Chapter II Medium-Term Prospects and Policy Issues in the Industrial Countries

International Monetary Fund. Research Dept.
Published Date:
January 1991
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This chapter begins with a description of the staff’s medium-term baseline projections and continues with an examination of the factors contributing to the projected growth of output, the future requirements for saving and investment, and the expected evolution of employment, labor force growth, and unemployment. The second section reviews some key policy issues in the industrial countries: monetary and fiscal policies; the projected evolution of current account imbalances; the appropriate policy response to structural distortions in labor markets; and the present status of trade negotiations. The third section examines the question of the adequacy of global saving, including the likely international repercussions of rising investment demands in the Middle East, east Germany, Eastern Europe, and the U.S.S.R., and discusses the appropriate policy response to these developments. This section includes a medium-term scenario that attempts to quantify the global macroeconomic effects of the increased demand for world saving. The final section reviews policy issues in individual countries.

Medium-Term Baseline Projections

Output, Inflation, and Sources of Growth

As in the past, the staff’s medium-term baseline projections are based on a number of technical assumptions, and should therefore not be interpreted as forecasts of the most likely outcomes. These assumptions include: unchanged policies—including measures that have been legislated and those that have been announced and are virtually certain to be implemented; constant real effective exchange rates among the major currencies and constant nominal bilateral rates among the ERM countries at the levels prevailing during August 1-22; and a world oil price averaging $18.43 a barrel in 1991 (roughly $3.60 below the level in 1990), rising to $18.61 a barrel in 1992, and remaining unchanged in real terms in subsequent years.

On the basis of these assumptions, real GDP growth in the industrial countries is projected to recover from 1¼ percent this year to an average of 3 percent in the period 1992-96 (Table 5). This would reflect the recovery from recession in the United States, the United Kingdom, Canada, and some of the smaller industrial countries (Australia, Finland, New Zealand, and Sweden), as well as the pickup in growth in France, Italy, and some of the other European countries (Belgium, Denmark, Norway, Portugal, and Switzerland), In Japan, output growth averaging 4 percent in 1991-92 is expected to moderate in the medium term; in west Germany growth would slow from 3 percent this year to 2 percent in 1992 but would firm somewhat over the medium term. In all of the major industrial counties, total domestic demand would grow approximately at the same rate as output over the period 1993-96, and changes in trade and current account balances would be relatively small in relation to GNP.

Table 5.Industrial Countries: Indicators of Economic Performance(Changes in percent except where otherwise noted)



All industrial countries
Real GDP/GNP2.
Real business fixed investment4.
Real total domestic demand2.
GDP/GNP deflator6.
Unemployment (in percent of labor force)
Major industrial countries
Real GDP/GNP2.
Real business fixed investment4.
Real total domestic demand2.
GDP/GNP deflator5.
Labor force1.
Unemployment (in percent of labor force)
Real GDP3.
Real business fixed investment0.l15.96.0-3.2-1.95.8
Real total domestic demand3.15.23.8-0.2-0.83.2
GDP deflator6.34,
Labor force2.
Unemployment (in percent of labor force)9.47.87,
United States
Real GNP22.
Real business fixed investment3.
Real total domestic demand2.
GNP deflator5.
Labor force1.
Unemployment (in percent of labor force)
Real GNP4.
Real business fixed investment6.614.815.613.99.45.4
Real total domestic demand3.
GNP deflator2.
Labor force1.
Unemployment [in percent of labor force)
Real GDP2.
Real business fixed investment1.411.
Real total domestic demand2.
GDP deflator8.
Labor force0.
Unemployment (in percent of labor force)
West Germany
Real GNP1.
Real business fixed investment2.75.98.610.49.45.1
Real total domestic demand1.
GNP deflator3.
Labor force0.
Unemployment (in percent of labor force)
Real GDP2.
Real business fixed investment1.
Real total domestic demand2.
GDP deflator13.
Labor force1.01.3-
Unemployment (in percent of labor force)9.512.
United Kingdom
Real GDP2. 1.82.4
Real business fixed investment5.417.78.1-0.7-12.0-2.0
Real total domestic demand2.67.83.3-0.1-3.12.3
GDP deflator8.
Labor force0.
Unemployment (in percent of labor force)
Other industrial countries
Real GDP/GNP2.
Real business fixed investment3.19.69.9-2.5-
Real total domestic demand1.
GDP/GNP deflator8.
Unemployment (in percent of labor force)

These projections are based on the assumptions of unchanged policies and constant real exchange rales and oil prices. The real business fixed investment series for each country and group is used, along with OECD estimates of depreciation, to generate the capital stock series underlying the factor contributions to output growth presented in Chart 20; for the projection period, average depreciation rates during 1987-89 are assumed.

After adjustments 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 rales and oil prices. The real business fixed investment series for each country and group is used, along with OECD estimates of depreciation, to generate the capital stock series underlying the factor contributions to output growth presented in Chart 20; for the projection period, average depreciation rates during 1987-89 are assumed.

After adjustments 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 medium-term projections for growth are broadly in line with current staff estimates of the rise in potential GNP. However, the contraction in output in 1991 in North America and the United Kingdom, and the slower-than-potential growth in France and Italy, have given rise to a gap between actual and potential output in these countries (Chart 1), which contributes to a moderation in inflation over the medium term. In west Germany, inflation (in terms of the output deflator) is projected to peak this year as a result of the demand pressures associated with unification and the recent increases in indirect taxes; as demand pressures subside and the impact of the tax increases on the level of prices diminishes, inflation is expected to slow over the next few years. These trends, together with similar output and price movements in most of the smaller European countries, would contribute to a convergence of inflation in the European Community during 1993-96.21 In Japan, real GNP growth over the medium term is projected to be broadly consistent with the estimated rise in potential output, and inflation would stabilize.

The medium-term projections are presented in Chart 20 in a growth accounting framework that identifies three sources of output growth: employment growth, capital formation, and the rate of increase in total factor productivity. The time periods in Chart 20 have been chosen to correspond roughly to complete business cycles in order to focus on the rate of expansion in supply capacity, abstracting from cyclical fluctuations in aggregate demand. On this basis, growth in the industrial countries as a group would average percent a year during 1991-96, close to the average of the two most recent expansions covering the periods 1974-79 and 1980-90. The contributions of different factors to output growth would remain relatively stable—with labor accounting for of 1 percentage point, capital formation nearly 1½ percentage points, and total factor productivity just under 1 percentage point. This aggregate pattern, however, masks substantial shifts in the contributions of different factors across countries.

Chart 20.Industrial Countries: Contributions to Real GDP Growth1

(Annual changes in percent)

1 The contributions of capital, labor, and total factor productivity are calculated with reference to the growth of output in the business sector and subsequently adjusted by the difference between the rates of growth of GDP and business sector output. Total factor productivity is defined as the growth of output in the business sector minus a weighted average of the rates of growth of capital and labor inputs in the business sector, with average income shares in 1987-89 used as weights. Labor input is measured in terms of employment except for Canada, the United States. Japan, and west Germany where hours worked are used. In the staff projections for the period 1991-96, the factor inputs used in calculating contributions to the growth of actual output are defined in terms of actual employment or hours worked, and a measure of the actual capital stock. Historical data are from the OECD Economic Outlook, Volume 48, December 1990.

2 Owing to the unavailability of data for a number of the smaller countries, the period 1967-73 is truncated to 1971-73 for the “other” and the “all” industrial countries groups.

In continental Europe and the smaller industrial countries taken as a group, the growth of labor input and its contribution to output growth is projected to increase in the first half of the 1990s, compared with the 1980s. In the larger countries, however, employment is not expected to grow much faster than the labor force, so that unemployment rates will come down only marginally, if at all, from their currently high levels. In the smaller countries, however, the average rate of unemployment is projected to ease somewhat more. In Japan, a slowdown in employment growth and further declines in average hours worked would lead to a decrease in the contribution of labor to output growth, and the unemployment rate would rise slightly.

In the United States, the contribution of labor input in 1991-96 also would decline relative to the 1980s, but largely because of the projected drop in employment in 1991. In the United Kingdom, the decline in employment in 1991 and 1992 is expected to result in a negative average contribution of labor to output growth in the period 1991-96. In both of these countries, however, employment in the recovery phase of the 1990s is expected to grow somewhat faster than the labor force, resulting in a lower unemployment rate. In Canada, employment growth during the recovery is expected to outweigh the loss in employment in 1991, resulting in a rise in the average contribution of labor to output growth and a fall in the unemployment rate.

The contribution of capital formation to output growth during 1991-96 is expected to be relatively strong in all of the industrial countries. This would reflect in part the strengthened profitability of businesses following the moderation of real wage growth in the 1980s and the investment incentives resulting from enhanced competition and potential economies of scale associated with structural changes, including those associated with the Single Market Program in the European Community. The contribution of total factor productivity growth to the expansion of output is projected to converge in most of the industrial countries. To some extent this convergence reflects cyclical developments, with productivity growth picking up in North America and the United Kingdom and falling in Germany and Japan. It also may reflect a winding down of the long-term process in which other countries gradually catch up to the higher productivity levels in North America.

Saving and Investment

Chart 21 presents a flow of funds framework in which the prospective evolution of national and foreign saving can be compared with the flows of investment required to sustain the growth of output envisaged in the medium-term baseline projections. The periods in Charts 20 and 21 are the same, so that period averages for saving and investment ratios can be compared to the corresponding average rates of output growth and factor contributions. However, it is also useful to examine the flow of funds expected during the projection period (that is, from 1990 to 1996, as shown in Table 7), rather than in terms of changes in the average levels of flows between periods (that is, from the period 1980-90 to the period 1991-96, as shown in Chart 21), to highlight changes from current levels.

Chart 21.Industrial Countries: Flow of Funds1

(In percent of GNP/GDP)

1 All ratios are in nominal terms. National income accounts definitions are used throughout, except for foreign saving, which is defined as the current account of the balance of payments with sign reversed. For the foreign sector, a positive number indicates a current account deficit or a use of foreign saving; for the government sector, a positive number indicates a budget surplus or a provision of saving. Government saving refers to the general government; it excludes government capital formation, which is included in investment, In Japan and the United Kingdom, public sector enterprises are included in the government sector. Data for the Federal Republic of Germany relate only to the former territory of west Germany in order to ensure the consistency of the data for the public, private, and foreign sectors; the figures exclude estimates of the current account and budgetary positions of the former German Democratic Republic, which are subject to a wide margin of uncertainly. Some historical data are from OECD Economic Outlook. Volume 48. December 1990; data for the period 1991-96 are staff projections. Figures may not add up to totals due to rounding, to the statistical discrepancy in the national accounts, and to the statistical difference between foreign saving on a national accounts basis and the current account balance.

2 Owing to the unavailability of data for a number of the smaller countries, the period 1967-73 is truncated to 1971-73 for the “other” and the “all” industrial countries groups.

Table 6.European Community: Convergence Indicators
(Annual percent change)
Consumer prices
Initial ERM narrow band members2
Standard deviation4.
Standard deviation6.
(In percent a year)
Short-term interest rates4
Initial ERM narrow band members2
Standard deviation2.
Standard deviation2.
(In percent of GNP/GDP)
Government balances5
Initial ERM narrow band members2
Standard deviation4.
Mean- 3.3-9.9-7.1-6.6-7.9-4.3
Standard deviation4.
(In percent of labor force)
Unemployment rates
Initial ERM narrow band members2
Standard deviation1.
Standard deviation2.

Average during period.

This group comprises Belgium-Luxembourg, Denmarkm France, Ireland, the Netherlands, and west Germany.

This group comprises Greece, Italy, Portugal, Spain, and the United Kingdom.

Yields on deposits of three to six months.

General government on a national income accounts basis.

Average during period.

This group comprises Belgium-Luxembourg, Denmarkm France, Ireland, the Netherlands, and west Germany.

This group comprises Greece, Italy, Portugal, Spain, and the United Kingdom.

Yields on deposits of three to six months.

General government on a national income accounts basis.

Table 7.Industrial Countries: Medium-Term Flow of Funds, Changes from 1990 to 19961(In percent of GNP/GDP)





National saving1.21.21.1
Private saving-0.7-0.71.1
Government saving1.91.92.2
Net foreign saving-0.2-0.2-0.1
Real business fixed investment22.12.3

See Chart 21, footnote 1.

Expressed in percent of real GNP/GDP.

See Chart 21, footnote 1.

Expressed in percent of real GNP/GDP.

The projections for output growth over the medium term envisage a reversal of the earlier decline in the average national saving rate of the industrial countries as a group: after falling by 4½ percentage points of GNP from 1967-73 to 1980-90, the national saving rate is projected to rise by 1¼ percentage points from 1990 to 1996. This increase would result entirely from a sharp rise in public sector saving, as private saving rates are projected to fall further, while changes in foreign saving in general would be relatively small.

The private saving rate in the industrial countries is expected to decline in relation to GNP by ¾ of 1 percent from 1990 to 1996—a substantial decrease, but considerably smaller than the percentage point drop registered during the 1980s.22 The decline would be widespread, affecting almost all countries. The expected rise in the average age of the population will tend to depress household saving rates in the 1990s in Japan and, to a lesser extent, in the European countries.

The projections envisage a continuation in the 1990s of the policies of fiscal consolidation initiated in the 1980s in most industrial countries. The net use of saving by the public sector is projected to drop substantially in relation to GNP in those countries where budget deficits have been relatively high for some time—for example, Canada, Italy, and the United States, and among the smaller countries, Belgium, Greece, and Spain. Public sector saving rates are projected to increase in Japan, Germany, and a number of smaller countries.23

The strengthening of public finances over the next five to six years would permit an increase in the ratio of real business fixed investment to real GNP of some 2 percentage points for the industrial countries as a group, in spite of the expected decline in private saving.24 Among the major countries, the rise in the investment ratio would be particularly large in the United States, Japan, and west Germany, but significant increases are also envisaged for Canada and France. The investment ratio is expected to fall only in the United Kingdom, and most of this decline would be associated with reduced reliance on foreign saving.

Key Policy Issues

Economic activity in the industrial economies is expected to recover in 1992, broadly along the lines of earlier staff projections, while consumer price inflation would moderate in most countries. Against this background, the task confronting the authorities is to set the stage for a lasting expansion accompanied by a sustained reduction in unemployment. This will require a resumption of fiscal consolidation, which will help expand the supply of global saving in the face of rising investment demands worldwide, as well as renewed progress in lowering inflation. It will also require further action on the structural front to reduce distortions and improve efficiency, particularly in the areas of labor markets and international trade.

Following a rise in 1990, inflation in the industrial countries is expected to moderate in 1991 and 1992 and to edge down further over the medium term. This relatively favorable evolution assumes the continuation of restrained monetary policies, particularly in Germany and Japan, where pressures on productive capacity (and, in the case of east Germany, excessive wage increases) suggest that inflation remains a significant risk. In North America, the United Kingdom, and in other countries that have experienced recession, the margin of unused resources at present is substantial, and the risk of an acceleration of prices appears to be small in the short run. As these economies recover, however, the monetary authorities will need to remain vigilant and be prepared to tighten monetary conditions at an early stage, particularly if the expansion proves to be stronger than expected.

Recent Developments in the European Community

In recent months the countries of the European Community (EC) have taken further steps to foster greater internal integration and to strengthen their ties with non-EC countries.

Internal Developments

Progress toward completing the single market among EC countries on January 1, 1993, has continued; to date, about three quarters of the measures required to implement the internal market have been incorporated into the laws of the European Community.1 A key element of the internal market program came a step closer to reality in June when EC finance ministers agreed that a minimum standard rate of 15 percent of value-added taxes and minimum rates for excise duties would apply throughout the Community beginning January 1, 1993.2 This would require three of the member states—Germany. Luxembourg, and Spain—to increase their VAT rates; in early September, Germany’s cabinet approved such an increase to become effective by the requisite date.

Negotiations conducted within the framework of the European Community’s Intergovernmental Conferences (IGCs) on economic and monetary union (EMU) and on political union are well under way. The June meeting of the European Council reaffirmed that these two conferences should continue in parallel, and that the final decision on the text of a treaty covering both EMU and political union would be taken by the European Council in Maastricht in December 1991; this would allow the new treaty to be submitted simultaneously to member states for ratification during 1992 and to enter into force on January 1, 1993. The draft treaty on EMU and its annexed draft statute of the European System of Central Banks (ESCB) reveals broad areas of agreement on the basic components of EMU, but final agreement by member states will only be given to the treaty as a whole.3 The remaining differences of view among countries relate primarily to the content and timing of stage two; the degree of convergence that must be attained before passage to stages two and three and how convergence is to be assessed (for example, whether qualitative or quantitative measures are to be used); other transitional arrangements for stage three; and the degree of independence to be granted the ESCB, particularly in the area of exchange rate policy.4 In order to reconcile these views, a new formula has been proposed.5 Under the proposed plan, the EMU treaty would contain three safeguard clauses that would come into effect once governments were ready to move to the final stage of EMU: no country could prevent its partners from establishing a single currency if they had met certain criteria for the convergence of their economic performance; no country that had met those criteria could be excluded; and no country could be compelled to join.

The EC summit in June emphasized the need for further progress on economic and monetary convergence, particularly on price stability and sound public finance.6 This emphasis reflects the deterioration in nominal convergence in the Community since the late 1980s, even within the initial group of countries participating in the exchange rate mechanism (ERM) of the European Monetary System—following the substantial progress achieved during the 1980s (Table 6).7 The recent divergence in economic performance resulted in part from the expansionary effect of unification in Germany, at a time when many of the other countries were experiencing a cyclical slowdown. Fund staff projections suggest that the recent divergence is temporary, but that differences in economic performance between the original ERM participants and some of the other countries are likely to persist. In this context, the European Council in June noted that several governments intended to submit to the EC specific multi-year convergence programs, which would quantify performance objectives and the means of securing them. The Council also called upon the Commission and the European Council of Finance Ministers (the ECOFIN Council) to report regularly on the implementation of these programs and on progress with convergence.

Since the June EC summit, the Commission has noted that a problem of convergence exists in at least one of four major areas (price performance, public finance, national saving, or external accounts) in all but one of the Community countries, and it has proposed that all 12 member states submit medium-term convergence plans to the Commission by October 1991. 8 The Commission will assess the objectives and policy measures in these plans and report to the Monetary Committee and the ECOFIN Council, while the regular biannual multilateral surveillance exercises would provide the framework for monitoring and implementing the plans. Until now the ECOFIN Council has concluded its deliberations on multilateral surveillance of economic policies and performance in the 12 EC member countries with public statements on general policy orientations. However, in light of the recent divergence in economic performance, the Commission has proposed to strengthen these procedures by incorporating into the public statements suggestions and recommendations on specific measures to achieve convergence.

External Relations

In June and July, the EC and the European Free Trade Association (EFTA) continued negotiations on the establishment of a common market—the European Economic Area or EEA—among their 380 million inhabitants.9 The EEA would extend the EC’s planned internal market to the EFTA countries, allowing the unrestricted movement of goods, services, capital, and labor among the member countries of the EC and EFTA. However, some problems remain to be resolved; these include EC access to northern fishing waters and duty-free EFTA access to EC fish markets, truck transit rights through the Alps, EFTA payments to the Community, and the additional time sought by some EFTA members to conform to EC regulations. Current plans envisage the accord to be completed before the end of 1991, signed by member states by the end of the year, and ratified by national governments in 1992. On these plans, the EEA could be in place by January 1, 1993, the same date as the scheduled introduction of the internal market in the EC.

As trade negotiations on the EEA have progressed, several EFTA countries have taken additional unilateral steps toward monetary integration with the EC. Norway linked the krona to the European currency unit (ECU) in October last year; subsequently, in May of this year Sweden tied its currency to the ECU, followed in June by Finland.10 Over time, the link to the ECU should facilitate a convergence of price performance in the EFTA countries toward EC levels and thereby ease their passage to full membership in the EC, which is the announced objective of Sweden and Austria.11 In Sweden, where increases in unit labor costs in manufacturing and in consumer prices recently have been double the EC average, a substantial reduction in cost and price inflation would be needed lo maintain external competitiveness.

The EC has continued negotiations with the Eastern European countries on association agreements that would provide aid and preferential access to the EC market.12 These agreements are potentially of great importance in the transition of the Eastern European countries to market-based systems, particularly in view of the collapse of trade among the former members of the CMEA. Products for which freer trade would provide immediate benefits to both Eastern European producers and EC consumers would include textiles, coal, and steel, as well as fruits and vegetables. Over the longer run, reform of the EC’s Common Agricultural Policy would further expand opportunities for trade, not only for the Eastern European countries but also for other developing and industrial countries. The negotiations on association agreements are most advanced with Poland, Hungary, and Czechoslovakia—the countries that to date have implemented the most economic reforms—but it is premature to predict when these agreements will be concluded. In addition, the European Council at its June meeting asked the EC Commission to begin exploratory talks with the U.S.S.R. on a broad agreement covering economic, political, and cultural matters. In July, the EC and Japan issued a joint declaration committing themselves to regular consultations on a wide range of economic and political issues, including access to each other’s markets and the removal of obstacles impeding trade and investment. Similar declarations were issued in November 1990 with the United States and Canada.

1To become effective, all measures must be incorporated into both the Community and each member state laws. At the end of May 1991, the rate of adoption at the national level of measures already passed at the Community level varied from less than 50 percent in Italy to 90 percent in Denmark.2The agreement allows a transition period of two years on certain excise duties in Greece, Luxembourg, and Spain. It also permits one or two reduced rates of at least 5 percent on a restricted list of products, and some countries (for example, Ireland, Portugal, and the United Kingdom) would be allowed to continue charging a zero rate of VAT on some necessities.3For a review of the basic components and stages of EMU, see Economic Integration in Western Europe: Policy Issues and Prospects, Supplementary Note 3 in World Economic Outlook, May 1991.4Information provided by the Fund’s Office in Europe. In the EC summit of October 1990, member countries (except the United Kingdom) agreed to begin stage two of E M U on January 1, 1994, subject to satisfactory progress toward nominal and real convergence. "Nominal" convergence, narrowly defined, means a move toward similar (low) inflation rates among countries; more broadly, the term is used to refer to similar behavior of the economic variables that are more directly responsible for price and exchange rate stability, including, for example, interest rates and budget balances. “Real” convergence refers to the long-term process of reducing disparities in living standards.5Financial Times, July 1, 1991.6Presidency Conclusions (Luxembourg: European Council, June 29, 1991).7The concept of convergence, as used in the context of EMU, refers to a tendency toward the best economic performance. Therefore, a rising mean (of inflation, budget deficits, and so forth), as well as an increasing standard deviation, is interpreted as a deterioration in nominal convergence.8Resuming Progress Toward Convergence of Economic Policies and Performance in the Community, EC Commission, July 15, 1991.9The EFTA comprises Austria, Finland, Iceland. Norway. Sweden. Switzerland, with Liechtenstein an associate member. For background information, see Supplementary Note 3 in World Economic Outlook, May 1991.10Norway maintains a fluctuation band of 2¼ percent, Sweden a band of 1 1/2 percent, and Finland a band of 3 percent on either side of their central exchange rates.11When linking its currency to the ECU in May, Sweden announced that this was the first of a three-step strategy that would lead to participation in the European Monetary System and eventually to full membership in the Community. In July, the Swedish Government formally applied for EC membership, which it hopes will be realized by 1995. Among other EFTA countries, only Austria has applied for EC membership (in 1989); Norway had applied in 1969 and was accepted in 1972, but Norwegian voters rejected membership in a referendum. Non-EFTA countries that have applied for E C membership include Turkey (1987), Cyprus (1990), and Malta (1990). For its part, the E C has announced it will not consider expanding E C membership until its monetary and political union treaty is in place, which is planned for January 1, 1993.12The former German Democratic Republic became part of the EC in 1990 as a consequence of German unification.

Staff projections envisage that consumer price inflation in the industrial countries will fall from 4½ percent in 1991 to 3¼ percent in 1996, which would represent a welcome reversal of the upward trend in inflation from 1987 to 1990. In a number of countries, however, the projected reduction in inflation would seem insufficient to convince markets of the authorities’ determination to pursue their stated long-term objective of price stability. The relatively strong growth envisaged for the next several years would provide a favorable environment for achieving a somewhat more ambitious improvement in price performance, particularly in such countries as Greece, Italy, Portugal, and Spain, where inflation is expected to remain well above the average of other industrial countries, including other members of the EMS.

After declining from 4 percent of GDP in 1982-83 to 1 percent in 1989, the combined fiscal deficit of the major industrial countries (general government basis) is expected to widen to 2 percent of GDP this year. This recent deterioration reflects in large measure cyclical developments and the substantial deterioration in Germany’s fiscal position. The staff’s medium-term projections suggest that the aggregate fiscal deficit of the industrial countries would be eliminated by 1996, although sizable deficits would remain in a number of countries, including in particular Italy and Greece. The projections assume large reductions in the deficits of Canada, Germany, Italy, the United States, and a number of other industrial countries (including Australia, Belgium, Greece, the Netherlands, and Portugal). Achievement of these reductions will require full implementation of the deficit-reduction plans announced by the authorities of many of these countries, which will involve sizable cuts in spending in relation to GNP. Achievement of these fiscal objectives is essential to sustain growth in the industrial world in the 1990s against the background of rising demands for saving in other regions and declining private saving in the industrial countries themselves.

The current account imbalances of the three major countries have narrowed substantially in recent years. The imbalances of the United States and Japan fell in relation to GNP from approximately 3½ percent in 1987 to 1¾ percent and 1¼ percent, respectively, in 1990; the U.S. deficit will drop further in 1991 reflecting the effects of recession at home and the receipt of warrelated official transfers. Germany’s external surplus declined from 4 percent of GNP in 1987 to 3 percent in 1990; it is expected to disappear in 1991 as national saving is rechanneled to finance both consumption and investment in the eastern part of the country.

The staff’s medium-term projections—based on the customary assumption of constant real exchange rates among major currencies—envisage a widening of current account imbalances after 1992, partly because investment income flows would tend to increase the surpluses of such creditor countries as Germany and Japan and to raise the deficits of such debtor countries as the United States. However, imbalances of the magnitude envisaged for the three major countries through the mid-1990s would not seem to pose a problem of sustainability.25 While even moderate external imbalances could be used as a pretext to justify protectionist pressures in some countries, the staff continues to believe that such pressures should be resisted directly and should not be allowed to exert an undue influence on the course of macroeconomic policies.

Unemployment in the Industrial Countries

During the past two decades, there have been pronounced differences in the evolution of unemployment rates among the industrial countries (Chart 22). In the United States and Canada, cyclical movements in unemployment have dominated, and by the early 1990s the average rate of unemployment was close to its level in the early 1960s. This is in sharp contrast to developments in most of Europe and in Australia and New Zealand, where from the early 1970s to the mid-1980s unemployment rates tended to increase during recessions but failed to decline during recoveries. Unemployment in these countries declined somewhat during the second half of the 1980s, but in the early 1990s it remained substantially higher than in the 1960s. Only in Japan and a number of smaller European countries has the unemployment rate remained relatively low and stable.

Chart 22.Industrial Countries: Unemployment Rates1

(In percent of labor force)

1 Based on 1989 labor force weights. Shaded areas indicate staff projections.

2 Belgium, Denmark, Greece, Ireland, Netherlands, Portugal, and Spain.

3 Austria, Finland, Norway, Sweden, and Switzerland.

In a number of countries such as the United States, Japan, and Canada, unemployment and wage developments generally have been consistent with a Phillips curve/natural rate model of the labor market. In this model, cyclical increases in unemployment above the natural rate of unemployment—defined as the equilibrium rate consistent with stable wage inflation—tend to generate downward pressure on real wages and inflation, thereby increasing the demand for labor and, over time, reducing unemployment. Similarly, cyclical declines in unemployment below the natural rate result in upward pressure on wage and price inflation that tends to persist until unemployment returns to the natural rate. In this model, the natural rate of unemployment is determined by structural features of the labor market, such as the generosity of the unemployment insurance system, payroll taxes, minimum wages, the degree of unionization, and the age-sex composition of the labor force. Current staff estimates of the natural rate of unemployment are about 5½ percent in the United States, 2¼ percent in Japan, and 7-8 percent in Canada.1

In most European countries, however, it is not clear that the Phillips curve/natural rate model adequately describes how the labor market works. First, although the natural rate of unemployment may have risen somewhat, it is difficult to identify structural changes in the labor market that could account for the large increases in the natural rate to the levels of unemployment that prevailed at the end of the long expansion of the 1980s. Second, the persistence of high rates of unemployment in an environment of relatively stable inflation and robust output growth after the recession of the early 1980s appears inconsistent with the dynamics of the Phillips curve/natural rate model.

A number of alternative models of the labor market have been offered to explain the puzzle of persistently high unemployment in Europe.2 A common feature of these models is the focus on the relationship between employers and employees—the “insiders”—in noncompetitive labor markets. If the unemployed—the “outsiders”—have little if any influence on wage bargaining, this will short-circuit the process through which high levels of unemployment restrain wage increases, and hence encourage employment, until unemployment declines to the natural rate.

In one version of this model, where the insiders are able to bargain for high wages that preserve the jobs of those currently employed but take no account of the situation of the unemployed, the unemployment rate tends to remain constant unless jolted by a shock that changes the number of insiders. In this case, the unemployment rate is said to have the property of hysteresis because temporary shocks have persistent effects on unemployment, and the equilibrium unemployment rate tends to follow the actual unemployment rate. Wage increases will be boosted by declines in unemployment and restrained by increases, but will be unaffected by the level of unemployment as long as this level remains unchanged.

In other versions of the model, the outsider group may be more narrowly defined to include only specific segments such as the long-term unemployed, the unemployed in economically depressed regions, or the unemployed young. In each case, high unemployment may persist because the unemployed outsiders are effectively disenfranchised in the wage determination process. This might reflect, for example, the bargaining strategies of trade unions, the impact of minimum wage laws, or features of unemployment insurance systems.

Unemployment and wage developments in many European countries in the last two decades are generally consistent with the predictions of insider-outsider models. The step increases in unemployment in the 1970s and early 1980s appear to have resulted from a series of negative supply shocks, such as the oil price increases of 1973-74 and 1979-80. During much of the 1980s, unemployment in many European countries was relatively high and stable but, as suggested by the insider-outsider model, there often appeared to be little if any downward pressure on wage inflation. The declines in unemployment in the mid- to late 1980s, according to this model, reflected the partial reversal of previous oil price increases, expansionary demand policies in some countries, and, in the case of west Germany, the demand stimulus associated with unification.3

1See Charles Adams and David T. Coe, “A Systems Approach to Estimating the Natural Rate of Unemployment and Potential Output for the United States,” Stuff Papers, International Monetary Fund (Washington). Vol. 37 (June 1990), pp. 232-93; Daniel A. Citrin, “Potential Output and the Natural Rate of Unemployment in Japan: Recent History and Medium-Term Prospects.” IMF-Working Paper (forthcoming); and David T. Coe, “Structural Determinants of the Natural Rate of Unemployment in Canada,” Staff Papers, International Monetary Fund (Washington), Vol. 37 (March 1990), pp. 94-114.2See, for example, Olivier Blanchard, “Wage Bargaining and Unemployment Persistence,” Journal of Money, Credit, and Banking. Vol. 23 (August 1991, Part I), pp. 277-92; and Assar Lindbeck and Dennis Snower, The Insider-Outsider Theory of Employment and Unemployment (Cambridge, MIT Press, 1988).3See David T. Coe and Thomas Krueger, “Wage Determination, the Natural Rate of Unemployment, and Potential Output,” in German Unification: Economic Issues, Leslie Lipschitz and Donogh McDonald (eds), IMF Occasional Paper No. 75 (Washington: International Monetary Fund, December 1990), pp. 115-29.

In recent years, considerable progress has been made in removing structural distortions and improving efficiency, notably through financial deregulation and tax reform. Progress has been noticeably slower in two important areas: labor markets and international trade. Structural problems in labor markets have been particularly evident in many European countries where unemployment has remained high despite the long economic expansion of the past decade. While the persistence of unemployment is due in part to the current slowdown of economic activity, it appears to reflect in large measure a sustained rise in long-term unemployment,26 There is broad agreement that this problem cannot be resolved by deflecting macroeconomic policies from their appropriate long-term objectives to achieve short-term employment gains, and that a lasting reduction in unemployment will require structural measures aimed at improving the functioning of labor markets. In several countries, a reduction in minimum wages would help reduce unemployment among young workers and allow these workers to improve their skills through on-the-job training. Changes in the wage bargaining system also may be necessary in some countries to ensure that wage increases reflect more closely the available supply of labor, particularly where unionization and other features of the labor market tend to separate outsiders from insiders. In addition, a restructuring of unemployment benefits aimed at encouraging job search (for example, by limiting the duration of benefits and/or linking them to participation in training) could have a favorable effect in some countries.

Trade Integration in the Western Hemisphere: Toward Free Trade in North America

The movement toward trade integration in the Western Hemisphere continued to gain momentum in 1991. In May, the Congress of the United States granted the Administration an extension of fast-track authority for trade negotiations, including the North American Free Trade Agreement (NAFTA). Formal discussions involving Canada, Mexico, and the United States started in June 1991. They are expected to continue until mid-1992, with possible implementation of the agreement and the first round of reductions in tariff and nontariff barriers taking place in 1993.

The key importance of the NAFTA stems not only from the potential benefits for the nations involved, but also from the role that this agreement could play in the eventual establishment of a continental market, as envisaged in the Enterprise for the Americas Initiative. Discussions are continuing on other proposals for bilateral and regional arrangements in the Western Hemisphere, which were conceived in part as the building blocks of a continental free trade area.1 More over, many countries in the region have continued with unilateral trade liberalization in the context of programs of adjustment and structural reform.

The three countries negotiating the NAFTA differ substantially in size and level of development, which contributes to the complexity of the negotiations. Canada, Mexico, and the United States would form a common market of 360 million people (69 percent in the United States, 24 percent in Mexico, and 7 percent in Canada). Measured in U.S. dollars at market exchange rates, real GDP per capita in the United States in 1990 was 18 percent higher than in Canada and more than 9 times larger than in Mexico. There is, however, no reason to suppose that differences in income and size would prevent all three countries from sharing in the benefits of a free trade area. In the short run, some transitional costs associated with the reallocation of labor are unavoidable as sectors of the economy adjust to the pattern of comparative advantage in the three countries. Consideration is being given to mechanisms involving compensation schemes and training programs that would help ease the transition. In the long run, the gains from regional trade liberalization will depend on the balance of trade-creation and trade-diversion effects, and the benefits to be derived from increased competition and from scale economies. In this connection, some countries outside the region have expressed concern about the potential trade-diversion effects, particularly the impact on their exports to the United States.

Canada, Mexico, and the United States are already major trading partners (Table 8), although trade flows between Canada and Mexico are substantially smaller than flows between each of these two countries and the United States. The current pattern of trade among the three countries reflects in part the structure of comparative advantage. Consumer goods and fuels constitute more than 30 percent of U.S. imports, but they account for only 15 percent of Canadian imports and 10 percent of Mexican imports. In contrast, more than three fourths of Canadian and Mexican imports are industrial supplies and machinery and equipment, while U.S. imports of these goods amount to 60 percent of total imports. On the export side, more than 80 percent of U.S. and Canadian exports are manufactured goods; in Mexico only 36 percent of exports are manufactures while oil and minerals account for 57 percent of exports. The relative abundance of labor in Mexico suggests that Mexico’s exports of labor-intensive manufactures could grow significantly, reducing the relative importance of exports of fuel and minerals. Canada and the United States will have an enlarged market for exports of machinery and equipment, for other capital-intensive manufactured goods, and potentially for financial and other services.

Table 8.North American Exports, 1989
OriginCanadaMexicoUnited StatesOtherTotal
(In billions of U.S. dollars)
United States78.225.0260.8364.0
(As a percent of total)
United States21.56.971.6100.0
Source: IMF, Direction of Trade Statistics, Yearbook 19
Source: IMF, Direction of Trade Statistics, Yearbook 19

Negotiations on the NAFTA are organized in six working groups: dispute settlement, investment, intellectual property, market access, services, and trade rules. The last three areas are particularly complex, and various subgroups for negotiations on specific topics have been established. The market access group has six subgroups—tariff and nontariff barriers, rules of origin, government purchases, agriculture, automotive industry, and other industrial sectors (including petrochemical and textiles); the services group has five subgroups—financial services, insurance, transportation, telecommunications, and other services; and the trade rules group has two subgroups—subsidies and unfair practices, and standards and certification systems.

Significant differences are expected to emerge in a number of areas. Canada and the United States had serious difficulties in reaching agreement on a dispute settlement mechanism and on trade barriers in “cultural” industries in the trade agreement signed by the two countries in 1989. The debate on the design of the dispute settlement mechanism is likely to re-emerge in a trilateral context. Unilateral reduction in tariffs by Mexico has simplified the discussions on tariffs, but the complex system of quotas and other nontariff barriers in Canada and the United States will have to be revised as it applies to Mexico. Discussions on rules of origin will also be difficult, as these rules affect the position of industries that are highly sensitive to outside competition, such as the automobile industry. On financial and insurance services, Mexico will face pressure to reduce protection levels to domestic banks and insurance companies. Difficulties are also expected regarding the elimination of subsidies and trade barriers in agriculture and textiles in Canada and the United States, as the transitional unemployment generated by the reallocation of labor is likely to face opposition from unions and other interest groups.

1See the World Economic Outlook, May 1991, pp. 68-69, for details of other regional initiatives.

It may also be necessary to introduce or expand both training programs, to develop the job-related skills of the unemployed so they can compete more effectively in the labor market, and job placement services to ensure that the unemployed maintain contact with potential employers and to facilitate the matching of people and jobs. Training programs also may be needed to deal with shortages of skilled labor in key sectors that in the past have slowed growth and contributed to wage pressures. Measures of this kind would help not only to reduce unemployment, but also to lower the unemployment costs that might result from future shocks to the economy.

In the past several years, pressures to grant additional protection to domestic producers generally have been resisted in the industrial countries, but progress in reducing trade restrictions has been limited. Unilateral trade liberalization has occurred in some countries as part of structural reform programs. In others it has occurred in the context of bilateral or regional arrangements. For the most part, however, actions to deal with the deep-seated problems of such declining industries as textiles have been delayed pending the outcome of the Uruguay Round of trade negotiations. In addition, frictions among trading partners have remained intense, particularly in connection with the heavy subsidization of agricultural output and exports by many countries, but also in the areas of industrial subsidies and antidumping practices. Moreover, the use of non-tariff measures to insulate domestic producers of manufactures from international competition (mainly in the form of voluntary export restraints and anti-dumping and countervailing actions) has increased over the past decade. In addition, successive Multifiber Arrangements (MFAs) have broadened the degree of protection afforded to textile producers, and the current MFA has been extended without change until the end of 1992.

In certain respects, however, progress has been made in the direction of a freer trade system. The benefits of freer trade in terms of increased efficiency and welfare are now broadly recognized, and this was reflected in the launching of the Uruguay Round in 1986. A number of countries (including Australia, Canada, Japan, New Zealand, and Sweden) have reduced quantitative restrictions on imports, and trade barriers have been eliminated in the context of general regional arrangements—between Australia and New Zealand, between the United States and Canada, and within the European Community and the European Free Trade Association (EFTA). The potential scope for regional liberalization also has been expanded with the start of negotiations between Canada, Mexico, and the United States on the North American Free Trade Association.27 Moreover, negotiations are under way between the EC and EFTA with the aim of creating a European Economic Area (see box on European Community). However, despite measures to liberalize agricultural trade in some countries—most significantly in Australia and New Zealand, and from high levels of protection in Japan and Sweden—agricultural support levels remain high in most industrial countries and they continue to involve large costs to both consumers and taxpayers in these countries and to efficient producers in many countries.

Against this background, the failure to conclude the Uruguay Round of multilateral trade negotiations on schedule has been a major setback. Postponement of the Round deprives the world of large welfare and efficiency gains and keeps important areas (such as agriculture, services, intellectual property rights, and trade-related investment measures) largely or completely outside the realm of multilateral rules. It also means that market access continues to be limited in general, and in particular to the many developing countries and formerly centrally planned economies that have—with the encouragement of the Fund and the industrial countries—liberalized their trade systems unilaterally and pinned their hopes for growth and development on an outward-looking, market-oriented strategy.

Further delays in concluding the Uruguay Round can only discourage the pursuit of this strategy. Some countries probably would react to such delays by intensifying efforts to pursue trade liberalization in the context of regional or bilateral arrangements. This would not be without risks for the multilateral trading system, as it could isolate many of the developing countries and strengthen the position of those who advocate a return to inward-looking policies. A decisive political effort to break the current deadlock and conclude the Uruguay Round is now urgently required. This could represent the most important single contribution of the industrial countries to a favorable evolution of the world economy.

Global Saving and Investment: Prospects and Policy Implications

This section examines one of the key issues facing the world economy: the adequacy of global saving. Following a discussion of the likely implications of rising demands on world saving, it examines the appropriate policy response to these demands. The section concludes with the presentation of a medium-term scenario that attempts to quantify the international repercussions of the new demands. Two important conclusions emerge from this examination. First, the implications of the new investment demands for world interest rates and incomes would not be negligible, but they are unlikely to be large. Second, the best way to avoid, or at least alleviate, any adverse international effects of these new investment demands would be to increase the availability of world saving—principally by reducing the use of saving by the public sector—and to ensure that those new investments that are financed through official transfers are accompanied by structural reforms and stabilization policies that help ensure an adequate rate of return on capital.

Macroeconomic Consequences of New Demands on World Saving

It is often said that the world is currently facing a “shortage” of saving. This view reflects concerns about the actual and potential claims on world resources associated with reconstruction in the Middle East, unification in Germany, the economic transformation of Eastern Europe, and prospects for reform in the U.S.S.R., which come on top of the sizable investment requirements of the industrial countries and the other developing countries. Of course, there cannot be, expost, an excess of world investment over world saving.28 But there can be an ex ante gap between planned investment and the current supply of saving. Such a gap would trigger adjustments in interest rates and other macroeconomic variables, which would ensure that, expost, actual investment equals the supply of saving.29

While it is difficult to quantify the additional demands for saving that will effectively materialize over the next several years, it may be useful to consider some illustrative estimates. The staff’s current baseline projections envisage that new demands for saving associated with reconstruction in the Middle East, German unification, and reform in Eastern Europe and the U.S.S.R, could amount to almost $100 billion in 1991 (equivalent to 0.6 percent of the combined GNP of industrial countries) and to an average annual rate of $80 billion (0.4 percent of industrial country GNP) during 1992–96. Assuming that the implementation of more ambitious reform programs would justify additional resource flows, the total rise in claims on global saving from these regions could amount to $100 billion a year during 1992-96.

The scenario presented below suggests that, without a commensurate rise in the availability of global saving, an increase in the demands on world saving of this size over the period 1992-96 would result in a rise in world interest rates of approximately ½ of 1 percentage point. Over the medium term, higher interest rates would lead to the crowding out of domestic investment and a decline in output elsewhere in the world economy. Whether such a decline would be associated with a fall in national income depends crucially on the rate of return on the new investments. It seems likely that a part of the investment spending associated with reconstruction in the Middle East will be forthcoming from the private sector. This would reflect the expectation on the part of private lenders that the new investment projects in Kuwait—notably those associated with reconstruction of oil facilities destroyed during the recent conflict—will yield a sufficiently attractive rate of return. If that rate of return were to exceed the return on the marginal investments that are crowded out elsewhere, the future stream of interest payments to the rest of the world could offset the decline in output, and national income in the rest of the world might rise.

It is unlikely, however, that the new demands on saving will be fully satisfied by private investors seeking a higher rate of return on capital. For example, the demand for resources associated with the unification of Germany so far has been satisfied mainly through the intermediation of the German Government and this has been reflected in a large fiscal deficit. As regards the U.S.S.R. and some of the Eastern European countries, the prospects for private financing appear limited at present, and the increased demand for external resources by these countries may have to be met predominantly by official financing, at least over the short to medium run. If these transfers are used to finance either consumption or investment yielding an inadequate rate of return, the rest of the world would experience a reduction in both domestic output and national income, as the average return on investments (both domestic and foreign) would fall. Whether or not the additional demand for capital leads to a decline in world output, regional differences in the geographic distribution of gains and losses could be significant. For example, the rise in world interest rates would involve a rise in debt-service costs and therefore a decline in the level of national income in the indebted developing countries. While such a decline could be offset by a rise in exports attributable to improved economic conditions elsewhere—particularly if the rate of return on the new investments is adequate—the offset would not necessarily be complete.

Policy Issues

In responding to the new demands for official financing from east Germany, Eastern Europe, and the U.S.S.R., it will be important to ensure that resources are used in the most productive way. This will require both appropriate macroeconomic stabilization measures and structural reforms that allow market forces to play a primary role in the allocation of resources in the borrowing countries. The implementation of such reforms and stabilization policies is already under way in varying degrees in Eastern Europe. In the case of the U.S.S.R., however, the reform process is only beginning, and much remains to be done to establish the institutions and mechanisms conducive to an efficient allocation of resources. Over time, the provision of official financing to these regions could help to foster conditions in which private capital can gradually replace official sources of credit, but only if financing is accompanied by appropriate policies and reforms.

Any assessment of the adequacy of world saving must involve judgments about the appropriate level of investment and growth in both industrial and developing countries. The analysis presented earlier in this chapter suggests that, in order to maintain the average annual growth rate of output of the past decade (2¾ percent, and just over 2 percent in per capita terms), the industrial countries will need to increase investment in relation to GNP by about 1 percentage point during 1991-96. It also suggests that if the major industrial countries were to achieve their intended budget targets, the absorption of saving by governments would be reduced by 2 percentage points of GNP over the next five years, and, given the expected decline in the private saving rate, national saving would rise by 1¼ percentage points. Thus, the full implementation of existing deficit-reduction plans (which is assumed in the staff’s projections) would be a minimum requirement to ensure that the increase in domestic investment needed to sustain growth can be financed.

The developing countries also will need to achieve a substantial increase in their domestic saving and investment ratios in the 1990s in order to improve their growth performance over the disappointing record of the last decade. The staff’s projections presented in Chapter III assume that the group of developing countries that have experienced debt-servicing difficulties will need to increase domestic investment and saving rates by approximately 3 percentage points during 1991-96. Such an increase would represent an extraordinary effort on the part of many of these countries and would require that strong macroeconomic and structural policies—including those envisaged in the context of Fund- or World Bank-supported programs—be implemented as planned.

Given the sizable investment requirements of both industrial and developing countries, a key question is what policy actions may be needed to avoid, or at least to moderate, the possible adverse international effects stemming from the new demands on world saving. As already noted, increased official transfers to east Germany, Eastern Europe, the U.S.S.R., and the Middle East would exert upward pressure on world interest rates unless they were matched by a corresponding rise in the supply of saving. Measures to increase the level and improve the allocation of private saving should be seriously considered, particularly in view of the declining trend in private saving rates over the past decade. But there appears to be a limit to the extent to which private saving can be raised without introducing distortions or imposing budgetary costs. Accordingly, the best way to limit pressure on interest rates would be to keep the net budgetary impact of increased official transfers to a minimum by matching these transfers with offsetting reductions in other spending categories—including, in particular, subsidies—and by adopting revenue-enhancing measures that do not discourage saving and work effort, such as reductions in certain tax preferences.

As international tensions subside and the economies of Eastern Europe and the U.S.S.R. become more closely integrated with those of the industrial countries, consideration should be given to financing part of the transfers associated with this process of integration through offsetting reductions in military expenditures in donor as well as recipient countries. By way of example, if military expenditures in the industrial countries were reduced by 20 percent from their level in 1989 (some $460 billion), this would imply budgetary savings on the order of $90 billion a year. This, of course, would need to be matched by large reductions in military spending in the U.S.S.R., which would provide part of the resources needed to bolster the civilian economy in that country. Budgetary savings also could be achieved through reductions in government subsidies to domestic producers, including in particular reductions in farm subsidies. By way of example, the abolition of agricultural support measures in the industrial countries would reduce government outlays by more than $100 billion a year.30 Measures of this kind would not only reduce the use of saving by governments and increase economic efficiency worldwide, but would also expand the opportunities for international trade available to the developing countries, and particularly to those that are in transition to market-based economies.

It could be argued that in order to increase saving the emphasis should be on generating rapid growth, rather than on cutting fiscal deficits. It is true, of course, that for a given ratio of national saving to GNP, faster growth would raise the level of national saving and therefore the level of investment in domestic and/or foreign assets. The question is: how can faster growth be achieved, and for how long? In those industrial economies with a significant margin of unused resources, an expansionary monetary policy aimed at lowering interest rates would boost capacity utilization and raise output and saving for some time. However, these economies are expected to recover even on the basis of the present stance of monetary policy. Thus, there is a danger that further monetary expansion could lead to renewed pressure on prices, particularly if expectations about inflation remain high, as is suggested by the relatively high levels of long-term interest rates in several industrial countries. Such price pressures would require a tightening of monetary policy at a later stage, raising the possibility that the initial increase in output and saving might be lost. Furthermore, monetary expansion is unlikely to have an appreciable effect on the economy’s long-run productive capacity; any resulting rise in the level of saving would thus be temporary because higher growth could not be sustained beyond the point where resources were fully utilized.

In contrast, a tightening of the fiscal position would lead to a direct increase in national saving and, although it could dampen economic activity in the short run, it would raise capital formation and potential output in the longer run and therefore lead to a further rise in national saving. The implication of this discussion is that the objectives of achieving a lasting rise in national income and national saving are closely related, and that both objectives require a reduction in the absorption of saving by the public sector. Of course, structural measures that contribute to an increase in potential output by raising total factor productivity also would help to achieve both objectives.

A Scenario Involving Increased Demands on World Saving

In order to gauge the possible magnitude of the interest rate effects and the other international repercussions of the new demands for world saving, an illustrative scenario was developed on the basis of the staff’s multicountry econometric model, MULTIMOD.31 As indicated in Table 9, the estimated total increase in the demand for world saving would average approximately $100 billion a year during 1991-96, of which $80 billion already has been incorporated in the staff’s medium-term baseline projections; for illustrative purposes, an additional $20 billion a year is assumed to be channeled to Eastern Europe and the U.S.S.R.

Table 9.Estimated Additional Demands for External Saving(In billions of U.S. dollars)
19901991Annual Averages

German unification357055
Reconstruction in the Middle East1712
Eastern Europe and the U.S.S.R.1033
Of which:
Included in the staff baseline projections359780

As the table shows, most of the additional demand for world saving has already been included in the staff’s short- and medium-term baseline projections. The macroeconomic effects of this increased demand (discussed below) are to a large extent already embodied in the staff’s projections.

The estimates for east Germany are based on methods described in a recent study32 and in the October 1990 World Economic Outlook. For the Middle East, the staff has estimated the likely magnitude and phasing of reconstruction expenditures, which are assumed to be concentrated in Kuwait. The numbers for east Germany and the Middle East should be interpreted as estimates of effective resource demands that are likely to be satisfied by voluntary private financing or, in the case of east Germany, by transfers from the government. In other words, it was assumed that sufficient financing from either public or private sources would be available to accommodate the capital requirements associated with both German unification and reconstruction in the Middle East. For Germany, this would involve a redirection of national saving from investment abroad to domestic investment.

In the case of Eastern Europe and the U.S.S.R., the rapid transformation toward market-oriented systems could, in principle, involve investment requirements that would exceed by a wide margin the financing available on a voluntary basis from the rest of the world.33 For this reason, the estimates of the net additional resource demands stemming from these regions were based on assumptions regarding the likely flows of external financing into Eastern Europe and the U.S.S.R, from both private and public sources, rather than on perceived capital requirements. These estimates are subject to considerable uncertainty, particularly in the case of the U.S.S.R. They should be interpreted as broad indications of what might happen if reforms were implemented on a sufficiently wide scale to warrant an increase in the transfer of resources to that region.

For the purpose of the scenario, the increase in resource demands—which are reflected in additional net imports by the three regions—needs to be allocated to the trading partners of these countries. For east Germany, two thirds of the additional imports are assumed to come from west Germany, and the remaining third is allocated on the basis of west Germany’s pattern of imports. For the U.S.S.R. and Eastern Europe and the Middle East, data on the trade between these regions and the rest of the world are used to allocate the increase in net imports. This assumes that, although Eastern Europe and the U.S.S.R. are expected to increase their trade with other regions significantly, the geographic pattern of trade would remain broadly unchanged.

The estimation of the international repercussions of the transfer of resources must take into account the fact that a rate of return is earned on the additional claims on the three regions that are acquired by the rest of the world as part of the transfer process. This analysis assumes that these claims are denominated in U.S. dollars and earn a rate of return equal to a simple average of the U.S. short- and long-term interest rates. In the case of the Middle East, all additional capital flows to the region are assumed to be private, while in the case of Germany, there is a mix of official and private financing; for Eastern Europe and the U.S.S.R., financial flows are assumed to be equally divided between private and official sources.

Another important assumption underlying the exercise relates to the financing of increased government transfers to these regions. In all cases except Germany, it is assumed that the budgetary impact of additional government transfers is not matched by higher taxes or offsetting reductions in other outlays. In the case of Germany, the simulation includes some fiscal offsets in the form of reduced expenditures on West Berlin and other border areas. Recent fiscal measures, however, such as the tax increases that went into effect on July 1, 1991, are not included in the simulation.

The estimated macroeconomic effects of the additional resource demands on the industrial countries are summarized in Table 10. This table shows the simulated effects of the total additional demands for external saving (as shown in Table 9), whether or not they are included in the staff’s baseline projections. These estimates should be regarded as only illustrative, for two reasons. First, as indicated above, the estimates of the new investment demands are very rough and could be substantially altered if economic developments in these regions were to differ substantially from current projections. Second, the limitations inherent in the use of a model based on historical relationships are particularly serious when moving into uncharted territory. For example, economic transformations of the magnitude envisaged for east Germany, Eastern Europe, and the U.S.S.R. could involve major changes in the trade patterns embodied in the model. For example, U.S. exports to the U.S.S.R., which are currently small, are likely to increase substantially over the medium term.

Table 10.Simulated Effects of Increased Investment Demands Related to German Unification, Reconstruction in the Middle East, and Economic Transformation in Eastern Europe and the U.S.S.R.(In percent)
All industrial countries
Real GDP0.10.2-0.2
GDP deflator0.10.40.6
Real long-term interest rate20.30.50.3
Current account balance30.20.50.4
United States
Real GDP0.10.2-0.1
GDP deflator0.20.50.8
Real long-term interest rate20.30.50.3
Real effective exchange rate Private investment3-1.6- 1.8-1.2
Private investment3-0.1-0.2-0.2
Current account balance30.20.2
Real GDP0.10.1-0.2
GDP deflator0.20.50.8
Real long-term interest rate20.30.60.4
Real effective exchange rate-0.8-0.8-0.6
Private investment3-0.1-0.2
Current account balance30.20.3
West Germany4
Real GDP0.61.80.4
GDP deflator0.21.11.9
Real long-term interest rate20.61.00.9
Real effective exchange rate1.41.92.0
Private investment3-0.3-0.6-0.8
Current account balance3- 1.2-2.4- 1.8
Other industrial countries
Real GDP-0.1-0.3
GDP deflator0.10.1
Real long-term interest rate20.60.90.6
Real effective exchange rate Private investment30.20.1-0.1
Private investment-0.2-0.5-0.4
Current account balance30.20.60.7
Net debtor developing countries
Real GDP0.20.3
Export volume0.51.00.2
Current account balance50.20.1
Debt service ratio5-0.3-0.10.1

Annual averages.

In percentage points.

In percent of GNP.

Data for Germany are for west Germany only, except the current account balance, which is for both east and west Germany and is expressed as a ratio of their combined GNP.

As a ratio to exports of goods and services at the end of the period. Differences from baseline are expressed in percentage points.

Annual averages.

In percentage points.

In percent of GNP.

Data for Germany are for west Germany only, except the current account balance, which is for both east and west Germany and is expressed as a ratio of their combined GNP.

As a ratio to exports of goods and services at the end of the period. Differences from baseline are expressed in percentage points.

The increase in the demand for imports stemming from the three regions would raise the level of output (GDP) in the industrial countries as a group by less than ¼of 1 percent in 1990 and 1991 (Table 10), but it would result in slightly lower output over the medium term except in west Germany. The short-run rise in output is largest in west Germany, owing mainly to the increased demand resulting from unification; this increase is sustained over the medium term, partly because of the assumed increase in migration of labor from eastern Germany.34 Real output in developing countries also rises in 1991 on account of a boost to exports, which also reduces the debt-service ratio in the short run. Over time, however, the increase in exports virtually disappears, and the level of output is unchanged from what it would otherwise have been.35

The rise in long-term interest rates in 1991 ranges from ½ of 1 percentage point in the United States and Japan to 1 percentage point in Germany. Over the medium term, the rise in interest rates averages about ½ of 1 percentage point for the industrial countries as a group with, again, a significantly higher-than-average increase in Germany. Higher interest rates tend to dampen investment in all the industrial countries and particularly in Germany, both in 1991 and over the medium term. In general, the magnitude of these effects is relatively modest.36

Except for Germany, the transfer of real resources to the three regions is reflected in a rise in net exports in the industrial countries and an improved current account position. The process that frees domestic resources involves a rise in real interest rates, which lowers domestic investment relative to domestic saving. In the case of Germany, however, increased exports from the western to the eastern part of the country have no direct effect on the overall trade balance. Widening interest-rate differentials in favor of German assets, however, give rise to an appreciation of the deutsche mark against other major currencies; if combined with a strengthening of aggregate demand in Germany relative to other industrial countries, such an appreciation results in a deterioration in Germany’s external current account.

Policy Issues in Individual Countries

In the Untied States, the recession that began in the third quarter of 1990 appears to have bottomed out in the second quarter of 1991, and inflation has begun to slow from its relatively high levels in 1990 and early 1991. While the short-term outlook for the U.S. economy is for a recovery of growth in the context of a cyclical moderation in inflation, medium-term prospects for sustained strong growth and price stability depend on the response of economic policies to a number of problems, including a national saving rate that is low by historical standards and an underlying rate of inflation that remains sufficiently high to warrant attention.

The key policy issue in the United States is the paucity of national saving. Following a sharp drop in the national saving rate between 1981 and 1987—the domestic counterpart to the deterioration in the external balance—saving remained at a relatively low level, and the improvement in the external balance after 1987 was accompanied by a marked decline in the investment ratio. There is little doubt that the achievement of sustained growth without excessive reliance on external saving requires a substantial rise in national saving, and that efforts to strengthen the federal fiscal position should play a major role in addressing this issue.

The federal budget of January 1990, which set the medium-term goal of eliminating the budget deficit by FY 1995 without reliance on social security surpluses, defined an appropriate standard for dealing with the problem of low national saving. In the event, the fiscal outlook deteriorated considerably during 1990, leading to an agreement on a multi-year deficit reduction package signed into law in November 1990. This package contains deficit reduction measures estimated to yield a cumulative total of approximately $500 billion over the period FY 1991 to FY 1995, as well as budget process reforms to ensure implementation of these measures.

The Budget Agreement of November 1990 provides a framework for achieving considerable progress toward fiscal consolidation, and its continued full implementation should be a key objective of fiscal policy. However, the budget of February 1991, which assumes full implementation of the Budget Agreement, projected a marked widening of the deficit in FY 1991 and much smaller improvements in subsequent years than the previous budget. Changes to economic and technical assumptions in the Mid-Session Review have resulted in further upward revisions to the deficit projections.37 On a current services basis, the federal deficit excluding the cash flows associated with deposit insurance and social security trust funds is expected to widen further in 1992, and additional deficit reduction measures equivalent to about 3 percent of GNP would be required to achieve the medium-term goal of eliminating the federal deficit by FY 1995. While the Budget Agreement does not mandate measures to offset changes in deficit projections that are due to revised economic and technical assumptions or emergency expenditures, prompt fiscal action to advance the process of deficit reduction would seem desirable in light of the magnitude of the national saving problem.

Steady progress toward price stability remains the most important contribution that monetary policy can make to sustained strong growth over the medium term. While economic slack has enhanced the short-term prospects for an improved price performance, the level of long-term interest rates could signal that inflation expectations remain entrenched, underscoring the importance of a monetary policy that is clearly aimed at lowering inflation. In this context, a continuation of the Federal Reserve’s policy of reducing over time the underlying growth of the monetary aggregates appears to be an appropriate medium-term strategy.

In recent years the difficulties faced by the U.S. banking system have been a source of concern. The proposal presented by the U.S. Administration in February 1991 represents a significant step toward addressing these difficulties. There are questions, however, whether the proposed reform of the deposit insurance system is sufficient to address adequately the issue of moral hazard and other problems underlying the current difficulties of the system. There is also a debate on whether the proposal of allowing corporate ownership of banks might generate conflicts of interest, and about the proposed treatment of foreign banks in the United States.

Led by strong domestic demand, economic activity in Japan expanded at an average annual rate of 5¼ percent during 1987-90. This was accompanied by a considerable decline in the current account surplus, tightening factor markets, and increasing pressures on costs and prices. Growth is expected to moderate this year, but the level of output would remain above potential. A significant slackening of factor market conditions is therefore unlikely, and price pressures are not expected to ease appreciably. In these circumstances, economic policies should continue to focus on safeguarding Japan’s exceptionally favorable price performance of recent years as a precondition for sustained growth over the medium term. Given the need for continued monetary restraint, it is important that the recent cut in the official discount rate not be perceived as a first step toward an easing of monetary policy and a relaxation in the authorities’ commitment to stable prices.

Over the past ten years, Japan has successfully pursued a policy of fiscal consolidation. The central government deficit (on a national accounts basis) was reduced from 5½ percent of GNP in FY 1980 to 1 percent of GNP in FY 1990. Local government operations improved significantly and the surplus of the social security funds widened. The authorities intend to continue fiscal consolidation with the aim of reducing further the financing of overall general account expenditures (including debt amortization) from new bond issues. Given the relatively high burden of public debt service and the expected increase in public expenditures on pensions and medical care benefits associated with the prospective aging of the population, this medium-term strategy seems appropriate. The broadly neutral fiscal stance programmed for FY 1991 is also consistent with the current cyclical situation.

The Japanese authorities have launched a ten-year plan for public investment in the period FY 1991-FY 2000 to improve social infrastructure. The plan provides for substantial increases in public investment spending during this decade, in contrast with virtual stagnation during the 1980s. If implemented flexibly as intended by the authorities, the planned increases in public investment spending need not interfere with the objective of continued fiscal consolidation over the medium term.

In the past several years, Japan has made substantial progress in the areas of tax reform, financial deregulation, and the liberalization of manufactured imports and foreign direct investment. In response to the rapid rise in land prices in recent years, the Government also has taken measures to reform land tax and management policies, including the introduction of a national land-holding tax, higher taxes on capital gains from land sales, reductions in the preferential treatment of agricultural land, and a relaxation of zoning regulations. In the area of competition policy, several laws and regulations governing the distribution system were liberalized last year, and steps are being taken to improve the enforcement of anti-trust regulations. Further progress in this area is needed, however, to enhance consumer welfare and improve resource allocation. For the same reasons—and despite recent steps to phase out import quotas on beef, citrus, and a number of other products—further efforts are needed to liberalize agricultural trade and domestic support policies.

Following German economic, monetary, and social union (GEMSU) in July 1990, and political unification in October, economic policies in Germany face the formidable challenge of restructuring and integrating the economy of east Germany. During the year following the GEMSU treaty, the sizable surplus of saving over investment in west Germany was rechanneled in the form of transfers to east Germany, which was reflected in a sharp widening in the fiscal deficit. As demand turned away from domestically produced goods, output in east Germany fell precipitously while economic activity in west Germany surged. The elimination of the large external surplus helped alleviate pressures on the already strained productive capacity in west Germany.

Economic developments in the eastern and western parts of the country are expected to continue to diverge. With output projected to decline further, unemployment in east Germany could reach 17 percent of the labor force by the end of 1991. While the rebuilding of the east German economy inevitably will involve large public expenditures, it is essential that fiscal policy be aimed at containing the budget deficit. And while the economic environment for monetary policy has become more difficult as a result of higher fiscal deficits and the impact of structural changes on monetary indicators, it is important for domestic as well as international reasons to reaffirm the authorities’ commitment to price stability.

Rapid privatization plays a key role in the reconstruction of the east German economy, but efforts in this area have been stymied by numerous obstacles. Although progress has been made in resolving some of the problems relating to property rights of previous owners and old company debt, potential buyers are still required to provide investment plans and, in many cases, employment guarantees. This could become an increasingly important constraint on privatization. The trust fund charged with control of east German state property has also been reluctant to liquidate nonviable enterprises, which may help protect employment in the short term but which slows down the process of reconstruction and adds to its cost.

Large transfers to east Germany will be unavoidable in the next few years but these transfers should be targeted toward new investment in physical and human capital, including subsidies for training but not wage subsidies. The special incentives that have been introduced to stimulate investment in east Germany—including investment premia, accelerated depreciation allowances, interest subsidies, and credit guarantees—can help offset exaggerated risk perceptions on the part of private investors. However, these measures should be phased out, as intended, according to a prespecified timetable. Stimulating private investment also requires a substantial upgrading of public infrastructure. After a slow start, large amounts have been made available for this purpose, planning procedures have been shortened, and efforts are being made to alleviate administrative bottlenecks in east Germany. This should contribute to a marked improvement in the environment for private investment and create new employment opportunities.

Given the low level of productivity in east Germany, estimated at less than one third the level in west Germany, recent wage developments are a cause for serious concern. Following large wage increases in 1990, settlements in 1991 pushed wages in east Germany to 60-65 percent of west German levels, and some medium-term settlements imply increases to 80 percent of parity by 1994. Wage increases of this magnitude will increase the number of nonviable enterprises and could have serious adverse effects on employment in the medium term, even with optimistic investment projections. In view of these dangers, measures to moderate wage increases should be urgently considered, including changes in labor market regulations that would give the unemployed and those threatened with unemployment more influence on wages, for example, by allowing renegotiation of wages at the enterprise level when a firm is facing liquidation.

The budgetary costs of unification are proving much higher than initially envisaged by the authorities. Notwithstanding the two fiscal packages announced in early 1991—estimated to yield budgetary savings equivalent to 2 percent of GNP—the deficit of the territorial authorities is projected to rise from 1¼ percent of GNP in 1989 (in west Germany) to 5½ percent in 1991 (in all of Germany). Further fiscal measures are planned, including cuts in subsidies beginning in 1992, and an increase in the basic value-added tax (VAT) rate beginning in 1993.

Assuming that the planned fiscal measures will be fully implemented—and assuming strict expenditure control at die federal, state, and local levels—Fund staff projections envisage that the deficit of the territorial authorities could come down to 3½ percent of GNP by 1994, which is somewhat above the authorities’ target of less than 3 percent. The projections do not, however, allow for potential new claims on public finances such as those related to the operations of the trust fund, the old government and housing debt of the former German Democratic Republic, and the equalization claims issued to banks. Also, many of the subsidies to support investment in east Germany are potentially an open-ended drain on the budget. A comprehensive assessment of the likely costs of reconstruction in east Germany and a clear statement of fiscal policy for the next few years would help reassure both the German public and international capital markets.

The proposed subsidy cuts in west Germany are particularly welcome as they would not only reduce the fiscal deficit but also enhance economic efficiency. Despite some progress in recent years in alleviating rigidities and distortions, however, many problems remain in the labor market, in agriculture, and in various industrial and service sectors; the need to deal with them has become even more urgent in the face of the challenges posed by unification.

In recent years, economic policies in France have followed a medium-term strategy of progressive fiscal consolidation, moderation of wage claims, and monetary restraint, complemented by structural reforms aimed at strengthening the economy’s efficiency and competitiveness. These policies have contributed to a decline in the rate of inflation to one of the lowest among the seven major industrial countries, to substantial improvements in competitiveness, and to strong growth of output and employment in 1988-89. This strategy should be continued as intended, particularly as the slowdown of economic activity that began in the last quarter of 1990, and the associated rise in unemployment, are expected to be temporary.

With a view to maintaining credibility and achieving further progress on fiscal consolidation, the Government has taken appropriate steps to minimize deviations from its fiscal deficit target in the face of a large cyclically induced shortfall in revenues. In the monetary area, policy should continue to focus on lowering inflation. Increased confidence in the franc has permitted a gradual narrowing of the interest differential vis-à-vis the deutsche mark during the past year. While the continuation of the Government’s medium-term strategy will not necessarily shorten the duration of the slowdown, it will help ensure that the subsequent recovery will be broadly based and prolonged.

In addition to continuing the general course of financial policies pursued in recent years, the authorities will need to take initiatives in a number of areas to create an environment conducive to sustained growth in the medium term. In the fiscal area, the tax burden continues to be high and fiscal consolidation will need to emphasize expenditure restraint much more than in the past, particularly in the social security system and at the local government level. There is also a case for reducing distortions in the system of direct taxation arising from widely divergent rates and numerous exemptions. A lower burden of direct taxes (including social security contributions) would help narrow the large wedge between the cost and the return to labor, thus enhancing incentives and contributing to a better functioning of the labor market.

The persistence of a high level of unemployment in France suggests the need for measures to reduce distortions that hinder employment prospects—particularly for the young and those with inadequate skills—including especially the minimum wage and high social security charges, which raise costs for the employer. To improve skills, training schemes should be streamlined, broadened, and linked less rigidly to individual hiring decisions. Growth and employment would also benefit from structural reforms that foster domestic and international competition in product markets.

In Italy, growth is projected to recover slowly in the second half of 1991 and in 1992—after a sharp deceleration last year—and price increases are expected to moderate. Wage pressures, however, have remained strong and inflation is projected to be significantly higher than in the partner countries of the ERM. Considerable progress in reducing inflation differentials will be needed to sustain the current exchange rate policy and avoid a further erosion of competitiveness. This will require monetary restraint, strong fiscal adjustment, and efforts to bring wage increases under control, particularly in the public sector. Eventually, failure to reduce inflation would erode the credibility of the lira’s adherence to the narrow band of the ERM, and interest rates might have to rise sharply to resist market pressure. With public debt exceeding GDP, this would add to the already large debt-service burden and would thus have serious implications for fiscal policy.

Notwithstanding some progress on fiscal consolidation in recent years, the large fiscal deficit remains the most pressing macroeconomic problem in Italy. The borrowing requirement of the central government is expected to fall from 10¾ percent of GDP in 1990 to 10 percent of GDP in 1991. In view of a large cyclically induced revenue shortfall, which threatened to raise the borrowing requirement by more than 1 percent of GDP, the Government approved in May a supplementary fiscal package yielding budgetary savings equivalent to 1 percent of GDP, equally divided between revenue increases and expenditure cuts. At the same time, the Government presented a medium-term fiscal plan for 1992-94 that envisages a reduction of the central government deficit to 5¾ percent of GDP by 1994, and a decline in the public-debt-to-GDP ratio starting in 1993. Achievement of these targets would be an important step in the right direction but is likely to involve a fiscal adjustment that is considerably larger than assumed in the official plan, which is based on highly optimistic growth projections. More important, the plan does not provide for the instruments necessary to meet the targets. While many of the fiscal measures introduced in the past were only temporary, comprehensive initiatives to improve the structure of public sector finances—particularly in the areas of pension and health expenditure, public employment, and privatization of public sector enterprises—will be required to meet the Government’s medium-term fiscal targets.

In the United Kingdom, the fall in GDP during the year ended mid-1991 was accompanied by a lessening of price and wage pressures that has allowed the authorities to reduce the base rate from 15 percent in October 1990 to 10½ percent at present. The 12-month rate of increase in the retail price index (headline inflation) dropped from almost 11 percent in October 1990 to 4¾ percent in August 1991. The decline in the underlying rate of retail price inflation (which excludes the effects of changes in mortgage rates) was less pronounced over this period—from 9½ percent to 6¾ percent. Moreover, the downward adjustment in wage settlements has not been sufficiently rapid to prevent a substantial rise in unemployment.

An important goal of policy is to achieve a rapid convergence of the U.K. inflation rate with that of the low-inflation countries of the ERM. To that end, financial policies will need to remain restrained in the period ahead. The authorities have indicated that progress made in reducing inflation would facilitate the transition of the United Kingdom to the narrow exchange rate band of the ERM.

The authorities’ medium-term fiscal objective remains that of attaining broad budget balance on a cyclically adjusted basis. After several years of debt repayment, the budget presented in March 1991 envisaged a borrowing requirement for FY 1991/92 equivalent to 1¼ percent of GDP. The change in the fiscal position was more than accounted for by the downturn of economic activity. The budget projects a further increase in the deficit in FY 1992/93. but the public sector borrowing requirement would be reduced as the economy recovers and would be eliminated by FY 1994/95.

After contracting for almost one year, output in Canada resumed growth in the second quarter of 1991, Inflation began to fall in early 1990 as the economy moved into recession; after a temporary rise in the first half of 1991—owing to the introduction of the goods and services tax—consumer price increases are projected to resume their decline in the second half of the year. In the absence of stronger fiscal adjustment, monetary policy had to assume the main responsibility for coping with inflation, while the fiscal position became increasingly vulnerable to high interest rates. Partly as a result of this unbalanced policy mix, inflation expectations appear to have remained stubborn so far and wage pressure has shown few signs of abating, despite a sharp rise in unemployment.

Notwithstanding significant reductions in the fiscal deficit, public debt continued to rise in relation to GDP during the second half of the 1980s, reaching 55 percent of GDP in FY 1990/91. In view of these developments, the federal budget presented in February 1991 included measures expected to yield budgetary savings of almost 1 percent of GDP when fully phased in during FY 1992/93. The measures are expected to offset partly the effects of automatic stabilizers and prevent a deterioration of the federal deficit in FY 1991/92, although the deficit at the general government level would widen markedly as a result of higher deficits at the provincial level. Over the medium term, the Government expects the federal deficit to decline to less than 1 percent of GDP by FY 1994/95. While the budget of February 1991 is likely to have a dampening effect on demand in the short term, it should have positive effects on credibility and expectations and alleviate the burden on monetary policy, thus enhancing the prospects for a permanent reduction of inflation and sustained growth over the medium term.

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