements affect other variables. On the one hand, an appreciation could be viewed as having an immediate deflationary impact through the foreign trade balance, which needed to be counteracted by an easing of monetary policy through higher monetary growth. On the other hand, the exchange market appreciation could be seen as causing, in itself, an easing of monetary conditions (since the initial downward pressure on prices would tend to increase the real money stock). On this view the authorities might, if they regarded monetary conditions as being initially appropriate, be tempted to tighten policy in order not to give an unintended stimulus to domestic demand. A similar dichotomy of view could arise in countries experiencing a depreciation of their currency.
Policy responses to exchange rate movements will also be affected by how desirable the movement is perceived to be. Undesired exchange rate movements can be resisted by a tightening of monetary policy in the country with a depreciating currency while easing policy in the appreciating currency. If an exchange rate movement is perceived as being in a desirable direction, however, monetary policy could be framed to accommodate the exchange rate movement without affecting domestic monetary conditions.
The staff’s projections involve relatively little change in real interest rates from the levels prevailing in mid-1985. (Some increase in short-term U.S. dollar rates is envisaged over the near term under the influence of a strengthening of economic activity, and a gradual decline is assumed from 1987 onward.) It is certainly possible, however, that the actual path of rates will be significantly higher or lower than that envisaged.
A lower path for real interest rates would generally improve the outlook for the world economy (except, of course, to the extent that it was caused by a weakness of final demand). Lower interest rates would encourage investment demand in the industrial countries, help strengthen fiscal positions, and ease external debt service burdens in the developing world. In the short term, however, policies should not overreact to any significant easing of rates on the assumption that easing would be permanent. A more prudent course of action, both in industrial and developing countries, would be to make allowance for the possibility of a subsequent rise. For the industrial countries, this means maintaining broadly the same stance of monetary and fiscal policies. For developing countries, it means using a part of the savings from reduced interest payments to strengthen the external position, especially for those countries whose existing level of debt impairs creditworthiness.
More difficult decisions would be created by a rise in rates to levels significantly above those projected. Higher rates would undermine the prospects for a sustained recovery of investment in the industrial countries, and would set back the adjustment efforts of developing countries. Nevertheless, a deliberate loosening of monetary policy, aimed at holding short-term interest rates down, would carry significant dangers. Given the sensitivity of market expectations, such a course of action might well be counterproductive to its intended effect, in anything other than the very short run. Even if interest rates were temporarily kept down, this would only be achieved by jeopardizing the credibility of medium-term policy objectives and introducing uncertainty about the future course of inflation. This uncertainty, in turn, would tend to undermine the basis of continued growth in real demand.
It follows that a rise in interest rates would call for policy actions to tackle the root cause of the higher rates (probably to be found in fears that budget deficits or incipient capital flows would be monetized), coupled with specific measures to alleviate strains that might develop in parts of the financial system. This might include ensuring that appropriate forms and amounts of finance were available to enable heavily indebted countries to adapt their adjustment programs to the new realities without undue disruption.
Slippages in Adjustment Efforts
By and large, adjustment efforts by countries facing debt-servicing difficulties have been pursued with determination. However, slippages have occurred, due to a variety of causes, and it is possible that more serious slippages might occur in the future. In judging the appropriate policy response, it is essential to consider the nature and cause of any slippage that occurs. Where an unexpected shortfall in performance is attributable to external circumstances that are likely to be temporary, no major change in an adjustment program is called for. In such cases the international community should assist the country concerned in finding the needed liquidity to carry through a period of external stringency.
Slippages arising from developments that are not likely to be reversed pose a more serious threat. It is important to recognize that such slippages will not necessarily show up in a widening balance of payments deficit. Indeed, given the tight external constraints faced by many heavily indebted countries, they are more likely to be revealed in domestic financial imbalances—weakness in investment, accelerating inflation, a widening budget deficit, and so on.
Where such developments occur it is important to deal with the basic causes of the problem, rather than focusing policy on suppressing external deficits and rationing scarce foreign exchange. Accelerating inflation requires, as discussed earlier, a combination of financial policies aimed at restraining the growth of nominal demand, coupled with structural policies that reduce inflationary expectations and limit the working of mechanisms that perpetuate inflation. Weak domestic savings and investment are a particularly serious early warning of future adjustment difficulties, since growth and adjustment are only sustainable on the basis of continued growth in capital formation. Incentives to productive investment can best be preserved when the aggregate price structure (including the price of foreign exchange and the price of capital) adequately reflect relative scarcities.
When countries are able to reformulate their adjustment programs to deal firmly with slippages in adjustment, there may be a need for additional financing during a transitional period. Absence of such financing could significantly increase the short-term loss of employment and output involved in reaching an equilibrium position. This, in turn, would tend to complicate the task of national authorities in mobilizing the necessary consensus for adjustment measures. It is important, therefore, that appropriate financial support be available for policy programs that offer realistic prospects for effective adjustment.
A related need is for an increased flow of official development assistance, particularly to low-income countries facing high debt-servicing burdens. Since much of these countries’ existing debt bears concessional interest rates, these economies have not benefited from recent declines in interest rates to nearly the same extent as countries that borrow predominantly from private sources. The debt service ratio in Africa, for example, is projected to rise from 26½ percent in 1984 to 32½ percent in 1985, the largest increase in any region. Many developing countries will require substantial continuing flows of concessional foreign assistance if they are to overcome the structural obstacles to growth that they face.
Role of the Fund
The role of the Fund is particularly crucial when the global economic outlook is uncertain, and when there are significant risks of adverse developments. In these circumstances, the international community can help avoid inappropriate or inconsistent policies through effective use of surveillance mechanisms. In addition, the financial resources of the Fund can ease the difficult process of transition that many members face as they undertake needed adjustments in their economies.
The importance of surveillance is a reflection of the increasingly close and complex interactions that characterize economic policies and conditions among member countries. The degree of success countries have in achieving their economic objectives, and the mix of policies chosen to pursue these objectives, have major implications for the policy options and constraints facing other countries. There is a clear need to avoid inconsistent policies through the use of mechanisms for international consultation. The pursuit of mutually compatible policies does not, of course, involve detailed fine-tuning of policy in pursuit of short-term demand-management objectives. What is required is rather a common medium-term framework that includes stabilizing mechanisms that can come into play as actual developments diverge from their expected course.
The Fund’s financial role (understood broadly to include both the use of the Fund’s own resources, and its role as a catalyst for resources from other lenders) will remain crucial in the period ahead. The recent weakening in world economic activity—the first deceleration in growth since the beginning of the present recovery—has interrupted the strengthening that was taking place in the economies of indebted countries. This interruption does not invalidate the staffs earlier judgment that these countries can sustain a viable external position over the medium term while restoring higher rates of growth domestically. However, it does reduce their room for maneuver. If a more protracted period of slowdown in industrial countries were to make policy modifications necessary, the Fund’s role would become even more central, both in consulting with members about the policy measures that are required, and in providing financial support.