Chapter

II Industrial Countries

Author(s):
International Monetary Fund. Research Dept.
Published Date:
January 1992
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Economic activity continued to be sluggish in the latter part of 1991 and early 1992 in North America, the United Kingdom, and several smaller industrial countries that have been in recession. In addition, signs of a slowdown became apparent in a number of other industrial countries. As a result of persistent weakness, some countries have eased the thrust of policy with the aim of supporting activity. The significant decline in short-term interest rates in North America and Japan—made possible by the continued moderation of inflation—is expected to contribute to a strengthening of growth during 1992.

Only in a few cases have expansionary fiscal measures been adopted, a reflection of the priority attached to the medium-term objectives that have guided policy since the early 1980s, Indeed, several countries appear to have pursued a relatively tight fiscal stance in 1991, partly offsetting the automatic stabilizers. The limited room to ease the thrust of fiscal policy can be attributed to the large structural budget deficits that persist in a number of countries, and the considerable gaps between the fiscal imbalances and the authorities’ medium-term deficit targets. Recent slippages suggest that major efforts will be required over the next few years to bring fiscal consolidation back on track, particularly in the United States and Italy, but also in some of the smaller industrial countries. In Germany, where unification necessarily led to a major budgetary imbalance, consolidation is required in the coming years to reduce the deficit to a sustainable level.

Performance in 1991 and Prospects for Recovery

Economic growth in the industrial countries declined from 2½ percent in 1990 to ¾ of 1 percentage point in 1991. The slowdown reflected recessions in North America, the United Kingdom, and a number of smaller industrial countries, as well as slower growth in Japan and continental Europe, particularly in Germany (Chart 2). A modest rebound is expected during 1992, even though average growth may not exceed 1¾ percent for the year as a whole; this would be about 1 percentage point below the projection in the October 1991 World Economic Outlook.1

Chart 2.Industrial Countries: Growth of Real GDP1

(Percent change from four quarters earlier)

1GNP for west Germany and Japan. Shaded areas indicate staff projections.

2Annual observations, as quarterly data are not available for some countries.

A number of factors account for the weaker-than-expected performance in 1991 and the lackluster nature of the projected recovery: adjustments in private sector financial positions (discussed more fully in Annex I) and a renewed worsening of consumer confidence in most of the major industrial countries (Chart 3); increased taxation and the tight stance of monetary policy in Germany as well as relatively high interest rates in the rest of Europe: and a reduction in the growth of business investment spending in Japan. These factors also highlight the uncertainties that attach to the near-term outlook.

Chart 3.Six Major Industrial Countries: Indicators of Consumer Confidence

Sources: United States, the Conference Board; Canada, the Conference Board of Canada; and for the lower panel, European Community.

1Quarterly observations.

2The percentage of respondents expecting an improvement in their situation minus the percentage expecting a deterioration.

Monetary and Fiscal Developments

Monetary conditions have mirrored the different cyclical positions of the three major industrial countries in 1991 (Chart 4 and Chart 5; Annex VI). To support activity against a background of reduced inflationary pressures, the U.S. Federal Reserve lowered both the discount rate and the federal funds rate by about 3 percentage points during 1991, with the discount rate falling to its lowest level since 1964. There was a further reduction of ¼ of 1 percentage point in the federal funds rate in April 1992, amid signs of a weak recovery. The Bank of Japan lowered its discount rate from 6 percent to 4½ percent during 1991 as growth slowed, and the overnight call rate also fell by over 2 percentage points. On April 1, 1992 Japan’s discount rate was lowered further to 3¾ percent in view of weaker domestic activity and recent trends in prices, money supply, and market interest rates. In contrast, the Bundesbank raised both the discount rate and the Lombard rate to historically high levels by the end of 1991–8 percent and 9¾ percent, respectively—in response to inflation rising above 4 percent, strong wage pressures, and growth of M3 at the top of the target range. Due to the requirements of the exchange rate mechanism (ERM) of the European Monetary System (EMS), most other European countries raised their interest rates as well, despite sluggish growth and increasing slack in labor markets.

Chart 4.Three Major Industrial Countries: Policy-Related Interest Rates1

(In percent a year)

1End of month except for the federal funds rate, which is the average of daily observations, and the repurchase rate, which is the average of weekly data.

Chart 5.Major Industrial Countries: Real Interest Rates1

(In percent a year)

1Interest rates deflated by the annual increase in the GDP deflator; annual averages through 1989 and quarterly data for 1990-91.

2A weighted average of yields on government bonds with remaining maturities of ten years or nearest, using 1987 GDP weights.

3Three-month certificate of deposit rates for the United States and Japan; three-month treasury bill rate for Italy; rate on three-month prime corporate paper for Canada; and three-month interbank deposit rates elsewhere with the following exceptions: Eurodollar rate for the United States before 1976; Gensaki rate for Japan before July 1984; money market rate for France before 1970; and the discount rate for Italy before 1978.

On a cyclically adjusted basis, fiscal policy in 1991 implied a withdrawal of stimulus in most major industrial countries (Chart 6 and Table A17 in the Statistical Appendix).2 In the United States, the discretionary tightening reflected efforts by state and local governments to contain their budget deficits. In some other countries, the automatic stabilizers in central government budgets did not operate fully (see below). Nevertheless, the combined fiscal deficit (general government basis) of the seven major industrial countries widened from 1½ percent of GDP in 1990 to 2½ percent of GDP in 1991, and is expected to rise further in 1992.

Chart 6.Major Industrial Countries: General Government Fiscal Indicators1

(In percent of GDP)2

1Calendar years. A positive fiscal impulse indicates an expansionary policy. Shaded areas indicate staff projections.

2GNP for Germany and Japan.

3Excludes Germany after 1989.

4Data are for west Germany for 1987-90 and for unified Germany thereafter. Because of data problems associated with unification, the fiscal impulse is not calculated for 1990-93.

In North America and the United Kingdom, fiscal positions on a general government basis deteriorated in 1991 with the decline in economic activity. In France, the budget deficit has widened because of slower growth, but it remains relatively small in relation to GDP. In the wake of unification. Germany’s general government deficit widened considerably in 1991, though by less than originally budgeted because of expenditure shortfalls and higher-than-expected revenues; a further small rise in the deficit is expected in 1992. In Italy, the deficit fell slightly to 10¼ percent of GDP in 1991; for 1992, the Italian budget aims at reducing the deficit by ¾ of 1 percentage point of GDP. A strong fiscal adjustment effort in Canada is expected to lower the budget deficit from 5½ percent in 1991 to 4 percent in 1992. In Japan, the general government balance, which includes social security contributions, is expected to remain at 3 percent of GNP in 1992, with the central government deficit remaining unchanged at 1¼ percent of GNP. (See Annex IV for further analysis of budgetary developments and prospects in the major industrial countries.)

Activity

Output in the United States declined by almost ¾ of 1 percentage point in 1991; stagnation in consumer outlays and a fall in fixed investment and inventories were only partly offset by an improvement in net exports. Following declines at the end of 1990 and the first quarter of 1991, real GDP expanded at an annual rate of about 1½ percent in the middle quarters of the year, but growth slowed again to only ½ of 1 percent in the fourth quarter. More recently, in the first two months of 1992, economic indicators such as retail sales, consumer confidence, industrial production, and housing starts have suggested that an economic recovery has begun, albeit a weak one.

Growth in the United States is expected to recover to a modest 1½ percent in 1992 as household consumption and business investment continue to respond to lower interest rates and as net exports continue to rise. This would imply a recovery well below the 5-6 percent growth rate typical of the four quarters following past recession troughs, in part because the recent recession was relatively shallow. In 1993, real GDP is expected to rise by 3½ percent, somewhat above estimates of potential growth. The projection nevertheless implies that only a fraction of the current output gap would be eliminated by the end of 1993 (Chart 7).

Chart 7.Major Industrial Countries: Output Gaps1

(In percent)

1The output gap is calculated as the percentage difference between actual or projected GDP and staff estimates of potential output; composites are based on 1988-90 GDP weights (GNP for west Germany and Japan). The shaded area indicates staff projections.

The recessions in the United Kingdom and Canada were more severe than in the United States, mainly because these two countries experienced greater inflationary pressures in 1989-90, which required more vigorous policy responses. In the United Kingdom, the financial positions of the personal and business sectors became unsustainable by mid-1990, as sharply higher interest rates led to a substantial decline in asset prices and in the net worth of the private sector (see Annex I). As a result, personal and business outlays were reduced sharply and are expected to recover only gradually. Growth in the United Kingdom is projected to remain weak at only ¾ of 1 percentage point in 1992, before strengthening to 3 percent in 1993. In Canada, interest rates are much lower than in the United Kingdom and households and businesses appear to be in stronger financial positions, which should allow consumption and investment to expand more rapidly. Real GDP growth is therefore expected to recover to 2¼ percent in 1992 and 5 percent in 1993.

Although growth slowed in both Japan and west Germany during 1991, output remained slightly above the estimated level of potential GNP in both countries (see Chart 7). In Japan, the slowdown in 1991 was mainly caused by a sharp deceleration in the growth of fixed investment to 3½ percent, compared with an average of more than 10 percent a year during the 1987-90 period. En the first two months of 1992, industrial production declined sharply and in March business confidence fell. With a pickup in consumer and government spending more than offset by slower growth in fixed investment and a reduction in net exports, the rise in output is projected to slow to 2¼ percent this year, but to accelerate again to 4 percent in 1993.

In west Germany, after rapid growth in the first quarter of the year, real GNP declined during the rest of 1991. Contributing to the slowdown were tax increases to finance unification, relatively tight monetary conditions, and weak foreign demand. Growth in west Germany is expected to decline to 1¼ percent in 1992 owing to weaker domestic demand and a modest decline in net exports. After declining sharply in 1991, output in east Germany is expected to start recovering in 1992-93, led by strong growth in construction and in consumption, financed in part by continued large transfers from the federal authorities. For Germany as a whole, after unsustainably high growth in 1990, output is estimated to have increased by only 1¼ percent in 1991 and is projected to expand by 2 percent in 1992 and 3 percent in 1993.

In France and Italy—where interest rates have remained relatively high and the margins of slack are relatively large—economic growth also slowed in 1991 and is expected to remain subdued in 1992 before recovering in 1993. The growth of consumer expenditure in France slowed significantly in 1991 and fixed investment declined: net exports, however, provided a small stimulus to growth. Output in France is expected to rise by 1¾ percent this year on a modest expansion of domestic demand, and then increase by 2½ percent in 1993. In Italy, economic growth slowed to 1 percent in 1991 as investment spending declined and net exports dropped sharply. Italy’s recovery is also expected to be slow, with real GDP rising by 1½ percent in 1992 and 2½ percent in 1993.

In most of the smaller industrial countries activity was quite weak in 1991. Although external factors played a role in some countries, the generally weak picture can be attributed mainly to the failure to address homegrown problems at an earlier stage. Output in Finland declined by about 6 percent, mostly on account of the collapse of its trade with the former U.S.S.R. Australia and Sweden also were in recession as major policy adjustments were required following financial deregulation during the 1980s in an environment of relatively expansionary policies. Activity in Norway (excluding the oil sector) was restrained by the effects of financial distress in both the financial and nonfinancial sectors. In Switzerland, output declined further last year as monetary policy remained tight to reduce inflation and correct earlier policy slippages. The Greek economy is still in the early phases of its medium-term adjustment program and growth has remained sluggish.

Growth was somewhat better sustained in Austria, Belgium, Denmark, and the Netherlands, as the positive spillover effects from Germany offset the impact of high interest rates. Growth slowed significantly in Spain and Portugal, but remained sufficiently strong to allow unemployment to decline further. While activity in the smaller European countries is expected to be restrained by high interest rates during the period ahead, the Australian economy is projected to recover in 1992-93, but the recovery is expected to be moderate and the unemployment rate would remain relatively high. For the smaller countries as a group, output is expected to grow by 2 percent in 1992 and by 2¾ percent in 1993.

Unemployment and Inflation

The average rate of unemployment in the industrial countries increased from 6¼ percent in 1990 to 7 percent in 1991; in the recession countries the rise was more marked (Chart 8). In view of the sluggishness of the projected recovery, the aggregate unemployment rate is expected to rise slightly in 1992, as small declines in North America and Italy are offset by further increases in most other industrial countries. Unemployment continued to fall in west Germany in 1991, although it is likely to increase somewhat this year as growth slows. In east Germany, the unemployment rate rose substantially in 1991 as output contracted, and it is expected to reach an average of 17 percent in 1992.

Chart 8.Industrial Countries: Unemployment Rates1

(In percent of labor force)

1Shaded areas indicate staff projections.

2Aggregation based on labor force weights.

Consumer price inflation in the industrial countries moderated to 4½ percent in 1991 as a result of the growing slack in product and labor markets—which contributed to a lowering of wage increases in most countries—and weak commodity prices (Charts 9 and 10; Annex VII). Inflation in the group of smaller industrial countries has remained more than 1 percentage point above inflation in the seven major industrial countries, however. With additional excess capacity, inflation in the industrial countries as a group is expected to slow further to 3¼ percent in 1992-93 and in some countries could approach levels not experienced since the 1960s. During the first two months of 1992, consumer prices in the major industrial countries were about 3 percent above their level during the first two months of 1991. The declines are projected to be largest in the United Kingdom, Italy, and Canada.

Chart 9.Industrial Countries: Consumer Price Indices1

(Percent change from four quarters earlier)

1Shaded areas indicate staff projections.

2Increases in indirect taxes raised consumer prices in 1989 in Canada, west Germany, Japan, and Italy, and in 1991 in Canada and west Germany. The projected decline in inflation in Italy in 1992 is related to a change in wage indexation in that year; the change is expected to result in a one-time reduction in inflation.

3Annual observations.

Chart 10.Major Industrial Countries: Consumer Price Inflation and the Output Gap1

(In percent)

1The output gap is calculated as the percentage difference between actual or projected GDP and staff estimates of potential output (GNP for west Germany and Japan). Data and estimates for west Germany are used to construct the composites, which are based on 1988-90 GDP weights. The shaded area indicates staff projections.

In contrast to moderation elsewhere, inflation in west Germany firmed to 3½ percent in 1991, in part due to an increase in indirect taxes in the second half of the year, but also because of light labor markets and excess demand related to unification. The rise in hourly earnings in manufacturing accelerated from 5¾ percent in 1990 to 7 percent in 1991. During the first three months of 1992, inflation continued to increase and by March consumer prices were about 4¾ percent above their year-earlier level. However, as growth slows in response to the tight monetary conditions, inflation should begin to moderate during the second half of 1992 and in 1993.

Current Account Developments

The combined current account deficit of the industrial countries is estimated to have narrowed from almost $100 billion in 1990 to about $25 billion in 1991. This reduction, however, can be traced almost exclusively to transitional factors, including war-related transfers from countries in the Middle East (one half of the decline) and an improvement in the terms of trade stemming from the decline in oil prices. Differences in cyclical developments, and the war-related transfers from Japan and Germany, accounted for most of the large reduction in the current account deficit of the united States (Chart 11). Lower-than-usual net payments to the EC and war-related transfers contributed to the large reduction in the United Kingdom’s deficit; a strong export performance and cyclically weak imports also played a role. The current account deficit of France is also estimated to have declined significantly in 1991. An improvement in the terms of trade contributed to a substantial increase in Japan’s current account surplus, in Germany, a large increase in imports and a reduction in exports to meet demand in the eastern part of the country generated a sizable swing in the external position from surplus to deficit.

Chart 11.Three Major Industrial Countries: Current Account Imbalances

(In percent of GNP)1

1GDP for the United States.

2Prior to July 1990, the current account balance of west Germany excluding the bilateral balance with east Germany; from July 1990, the current account balance of unified Germany. The shaded area indicates staff projections.

The current account deficit of the United States is expected to widen again in 1992–93—to an average of 1 percent of GDP—as the war-related transfers are phased out and as imports rise with the recovery. The moderate growth of demand expected in Germany should allow the external deficit to decline steadily during the next few years. Japan’s external surplus is projected to increase slightly to an average of 2½ percent of GNP in 1992–93. The current account deficits of Italy and the United Kingdom are also expected to widen somewhat in 1992–93, while the deficit of France would remain low. Canada’s relatively large current account deficit in 1991 is anticipated to decline somewhat over the forecast period.

Short-Term Policy Concerns

In the current environment of general sluggishness—the first economic downturn since the adoption of the medium—term growth strategy in the early 1980s—the challenge facing economic policymakers is to pursue policies that support activity in the short run and continue to promote the achievement of the medium-term goals of sustainable growth and price stability. In order to meet this challenge successfully, the medium-term implications of any adjustments to the thrust of policy must be carefully considered.

The lessons from the 1970s and early 1980s illustrate the dangers associated with discretionary action to stimulate activity. It was this experience that led to the adoption of the medium-term strategy, which has been a major reason for the considerable reduction of inflation and the strengthening of growth trends during the past decade. However, without changing the basic orientation of policy, it would seem fully consistent with the medium-term strategy to allow the effects of policy to vary over the cycle in order to alleviate recessionary tendencies when they occur, and to help dampen inflationary pressures at the peak of the cycle.

With respect to fiscal policy, a sensible principle is to let the automatic budgetary stabilizers work unless this would seriously jeopardize credibility and undermine private sector confidence. Symmetrically, when growth recovers, the automatic stabilizers should be allowed to reduce budget deficits, if possible even faster than envisaged in governments’ medium-term fiscal plans. The applicability of this rule may be questioned for countries where progress on fiscal consolidation is inadequate, and in such cases it is clearly risky to acquiesce to any departure from medium-term budget plans. It should also be noted that there is a risk that the stabilizers would not be allowed to operate symmetrically during a recovery, as illustrated by the tendency for some countries to increase public expenditures in line with the growth in tax revenue. Nevertheless, under conditions of a generalized slowdown affecting most of the industrial countries, it may be necessary to allow the stabilizers to operate at least to some extent to alleviate the impact on the global economy.

A similar principle would seem appropriate for monetary policy. During a period of overheating and excessive growth of liquidity it is necessary to use the instruments of monetary policy to reduce demand pressures. The corollary during a period of cyclical weakness, moderate and generally declining inflation, and sluggish growth of liquidity—as at present—is that the same instruments can be relaxed. This would not put credibility at risk as long as the resulting decline in interest rates does not lead to an excessive buildup of liquidity, and provided that the medium-term orientation of monetary policy remains firmly geared toward price stability (broadly defined as a low and stable rate of inflation that does not distort economic decisions).

In view of these considerations, it is appropriate that the authorities in countries that have been in recession (Canada, the United Kingdom, and the United States) or have experienced a substantial slowdown (Japan) have allowed interest rates to decline. In all four countries, the lowering of short-term interest rates has been facilitated by improvements in inflation performance. Long-term interest rates, however, have not declined as much as short-term rates, partly because of the persistence of large budget deficits in North America, in particular.

Barring evidence that growth continues to falter, a further significant reduction of interest rates does not seem warranted in the United States. Canada, or Japan. As monetary conditions affect activity with a lag, the decline in interest rates already in place should in time produce the strengthening in activity embodied in the staffs projections for 1992 and 1993. Moreover, in the United States, underlying inflation still appears to be above long-term objectives. In Japan, the labor market remains tight and only a moderate slowdown in growth is projected for 1992. In all three countries, there is a need for caution and for readiness to tighten promptly in response to signs of potential inflationary pressures.

The monetary authorities in Europe are faced with conflicting considerations. In Germany, the inflation outlook remains the main cause for concern, and it is this concern that led to a further tightening of monetary conditions late in 1991. This move was taken in response to monetary growth approaching the ceiling of the targeted growth range, a rate of inflation that exceeded 4 percent, and as a signal to the labor market about the need for restraint in the current wage round. However, the effects of last year’s increase in taxation and the high level of interest rates have now become visible, and growth in west Germany came to a halt in the second half of 1991 following the earlier unsustainably rapid expansion. This suggests that inflationary pressures should begin to subside during 1992, which in turn would allow a lowering of short-term interest rates.

The recent tightening of monetary conditions in Germany initially increased tensions within the exchange rate mechanism of the EMS, and has had spillover effects on monetary conditions in other European countries. Particularly in France and several of the smaller EC countries, where inflation is lower and unemployment is higher than in Germany, the current high level of short-term interest rates does not seem to be warranted from a domestic perspective. Italy and several of the smaller EC countries face less of a conflict; in these countries the need to converge toward the lowest inflation rates in the EC remains of high priority and continues to require a cautious monetary stance. Notwithstanding progress already made in reducing inflation, there is also a remaining need for the United Kingdom to converge.

So far, differences in monetary stances have not had disturbingly large effects on exchange rates among the major currency areas and cumulative movements in the exchange rates have been fairly small, or, in the case of Japan, in line with fundamentals during 1991 and the opening months of 1992. However, there have at times been significant fluctuations linked to the widening of interest rate differentials (see Annex VI).

Prospects for a reduction of interest rates in Europe would be significantly enhanced if Germany’s monetary growth was brought well within the target range, which would be facilitated if Germany’s fiscal deficit were brought down more rapidly than is currently envisaged under the medium-term fiscal program. The large deficit that has emerged in connection with the unification process initially provided considerable stimulus to activity in Germany and its partner countries, but growth in Europe is now being constrained by the high level of interest rates required to deal with the resulting inflationary pressures in Germany. The German authorities are fully aware of the external consequences of their fiscal policy and aim at reducing the deficit progressively over the medium term. (See Annex VI for a description of recent fiscal measures in Germany.) However, there would seem to be scope for a strengthening of the deficit reduction process through an early announcement of additional measures or an accelerated implementation of the existing plans for fiscal consolidation. Such a response to the domestic policy challenges confronting Germany would be fully consistent with its key role in the EMS.

Indeed, the level of interest rates in Germany continues to constitute a floor for monetary conditions in the countries participating in the EMS, and also in other European countries linked to the EMS. This reflects the German Bundesbank’s long-standing and successful resolve to resist inflationary pressures, the credibility of which appears to have been little affected by the recent rise in inflation. Other European countries will gradually reduce the premium on their interest rates as they succeed in reducing inflation. But to reduce interest rates below those in Germany, they would have to acquire greater credibility than the Bundesbank. The special role of Germany therefore implies that fiscal consolidation in Germany would lower interest rates throughout Europe with beneficial effects on interest-sensitive components of demand. Such action should also stimulate exports because of the likely impact on European exchange rates. A scenario examining the consequences of a strengthening of the fiscal adjustment process in Germany is presented in Annex III.

In contrast to Germany, where the main problem is to control inflationary pressures, the basic policy issue in most of the other industrial countries concerns the extent to which it is appropriate to ease the thrust of policy during the current period of cyclical weakness. The scope for discretionary fiscal measures to counteract this weakness is extremely limited. Moreover, even though as a general principle the automatic budgetary stabilizers should be allowed to operate, provided that the medium-term fiscal objectives are not compromised, this rule must be applied with caution. Indeed, in 1991 several countries introduced measures to offset the effect on budget deficits of sluggish growth. Such steps were felt to be required to safeguard the credibility of the authorities’ medium-term fiscal strategies, or they reflected financing constraints on local authorities, as appears to have been the case in the United States. Nevertheless, should activity remain weak during the period ahead, some increase in deficits relative to targets may have to be accepted to help avert further slackening. Symmetrically, of course, the stabilizers also need to operate to reduce budget deficits when stronger growth resumes.

The degree to which fiscal policy in 1991 and the budget assumptions for 1992-93 imply that discretionary changes offset the impact of the built-in stabilizers is illustrated in Table 2, which contains estimates of fiscal impulses and budget balances for general government.3 The actual or projected change in the budget balance plus the fiscal impulse for that year provides a measure of the impact of the cycle on the budget balance. The magnitude of the fiscal impulse in relation to the impact of the cycle on the budget indicates the extent to which the fiscal stance may be said to offset the impact of the automatic stabilizers.

Table 2.Fiscal Impulse and Changes in General Government Budget Balance(In percent of GDP/GNP)
Change in Budget Balance1Fiscal Impulse2Implied Impact of the Cycle on the Budget3
199119921993199119921993199119921993
United States-1.0-1.21.0-0.30.80.4-1.3-0.40.6
Japan40.10.1-0.50.2-0.5
Germany-1.2-0.30.5
France-0.30.10.1-0.5-0.5-0.2-0.8-0.4-0.1
Italy0.4-0.2-0.9-0.2-0.1-0.5-0.4-0.1
Untied Kingdom-1.6-2.8-0.6-0.91.81.0-2.5-1.00.4
Canada-1.61.51.3-0.6-1.7-0.7-2.2-0.20.6
Total of seven countries above-0.8-0.60.4
Of which:
Total excluding Germany-0.7-0.50.6-0.30.2-0.2-1.0-0.30.4

A positive number indicates a smaller deficit or a larger surplus, and a negative number indicates a larger deficit or a smaller surplus.

A positive number indicates an injection of stimulus, and a negative number a withdrawal of stimulus (see Table A17 in the Statistical Appendix). The fiscal impulse is not computed for Germany because of a break in the data as a result of unification.

The impact of the cycle on the budget is calculated as the sum of the change in the budget balance and the fiscal impulse. A positive number indicates an improvement, and a negative number a deterioration, in the budget balance.

The fiscal impulse of -0.5 percent in 1992 reflects mainly the timing of the special corporate taxes introduced to finance Japan’s contribution in connection with the conflict in the Middle East. On a fiscal year basis, which provides a more appropriate indicator of the Government’s policy intentions, there is estimated to be a negative fiscal impulse of -0.2 percent of GNP in FY 1992.

A positive number indicates a smaller deficit or a larger surplus, and a negative number indicates a larger deficit or a smaller surplus.

A positive number indicates an injection of stimulus, and a negative number a withdrawal of stimulus (see Table A17 in the Statistical Appendix). The fiscal impulse is not computed for Germany because of a break in the data as a result of unification.

The impact of the cycle on the budget is calculated as the sum of the change in the budget balance and the fiscal impulse. A positive number indicates an improvement, and a negative number a deterioration, in the budget balance.

The fiscal impulse of -0.5 percent in 1992 reflects mainly the timing of the special corporate taxes introduced to finance Japan’s contribution in connection with the conflict in the Middle East. On a fiscal year basis, which provides a more appropriate indicator of the Government’s policy intentions, there is estimated to be a negative fiscal impulse of -0.2 percent of GNP in FY 1992.

Discretionary budgetary changes (that is, the cumulative fiscal impulses during 1991-93) are estimated to be largest in the case of Canada. As described in more detail in Annex IV, the Canadian authorities have maintained a cautious fiscal stance in 1991 and are expected to make considerable progress toward fiscal consolidation this year and next. The next largest estimated and projected withdrawals of stimulus are in France and Italy. In both Canada and Italy the actual and projected deficits are quite large, and it would therefore appear to be appropriate to offset the effects of the automatic stabilizers. This is especially true in Italy, where the need for deficit reduction is particularly pressing.

The figures for the United States in Table 2 show that fiscal measures only offset part of the effects of the automatic stabilizers in 1991 and that the budgetary impulse is positive in 1992. The budgetary impulse in 1992 reflects primarily four factors that were incorporated in the Administration’s budget for FY 1993: a less optimistic view of growth potential in 1992, technical re-estimates of receipts and mandatory program spending, and two measures in the Mid-Session Review—a measure to reduce personal income tax withholding, and an acceleration of previously appropriated federal spending. Given the persistence of high budget deficits in the United States, it would have been appropriate to introduce measures to offset, to some extent, the mostly unanticipated impulse. In theory, further increases in fiscal deficits beyond the impact of automatic stabilizers might help to stimulate demand in the short run. However, in view of the unsustainably large structural deficit, stimulatory measures would be likely to put further pressure on long-term interest rates and undermine confidence. Any short-term discretionary action should therefore be limited to revenue-neutral tax and expenditure reforms aimed at enhancing efficiency.

In France, the projected fiscal deficit is relatively small, which would suggest some room to maneuver for fiscal policy by allowing the automatic stabilizers to operate if economic conditions were to weaken further. Nonetheless, the scope for this is limited by the medium-term objective of containing the growth of public spending and strengthening national saving. Consistent with this objective, Table 2 indicates that fiscal policy in France has operated to offset the working of the automatic stabilizers. In the United Kingdom fiscal policy is currently expansionary. At the same time, budgetary revenues and expenditures are being heavily influenced by the presently weak state of the economy, which accounts for most of the sharp widening of the general government deficit from 2½ percent of GDP in 1991 to an estimated 5 percent of GDP in 1992.

In Japan, the general government fiscal position is relatively strong, but the room for action is constrained by the pressures on public resources that are expected to result from the rise in the proportion of elderly in the population over the medium term. Furthermore, given Japan’s high rate of capacity utilization and the relatively moderate slowdown in growth projected for 1992, there is no evident case for a shift in fiscal policy. Nevertheless, if growth were to slow more than expected at present, the authorities should allow the automatic fiscal stabilizers to work.

Growth is expected to recover moderately in the smaller industrial countries in 1992. For most of these countries, while it would also be appropriate to allow the automatic stabilizers to operate in the face of weaker-than-expected growth, it is essential to ensure a rapid return to the budget path implied by countries’ medium-term objectives. This would be particularly important in countries with relatively large deficits—such as Belgium. Greece, the Netherlands, Portugal, and Spain. There are also a number of countries in which budgetary positions recently have deteriorated markedly, most notably in Australia, Norway, and Sweden. In these countries it would also be appropriate to pursue a cautious stance of fiscal policy.

More generally, as stressed above, it is particularly important that efforts to ease the thrust of policies to alleviate the recessionary tendencies do not jeopardize the achievement of medium-term objectives. Care must also be taken at this point in the cycle not to overstimulate those economies currently showing weakness. The lessons from earlier cyclical episodes demonstrate the risk of policy mistakes leading to periods of excessively rapid growth. When this occurs, inflation tends to accelerate, which makes a subsequent tightening of monetary policy and a renewed economic downturn almost inevitable.

The experience of the latter half of the 1980s illustrates these dangers (see Chart 10). For the major industrial countries as a group, when output reached and began to exceed the level of sustainable production capacity—that is, potential output—in 1988-90, inflation shifted from a declining to a rising trend. To achieve a better balance between demand and capacity output, and in view of the persistence of excessive budget deficits, the present period of slower growth therefore seems to have been unavoidable.

As the stage is being set for a more robust expansion in economic activity in 1993, the lesson of past cycles for the conduct of monetary policy over the medium term is clear. While the danger of overheating would not appear to be particularly large at this time, the monetary authorities must be prepared to tighten promptly on signs of an increase in potential inflationary pressures. In addition to monetary aggregates, indicators to monitor closely include labor market conditions and wage developments, as well as commodity market conditions. Monetary policy should continue to be implemented with the objective of avoiding pressures on capacity and the excessive increases in asset prices that characterized the latter part of the 1980s.

The staff’s projections envisage a significant decline in inflation over the medium term—for many countries to the lowest levels since the 1960s (Annex III). For this favorable scenario to materialize, monetary policy will need to remain suitably restrained. Moreover, for a number of countries, such as Greece, Italy, Portugal, and Spain, rates of inflation are expected to remain noticeably above the average of other industrial countries, in view of the convergence requirements for economic and monetary union in the EC (see Annex II), substantial policy changes are needed in these countries.

The Need to Reinvigorate Efforts to Achieve Medium-Term Objectives

During the past decade, the industrial countries have placed greater emphasis on achieving sustained noninflationary growth over the medium term. This reflects the consensus reached among the industrial countries at the beginning of the 1980s that medium-term objectives were best served by adhering to anti-inflationary monetary policies, by reducing fiscal deficits (preferably by restrictions on government spending rather than tax increases), and by eliminating structural rigidities.4 Implementation of this strategy has already paid dividends in improved fiscal positions in some countries, enhanced economic efficiency, substantially reduced rates of inflation, and a relatively long period of expansion in the 1980s.

However, many challenges remain if the industrial countries are to achieve fully the goals of the medium-term strategy. Lack of success in this regard is particularly evident in the United States and Italy, which both missed the opportunity to consolidate their budgetary positions during the long period of sustained growth in the 1980s. More recently, two countries that were relatively successful in implementing many features of the strategy, namely, Germany and—albeit to a lesser extent—the United Kingdom, have experienced a shift from fiscal balance (Germany) or budget surplus (United Kingdom) to substantial actual and projected fiscal imbalances.

The magnitude of the task ahead in terms of fiscal consolidation can be illustrated by comparing the staffs current medium-term baseline projections of government deficits with those embodied in the authorities’ medium-term fiscal plans. As the analysis in Annex IV shows, the discrepancies between the fiscal objectives of the authorities and the staff’s estimates of the likely budgetary realizations are particularly large for Italy and the United States, ranging up to 4½ percent of GDP over the medium term. These gaps point to the lack of success in achieving national goals in reducing government dissaving in these countries, and they underscore the need for stricter budgetary discipline in the future.

The important long-term benefits of fiscal consolidation in the United States and other countries with excessive deficits have been underlined on many occasions within the context of the World Economic Outlook exercise.5 A fiscal contraction normally would be associated with a temporary reduction in output and employment, which is relatively quickly reversed as the private sector increases spending in response to lower interest rates and improved competitiveness. However, typically by the third year after the tightening of fiscal policy, output and employment would begin to increase relative to the baseline scenario, and the beneficial effects would continue to improve over the medium-term as both supply and demand increase in response to improved efficiency, productivity, and income growth. In current circumstances, given the high structural deficit in the United States, the persistence of high long-term interest rates, and the relatively low levels of confidence, it is quite possible that a credible package of measures to reduce the deficit over the medium term would have substantial positive effects on confidence. Such an improvement in confidence would be likely to lead to an increase in demand that would considerably reduce the adverse short-term impact that is usually associated with a withdrawal of fiscal stimulus. In any event, the favorable opportunity to enhance fiscal consolidation during a period of expansion of the U.S. economy should not be missed in the 1990s, as it was during much of the 1980s.

Adequate emphasis on fiscal consolidation is not the only element of the medium-term strategy that needs to be revived. Another important area concerns the need for further progress in addressing structural issues. For example, the removal of tax provisions that distort the allocation of private saving and investment would help to enhance productivity and investment. This is particularly important in the United States, where the elimination of certain tax expenditures that are distortionary and result in a considerable revenue drain should be considered.6

In addition, in all the major countries, substantial steps are required to liberalize agricultural trade and reduce domestic support. In Japan, further reforms are needed in the areas of financial deregulation, competition policy, and land management. And in Germany, action is needed to reduce rigidities in the economy, particularly in the industrial and service sectors; substantial reductions in subsidies, especially to the coal mining and agricultural sectors, are long overdue.

Improvements in the functioning of labor markets especially need greater emphasis in order to permit stronger growth without an increase in inflation. While the high level of unemployment in Europe is due in part to the current slowdown of economic activity, it also reflects a high level of long-term or structural unemployment. To reduce unemployment and cost pressures, structural measures aimed at improving the functioning of labor markets will be essential. In several countries, a reduction in minimum wages would help to reduce unemployment among young workers and allow them to improve their skills through on-the-job training. Changes in the wage bargaining system may also be necessary to ensure that wage increases reflect more closely the available supply of labor. In addition, unemployment benefit schemes should be redesigned to encourage job search and training. More generally, there is a need to introduce or expand training programs and to expand job placement services to ensure that the unemployed maintain contact with potential employers and to facilitate the matching of people and jobs.

In addition to tackling the unfinished tasks from the 1980s, a reinvigoration of efforts to achieve the goals of the medium-term strategy must also be forward looking and take into account the new challenges and opportunities that arise from recent developments, such as the restructuring of Eastern Europe and the former Soviet Union; the possibility of large-scale reductions in military spending; the movement toward economic and monetary union in the EC; developments affecting the world trading system; and progress in resolving the debt crisis. For example, the much-enlarged scope for reductions in military spending would seem to call for an evaluation of the extent to which such reductions should be used to achieve fiscal consolidation more rapidly; to reduce the level of taxation; or to redirect resources toward other types of government expenditure, for example, infrastructure, education and training, health, and environmental protection.

A reaffirmation of the objectives underlying the medium-term strategy should also take into account the adequacy and allocation of global saving. As economic-conditions improve in the developing countries (Chapter III) and the massive reforms underway in Eastern Europe and the republics of the former U.S.S.R. begin to take hold (Chapter IV), the demands for foreign capital in these regions are likely to expand considerably. It is important to ensure that economic policies in the industrial world will allow financial markets to direct resources toward the reforming countries in other regions.

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