Chapter

Medium-Term Prospects and Policy Issues in the Industrial Countries

Author(s):
International Monetary Fund. Research Dept.
Published Date:
January 1990
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Medium-Term Baseline Projections29

As in the past, the staff’s medium-term baseline projections for the industrial countries are developed on the basis of several technical assumptions: unchanged policies (except for those measures that have already been announced and are virtually certain to be implemented); constant real exchange rates; and unchanged oil prices in real terms. The medium-term projections are conditional upon these assumptions and therefore should not necessarily be interpreted as forecasts of the most likely outcomes. The projections include the estimated effects of economic unification in Germany; these effects are discussed later in this Chapter.

On the basis of the assumptions mentioned above, the staff is projecting that real GNP growth in the industrial countries would slow to an annual rate of 2½ percent in 1990–91 (from nearly 4 percent in 1988-89) before rising to an average of just over 3 percent during 1992–95, which would be broadly in line with current estimates of the rise in potential GNP (Table 10). Over that period, growth would be above the average for industrial countries in Japan and, to a lesser extent in Canada; somewhat below the average in the United Kingdom and the United States; and near the average in France, the Federal Republic of Germany, Italy, and the other industrial countries considered as a group. In all major industrial countries except the United Kingdom, total domestic demand would grow approximately at the same rate as output in the period 1992–95, and changes in trade and current account balances would be relatively small in relation to GNP. The deficit of the United Kingdom, which is expected to fall substantially from 1989 to 1991, would continue to narrow over the medium term.

The projections envisage a continuation of the policies of fiscal consolidation. In relation to GNP, fiscal deficits at the general government level would decline somewhat in France and fall substantially in the United States, Canada, and Italy, while Japan’s surplus would widen over the medium term. In the Federal Republic of Germany, the financial position of the Government would deteriorate from 1989 to 1991, partly as a result of increased outlays associated with unification with the German Democratic Republic, but it would improve subsequently and move toward balance in 1995. In the United Kingdom, there would be a shift from a moderate surplus in 1989 to a small deficit in 1995. Public sector debt-to-GNP ratios would decline over the medium term in all countries with the exception of Italy, where it would continue to rise, albeit at a diminishing rate.30

The strengthening of the public finances over the next five to six years would permit some rise in the ratio of private domestic investment to GNP in Canada, France, Italy, and the United States. The investment ratio also would increase in Germany—despite little net change in the government’s financial balance from 1990 to 1995—reflecting a substantial drop in the outflow of savings to the rest of the world, and some rise in the private saving rate. The continued strength of investment in many European countries would result in part from the process of economic integration, which is discussed in detail later on.

Key Policy Issues

Over the past seven and a half years, the industrial world has experienced continued economic expansion and declining unemployment and, until 1986, growth was accompanied by a substantial drop in inflation (Chart 22). Since then, however, significant cost-price pressures have reemerged in most countries, as the degree of resource utilization rose to high levels, even though such pressures have been relatively low by the standards of previous cyclical episodes. Throughout the current expansion, interest rates have remained high by historical standards, reflecting the effect of restrained monetary policies but also the combination of relatively high demand for investment in many countries and, until the past few years, a downward trend in national saving (Chart 23). The pace of the expansion has moderated over the past two years, and the staff is projecting that growth will continue at a reduced but sustainable pace while inflationary pressures will diminish slightly.

Table 10.Major Industrial Countries: Indicators of Economic Performance, 1977–95(Changes in percent, except where otherwise noted)
Average

1977–86
19871988198919901991Average1

1992–95
Canada
Real GDP3.14.04.43.01.11.1
Real total domestic demand2.95.25.04.10.41.1
GDP deflator6.54.84.84.93.65.1
General government financial balance2 (in percent of GDP)–4.4–4.0–2.9–3.4–3.6–3.0
Current account balance (in percent of GDP)–0.8–1.7–1.7–2.6–2.7–2.7
Gross private investment (in percent of GDP)19.219.219.920.219.820.1
United States
Real GNP42.83.44.52.51.31.7
Real total domestic demand3.13.03.31.90.81.6
GNP deflator6.13.23.34.14.34.2
General government financial balance2 (in percent of GNP)–2.0–2.4–2.0–1.7–1.7–2.3
Current account balance (in percent of GNP)–1.2–3.6–2.6–2.1–1.8–1.7
Gross private investment (in percent of GNP)16.515.515.414.814.114.0
Japan
Real GNP4.34.65.74.95.13.7
Real total domestic demand3.65.47.65.95.03.5
GNP deflator2.8–0.30.61.51.52.1
General government financial balance2 (in percent of GNP)–3.40.72.12.83.13.3
Current account balance (in percent of GNP)1.53.62.82.01.71.8
Gross private investment (in percent of GNP)21.522.123.925.826.626.6
France
Real GDP2.22.23.91.63.13.0
Real total domestic demand2.03.34.03.13.23.1
GDP deflator9.22.73.03.53.43.2
General government financial balance2 (in percent of GDP)–2.0–1.9–1.8–1.4–1.3–1.2
Current account balance (in percent of GDP)–0.2–0.5–0.4–0.4–0.4–0.4
Gross private investment (in percent of GDP)18.617.017.918.118.518.9
Germany, Federal Republic of
Real GNP2.01.63.73.93.93.1
Real total domestic demand1.72.83.72.74.73.3
GNP deflator1.62.01.62.62.93.6
General government financial balance2 (in percent of GNP)–2.4–1.8–2.10.2–2.2–3.5
Current account balance (in percent of GNP)0.94.14.24.63.32.3
Gross private investment (in percent of GNP)18.017.218.119.219.920.5
Italy
Real GDP2.83.04.21.22.72.7
Real total domestic demand2.34.74.73.32.72.7
GDP deflator14.45.86.36.36.55.7
General government financial balance2 (in percent of GDP)–10.2–11.1–10.9–10.2–9.8–9.6
Current account balance (in percent of GDP)–0.2–0.2–0.7–1.2–1.1–1.0
Gross private investment (in percent of GDP)19.716.517.217.317.317.5
United Kingdom
Real GDP2.04.74.62.21.41.3
Real total domestic demand2.05.57.63.1–0.00.6
GDP deflator9.65.06.56.95.55.7
General government financial balance2 (in percent of GDP)–3.70.32.21.50.70.4
Current account balance (in percent of GDP)0.8–0.9–3.1–3.7–2.8–2.0
Gross private investment (in percent of GDP)12.814.917.717.915.716.2
Major industrial countries
Real GDP/GNP2.93.54.63.32.72.43.1
Real total domestic demand2.83.84.73.22.42.33.1
GDP/GNP deflator6.32.73.03.73.63.83.4
General government financial balance2 (in percent of GDP/GNP)3–3.0–2.1–1.5–0.9–1.1–1.4–0.5
Current account balance (in percent of GDP/GNP)3–0.2–0.4–0.4–0.5–0.40.4–0.2
Gross private investment (in percent of GDP/GNP)317.817.218.018.618.518.620.0
Other industrial countries
Real GDP/GNP2.12.83.33.72.52.32.8
Real total domestic demand1.73.33.94.42.42.22.8
GDP/GNP deflator8.54.95.15.55.95.24.0
Current account balance (in percent of GDP/GNP)3–1.5–0.4–0.5–1.3–1.5–1.5–0.8
All industrial countries
Real GDP/GNP2.83.44.43.42.62.43.1
Real total domestic demand2.73.74.63.42.42.33.1
GDP/GNP deflator6.63.03.33.93.94.03.5
Current account balance (in percent of GDP/GNP)3–0.4–0.4–0.4–0.6–0.6–0.6–0.3

These projections are based on the assumptions of unchanged policies and constant real exchange rates and oil prices.

National account basis.

The last column refers to 1995.

After adjustment for the effects of the drought on farm output, the growth of real GNP in the United States would be 5 percent in 1988 and 2.2 percent in 1989.

These projections are based on the assumptions of unchanged policies and constant real exchange rates and oil prices.

National account basis.

The last column refers to 1995.

After adjustment for the effects of the drought on farm output, the growth of real GNP in the United States would be 5 percent in 1988 and 2.2 percent in 1989.

The strategy for sustained growth in the industrial countries identified in previous issues of the World Economic Outlook emphasized three basic components: a monetary policy aimed at controlling inflation and achieving steady progress toward price stability; a fiscal policy directed at fostering an adequate level of national saving and a rate of capital formation sufficient to attain a satisfactory growth performance over the long run; and structural policies that help to increase efficiency and raise welfare, particularly through trade liberalization.31 It was emphasized that these policies were required not only to maintain and, if possible, improve standards of living in the industrial world, but also to foster growth in the developing countries and, in particular, to help the heavily indebted countries overcome their present difficulties. It was also stressed that the long-term focus of the strategy was essential, given the likelihood that prospective demographic changes would exert substantial downward pressure on both private and public saving, and the expectation that substantial resources would be needed to protect the environment.

A number of major political and economic developments have occurred during the past year, including dramatic changes in Eastern Europe and in Germany; significant movements in financial, equity and foreign exchange markets; and, recently, a sharp increase in oil prices. (The policy issues raised by the recent increase in world oil prices are discussed in the Box.) These developments, however, do not alter the fundamental design of the strategy required to achieve sustained growth in the world economy. Indeed, they give the implementation of that strategy increased importance and urgency. In particular, given the upward drift in consumer price inflation in the industrial countries—from an average of around 3 percent in 1987–88 to a range of 4–5 percent during the past year—a degree of restraint on the part of monetary policy remains appropriate. Also, the additional demand for resources associated with unification in Germany and reform in Eastern Europe, coupled with the continuing and pressing needs of the indebted developing countries, underscores the need to increase world saving.

The importance of dealing with the problems of saving and inflation has been highlighted by the significant rise in interest rates that has taken place in the industrial countries over the past year, particularly at the long end of the maturity spectrum. This rise reflects in part the prospective surge in the demand for funds associated with the reconstruction of Eastern Europe and the unification of Germany. In themselves, these developments are, of course, positive. Over the longer run, the fundamental reforms that are in prospect—or are now being implemented—will be beneficial to the countries involved and also to the world economy, as they will bring about significant improvements in efficiency and expand productive capacity. Initially, however, the rising demand for investment is taking place at a time when resources in most of the industrial countries are close to being fully utilized.

Chart 22.Major Industrial Countries: Comparison of Expansions1

(In percent)

1 The expansions begin in 1971–Q4, 1975–Q1, and 1982–Q4. The variables shown are averages for individual countries weighted by the average U.S. dollar value of their respective GNPs over the preceding three years.

2 Some data for recent quarters for Japan and Italy are staff estimates.

3 Percent change from the same quarter of previous year.

4 Long-term bond yield less the percentage change in GNP deflator from the same quarter of previous year. See Statistical Appendix Table A15, note 3, for the definition of long-term interest rates.

Chart 23.Industrial Countries: Saving and Investment

(In percent of GNP)

In this environment, and given the developing countries’ continued need for additional resources, action to raise saving in the industrial world has become of paramount importance. To be sure, any structural measures that could raise private saving by removing existing distortions should be given full consideration; a number of countries, including the United States, have taken steps in this direction. But it seems clear that the most effective way to achieve a substantial rise in national saving is to speed up the process of fiscal consolidation and cut the absorption of saving by governments.

Policy Issues Raised by the Recent Increase in World Oil Prices

An important question at this juncture is how economic policies should respond to the recent developments in oil markets. In answering this question it is important to put the likely economic effects of these developments in perspective. The estimates presented in the Appendix to Chapter I suggest that these effects could be significant and that, in those oil importing countries where growth was already quite sluggish, there could be a period of weak economic activity. However, even if the price of oil were to average $30 per barrel for an indefinite period, the adverse effects on output in the industrial countries probably would be considerably less than those attributable to the oil price increase in 1979–80.

To be sure, the consequences of recent events in the Middle East could be more serious than suggested by the staff’s simulations described in that Appendix because of the large increase in uncertainty that has been reflected in sharp drops in equity and bond prices. To a large extent, the reaction of financial markets can be attributed to the unsettled political and military situation in the Middle East, including the possibility that armed conflict might result in the destruction of major oil-producing facilities and lead to a further reduction in oil supplies. However, the reaction of financial markets also appears to have reflected uncertainty about the response of economic policies to the oil situation. It is therefore essential that the authorities provide clear signals to the public that economic policies will not be derailed by recent events, and that the mistakes made in similar circumstances in the past will not be repeated.

First, the experience of previous oil shocks indicates that attempts to prevent or to limit the pass-through of oil price increases to domestic energy prices would be counterproductive. Subsidizing domestic oil consumption would have undesirable effects on the government’s fiscal position. Unless the subsidies were offset by higher taxes, which would amount to an inefficient reshuffling of the adverse effects of higher oil costs among consumers and businesses, the result would be to increase government borrowing, raise interest rates, and crowd out the interest-sensitive components of expenditure. Efforts to cushion the impact of higher world prices on energy users by resorting to domestic price controls would distort the functioning of markets and give rise to shortages of oil products. For the longer run, any attempt to keep domestic oil prices below world levels would hinder efforts to conserve energy and would discourage the development of new sources of energy.

The experience with previous rounds of sharp increases in oil prices also indicates that attempts to mitigate the adverse short-run economic effects of higher oil prices by easing monetary policy could give rise to even stronger price pressures, and to market expectations that such pressures would evolve into an inflationary process. In the current situation, where many industrial countries are operating at high levels of resource utilization and where cost/price pressures have been evident for some time, a further escalation of inflation and expectations about inflation would ultimately require a sharp tightening of monetary conditions, as occurred in the late 1970s. As a result, interest rates would be higher, and output and employment would be lower, than if the stance of monetary policy had not been altered in response to the oil shock.

An easing of monetary policy in response to the rise in oil prices would thus be inappropriate. In the short run, the best response would be to adhere to a monetary policy aimed at bringing existing price pressures under control. Specifically, a policy directed at achieving approximately the same rate of expansion of nominal GNP that was envisaged prior to the rise in oil prices would be appropriate. Such a policy would mean somewhat lower output growth and somewhat faster price increases for a period of one to two years, but it would offer greater assurance that growth would proceed at previously projected rates in subsequent years. Moreover, a clear signal that the authorities are united in their determination to adhere to this policy would help to reassure financial markets that inflation will be contained, thus helping to reduce the risk premium presently incorporated in long-term interest rates.

The lower level of economic activity and the higher interest rates that are expected to result from higher oil prices will tend to have adverse effects on the fiscal position in most industrial countries—and in many developing countries as well. Moreover, in several countries, notably in the United States, the fiscal position also will be affected negatively because of the expenditures related to military operations in the Middle East. While these developments are likely to complicate the task of fiscal correction in several countries, they do not alter the urgent need for a credible plan to lower fiscal deficits over time. If anything, recent developments indicate that the magnitude of the fiscal problem is likely to increase as a result of recent developments in the Middle East.

The rise in interest rates during the past year also appears to have reflected expectations of higher inflation in the future. This worsening of expectations suggests that market participants remain highly sensitive to news concerning possible inflationary disturbances—such as, for example, monetary unification in Germany, although in this case market concerns may have been exaggerated. It also underscores the importance of some of the lessons learned in the 1970s. First, there is no lasting tradeoff between inflation and growth: a significant relaxation of monetary policy at this juncture would not yield a lasting reduction in interest rates nor a durable improvement in employment; it would only store up problems for the future. Second, in the past the escalation of inflation expectations had been a major factor in the sequence of accelerating inflation, sharply rising interest rates, and, finally, recession that affected the industrial economies in the 1970s. It is precisely to avoid this chain of events that central banks attempted during the 1980s to establish the credibility of monetary policy; this, in turn, has been one of the key elements behind the durability of the current expansion. The authorities are now in a better position to confront the challenge of inflation. What is now needed is to allay the market’s fears by giving the clearest signals that wage and price pressures will be contained and that the authorities are undivided in their determination to resume tangible progress in reducing inflation.

In recent years, concern has been raised about the possible macroeconomic repercussions of large movements in financial asset prices and the fragility of certain financial institutions. The sharp drop in stock prices in Japan in the early months of this year, and the more generalized fall in the wake of events in the Middle East in early August, have renewed the concerns raised earlier by the large equity market breaks of October 1987 and October 1989. In the United States, the unprecedented losses of the thrift industry are certain to have serious budgetary implications, although so far they have not resulted in major disruptions in other parts of the financial system. In a number of countries—including the United States, the United Kingdom, and Australia—corporate debt/asset ratios have risen significantly in recent years, partly in connection with a wave of corporate mergers, acquisitions, and leveraged buy-outs. This has resulted in a pronounced increase in interest cost as a percent of cash flows, raising questions about the increased vulnerability of corporations—and, indirectly, of credit institutions—in the event of a cyclical downturn.

These financial developments will, no doubt, be taken into consideration by the authorities in conducting monetary policy in the near term. In particular, central banks will ensure, as they have on previous occasions, that the problems of particular financial markets or institutions do not spill over to other sectors, posing the risk of systemic reactions. However, the fragility of certain financial institutions and the movements in the prices of individual assets should not obscure the main goal of monetary policy—to achieve price stability over the long term. It is clear that a lasting solution to the specific problems mentioned above cannot be brought about by easing monetary conditions. Rather, attention must focus on such structural issues as reform of deposit insurance and elimination of tax provisions that encourage excessive corporate leverage.

Major developments also have taken place in foreign exchange markets during the past year, including a substantial weakening of the yen until April 1990, and a considerably less pronounced weakening of the U.S. dollar. The reasons for these developments, which are reviewed in detail in Chapter I, are not fully understood, and thus the policy reactions that would be appropriate are not readily apparent. Nevertheless, several points would appear to be relevant. First, the recent decline in the value of the dollar should help boost net exports and output in the United States and contribute to a further reduction in the U.S. trade and current account imbalances. But the economy’s proximity to full employment suggests that a further large improvement in net exports is likely to come at the expense of other components of private demand—including investment—unless the U.S. fiscal position is improved. Second, any attempt to influence the pattern of exchange rates, for example through official intervention in the foreign exchange markets, should be consistent with the overall economic strategy and should not be viewed as a substitute for action on underlying economic fundamentals.

The issue of external adjustment among the major industrial countries must take into account the progress made in reducing current account imbalances in recent years and must be seen in the context of the need to increase global saving. First, as was noted in the previous section, the imbalances of Japan and the United States have been sharply reduced since they peaked in 1986–87; and the surplus of Germany, which has remained quite large relative to GNP, is now expected to narrow substantially over the next two years. However, the staff’s medium-term projections envisage that, in the absence of policy changes or exchange rate adjustments, the imbalances of these three countries would remain broadly unchanged or even rise a little in relation to GNP. The projected level of these imbalances suggests that the risk of an unsustainable accumulation of external assets and liabilities, and therefore the risk of sharp and disruptive reactions in financial markets, has been somewhat reduced. Of course, the possibility that market participants might, at some point, be reluctant to finance these imbalances at existing levels of interest rates and exchange rates cannot be ruled out. Also, the continuation of sizable imbalances would pose the serious risk of an intensification of protectionist pressures. However, this risk must be confronted by resisting such pressures rather than by allowing protectionism to exert an undue influence on macroeconomic policies.

From a policy perspective, the issue is how to ensure that external adjustment does not take place in a way that jeopardizes growth objectives by exerting upward pressure on prices and interest rates. In other words, the task is to ensure that the process of adjustment is consistent with the goal of raising national saving. In these circumstances, the proposition that external adjustment should involve primarily policies aimed at raising saving in the deficit countries, rather than actions to reduce saving in the surplus countries, continues to be valid. This proposition underscores the need for measures to strengthen the public finances in a number of countries with external deficits—including Canada, Italy, Spain, and the United States—where fiscal deficits remain large. In these countries, and also in other countries with relatively high rates of inflation, a tighter fiscal policy would reduce the burden now being borne by monetary policy in containing price pressures and would help to achieve a lasting decline in interest rates.

It may be argued that external adjustment could also be brought about by boosting investment in the surplus countries. The critical question, however, is the extent to which this can be achieved while at the same time increasing global saving. Given the high level of resource use now prevailing in the industrial economies, a substantial rise in investment in countries like Germany and Japan would, in the absence of other actions, need to be financed in large measure by reducing the supply of saving to other countries. This would indeed reduce external imbalances, but it would do so by exerting upward pressure on world interest rates and by crowding out investment in other countries. By way of illustration, the simulations presented below suggest that the large rise in investment that is expected as a result of unification in Germany is likely to be associated with—and may already have resulted in—a rise in world interest rates.

International Implications of German Unification

The economic, monetary, and social union (GEMSU) of the German Democratic Republic (G.D.R.) with the Federal Republic of Germany (F.R.G.) commenced with the signing of a State Treaty between the two countries in May and its ratification by the two legislatures in June 1990. It went into effect on July 1, 1990, at which time the deutsche mark became the sole legal tender of the G.D.R., and much of the legal and institutional framework of the Federal Republic was adopted by the Democratic Republic.32 Political unification will take place on October 3, 1990.

The major economic impact of GEMSU will be on the Democratic Republic as it undergoes a fundamental transformation from a centrally planned economy to one based on market principles. This transformation, which will involve a considerable increase in the demand for resources in the Democratic Republic, will also affect the economy of the Federal Republic in a major way as exports, transfers, and investment flows to the G.D.R. are expected to increase sharply. (These changes have been incorporated in the staff’s baseline projections for the Federal Republic.) The process of unification will involve a rise in the demand for world saving, stemming from higher investment and public expenditure in the Democratic Republic, and will therefore have international repercussions.

The short- to medium-term impact of German unification on the world economy can be interpreted as an aggregate demand shock that will raise global investment relative to world saving. With large parts of the industrial world, including the Federal Republic of Germany, operating at high levels of resource utilization, the rise in demand will result in some upward pressures on prices and real interest rates. These pressures will be concentrated in Germany but will spill over to other countries, as will the aggregate demand effects of unification, depending in part on how exchange rates adjust to the shock. The rise in real interest rates reflects in part the higher rate of return on investment in the Democratic Republic. Over the longer run, the prospective growth of the capital stock and the more efficient allocation of capital and labor in the G.D.R. will raise productive capacity in a united Germany. Thus, the supply of output will increase over time and the short-run aggregate demand effects of unification would gradually be offset by the increase in productive capacity. Over the medium to long run, excess demand pressures will abate, Germany’s investment demand relative to domestic saving will diminish, and the pressure on real interest rates arising from unification will ease.

In order to gauge the international effects of the unification, it is necessary first to examine its likely effect on the economy of the Democratic Republic. This examination must be based on certain assumptions about the prospective increase in resource demands in the G.D.R., particularly for government infrastructure and private plant and equipment outlays. These assumptions are embodied in a specific scenario about the likely evolution of the economy of the Democratic Republic over the coming decade; this should not be regarded as a forecast but rather as a consistent framework within which some of the important changes involved in unification can be analyzed explicitly and in which some rough orders of magnitude can be provided.

In this scenario, the key assumption underlying the evolution of the Democratic Republic is that output per worker will rise over the next ten years to about 80 percent of its level in the Federal Republic in the year 2001. Assuming that the level of labor productivity in the G.D.R. is at about 35 percent of the level in the F.R.G., and that productivity in the Federal Republic is projected to increase at roughly 2½ percent a year, the catch-up in productivity in this scenario implies annual gains in output per worker in the Democratic Republic of about 10 percent a year. Part of this gain is assumed to come from the more efficient allocation of labor and capital that would be associated with the shift to a market-oriented economy, with the remainder assumed to result from a large increase in investment in plant and equipment and in infrastructure. The latter component of capital spending is viewed as a prerequisite for profitable private investment. Over the entire ten-year period, total net fixed investment would be on the order of DM 1.2 trillion (at 1990 prices), over half of which is assumed to be financed by external resources, including fiscal transfers from the Federal Republic.

Table 11.Potential Demands on Global Saving Resulting from GEMSU(At 1990 prices)
Change in Net Imports in the

German Democratic Republic
In Billions of

Deutsche Mark
In Billions of

U.S. Dollars1
19903620
19917344
19927041
19936538
19946136
19955634
19965131
19974528
19983823
19993018
20002313
2001168
Note: The figures in this table show the assumed increase, relative to the pre-unification baseline, in total net imports of the G.D.R. Of this total, two thirds are assumed to be supplied by the F.R.G.

At the deutsche mark-U.S. dollar rate prevailing at the end of 1989.

Note: The figures in this table show the assumed increase, relative to the pre-unification baseline, in total net imports of the G.D.R. Of this total, two thirds are assumed to be supplied by the F.R.G.

At the deutsche mark-U.S. dollar rate prevailing at the end of 1989.

In addition to the increase in investment, it is also assumed that a significant rise in consumption and government spending will occur in the Democratic Republic. Part of the resulting expansion of aggregate demand would be satisfied by increased output in the G.D.R., but a significant fraction would be reflected in a rise in net imports from the rest of the world (Table 11). Of the total net increase in the demand for goods and services assumed to be satisfied from external sources, two thirds would be supplied by the Federal Republic, and the remaining one third by other countries on the basis of their shares in world trade. Thus, exports from the F.R.G. to the G.D.R. would increase substantially: for example, in 1991—the year in which unification has its largest impact on the economy of the Federal Republic under this scenario—the additional demand stemming from the Democratic Republic would reach almost 2 percent of the Federal Republic’s GNP.

Part of the increase in the demands for resources in the G.D.R. would be financed by transfers from the Federal Republic. A small part of these transfers, primarily assistance for the G.D.R.’s social security system, would be made directly by the Government of the Federal Republic. The bulk of these transfers would be made by the Unity Fund, which was set up in the F.R.G. to finance the government spending in the Democratic Republic associated with unification.33 GEMSU would have a number of other effects on the fiscal position of the Federal Republic and a united Germany, including in particular a rise in tax revenue as a result of higher output. The estimated total impact on the fiscal position is discussed below.

An important effect of the opening of the border between the two German states was the increased mobility of labor from the Democratic Republic to the Federal Republic; in 1989, 344,000 persons left the Democratic Republic for the Federal Republic. In estimating the effects of unification, it has been assumed that further net migration will take place; estimates are for 280,000 in 1990, 100,000 in 1991, with a decline to 20,000 a year in each year from 1994 to 2000. This migration would lead to increases in both aggregate demand and supply in the F.R.G. Within a united Germany there would be some offset, as aggregate demand and supply would tend to fall in the G.D.R., but the offset would not be complete because of the lower labor productivity and higher unemployment in the latter.

The order of magnitude of the economic effects of unification on the F.R.G. and other countries was derived on the basis of a simulation performed with the Fund’s MULTIMOD model.34 Specifically, the macroeconomic effects on the Federal Republic and other countries of the additional demand originating in the Democratic Republic were computed as the difference between a simulation of MULTIMOD that embodies the exogenous components of the unification scenario described above, and a preunification baseline scenario.35 The estimated effects of unification reported in Table 12 should be regarded only as illustrative of the possible order of magnitude of the impact of GEMSU, and not as precise estimates. First, the scenario described above for the evolution of the G.D.R. economy may not be realized; the economic expansion of the Democratic Republic could, for example, be much slower than envisioned in the scenario. Second, the process of unification could alter the parameters of MULTIMOD, especially for the F.R.G., which would introduce an additional degree of uncertainty regarding the estimated effects of German unification.

With the economy of the Federal Republic operating near full capacity in 1990, the extent to which the higher exports to the Democratic Republic would result in higher output or in the crowding out of other components of expenditure via higher prices, higher real interest rates, or exchange rate appreciation, would depend importantly on the stance of monetary policy and the response of exchange rates. With regard to the latter, it has been assumed that the parities of those members of the European Monetary System (EMS) participating in the exchange rate mechanism (ERM) would remain fixed and that interest rates in these countries would be adjusted to ensure that these parities are maintained. With regard to monetary policy in the Federal Republic, it has been assumed that the Bundesbank will pursue the same degree of monetary restraint as in the absence of unification. This implies that the Bundesbank would adjust short-term interest rates to achieve on average the desired growth rate in the monetary aggregate that it targets, namely M3. With regard to fiscal policy, the budgetary positions of the two governments have been combined, and the combined deficit therefore reflects all government expenditures related to unification.36 Tax rates are assumed to remain unchanged, but tax revenues are allowed to rise in response to the increase in economic activity resulting from unification.

The simulation results reported in Table 12 indicate that unification would lead to an increase in the rate of growth of GDP in the F.R.G. of about ½ of 1 percent in 1990 and ¾ of 1 percent in 1991. Subsequently, the rate of growth of output is estimated to be less than it would have been in the absence of unification, as the magnitude of the additional net demand from the G.D.R. diminishes and as increases in real interest rates and exchange rate appreciation dampen the growth of domestic and foreign demand.37 However, the level of output remains higher than it would have been in the absence of GEMSU. Combining the simulated output effects in the F.R.G. and the increase in output assumed in the scenario for the G.D.R., Table 12 shows a substantial rise in the level of GNP of a united Germany during the 1990s. There is a modest increase in inflation in the Federal Republic, which peaks at about ½ of 1 percent in 1991, but this is temporary and disappears by 1995. The estimated financial market effects of unification are also relatively modest; by 1991 long-term real interest rates increase by ¾ of 1 percentage point and the deutsche mark appreciates by 1½ percentage points in real effective terms (4 percent against the U.S. dollar in 1990).38 However, by the end of the ten-year period, the effects of unification on interest rates and exchange rates essentially disappear.

Table 12.Simulated Effects of German Unification(Deviations from baseline, in percent)
199019911992–9411995–9712001
Federal Republic of Germany
Real GDP0.51.30.60.40.7
(F.R.G. + G.D.R.)(0.5)(2.0)(3.6)(5.8)(10.6)
Real domestic demand0.10.1–0.1–0.20.4
GDP deflator (inflation rate)20.30.10.2–0.1–0.1
Real long-term interest rate20.50.70.70.4–0.2
Real effective exchange rate1.41.41.51.0–0.2
Current account3
(F.R.G. + G.D.R.)(–0.9)(–1.8)(–1.8)(–1.4)(–0.6)
Government balance34
(F.R.G. + G.D.R.)(–1.3)(–1.8)(–1.2)(–0.8)(0.5)
Other ERM countries
Real GDP–0.1–0.2–0.4–0.30.3
Real domestic demand–0.3–0.5–0.7–0.70.1
GDP deflator (inflation rate)20.1–0.1–0.10.2
Real long-term interest rate20.50.60.60.2–0.2
Real effective exchange rate0.70.60.2–0.1–0.3
Current account30.10.20.10.20.2
Other industrial countries
Real GDP0.10.2
Real domestic demand–0.1–0.2–0.3–0.3
GDP deflator (inflation rate)20.10.10.1–0.1–0.1
Real long-term interest rate20.20.20.2
Real effective exchange rate–1.3–1.2–0.8–0.20.3
Current account30.10.10.1
All industrial countries
Real GNP0.10.30.30.41.1
GDP deflator (inflation rate)20.20.20.1–0.1

Period averages.

Percentage points.

Percent of GNP.

General government, including the Unity Fund and the Trust Fund.

Period averages.

Percentage points.

Percent of GNP.

General government, including the Unity Fund and the Trust Fund.

Table 12 also shows that the combined current account position of a united Germany would deteriorate significantly, reflecting the rise in imports from countries outside Germany by both the G.D.R. and the F.R.G. directly associated with GEMSU, and the effects arising from the appreciation of the deutsche mark in real effective terms. The negative effect on the combined general government balance of the F.R.G. and the G.D.R. is also substantial in the short run. Indeed, the decline in output and increase in unemployment in the Democratic Republic in the summer of 1990 have been greater than expected, and therefore the increase in the combined government deficit in 1990 and 1991 is likely to be considerably larger than estimated here. However, as output is expected to expand more rapidly than domestic demand in a united Germany in the second half of the 1990s, the impact on the current account declines substantially. In addition, the strong growth in income resulting from GEMSU is also expected to generate a significant rise in tax revenue, so that by 2001 the net effect of unification on the general government balance—including an assumed policy of expenditure restraint that lowers the share of government expenditure in GNP over time—is estimated to be slightly positive.

Turning to the external effects of GEMSU, it is important to distinguish between those industrial countries that participate in the exchange rate mechanism (ERM) of the EMS and those that do not. Because countries in the former group are assumed to maintain existing parities within the ERM, the rise in their interest rates would be almost the same as in the Federal Republic.39 In addition, as the currencies of the other ERM member countries are tied to the deutsche mark, they also would appreciate somewhat both in nominal and in real effective terms. In the simulation, these factors have a dampening effect on total demand in the other ERM countries, which more than offsets the stimulus arising from increased exports to the Democratic Republic and the Federal Republic. In the other ERM countries the current account improves slightly, but there is a small decline in output (less than ½ of 1 percent). Over time, however, the negative effects of higher interest rates and exchange rate appreciation disappear, and real output is somewhat above the baseline toward the end of the ten-year period, reflecting the improvement in the current account position.

These estimates of the output effects of German unification on ERM countries are subject to especially wide margins of uncertainty as they are the net result of variables moving in different directions. Also, the rise in interest rates that has occurred in many ERM countries in the first half of 1990 may already have reflected some of the effects described here, and there may well be no further significant increase in interest rates arising from GEMSU. Moreover, it should be noted that the simulation results are based on the explicit assumption that exchange rates and interest rates in the ERM countries are essentially tied to those in the Federal Republic. In fact, there is some scope for exchange rate movements within the 2¼ percent margins, and there is greater latitude for interest rates to diverge from those in the Federal Republic. Indeed, some changes in interest rate differentials occurred during the first half of 1990 among ERM participants. Furthermore, to the extent that inflation performance improves relative to Germany, interest rate differentials of the other ERM participants relative to Germany would narrow.

The possible impact of unification on those industrial countries that do not participate in the ERM (including the United States and Japan) is also illustrated in Table 12. In addition to the direct stimulus stemming from increased exports to a unified Germany, there is an additional expansionary effect resulting from the exchange rate depreciation that is the counterpart to the appreciation of ERM currencies. This depreciation leads to upward pressure on prices and interest rates, with adverse effects on real domestic demand, but this is more than offset by the rise in net exports. On balance the initial impact of unification on output in these countries is slightly positive. Over time, however, output tends to return to its baseline value.40

As noted above, the estimated effects of unification shown in Table 12 depend critically on the specific assumptions adopted with regard to the economic transformation of the Democratic Republic, as well as the assumed stance of policies in the Federal Republic and in other ERM member countries. To illustrate the influence of alternative policy responses, it could be assumed that the deficit of the general government in a unified Germany would be partly financed by raising the value-added tax (VAT) in the Federal Republic, rather than through debt financing. This would not only raise revenue to finance unification but also would help harmonize VAT rates in the European Community, as the VAT in the Federal Republic is relatively low.

Table 13 presents the results of an alternative simulation in which standard VAT rates in the Federal Republic are increased by somewhat less than 2 percentage points starting in 1991, raising indirect tax receipts by DM 20 billion a year (compared with the situation described in Table 12, where tax rates are unchanged). This reduces the budgetary impact of unification, so that by 1995–97 the rise in tax receipts is equal to the increased outlays associated with unification, and there is no net impact on the combined government balance. However, raising indirect taxes also has the effect of reducing the positive output effects in the Federal Republic and has a substantial impact on the rate of inflation, which would increase by about 1½ percentage points in 1991. This inflationary impact is only a one-time effect, however, as the rate of inflation tends to return to its baseline in 1995–97. With the VAT increase, the negative output effects of unification on other ERM countries disappear more rapidly than in the absence of tax changes, primarily because the exchange rate effects are relatively more favorable.

Table 13.Simulated Effects of German Unification with Increased Value-Added Taxes(Deviations from baseline, in percent)
199019911992–9411995–9712001
Federal Republic of Germany
Real GDP0.51.00.10.20.8
(F.R.G. + G.D.R.)(0.5)(1.8)(3.2)(5.6)(10.6)
Inflation: GDP deflator20.31.40.4–0.3–0.1
Real long-term interest rate20.50.70.80.3–0.2
Real effective exchange rate1.41.21.50.6–1.1
Government balance3,4–1.3–1.0–0.51.4
(F.R.G. + G.D.R.)
Other ERM countries
Real GDP–0.1–0.2–0.30.5
Inflation: GDP deflator20.1–0.10.4
Real long-term interest rate20.50.70.6–0.2–0.4
Real effective exchange rate0.70.2–0.2–0.5–0.4
Other industrial countries
Real GDP0.10.2–0.10.1
Inflation: GDP deflator20.10.10.1–0.1–0.1
Real long-term interest rate20.20.30.2–0.1
Real effective exchange rate–1.3–0.8–0.50.30.7

Period averages.

Percentage points.

Percent of GNP.

General government, including the Unity Fund and the Trust Fund.

Period averages.

Percentage points.

Percent of GNP.

General government, including the Unity Fund and the Trust Fund.

A fiscal policy action that would avoid the short-run inflationary impact of an increase in the VAT would be a direct tax increase. To explore the possible effects of this measure, MULTIMOD was simulated on the assumption that direct income taxes (on both corporations and households) would be raised sufficiently to cover one half of the increase in the combined primary deficit resulting from GEMSU.41 This fiscal policy response has a rather small dampening effect on the level of output in the Federal Republic, compared with the case where unification is not accompanied by any increases in tax rates.42 The very small impact of the tax increase reflects mainly the largely offsetting reduction in private saving that is a feature of MULTIMOD. With a less expansionary effect of unification on the German economy, real interest rates are slightly lower and the deutsche mark appreciates somewhat less, relative to the case where taxes remain unchanged. As a result, the negative output and domestic demand effects of unification on other ERM countries reported above are attenuated somewhat.

Finally, it may be useful to consider a policy alternative in which the other ERM countries could be “de-linked” from the deflationary effects that might result from unification when their currencies are tied to the deutsche mark. The tightening of monetary conditions in these countries as they match the rise in German rates to maintain their parities might be avoided by a “one-shot” realignment vis-à-vis the deutsche mark. Such a realignment, assumed to involve an unanticipated 4 percent appreciation of the deutsche mark against other ERM currencies in 1991, would result in lower inflation and a smaller increase in output in the Federal Republic than in the simulation presented in Table 12. However, it would lead to a modest rise in output in other ERM countries, instead of a small decline as in the previous simulations; by avoiding a short-run real appreciation (principally against non-ERM currencies), these countries could take on some of the additional demand resulting from unification that would otherwise be directed to the Federal Republic. This favorable effect, however, would have to be balanced against the adverse implications of a possible loss of credibility in the commitment of other ERM countries to price stability and to the “hard currency” option. Such a loss in credibility would magnify the inflationary impact of the realignment on the other ERM countries and could lead to destabilizing speculation against the currencies that were depreciated.

Overall, this discussion of the international implications of German unification suggests that the price, interest rate, and exchange rate effects are unlikely to put undue strain on the world economy. While there may be some short-run negative effects on countries outside of Germany, these are likely to be relatively small and transitory. The overall effect of unification on the world economy would be clearly positive as it would raise output in the industrial countries (particularly in Germany) in the short run and would have favorable effects on the productive capacity of the world economy in the longer run. It needs to be stressed, however, that this analysis is based on a large number of assumptions about the evolution of the economy of the Democratic Republic, and thus the estimated effects of unification are subject to a considerable range of uncertainty.

The Challenge of Trade Liberalization

The international trading system is now at an important juncture, with its future hinging crucially on the outcome of the Uruguay Round of multilateral trade negotiations. A successful conclusion of the Round would have far-reaching, favorable consequences. It would lead to a significant worldwide reduction of tariff peaks and escalation; improve market access for all countries; lower the subsidies and other measures that seriously distort trade in agricultural products; extend multilateral disciplines to important new areas such as services, intellectual property rights, and trade-related investment rules; promote greater discipline on the use of industrial subsidies; shorten delays in the adoption of dispute-settlement findings and assure their effective implementation; and increase the commitment of developing countries to the rules of the multilateral trading system. By contrast, failure to reach agreement is likely to have serious, adverse repercussions for the international community. It could intensify protectionist pressures, weaken support for trade liberalization among those countries and sectors that feel excluded from the full benefits of free trade under the existing system, and aggravate current disputes among trading partners. Moreover, failure to conclude the Uruguay Round successfully could encourage the search for unilateral and bilateral solutions to trade problems (and increase the risk that these solutions would be seen as substitutes, rather than as complements to the General Agreement on Tariffs and Trade (GATT)), and might contribute to the creation of protectionist trading blocks. Most likely, these unfavorable effects on the world trading system would give rise to adverse reactions in financial markets.

While it is difficult to quantify the effects of trade measures with any precision, the sizable benefits that would result from multilateral trade liberalization are now supported by a substantial body of empirical evidence.43 For example, it has been estimated that a 50 percent reduction in all tariff and nontariff barriers in the United States, the European Community, and the Asia-Pacific region would raise GDP in these three regions by 5 percent ($740 billion), with regional gains ranging from $208 billion in North America to $287 billion in the Asia-Pacific region.44 Another recent examination of various trade liberalization scenarios using the Michigan Model of World Production and Trade suggests that the elimination of all tariff and nontariff barriers by the industrial countries could raise both exports and imports in these countries by more than 5 percent; the effects might be even larger if the possibility of economies of scale and the effects of increased competition and innovation were taken into account.45

A number of sectoral studies also indicate the potential for large welfare gains. For example, it is estimated that the liberalization of trade in agricultural products would result in welfare gains for the industrial countries on the order of $35 billion to $50 billion.46 A study based on a global general equilibrium model concludes that the removal of quotas under the Multifiber Arrangement and of all tariffs on textiles would generate net welfare gains of $3.5 billion (in 1986 prices) in both the European Community and the United States. And another study estimates the costs to domestic consumers of protection for the U.S. apparel industry at more than $22 billion in 1989.47 Several studies have also documented the large welfare costs of protection in the steel and auto industries, notably through so-called voluntary export restraints.

The Trade Negotiations Committee (TNC) of the Uruguay Round met in Geneva on July 23–26 to assess the current status of the negotiations. According to the previously approved schedule, the TNC was to have before it basic negotiating texts from each of the 15 negotiating groups. However, the reports from most of the groups consisted largely of statements of individual country positions, rather than draft agreements. Thus, while progress has been made in some areas, many important questions remain unresolved, including how to deal with agricultural export subsidies and internal support; whether to phase out the Multifiber Arrangement by liberalizing existing quotas over time or by moving to a transitional system of global quotas; the nature of additional provisions needed to ensure the effectiveness and predictability of antidumping and countervailing measures; whether or not the sectoral coverage of an agreement on services should be universal; and what new disciplines should apply to trade-related investment measures that are not covered by existing GATT rules.48 Recognizing the magnitude of the task that lies ahead, and the little time remaining to reach agreement, the Chairman of the TNC proposed a tight work program that would allow the Uruguay Round to be completed as scheduled at the Ministerial Meeting, which will take place in Brussels beginning on December 3, 1990.

Prospects and Issues in the European Community

Overview

Medium-term prospects and policy issues in the European Community (EC) are crucially influenced by the ongoing movement toward economic integration in the region. The process leading the 12 EC countries toward economic and monetary union (EMU) gained considerable momentum with the publication in April 1989 of the Delors Committee Report, which outlined the broad objectives of EMU and a proposed strategy for reaching these objectives.49 The report suggested that monetary union be achieved in three stages, culminating in the full centralization of monetary authority and the use of a common currency. Economic union would comprise a single market in which persons, goods, services, and capital would move freely; common policies would be aimed at structural and regional development; market strengthening mechanisms—including a common competition policy—would be put in place; and macroeconomic policies would be coordinated.

Completion of the single market (the “1992” project) is well under way. The European Council has adopted more than half of the measures that are required to dismantle physical barriers (customs and passport control), technical barriers (regulatory restrictions that affect trade and financial flows), and fiscal barriers (border controls involving indirect taxation) among the member countries.50 However, many of the measures adopted at the Community level have yet to be incorporated into the national legislation of the member states. The areas in which the most progress has been achieved include financial services, government procurement, and technical standards; by contrast, progress has been slower in other important areas, including the automobile regime and the value-added tax regime. The first stage toward economic and monetary union, which began on July 1, 1990, will include the following key elements: the completion of the single market; full participation of all EC currencies in the narrow band of the ERM; and enhanced policy coordination.51 The timing of the second and third stages toward EMU, which are discussed more fully below, was left deliberately vague by the Delors Committee.

The European Council has called two Inter-Governmental Conferences to be convened in mid-December 1990. The first will frame economic and monetary union within the EEC Treaty, while the second will deal with political union of the EC countries. In March 1990, the EC Commission issued a background document for the Inter-Governmental Conference on EMU.52 This report contains proposals for economic and monetary union that make more precise, and modify in some respects, the ideas advanced in the Delors Committee Report. In particular, the Commission proposes that a European System of Central Banks—or ESCB—be established with a Council, made up of the 12 national central bank governors, that would be responsible for deciding the stance of European monetary policy. It would pursue price stability as its principal objective, but it would also support the general economic policy objectives set at the Community level. The proposed ESCB would be independent of national governments and would be governed by rules that exclude monetary financing of public deficits and bailing out of member states in budgetary difficulty. As regards national fiscal policies, the report modified the emphasis of the Delors Committee Report on budget deficit ceilings and instead argued for voluntary coordination and surveillance. The report expresses the view that, ultimately, national moneys would be replaced by a single currency, the European currency unit, or ECU.”

The EC Commission document raises important issues concerning the transition to EMU in Europe. The appearance of this document and the impending Inter-Governmental Conferences on economic and monetary union and on political union have given rise to considerable discussion of these issues in both academic and official circles. After a brief review of the economic outlook and some other policy issues in the European Community, the final section will turn to a discussion of some of the transition issues, including the proposal of a “hard ECU” by the United Kingdom.

Economic Prospects

On the basis of the usual assumptions of unchanged policies and fixed real exchange rates, output growth in the EC as a whole is projected to moderate somewhat from the unsustainably rapid pace of the past two years; it will nevertheless remain quite strong through the medium term. During 1990–95, real GDP growth would be sustained at 3 percent a year, broadly in line with current estimates of potential GDP growth, compared with annual average growth of 2¼ percent during the 1980s. Fixed investment would rise at an average annual rate of 4 percent during 1990–95 and would be financed internally in the Community, as the combined external current account of the EC is projected to be close to zero for the next few years. By the mid–1990s, however, the EC is expected again to become a net supplier of saving to the rest of the world.

After picking up slightly in 1990 to more than 4¾ percent, inflation (based on GNP deflators) is expected to come down slowly to about 3½ percent by 1993, but to remain at this level thereafter. The inflation rates of Italy and Spain are expected to remain above the average for the ERM countries through the medium term. Among those not yet in the ERM, the United Kingdom’s rate of inflation is expected to decline somewhat this year, although it too is projected to remain above the average ERM rate through 1995, as are the inflation rates of Greece and Portugal.53 The average rate of unemployment in the EC is likely to decline somewhat further—to below 9 percent for the first time since 1981—although unemployment rates are expected to remain in double digits in several countries. Overall, the EC economy is expected to continue operating near capacity limits through the mid-1990s, reflecting the stimulative effects on both supply and demand of the completion of the single market, German unification, and the liberalization of the economies of Eastern Europe.

Economic Policies and Convergence

The projections for the EC as a group conceal substantial differences in the prospective performance of individual member countries. Whether these differences, particularly as regards inflation, are fully compatible with the degree of economic convergence required to complete stage one of EMU is an open question. Recent experience would suggest that broad stability in exchange markets can be maintained despite substantial differences in economic performance.54 However, the continuing large current account imbalances within the EC (substantial deficits in Greece, Spain, and the United Kingdom and large surpluses in the Federal Republic of Germany and the Netherlands) presumably could give rise at some point to pressures on exchange rates. To a large extent, these imbalances can be seen as a natural by-product of Europe’s economic integration, and to that extent they need not lead—and indeed have not led—to exchange rate instability. But these imbalances also reflect divergent macroeconomic policies and performance. Moreover, the risk of exchange market pressures may have increased with the removal of restrictions on capital movements in Belgium, France, Italy, and Luxembourg in recent months, although it must be recognized that, so far, this has not given rise to instability.55

The objective of medium-term exchange rate stability among the currencies of all 12 of the EC countries could be advanced considerably if a greater degree of nominal convergence could be achieved early in stage one of EMU. Convergence could be facilitated most directly by tighter financial policies in several EC countries, including in particular Greece, Italy, Portugal, and Spain. Increasingly, national monetary policy—which is already overburdened in many countries—is expected to lose its autonomy as integration proceeds and fiscal policy may have to play a greater role in correcting underlying macroeconomic imbalances.56 What may be required is not a return to fiscal fine-tuning, but rather a steady and determined reduction of government dissaving in the countries where fiscal deficits remain substantially above the EC average, including in particular Greece, Italy, and Portugal.

In the United Kingdom, a reduction in inflation to the levels prevailing in the ERM countries would be facilitated by a decline in inflation expectations. While the entry of the United Kingdom into the ERM will ultimately enhance the credibility of monetary policy—as it has in some other countries—the entry of sterling into the mechanism while inflation differentials remain large would involve serious transitional difficulties. In particular, once the immediate risk of exchange rate depreciation is lessened, the size and openness of the United Kingdom’s capital markets could encourage potentially large capital inflows, which would exert downward pressure on domestic interest rates, and thus undermine the disinflationary stance of policy. The dangers involved in such a premature easing of monetary conditions became apparent when interest rates fell in 1987–88 as the authorities resisted upward pressure on sterling and responded to the expected impact of the fall in stock markets, while underestimating the strength of domestic demand. In the present situation, a substantial reduction of the inflation differential would appear to be a prerequisite to the entry of the United Kingdom into the ERM.

The recent experiences of Italy and Spain also illustrate the potential conflicts that can arise between the internal and external objectives of monetary policy when capital controls are liberalized. In both of these relatively high-inflation countries pressures have mounted to lower domestic interest rates in order to arrest the upward movement of the exchange rate, even though such a shift in the stance of monetary policy would be undesirable from the perspective of these countries’ inflation objectives.

Economic performance over the medium term in the other ERM countries (Belgium, Denmark, France, the Federal Republic of Germany, Ireland, Luxembourg, and the Netherlands) is not expected to threaten the convergence objective of EMU. However, as monetary integration proceeds and interest rates converge further, relative fiscal positions will become more important in the market’s assessment of a country’s policy stance and exchange rate.57 At the same time, the room for maneuver of national budgetary policies is likely to narrow. From this perspective, it would appear prudent for those countries with relatively large public sector deficits and/or high levels of public debt (Belgium, Ireland, and the Netherlands) to intensify their efforts toward fiscal consolidation.

Another important, and perhaps more immediate, objective of EC economic policies is to ensure a noninflationary adjustment to German unification. The potential effects of unification on German and EC-wide economic conditions have been discussed above. What must be emphasized in the present context is that the ERM and the other formal links to be established in stage one of EMU—in particular, enhanced policy coordination—may help to achieve this objective. Within the EMS, there is now a core group of countries, in addition to the Federal Republic of Germany, that have made significant progress toward price stability. These countries are well placed to play a valuable role in anchoring the system, particularly in view of the uncertainties that could complicate monetary management in Germany. Also, the resource needs that are expected to result from German unification could help to reduce intra-European current account imbalances. As some of the European economies—including in particular the Federal Republic of Germany—are operating at high levels of capacity utilization, upward pressures on interest rates may have to be accepted for some time to avoid inflationary pressures. However, such interest rate pressures could be eased by tighter fiscal policies in Germany as well as in those ERM countries where convergence of fiscal performance remains insufficient. Such a shift in the policy mix of the EC countries toward greater fiscal restraint could also reduce upward pressure on the European currencies.

Transition Issues

The transition from the prevailing system of national monetary and fiscal policies and adjustable exchange rates in the European Community, to a system of “irrevocably” fixed exchange rates and ultimately to a single currency area, raises a number of complex issues.58 First, there is the question of whether it is necessary in a monetary union to have explicit rules for national fiscal policies that go beyond the “no bail-out” and “no monetary financing” guidelines suggested by the EC Commission.59 Those who support fiscal policy rules argue that the no bail-out provisions will not be credible in a situation where there are large, sovereign borrowers and where failure to rescue could lead to the fragmentation of institutions in which members have already invested high political stakes. Those opposed to binding fiscal policy rules generally argue that market forces will be adequate to impose the necessary fiscal discipline.60 A country that has consistently opted for a relatively high level of public expenditure would obviously need to maintain relatively high tax rates. But high tax rates could cause both capital and labor to migrate to lower tax jurisdictions, thereby exerting pressures for expenditure control.61

A related question is whether there is a need for a federal authority that could bring some coordination to national fiscal policies. It has been argued that such an authority could facilitate the cushioning of region-specific shocks and negative spillover effects from national budgetary policies. In contrast, opponents of a strong federal fiscal authority argue that the loss of the monetary/exchange-rate policy tool that is inherent in the formation of a monetary union may itself increase the need to retain some degree of national budgetary flexibility in order to respond to localized shocks. This would be the case especially if serious price and wage rigidities and limited international mobility of labor were to persist after achievement of monetary union.62

A third key issue is whether there are significant differences between irrevocably fixed exchange rates and a common currency, and if so, whether there are good reasons for adopting the former on the way to the latter. One view is that irrevocably fixed rates carry the same constraint as a common currency—namely, the inability to use the nominal exchange rate as a policy instrument to deal with country-specific economic shocks—without having all the benefits of a single currency. These additional benefits are thought to include the elimination of exchange-related transaction costs, a lower need for international reserves, and a stronger presence for the union in the international monetary system.63 A second view is that, official statements notwithstanding, market participants will never be truly convinced that exchange rates are “irrevocably fixed”; so long as separate currencies exist, the option of changing the exchange rate will always be present. In contrast, the costs of undoing a common currency are thought to be considerably higher.

Without disputing the advantages of a common currency, some advocates of irrevocably fixed rates see merit in delaying the ultimate move until other aspects and institutions of the integrated Europe are more fully developed and until experience with common operations is gained and evaluated. However, there is now a growing consensus that a transitional period with new common institutions that have no effective power could well prove counterproductive and therefore that stage two of EMU should be kept brief, if not dispensed with altogether.

Recent thinking also has centered on the question of whether EMU should wait until all EC members are ready, economically and politically, to participate. Some have argued that EMU should start with a core group of countries with a good record of monetary and price stability, with others joining at a later stage. The core group has been described as comprising Belgium-Luxembourg, France, Germany, and the Netherlands. However, questions remain in some circles about the implications of such a two-stage procedure for the economic and political coherence of the EC.

Finally, there is renewed interest in creating an EC exchange rate system with a parallel currency as an anchor. The United Kingdom recently proposed that a “hard ECU” should supplant alternative medium-term proposals for institutional development after the first stage of the Delors program toward EMU has been completed. Under the British plan, a newly established European Monetary Fund (EMF) would issue ECU bank notes alongside existing EC currencies. To prevent any inflationary expansion of the money supply—a perceived weakness of earlier parallel currency schemes—the EMF initially would be empowered to issue only notes that were fully backed by its own holdings of the various EC currencies that make up the ECU. At a later stage, the ECU would become a currency in its own right and would no longer be defined as a basket of the EC currencies, as it is at present.

The hard ECU scheme would require national central banks to repurchase their own currencies for ECUs, or equivalent hard currencies, on demand by the EMF. Depending upon how this requirement would be implemented, it could strengthen national monetary discipline.64 The ECU would be “hard” in the sense that it would be defined so as never to devalue against other EC currencies.65 Accordingly, the “hard ECU” would match the EC currency of the country with the best price performance, and hence the best maintained purchasing power, at any point in time.66 In that way, the hard ECU would gradually win support as a common currency, thereby providing a gradual, market-oriented transition toward full monetary union.

The British proposal, along with those of other member states and the EC Commission, will be considered by the upcoming intergovernmental conferences in December on economic and monetary union and on political union of the European Community. These conferences should help to clarify both the timing and the specific institutional arrangements of further steps toward European integration following the completion of the first stage of economic and monetary union.

Policy Issues in Individual Countries

After a period of rapid growth that brought the U.S. economy to high levels of resource use, cost and price pressures intensified in the United States and monetary conditions were tightened in 1988–89. In the absence of significant fiscal action, monetary restraint resulted in a substantial rise in interest rates, and since mid-1989 the economic expansion has slowed appreciably. This year, monetary policy has successfully sought to contain inflationary pressures without pushing a sluggish economy into recession, while the federal fiscal deficit—which had declined substantially from fiscal year 1983 to FY 1989—appears to have stabilized at about 3 percent of GNP in FY 1990. Recently, however, the fiscal outlook has deteriorated significantly, suggesting that the task that lies ahead is considerably larger than previously anticipated. The deficit for FY 1990 (ending September 30, 1990) is now estimated by the Administration at $163 billion, compared with a Gramm-Rudman-Hollings (GRH) target of $100 billion.67

The staff projects that the U.S. economy will continue to expand over the next several years, albeit at a relatively slow pace, with no significant improvement in inflation anticipated. Moreover, on the basis of present policies and real exchange rates, the external current account deficit is projected to widen somewhat over the medium term, following a substantial decline in the last three years. With the U.S. economy operating at high levels of employment, the achievement of strong growth coupled with progress toward lower inflation and external adjustment will require policies aimed at restraining the expansion of nominal demand and boosting the economy’s productive capacity by raising national saving and increasing efficiency.

There is no doubt that efforts to strengthen the federal fiscal position should play a major role in this strategy. Recent estimates suggest that the large fall in the federal deficit that was envisaged in the Administration’s January 1990 budget will not take place and that the objective of balancing the federal budget by FY 1993—as mandated by the GRH law—will not be attained.68 These developments have prompted a “budget summit” between representatives of the Administration and the Congress to seek an agreement on how to deal with the budgetary situation. And on June 26, the President of the United States stated that a solution to the fiscal problem would require “entitlement and mandatory program reform; tax revenue increases; growth incentives; discretionary spending reductions; orderly reductions in defense spending; and budget process reform.”

In view of the magnitude of the fiscal problem, and given the political difficulty of achieving further reductions in the deficit mainly through cuts in discretionary spending, a broad-based approach appears to be entirely appropriate. A budget agreement based on the principles enunciated by the President should succeed in bringing about a decisive improvement in the fiscal position; this would raise national saving and set the stage for a decline in interest rates and for exchange rate adjustments conducive to a reduced external deficit. To be consistent with the economy’s need for saving, the long-term objective of the fiscal plan should be to balance the operational budget—the unified budget balance less the balance of the Social Security Trust Fund. A decision to pare the size of the cut to be implemented out of concern that a large fiscal cut should trigger a recession would risk damaging the credibility of the multi-year package that the budget summit is seeking, and thus keep interest rates from declining and raise the medium-term cost of fiscal adjustment.

The handling of monetary policy by the Federal Reserve has helped to avoid both a recession and a significant acceleration of inflation. However, inflation has been stabilized at a relatively high rate and progress toward the Federal Reserve’s ultimate objective of achieving price stability remains to be seen. A sharp tightening of monetary policy aimed at a quick reduction of inflation could precipitate a recession—particularly in a situation where relatively high levels of corporate and household debt and the fragility of certain financial institutions raise the economy’s vulnerability to high interest rates—and might erode the support required to maintain an anti-inflationary monetary policy. Also, the recent increase in oil prices—if sustained—will result in a one-step increase in consumer prices. It is important, however, that visible progress be made in reducing inflation in the not too distant future. Keeping inflation at present levels would postpone the efficiency gains that would result from price stability, increase the danger that inflationary disturbances might need to be tackled through a sharp monetary contraction, and reduce the credibility of the authorities’ long-term strategy, thus raising the costs of moving toward price stability. Of course, the chances of success of this strategy would be greatly enhanced by substantial progress in lowering the fiscal deficit.

In recent years, the United States has sought a solution to the U.S. trade and current account imbalances through actions that aim at the objective of opening up markets rather than seeking an unfair advantage for U.S. producers. However, concern has been raised that these actions in the trade area, particularly those based on the Super 301 provisions of the Trade Act, have been harmful because of their unilateral or bilateral character. Against this background, it is encouraging that the U.S. Administration appears to have downplayed the role of these actions and has affirmed that it attaches the highest priority to the achievement of a more open trading system through a successful conclusion of the Uruguay Round.

Since late 1986 the economy of Japan has registered rapid growth based on a very strong expansion of domestic demand, including notably business fixed investment. At the same time, the economy has reduced the dependence of its manufacturing sector on external demand while shifting production abroad, and the current account surplus has narrowed sharply. Strong economic growth has brought the economy to a very high level of resource use, particularly in the labor market, and has led to the emergence of cost and price pressures. These pressures were exacerbated by the substantial depreciation of the yen from late 1988 to the spring of 1990. More recently, the value of the yen has firmed and growth has remained quite strong, as the economy successfully weathered the financial market turbulence of the early months of 1990. The economic policies pursued by Japan in the 1980s have established a strong foundation for sustained growth in the future. However, a number of important challenges remain, including the need for structural policies to remove the distortions that hinder efficiency and restrain market access and, most important in the short run, the need to confront the risk of inflation.

Following a period in which the strength of the yen and favorable cost developments made possible the pursuit of an accommodative stance, monetary policy was tightened significantly during 1989 in the face of emerging capacity constraints, a weakening yen, and an acceleration in the growth of money and credit. Interest rates were allowed to rise considerably, helping to contain the increase in inflation and to prevent a worsening of price expectations. However, cost and price pressures have not yet abated, and while the current rate of inflation of some 2¾ percent is low by international standards, the danger of an intensification of inflation should not be underestimated given the continued strong momentum of aggregate demand and the tight labor market conditions. In view of the crucial role played by price stability in Japan’s strong economic performance, it seems clear that, in present circumstances, monetary policy must continue to lean on the side of restraint.

During the 1980s fiscal policy in Japan focused successfully on the objectives of fiscal consolidation and tax reform. The central government deficit (national accounts basis) fell in relation to GNP from 5½ percent in FY 1980 (ending March 31, 1981) to an estimated ¾ of 1 percent of GNP in FY 1989, and the objective of eliminating bond financing of current expenditure by the central government has been virtually attained. This was accompanied by a significant improvement in the fiscal position of the local governments and a rise in the sizable surplus of the social security funds, which helped the financial balance of the general government shift from a deficit of 4½ percent of GNP in FY 1980 to a surplus of 2¾ percent of GNP in FY 1989. Against this background, and given the current strength of the economy and existing pressures on prices, the budget plan for the current fiscal year—which is likely to have a mildly restrictive effect on the economy—appears to be appropriate. Looking at the longer term, further efforts toward fiscal consolidation would seem to be required, given the substantial rise in social expenditures expected to result from the prospective aging of the Japanese population69 and the need to reduce the gross public debt.70 At the same time, it must be recognized that fiscal austerity during the 1980s has involved considerable restraint on public investment, and the government should now play a more important role in improving social infrastructure in those areas in which the social rate of return is high but cannot be fully captured by the market.

In recent years, there has been substantial progress with structural reform in the areas of financial deregulation, tax reform (featuring the introduction of a consumption tax, the elimination of most selective commodity taxes and income tax deductions), and the privatization of public enterprises (including the national telephone and railway companies). In other areas, however, progress has been slower. The urgent need for land management reforms has been underscored by the recent escalation of land prices. The Basic Law of the Land, enacted in late 1989, is a step in the right direction, but much remains to be done to remove the distortions caused by land use regulations and low property taxes, which hinder urban renewal and development. Also, in spite of a number of recent steps, certain aspects of Japan’s distribution system (notably the Large Scale Retail Store Law) continue to restrict market access by both foreign and new domestic firms. Finally, while progress has been made in liberalizing access to certain commodities, severe restrictions continue to affect imports of agricultural goods, most notably rice.

It is clear that the pace of structural reform in these areas must now be intensified, both to improve economic efficiency and the welfare of the Japanese population, and to resolve trade disputes with Japan’s trading partners. Most important, given its growing leadership role in the world economy, it is incumbent on Japan to make a strong contribution in the coming critical months of the Uruguay Round.

In the Federal Republic of Germany real GNP rose by 4 percent in 1989, the strongest performance so far in the current expansion. Output continued to expand rapidly during the first half of 1990, boosted in part by a surge in consumption following a tax cut related to fiscal reform. With the economy operating at historically high levels of capacity utilization, prices increased more rapidly than in earlier years. Interest rates rose sharply in response to a tightening of monetary policy in 1989, and somewhat further in the first half of 1990 in light of prospects for economic unification between the Federal Republic and the German Democratic Republic. The foreign sector also contributed strongly to economic activity during this period, and the current account surplus rose to 4½ percent of GNP in 1989.

The key policy issues facing the German authorities at this juncture are closely related to the process of unification. This process is expected to involve rising demand pressures on productive capacity, reflecting large scale private and public infrastructure investment in the G.D.R. Much of the task of limiting the inflationary consequences of rising demand will rest on monetary policy, as current fiscal plans do not envisage tax rate increases to help finance the additional government outlays associated with unification, although fiscal policy also could make a contribution by emphasizing expenditure restraint. While real interest rates have already risen in the first half of 1990, perhaps in anticipation of the prospects just described, a further increase in connection with unification cannot be ruled out and should not be resisted. Higher real interest rates would tend to exert upward pressure on the deutsche mark, which would help relieve demand pressures in Germany and contribute to a decline in the current account surplus.

In the current and prospective environment of considerable pressure on resources, it is urgent to speed up the implementation of measures to raise potential GNP and to enhance the responsiveness of output to additional demand. These would include structural policies in such areas as international trade, the structure of taxes, subsidies, agriculture, mining, and retail trade. Moreover, the substantial increase in the fiscal deficit projected for 1990–91 also underscores the need to restructure government expenditures with emphasis on cutting subsidies. If the budgetary implications of unification turn out to be larger than expected—which has already occurred as unemployment in the G.D.R. has risen more sharply than originally anticipated—the implementation of tax increases should not be ruled out.

In the area of subsidies, it is particularly important that in restructuring the G.D.R. economy, the Trust Fund should refrain from using the profits of firms that prove to be viable in a market system to support those enterprises that are not viable. To facilitate this process of transformation, the authorities need to ensure not only a stable macroeconomic environment but also avoid ad hoc policy interventions in response to short-term adjustment problems. Specifically, some short-run increase in unemployment and the bankruptcy of certain enterprises will have to be accepted in order to achieve the reallocation of resources and the longer-term efficiency gains that should result from a market-based economy. Such a policy orientation would seem appropriate in view of the need to attract the capital needed to support the rapid economic growth envisaged in the G.D.R.

In France the economy continued to perform well in 1989. After an increase of almost 4 percent in 1988, real GDP grew by 3½ percent in 1989. Export growth was particularly buoyant but domestic demand slowed somewhat from the rapid rate of the previous year. Inflation rose only moderately, partly because of the effects of the depreciation of the French franc and certain special factors, but wage costs remained under control. Employment growth strengthened further in 1989, although the unemployment rate remained at 9½ percent reflecting in part the influence of demographic factors. Strong import demand resulted in a sizable deterioration in the trade balance, but the current account deficit remained quite moderate, owing to an upturn in services receipts. Growth slowed somewhat during the first months of 1990 but remained relatively strong; unemployment declined to around 9 percent of the labor force and consumer price inflation fell.

Monetary conditions tightened over the course of 1989, with the official tender rate moving from 7¾ percent in January to 10 percent at the end of the year, but it eased thereafter. By contrast, fiscal policy was moderately expansionary in 1989, mainly because of higher expenditures in a number of new priority areas. Moreover, the 1989 budget again included significant tax cuts intended to support competitiveness and European harmonization objectives. However, given the strength of economic activity, tax revenues remained buoyant and the fiscal deficit target, at F 10 billion below the 1988 outturn, was reached. The deficit is to be reduced further in 1990. While structural adjustment remains a principal objective of the authorities, progress appears to have slowed following the achievement of such major reforms as the liberalization of prices and foreign exchange transactions. As regards labor markets, concerns about the equitable distribution of the fruits of the recovery have led to pressures to increase minimum wages in step with average wages.

The economic expansion in Italy entered its seventh year in 1990, with GDP growth over this period somewhat above the average for the European Community. The rate of inflation has been brought down considerably in the past few years, but it edged up in 1989 and remains some 3 percentage points above corresponding rates in France and Germany. The unemployment rate has been high over this period, although it has declined significantly over the past 12 months. The external current account moved to a deficit of just over 1 percent of GDP in 1989, from approximate balance in 1986–87.

The primary focus of economic policy has been the achievement of a reduction in the central government deficit, which averaged over 11 percent of GNP in 1988–89. In May of this year, the Government adopted a medium-term fiscal adjustment plan that aims at a primary budget surplus by 1991, one year earlier than under the previous plan. The new program is an important step in the right direction. However, because debt-service payments remain very large—reflecting a slock of government debt nearly equal to GDP and relatively high interest rates—the total deficit is likely to remain quite high over the medium term. With large nominal interest rate differentials in favor of the lira, the currency showed considerable strength in the first half of 1990, following the removal of remaining capital controls and the movement of the lira into the narrow band of the ERM. While this development could help to contain inflation in the short run, continued upward pressure on the lira could, given Italy’s exchange rate commitments, force a decline in interest rates, and contribute to renewed inflation at a later stage. This risk reinforces the case for decisive action on the fiscal front. At a minimum, any slippage from the current fiscal program must be avoided and consideration should be given to additional measures to increase the primary surplus further, with emphasis on cutting expenditures, reducing transfers to public enterprises, and enhancing the efficiency of the tax collection system.

The overheating of the United Kingdom’s economy, which has been evident for the past two years, has proved difficult to reverse. Excluding mortgage interest payments and the community charge, retail price inflation has risen further to nearly 8 percent in the latest 12-month period. In 1990 the general government fiscal balance has continued to be in surplus and in 1991 fiscal policy is expected to be slightly contractionary. Domestic demand is projected to contract a little in 1990, mainly as a result of an anticipated drop in corporate spending. Nevertheless, inflation is expected to remain well above the average of other industrial countries in 1990–91, although it would decline somewhat over the medium term.

The resilience of consumption in the first five months of 1990, and a relatively muted reduction in stock levels so far, suggest that growth of demand in the United Kingdom is again proving to be more robust than expected. Moreover, the resistance of employers to wage demands, a crucial element in the restoration of sound economic conditions, has been weakened by favorable trends in industrial input prices. Underlying earnings growth rose to 10 percent in the 12 months to July 1990, with a fall in productivity contributing to a rise in unit wage costs of just over 10 percent a year in the first quarter of 1990. Renewed pressure on profit margins, and ultimately on wages, is likely to result from the recent sharp appreciation of the exchange rate associated with speculation over a relatively early entry of the United Kingdom into the ERM of the EMS.

On balance, these developments suggest that the process of adjustment will be protracted and will require maintenance of a stringent monetary policy for longer than previously thought. Although the continuation of a sizable inflation differential with the core EMS countries will tend to complicate the entry of the United Kingdom into the ERM, a widespread expectation that this will occur soon seems to have underpinned confidence in the pound sterling despite a continuing large external deficit.

Faced with persistent cost and price pressures and strong growth of nominal demand, the Bank of Canada tightened monetary policy progressively over the course of 1988 and 1989, leading to a marked increase in short-term interest rates—to almost 400 basis points above corresponding U.S. rates by the end of 1989—and a rise in the value of the Canadian dollar. As a result, output growth in Canada slowed to 3 percent in 1989 from its strong pace in 1987 and 1988, but the slowdown was not sufficient to reduce significantly the level of resource use. In these circumstances, wage and price inflation intensified somewhat in 1989, with the 12-month change in consumer prices reaching 5½ percent by midyear. The continued strength of domestic demand and the real effective appreciation of the Canadian dollar contributed to a further widening of the current account deficit to 2½ percent of GDP by the end of 1989.

Output growth slowed further in the first quarter of 1990, and turned negative in the second quarter in the face of continued high interest rates. Price inflation has shown signs of moderating, with the 12-month change in consumer prices dropping to 4¼ percent by July 1990. However, the evidence on wage settlements is less encouraging and continuation of the present stance of monetary policy would seem appropriate. Such a stance would nevertheless facilitate some easing of monetary conditions in the face of a continuing slowing of nominal income growth.

Progress has been slow in reducing the federal deficit (which amounted to 4½ percent of GDP in FY 1989), as Canada’s high debt-to-GNP ratio has made the fiscal position quite vulnerable to increases in interest rates. The fiscal measures contained in the budget for FY 1990/91 were intended to resume progress in reducing the deficit/GDP ratio but, once again, higher than assumed short-term interest rates may postpone achievement of this goal. Consequently, additional measures should not be ruled out if fiscal policy is to play its role in fostering conditions conducive to sustained growth coupled with lower inflation and a reduced current account deficit.

A number of important structural initiatives are under way in Canada, including reforms relating to the sales tax and the unemployment insurance system. Together with previous tax reform measures and with the implementation of the Free Trade Agreement with the United States, these initiatives should significantly improve the efficiency of the economy and enhance growth prospects. Further progress in the structural area could be achieved by moving toward greater market orientation in the farm sector and by liberalizing imports of textiles.

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