The dismantling of trade barriers among the industrial countries in the 1950s and 1960s contributed to a period of unprecedented world economic growth (Chart 23). In the 1970s and the 1980s, an increasing number of developing countries adopted outward-looking trade policies as part of a strategy of structural economic reform. Those countries that have succeeded in implementing these reforms have experienced a significant and durable improvement in economic performance. Most recently, the countries in transition in central Europe have liberalized their previously distorted trading regimes as an essential element of the process of transformation to market-based economies, and some progress has been made in several countries of the former Soviet Union. Trade in both industrial and developing countries has tended to become more regionalized, in part because of regional trade arrangements, which are discussed in detail in Annex III.

The dismantling of trade barriers among the industrial countries in the 1950s and 1960s contributed to a period of unprecedented world economic growth (Chart 23). In the 1970s and the 1980s, an increasing number of developing countries adopted outward-looking trade policies as part of a strategy of structural economic reform. Those countries that have succeeded in implementing these reforms have experienced a significant and durable improvement in economic performance. Most recently, the countries in transition in central Europe have liberalized their previously distorted trading regimes as an essential element of the process of transformation to market-based economies, and some progress has been made in several countries of the former Soviet Union. Trade in both industrial and developing countries has tended to become more regionalized, in part because of regional trade arrangements, which are discussed in detail in Annex III.

Chart 23.
Chart 23.

World Exports and Production of Goods1

(Annual percent change)

Source: General Agreement on Tariffs and Trade, International Trade, several issues.1Agriculture, mining, and manufacturing.

The outward-oriented strategies of many developing countries and the economies in transition contrast with the increasingly negative attitudes toward free trade in the very same countries that drew the largest benefits from earlier efforts at trade liberalization. The re-emergence of large external imbalances and rising levels of unemployment in the industrial countries have contributed to heightened protectionist pressures and have spurred a large and growing interest in managed trade and in strategic trade theories (Box 9). At the same time, the Uruguay Round remains deadlocked, and there is widespread resort to countervailing and antidumping measures and to “voluntary” export restraint agreements.60 A reversal of these developments is essential to improve the economic climate and to provide new impetus to world growth during the period ahead.

New Theories of Growth and Trade

Recent developments in growth theory have emphasized the potential growth-enhancing roles of physical and human capital accumulation and research and development, as well as the possibility of increasing returns to scale at the aggregate level.1 This literature contrasts with traditional growth models, in which capital accumulation raises the level of output but not its long-term growth rate. In traditional growth models, policies that stimulate saving and investment raise output growth only temporarily because each addition to the capital stock is assumed to generate diminishing amounts of extra output.2 The new growth theories assume either that investment does not have such diminishing returns or that some of the extra output is used in activities that directly increase the rate of technical change and economic growth.

The new growth theories predict that structural reforms such as trade liberalization could permanently increase economic growth under some circumstances. Lowering barriers to trade, for example, could affect economic growth through several mechanisms.3 First, closer economic links increase the transmission of technology, thereby reducing the duplication of research and development activities. Because knowledge is a public good, its accumulation increases the rate of technical progress. Second, the international integration of sectors characterized by increasing returns to scale raises output without requiring more inputs. Third, the opening of trade reduces price distortions, reallocating resources across sectors and increasing economic efficiency. The first two effects unambiguously raise economic growth; the third raises growth to the extent that greater efficiency frees resources for research and development, but it could also lower growth if the change in relative prices causes resources to shift out of research and development.

Recent developments in trade theory, by contrast, have focused on economies of scale at the firm or industry level and on market imperfections that generate excess economic profits. In principle, trade barriers could be used to shift these oligopolistic profits from foreign to domestic producers.4 Alternatively, economies of scale at the industry level may provide strategic advantage to the country that first provides protection in order to establish an industry ahead of its trade partners. Although these theories have been used to support policies of government intervention in international trade, the key characteristic of such policies is that one country gains at the expense of its trading partners. Beggar-thy-neighbor policies will not promote worldwide growth; instead, they will reduce growth by misallocating resources and by provoking retaliation and a shrinkage of world trade.

In any case, governments have not been very successful in picking winners—determining which industries to support—because this depends on details of production technology and market structure about which governments typically know little. Moreover, if specific industries are “winners” because of market imperfections, trade policies should not aim to exploit these imperfections; rather, structural policies should seek to correct them by increasing competition and by encouraging new entrants. Protecting the wrong industries, providing the wrong degree of protection, or accepting market imperfections reduces living standards, even from the narrow perspective of one country. The few studies that have investigated initiatives potentially consistent with the recommendations of the new trade theory—in the automobile, semiconductor, and commercial aircraft sectors5—suggest that even the unilateral gains have been modest at best. Perhaps the most important consideration, however, is that a policy of granting selective protection would almost certainly open the door to calls for more widespread intervention, diverting resources to socially unproductive, rent-seeking activity.

1 See Paul M. Romer, “Crazy Explanations for the Productivity Slowdown,” NBER Macroeconomics Annual (Cambridge, Massachusetts: National Bureau of Economic Research, 1987), pp. 163–210; Xavier Sala-i-Martin, “Lecture Notes on Economic Growth (I): Introduction to the Literature and Neoclassical Models,” NBER Working Paper 3563 (Cambridge, Massachusetts: National Bureau of Economic Research, December 1990); and Elhanan Helpman, “Endogenous Macroeconomic Growth Theory,” European Economic Review, Vol. 36 (April 1992), pp. 237–67.2 This is a consequence of the assumption of constant returns to scale to all inputs—usually labor and capital—at the aggregate level, and hence diminishing returns to capital.3 Paul M. Romer and Luis A. Rivera-Batiz, “International Trade with Endogenous Technological Change,” European Economic Review, Vol. 35 (May 1991), pp. 971–1004.4 See Robert E. Baldwin, “Are Economists’ Traditional Trade Policy Views Still Valid?” Journal of Economic Literature, Vol. 30 (June 1992), pp. 804–29; and Paul R. Krugman, “Is Free Trade Passe?” Journal of Economic Perspectives, Vol. 1 (Fall 1987), pp. 131–44.5 See, respectively, Avinash K. Dixit, “Optimal Trade and Industrial Policy for the Automobile Industry,” and Richard E. Baldwin and Paul R. Krugman, “Market Access and International Competition: A Simulation Study of 16K Random Access Memories,” both in Empirical Methods for International Trade, edited by Robert C. Feenstra (Cambridge, Massachusetts: MIT Press, 1988); and Richard E. Baldwin and Paul R. Krugman, “Industrial Policy and International Competition in Wide-Bodied Jet Aircraft,” Trade Policy Issues and Empirical Analysis, edited by Robert E. Baldwin (Chicago: University of Chicago Press, 1988).

Trade and Growth in Industrial Countries

From 1950 to the early 1970s the industrial economies experienced unusually high productivity and real output growth, both by historical standards and by comparison with the two decades that followed.61 Trade also grew rapidly as the industrial economies became more closely integrated (Table 18). Those economies that recorded high rates of output growth also tended to experience large increases in trade growth. The links between trade and economic growth are complex and run in both directions, and this extraordinary performance must therefore be attributed to several factors. In particular, the reconstruction from World War II and reductions in the cost of transportation and communication fostered both growth and international trade.

Table 18.

Industrial Countries: Export Volume

(Annual percent change)

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Source: IMF, International Financial Statistics.

Aggregate excludes Portugal for 1951–60, 1961–70, and 1971–80.




The key policy initiatives, however, were the cuts in tariffs and nontariff barriers from the very high levels of the interwar period, and a widespread move toward currency convertibility for current account transactions. Successive rounds of multilateral trade negotiations reduced average tariffs for manufactured goods among industrial countries from about 40 percent in the late 1940s to as low as 5 percent after the Tokyo Round in 1979. These cuts were front-loaded, in the sense that particularly large reductions took place in the Geneva Round in 1947 and the Annecy Round in 1949. By 1961, after the Dillon Round, the average tariff for manufactured imports into the United States was only one-fifth of its prewar level, or just over 10 percent.62

Since the early 1970s, trend productivity and output growth have slowed significantly in the industrial countries, as has the growth of trade. The large tariff reductions undertaken during the 1950s may have had their main impact in the 1950s and 1960s and, therefore, provided less impetus to trade and growth in the period that followed.63 The rise in nontariff barriers in the 1970s and 1980s may also have played a part. Moreover, the output share of services, many of which are nontradable or are subject to trade barriers, has increased at the expense of manufactures. In contrast, even closer economic integration was fostered within Europe by the development of the European Community. Recent studies suggest that European integration has continued to contribute to productivity growth during the past two decades, although the impact has diminished over time, and that the single market project will further boost growth during the 1990s (see Annex III).64

The multilateral trade system has served the industrial economies well by greatly reducing barriers to trade in manufactured goods and by promoting a period of virtually unprecedented economic growth. Recently, however, these gains have been threatened by the resurgence of nontariff barriers, such as voluntary export restraints, quotas, import licensing, and state support for industry. If these nontariff barriers can be reduced and a return to tariff protection avoided, the achievements of the past four decades will be secured. Further growth through trade, however, now requires the expansion of free trade principles to include the agricultural, textile, and service sectors, and to encompass all trade with the developing countries and the countries in transition.

Outward-Oriented Growth Strategies in Developing Countries

As discussed in Chapter IV, an increasing number of developing countries have adopted outwardoriented economic policies. A basic feature of an outward-oriented strategy is that trade and industrial policies do not discriminate between production for the domestic market and exports, or between purchases of domestic and foreign goods. This approach explains the successful export performance and increased pace of economic development of many developing countries. From 1960 to 1990, exports of non-oil developing countries increased more than five times, broadly similar to the increase observed in industrial country exports (Table 19). In contrast to the industrial countries, the developing countries have registered the strongest growth in export volume since the mid-1970s. In value terms, however, the non-oil developing countries’ share of world exports changed little, because volume changes were offset by shifts in the terms of trade.65

Table 19.

Industrial and Developing Countries: Export Volume Growth

(In percent)

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Source: United Nations, Monthly Bulletin of Statistics.

The expansion of trade by the developing countries was accompanied by an increased importance of trade and direct foreign investment among them. The share of developing country nonfuel exports going to other developing countries rose from 19 percent in 1960 to 26 percent in 1975 and then jumped to 35 percent in 1990 (Table 20). This increase reflected higher demand growth in developing countries than in the industrial countries and a sharp increase in intraregional distribution of labor and direct investment among the developing countries, especially in Asia. The decreased dependence on industrial country export markets, together with the adoption of appropriate macroeconomic policies in many developing countries, has contributed to the resilience of growth in the developing countries during the recent downturn in the industrial countries.

Table 20.

Developing Countries: Destination and Source of Exports

(In percent of total)

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Source: United Nations, Monthly Bulletin of Statistics; and IMF, Direction of Trade Statistics.

Four newly industrializing economies. Data before 1970 exclude Singapore; data for 1970–80 include estimates for Taiwan Province of China.

The composition of developing countries’ exports has also changed substantially. Their exports of manufactures increased twenty fold from 1960 to 1990, and the share of manufactured goods in total nonfuel exports of the developing countries rose from 15 percent to 68 percent (Chart 24). By comparison, nonfuel primary exports only doubled over this period. The shift toward manufactures was spurred by weak demand and deteriorating terms of trade for commodities, but the main factor was the rapid integration of many developing countries into the world trading system in the 1970s and 1980s. The growing importance of developing countries in world trade has, however, largely been concentrated in Asia, where output growth has also been the highest. The share of all exports of developing countries originating in the developing countries of Asia rose from 29 percent in 1960 to 56 percent in 1990, and the share of nonfuel exports expanded even faster (see Table 20).

Chart 24.
Chart 24.

Developing Countries: Share of Manufactured Goods in Nonfuel Exports

(In percent)

Source: United Nations, Monthly Bulletin of Statistics.

The outward-oriented strategy—lowering trade barriers, removing disincentives to exports, and implementing currency convertibility—pursued by many, but by no means all, countries has promoted more efficient use of resources, the gains from which go well beyond those suggested by standard analyses of resource allocation and economies of scale. Dismantling the administrative systems associated with import licenses, selective credit policies, and foreign exchange controls redirects the energies of entrepreneurs away from unproductive rent-seeking activities toward the production of marketable goods. Because exporting firms have a clear incentive to keep up with modern technology and to improve management, they benefit from the transfer of technology and from the exposure to foreign know-how. The outward-oriented strategy also encourages the adoption of sustainable and prudent macroeconomic policies to ensure a stable domestic environment that safeguards external competitiveness and encourages domestic saving. Taken together, these benefits of liberalized trade raise the returns to productive investment, including foreign direct investment, which reduces reliance on debtcreating capital inflows.

The benefits of an outward-oriented strategy in terms of macroeconomic performance are clear (Table 21).66 The performance of the outwardoriented economies has been clearly superior to that of the inward-oriented economies, where tariff and nontariff barriers have been high and there has been a bias against exports in favor of import substitution. Although not all differences can be fully attributed to trade policy, growth rates of GDP per capita show a descending pattern from the strongly outward-oriented to the strongly inward-oriented economies; similar marked differences are seen in saving and investment rates; the variation in incremental capital-output ratios, which may reflect efficiency in the use of capital, suggests that investments have been more productive in the outwardoriented economies; and differences in the growth of total factor productivity, which measures the efficiency of both capital and labor inputs, also testify to the benefits of outward-oriented strategies.

Table 21.

Developing Countries: Trade Orientation and Economic Performance

(Annual percent change unless otherwise noted)

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Note: Developing countries are classified into four categories according to the orientation of their trade strategy during the past two decades: (1) strongly outward-oriented, where trade controls are either nonexistent or very low; (2) moderately outward-oriented, where the average rate of effective protection for the home market is relatively low and the range of effective protection rates relatively narrow; (3) moderately inward-oriented, where the overall incentive structure favors production for the domestic market; and (4) strongly inwardoriented, where the overall incentive structure strongly favors production for the domestic market.

Importance of Trade for Countries in Transition

Nowhere are the costs of rigid trade restrictions and isolation from the competitive forces of world markets more apparent than in the former centrally planned economies. Decades of central planning, including managed trade, resulted in unproductive investments and an obsolete capital stock. In recognition of the need to restructure their economies, the countries of central Europe have made early liberalization of the trade and exchange system a major component of their efforts to adopt market principles. Fundamental reforms have been undertaken in Hungary, the former Czechoslovakia, Poland, Bulgaria, and Romania to eliminate state monopolies on foreign trade operations, reduce quantitative import restrictions, and modify the structure of tariffs. All these countries have also unified their exchange rates and established current account (but not capital account) convertibility. More limited reforms have been carried out in the countries of the former Soviet Union and, at the same time, trade and payments relations within the former Soviet Union have deteriorated sharply. Although some of these countries have begun to liberalize their trade and payments systems, trade continues to be distorted by export restrictions, price controls, lack of currency convertibility, settlement problems, Russia’s “centralized exports” scheme, and other impediments.

The collapse of central planning was accompanied by a sharp decline in trade among the former members of the CMEA. Within central Europe, this decline has been especially severe for Romania and Bulgaria, although there has also been a significant drop in trade among Poland, Hungary, and the former Czechoslovakia. The contraction of trade between central Europe and the former Soviet Union has been even more pronounced, with recent estimates suggesting a cumulative decline of 60–70 percent in 1990–92.67 The causes of this steep fall—the breakdown of the command system, the switch to world market pricing, and the change in the CMEA settlement system—are well known and have been discussed in previous issues of the World Economic Outlook. The recent worsening of the disruptions in production and interregional economic relations in the former Soviet Union has been aggravated by reductions in the supply of energy and raw materials for export, which have in turn depressed demand for imports from central Europe.

A significant amount of CMEA trade had been an artifact of the planning system, and the reorientation of trade has been a necessary prerequisite to ending the artificial isolation of these economies from world markets. New patterns of trade, involving closer integration with market economies, are already emerging, and estimates point to increases in export volumes in 1992 of between 10 and 20 percent for Hungary, Poland, the former Czechoslovakia, and Bulgaria. This performance is remarkable against the background of depressed domestic demand in the industrial countries, and it demonstrates the importance of reduced trade barriers and the ability of firms in the central European countries to respond to new opportunities. In contrast, exports from Romania and Albania have continued to decline, in part because of severe input shortages.

The liberalization of international trade and the early exposure to world markets have played a key role in those economies of central Europe that have made the most progress. Trade liberalization has helped to establish a rational set of relative prices and has introduced competition in monopolistic sectors. Access to imports from industrial countries has provided much-needed investment goods, although foreign direct investment has lagged behind initial expectations. Export earnings have eased financing constraints, and the expansion of exports has also been an important factor in attracting foreign investment.

Much of the expansion of trade has been with the EC, in part because of the improved access to EC markets for some central European countries resulting from the bilateral Association Agreements (also called Europe Agreements) between the EC and Bulgaria, the former Czechoslovakia, Hungary, and Poland.68 These agreements envisage the eventual elimination of trade barriers on many goods, although separate provisions deal with textiles, steel, and agricultural products. For these goods, the lowering of trade barriers will be more gradual, and safeguard clauses and antidumping measures have been retained by the EC. The EC Commission has recently begun to explore a free trade agreement with Russia. The former Czechoslovakia, Poland, and Romania signed free trade agreements with the European Free Trade Association (EFTA) in 1992, while negotiations between Hungary and EFTA are still taking place. Central European countries that had been GATT members are in the process of negotiating the same obligations and advantages accorded to market economies.

A sustained effort by the industrial countries to open their markets to imports from the countries in transition will be crucial to the success and speed of the economic transformation now under way. The recent antidumping measures imposed by the EC and the United States are, therefore, a matter of concern.69 Such measures also increase the risk that trade barriers will be raised in the reforming countries. As domestic demand in these countries picks up, trade imbalances may appear, and it will be necessary to resist protectionist pressures. Although closer economic relations with the market economies will be important, trade opportunities within the region of the former CMEA—including those between central Europe and the former Soviet Union—should not be neglected, and the bilateral preferences granted by the EC and EFTA should not be allowed to unduly divert trade from former CMEA partners. The recent agreement between Poland, Hungary, the Czech Republic, and the Slovak Republic to establish a free trade zone by the end of the decade is an important step in this regard.

Extensions of the GATT Process

The sweeping reductions in trade barriers in the past four decades under the auspices of the GATT have left the important agricultural, textile, and service sectors largely outside the system of multilateral, nondiscriminatory agreements on tariffs. Moreover, protection of intellectual property varies considerably from country to country. The Uruguay Round has sought to broaden the multilateral trade liberalization process by including these areas, although the sensitive issues raised in relation to these sectors have made the negotiations difficult.

Most industrial countries have put in place complex policies to protect agriculture, the economic impact of which has been quantified by the OECD and others in calculations of producer subsidy equivalents (PSEs), a standardized measure of the degree of agricultural protection. By this measure, support for agriculture is considerable, with an average subsidy of roughly 45 percent of the domestic price, or the equivalent of $170 billion annually during 1990–91 (Table 22). In contrast, there is relatively little protection for agriculture in many developing countries.70 Although PSEs are not widely available for developing countries, estimates by the U.S. Department of Agriculture for a small group of large developing countries Argentina, Brazil, China, India, and Mexicoindicate levels of protection in 1985–88 that are generally low, typically less than 3 percent of the domestic price for most agricultural products.

Table 22.

Industrial Countries: Agricultural Producer Subsidy Equivalents1

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Sources: OECD, Agricultural Policies, Markets and Trade: Monitoring and Outlook (Paris, several issues).

For each country, the first row is the producer subsidy equivalent (PSE) in billions of U.S. dollars. The second row is the PSE expressed as a percentage of the value of agricultural production, inclusive of the PSE.



The economic effects of the high levels of agricultural protection characteristic of the industrial countries are twofold. First, these policies distort production, employment, and consumption, thereby lowering real incomes. According to one estimate, eliminating agricultural support in the OECD countries from levels prevailing in 1988 would raise real incomes in the region by $72 billion in 1988 dollars (or by 1 percent of GDP in the OECD).71 Second, despite a shift in patterns of trade and production toward manufactured goods, many developing countries—especially those in the Western Hemisphere and Africa—remain dependent on agriculture. Liberalizing agricultural trade would, therefore, substantially increase the welfare of the developing world, although there is concern that higher world food prices would raise import costs. Multilateral liberalization would have a much larger impact in this region than would a reduction of agricultural support by the developing countries alone, in view of the relatively high levels of protection in the industrial countries.72

Managed trade of textiles and clothing was broadened significantly with the negotiation of the first Multifiber Arrangement (MFA) in 1974. The MFA is a web of bilateral agreements establishing country-specific import quotas that, contrary to the principles established by the GATT for other traded goods, discriminate extensively among countries. As in the case of agriculture, it is the developing countries that have the most to gain from a liberalization of textile trade, although some countries now benefit from the system of preferential agreements. The industrial countries would also benefit from lower prices and the rationalization of resources. Proposals currently under discussion envisage phasing out the MFA in the course of ten years, although in view of the inconclusiveness of the Uruguay Round it was decided to extend the current arrangement to end-1993.

International trade in services, although less distorted than agricultural and textile trade, is now under discussion in the Uruguay Round. In particular, it is proposed that an agreement on trade in services incorporate most favored nation treatment. Services trade raises issues that are distinct from those in trade in goods, largely because trade in services often does not require the cross-border shipment of a product, but rather movement of service providers or receivers. As a result, the barriers to trade have not mainly been tariffs, but regulations and an array of nontariff barriers. Although some regulations may not be intended to discriminate against foreign providers, they nevertheless hinder trade. Other barriers, however, are specifically designed to restrict international competition in services.

The subtle nature of these restrictions has complicated efforts to liberalize trade in services. The problems are compounded by a divergence of views between industrial and developing countries about what should be included in the definition of services. In general, developing countries prefer to limit the negotiations to cross-border movements of services and to factors of production specifically necessary for the provision of such services. Industrial countries argue, in contrast, that this would leave out services that require foreign direct investment and the right of establishment in the recipient country, which are important to compete effectively with domestic service providers. Initial commitments on services are still to be undertaken by Uruguay Round participants, so the outcome is still far from settled. The objective of integrating services into the GATT is, nevertheless, a positive development.

Another area that is now receiving attention is intellectual property. Without legal protection, the producers of inventions may lose royalties, which could undermine the incentive to carry out research. As trade in the products of research has grown, and as the importance of research and development in the growth process has become more widely recognized (see Box 9), the international extension of patent and copyright protection has taken on greater importance. In this case, as with other services, there is a conflict between the interests of the industrial, or “technology-exporting” countries, which seek relatively high levels of protection for intellectual property rights, and the developing, or “technologyimporting” countries, which are concerned that too much protection could give rise to excessive monopoly power, leading to higher prices for certain goods.

The outcome of the Uruguay Round remains in considerable doubt because the major trading powers—the United States, the EC, and Japan—as well as other participants have yet to come to full agreement. It now appears likely, however, that in many respects the Round will achieve less than had originally been hoped. The agreement on agriculture, for example, seems likely to fall far short of the goal of trade liberalization. Nevertheless, as was the case with manufactured goods after World War II, bringing agricultural and service trade into the GATT process would result in a formal, multilateral mechanism that might permit further reductions in trade distortions over time.

Trade Liberalization as a Strategy for World Growth

Although the links between trade and growth are complex, empirical evidence indicates a close relationship.73 An important way in which lower barriers to trade and access to world markets raise incomes is by promoting productive activity, increasing competition, stimulating foreign and domestic investment, and facilitating the exploitation of economies of scale and the transmission of technology and best-practice techniques. These mechanisms yield more than just “static” gains; they also promote dynamism by encouraging firms to adjust rapidly to changing circumstances in order to remain efficient and technologically competitive. Although specific enterprises or industries might suffer, at least initially, when exposed to world competition, all countries benefit from trade liberalization as they exploit more fully their comparative advantages. For these reasons, the mercantilist metaphors of “trade wars” and “sporting competitions,” with the implication that a country either loses or wins, are inappropriate. Similarly, the elevation of bilateral trade balances to the status of policy goals is misguided. Trade is not a zero-sum game; trade liberalization benefits all countries.

Despite the significant benefits in terms of economic growth that the rapid expansion of trade has brought to many countries, further advances now seem threatened, and there is a risk that the recent increases in trade barriers will accelerate. It has proved difficult to extend the multilateral, nondiscriminatory trade rules that have been negotiated for trade in manufactured goods under the GATT to other sectors, such as agriculture, textiles, and services. The industrial countries have increasingly resorted to countervailing and antidumping duties and to nontariff barriers. This has gone hand in hand with a focus on bilateral trade balances—sometimes even in specific sectors—and a heightened interest in managed trade, often in the context of regional trading blocs (see Annex III).

These developments have emerged against a backdrop of macroeconomic imbalances, including persistent current account imbalances, recessions or periods of slow growth, and historically high unemployment in Europe. In the near term, larger surpluses in Japan and larger deficits in the United States and Europe—in the latter case accompanied by increased unemployment—risk leading to still greater pressures to restrict trade.

In contrast to the significant trade liberalizations undertaken by many developing countries, tariffs and quantitative restrictions abound in others. These countries, which have much to gain from world trade, have a growing responsibility to open their markets further, both to each other and to the industrial countries. Those developing countries with sizable, sustained surpluses need to be aware of the reactions these can produce in their trading partners and need to implement both structural and macroeconomic policies to reduce these imbalances.

The multilateral trading system is particularly critical for the countries in transition. Granting access to their markets is probably the single most important way that the industrial countries can help to ensure that the countries in transition successfully manage the difficult process of restructuring and transformation. Impeding access to world markets could have severe consequences for these countries and for the rest of the world, at a minimum hindering the transition process, leading directly to a need for potentially much larger amounts of direct financial aid for both stabilization and structural reform.

It is crucial that the Uruguay Round of multilateral trade negotiations be successfully concluded. This would confirm and reinforce the longstanding commitment to the principles of free and nondiscriminatory trade. By further reducing trade barriers and by extending the GATT process to nonmanufactures, completion of the Round would also raise economic prosperity. Although quantitative estimates of the gains are necessarily uncertain, recent studies suggest that completing even the partial liberalization now envisaged would raise annual world real income permanently by $120 billion to $200 billion.74 The failure of the Round, in contrast, could roll back gains already made—notably reforms to dispute settlement—as well as raise pressures for protectionism and discourage the growing movement toward liberalization in the developing countries. The macroeconomic imbalances that could give rise to protectionism must also be addressed, in many cases by reducing excessive government budget deficits and raising national saving. By demonstrating the willingness of the major industrial countries to cooperate in solving common problems, such efforts would bolster confidence and provide a new spur to activity, in both the industrial and developing countries, and would provide an environment conducive to successful economic restructuring in the countries in transition.


For detailed analyses of trade policy developments in the 1980s, see Shailendra J. Anjaria, Naheed Kirmani, and Arne B. Petersen, Trade Policy Issues and Developments, Occasional Paper 38 (IMF, July 1985); and Margaret Kelly and Anne Kenny McGuirk, Issues and Developments in International Trade Policy, World Economic and Financial Survey (IMF, August 1992).


See Angus Maddison, The World Economy in the 20th Century (Paris: OECD, 1989), for extensive evidence on long-term growth trends in industrial economies.


For a discussion of the GATT process see J.M. Finger, “Trade Liberalization: A Public Choice Perspective,” in Challenges to a Liberal International Economic Order, edited by Ryan C. Amacher, Gottfried Haberler, and Thomas D. Willett (Washington: American Enterprise Institute for Public Policy Research, 1979).


See Charles Adams, Paul R. Fenton, and Flemming Larsen, “Potential Output in Major Industrial Countries,” Staff Studies for the World Economic Outlook (IMF, August 1987), pp. 1–38.


See Richard Baldwin, “The Growth Effects of 1992,” Economic Policy, Vol. 4 (October 1989), pp. 247–81; David T. Coe and Thomas Krueger, “Why Is Unemployment So High at Full Capacity? The Persistence of Unemployment, the Natural Rate, and Potential Output in the Federal Republic of Germany,” IMF Working Paper 90/101 (October 1990); and David T. Coe and Reza Moghadam, “Capital and Trade as Engines of Growth in France: An Application of Johansen’s Cointegration Methodology,” IMF Working Paper 93/11 (February 1993).


The terms of trade of the developing countries for their nonfuel exports rose by 11 percent between 1960 and 1975 but then declined by 20 percent between 1975 and 1990, leaving these countries’ share of world exports unchanged at slightly more than one-fifth.


Table 21 extends the analysis of 40 developing countries contained in the World Bank’s World Development Report 1987, Chapter 5 (New York: Oxford University Press, 1987), from which the classification of countries for the period 1973-85 is taken. This classification was extended to cover the 198592 period using IMF data. The analysis here is complementary to the one presented in the October 1992 World Economic Outlook (Chapter IV), which examined the role of structural reforms, including trade liberalization, in the successfully adjusting developing countries.


Economic Commission for Europe, Economic Bulletin for Europe, Vol. 44, Table 2.1.1 (November 1992).


These agreements, which cover a broad range of economic relations between the contracting parties, were signed at the end of 1991 and contain trade provisions that entered into force in March 1992 except for Bulgaria, which signed its agreement in March 1993. The arrangements provide for a move to free trade between the EC and each of the contracting countries, with tariffs and quotas for a number of goods being eliminated immediately and a timetable covering the next ten years being established for other products.


In 1992 the EC imposed antidumping duties on steel products from Hungary, Poland, the former Czechoslovakia, and Croatia. In early 1993, the United States imposed preliminary antidumping duties on steel imports from Poland and Romania.


See Anne O. Krueger, Maurice Schiff, and Antonio Valdes, “Agricultural Incentives in Developing Countries: Measuring the Effect of Sectoral and Economywide Policies,” World Bank Economic Review, Vol. 2 (September 1988), pp. 255–71.


John P. Martin, Jean-Marc Burniaux, Francois Delorme, Ian Lienert, and Dominique van der Mensbrugghe, “Economy-wide Effects of Agricultural Policies in OECD Countries: Simulation Results with WALRAS,” in OECD Economic Studies, Vol. 13 (Paris: OECD, 1989–90). Although a 1 percent gain seems small, it is worth recalling that agriculture accounts for only 3 percent of output.


Rod Tyers and Kym Andersen, Disarray in World Food Markets: A Quantitative Assessment (Cambridge and New York: Cambridge University Press, 1992); and Barry Krissoff, John Sullivan, and John Wainio, “Developing Countries in an Open Economy: The Case of Agriculture,” in Agricultural Trade Liberalization: Implications for Developing Countries, edited by Ian Goldin and Odin Knudsen (Paris: OECD Development Centre, 1990).


For econometric evidence on the relation between trade restrictions and growth, see Malcolm Knight, Norman Loayza, and Delano Villanueva, “Testing the Neoclassical Theory of Economic Growth: A Panel Data Approach,” IMF Working Paper 92/106 (December 1992).


See Ian Goldin and Dominique van der Mensbrugghe, “Trade Liberalization: What’s at Stake,” OECD Development Centre Policy Brief No. 5 (Paris: OECD, 1992); and Trien T. Nguyen, Carlo Perroni, and Randall M. Wigle, “The Value of a Uruguay Round Success,” World Economy, Vol. 14 (December 1991), pp. 359–74. The second study estimates the benefit of more complete liberalization to be twice that from partial liberalization.

Annex I Monetary Policy, Financial Liberalization, and Asset Price Inflation

Previous issues of the World Economic Outlook have examined the consequences of asset price inflation and deflation for private sector financial positions and for the business cycle. Asset price inflation has been most pronounced in Japan, the United Kingdom, Australia, New Zealand, and the Nordic countries, but it also occurred on a more limited scale in the United States and some continental European countries.1 Because the asset price inflations were associated with very rapid expansions of credit and, in some places, excessive money growth, it is important to consider the role that monetary policy may have played in permitting these sharp price increases to occur. There were several factors that made it difficult for policymakers to judge the stance of monetary policy and the impact of policies on asset prices and, more generally, on the economy.

First, financial liberalization distorted the intermediate targets used in the conduct of monetary policy and altered the transmission of monetary policy to the real economy. Many analysts at the time suggested that credit aggregates were more accurate indicators for assessing the stance of monetary policy than were monetary aggregates. Others suggested that, in a deregulated and liberalized financial environment without credit rationing, interest rates would tend to become more volatile and would have to change more sharply to tighten or ease credit conditions. In part as a result of these arguments and events, by the end of the 1980s many central banks had adopted more eclectic approaches toward monetary policy. In retrospect, it is apparent that earlier adjustments to the framework underlying monetary policy might have provided a more timely response to the accumulation of credit.

Second, more than in other recent inflation episodes, conventional measures of inflation in the 1980s did not adequately reflect the strong price pressures that were building and that ultimately led to unsustainable increases in the prices of tangible and financial assets. For example, conventional measures of inflation in Japan were below 2 percent throughout the 1980s, yet money and credit growth were excessive and asset prices soared. In the United States, inflation rose slightly but was relatively stable during this period, while there were large price increases in commercial and residential real estate markets.

Given the emphasis placed on conventional measures of inflation—which focus on prices of the flow of goods and services—important information contained in asset prices was not given sufficient attention during this period. This is not to suggest that monetary policy should explicitly target asset prices or that policymakers should react to sharp movements in stock prices, for example, whenever they occur. It is clear, however, that the indicators of inflation used by policymakers to judge the appropriateness of money and credit policies did not provide a complete and accurate assessment of the inflationary pressures that were building during the mid- to late 1980s. Additional transaction-based measures of prices, with broader coverage than the production- or consumption-based measures, might have alerted policymakers earlier.

Third, there was an initial tendency to view the sharp asset price increases as relative price adjustments associated with changes in tax policies, demographic changes, and other structural changes. This explains much of the acquiescence to the runup in asset prices and the related rapid growth in credit aggregates. With the benefit of hindsight, only a part of the increase in asset prices appears to have been caused by structural factors, and in most countries—especially in Japan and the United Kingdom—much of the relative price adjustment was reversed as a result of the monetary tightening that occurred in 1989–90 (Chart 25).

Chart 25.
Chart 25.

Selected Countries: Property Prices

(As a ratio to the consumer price index; 1980: Q1 = 100)

Sources: For the United States, Data Resources, Inc. data base; for the United Kingdom, Central Statistical Office, Financial Statistics; and for Japan, Japan Real Estate Institute, Bulletin of Japan Land Prices.1Urban residential land price in six largest cities.2Index of prices on dwellings.3Average price of a new house.

An exception in this regard may be the United States, where property price changes—which were small compared with those in other countries—were directly related to tax reforms that provided incentives for real estate investment and to capital inflows that reflected international portfolio adjustments. Part of the subsequent decline in U.S. property prices resulted from the reversal in 1986 of tax incentives provided earlier in the decade and was therefore unrelated to monetary tightening. Nevertheless, there clearly were excesses in the U.S. commercial property market, which experienced high inflation rates and overbuilding.

This annex briefly examines the adaptation of monetary policy to the changing financial environment in the 1970s and 1980s. An analysis of the relationship between monetary growth and inflation in the mid- to late 1980s attempts to shed light on the reasons for the concentration of inflationary pressures in asset markets during this period. The discussion then examines how financial deregulation and liberalization in the 1980s—and the globalization of financial markets—made it increasingly difficult to assess the stance of monetary policy and changed the ways in which monetary actions affected the economy. The final section draws some lessons from the industrial countries’ experiences with inflation for the conduct of monetary policy in the 1990s.

Monetary Policy and Inflation

The widespread commitment to monetary aggregate targeting in the 1980s had its roots in the 1960s and 1970s, when there were relatively strong links between changes in the money supply and changes in prices. The transmission of excessive money growth to inflation was generally understood as follows: expansionary monetary policy increased bank reserves and lowered interest rates; banks provided more loans and issued more deposits, which expanded both sides of their balance sheets; loans to the private sector supported increased spending; and, as monetary growth continued and production constraints were reached, prices and price expectations rose. In the absence of a large shift in the pattern of transactions, conventional price measures such as the consumer price index or the GDP deflator—which measure the average price of goods and services consumed or produced in the periodwere adequate gauges of inflationary pressures, including those in asset markets.

Expansion of the money supply affected real economic activity in the short term, because of rigidities in the price- and wage-setting process, but generally led to price increases in the medium term. Changes in monetary aggregates, which reflected changes on the liability side of bank balance sheets, were useful indicators of the stance of monetary policy. Changes in credit aggregates, which reflected changes on the asset side of bank balance sheets, were also useful indicators, although monetary policy was viewed as having a more direct influence on bank deposits.

In the United States, target ranges for Ml growth were announced throughout the 1970s. The U.K. authorities set targets for broad money starting in 1976, and the Bundesbank established targets for central bank money in 1974; other central banks shifted similarly. The Bank of Japan did not specifically target a monetary aggregate, but in 1978 it began to include “projections” for the broad aggregate M2 + CDs (certificates of deposit) in its policy announcements.

By the early 1980s, control of inflation became the primary concern of economic policy in the major industrial countries. Determined reductions in money growth, sharp increases in interest rates, and a deep recession in 1981–82 brought inflation down (Table 23). By 1985, the strong and persistent rise of the dollar in currency markets and other external factors became important considerations for the industrial countries and prompted greater policy coordination following the Plaza Accord. Thereafter, monetary policy eased decisively in many industrial countries.

Table 23.

Five Major Industrial Countries: Monetary Policy Record Since 19801

(Percent change, fourth quarter to fourth quarter, unless otherwise stated)

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Sources: Bank for International Settlements, Annual Report (Basle, various years); Board of Governors of the Federal Reserve System; and World Economic Outlook data base.

Inflation is measured as the annual percent change in the GDP deflator; “actual” refers to money growth over the target period.

West Germany through December 1990, unified Germany thereafter.

Targets are for Ml through 1982 and for M2 thereafter. For 1983, targets shown are for growth from a February-March 1983 base through the fourth quarter.

The Bank of Japan publishes projections of the growth of M2 + CDs each quarter over the corresponding quarter of the previous year. Projections above are for the fourth quarter over preceding fourth quarter.

Target refers to central bank money through 1987, and to M3 in 1988–92.

For 1980 to 1982, December-to-December growth rate of M2; for 1983 to 1985, growth from average November–December–January to same period of following year of M2 (in 1983) and M2 holdings of residents (1984–85); thereafter, fourth quarter to fourth quarter. Targeted aggregate is M3 for 1986–87; M2 for 1988–90; M3 for 1991–92.

Through 1984, target periods are from February to April of the following year; then for twelve-month periods from May 1985, and from April each year thereafter. The targeted aggregate is M3 through 1986, M0 thereafter.

Actual growth, December to December.

Second quarter to second quarter.

Concern about the effects of the stock market crash in October 1987 led to a further easing of monetary policy, but the event itself may have been an early warning of growing financial imbalances and latent inflationary pressures, especially in asset markets. If nothing else, the correction of stock market prices suggested that the revaluation of corporations that had taken place in the preceding period was not consistent with fundamental changes in values. Asset market developments prompted the Bank of Japan in 1987 to urge caution in bank lending practices. Inflationary pressures also led to tightening in the United Kingdom in mid-1988, and short-term interest rates were raised significantly. By 1988, concern about overheating in the United States led to progressive increases in the federal funds rate. Policy was tightened in 1989 in Japan, and by the end of 1990 interest rates had been raised considerably, and the growth of broad money slowed.

During the 1980s, deregulation made monetary targeting and the assessment of monetary conditions increasingly difficult in many countries. As a result, many countries used a broader range of economic indicators to monitor monetary and financial conditions.2 Emphasis shifted in the United States to broader aggregates and to the federal funds rate, and in the United Kingdom it shifted to a narrower aggregate, the exchange rate, and other financial indicators.

Measures of Potential Inflation

The practical problems of monetary targeting in an environment of financial deregulation were evident throughout the 1980s. Less apparent were the changes in the relationships between money and credit growth and a broader measure of inflation that included asset transactions. At the time, it may not have been possible to assess properly the extent to which money and credit policies were adding to inflationary pressures in asset markets. In retrospect, however, monetary and financial data suggest that by 1985–86 both money and credit growth were excessive in Japan and, especially, in the United Kingdom, and credit growth was unusually high in the United States. Overly expansionary money and credit policies also were evident in many other countries that experienced asset price inflation, including Australia, New Zealand, the Nordic countries, and Switzerland.

In a monetary accounting framework, expansion of the money supply in excess of real GDP growth—which can be referred to as “excess money growth”—is potentially inflationary. Ex post, the gap between this excess money growth and actual inflation (in the GDP deflator) is usually interpreted as a change in velocity—that is, a change in the rate of circulation of money relative to nominal GDP. Changes in velocity are often attributed to improvements in transaction technology or to other institutional factors. Policymakers regularly adjust for velocity changes when the changes deviate significantly from trend movements or when they are known to be associated with special factors.

An alternative interpretation of the gap between excess money growth and actual inflation—one that is particularly relevant for the 1980s—is that it is a residual that represents potential inflationary pressures in markets, pressures that are not captured by national income account measures of output and prices. If there is a shift in the pattern of economic transactions, for example, changes in this residual may not be due to shifts in the demand for money, but instead may carry important information about inflationary pressures affecting other types of economic transactions. As discussed below, this gap is useful for examining the role that monetary policy may have played in the asset price inflation in many countries. By implication, broader transactionbased price indices, although conceptually difficult to define precisely, would have been more complete and useful indicators and could have provided information to policymakers about the inflationary pressures that were building at that time.

For Japan and the United Kingdom, measures of both excess money and credit growth suggested that inflationary pressures were building in the mid- to late 1980s. In Japan, growth in the monetary aggregates in the mid- to late 1980s was high—relative to inflation—and variable, yet nominal GDP growth was relatively low, and inflation measured by the GDP deflator was fairly steady at its lowest level in decades (Chart 26). This divergence reflected a breakdown in the 1980s of the money-price relationships that had prevailed in the 1970s and was associated with changes in the transmission of money and credit growth to goods prices and asset prices. Excess money and credit growth—that is, money and credit growth in excess of growth in real economic activity—increased and remained high during this period (Chart 27). Moreover, the annual gaps between excess money growth and measured inflation (GDP deflator), and between excess credit growth and inflation, averaged 3¼ percentage points and 3¾ percentage points, respectively. By construction, these gaps represent either a sharp change in behavior—in the form of a significant change in the demand for money and credit balances—or a substantial shift in the pattern of transactions toward assets and other markets not captured in national income measures of final goods transactions. Viewed in this way, the money and credit gaps represented inflationary pressures in the economy that were fully consistent with the inflation that occurred in asset markets.

Chart 26.
Chart 26.

Japan: Money, Incomes, and Prices

(Percent change from four quarters earlier)

1Urban residential land price in six largest cities.2In the fourth quarter of 1972, the increase was 95.2 percent.
Chart 27.
Chart 27.

Japan: Money, Debt, and Inflation

(In percent)

1Total financial liabilities of the private nonfinancial sectors less trade credits.

In the United Kingdom, narrow money growth and inflation had been closely linked in the 1970s, and the relationship strengthened in the 1980s (Chart 28). Growth in the broad aggregate remained high and increased in the second half of the decade, but changes in the GDP deflator remained relatively low and even declined, although housing prices increased sharply. Both excess money and excess credit growth emerged in the United Kingdom in the mid-1980s and persisted through the end of the decade (Chart 29). The differences between these measures at potential inflation and actual inflation averaged 5¾ percentage points and 7¾ percentage points, respectively, suggesting the accumulation of strong inflationary pressures.

Chart 28.
Chart 28.

United Kingdom: Money, Incomes, and Prices

(Percent change from four quarters earlier)

1Index of prices on dwellings. In the first quarter of 1973, the increase was 50.0 percent.
Chart 29.
Chart 29.

United Kingdom: Money, Debt, and Inflation

(In percent)

1Total financial liabilities of the personal and the industrial and commercial sectors less outstanding domestic trade credits and ordinary and preference shares.

The case is not as clear in the United States. There had been a fairly close relationship between the growth of narrow money and inflation (as measured by the GDP deflator), and between money growth and nominal GDP growth (Chart 30). After the 1981–82 recession, however, higher growth in both the narrow and broad monetary aggregates was associated with lower or stable inflation and lower growth in nominal GDP.3 This apparent change in the relationship between money growth and inflation was in part the result of much higher real economic growth in the United States in 1983–88. Moreover, during this expansionary period, excess money growth in the United States was generally consistent with measured inflation; the gap between excess money growth and inflation was a negligible annual average of ¼ of 1 percentage point (Chart 31, top panel).

Chart 30.
Chart 30.

United States: Money, Incomes, and Prices

(Percent change from four quarters earlier)

1Average price of a new house. In the third quarter of 1970, the decrease was 7.5 percent.
Chart 31.
Chart 31.

United States: Money, Debt, and Inflation

(In percent)

1Total credit market debt outstanding of the private nonfinancial sectors.

The growth of the monetary aggregates in the United States, which were the primary intermediate indicators for monetary policy, did not suggest that general inflationary pressures might be building elsewhere in the economy. In addition, there were reasons to expect higher relative prices in real estate markets. The expansion of credit, however, far exceeded the expansion in the real economy (see Chart 31, bottom panel). Even though money growth was in line with measured inflation, credit growth would have been consistent with much higher inflation (in the GDP deflator), providing some indication that inflationary pressures might be building in the economy. During the 1980s, the annual gap between excess credit growth and actual inflation (in the GDP deflator) averaged 2½ percentage points in the United States. The cumulative effect of this excess credit growth turned out to be considerable, especially in commercial real estate markets.

In retrospect, it would appear that within a broader monetary policy framework—one in which measures of transaction prices were used as complementary indicators along with standard inflation indicators for goods and factor markets—the persistence of growth in money and credit in excess of nominal GDP growth (in Japan and the United Kingdom, especially) would have suggested that inflationary pressures were building. The need for an adjustment, however, was not recognized until the process of debt accumulation and asset price inflation had reached a critical stage.4

Concentration of Inflation in Asset Markets

Why did the excess liquidity and credit that was provided in the mid-1980s create excess demand for assets rather than excess demand for the flow of goods and services? As just described, the transmission from monetary policies to inflationary pressures in the late 1980s was unusual in the sense that inflation, as conventionally measured, did not increase as sharply as it had in other recent episodes of expansionary macroeconomic policies. A possible resolution of this puzzle is that financial liberalization and innovation and other structural changes in the 1980s created an environment in which excess liquidity and credit were channeled to specific groups active in asset markets. These included large institutions, high-income earners, and wealthy individuals, who responded to the economic incentives associated with the structural changes. These groups borrowed to accumulate assets in global markets—such as real estate, corporate equities, art, and commodities such as gold and silver—where the excess credit apparently was recycled several times over.

In the United States, ongoing financial innovations—related to earlier financial deregulation and liberalization—and tax reform provided opportunities and incentives for investment, and these opportunities were particularly significant for the corporate sector and high income earners.5 The expansion in credit financed, for example, mergers and acquisitions, leveraged buyouts, commercial real estate, and residential real estate. In Japan, tax provisions created incentives for the construction of apartment houses and condominiums, and changes in the capital gains tax treatment of real estate transactions encouraged upgrade purchasing. Spending in the late 1980s shifted significantly toward luxury goods and those components of demand that are typically financed on credit, such as business investment, home construction, and durable goods.6 By contrast, in the United Kingdom, the increase in borrowing was more broadly based, suggesting that the debt accumulation reflected a backlog of unsatisfied demand for credit that was unleashed after financial liberalization. Although the increase in inflation in the United Kingdom was also more broadly based, in that conventional measures of inflation increased, real asset prices rose substantially.

Intense competition among financial intermediaries resulted in high-risk lending in new areas of business, which contributed to increased asset market activity. This increase in the supply of credit to relatively risky asset markets can be directly related to financial liberalization and the subsequent waves of financial innovations, which together led to an erosion in the franchise value of banks, an expanded role for other financial institutions, greater competition and risk taking, and a general squeeze on profit margins.7 Whereas in the 1970s there was increased lending to developing countries, in the 1980s there was increased lending for highly leveraged transactions and real estate purchases. In the United Kingdom, banks aggressively entered the mortgage market. In Japan, the decline in banks’ corporate business, which shifted to securities markets, led city banks to lend for real estate transactions and to small and medium-size businesses. With key safety nets still in place—most notably deposit insurance systems—the removal of earlier restrictions on lending practices (as in the U.S. savings and loan industry, for example) also led to increased risk taking. The increased risk taking suggests that supervisory and oversight systems were not expanded sufficiently to keep pace with deregulation. This institutional inertia may have contributed to an environment that encouraged excessively speculative behavior in asset markets.

There were other, nonfinancial, factors in the late 1980s that tended to restrain demand and inflation pressures in markets for goods and services, thereby making it more likely that excess credit and liquidity would be concentrated in asset markets. Structural reforms, along with a general increase in global competition, created pressures on profit margins and discouraged price increases. Wage increases were restrained by high and rising unemployment—particularly in Europe—by reduced expectations of inflation, and by government wage policies.

Finally, prices for goods and services may have adjusted more slowly to monetary growth in the mid- to late 1980s. Because asset prices depend on expectations of future economic developments—unlike most goods prices, which are mainly determined as a markup over costs—and are determined in deep active auction markets, they often respond first to monetary stimulus. This was true even before deregulation, but financial liberalization appears to have strengthened the link between money growth and asset prices. Given the expansion in financing possibilities, spending on items that require credit rose more rapidly than spending on other goods, and this shifted the pattern of transactions away from goods and services and toward assets.

Once the process of asset price inflation got started, in the absence of a restrictive monetary policy, expectations of further capital gains apparently became an important aspect of increased demand for assets.8 To the extent that past price increases determined expectations of future price increases, the real cost of borrowing for investment in asset markets was often negative in the United States, Japan, and the United Kingdom. In 1986–89, for example, building society loan rates in the United Kingdom stayed below 15 percent and were often below 12 percent, while housing prices rose annually by 20 percent on average. In Japan, the average new loan rate was below 6 percent and declined for most of the 1985–89 period, while stock prices increased at an annual rate of 27 percent.

Financial Liberalization and Monetary Policy

Even if broader measures of inflation had been closely monitored in the conduct of monetary policy during the 1980s,9 inflation is a lagging indicator, and other indicators would have been necessary to assess monetary and financial conditions. The structural factors described earlier—and the evolving responses to financial deregulation, liberalization, and globalization—altered important relationships between monetary instruments and intermediate targets and the impact of monetary policy on the real economy. The difficulties of quantifying the impact of these structural changes in the daily conduct of monetary policy were compounded by uncertainties created by the fundamental changes in the behavior of financial intermediaries, businesses, and households in response to changes in economic incentives.

Monetary Policy Transmission Before Deregulation

Before deregulation, the conduct of monetary policy in the major industrial countries relied heavily on official interest rates. In the United States, for example, the federal funds rate was a primary policy instrument, but deposit rate ceilings also played a major role in changing the amount of liquidity and credit provided to the private sector. The U.K. authorities conducted open market operations to influence the cash positions of banks and interest rates, but they also relied heavily on changes in the minimum lending rate. Administrative policies, and control of official rates, also played a central role in Japanese monetary policy before the early 1980s.

In addition to interest rate policies, quantity constraints played a significant role in all three financial systems, although Japanese monetary policy was the most explicitly quantity-oriented.10 In the United States, the tightening effect of an interest rate increase was reinforced in periods when market rates rose above the deposit rate ceilings. Deposit holders shifted their funds out of banks and into accounts earning market rates. This process of disintermediation, prevalent in the 1960s and 1970s, reinforced the contractionary effects of reserve withdrawal on bank balance sheets and forced a further reduction in bank lending. Some borrowers had access to funds from nonbanks, so the initial impact of monetary contraction fell primarily on those sectors without such access, such as mortgage borrowers. The disproportionate burden on the housing loan market was mitigated somewhat by the advent of mortgage securitization and government mortgage assistance agencies in the early 1980s.

In the United Kingdom, where lending restrictions largely kept banks out of the residential mortgage market before 1980, quantity rationing also played a role in the transmission of monetary policy. The market was dominated by building societies, who adopted a collective practice of smoothing the interest rate charged on their variable rate mortgages.11 Periods of excess demand were handled by rationing, either in terms of delayed granting of loans or reductions in loan size. This system was a feature of the exclusive role that building societies enjoyed, and it eroded rapidly once banks entered the market.

The real effects of monetary policy were therefore transmitted through two channels: through changes in official interest rates and through changes in the availability of credit. The magnitude of the effects of policy changes depended critically on the sensitivity of foreign and domestic spending decisions to changes in interest rates and any associated changes in the exchange rate. Interest rate changes affect demand through a substitution effect, by changing the relative cost of current and future consumption; through a wealth effect, by changing the current values of long-lived financial and real assets; and through an income or “cash flow” effect as the size of interest payments and receipts move with current rates. The impact of changes in the availability of credit through disintermediation or rationing depended heavily on the existence of alternative sources of funds, including overseas markets, and on the access that different domestic borrowers had to these alternative sources.

Deregulation and the Monetary Policy Transmission Process

Deregulation changed key aspects of the monetary policy transmission process by changing bank activity and behavior, by encouraging the growth of competing nonbank intermediaries and direct securities markets, by altering the financial opportunities available to businesses and households, and by changing international capital flows.12 One of the most significant effects of liberalization has been the increase in financial activity outside of banks. The growth in commercial paper and money market mutual funds, and declining proportions of household and business assets and liabilities held with banks, attest to the diminished role of traditional financial intermediaries. Because banks are the intermediaries most closely connected (through reserve accounts and regulations) to central banks, this shift in the locus of financing and saving activity changed the linkages between monetary policy and economic activity.

The banking sector’s response to liberalization has been, in part, to compete more aggressively for deposits by offering new types of accounts and more accounts with market-determined rates of return. The resulting flexibility of deposit interest rates in the United States has significantly reduced the phenomenon of cyclical disintermediation.13 This, in turn, has reduced the impact of monetary tightening on the residential housing market. The shift by corporations in Japan from bank-intermediated finance to direct securities markets has led city banks to shift their attention to small and medium-size borrowers, who previously had access only to funds at regional banks. In both of these economies, an additional consequence of heightened competition and the declining franchise value of the banking system has been an increase in off-balance-sheet activities of banks and increased allocation of bank loans to those sectors promising high returns. Bank real estate lending, in particular, increased substantially in the late 1980s, thereby channeling excess liquidity to property markets.14

Household financial activity also changed considerably in response to deregulation. Innovation in deposit and loan instruments led households to expand both financial assets and liabilities. As a consequence, net wealth increased in the United States, the United Kingdom, and Japan until the asset market downturns eroded the value of some of the holdings. Studies have found a significant reduction in liquidity constraints in the United States, Japan, France, the United Kingdom, and Canada.15 Consumption decisions have thus become more responsive to interest rate changes. That is, the substitution effect of interest rate changes strengthened.

Reinforcing this has been a change in the income or “cash flow” effect of interest rate movements. As the proportion of variable rate loans has increased, adjustments in interest payments, and hence spending patterns, have taken place more rapidly. Although households remain net creditors for all debt instruments, in the United Kingdom they have become net debtors in terms of floatingrate instruments. Thus, an increase in interest rates requires that a larger portion of current household income be used to meet the obligations of increased interest payments on floating liabilities. This increased effect of interest rates may be partially offset because with variable rate contracts, the initial level of the interest rate plays a somewhat smaller role in the loan screening process.16

The increased internationalization of financial markets has reduced the control that domestic policy authorities have over the quantity of credit; control of interest rates remains the key policy instrument. An example is the role that foreign bank lending played in offsetting credit shortages to U.S. corporations in the late 1980s.17 Japanese corporations also have increased their use of foreign financial markets: foreign bond issues as a portion of total corporate bond issues rose from 40 percent in 1980 to 60 percent in 1991. Such increased access to external funds reduces the contractionary effect on domestic spending of central bank tightening, at least among certain sectors of the economy. Moreover, the sensitivity of international capital flows to international interest rate differentials makes it more difficult for monetary authorities to balance domestic and external policy objectives when these conflict.

These changes in behavior and opportunities alter, individually, some component of the monetary policy transmission process. The net effects are manifested in changes in historical macroeconomic relationships. Ongoing problems in defining the monetary aggregates, and apparent shifts in money demand functions, have been features of monetary policy discussions since the onset of deregulation. There was also a change in the relationship between the yield curve and the relative growth of broad and narrow monetary aggregates in the 1980s. Policymakers have responded to these problems in part by reducing their exclusive focus on one monetary aggregate and by broadening the set of indicators used to assess the stance of monetary policy. The U.K. authorities suspended targeting of M3 in 1987 and adopted a more broadly based approach that includes attention to MO, the exchange rate, and other financial indicators.18 The Bundesbank shifted in 1987 from targeting central bank money to targeting M3. The Federal Reserve Board reduced its emphasis on Ml targeting in 1982 and ceased setting targets for M1 altogether in 1987. The Federal Reserve Board continues to set targets for the broader aggregates, but in recent years it has downplayed strict reliance on monetary aggregates and instead considers a range of indicators. The Bank of Japan has not changed its targeted aggregate, but it was prompted in the mid-1980s to revise substantially its projections for M2 + CDs as deregulation changed the behavior of the aggregate.

The changes go beyond measurement problems, however, and include changes in the relationship between monetary aggregates, inflation, and nominal GDP. Evidence from vector autoregressions of the relations between monetary aggregates and nominal income indicate important changes associated with deregulation.19 In the United States, Ml and M2 broke down as predictors of income by 1978. In Japan, Ml and M2 + CDs retained a significant relation to income in the 1970s and 1980s, but the underlying directions of causality appear to have shifted. In the United Kingdom, sterling M3 ceased to be a good predictor of income after 1983.

Deregulation has made it more difficult to assess the stance of monetary policy and to forecast future activity. The yield curve has been used increasingly as an indicator of future nominal GNP growth and inflation since the 1980s. In the United States, studies have shown that the best predictor is the spread between the commercial paper rate and the treasury bill rate. Analysis of this relationship in other countries found similar predictive power in Canada and the United Kingdom, but not in Japan, France, or Germany.20 One explanation for the predictive power of the spread between the commercial paper rate and the treasury bill rate is that monetary tightening curtails bank lending and leads to an increase in commercial paper issuance for those firms that can substitute between bank loans and direct issuance markets. This increase in borrowing in the commercial paper market drives up that interest rate relative to other comparable maturity market rates and signals the upcoming contraction in economic activity induced by monetary policy.21 As deregulation deepens commercial paper markets and increases substitution between bank loans and market instruments, however, this effect can be expected to weaken. Preliminary evidence of this weakening has already emerged in the United States and may emerge in other economies for similar reasons.

Implications for Monetary Policy

As the preceding section indicates, a wide range of forces has affected the monetary transmission mechanism, and some evidence of these changes is already apparent. This section addresses three policy issues: changes in the nature of the monetary control mechanism, prospective shifts in the sectoral impact of monetary policy actions, and adjustments in the set of information variables that are monitored.

One of the most immediate effects of financial liberalization has been a reduction in the monetary authorities’ direct control over the quantity of credit. Without regulated deposit rates, the authorities have much less ability to influence interest rate spreads and, thus, to induce shifts in business and household financing and saving decisions. The extensive development of alternative sources of funds—both domestic and foreign—has reduced the central bank’s influence over intermediation. What remains is the central bank’s control over certain interest rates. The channel of monetary policy has thus narrowed—from one in which credit supply repercussions reinforced the effects of interest rate changes, to one in which these rationing elements are greatly reduced if not altogether absent.

Several relationships, therefore, have taken on increased importance. The first concerns the ability of central banks to affect market rates, including those on longer-maturity instruments. As markets deepen and innovation proceeds, arbitrage is likely to strengthen the ties among different market rates. At the same time, deregulation has eliminated sources of inflexibility in many rates, so that long-term rates can be expected to respond more freely to expectations of inflation. The central bank’s ability to influence a broad array of market interest rates will therefore depend on the state of the economy and on expectations about future policies. In addition, international integration of capital markets has increased the importance of the exchange rate as part of the policy transmission mechanism.

Some aspects of deregulation have tended to diminish the sensitivity of components of demand to interest rates; others have tended to amplify it. Because more loan contracts are arranged on a variable rate basis, borrowers have less need to worry about being locked into high rates prevailing at a particular time, so borrowing may not be reduced as much by an interest rate increase as it would have been when primarily fixed-rate contracts were available. Interest rates play a somewhat smaller role in the loan screening process now, and there are more opportunities for firms to hedge against interest rate changes. But the prevalence of floating-rate contracts also means that interest rate changes are transmitted much more rapidly to loan payments, so that the impact on disposable income and spending is likely to be larger. In addition, the decreased use of nonprice rationing in the loan market means that borrowers will be responding more exclusively and flexibly to interest rate changes. With respect to consumption, a number of studies have found evidence of diminished liquidity constraints in those countries that have experienced extensive deregulation. The response of exchange rates to interest rate differentials, and the elasticities of foreign demand for domestic goods, play a more important role in an environment of increasingly integrated capital and goods markets. The net effect on aggregate demand remains to be determined in empirical studies. Estimates in the United Kingdom, where the proportion of variable rate loans is much higher than elsewhere, have indicated that the interest rate effect on spending is clearly stronger than in the period preceding deregulation.22

One consequence of the increased securitization and integration of financial markets—particularly of the mortgage market, but also of markets for corporate financing—is that the impact of monetary policy is likely to be spread more broadly throughout the economy and less concentrated on certain sectors. Monetary policy will continue to have different sectoral impacts, however, because access to, and dependence on, international capital flows differ. In addition, to the extent that central banks can control short-term interest rates to a much greater extent than long-term rates, the impact of policy is likely to be felt in sectors that are sensitive to short-term rates. These effects may be offset by the expanded use of hedging devices, such as swap contracts, that can insulate firms from exchange rate and interest rate changes.

To the extent that aggregates are used as policy guides, greater attention is likely to be paid to the asset side of the balance sheet of financial intermediaries. Changes in bank assets will continue to be important sources of information on borrowing and spending behavior in the household and small business sectors, which will continue to rely heavily on intermediated finance.23 Broader credit aggregates that include nonbank financial institutions and capture financing activity outside banks will provide information about the financing behavior of larger private sector entities with more direct access to securities markets.

Because of the decrease in central banks’ direct control over the volume of lending, interest rates are likely to become more important indicators of the stance of monetary policies. In addition, because asset prices can convey important information about the supply of liquidity, as they did in the late 1980s, changes in asset prices may be incorporated judgmentally into policy analyses. The U.K. authorities, for example, have announced that they now include asset prices among their indicator variables. The recent episode would suggest that changes in monetary policy will continue to affect asset prices beyond the current adjustment period.

Lessons for the 1990s

In the past it has been sufficient for monetary authorities to concentrate on inflation in consumer prices—or more broadly on the prices of the flow of goods and services—and to consider asset price inflation only insofar as it was a signal of future general inflation. The recent period has demonstrated, however, that inflation in asset prices can occur without significant movement in standard price indices. In retrospect, monetary policy in some countries inadvertently permitted an overly rapid expansion of money and credit during the 1980s, and there was not a full appreciation of the emerging financial imbalances in both the financial and nonfinancial sectors. Policymakers allowed the real cost of credit for real estate and equity purchases to remain too low for too long.

Without the confluence of events—structural changes in financial markets, expansionary fiscal policies, and expansionary monetary policies—the asset price cycle might not have occurred. Although economic policy should not be designed to offset regulatory and structural changes explicitly, dealing with the effects of such changes should be a vital part of the policy strategy. Moreover, experience in many countries clearly suggests that there should be greater coordination of macroeconomic and regulatory policies.

Some of the problems that complicated monetary policy during the 1980s stemmed from the underappreciation of the innovative ability of the private sector and of the effects of competition on the financial sector. In some cases, the speed and scope of deregulation resulted in excessive risk taking or allowed financial institutions to move into new and unfamiliar lines of business. This placed heavy and unexpected demands on supervisory institutions, which were not fully prepared for the consequences of deregulation. Thus, it would appear that supervisory practices need to be strengthened as deregulation proceeds. Prudential regulation, oversight, and increased capital standards are needed in order to ensure that the gains from increased competition in financial markets are not offset by the systemic weaknesses arising from the insolvency of financial institutions. The sequencing and pace of deregulation, and the need for coordination among regulators, are critical components of any deregulation effort.

Many questions remain unanswered, but perhaps the most important is whether the asset price inflation was a temporary development, associated with a particular combination of structural changes in financial markets and expansionary macroeconomic policies, or whether it can be expected to be a permanent feature of the transmission process of monetary policy. Key features of financial liberalization in the 1980s were the expansion of the nonbank financial sector and the increased level of financial activity undertaken by both businesses and households. Policymakers should have expected, as some did, that the components of expenditure that would be most affected would be those that are typically financed with credit, rather than those that are financed out of current income and profits.

Although standard price measures will continue to be the main focus of monetary policy, it is important to realize that these may not adequately identify inflation pressures in all parts of the economy. Perhaps the most dramatic example is what occurred in Japan, where, by conventional measures, price stability was maintained throughout the 1980s, even during the dramatic asset price inflation of 1986–90. The flow of goods and services is only a small part of total transactions that occur during any given period, and focusing on consumer or producer prices discards much of the information available for measuring inflationary pressures. Although asset prices are volatile and are determined by many factors other than monetary policy, they should not be ignored when there is reason to believe that excess liquidity is being channeled into asset markets rather than flow markets.

Another question is whether monetary policy should respond to sharp movements in asset prices. To the extent that asset prices adjust rapidly—because of portfolio adjustments or other fundamental changes in the real economy, for example—monetary policy would have little if any role except to ensure that these adjustments occur in a stable financial environment. To the extent that asset price changes are related to excess liquidity or credit, however, monetary policy should view them as inflation and respond appropriately. There is nothing unique about asset markets that would suggest that asset prices can permanently absorb overly expansionary monetary policies, without ultimately leading to costly real and financial adjustments. One very clear lesson of this experience is that an excessive buildup of private debt to finance asset accumulation in certain sectors can have significant adverse macroeconomic consequences, including deep recessions, slower economic recoveries from recession, and sharp and costly adjustments in many parts of the private sector.

Although they do not yet generally exist, broadly defined transaction-based price indices could serve as useful complementary indicators for economywide inflation.24 If asset price changes reflect relative price adjustments, the aggregate transactionbased price index would remain unchanged because increases in some asset prices would be offset by decreases in others. Increases in an aggregate transaction-based price index that were large, persistent, and not attributable to special or temporary factors would suggest—as with other price indices and consistent with current monetary policy practices—the need for a tighter monetary policy.

This problem goes beyond that of inadequate price measures, however. Policymakers regularly review a broad set of price indices, including those for commodities and assets. The fundamental problem is that the analytical framework used in most countries to assess the stance of monetary policies was not sufficiently broad and flexible to assess developments in key asset markets properly. In effect, the asset price developments were not viewed as requiring an adjustment in monetary policy. Thus, it would appear that the conventional framework—and more specifically, the class of models—used to formulate monetary policies and targets needs to be re-examined and altered in light of the experience of the late 1980s.

Finally, although international capital flows did not play a prominent role in recent episodes of asset price inflation, they seem likely to become increasingly important features of the global financial environment in the coming years—as they already have in Europe. These developments may require a further shift in the policy framework in the future. As has been clear from recent experience, historical macroeconomic relationships may not be reliable guides, and it may be necessary to evaluate developments from a microeconomic, as well as macroeconomic, perspective. In the asset price inflation episode, for example, greater attention to shifts in the composition of borrowing and the channels of spending might have alerted policymakers to changes in the way monetary policy was being transmitted to inflation. Reliance on the historical links between monetary policy and standard price indices turned out to be misleading.


This annex was prepared by Monica Hargraves and Garry J. Schinasi.


For example, residential property prices rose an average of 22 percent in Japan and 20 percent in the United Kingdom during 1986–89, whereas they rose an average of 10 percent in the United States. See Annex I of the October 1992 World Economic Outlook.


See the discussion in Chapter III of the main text and the annex, “Assessing the Stance of Monetary Policy,” in the January 1993 World Economic Outlook: Interim Assessment.


These visual images are supported by econometric evidence. Inflation (GDP deflator) was regressed on its previous value and past values of narrow money growth (using a polynomial distributed lag) over two time periods in the United States, Japan, and the United Kingdom-1970:Q1 to 1982:Q4 and 1983:Q1 to 1992:Q2. According to this specification, the relationships between money growth and inflation were relatively strong and statistically significant in the 1970s, and, except for the United Kingdom, the relationship was weak and not statistically significant in the 1980s. Supporting evidence for Japan is reported in Guy Meredith, “Japan—Implications of the Recent Slowdown in Broad Money Growth” (unpublished; IMF, 1992); and in Robert Corker, “Wealth, Financial Liberalization, and the Demand for Money in Japan,” Staff Papers (IMF), Vol. 37 (June 1990), pp. 418–32.


Traditional theories of inflation have focused on how excess liquidity leads to an increase in the average price of the flow of goods and services in the relevant time period. Wage developments have also played a central role in macroeconomic stabilization strategies and policies. Economic theories have been helpful in monitoring and explaining inflation, ex post, but judging from the inflation record of the postwar era, they have not been effective in anticipating inflationary episodes. Some economists in the early part of this century thought that prices on all types of transactions—both stocks and flows—were important for properly measuring inflationary pressures. See Irving Fisher, The Purchasing Power of Money (New York: Macmillan, 1913; A.M. Kelley, 1985). See also Box 2, on price stability, in Chapter III.


In the United States, much of the increase in debt between 1983 and 1989 was concentrated in families reporting the most financial assets. The mean real home value rose much more than the median, and the increase occurred largely in families with incomes above $50,000. The highest income groups increased the median size of their mortgage debt, while the lowest reduced their median value. See Arthur Kennickell and Janice Shack-Marquez, “Changes in Family Finances from 1983 to 1989: Evidence from the Survey of Consumer Finances,” Federal Reserve Bulletin, Vol. 78 (January 1992), pp. 1–18.


See Masahiko Takeda and Philip Turner, “The Liberalisation of Japan’s Financial Markets: Some Major Themes,” Economic Papers, No. 34 (Basle: Bank for International Settlements, November 1992).


See Steven R. Weisbrod, Howard Lee, and Liliana Rojas-Suarez, “Bank Risk and the Declining Franchise Value of the Banking Systems in the United States and Japan,” IMF Working Paper 92/45 (June 1992). This “franchise value” arises from banks’ access to funds from the central bank, which gives banks a distinct role as providers of liquidity and payments services.


For a detailed analysis of the tendency for persistence in price changes in a broad array of asset markets in a number of countries, see David M. Cutler, James M. Poterba, and Lawrence H. Summers, “Speculative Dynamics,” NBER Working Paper 3242 (Cambridge, Massachusetts: National Bureau of Economic Research, January 1990).


During the 1980s, there were several studies of likely consequences of financial deregulation and liberalization for the implementation of monetary policy; see Bank for International Settlements, Financial Innovation and Monetary Policy (Basle, March 1984), and Changes in Money-Market Instruments and Procedures: Objectives and Implications (Basle, March 1986).


Before the official recognition of the Gensaki market—a market for repurchase agreements for long-term securities, including government bonds—and the deepening of a secondary market for government securities in Japan in the late 1970s and early 1980s, the Bank of Japan relied primarily on credit rationing at the discount window, administrative guidelines on bank loan allocation, and “window guidance,” which specified lending limits for individual banks and ensured that the Bank of Japan had extensive influence over all major financial institutions and over corporate spending.


See John S. Flemming, “Financial Innovation: A View from the Bank of England,” in Monetary Policy and Financial Innovations in Five Industrial Countries: the UK, the USA, West Germany, France and Japan, edited by Stephen F. Frowen and Dietmar Kath (New York: St. Martin’s Press, 1992).


See Annex I in the May and October 1992 issues of the World Economic Outlook for more detailed discussion of the responses of the financial and nonfinancial sectors to deregulation.


See Adrian W. Throop, “Financial Deregulation, Interest Rates, and the Housing Cycle,” Federal Reserve Bank of San Francisco, Economic Review (Summer 1986).


For a discussion of increased real estate lending, see Annex I in the October 1992 World Economic Outlook.


See Tamim Bayoumi and Pinelopi Koujianou, “The Effects of Financial Deregulation on Consumption,” IMF Working Paper 89/88 (October 1989); and Tamim Bayoumi, “Financial Deregulation and Household Saving,” Bank of England Working Paper Series, No. 5 (London, October 1992).


In the United States, there is some evidence of reduced sensitivity of housing starts to interest rate changes, due in part to the increased use of variable rate instruments, which has affected affordability and credit scoring constraints. See Randall J. Pozdena, “Do Interest Rates Still Affect Housing?” Federal Reserve Bank of San Francisco, Economic Review, No. 3 (Summer 1990), pp. 3–13.


Robert N. McCauley and Rama Seth, “Foreign Bank Credit to U.S. Corporations: The Implications of Offshore Loans,” Federal Reserve Bank of New York, Quarterly Review, Vol. 17 (Spring 1992), pp. 52–65.


See “Financial Change and Broad Money,” Bank of England, Quarterly Bulletin (December 1986), pp. 499–507.


See Adrian Blundell-Wignall, Frank Browne, and Paolo Manasse, “Monetary Policy in the Wake of Financial Liberalisation,” Economics and Statistics Department Working Paper 77 (Paris: OECD, April 1990).


See Frank Browne and Warren Tease, “The Information Content of Interest Rate Spreads Across Financial Systems,” Economics and Statistics Department Working Paper 109 (Paris: OECD, 1992).


See Anil K. Kashyap, Jeremy C. Stein, and David W. Wilcox, “Monetary Policy and Credit Conditions: Evidence from the Composition of External Finance,” American Economic Review, Vol. 83 (March 1993), pp. 78–97. For an explanation based on liquidity differences in these instruments, see Peter M. Garber and Steven R. Weisbrod, The Economics of Banking, Liquidity, and Money (Lexington, Massachusetts: D.C. Heath, 1992), Chapter 13.


See “The Interest Rate Transmission Mechanism in the United Kingdom and Overseas,” Bank of England, Quarterly Bulletin (May 1990), pp. 198–214.


For a discussion of the effects of credit supply in the Canadian economy, see William Lee, “Balance Sheet Risk, Credit Supply, and Their Impact on Real Economic Activity,” IMF Working Paper (1993, forthcoming).


Irving Fisher discussed the construction of such indices in the Purchasing Power of Money (New York: Macmillan, 1913; A.M. Kelley, 1985).

Annex II Medium-Term Baseline Projections and Alternative Scenarios

The medium-term projections in the World Economic Outlook are conditional on several technical assumptions and thus are not necessarily forecasts of most likely outcomes. These assumptions include unchanged policies, except for measures already announced and likely to be implemented; constant real effective exchange rates, except for bilateral rates in the ERM, which are assumed to be constant in nominal terms; and specific projections for interest rates and world oil prices.1

Baseline Scenario for Industrial Countries

Annual growth in real GDP in the group of industrial countries is projected to rise from 2 percent in 1993 to an average of 3 percent in the period 1995–98 (Table 24), slightly in excess of potential output growth, allowing slack to be gradually taken up. Further progress in reducing inflation is also expected, owing to the current large margin of unused productive capacity in many countries and the projection of only a modest pickup in activity, especially in Europe and Japan. Inflation is therefore projected to decline gradually to 2½ percent by 1998.

Table 24.

Industrial Countries: Selected Indicators of Economic Performance1

(Percent change unless otherwise noted)

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

In percent of GDP on a national accounts basis.

Administration projections in percent of GDP for fiscal years.

The recovery of output together with continued—and in some cases reinvigorated—efforts toward fiscal consolidation are expected to lead to a significant reduction in general government budget deficits over the medium term. For the industrial countries as a whole, the general government deficit is projected to decline from 4¼ percent of GDP in 1993 to about 3 percent of GDP in 1995–98. Because most industrial countries are expected to be operating near potential levels of output by 1998, the remaining deficits would be structural and would persist in the long term in the absence of further policy action. Substantial deficit reduction is projected in most major industrial countries, particularly in those having the most severe cyclical difficulties—Canada and the United Kingdom—and in Italy. Progress in deficit reduction is also projected for most of the smaller industrial countries, although deficits are expected to remain relatively high in the medium term in Belgium, Greece, Norway, and Sweden.

External imbalances in the major industrial countries narrowed significantly in 1991 and 1992. The slowdown of activity in the United States helped to reduce its deficit, and relatively strong growth in Japan in 1991 narrowed its surplus, whereas the German surplus had become a deficit because of the costs of unification. These factors are expected to unwind, however, and a renewed widening of external imbalances is projected for several large countries in the short term. Given the fiscal policy and the exchange rate assumptions underlying the projections, relatively large imbalances—particularly the deficits in Canada, the United States, and the United Kingdom, and the Japanese surplus—are likely to persist in the medium term.

Alternative Scenario for Industrial Countries

As discussed in Chapters I and III, the prospects for economic recovery and subsequent growth in the industrial countries would be enhanced by the adoption of a strategy of coordinated policy adjustments. To illustrate the possible gains from this approach, MULTIMOD, the IMF’s multicountry macroeconometric model, has been used to simulate the economic effects of a cooperative policy package involving credible efforts to reduce structural budget deficits over the medium term in countries where such deficits are projected to be unsustainable, as well as a significant lowering of interest rates in Europe. Policies are assumed to be implemented in the first half of 1993, except in Canada, where fiscal consolidation is assumed to begin in 1994.2 Compared with a no-policy-change scenario, in the United States the government deficit is assumed to fall by twice as much over the medium term as envisaged in the administration’s economic plan presented in February 1993. In Japan, the government is assumed to pursue a somewhat more expansionary financial policy in the short run (in line with the recently announced package), and then to resume progress on fiscal consolidation over the medium term. Fiscal consolidation in Germany is assumed to proceed more rapidly than envisaged in the baseline and, as a result, the government deficit is 1 percent of GDP lower in 1994–97. In addition, the scenario assumes a faster and slightly more pronounced reduction of interest rates in Germany and across Europe than in the baseline. This permits an easing of tensions in exchange markets and, hence, a marked narrowing of interest differentials vis-à-vis Germany. Both Italy and the United Kingdom, as for Germany, are assumed to speed up fiscal consolidation. In Italy, this is assumed to reduce the current risk premium by 200 basis points; in the United Kingdom, it is assumed to reduce the long-term risk premium by about 100 basis points.3

The implementation of credible fiscal consolidation packages in the United States and Europe results in an immediate decline in long-term interest rates and a rise in investment in the industrial countries (Table 25). Real investment also rises in Japan in direct response to the monetary and fiscal stimulus. In the EC and Japan, output rises well above the nopolicy-change scenario by 1994. In the United States, fiscal consolidation puts downward pressure on interest rates, but this is attenuated by the gradual nature of fiscal consolidation and is offset by the depreciation of the dollar owing to a widening of the risk premium.4 The depreciation of the exchange rate improves the external position, which essentially offsets the direct effect of the fiscal contraction, leaving little change in output. There is, of course, a marked and increasing improvement in the government fiscal balance.5 In the medium term, potential output is slightly higher, primarily as a result of the fiscal consolidation in the United States and Europe and the higher investment it induces. In the developing countries, output is somewhat higher owing to lower interest rates and somewhat higher demand in the industrial countries.

Table 25.

Industrial Countries: Alternative Projections Assuming Policy Coordination

(Percent deviation from no-policy-change scenario)

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In percentage points.

In percent of GDP.

In billions of U.S. dollars.

In percent of exports of goods and services.

Baseline Scenario for Developing Countries

In developing countries with IMF-supported adjustment programs, the medium-term projections assume that the policies underlying the programs will be implemented.6 More generally, many countries have undertaken or begun to put in place significant structural reforms that are expected to raise long-term growth prospects. The continued success of these reforms underpins the projections, particularly for countries in the Western Hemisphere and Africa.

Nonfuel primary commodity prices are assumed to increase, on average, by 3¾ percent a year in 199598, and exchange rates are assumed to remain unchanged in real terms. Given projected price developments in industrial countries and in other traded commodities, these assumptions imply little change in the terms of trade of developing countries in 1995–98 (Table 26). Total financing flows to the net debtor developing countries are expected to increase in the medium term compared with 1983–92 as private capital inflows and commercial bank lending continue to expand in line with recent experience.

Table 26.

Developing Countries: Indicators of Economic Performance

(Annual averages unless otherwise noted)

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Estimate of long-term borrowing from official creditors. See footnotes to Table A32 in the Statistical Appendix.

Estimate of net lending from commercial banks. See footnotes to Table A32 in the Statistical Appendix.

End of period, excluding liabilities to the IMF.

Excludes eight net creditor countries from all developing countries. See the introduction to the Statistical Appendix for definition of net creditor countries.