CHAPTER IV Policy Interactions in Industrial Countries
- International Monetary Fund. Research Dept.
- Published Date:
- January 1986
Discussions of policy interactions among countries have always been an important feature of the World Economic Outlook exercise. In the past these discussions have been fairly general and have avoided detailed analysis of the specific implications of alternative settings of policy in individual countries. During 1985, however, reports were issued by both the Group of Ten and the Group of Twenty-Four that called for more extensive and detailed presentations of such issues. The Group of Ten report requested that a chapter of the World Economic Outlook be devoted to “analyzing the repercussions of national policies of G-10 countries and of their interaction in the determination of exchange rate developments and international adjustment.” The Group of Twenty-Four report states, inter alia, that “The WEO should clearly spell out the repercussions and interactions of national policies of the major industrial countries and contain fairly specific proposals of policies for these countries.” This chapter is an initial response to these suggestions. (See also Chapter II for a detailed analysis of recent and prospective balance of payments and exchange rate developments in industrial countries.)
The particular focus of this chapter is on the consequences of the plans to undertake major action to reduce and eventually eliminate the fiscal deficit in the United States over the medium term (defined as the period through 1991). The second section outlines the Fund staffs medium-term “baseline” scenario (in which the U.S. fiscal deficit is substantially reduced) and discusses the potential effects of a variant scenario in which additional expenditure cuts are implemented in the United States.1 The third section discusses a number of possibly related developments that might alter the outcome of these scenarios, including shifts in monetary policies, changes in non-U.S. fiscal policy, and other possible developments such as an increase in lending to developing countries. The final section reviews the circumstances facing individual countries that would influence their ability to undertake various types of policy adjustments.
One conclusion that might be drawn from the analysis presented in this paper is that a major shift in fiscal policy in the United States would have large enough international effects that a number of countries might find it appropriate to modify temporarily their financial policies during the adjustment period. However, it is important to emphasize that economic forecasting is not an exact science. A major shift in fiscal strategy, such as the one being undertaken by the United States, can change past behavioral relationships. In particular, the speed with which proposed expenditure cuts lead to favorable financial market responses may be positively affected by shifts in expectations. More generally, private market responses to government policy initiatives can differ from those predicted by economic models and can thwart attempts to “fine tune” the international economy in response to disturbances. The first task of policy must be to establish a stable environment for the planning and implementation of private sector decisions. Of course, this prescription need not imply that policy settings should remain unchanged in the face of major external disturbances. Indeed, attempting to hold constant such variables as interest rates, the growth of monetary aggregates, or the level of government borrowing, at times when policy changes in other countries were generating international repercussions, might itself be destabilizing.
The Medium-Term Scenario
The background for any discussion of policy interactions among industrial countries must include a set of assumptions about the policies to be pursued and the economic outturn that those policies imply. Arriving at realistic policy assumptions is not an easy task, especially under current circumstances, when the United States is in the process of undertaking a major reorientation of fiscal policy over the medium term. Specifically, legislation has been enacted (the so-called Gramm-Rudman-Hollings Act) that is aimed at eliminating the budget deficit of the federal government by 1991. (For more details on this legislation, see Supplementary Note 1.) This legislation designates maximum deficits for each fiscal year through 1991; however, it does not specify how the reductions are to be achieved, and constitutional questions have been raised regarding the mechanism for imposing deficit reductions in the event that the President and the Congress are unable to agree on a budget. A final decision on this matter by the U.S. Supreme Court has not yet been issued.
The most important point to emphasize about the implementation of the Gramm-Rudman-Hollings legislation is that it has reversed the pattern that had prevailed over the past few years, during which time fiscal deficits in the United States had grown to proportions that had threatened the stability of the economy. In the absence of corrective action, these deficits would have been expected to rise still further (Chart 27). As had been argued in several previous World Economic Outlook reports, the continued absorption of savings by the U.S. federal government at this pace would eventually have led to one or more serious consequences. By 1983 and 1984, the fiscal deficit, as well as other factors, had contributed to very high real interest rates, a sharp appreciation of the U.S. dollar, and a serious weakening of the current account balance. Over the medium term, real interest rates could have remained very high, crowding out private investment; economic growth might have slowed down more than expected; monetary policy might eventually have been loosened, supporting growth in the short run but leading to an intensification of inflationary pressures in the longer run; and the dollar could have come under severe downward pressure as the size of U.S. deficits and external debt mounted. Although the outcome of the pursuit of unsustainable policies is difficult to foresee, quite possibly some combination of these pressures would have occurred, with adverse effects on growth, both in the United States and abroad.
Chart 27.United States: Ratios of Federal Government Deficits to GNP, 1970–911
1 Data are on a fiscal year basis, with actual data through fiscal year 1985, The assumptions for the projections are described in the text. The fiscal year in the United States ends September 30. Prior to fiscal year 1977 the fiscal year ended in June, but the current definition has been applied to the whole period in this chart.
The shift in policies toward a greater commitment to reducing fiscal deficits in the United States has diminished the likelihood that financial imbalances will pose a major threat to the health of the world economy, and it is expected to lead to a much more favorable outcome both for the United States and for other countries than could have been achieved without such an adjustment. It appears already to have had beneficial effects on market expectations and on confidence, as evidenced by a substantial decline in long-term interest rates and a surge in stock prices. Nonetheless, the magnitude of the effort that has now begun is large enough that one cannot ignore the possibility that less-than-full achievement of the fiscal targets may occur. Given the determination of the U.S. Administration to avoid raising taxes, reducing the federal government deficit from 5 percent of GNP in fiscal year 1986 to zero by 1991 will require either very favorable economic growth or large expenditure cuts.
The Baseline Scenario
For expositional purposes, the baseline scenario takes a cautious approach, neither assuming the continuation of large deficits nor assuming their complete elimination. It assumes that the United States will cut spending by enough to reduce the fiscal deficit by half, to about 2½ percent of GNP by 1991. The projected decline in the fiscal deficit would be sufficient to stabilize the ratio of debt to GNP, though not until near the end of the decade, by which time the ratio would have risen by another 6 or 7 percentage points (Chart 28). To achieve this objective, the staff estimates that expenditure reductions of approximately $12 billion a year from currently planned levels would have to be undertaken. It may be noted that the expenditure reductions that the U.S. Administration estimates are required to balance the budget are only slightly higher than this ($15 billion a year on average). The main sources of the differences between the staffs projections of the fiscal deficit and those of the U.S. Administration lie in the projected rate of economic growth and projected interest rates. The U.S. Administration assumes a real growth rate averaging 3¾ percent a year over the period to 1991; the staff, by contrast, projects an average growth rate of about 3 percent per annum.
Monetary policy is assumed to be framed to prevent any acceleration of the underlying inflation rate. Within this constraint, it is assumed that monetary targets would accommodate the continuation of economic growth at the rate that is in prospect for 1986–87, and thereafter at a rate roughly in line with the growth of potential output. The assumption of a monetary policy stance that does not accommodate inflation, together with a declining value of the dollar in exchange markets (see below), are expected to lead to some tightening of domestic monetary conditions (as the real money stock is reduced). Interest rates would therefore be under conflicting pressures in the medium term. The downward movement of the fiscal deficit would be an important factor relieving pressures on real interest rates. On the other hand, the passing of the transitory effects on inflation of oil prices, together with the tightness of monetary conditions just referred to, would tend to work in the other direction. The staff has assumed that the balance of these forces would lead to interest rates remaining lower over the medium term than they were in 1985. However, this interest rate assumption (that short-term rates would average about 4 percent in real terms) is still significantly above the U.S. Administration’s assumption of 1¾ percent.
Fiscal policies in other industrial countries are assumed to be broadly consistent (in direction, if not always in degree) with the declared intentions of the authorities concerned. A substantial fiscal consolidation is assumed in Canada, while in European countries and Japan a moderate further withdrawal of fiscal stimulus is assumed. These developments are thought to be broadly consistent with a reduction in the real exchange rate for the U.S. and Canadian dollars relative to the currencies of other major countries.
The exchange rate assumption underlying the baseline scenario is that the U.S. and Canadian dollars will decline in real terms against the other major currencies by an average of 2½ percent each year from 1988 through 1991.2 Real bilateral exchange rates among the currencies of European countries and Japan are assumed to remain unchanged.
Against the background of these assumptions, output in the major industrial countries is projected to grow at rates close to the rate of growth of potential output (which is estimated to be about 2¾ to 3 percent per year) throughout the medium-term period (Table 17). Fiscal policy would be exerting a contractionary impact throughout the projection period, but to a relatively mild extent (a withdrawal of stimulus equivalent to somewhat over ¼ of 1 percent of GDP a year for the industrial countries as a group). The dampening effects of such a fiscal stance would tend to be offset in the short run by the favorable effects of lower prices for oil and primary commodities, and in the longer run by the private sector responses to the reduction in government borrowing requirements. Inflation would continue at rates close to those prevailing in 1985 (between 3½ and 4 percent for the average of industrial countries). On the assumption that oil prices average $15 a barrel in 1986–87, there would be downward pressure on inflation during these two years, but as this effect passed, inflation would tend to edge up thereafter. Japan and the Federal Republic of Germany are expected to continue to experience rather lower inflation than the other large countries.
|Real GNP||(Annual change, in percent)|
|Of which: United States||4.2||3.3||3.3||3.0||3.8|
|Unemployment||(Percent of labor force)|
|Seven major industrial countries||7.7||7.6||7.6||7.4||6.7|
|Of which: United States||7.5||7.2||7.0||6.7||6.4|
|U.S. dollar||(Annual change, in percent)|
|Nominal effective exchange rate||8.0||4.5||-11.2||—||-2.1|
|Interest rates||(In percent)|
|World trade||(Annual change, in percent)|
|Unit value (in U.S. dollars)||-2.4||-1.7||6.2||3.6||4.5|
The Effect of Additional Expenditure Cuts
In order to assess how the baseline scenario might be affected by the implementation of a more ambitious deficit-reduction program in the United States, it is necessary to specify assumptions about how the program would be put into effect. In what follows, it is assumed that the reduction would be achieved primarily through further spending reductions across the whole spectrum of government activities. The staff estimates that the achievement of a balanced budget by 1991 would require additional spending cuts(beyond those assumed in the baseline scenario) averaging $35 billion (about ¾ of 1 percent of GNP) a year.
A further assumption underlying this variant of the medium-term scenario is that monetary policy in the United States (expressed as the target rate of growth of the monetary aggregates) is unchanged, and that fiscal and monetary policies in other countries are also held constant. The assumption of unchanged policies, while analytically convenient, may be regarded as somewhat unrealistic, and the implications of relaxing it are considered further in the third section below.
Empirical estimates of the effects of this more ambitious program, based on past behavioral relationships, suggest that output growth would decline, relative to the baseline projection, by some 1 percent a year for perhaps two or three years, followed by small increases thereafter.3 Over the longer run, output would be expected to rise above its baseline path, owing to the stimulus to capital formation from the expected decline in interest rates and to the strengthening of the current account balance from the expected depreciation of the real exchange rate.
It is possible, of course, that the implementation of additional spending cuts would have only a minor negative effect on economic activity in the short run, if the private sector responded with unusual vigor when faced with the prospect of reduced absorption of savings from the government. In assessing this possibility, however, two considerations should be borne in mind. First, the beneficial effects on market expectations and behavior are already reflected, to some extent, in the baseline scenario, under which output in the United States is projected to grow at rates at or slightly above the rate of growth of potential output in spite of significant cuts in government spending. Second, the spending cuts in this variant scenario are assumed to take place over a number of years; even though the long-run benefits of the first round of cuts might be felt fairly quickly, it could take some time for the net effect of the whole program to be positive. Nonetheless, it must be emphasized that the long-run effects of such a program—which will be positive in any event—could come rather sooner than expected.
Under this variant, the decline in real interest rates relative to the path in the baseline scenario is estimated to amount to around 2 percentage points in the latter years of the program. In spite of the slower growth of nominal incomes, the ratio of government debt to GNP would peak (in 1988) at a level some 3 percentage points below the peak of the baseline scenario. It would then decline steadily, falling to around 38 percent by 1991 (Chart 28).
The effects on exchange rates are even more difficult to assess than those on other major variables, corresponding to the lack of clear empirical evidence on the subject. On the one hand, it seems likely that fiscal expansion played an important role in generating the appreciation of the U.S. dollar during the early part of the present decade, so that a reversal of this expansion might be expected to have the opposite effect. On the other hand, the size (and even the direction) of the effect is open to considerable uncertainty, given the other factors at work and the importance of expectations. Nonetheless, it is reasonable to expect a sizable depreciation. As noted above, interest rates would tend to be lower in the United States, especially in the later years of the program; if monetary and fiscal policies in other countries were unchanged, a depreciation of the dollar against other currencies would be required in order to make people willing to continue to hold the outstanding stock of dollar-denominated assets. For illustrative purposes, it is assumed here that the real value of the U.S. and Canadian dollars would fall by 10 percent against other industrial country currencies relative to their values under the baseline scenario, with half of the depreciation occurring in 1987 and the other half in 1988.4
Inflation in the United States (measured by changes in the GNP deflator) is expected to be reduced slightly in the medium term as a consequence of the fiscal retrenchment, even allowing for the effects of the assumed depreciation of the dollar. That is, the deflationary effects on the U.S. GNP deflator of declining domestic demand and of the stimulus to aggregate supply are expected to be somewhat greater than the inflationary effects of the dollar depreciation. However, prices of internationally traded goods would be expected to rise in dollar terms by perhaps 6 percent or 7 percent, relative to the baseline, over about a two-year period. The U.S. current account deficit would be substantially reduced as a result of both the decline in domestic demand and the depreciation of the dollar. Whereas the baseline scenario shows the current account deficit falling from about 2½ percent of GNP in 1986 to about ¼ percent in 1991, the further fiscal cuts in this variant are estimated to have the effect of producing a small current account surplus by 1991. This would partly reflect lower imports in response to a slowing of economic growth, and partly the effects on competitiveness of the further decline in the dollar.
The impact of additional expenditure cuts in the United States on economic activity in other industrial countries operates through two channels. On the one hand, lower growth of demand in the short term in the United States and the depreciation of the U.S. dollar have negative direct effects on output in other countries, through a weakening in these countries’ real foreign balance. On the other hand, the appreciation of other currencies would tend to reduce inflationary pressures in those countries, with favorable effects on real incomes and aggregate supply conditions. Empirical evidence suggests that the balance of these effects would be to cause a temporary decline in output in the other industrial countries, taken together.
Japan and Canada, which have the closest direct trading linkages with the United States, would be most affected by any change in the growth rates in the United States, although the effects would be expected to occur with something of a lag. European countries, which conduct a much smaller portion of their trade with the United States than do either Canada or Japan, should experience somewhat smaller short-term effects. Thus it is unlikely that growth rates in any of the European countries would decline, relative to baseline, by much more than ¼ of 1 percent, given the output effects described above for the United States. Subsequently, as the long-run stimulus to growth begins to accumulate, these initial declines would tend to be reversed.
The developing countries as a group would experience little change in real growth as a result of the U.S. deficit reduction program, owing to the importance of offsetting effects. There would be beneficial effects from the decline in interest rates associated with declining activity in industrial countries. The effects of this benefit on current account balances would, in the aggregate, be offset by the adverse effects of declining demand for developing countries’ exports by industrial countries and by the induced worsening of the terms of trade of developing countries. Individual countries might, of course, experience large positive or negative effects, depending on their own circumstances. (These effects are discussed in more detail in Chapter V.)
In assessing the overall impact of expenditure cuts beyond those already included in the baseline scenario, it must be remembered that the reduction in the deficit under the baseline scenario would, in itself, have highly beneficial effects on confidence and thus on the sustainability of expansion. Cuts additional to those in the baseline scenario would, on the basis of empirical evidence, tend to reduce growth in the short run, perhaps for a period of two or three years; thereafter growth would be higher than in the absence of the additional cuts. That the length of the adjustment period is expected to be so long is attributable both to the magnitude of the intended fiscal retrenchment in the United States and to the fact that its implementation is spread out over a period of years. The budget cuts attributable to any given year tend to have positive effects that accrue sooner; but these positive effects are overlaid by the negative short-run effects of subsequent rounds of cuts.
There are, of course, many sources of uncertainty in these projections. Most important, the Gramm-Rudman-Hollings program, if implemented as planned, would mark the first time that the United States had undertaken a major deficit-reduction program over a multiyear horizon. Empirical evidence based on historical data cannot be expected to provide more than a general guide to the evaluation of events that are radically different from the past. To the extent that the deficit reduction program is viewed as appropriate and credible, its beneficial effects on financial markets could well accrue more quickly, so that the short-run consequences for aggregate demand would be diminished. On the other hand, to the extent that people are skeptical about the likelihood of such large spending cuts actually being implemented, it may be more difficult to bring about the desired shifts in conditions in capital and exchange markets. This would make it more difficult to achieve the hoped-for revival in investment and the orderly re-establishment of external competitiveness.
Another uncertainty concerns the nature of the concurrent policy adaptations that will be made, both in the United States and elsewhere. Even though major countries have adopted medium-term economic strategies, it is quite possible that policy settings would be changed in the event that economic developments diverged in a substantial manner from the projected path.
Policy Reactions and Other Possible Disturbances
The foregoing analysis of the implications of eliminating the U.S. budget deficit was predicated on the assumption that U.S. monetary policy, as well as fiscal and monetary policies in other countries, would remain unchanged in the face of a fiscal retrenchment in the United States. It also employed a number of simplifying assumptions about other economic conditions, notably that the U.S. dollar would depreciate by 10 percent over a two-year period (in addition to the depreciation already assumed under the baseline scenario). The purpose of this section is to examine the sensitivity of the analysis to these various assumptions.
The assumed 10 percent depreciation of the U.S. dollar has a major redistributive impact on the estimated effects of the U.S. fiscal program. Specifically, because the dollar’s depreciation serves to strengthen the U.S. current account balance, it reduces the short-term output losses in the United States but correspondingly amplifies them for other industrial countries. While the direction of this effect seems plausible, its magnitude and its timing are highly uncertain. The reliance on the simplifying (but perhaps unrealistic) assumption of other policies remaining unchanged adds to these uncertainties. With unchanged monetary policies, the U.S. fiscal cuts are expected, by themselves, to lead to a reduction in interest rates. Nonetheless, faced with temporarily reduced growth of output, the authorities both in the United States and in other countries might decide to seek further reductions in interest rates through an easing of monetary policies. Moreover, in view of the progress achieved in several industrial countries with respect both to inflation control and to budget consolidation, some governments might also decide to ease the stance of fiscal policy.
In most cases, because of the continued consolidation of budgetary positions that is implied by countries’ medium-term policy objectives, such a shift in fiscal policy would constitute a postponement of budget consolidation efforts rather than a major injection of stimulus.
A sharp reduction in the U.S. budget deficit, by contributing to a lowering of net capital imports into the United States, would free financial resources that might be used to increase lending to developing countries. This development, which would be consistent with the objectives of the recent initiative by the Secretary of the U.S. Treasury, could lead to an increase in industrial country exports to the developing countries and hence to an increase in the industrial countries’ output.
There are thus a number of circumstances in which demand and activity in the industrial countries could be expected to strengthen significantly compared with the results described above. To assess the implications of such developments, the following subsections provide some quantitative evidence of the effects of four possible eventualities: an easing of monetary policies in industrial countries; easier fiscal policy outside the United States; increased lending to developing countries; and a further depreciation of the dollar.5
Easier Monetary Policy
As discussed above, a key transmission mechanism in the adjustment of both the United States and other countries to the elimination of the U.S. budget deficit would be a marked reduction in interest rates. An easing of monetary conditions would result automatically from holding the growth of monetary aggregates unchanged as government demands on credit markets were reduced. If the United States or other countries were to decide to ease monetary conditions further, by allowing monetary aggregates to grow somewhat faster for a while, activity could be expected to return to its baseline path rather earlier than would otherwise be the case. For example, if the United States were to expand monetary growth by enough to reduce short-term U.S. interest rates by 1 percentage point more than is allowed for in the baseline scenario, the level of real GNP might increase by approximately ½ of 1 percent more after some two to three years. For Europe and Japan, the corresponding multipliers are estimated to be between ½ and 1½ percent, reflecting the rather different exchange rate effects that are associated with lower interest rates in the various models. Abstracting from exchange rate movements, the evidence for most industrial countries suggests that a reduction of interest rates of 1 percentage point might raise real GNP by about ½ of 1 percent after a period of two to three years.
While easier monetary conditions might help to offset the short-run effects of fiscal contraction in the United States, it is important to recognize that the positive effects of monetary easing on output growth would, for the most part, be temporary, and that an extended acceleration of monetary growth would involve the risk of leading to a rise in inflation.
Postponement of Budget Consolidation in Japan or Europe
In view of the considerable progress that has been achieved in reducing budget deficits in a number of countries outside the United States, questions could arise as to whether some countries might be in a position to ease fiscal policy temporarily to help offset any short-term output losses associated with major reductions in government expenditure in the United States. For illustrative purposes, the staff has examined the possibility of Japan and the European countries acting to shift their fiscal policies in an expansionary direction in 1987 corresponding to 1 percent of GDP, which would be sustained through the medium-term period. It may be recalled that the baseline projections are based on an assumption of the continued removal of fiscal stimulus in several of these countries, in line with their medium-term fiscal objectives. The assumed shift in fiscal policy would therefore involve essentially a postponement of consolidation efforts rather than a major reversal of the fiscal stance. For purposes of simplification no attempt is made in this subsection to differentiate among countries in terms of the appropriateness of these adjustments. However, as discussed below, some countries may be in a better position to ease fiscal policies than others.
An easing of fiscal policy outside the United States would tend to stimulate demand and activity, at least for a period. For the industrial countries as a whole, the short-run adverse effect on output resulting from the additional U.S. fiscal contraction would be reduced by about half as compared with a situation in which policies outside the United States were left unchanged. Assuming a nonaccommodating monetary policy stance, interest rates would fall by less in Europe and Japan than if no fiscal relaxation were undertaken; the dollar would therefore tend to depreciate more rapidly. These forces would begin to reduce the demand-supporting effects of fiscal relaxation after a period of two to three years. By then, the effects of fiscal contraction in the United States would also begin to taper off. The expected magnitudes of these effects, based on a sampling of recent econometric evidence, are summarized in Table 18.
|Country Changing Fiscal Policy||United States||Europe||Japan|
|Impact on Europe||Impact on the United States||Impact on the United States|
|Impact on Japan||Impact on Japan||Impact on Europe|
An important implication of fiscal action outside the United States would be to raise U.S. exports, which in turn would increase the level of U.S. real GNP slightly—by perhaps ¼ of 1 percentage point after two or three years—compared with what otherwise would be predicted. The contribution this would make to the reduction of the U.S. budget deficit would be relatively small, however, and would probably not exceed 1/10 of 1 percentage point of GNP.
For the developing countries, an easing of fiscal policy in the industrial countries outside the United States would raise both the demand for their exports and their export prices. Overall, fiscal action of the size assumed might increase the developing countries’ export revenue by 1–1½ percent after a period of two to three years compared with the outcome of the scenario in which the U.S. budget was balanced but no other policy changes occurred. Assuming that the increment to export revenues would be used to finance higher imports, staff estimates suggest that the level of real GDP in developing countries could also be expected to increase by about 1–1½ percent.
Increased Lending to Developing Countries
An important implication of additional action on the U.S. budget deficit would be to raise total domestic saving in the United States. As a result, both domestic interest rates and the current external deficit in the United States would decline. Lower interest rates would result in a fall in debt service ratios in developing countries, which in turn could facilitate a rise in lending to these countries. That increase would enable them to raise imports, investment, and growth above the levels that would otherwise prevail.
On the assumption that the level of lending to developing countries were to increase by $20 billion above the baseline level in 1987 and to remain at the new level thereafter, staff estimates suggest that the level of both imports and real GDP in these countries could be expected to be some 3 percent higher after a two-to-three-year period. Because of multiplier effects stemming from higher exports to the developing countries, the industrial countries’ level of activity would also strengthen, increasing GDP by perhaps ¼ to ½ of 1 percent relative to what otherwise would be the case. Real GNP in the United States would probably increase by a smaller percentage than that of Japan and Europe, although this relationship would depend on the geographical distribution of the increase in lending, which would affect the proportion of the rise in developing countries’ imports that would represent increased U.S. exports.
The balanced budget scenario assumed that the dollar would depreciate by some 10 percent relative to the baseline, as a result of the decline in U.S. interest rates following the implementation of deficit-reducing measures. In view of the uncertainties involved, it is worth examining the implications of different assumptions. In particular, the dollar might fall by significantly more than 10 percent in the short run, perhaps appreciating somewhat in the longer run as the deficit on current account narrowed.
A depreciation of the dollar of, for example, 20 percent instead of the 10 percent assumed earlier, would change the results of the balanced-budget scenario quite significantly. With higher import prices, the rate of inflation in the United States would tend to rise temporarily, raising the price level by l½-2 percent after a period of two to three years. With unchanged monetary growth (and a higher domestic price level) interest rates would therefore be likely to fall by much less than if the exchange rate decline were more moderate.
The impact of dollar depreciation on U.S. output is more difficult to assess than its impact on prices. Improved net exports would tend to raise real GNP whereas higher inflation and interest rates would tend to depress demand and activity. On the basis of empirical evidence, a central estimate of the likely outcome might be a rise in output of ¼-½ of 1 percent over a period of two to three years. The corresponding negative impact on other industrial countries would be similar in absolute terms, although it would not be evenly spread. In the absence of exchange rate changes among the other industrial countries, the fall in external demand and therefore in output in Japan would be expected to be significantly greater than in Europe, owing to Japan’s greater reliance on trade with the United States.
There are, as this discussion has illustrated, a number of developments that might modify the implications for other industrial countries of the implementation of budget deficit reductions in the United States. To the extent that these developments involve fiscal or monetary relaxation, they involve temporary departures from the expressed medium-term stance of policies. The risks inherent in such a course of action must, of course, be balanced against the short-run benefit of supporting existing levels of output and employment. Monetary relaxation, for example, brings with it the danger of stimulating a revival of inflation, while an easing of the fiscal stance outside the United States would limit the extent to which U.S. budget cuts resulted in lower worldwide interest rates. However, it must be recognized that the implementation of credible measures to eliminate the U.S. budget deficit would create circumstances in which global inflation and interest rates would be under considerable downward pressure, increasing the freedom of maneuver that authorities have to use policy to support demand. In weighing the advantages and disadvantages of various policy responses, therefore, a balancing of short-run and longer-run consequences must be undertaken, with due recognition of the fact that countries will be affected in different ways and to varying degrees by deficit reduction measures in the United States.
Because of the relatively small share of foreign trade in U.S. aggregate output, most of the external developments just discussed would have only minor direct effects on U.S output and on the magnitude of the fiscal measures necessary to eliminate the U.S. budget deficit. However, to the extent that the dollar were to depreciate substantially following the budget cuts, for example as a result of an easier stance of U.S. monetary policy, both the magnitude of the required discretionary budgetary cuts as well as the impact on output would be somewhat reduced relative to a scenario with little impact on the dollar and with no change in monetary policy.
Circumstances Affecting Individual Countries
Policy changes of the kind discussed above become more likely to the extent that national authorities feel that their freedom of policy maneuver is increased by a stronger budgetary position in the United States. In present circumstances, the revival of confidence and activity outside the United States is vulnerable to setbacks, and the management of the debt situation could be destabilized by a sharp slowing in industrial country growth. These considerations argue for a willingness to adapt policies to support demand. It is equally clear, however, that to modify policies could be risky in situations where countries have themselves embarked on a path of medium-term adjustment and where inflationary expectations are latent. Whatever adjustments are made to policies in order to cope with external developments must be fully consistent with countries’ medium-term strategies, and must not risk destabilizing expectations. This section discusses the circumstances and the constraints that currently prevail in particular countries, as they relate to the possibility of easing monetary or fiscal policies in response to a temporary slowdown that might be induced by the fiscal deficit reduction program in the United States.
Significant action to reduce the fiscal deficit would greatly enhance the prospects for improved macro-economic balance in the United States. Higher domestic savings would make possible a strengthening of the current account position and a growth in investment, through absorbing resources freed from public sector use. The key to achieving such a smooth reallocation of resources lies in the behavior of interest rates and the exchange rates, as well as in the maintenance of financial stability and private sector confidence.
Obtaining the appropriate evolution of interest rates and the exchange rate will not be easy. A temporary relaxation of monetary policy would help limit the initial weakening of activity stemming from fiscal measures. Such a policy stance would also help to maintain downward pressure on the dollar exchange rate, if that were needed. The danger, however, is that if monetary easing is perceived as going too far, it may be counterproductive. Fears of inflation could produce both a movement out of the dollar and upward pressure on interest rates. If such a development gathered momentum, it could have potentially serious consequences. A rapid depreciation of the dollar would further exacerbate inflationary tendencies, while monetary action to halt depreciation might require a substantial upward movement in interest rates, threatening to undermine domestic economic growth. It is obviously important for the U.S. authorities to seek to avoid being placed in such a dilemma, through exercising prudence in any easing of their monetary stance.
The recovery of the Japanese economy was, in its initial stages, largely led by exports, benefiting from strong growth in the United States during 1983 and the first half of 1984 and from the relatively low value of the yen in exchange markets. However, while the increasing surplus on current account has been a source of stimulus to the domestic economy, its size has placed a strain on Japan’s relations with its trading partners and has aggravated protectionist pressures. The slowdown in the U.S. economy after mid-1984 and the sharp appreciation of the yen against the U.S. dollar following the Group of Five meeting in September 1985 are reflected in the projection of a negative contribution to growth from external demand in 1986 and 1987.
The importance of maintaining strong growth of domestic demand in Japan under these circumstances raises the question of whether adjustments to the current monetary or fiscal stance might be appropriate. In the area of monetary policy, the options open to the Japanese authorities have been constrained by exchange rate considerations. Following the meeting of the Group of Five in September 1985, interest rates were permitted to rise sharply in order to encourage a further strengthening of the yen. However, the substantial appreciation of the yen, especially since late January 1986, appears to have increased the authorities’ freedom of maneuver. As a result, not only was the earlier increase in interest rates reversed, the authorities were able to lower the discount rate by 1 percentage point in two steps at the end of January and the beginning of March 1986. The authorities view the success of their current program of fiscal consolidation as critical to restoring fiscal flexibility and placing the Government in a better position to accommodate the prospective sharp rise in social welfare expenditure. The medium-term fiscal objective is to reduce the central government deficit without recourse to tax increases, so as to eliminate bond financing for current expenditure by fiscal year 1990/91. In view of the constraint on the central government budget, the authorities have increased expenditure by local governments and public enterprises to mitigate the withdrawal of fiscal stimulus. Beyond this, the Japanese authorities have emphasized structural policies, including deregulation and privatization of public enterprises, to ensure strong private demand.
In the baseline scenario, the external constraint on monetary policy would basically remain in place, at least for the time being. A substantial easing of monetary policy would run the risk of a reversal of the appreciation of the yen and a slower current account adjustment. From a cyclical perspective, it would not be desirable for the public sector to withdraw stimulus from domestic demand in 1986 or 1987. However, these short-term considerations need to be weighed against the medium-term fiscal objectives, and it remains important that the medium-term course of fiscal policy not be fundamentally changed. In view of the constraint on the central government budget, there is merit in making use of the scope to support demand through actions at other levels of government to the fullest extent possible. Some short-run flexibility at the central government level might also deserve consideration, if it could be done within the framework of the medium-term objectives of fiscal consolidation.
In the scenario in which the U.S. budget is brought into balance or a steeper fall of the dollar occurs, the constraint on monetary policy would be greatly eased or removed altogether. Monetary policy could and should then be directed firmly toward supporting demand. If there were to be a large and sustained real appreciation of the yen and a weak U.S. economy, the Japanese economy would experience a severe cutback in net foreign demand, and would therefore need strong growth of domestic demand to avoid the emergence of substantial slack. It would be all the more important in this case that the vitality of the private sector be fully utilized through deregulation and other measures. While both monetary and fiscal policy would also have a role to play, the scope for an easing of monetary policy would be somewhat greater than under the baseline scenario. Such an easing would facilitate a trend toward lower interest rates in other countries.
The possibility of lower oil prices would modify the conclusions just sketched, but it would not change their basic thrust. Lower oil prices should improve real domestic incomes and thus help support demand. However, even at $15 per barrel, the addition to real incomes would not appear to be sufficient to prevent the emergence of some slack in the Japanese economy. At the same time, lower oil prices would be apt to be associated with a stronger yen, thus resulting in a withdrawal of external stimulus.
Federal Republic of Germany
The German economy, which experienced very little growth from 1980 to 1983, has recovered somewhat during the past two years, with real growth averaging about 2½ percent. As in Japan, the recovery has been led by export demand, largely reflecting the strong growth of markets in the United States in 1983 and the first half of 1984. The deceleration in the U.S. growth rate and the recent substantial real appreciation of the deutsche mark against the U.S. dollar thus create a situation for Germany that is similar in many respects to the one described above for Japan. The effects of these international developments, however, are somewhat smaller for the German economy, reflecting the smaller trade linkages with the United States. Moreover, the implementation of tax cuts, an easing of interest rates, and terms of trade improvements are expected to result in a rise in domestic demand in the short term.
Monetary policy in the Federal Republic of Germany remains geared toward maintaining a steady growth in potential output through reducing inflationary pressures. Fiscal policy is also formulated within a medium-term framework and is oriented toward reducing the share of government in the economy and lowering the budget deficit. The authorities believe that the policy of fiscal consolidation that is under way is fundamental to a durable recovery in the private sector and hence to expansion in employment. Considerable progress has already been achieved in fiscal consolidation, with a lowering of the general government deficit from 3½ percent of GNP in 1981 to a projected level of less than 1 percent in 1986. The progressive reduction in the share of general government spending in GNP, from 50 percent in 1982 to an estimated 48 percent in 1985, provided scope for the income tax reductions to be implemented at the start of 1986, which are expected to stimulate private sector activity.
A matter for discussion is whether the German authorities could respond to a program of U.S. fiscal restraint through a relaxation of their fiscal stance. If at the same time monetary policy was left unchanged, the resulting upward pressure on short-term real interest rates in the Federal Republic of Germany and the real appreciation of the deutsche mark against the U.S. dollar would, it might be argued, reinforce the effects of the U.S. fiscal program in reducing current account imbalances. However, the scope in Germany for a further short-term increase in domestic demand growth may not be as great as the relatively high unemployment level implies. Domestic demand picked up significantly in the last three quarters of 1985, and the rate of capacity utilization rose. In addition, the fiscal stance in 1986 is expected to be mildly expansionary, under the influence of the tax cuts introduced in January 1986, and lower oil prices will provide a stimulus to demand as they work their way through the economy.
Much will therefore depend on developments during the course of 1986. The German economy will be less affected than Japan by the possibility of weaker U.S. activity or a lower dollar. Nevertheless, if these developments were to be accompanied by some slackening in the pace of domestic demand, this would strengthen the case for offsetting action. One possibility would be to bring forward the tax cuts projected for 1988. Another would be to ease somewhat the stance of monetary policy. An easing of monetary policy might tend to limit tensions in the EMS, at a time when a weakening of the dollar would probably be tending to exert upward pressure on the deutsche mark.
The performance of the U.K. economy has strengthened over the past several years, with an average rate of real output growth of about 2½ percent and an inflation rate declining to around 5 percent. However, there continue to be large labor market imbalances, with unemployment at over 13 percent of the labor force. Despite the effects of the recent weakness in oil prices, the pound sterling remains high in real terms in relation to its longer-run historical average level. The real effective exchange rate of the pound in December 1985 (measured by relative normalized unit labor costs adjusted for exchange rate changes) is estimated to have been about 17 percent above its average value for the decade 1975–84, and only 10 percent below the peak level reached in the first quarter of 1981.
The medium-term objective of policy in the United Kingdom is to slow progressively the pace of monetary expansion in order to reduce inflation, supported by a scaling back of the public sector borrowing requirement from about 3¼ percent of GDP in fiscal year 1984/85 to 1¾ percent of GDP by fiscal year 1988/89. Within this broad framework, exchange rate considerations have come to play an increasingly important indicative role in the conduct of monetary policy. The authorities have kept interest rates high relative to those in partner countries, partly in reflection of the judgment that in recent circumstances a narrower differential would be likely to loosen monetary conditions by enough to induce a depreciation of sterling and rekindle inflationary pressure. Of course, the authorities are well aware that downward pressure on the pound stemming from factors having lasting influences on the external position—such as a sustained lower level of oil prices—should be accommodated, though not in a way that would compromise the inflation objective. Thus, in reacting to the downward pressure on sterling that began in December 1985, the U.K. authorities permitted interest rates to rise in a manner that was consistent with a moderate effective depreciation of the pound.
Looking ahead to the possible consequences of major budgetary consolidation in the United States, a temporary weakening in the growth of world activity, coupled with a decline in short-term real interest rates in the United States and other countries, could tend to reduce downward pressure on sterling and permit an easing of interest rates in the United Kingdom. Given the authorities’ commitment to a policy of fiscal consolidation, there may be little scope for a temporary easing of fiscal policy, particularly in view of the fact that the curbing of budget deficits has relied increasingly on asset sales. Fiscal policy, as gauged by the fiscal impulse at the general government level, has been broadly expansionary since 1982. In addition, fiscal easing would tend to place upward pressure on interest rates and on the exchange rate, neither of which would be appropriate under circumstances where the maintenance of international competitiveness is an important concern. In the longer run, a permanent improvement in the domestic situation can best be achieved by a reduction in short-term and long-term real interest rates through a continuation of the present policy of fiscal consolidation, along with measures to reduce structural rigidities in the labor market.
The moderate recovery of the French economy since 1983 has been accompanied by considerable progress in reducing the inflation rate, by an increase in profitability, and by a strengthening of the current account position. However, the recent decline in the inflation differential between France and the Federal Republic of Germany has not quite been sufficient to prevent a small deterioration in France’s external competitiveness relative to Germany’s. The rate of growth of real GDP in France fell back from 1½ percent in 1984 to ¾of 1 percent in 1985, and real growth remains considerably below that of France’s main trading partners. In addition to the goal of further reducing the inflation rate, the main domestic concern arises from the continuing deterioration of labor market conditions. This deterioration has become of particular concern in view of the rise in unemployment to close to 11 percent of the labor force by 1985, at a time when rates in many other European countries had stabilized.
While the current account of the balance of payments is now in surplus, the external constraint on policy remains of significance. The French authorities have had to maintain a fairly tight monetary stance in order to preserve an interest differential with deutsche mark-denominated assets that is sufficient to limit exchange market pressures. A further decline in U.S. and German interest rates would give the French authorities an opportunity to allow interest rates to fall without creating additional pressure on the parity of the French franc within the EMS. However, as noted earlier, a shift toward a more expansionary monetary policy by Germany (or Japan) would serve to limit any incipient real depreciation of the U.S. dollar and the corresponding reduction in current account imbalances. An additional argument against monetary easing in the French case is that inflation has only recently declined. Any re-awakening of inflationary expectations in France could induce a speculative movement out of French francs, thereby endangering the stability of the French franc within the EMS.
A slowdown in U.S. economic activity would have a greater effect on Canadian economic growth than on European growth because of the close trading links between Canada and the United States. At the same time, Canadian authorities would face significant constraints on their ability to pursue policies that would counter the effect of a U.S. slowdown. The size of the Canadian budget deficit and the continued buildup in government debt limits the room for maneuver of fiscal policy. Moreover, the need to preserve the progress made in bringing down inflation restricts the ability of the Canadian authorities to pursue a significantly easier monetary policy.
Over the past year and a half, the Canadian Government has taken measures to correct the central government fiscal imbalance and arrest the growth of the ratio of debt to GNP. Yet the deficit remains large and the debt ratio continues to increase. In 1985, the fiscal deficit was almost 7 percent of GNP on a national accounts basis, and central government debt amounted to 42½ percent of GNP. The authorities have therefore indicated that a strengthening of the budgetary position will be a key priority.
Significant fiscal retrenchment in the United States would have some adverse short-run effects on economic activity in Canada that would make it more difficult for the Canadian authorities to achieve a sizable reduction in the Canadian deficit. However, failure to undertake additional deficit reduction measures in Canada in the face of such action in the United States could well generate a loss of confidence and exert downward pressure on the value of the Canadian dollar vis-à-vis the U.S. dollar, thereby limiting the extent to which Canada might benefit from a reduction in U.S. interest rates. There is, therefore, little room for expansionary fiscal policy action in Canada to counteract any adverse real activity effects stemming from a fiscal correction in the United States. The ability of the Canadian authorities to lower interest rates to take advantage of any reduction in U.S. rates is also constrained by the need to resist sharp downward movements in the exchange rate. The most that might be possible would be for a reduction in Canadian interest rates to follow a corresponding decline in the United States, provided that it could be achieved without provoking an adverse reaction in exchange markets.
The impact of international economic developments on the policy options facing the Italian authorities has to be seen against the background of the fact that the constraints on Italy’s financial policies are essentially domestically generated, with favorable developments abroad consequently providing only marginal and short-term relief. Until a substantial improvement in the public sector financial position is achieved, an easing of financial policies in the main partner countries can provide only a limited scope for relaxation of the stance of policies in Italy.
Consistent with Italy’s participation in the EMS, the authorities are committed to the pursuit of a steady disinflationary policy, and counteracting domestic sources of inflationary pressures has consequently been a central element of their medium-term strategy. The authorities recognize that a sustained adjustment effort in public finances is an essential condition for a lasting improvement in economic performance, and they have put forward a medium-term budget consolidation plan. The plan targets the elimination of the non-interest deficit of the state sector, an objective that would require substantial expenditure restraint even under the most favorable international circumstances. There would thus be no room to ease fiscal policy even if international economic conditions were to change. Much the same applies to monetary policy. A generalized decline in interest rates abroad may provide some scope for a modest decline in nominal interest rates in Italy as well, particularly as inflation decelerates in the course of 1986. Over the longer term, however, the level of real interest rates in Italy is largely determined by the need to generate the necessary domestic savings in the face of substantial fiscal deficits, and to secure a steady deceleration in the rate of growth of the monetary aggregates. The level of real interest rates that is appropriate from this domestic perspective may well be higher than in most of Italy’s EMS partners.
Other Industrial Countries
Among the smaller EMS countries, the scope for changes in monetary policy is quite limited. Movements in short-term interest rates have had to follow closely those in the Federal Republic of Germany in order to maintain parities within the EMS. In some countries, downward pressure on the exchange rate has led to a tightening of monetary policy, with the recent increases in the Belgian discount rate in August and in December 1985 being notable examples.
The maintenance of interest rates in line with those in the Federal Republic of Germany has posed policy dilemmas for the authorities in these countries in view of their large domestic labor market imbalances. At the same time, the need to reduce large fiscal deficits over the medium term leaves little room for any fiscal stimulus. A fall in U.S. interest rates and a depreciation of the U.S. dollar might reduce somewhat the pressures currently faced by the monetary authorities in these countries. At the same time, the large fiscal imbalances would make it inappropriate to respond to a weakening in the international climate through a loosening of fiscal policy. Fiscal easing would mean that monetary conditions would have to be allowed to tighten in order to protect the exchange rate. In the case of the Netherlands, the relatively strong position of the guilder within the EMS, together with the continuation of a large domestic fiscal imbalance, means that scope for combatting incipient weakness in the economy lies more on the monetary side than on the fiscal side. Monetary easing, however, would have the consequences of limiting the appreciation of the guilder and thus postponing the adjustment of the large external surplus.
Spain faces a situation in which its current account surplus is relatively large, but domestic economic performance is weak, with very high unemployment (over 20 percent) and inflation well above the average of other industrial countries. In addition, Spain may well face problems of structural adaptation following membership in the European Communities. The relatively high level of the public sector borrowing requirement makes it inappropriate to respond to a weakening in the international economic environment by significant budgetary easing. Monetary policy also needs to be cautious, in light of the need to improve inflation performance; it may, however, be possible to respond to a decline in international interest rates with an easing of monetary conditions in Spain also.
Smaller industrial countries that have recently experienced large depreciations of their currencies might also benefit from a sustained depreciation of the U.S. dollar. Since the shift to floating exchange rates in Australia in December 1983, and in New Zealand in March 1985, the effective values of the Australian and New Zealand dollars have undergone sharp fluctuations. The depreciation of the Australian dollar during 1985 of about 25 percent and the sharp drop in the New Zealand dollar in December 1985 have raised concerns about the possibility of a revival in inflation. On the other hand, since both countries have strong trading links with the United States and Japan, any weakening in activity in those countries would be expected to exacerbate the existing domestic unemployment problem, especially in Australia. In view of the large fiscal imbalances and strong domestic inflationary impulses already present in both economies, the scope for any relaxation of the present restrictive stance of financial policy is somewhat limited. A decline in U.S. interest rates might allow some fall in domestic interest rates and stimulus to domestic demand without preventing an appreciation of the currency against the U.S. dollar. In the longer term, the restoration of confidence in the exchange rate and accompanying reduction in current account deficits will necessitate a continuation of the present programs of fiscal retrenchment.