Chapter

Chapter III Policy Issues in Industrial Countries

Author(s):
International Monetary Fund. Research Dept.
Published Date:
January 1990
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The recent slowdown of aggregate demand in the industrial world has reflected in part the widespread tightening of monetary conditions since mid-1988 that was required to alleviate excess demand pressures and avoid a dangerous acceleration of inflation. The slowdown has been most pronounced in countries such as Canada, the United Kingdom, and the United States, where capacity constraints had appeared at a relatively early stage and inflation had reached comparatively high levels. On the basis of present policies, the staff’s projections envisage that the economic expansion in the industrial countries will continue over the next several years, approximately at its pace in 1990–91, and that inflation will tend to moderate. While a more pronounced slowdown cannot be ruled out, the balance of risks would seem to remain generally on the side of higher inflation.

Against this background, monetary policy will need to remain generally cautious and, in some countries, sufficiently tight to guard against the risk of a further acceleration of prices. On the basis of current fiscal policies, continued monetary restraint will mean the persistence of relatively high real interest rates, with unfavorable consequences for capital formation and for the debt burden of the developing countries. It is clear, however, that a lasting decline in interest rates cannot be sought by easing monetary policy and risking a flareup of price pressures that will have to be confronted at a later stage, and ultimately would call for even tighter monetary conditions. Instead, lower real interest rates will require that monetary policy be strongly supported by fiscal action aimed at raising national saving, particularly in those countries where budget deficits remain high, including Canada, Italy, Spain, and the United States. Decisive steps to improve the fiscal position in countries that are presently running large current account deficits, notably the United States, also would be the most effective way to reduce external imbalances among the major industrial countries.

The October 1989 issue of the World Economic Outlook identified three major objectives for a long-term strategy aimed at maximum sustainable growth—objectives which the industrial countries have pursued with varying degrees of success for the past decade: (i) to promote an environment of confidence and stability, particularly as regards the general level of prices; (ii) to ensure adequate rates of national saving and capital formation; and (iii) to remove the distortions that reduce the efficiency of resource use, and particularly those that affect international trade. These objectives remain valid. The following sections focus on the progress made so far and on what remains to be done to achieve these goals.

Price Stability as an Objective of Monetary Policy

From 1980 to 1988, consumer price inflation in the industrial countries was brought down from about 12 percent to about 3 percent. Progress was broadly based, but a few countries succeeded in reducing inflation to very low levels. For example, in the period 1986–88 the annual rate of increase in consumer prices averaged less than 1 percent in Japan, Germany, and the Netherlands. It is not a coincidence that the reduction of inflation in the industrial countries has been accompanied by an exceptionally long expansion of output and employment. It is also noteworthy that the countries with a recent history of very low inflation have succeeded in controlling wage/price pressures over the past year while maintaining comparatively strong growth of output. Against this background, the monetary authorities of many industrial countries have repeatedly emphasized the importance of price stability as a key goal of monetary policy. This section examines the basic proposition underlying these views—and also those expressed in previous reports on the World Economic Outlook: that the elimination of inflation would bring about a large and lasting improvement in economic performance.20

Even when it is steady and fully anticipated, inflation can have serious adverse effects on economic efficiency. First, by blurring the distinction between changes in relative prices and changes in the general price level, it can seriously hinder the ability of market participants to allocate resources efficiently. Second, because most goods and services are advertised and offered for sale at specified prices, inflation will involve “menu costs,”. The higher the rate of inflation, the more frequent the need—and the higher the cost—of changing the lists, catalogues, and advertisements in which the prices of specific goods and services are quoted. Third, because the timing of individual price adjustments is likely to vary among firms, higher rates of inflation are likely to be associated with increasingly large deviations from an optimal price structure in which relative prices are determined only by fundamental factors such as technology and tastes. Fourth, a rise in inflation will increase transactions costs by reducing real money holdings. Several estimates suggest that these “shoe leather” costs of inflation are small (in the order of 0.1 percent of GNP for a rate of inflation of around 4–5 percent), but this may well be an understatement because these estimates are based on an excessively narrow definition of transaction balances.21

The adverse effects of inflation will be exacerbated by the existence of tax systems, government transfer programs, and private contracts (including mortgages and installment loans) that are not fully indexed to inflation.22 In particular, the interaction between inflation and a non-indexed corporate tax system can distort relative rates of effective taxation among different types of assets, and therefore reduce efficiency. For example, under the historical costs accounting system prevailing in many countries, the value of sales for tax purposes is measured by the nominal costs of inventories at the time the goods were produced. Inflation thus understates the replacement cost of goods and therefore raises the relative cost of investing in inventories. Historical cost accounting also understates the real cost of depreciation by an amount that rises with inflation, thus increasing the relative cost of investment in assets with comparatively long useful lives, such as industrial plant and heavy machinery. At the same time, because nominal interest payments are often tax deductible, inflation will encourage firms to rely on debt rather than equity financing, thus increasing the economy’s vulnerability to cyclical fluctuations.

If, in addition, there is uncertainty about the rate of inflation itself, individuals and firms (including financial institutions) will be at greater risk of capital gains and losses through imperfectly indexed contracts. By redistributing income and wealth arbitrarily between creditors and debtors and between homeowners and renters, unanticipated inflation will increase the risk of social and economic disruptions. Furthermore, uncertainty about future inflation—which may, in turn, give rise to uncertainty about economic policies and developments more broadly—will raise the cost of capital and therefore discourage capital formation, as the added risk will need to be compensated by higher real interest rates. Saving will be diverted away from fixed investment toward real estate and other inflation hedges and valuable resources will be drawn into wasteful attempts to benefit from inflation by inventing and implementing financial techniques and corporate strategies.

The various elements of the cost of inflation are exceedingly difficult to measure, and the existing quantitative estimate must therefore be interpreted with considerable caution. However, the problems encountered by countries with high inflation and some empirical estimates suggest that these costs are substantial and are likely to exceed the transitory costs of bringing down inflation by a substantial margin.23 It is also important to note that achievement of price stability could reduce the probability of sharp cyclical downturns. With inflation fluctuating randomly around a mean value of zero, the probability that adverse shocks would push up inflation into the range where a sharp reaction of the monetary authorities would become necessary would be considerably lower than if inflation were to fluctuate around the levels of 4 to 8 percent currently prevailing in several industrial countries.

The simulation results presented in Chapter II suggest that the transitory costs of achieving price stability can be reduced substantially through the gradual implementation of a pre-announced and credible program of cuts in monetary growth. They also suggest that structural measures to enhance wage flexibility could go a long way to lower further, or even to eliminate, the losses incurred in bringing down inflation. But as long as some degree of wage/ price stickiness remains, credibility is likely to be the key to achieving price stability while minimizing output and employment losses. This will require, above all, consistent adherence to the objective of price stability by the monetary authorities. But it will also require adequate action on the fiscal front where appropriate and, in all cases, continued and unqualified government support for the policies of the central bank.

Fiscal Consolidation: Medium-Term Trends and Prospects

From 1970 to 1983 the national saving rate of the industrial countries fell from almost 25 percent of the group’s combined GNP to 20 percent of GNP (Chart 23). This fall, which was accompanied by a sizable decline in the ratio of investment to GNP, reflected in large measure a rise in the absorption of saving by the public sector. The general government’s financial balance for the industrial countries taken as a group moved from a small surplus in 1970 to a deficit of 2¼ percent of GNP in 1979. The combined deficit continued to rise during the global recession in the early 1980s, and in 1983 it had reached 4¼ percent of GNP. Since then, however, the deficit has been substantially reduced to an estimated 1¼ percent of GNP in 1989. This has been reflected in some pick-up in national saving and investment rates, although both rates remain well below their levels in the early 1970s. The tendency for government debt/ GNP ratios to rise has generally slowed, and even arrested in some cases, but in most countries these ratios are now much higher than in the late 1970s.

In a number of countries (including Australia, Denmark, Japan, Sweden, and the United Kingdom) the fiscal position of the general government has moved from sizable deficits in 1983 to surpluses in 1989. Moreover, fiscal deficits have been lowered in Belgium, Canada, France, Ireland, the Netherlands, Spain, and the United States, although they remain high in most of these countries. In Greece and Italy, however, deficits have failed to come down significantly and remain above 10 percent of GDP. The staff’s projections envisage a further improvement in the general government financial balance (including social security) of most major industrial countries in the period ahead (Table 8).

Chart 23.Industrial Countries: Saving and Investment

(In percent of GNP)

Source: Organization for Economic Cooperation and Development, national accounts.

The interpretation of the fiscal position in certain major industrial countries is significantly influenced by the treatment of social security funds. The effect of excluding social security surpluses is to raise the U.S. deficit in relation to GNP by 2¾ percentage points in 1989, and to turn Japan’s surplus into an estimated deficit of ¾ of one percent of GNP. (See bottom panel of Table 8.) In contrast, the exclusion of social security deficits raises the surplus of the United Kingdom and reduces Italy’s deficit. The differences between the two panels of Table 8 do not imply that it is more appropriate to use a concept of fiscal balance excluding social security. It does, however, underscore the need to focus on the extent to which the fiscal balance of a particular country may be influenced by including social security surpluses that are associated with future government liabilities and therefore cannot be counted on indefinitely to finance deficits in other parts of the budget. These considerations are particularly relevant given the prospect that the aging of population in the many industrial countries—and particularly in Japan—would lead to a sharp increase in the demand for public services, notably in the social security area.24

Table 8.Major Industrial Countries: General Government Financial Balances Including and Excluding Social Security, 1980–911(Percent of GNP/GDP)
Staff Projections
19801985198619871988198919901991
Including Social Security
Canada−2.8−6.8−5.5−4.4−2.6−3.4−3.4−2.6
United States−1.3−3.3−3.4−2.4−2.0−2.0−1.3−1.1
Japan−4.4−0.8−0.90.72.12.83.23.6
France−0.2−2.7−2.6−1.6−1.6−1.4−1.3−1.2
Germany, Fed. Rep. of−2.9−1.1−1.3−1.8−2.10.2−0.3−0.1
Italy−7.0−12.5−11.6−11.2−10.5−10.3−10.1−9.7
United Kingdom2−3.4−2.7−2.4−1.50.80.80.20.1
Excluding Social Security
Canada−3.7−7.5−6.2−4.8−3.0−3.7−3.6−2.7
United States−1.8−4.8−5.2−4.4−4.6−4.7−4.2−3.9
Japan3−7.1−3.9−4.1−2.4−1.6−0.7−0.3
France−0.8−3.2−2.4−2.1−1.5−1.4−1.3−1.3
Germany, Fed. Rep. of−3.2−1.4−1.8−2.2−2.2−0.5−1.0−0.4
Italy−3.5−7.9−7.4−6.8−6.2−6.1−6.0−5.7
United Kingdom21.21.62.43.93.43.42.9

Structural Policies

The importance of structural policies as part of a strategy for long-term growth is now broadly recognized. A number of industrial countries have taken important steps toward improving efficiency in recent years, including major tax and financial reforms, privatization, and measures to enhance the flexibility of labor markets. It is now essential to consolidate the progress made in these areas and to extend structural reform to sectors where relatively little progress has been made.

The most important measures that should now be considered are to cut industrial and farm subsidies and to reduce the restrictions that distort agricultural production and trade; to reform land regulations and those aspects of the distribution system that add to domestic costs and restrict market access; to further reduce distortions and rigidities in labor markets, including barriers to the intersectoral and interregional mobility of labor; and to modify certain features of existing tax systems, including certain tax preferences that affect the level and distort the allocation of private saving or unduly reduce government revenue. Forceful action in these areas would help to raise productive capacity, lower unemployment, and reduce price pressures. It would also enhance the flexibility of markets in reacting to changes in relative prices (including real exchange rates) and therefore would facilitate the process of external adjustment. It should be recognized, however, that the direct impact of structural reforms on the external current account cannot always be unambiguously determined, and that the basic justification for structural policies is to enhance economic efficiency and welfare.

Multilateral trade negotiations under the Uruguay Round have entered their final and crucial year, and while some progress has been made, many substantive issues remain to be resolved. The first country reviews were initiated under the newly established Trade Policy Review Mechanism to strengthen General Agreement on Tariff and Trade (GATT) surveillance over trade policies. Liberalization of trade in tropical products has also begun, and the GATT’s dispute settlement procedures have been streamlined. Discussions continue on ways to enhance access under more predictable and strengthened trade rules.

The most difficult area in the negotiations is agriculture, where considerable differences remain, notably between the United States and the European Community, on the extent and nature of prospective reforms, and where Japan and some other countries continue to emphasize food security issues. Also, it has not been possible so far to agree on methods to negotiate the liberalization of trade in textiles and clothing, and to agree on rules for temporary nondiscriminatory safeguards against fairly traded imports. In addition, it remains to be seen whether the negotiations will result in a significant reduction of tariff peaks and escalation. All these areas are, of course, of great interest to the developing countries. Other difficult areas include new disciplines on intellectual property rights and trade-related investment measures (with a number of developing countries having major reservations) and trade in services, although in the latter area negotiations have proceeded somewhat faster than originally expected.

Thus much remains to be done, and the coming months will prove crucial in determining whether governments are willing to make the compromises needed to conclude the Uruguay Round successfully by the end of 1990. A successful conclusion is essential to reverse the drift toward protectionism and the use of bilateral and unilateral solutions to trade difficulties which seriously endangers the system of free and multilateral trade that has served the world economy so well. An improvement in market access for developing countries would also greatly facilitate their efforts to achieve higher, sustainable growth through more market-oriented policies and to adjust their balance of payments and debt situations.

Current Account Imbalances in the Largest Industrial Countries

The emergence of large external imbalances in most of the major industrial countries has been one of the most remarkable macroeconomic developments of the 1980s, and it has raised a number of questions that remain to be fully resolved. As recently as 1981, the external current account positions of the three largest industrial countries were in approximate balance (Table 9). In relation to GNP, the deficit of the United States had reached more than 3 percent of GNP by 1986, and the surpluses of Germany and Japan had risen to almost 4½ percent. Since then the imbalances of Japan and the United States have narrowed significantly, but Germany’s surplus has remained unchanged.

Table 9.Major Industrial Countries: Sectoral Financial Balances, 1981–891(In percent of GNP)
Changes
1981198619891981–861986–89
United States
Current account balance0.3−3.1−2.0−3.41.1
Fiscal balance2−1.0−3.4−2.0−2.41.4
Private sector: saving
minus investment31.10.20.8−0.90.6
Japan
Current account balance0.44.32.03.9−2.3
Fiscal balance2−3.8−0.92.82.93.7
Private sector: saving
minus investment34.45.3−0.50.9−5.8
Germany
Current account balance− 0.54.44.94.9
Fiscal balance2−3.7−1.30.22.41.5
Private sector: saving
minus investment33.15.74.22.6−1.5

Some of the explanations that have been offered to account for these developments have relied on models of current account transactions and have focused on the role of real exchange rates and relative levels of aggregate demand. The sharp real appreciation of the U.S. dollar from 1980 to early 1985, coupled with higher growth in the United States than among its trading partners in the early stages of the current expansion, resulted in a sharp deterioration of the U.S. trade position. The effects of this deterioration were aggravated over time by a weakening of the U.S. net investment income balance, reflecting the decline in the net external asset position of the United States. Broadly speaking, the same explanations can be used, reversing all signs, to account for the widening surpluses of Germany and Japan. The narrowing of the U.S. and Japanese imbalances from 1986 to 1989 can be explained in part by the effects of the real depreciation of the U.S. dollar in 1985–86 and the associated real appreciation of the yen. Indeed, these exchange rate effects probably have been more powerful than what is suggested by the narrowing of external imbalances in the past few years. A number of model simulations indicate that these imbalances would have continued to widen sharply had real exchange rates remained at their levels in early 1985.

These explanations are useful, but they are limited to the proximate determinants of the current account, such as incomes and relative prices. They do not deal directly with the impact of key policy variables on the external position. A second, and complementary, group of explanations looks at external imbalances as representing differences between national saving and domestic investment. Within that group, one view emphasizes the role of the fiscal position. The current account can be expressed as the sum of the financial surplus of the general government and the excess of private saving over investment. Therefore, if there is no systematic tendency for private saving to offset movements in public sector saving, a rise in the fiscal deficit should be reflected in a rise in the external deficit, or, depending on the degree of capital mobility, in the crowding out of domestic investment. An example of this type of explanation is the “twin deficits” hypothesis, which maintains that fiscal deficits give rise to external deficits, with the transmission mechanism working through upward pressure on the real interest rate and a consequent real exchange rate appreciation.

As shown in Table 9, in the period 1981–86, the U.S. current account deficit rose in relation to GNP by 3½ percentage points while the deficit of the general government worsened by about 2½ percentage points. During the same period, Japan’s external surplus widened by 4 percentage points while the fiscal position improved by nearly 3 percentage points. And in Germany the external surplus surged by almost 5 percentage points in relation to GNP while the fiscal deficit narrowed by approximately 2½ percentage points. While these changes are broadly consistent with the hypothesis of a link between fiscal and current account imbalances, they also suggest that other factors were at play. The widening of the external imbalances from 1981 to 1986 also reflected significant changes in the difference between private saving and investment—specifically a decline in the United States and a rise in Japan and, even more so, in Germany. For the period 1986–89, the data still suggest a relation between fiscal and current-account imbalances for the United States, but not for Germany or Japan.25

A third school of thought also focuses on differences between saving and investment but emphasizes the behavior of the private sector. In its most extreme form, it argues that current account imbalances reflect the implications of differences in the balance between private saving and investment among countries, resulting, for example, from different tax systems, different demographic and technological trends, or other factors that affect international comparisons of risk-adjusted rates of return. According to this view, the widening of external imbalances during the 1980s represents a process of convergence to a new equilibrium in which these factors have begun to play a more prominent role owing to the widespread liberalization of financial markets in many countries. These arguments have been used in a variety of ways to explain the external deficits of countries like Spain and the United Kingdom and the large surplus of Germany.

A particular version of this argument also has been used to explain the emergence of U.S. current account deficits during the first half of the 1980s. According to the “safe haven” hypothesis, tax and regulatory measures to improve the rate of return on investment in the United States, together with economic and political uncertainties in some parts of the world (including the developing countries), resulted in a large inflow of foreign private capital into the United States. The real appreciation of the dollar in the first half of this decade and the rise in the U.S. current account deficit were, according to this view, mostly the by-products of these autonomous capital inflows, and not the result of fiscal deficits. One difficulty with this hypothesis is that the drop in the U.S. private saving/investment balance in the period 1981–86 reflected predominantly a decline in the private saving rate, rather than a rise in the share of investment in GNP.

The various approaches to the explanation of current account imbalances are not mutually exclusive, but rather complementary. In particular, the “fiscal/current account nexus” hypothesis appears to explain some of the facts, particularly for the three largest industrial countries, but not all the facts; the “private saving/investment” hypothesis provides an appealing and complementary source of explanation, although it has yet to be subject to rigorous empirical tests. What is clear is that world financial markets are now more closely integrated than in previous decades, as indicated by the weakening in the 1980s of the previously close cross-country correlations between saving and investment among industrial countries. The higher degree of financial integration means that persistent domestic imbalances in both the public and the private sector are more likely to be reflected in capital movements among countries and therefore in persistent external imbalances.

These considerations suggest that the interpretation of current account imbalances is a complex matter that requires an assessment of the underlying factors affecting saving (both public and private) and investment. The question whether the prospects for persistent external imbalances over the medium term should be viewed with concern thus cannot be answered simply by reference to the size of the imbalance, but requires an examination of the underlying stance of policies. Inasmuch as the imbalances reflect an inadequate budgetary position, there is a clear implication for fiscal policy. If they reflect microeconomic distortions that affect private decisions to save and invest, then these distortions should be removed. If the concern is that large and prolonged external deficits could, no matter how unjustifiably, encourage attempts to rely on restrictive trade policies, then the first best would be to resist those attempts, rather than allow trade and macroeconomic policies to be unduly influenced by protectionist pressures. Finally, the high demand for world saving that is likely to result from the reconstruction of Eastern Europe, the prospective unification of Germany, and the continued needs of the developing countries strongly reinforces the proposition that any reduction in existing current account imbalance should emphasize policies to increase national saving in the deficit countries, and not to lower saving in the surplus countries.

Issues and Prospects in the European Community

Economic activity in the European Community (EC) has been quite strong in the past two years, and growth is expected to moderate only slightly in 1990–91. While the United Kingdom is experiencing a relatively pronounced weakening of growth, the expansion has been well sustained in continental Europe, owing partly to the strength of business investment. The favorable investment climate reflects a number of factors, including the planned completion of a single European market by 1992 and expectations of increased trade opportunities arising from an early liberalization of the Eastern European economies.

The strong economic performance of the Community in recent years has been reflected in substantial job creation, and the overall rate of unemployment has begun to decline although it remains significantly higher than in North America and Japan. However, the rapid expansion of demand also has been accompanied by a rise in inflation. This rise has been most pronounced in some of the countries where the level of inflation already was relatively high, posing the risk of a reversal of the process of “nominal convergence” that is both a key objective of the European Monetary System and a condition for its smooth functioning. Also, there has been a significant widening of external imbalances within the EC in recent years: whereas the Community’s overall current account position moved from a surplus of 1½ percent of GDP in 1986 to approximate balance in 1989, the gap between the country with the largest surplus (Germany) and those with the largest deficits (the United Kingdom and Spain) has continued to widen. The growing disparity in current account positions has become a matter of some concern because of the perception that it might give rise to adverse reactions in financial markets. However, a significant transfer of resources among members of an integrated economic union is hardly surprising and, indeed, may be desirable in order to achieve the goal of “real convergence.”26 Indeed, this process may intensify in the coming years as economic integration continues, all restrictions on capital movements are removed and a single financial area is established. But this would not necessarily lead to higher external imbalances. Indeed, Germany’s surplus could be substantially reduced if economic integration between the German Democratic Republic and the Federal Republic of Germany were to be achieved and resulted in a large rise in the demand for capital in a unified Germany.

At the Madrid Summit in June 1989, the European Council decided that the first stage in the realization of the Economic and Monetary Union would begin on July 1, 1990, as had been proposed earlier in the year by the Delors Committee.27 This stage of the process will include the following principal elements: (i) the internal market program will be completed by 1992;28 (ii) procedures for multilateral surveillance of economic developments and policies will be established on the basis of agreed indicators, with the objective of strengthening the coordination and consistency of economic policies among member states; and, (iii) all EC currencies (including sterling, the drachma, and the escudo) will become participants in the European Monetary System (EMS) exchange rate mechanism. It is envisaged that the first stage would be implemented under the existing institutional framework. However, at the Strasbourg Summit in December 1989 it was decided to convene an intergovernmental conference by the end of 1990 to consider treaty and institutional changes which would be required to implement subsequent stages of the process toward the Economic and Monetary Union. Such changes might include the creation of a European System of Central Banks (second stage), a move to irrevocably locked exchange rates, and eventually the transition to a single Community currency (third stage).

The impact of these far-reaching proposals is difficult to assess. It has been estimated that the single market program alone could raise the level of output in the Community by 4 to 5 percent; but the margin of uncertainty is quite large.29 The implications of full economic and monetary union are even more difficult to evaluate, as it would constitute a major systemic change and would likely be accompanied by substantial modifications in policymaking and in the way policy changes are transmitted through the economy. If closer fiscal policy coordination could be achieved, the coordination of monetary policy—which is already taking place through the constraints imposed by the European Monetary System—would be greatly facilitated. Insofar as the Economic and Monetary Union would contribute to inflation control, promote financial market stability, and increase competition and efficiency, its benefits could be substantial.

The Community’s promising economic outlook for the 1990s is based not only on the prospects for integration within the EC, but also on the process of economic and political liberalization in Eastern Europe and the growing interest among non-EC countries in Western Europe to strengthen trade and financial ties with the Community. EC institutions already play a major role in channelling financial and technical assistance to several Eastern European countries, and the EC Commission has expressed its willingness to expand the scope of its trade agreements with those countries, as it already has with the European Free Trade Area. While it is difficult to predict the nature and extent of the future economic linkages between the Community and the rest of Europe, intra-European trade and cross-border portfolio and direct investment flows probably will expand considerably in the 1990s, providing economic stimulus to the entire region.

Europe’s relations with other regions are also likely to be affected by the structural changes that could result from the Economic and Monetary Union. In this context, it is essential for the Community to ensure that the fears about the possible emergence of an inward-looking Europe prove unfounded, notably with regard to replacement of national barriers with Community-wide restraints and the application of reciprocity, local content, and rules of origin principles. The Community has an important responsibility, together with other major trading nations, to contribute to a successful conclusion of the Uruguay Round of trade negotiations, including a reduction of farm subsidies, a liberalization of world trade in agricultural products, and improvement in market access for developing countries.

Policy Issues in Individual Countries

After several years of moderate growth, economic activity in Germany strengthened markedly in 1988–89—a performance which reflected the successful implementation of the medium-term strategy of fiscal consolidation and the pursuit of an anti-inflationary monetary policy. However, as economic activity accelerated, prices rose somewhat more rapidly in 1989 and interest rates increased sharply during 1989 and early 1990. At the same time, the current account surplus rose to 4½ percent of GNP.

In the near term, the growth of output is expected to remain strong and the appreciation of the deutsche mark since mid-1989 should help to contain inflation. However, monetary policy should continue to be restrained, as the economy is close to full capacity and there is an increased danger of wage-price pressures. The current budget stance implies a net fiscal stimulus for 1990 stemming from the reduction in revenue associated with the next stage of tax reform. Furthermore, the outlook could be significantly affected by the impact on the economy of the Federal Republic of Germany of the influx of workers from the German Democratic Republic and, more fundamentally, by the possible ramifications of the prospective unification of Germany. These developments (which are not taken into account in the staff’s projections) could well lead to a substantial rise in aggregate demand in Germany. Of course, this could well be accompanied by an increase in potential GNP which would need to be taken into account in setting the course of monetary policy. With regard to fiscal policy, the evolving situation in the German Democratic Republic suggests that a rise in government expenditures over planned levels may be difficult to avoid. In this case, attention should clearly focus on some offsetting reductions in expenditure and subsidies.

Following several years of moderate growth, economic activity in France rebounded in 1988 and 1989. Faster growth was accompanied by a slight firming in wage and price inflation, albeit from low levels, and by a further deterioration of the trade balance. However, the current account deficit remained small in relation to GNP owing to an upturn in the services balance. An improvement in performance was also indicated by the strength of industrial investment and exports. These developments were accompanied by an effective appreciation of the French franc, which reflected the strategy pursued since 1983 which aimed at reducing inflation. The key components of this strategy include a fiscal policy aimed at achieving continued reductions in the budget deficit and in the tax burden and a policy of wage restraint, particularly in the public sector, notably in publicly owned enterprises. Wage moderation, together with relatively high productivity growth, has improved the competitive position of French producers in spite of the appreciation of the franc. These policies have been complemented by a number of structural adjustment policies, in particular the liberalization of prices, the foreign exchange market, and the financial sector. At this juncture of strong growth in demand and high rates of capacity utilization, the continuation of policies of monetary and fiscal restraint is required. Moreover, while the unemployment rate has declined somewhat, it remains quite high, suggesting that policies of wage moderation and of increasing labor market flexibility remain essential.

Economic growth in Italy has been close to the average of other European countries in the past few years. However, while inflation declined considerably during most of the 1980s, prices have continued to rise more rapidly in Italy than in most of its European trading partners. The strength of economic activity fostered some gains in employment in the past few years, but the unemployment rate has remained unchanged at about 12 percent. The external current account, which was in approximate balance in 1986–87, has shifted to a deficit of about 1 percent of GDP in 1989.

Notwithstanding continued buoyant economic conditions, the deficit of the general government has remained essentially unchanged at more than 10 percent of GDP and the rapidly growing public debt is now as large as GDP. The key issue facing the authorities is therefore to bring about a substantial reduction in the budget deficit. Progress in this area has become increasingly urgent in light of the first stage of the Economic and Monetary Union and of the decision at the beginning of this year to narrow the margin of fluctuation of the Italian lira in the exchange rate mechanism of the EMS. To ensure progress in achieving convergence of inflation and interest rates toward the European average, the official objective of achieving a primary surplus of ½ percent of GDP in the central government’s accounts by 1992 should be considered a minimum. In reducing the deficit, emphasis must be placed on cutting expenditure, improving the overall efficiency in tax collection, and lowering transfers to public enterprises and regions.

In contrast to the continued buoyancy of activity in the rest of the European Community, the United Kingdom has experienced a substantial economic slowdown. This followed a long period of sustained growth, supported by strong investment, that brought the unemployment rate to the lowest level of the decade in 1989, but culminated in a gradual rise in the underlying rate of inflation. The fiscal position improved markedly during the 1980s, but the private saving rate fell and the current account moved into a deficit of about 4 percent of GDP in 1989.

In the face of the unsustainable rapid growth in aggregate demand and the related intensification of wage/price pressures, since mid-1988 the authorities have progressively acted to tighten monetary conditions. As a result, short-term interest rates have risen sharply, and the growth of domestic demand has been restrained. In retrospect, however, economic activity consistently turned out to be more robust than expected following each stage of monetary tightening, and the success in containing inflation has been less than anticipated. Although the growth in demand is now slowing in response to the tight stance of policy, the question remains whether monetary policy is sufficiently tight to arrest, and then gradually reverse cost/price pressures, particularly in view of the tight conditions now prevailing in labor markets. Moreover, given the critical importance of reducing inflation, the budgetary surplus for the next fiscal year would seem to be appropriate. Restraining the growth of domestic demand and containing the rise in wages and prices is also required in order to make room for an expansion of net exports, and to enhance the international competitiveness of the U.K. economy without reliance on a nominal exchange rate depreciation that would exacerbate wage-price pressures.

During the past several years the economy of Japan has undergone a considerable transformation in an environment of rapid growth. Domestic demand has increased rapidly, with business investment showing particular strength, and the dependence of the manufacturing sector on external demand has been reduced as production has been shifted abroad, resulting in a substantial decline in the current account surplus. This transformation has taken place in an environment of low inflation. Concern about the price situation did arise last year as factor markets tightened, commodity prices rose, and the yen depreciated. Monetary policy was tightened in 1989, following a period in which the strength of the yen and favorable wage and productivity developments allowed the pursuit of a relatively accommodative stance, and underlying inflation (adjusted for the direct impact of the new consumption tax) has been kept under control. Finally, the Japanese authorities have successfully pursued the objective of fiscal consolidation. The financial balance of the general government has improved considerably, and the Government has achieved its goal of eliminating the issue of deficit-financed bonds in the FY 1990 budget.

The Japanese economy is in a strong position to address the challenges of the future: to maintain the momentum of growth with low inflation; to improve resource allocation and welfare; and to contribute to international growth and stability. Success in achieving these goals will require the continuation of cautious macroeconomic policies. In addition, the progress made in recent years in the structural area, particularly on financial and tax reform, must now be extended to other areas, including land management, and certain aspects of the distribution system that restrict market entry by both foreign and new domestic firms. The public sector also should continue to play an important role in improving Japan’s social infrastructure in those areas where the social rate of return cannot be fully captured by the market. Progress also has been made in the trade area, but imports of certain agricultural goods remain subject to quotas, and agricultural reform must be extended to cover domestic support policies. These measures would help to improve efficiency domestically and contribute to the strengthening of a free international trade system in which Japan has a major stake.

Japan’s current account has declined markedly over the past three years, but on the basis of current exchange rates, little further adjustment would seem to be forthcoming. Given the need to maintain price stability, and in view of the relatively high burden implied by Japan’s gross public debt and the prospective aging of the Japanese population, an expansionary shift in monetary and fiscal policies aimed at reducing the external surplus would not seem to be appropriate in the absence of strong adjustment measures in the deficit countries. Moreover, the possibility of a rise in world demand for saving associated with recent and prospective developments in Germany and Eastern Europe suggests that it might not be desirable for Japan to eliminate its external surplus over the next few years, especially through actions that would reduce national saving.

The unusually long economic expansion in the United States has now slowed considerably, and although wage and price pressures have not yet subsided, the rise in the underlying rate of inflation appears to have been contained. Moreover, in the past few years the United States has made progress in reducing its budgetary imbalance in relation to GNP, and there has been a significant narrowing of the current account deficit. Against this background, the prospects for moderate economic growth over the next two years appear to be favorable. For the longer run, however, the United States will have to tackle a number of problems that could undermine the prospects for sustainable growth, including in particular historically low levels of national saving, and a rate of inflation that remains too high both in absolute terms and relative to that achieved by other major countries. In view of the high costs of accepting the continuation of inflation at present rates, the case for moving toward price stability—the key objective of the Federal Reserve—appears to be compelling.

While proposals to increase private saving deserve serious consideration, it is clear that the objective of raising national saving must involve primarily a substantial improvement in the federal fiscal position. The Administration’s budget for FY 1991, presented earlier this year, contains proposals that would, on the basis of the Administration’s economic assumptions, eliminate the federal deficit by 1993 in line with the Gramm-Rudman-Hollings (GRH) targets. However, recent experience indicates that Congressional approval of the proposed budget cuts cannot be taken for granted. Without such cuts, and on the basis of the staff’s more conservative economic assumptions, substantial deficits would persist over the medium term. In these circumstances, decisive steps are now required to reduce federal spending, and if necessary to increase revenue, so as to achieve the targets mandated by the GRH legislation and balance the budget by 1993. It is possible that further reductions in defense expenditure—beyond those already achieved in the past several years and those proposed in the budget for FY 1991—might allow for deeper cuts in the deficit. However, as indicated in Chapter II, the scope for reducing such expenditures over the short- to medium-term should not be overestimated. Moreover, there is considerable pressure to increase non-defense spending in various areas—including education, infrastructure, drug enforcement, and environmental protection. The scope for increased spending in these areas—which are undoubtedly important to the welfare of the U.S. population—could expand over the longer run if continued reductions in world tensions were to give rise to further cuts in defense spending. For the next few years, however, the need to reduce the budget deficit—and therefore to make room for private investment—will require restraint on all categories of federal spending.

As was indicated earlier in this chapter, much of the decline in the U.S. budget deficit in recent years has reflected the growing surpluses of the social security trust funds and these surpluses are expected to rise substantially in the next several years. (See the discussion above concerning fiscal consolidation.) Whether or not they are included as part of the federal budget, these surpluses do represent a contribution to national saving. Thus, the cut in social security taxes that has been proposed recently in the Congress would, unless it were immediately offset by increases in other taxes or by reduced retirement benefits, exacerbate the shortage of saving. What must be recognized is that the social security surpluses are associated with future government liabilities of an even greater magnitude and should therefore be used to increase national wealth, not government consumption. The Administration’s latest budget proposed to set up a framework in which a rising proportion of the social security surplus would be devoted to reducing the federal debt. This proposal, which is tantamount to seeking a surplus on the unified budget equal to the social security surplus as a longer-term objective of fiscal policy, would seem to be entirely appropriate and, if implemented, would boost capital formation and the growth of potential output in the United States. It would also contribute to lower the U.S. current account deficit, thus reducing pressure on world interest rates at a time when the demand for world saving could be rising as a result of developments in Germany and Eastern Europe.

In recent years, there has been concern about the possibility that certain provisions of the Trade and Competitiveness Act of 1988 might be implemented in a protectionist way, or with undue emphasis on a unilateral/bilateral approach. There has also been concern about the continuation of voluntary export restraint agreements and other measures that restrict access to the U.S. market. While the trade measures maintained by the United States are, on the whole, less restrictive than those maintained in most other major countries, there is undoubtedly scope for liberalizing imports in certain areas, and also for removing the distortions introduced by existing farm programs. Such actions would be highly beneficial to the world economy, and would reaffirm the leadership role of the United States in the trade area.

Output and employment in Canada expanded strongly in 1987 and 1988 and, with the economy operating virtually at full employment, wage and price inflation increased last year. The current account deficit has widened substantially in the past year and a half, to about 3 percent of GDP, reflecting the strength of domestic demand and the real effective appreciation of the Canadian dollar over the last three years. Faced with increasing cost/price pressures, the Bank of Canada has been compelled to maintain a stringent monetary policy in order to dampen the expansion of aggregate demand. Continuation of the present monetary policy would seem appropriate until there are convincing signs that inflationary pressures are abating. Notwithstanding strong economic growth, progress has been slow in the last two years in reducing the federal deficit, which is estimated at about 4½ percent of GDP in FY 1989, and Canada’s high debt to GNP ratio has made the fiscal position quite vulnerable to increases in interest rates. The important fiscal measures proposed in the budget for FY 1990/91 would permit a resumption of progress in reducing the deficit/GDP ratio. The extent of such progress, however, will depend on the evolution of interest rates, and it cannot be ruled out that additional measures might be required, if fiscal policy is to play an adequate role in alleviating pressure on resource use and fostering conditions conducive to an expansion in investment and a reduction in Canada’s large current account deficit.

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

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