II Policies for Sustained Growth in Industrial Countries
Author: International Monetary Fund. Research Dept.
Language:
English
Keywords:
WEO; country; developing country; price; saving rate; exchange rate; deutsche mark; debt ratio; potential GDP; federal funds rate; debt-service cost; Inflation; Budget planning and preparation; Government debt management; Long term interest rates; Europe
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Abstract

The achievement of reasonable price stability in most industrial countries under circumstances of generally robust growth is a particular cause for satisfaction. The near-term outlook is for continued solid economic expansion in most countries and for a gradual absorption of cyclical unemployment in countries where labor market slack remains large. But many challenges continue to confront policymakers, including the need to safeguard progress on the inflation front, restore fiscal balance and reduce debt-to-GDP ratios, and improve the functioning of labor markets. Meeting these objectives is essential to strengthening the medium-term outlook for growth and employment.

The achievement of reasonable price stability in most industrial countries under circumstances of generally robust growth is a particular cause for satisfaction. The near-term outlook is for continued solid economic expansion in most countries and for a gradual absorption of cyclical unemployment in countries where labor market slack remains large. But many challenges continue to confront policymakers, including the need to safeguard progress on the inflation front, restore fiscal balance and reduce debt-to-GDP ratios, and improve the functioning of labor markets. Meeting these objectives is essential to strengthening the medium-term outlook for growth and employment.

The industrial countries have generally adopted price stability as a medium-term policy objective, but the real test of the commitment to price stability will come in the years ahead, when the expansion matures and countries have absorbed the slack generated in the last recession. Thus far, signs have been encouraging (Table 2). The countries most advanced in the cycle, such as the United States, the United Kingdom, Australia, and New Zealand, have acted to raise interest rates to dampen demand, even as inflation was falling. While further moderate tightenings may prove necessary, these actions have demonstrated strong resolve to prevent an acceleration of inflation. As for countries where increases in official interest rates have not yet been called for, such as Germany and Japan, their well-established anti-inflation record suggests that they too can be expected to act on a timely basis.

Table 2.

Industrial Countries: Real GDP, Consumer Prices, and Unemployment Rates

(Annual percent change and percent of labor force)

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The projections for unemployment have been adjusted to reflect the new survey techniques adopted by the U.S. Bureau of Labor Statistics in January 1994.

Data for consumer prices are based on the retail price index excluding mortgage interest.

In the area of fiscal policy the picture is much less satisfactory, which has been an important contributing factor behind recent exchange market pressures and the rise in risk premiums on interest rates in many countries during the past year. While a few countries have embarked on meaningful fiscal adjustment programs, the pace of consolidation in most countries remains inadequate. Governments are generally taking insufficient advantage of the economic expansion to accelerate fiscal consolidation. Greater progress is also needed in the structural policy area. Although some countries have committed themselves to structural reforms, many have yet to announce and implement specific proposals. Selective measures to address the high levels of structural unemployment in Europe, in particular, have been ineffective in most cases, and only a few countries have undertaken the broad-based labor and product market reforms necessary to tackle the problem. Progress has also been limited in containing health care costs and with respect to pension reform. Success has been greater with privatization of state enterprises and deregulation.

Cyclical Developments and Stance of Monetary Policies

Economic recovery is now under way in all industrial countries. As a group, they achieved a growth rate of 3 percent in 1994 and output is projected to expand by 3 percent again this year before slowing slightly in 1996. There are important differences in cyclical positions across countries, however (Chart 3). For countries that are well into their third or fourth year of expansion, including the United States, Canada, the United Kingdom, Australia, and New Zealand, growth is expected to moderate this year and next. For most of the continental European countries and Japan, which emerged from the recession only in 1994, growth is expected to remain high or to strengthen further. Inflation may edge up slightly on average but should remain relatively low, reflecting the pre-emptive tightening of monetary policy in the countries most advanced in the cycle, and the continuing existence of significant margins of slack in continental Europe and Japan (Chart 4).

Chart 3.
Chart 3.

Major Industrial Countries: Real GDP1

(Percent change from four quarters earlier)

1Blue shaded areas indicate IMF staff projections; data for Italy for the fourth quarter of 1994 are also projected.2Through 1991, west Germany only; thereafter, IMF staff estimates for unified Germany.
Chart 4.
Chart 4.

Major Industrial Countries: Output Gaps1

(Actual less potential, as a percent of potential)

1Blue shaded areas indicate IMF staff projections. The gap estimates are subject to a significant margin of uncertainty. For a discussion of the approach to calculating potential output, see the October 1993 World Economic Outlook, p. 101.2Data through 1990 apply to west Germany only.

Underpinned by strong domestic demand, the economic expansion in the United States accelerated in 1994. Real GDP grew by 5 percent in the fourth quarter and by 4 percent for the year as a whole. Business investment was particularly buoyant and more than offset a drop-off in residential investment. Capacity utilization has reached its highest level since 1979, while unemployment has dipped below most estimates of the natural rate of unemployment. Meanwhile, inflation has remained relatively subdued; but survey evidence of shortages of skilled workers and rising crude and intermediate goods prices point to incipient price pressures in some sectors and the likelihood of somewhat higher inflation during the period ahead. The weakness of the dollar is an additional reason to expect somewhat stronger price increases this year and next.

Growth in the U.S. economy is projected to moderate to about 3¼ percent in 1995 and to slow further in 1996 in response to tighter monetary conditions. The projected slowdown in demand and activity should permit inflation to level off at about 3½ percent in 1996. Following a sharp rise in the current account deficit to an estimated $156 billion (or 2¼ percent of GDP) in 1994, the external deficit is expected to widen somewhat further in the near term, and to remain at about 2¼ percent of GDP into the medium term. Mexico’s financial crisis is expected to reduce exports in the short run, but the medium-term impact on the U.S. economy is likely to be small.

In response to the rapid pace of economic growth, monetary policy has become progressively less accommodating since February 1994. The federal funds rate has been raised by 3 percentage points, to 6 percent, and real short-term interest rates have risen by a similar amount. Long-term interest rates rose by about 1½ percentage points in the early months of 1994 and by a further 1 percentage point in the second half of the year, but have since declined to their fall 1994 levels (Chart 5). The flattening of the yield curve at both ends of the maturity spectrum suggests that most of the needed adjustment of monetary conditions may already have occurred (Chart 6). But some further tightening would be warranted if the underlying momentum in economic activity and the downward pressure on the dollar do not abate sufficiently. In the staff’s projections, short-term interest rates are expected to rise to 6¾ percent by the end of 1995.

Chart 5.
Chart 5.

Selected Industrial Countries: Policy-Related Interest Rates and Ten-Year Government Bond Rates1

(In percent a year)

1The U.S. federal funds rate, Japanese overnight call rate, German repurchase rate, Italian treasury bill rate, Australian cash rate, and all ten-year government bond rates are monthly averages. The Canadian bank rate and overnight money market financing rate are those of the last Wednesday of each month. All others are end of month.
Chart 6.
Chart 6.
Chart 6.
Chart 6.

Selected Industrial Countries: Short-Term Interest Rates and Yield Curves1

(In percent)

1Yield curve slope is lagged one year with respect to GDP growth.

Canada’s exports and growth have been buoyed by robust U.S. growth, strong markets for commodities throughout the past year, and the weakness of the Canadian dollar. The strength of foreign demand was particularly marked in the second half of the year, but the recovery in final domestic demand has slowed, partly in response to higher interest rates. The current account deficit narrowed by about 1 percent of GDP. The relatively strong expansion brought the unemployment rate down by over 1½ percentage points since early 1994 to 9.7 percent in March 1995, which nevertheless remains above estimates of the natural rate. Real GDP growth is projected to moderate to 4¼ percent in 1995 and to 2½ percent in 1996, reflecting a weaker U.S. economy and the effects of high real interest rates. The still-large output gap is projected to close gradually over the medium term, thus keeping core inflation under control, even though the recent exchange rate depreciation is likely to raise inflation temporarily.

Interest rates in Canada have been strongly influenced by exchange market developments and by investor concerns about public finances and political uncertainty over Quebec. Thus, in spite of weak labor market conditions, significant margins of slack, and very low inflation, real interest rates have risen to relatively high levels across all maturities. The new budget announced in February helped to reduce long-term premiums somewhat, but greater progress on fiscal consolidation is necessary to relieve the pressure on monetary policy and to allow a more balanced expansion.

In Japan, the recovery that began in early 1994 has been weak and erratic. It has been underpinned by private consumption, which was buoyed by the income tax cut in June. Residential and government investment have also been strong, and business investment rose in the third quarter of 1994 for the first time in three years. The recovery marked time in the fourth quarter as a sharp fall in private consumption and a steep decline in residential investment contributed to almost a 1 percent contraction in real GDP. Business investment, however, continued to rise. Because of the unexpectedly weak fourth quarter, Japan was the only major industrial country for which 1994 GDP growth was weaker than had been projected in the October 1994 World Economic Outlook. Net exports made a negative contribution to growth during the past year: imports surged, while the effects on exports of the global recovery have been blunted by the approximately 33 percent real appreciation of the yen since mid-1992. For 1995, moderate growth of 1¾ percent and a decline in inflation to ¼ of 1 percent is projected; the large output gap is not expected to begin to decline until 1996, as growth gradually accelerates.

The strength of Japan’s recovery remains uncertain, however. There are some recent indications of a pause in the strong growth of household consumption. Low capacity utilization and the lagged effects of the yen’s continued appreciation may also have a dampening effect on investment. On the positive side, the unemployment rate has stabilized, and indicators of business confidence have improved as the recovery in profits observed in 1994 is expected to continue this year. The January earthquake should not impede the recovery beyond the very short run: although economic activity in the first quarter of 1995 is likely to have been affected by the disruption of production and transportation, output in subsequent quarters is expected to be boosted by higher spending for reconstruction (Box 1).

As in other industrial countries, monetary policy in Japan has been supportive of the recovery, although the stimulative effects of low nominal interest rates have been partly offset by the appreciation of the yen and lower inflation. Money supply growth has picked up over the past year, reflecting the strengthening of activity. Short-term interest rates rose slightly in late summer of 1994 and remained relatively stable, with three-month rates at about 2¼ percent through early 1995. At the end of March, the Bank of Japan signaled an easing of monetary policy, resulting in a decline in both the overnight call rate and other short-term interest rates of about 50 basis points, and the discount rate was cut by 75 basis points to 1 percent in mid-April. The stability of prices, the large output gap, and the excessive strength of the yen argue for a continued accommodative monetary policy stance for the time being.

The pace of economic activity in the United Kingdom picked up in 1994. Real GDP grew by 3¾ percent, with net exports contributing approximately 1 percentage point. Until early 1994, the recovery was sustained mainly by private consumption, which was financed largely by a sharp decline in the household saving rate and in mortgage interest payments following earlier interest rate reductions. During the year, consumption growth slowed in response to tax increases, but this was more than offset by a surge in both oil and non-oil exports. The current account deficit as a proportion of GDP narrowed by 1¾ percentage points during 1994 to a position of approximate balance. With real GDP growth in 1994 well above trend, the output gap narrowed considerably, and the unemployment rate declined steadily to 8½ percent in February 1995 from 9¾ percent a year earlier. Underlying inflation (retail prices excluding mortgage payments) fell to 2 percent in the fall of 1994, but subsequently picked up to 2 ¾ percent in early 1995, in part reflecting higher indirect taxes but also an increase in retail price margins. Private consumption is projected to remain subdued in 1995–96, in response to the already scheduled fiscal tightening and recent interest rate increases, but growth will be underpinned by strong exports and rising investment.

Monetary conditions in the United Kingdom began to be tightened in the second half of 1994 with a view to slowing the rate of economic expansion to a more sustainable pace. Base rates were raised in two 50basis-point steps in September and December. With most indicators of inflation rising and with the growth of M0 remaining well above its target range, base rates were raised by a further 50 basis points to 6¾ percent in February. The yield curve has flattened considerably since mid-1994, but still remains rather steep. A further firming of monetary conditions may soon be required to achieve the medium-term inflation target.

In continental Europe, the recovery has been stronger than earlier anticipated and consumer confidence remains high. In Germany, the upswing was initially export led but it has now become more broadly based. Business fixed investment has strengthened whereas private consumption has been affected by tax increases. Real GDP grew by 3 percent in 1994 and is expected to rise by 3¼ percent this year. Inflation has declined to about 2¼ percent in the 12 months to March, and although some pressures are apparent in producer prices and wage demands, a renewed upsurge in inflation is unlikely in the short run, especially in light of the appreciation of the deutsche mark.

Short-term interest rates in Germany continued to decline in the first half of 1994 and stabilized at between 5 percent and 5¼ percent until the end of March 1995, when they declined by about 50 basis points following a similar reduction in the discount rate. The yield curve has started to level off in recent months, while the growth of M3 decelerated sharply during the second half of 1994 and came within the official target range at the end of the year.1 The stance of monetary policy has helped the recovery to become firmly established, and although the expansion is expected to remain strong, a number of factors suggest that monetary conditions remain broadly appropriate: the output gap is projected to close only gradually, unit labor costs are declining, fiscal consolidation is proceeding at an appropriate pace, and the continuing decline in inflation is resulting in a firming of real interest rates. Excessive upward pressure on the deutsche mark justified the recent further easing of official interest rates. Nonetheless, a gradual tightening of monetary conditions will probably need to begin toward year-end, especially if economic activity shows signs of being much stronger than expected.

Growth has also firmed in France, where real GDP rose by 2½ percent in 1994 and is projected to accelerate to 3¼ percent this year as both domestic and foreign demand continue to strengthen. Inflation has declined further and is expected to remain low in view of the persistence of a significant output gap and provided wage cost pressures can be contained. The unemployment rate, which was at 12.5 percent until September 1994, has eased only marginally despite a pickup in employment. The projected pickup of growth, however, should permit a gradual reduction in labor market slack.

The stance of monetary policy has also been supportive of recovery in France. Short-term interest rates declined in the first half of 1994 and subsequently stabilized at around 5¾ percent until the end of February 1995, some 60 to 70 basis points above comparable German rates. In March, however, short-term rates rose by about 2 percentage points in the wake of exchange market tensions; by early April about half of this increase had been reversed. Largely reflecting developments in international bond markets, long-term interest rates rose through November to around 8 ¼ percent before declining to 8 percent in February and March. The yield curve has been positively sloped since March 1994, and both short- and long-term real interest rates appear high in view of the impressive inflation performance and the remaining margins of slack. Nevertheless, barring significant adverse effects on business and consumer confidence, the rise in short-term interest rates prompted by recent exchange market tensions is unlikely to derail the recovery.

Macroeconomic Impact of the Japanese Earthquake

Damage from the earthquake that struck the Kansai region of Japan on January 17 was centered on Kobe, a city of 1.5 million people. The area accounts for slightly less than 5 percent of Japan’s industrial output, while the port, the nation’s second busiest, handles about 10 percent of foreign trade. In addition to the tragic loss of over 5,000 lives, initial estimates of the total material damage center on about ¥6 trillion (or $60 billion), equivalent to 1¼ percent of Japan’s GDP. This estimate is substantially larger than the damage of about $20 billion resulting from the 1994 earthquake in California. The initial reaction of financial markets was mixed. The stock market fell by about 6½ percent in the week following the earthquake, reflecting, inter alia, investors’ uncertainty about the extent of the damage.1 Bond and foreign exchange markets, by contrast, were little affected. The Bank of Japan increased market liquidity, and overnight interest rates declined slightly.

The earthquake will affect economic activity in various ways. The reduction in Japan’s capital stock—estimated at about ½ of 1 percent of the total existing stock—will tend to reduce output through supply effects, while reconstruction spending will raise aggregate demand. In the very short run, the supply effect is likely to dominate, and economic growth in the first quarter of 1995 is expected to be reduced from what would otherwise have been observed. In addition, Japan’s external trade has been adversely affected in the near term given Kobe’s importance as a transportation center. Over time, the effect of the aggregate demand stimulus on output will become more important, especially as the Japanese economy is currently operating at well below its longer-run capacity.

The government has declared Kobe and the surrounding area a “special” disaster zone, making it eligible for additional national assistance. The authorities have also decided to take a liberal approach in applying the Disaster Relief Law, allowing the central government to shoulder an increased share of financing rescue work and reconstruction costs. In addition, new legislation has been introduced to facilitate the restoration of transportation infrastructure, as well as to provide tax concessions for enterprises and individuals. As there is little room for new earthquake-related claims in the existing budget, additional fiscal measures will be necessary: the government has passed a supplementary budget for FY 1994 of about ¥1 trillion to deal with immediate needs. A supplementary FY 1995 budget containing a comprehensive reconstruction plan will be introduced in the months ahead.

Simulated Macroeconomic Impact of Earthquake

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To illustrate the possible macroeconomic impact of the earthquake over the medium term, a simulation was performed using the staff’s simulation model (MULTIMOD). The simulation incorporates a drop in capacity output starting in 1995 due to capital destruction of the amount discussed above, as well as an equivalently sized demand stimulus arising from reconstruction. For this exercise, it was assumed that the reconstruction spending would be spread over the period 1995–97, with the effect in 1995 being somewhat smaller than in the latter two years owing to the initial dislocation caused by the earthquake.

In the simulation, potential output falls by about ¼ of 1 percent in 1995 relative to its baseline level, while actual GDP rises by a similar amount, reflecting higher investment spending. In 1996, the effect on GDP rises to almost ½ of 1 percent given the assumed scaling up of the reconstruction process and the induced effects on other components of demand, while potential GDP converges to its baseline level. Inflation is raised by less than ¼ of 1 percentage point during 1995–97, reflecting the large margins of excess capacity in the Japanese economy. Increased capital demands put modest upward pressure on long-term interest rates, while the current account surplus falls by 0.1 percent of GDP in 1996 and 1997 in response to higher domestic demand. These results, of course, are sensitive to both the assumed size and timing of the reconstruction expenditures, which remain uncertain. Nevertheless, they suggest that the earthquake should not have a large impact on Japan’s medium-term economic prospects.

1The market decline implies an estimated loss of ¥12 trillion in the (noncorporate) shareholder value in the first section of the Tokyo stock exchange, twice the estimated damage caused by the earthquake.

The economic upswing gathered momentum in Italy in 1994, with a continuing strong export performance and a resurgence of domestic demand. Business investment began to recover, aided by improved profitability and notwithstanding relatively high real interest rates. Unemployment has not yet shown any decline from the high levels reached during the recession, however, and a substantial degree of slack remains to be absorbed. The projections show a strengthening of growth to 3 percent in 1995. But there are risks of setbacks to the recovery process stemming from political instability and the resulting skepticism about the political system’s ability to reduce the level of public debt over the medium term. Inflation is expected to rise to 5¼ percent in 1995. As in Canada and Sweden, recent increases in official interest rates were linked to downward pressure on the exchange rate and the resulting risk of a pickup in inflation.

In Spain and Portugal, the recovery has been led by strong export growth, which was spurred by the depreciations of the peseta and the escudo in the past couple of years. Domestic demand started picking up in 1994 and is expected to sustain the expansion in 1995 and 1996. In Spain, stronger growth, together with the effects of labor market reforms that entered into force in 1994, should help to reduce the very high level of unemployment. Inflation will be adversely affected temporarily by the value-added-tax increase in 1995 and by the further adjustment of the peseta within the ERM in early 1995. The recovery has proceeded at a moderate pace in Austria, Belgium, the Netherlands, and Switzerland as private consumption and business investment have gradually gathered strength. The pace of economic activity has been more brisk in Ireland, Denmark, and Norway. In Ireland, the confidence engendered by low inflation and relatively low interest rates has encouraged domestic spending. In Denmark, domestic demand has reacted strongly to a temporary relaxation of the fiscal stance and the improved international environment. Booming exports have pulled Finland and Sweden out of their deep recessions. The recovery remains very uneven in Finland, however, but domestic demand should begin to strengthen as the consolidation of financial positions by households and the sheltered sector nears completion. In Sweden, the rapid accumulation of public sector debt has increased risk premiums on long-term interest rates, which have retarded the pickup of domestic demand and, as in Italy, poses risks for the recovery. In Greece, economic activity has remained weak, and only a modest recovery is expected, reflecting the very slow progress in tackling the large budget deficit and in reducing inflation.

Growth in Australia and New Zealand accelerated markedly in 1994 as robust domestic spending boosted activity. Both countries have allowed monetary conditions to firm significantly, despite low rates of inflation. In Australia, the current account deficit deteriorated sharply in 1994 to an estimated 4½ percent of GDP. Although consumer spending and investment growth are expected to moderate, the current account deficit is projected to remain relatively large. Inflation is expected to rise in 1995, but should moderate subsequently on the assumption that the monetary tightening that has already occurred, and any additional measures that may be taken, will be sufficient to slow the pace of expansion.

Monetary policy in Australia was tightened on three occasions in the second half of 1994, raising the official cash rate by a cumulative 2¾ percentage points to 7½ percent in December. Long-term government bond rates rose steeply through 1994, with the differential against U.S. rates widening by about 200 basis points. The yield curve has flattened slightly in recent months but remains steep. Concerns about inflation are also reflected in the high yields on index-linked bonds. The extent of further monetary tightening that may be necessary will depend in part on the degree of fiscal consolidation undertaken in the 1995/96 budget (to be presented in May 1995). In New Zealand, the Reserve Bank has allowed short-term interest rates to rise by about 4½ percentage points during the past year to 9½ percent in early 1995.

Foreign Exchange and Financial Markets

The U.S. dollar has weakened sharply so far in 1995, reaching record lows against the Japanese yen and the deutsche mark. Through February 1995, the U.S. dollar was still above its lows for the 1990s against the industrial country currencies on both a nominal (and real) effective basis (Chart 7). The weakening of the U.S. dollar against the yen and the deutsche mark was offset by its strength against the Canadian dollar and some European currencies. On a broader effective basis, which takes into account key developing country trading partners, the U.S. dollar also benefited from its strength against the Mexican peso in particular. However, in considering the role of the U.S. dollar as the world’s leading reserve and financial currency, its value against the other key currencies—in particular, the deutsche mark and the yen—should be assigned a larger importance than trade weights alone might suggest. From the end of 1994 to April 10, 1995, the U.S. dollar declined by 17 percent against the Japanese yen and by 10 percent against the deutsche mark.2 The declines since the end of February were 14 percent and 4 percent, respectively. Moreover, these latter developments brought the dollar on an effective basis near its lows of recent years, in circumstances where, with the U.S. economy operating at or above full capacity, a weakened dollar heightened concerns about future inflationary pressures. The U.S. dollar steadied against the deutsche mark after the Bundesbank lowered official interest rates on March 30, but continued to decline against the yen, even after the Bank of Japan guided the call money interest rate lower in late March.

Chart 7.
Chart 7.

Major Industrial Countries: Nominal and Real Effective Exchange Rates

(1980 = 100; logarithmic scale)

1Constructed using 1989–91 trade weights.2Defined in terms of relative normalized unit labor costs in manufacturing, as estimated by the IMF’s Competitiveness Indicators System, using 1989–91 trade weights.

As a counterpart to the dollar’s weakness, both the deutsche mark and the Japanese yen have strengthened significantly in recent months. The appreciation of the deutsche mark reflected not only its rise against the U.S. (and Canadian) dollar, but also increases against several European currencies affected by political uncertainties or fiscal difficulties, or both, including especially the lira, the peseta, the krona, and sterling; the French franc and the Belgian franc were affected to a lesser extent. Accompanying pressures on the exchange rate mechanism (ERM) of the European Monetary System resulted in the devaluation of the central parity of the Spanish peseta by 7 percent and of the Portuguese escudo of 3½ percent during the first weekend of March. In the week that followed, currency pressures were also reflected in increased official interest rates in a number of European countries. The Japanese yen appreciated across a range of currencies, including the deutsche mark and the Swiss franc.

It is always difficult to explain with any degree of precision the movements in exchange rates, or other financial variables for that matter, but several factors are particularly relevant to the recent developments in key currencies. First, Japan’s large current account surpluses and concerns over recent and prospective U.S. current account deficits and their financing would seem to have been a positive force on the yen and a negative one on the dollar. Indeed, in the United States, the persistence of current account deficits has resulted in a gradual and continuing buildup of net foreign liabilities that has underscored the need for further fiscal consolidation and higher domestic saving. In these circumstances, the poor prospects of further reductions in the U.S. budget deficit seem to have contributed to a weaker dollar. Despite mixed indications of the extent of a slowdown in U.S. growth, there also appeared to be a growing perception in the market that U.S. short-term interest rates were near their peak in this cycle. And the continuing economic crisis in Mexico and worries in the market about the situation in the rest of Latin America weighed adversely on the U.S. currency. Efforts to support the dollar by coordinated central bank intervention appeared to have had little lasting impact; there was little expectation that intervention would be backed by interest rate adjustments by the leading central banks, or by more fundamental policy changes.

In Europe, with several countries beset by political uncertainties and fiscal difficulties, the deutsche mark (and the Swiss franc) benefited considerably from increased demand from risk conscious investors. Indeed, market perceptions of weak fiscal fundamentals, associated concerns about inflation and public debt positions, and political uncertainties have contributed during the past year to periodic bouts of downward pressures on the Italian lira, the Spanish peseta, and the Swedish krona. The Canadian dollar has been in a similar situation (Chart 8). These circumstances have been reflected in substantial risk premiums on long-term interest rates and have prompted these countries to increase policy-related short-term interest rates. General nervousness related to developments in several emerging markets may also have played a role through flight-to-quality effects.

Chart 8.
Chart 8.

Selected Industrial Countries: Exchange Rates and Long-Term Interest Rate Differentials

1Nominal effective exchange rates are based on 1980 = 100.

An important additional factor until late March was the strengthening expansion in Germany, along with high wage demands and recent wage settlements in some sectors. These considerations had contributed to expectations that the Bundesbank was more likely to tighten—or less likely to ease—and perhaps sooner than might be warranted in some of Germany’s trading partners. In the event, in late March the Bundesbank lowered official interest rates in light of domestic considerations, in particular the slow growth in its main monetary aggregate, and the effective tightening of monetary conditions implied by the appreciation of the mark. The monetary easing in Germany helped to relieve currency pressures in Europe and facilitated a lowering of official interest rates in several countries.

The deutsche mark appreciated by 10 percent against the U.S. dollar and by 4 percent in nominal effective terms from the end of 1994 to April 10, 1995. The krona, the peseta, the lira, and sterling fell to record lows against the deutsche mark. The French franc, amid election uncertainties, fell well below the central rate in the ERM although it remained quite strong in real effective terms; however, three-month interest rate differentials with respect to Germany rose to over 3 percentage points in March before narrowing somewhat in early April. The Japanese yen appreciated by 17 percent against the U.S. dollar, and by 16 percent in nominal effective terms from the end of 1994 to April 10, 1995.

In government bond markets, much of the general rise in long-term interest rates in the largest industrial countries during the past year or so was attributable to the strengthening of growth prospects and inflation expectations. More recently, long-term interest rates in several of the larger countries—the United States, Japan, Germany, France, and the United Kingdom—have declined, as the credibility of commitments to resist inflationary pressures appears to have strengthened. For the United States and the United Kingdom, where the expansions are more advanced and where pre-emptive actions have been taken to firm monetary conditions, yield curves have leveled on both ends. More generally, from their peaks in the fall, long-term interest rates have declined by about 90 basis points in the United States and by 60 to 70 basis points in France, Germany, and the United Kingdom. Recently, long-term interest rates in Japan have declined by about 125 basis points, apparently in the expectation of a cut in the official discount rate.

Under the weight of rising long-term interest rates, and their offset to the impact on stock markets of the buoyancy of growth and generally strong profits, equity prices in the major markets fell in the latter half of 1994. With the main exception of U.S. equity prices, they have remained at comparatively low levels into 1995. From August 1994 through April 10, 1995, equity prices have declined on balance by 8 to 16 percent in Germany, France, and Italy. Over the same period, the Nikkei in Japan was down almost 22 percent, 16 percent of which has been since the earthquake. The recent strength of the deutsche mark and the yen appears to have had a negative effect on share prices in Germany and Japan. Share prices in the United Kingdom and Canada increased by 1 to 3 percent, while equity prices in the United States have recently rebounded markedly to test new highs.

Need to Safeguard Reasonable Price Stability

A key policy lesson of the past two decades has been that the costs of allowing inflation to rise are very high and that deep and protracted recessions have typically been required to subdue the inflationary forces generated during booms. This experience suggests an asymmetric relationship between inflation and economic activity whereby excess demand has a much stronger effect in raising inflation than excess supply has in reducing inflation.3 The implication for monetary policy of this asymmetry, and the long lags in the effects of policy action, is the need to pre-empt inflationary pressures before they build so as to avoid having to respond more forcefully later to economic overheating. Failure to respond promptly is costly, as it raises the cumulative loss of output and adds to structural unemployment due to persistence effects. In contrast, policies that prevent overheating and thereby reduce fluctuations of output around its long-run trend can be expected to raise the average level of output and employment.

In accordance with this experience, monetary policies in the industrial countries have become increasingly focused on the goal of price stability. A growing number of countries are making this goal operational by adopting formal targets for inflation, or at least implicit medium-term objectives (Table 3). In a number of countries, the exchange rate or a monetary aggregate continues to serve as the intermediate target of monetary policy. To strengthen the credibility of inflation objectives, a number of countries have recently revised central bank legislation and practices to enhance the independence of their central banks. This strong commitment to safeguard price stability comes at a time when actual inflation in industrial countries is at 30-year lows, and most countries have either attained or are within reach of their medium-term inflation objective; only Greece and, to a lesser extent, Italy, Portugal, and Spain, have some distance to go.

Table 3.

Industrial Countries: Inflation Objectives

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Consumer prices; for the United Kingdom, retail price index excluding mortgages.

Countries with formal inflation targets.

Under the Maastricht Treaty convergence criteria, the inflation rate should not exceed that of the three best performing members of the European Union by more than 1½ percentage points.

To some extent, of course, the recent favorable inflation performance has reflected the existence of considerable economic slack in a number of countries. As slack is absorbed, monetary policy faces the challenge of avoiding a re-emergence of inflationary pressures through timely adjustments of monetary conditions. The degree to which official interest rates will have to be tightened and the timing of policy actions will vary across countries depending importantly on the evolution of the cycle and the stance of fiscal policy. Countries with weak anti-inflation credentials will need to pay particular attention to market expectations about future inflation and to exchange market developments. So far, however, there are encouraging signs that monetary authorities are responding with greater determination than in the past.

Will the strong commitment of monetary authorities be able to ensure a “soft landing” and prevent the excesses often experienced in the past? Although a soft landing is indeed assumed in the staff’s projections, it cannot be taken as a foregone conclusion. It is important to recall that forecasters have typically underestimated the strength of economic recoveries just as they have tended to underestimate the severity of economic downturns. In fact, this was again the case in 1994, when the growth momentum was stronger than expected in most industrial countries. Looking ahead, it is possible that the strength of activity will continue to exceed expectations in the United States and other countries that are advanced in the cycle. The likely degree of underestimation, however, would probably be smaller than in 1994, in light of the pre-emptive tightenings of monetary policy that have occurred. In continental Europe, by comparison, the possibility of a stronger-than-projected outlook is probably somewhat greater at this stage in the expansion although there is also a risk of setbacks in the recovery process, at least in some countries. For Japan, the risks appear to be more evenly balanced.

While it is difficult to assess the degree of monetary tightening consistent with a soft landing, it is important to consider whether the adjustments in monetary conditions that have occurred so far appear to be more timely than in the past. Such an analysis is, of course, mainly relevant for those countries, such as the United States, the United Kingdom, Australia, and New Zealand, where recovery from the recent recessions is already complete or well advanced.

In the United States and the United Kingdom, both nominal and real short-term interest rates were lower in the early stages of this recovery, relative to their values at the troughs of the cycles, than at similar stages in previous recoveries (Chart 9). Furthermore, yield curves have been fairly steep, indicating continued monetary support for the economic expansions. These developments reflect the fact that at the cyclical troughs the levels of real interest rates were relatively high, while in the early stage of the current recovery output growth was comparatively weaker and the pressure on resources has been less intense. The major difference, however, has been that the monetary authorities raised short-term interest rates at the first signs of incipient price pressures in the current recovery even though actual inflation was still declining and was generally at the lowest sustained levels in decades. In Australia, the situation has been similar. While monetary conditions have been tightened, underlying inflation has remained at around 2 percent. In New Zealand, actual inflation has remained subdued so far, but the monetary authorities have allowed short-term interest rates to rise sharply in anticipation of inflation pressures stemming from rapid economic growth. Overall, the prompt monetary policy actions, together with the nonsynchronized business cycles in the United States and the United Kingdom as compared with continental Europe and Japan, suggest that the cyclical upturn in inflation in industrial countries may prove to be more short-lived in the present upswing than in the past. Interest rates may not have to rise as much in the future, and yield curves may not become as sharply inverted as in previous cycles. This would help to ensure longer-lasting economic expansions with inflation peaking at relatively low levels.

Chart 9.
Chart 9.

Selected Industrial Countries: Inflation and Real Short-Term Interest Rates in the Recovery

(Horizontal scale indicates number of quarters from cyclical trough for GDP)

1Real interest rates are deflated by percent change of consumer prices from four quarters earlier.

Urgency of Fiscal Consolidation

Almost all of the industrial countries have entered the second half of the 1990s with large fiscal imbalances. In part, these reflect the effects of the cyclical downturn on actual balances, which will be reversed as the expansion proceeds. But they also reflect the persistence of large structural budget deficits in a large number of countries (Chart 10). The structural deficit averaged 2½ percent of GDP in 1994 for the seven major industrial countries, and it was somewhat higher in the group of smaller industrial countries (Table 4).4 Reflecting the large fiscal imbalances, government debt has continued to rise sharply, with general government gross debt now averaging 70 percent of GDP. The high levels of government debt are a key contributing factor behind the high level of real interest rates. They have also reduced the ability of fiscal policy to respond to cyclical downturns. The notable exception is Japan, where the successful fiscal consolidation strategy of the 1980s allowed the adoption of stimulative fiscal measures during the past couple of years.

Chart 10.
Chart 10.

Major Industrial Countries: General Government Budget Balances1

(In percent of GDP)

1Blue shaded areas indicate IMF staff projections.
Table 4.

Industrial Countries: General Government Fiscal Balances and Debt1

(In percent of GDP)

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The output gap is actual less potential output, as a percent of potential output. Structural balances are expressed as a percent of potential output. The structural budget balance is the budgetary position that would be observed if the level of actual output coincided with potential output. Changes in the structural budget balance consequently include effects of temporary fiscal measures, the impact of fluctuations in interest rates and debt-service costs, and other noncyclical fluctuations in the budget balance. The computations of structural budget balances are based on IMF staff estimates of potential GDP and revenue and expenditure elasticities (see the October 1993 World Economic Outlook, Annex I). Net debt is defined as gross debt less financial assets, which include assets held by the social security insurance system. Estimates of the output gap and of the structural budget balance are subject to significant margins of uncertainty.

Data before 1990 refer to west Germany. For net debt, the first column refers to 1986–90. Beginning in 1995 the debt and debt-service obligations of the Treuhandanstalt (and of various other agencies) are to be taken over by the general government. This debt is equivalent to 8 percent of GDP, and the associated debt service to ½ of 1 percent of GDP.

Figure for 1981–90 is average of 1983–90.

Net debt includes tax refund liabilities. Net debt figure for 1981–90 is for 1984–90.

Includes Australia, Austria, Belgium, Denmark, Finland, Ireland, the Netherlands, New Zealand, Norway, Spain, and Sweden. See Annex III.

Governments have generally recognized the need for fiscal consolidation, and a number have announced medium-term deficit-reduction objectives (Table 5). However, while a few countries are making considerable progress, most others will need to put in place additional measures in order to ensure a significant decline in budget deficits and debt ratios. The need to strengthen the pace of fiscal consolidation is all the more pressing for several reasons. First, the envisaged progress toward fiscal consolidation is generally based on medium-term scenarios that assume robust growth and declining long-term interest rates. If growth turns out to be weaker than expected, or interest rates higher, progress in reducing deficits and debt ratios could easily be reversed. Second, levels of public debt in 1994 are already very high in absolute terms and relative to the last cyclical peak. The high debt ratios put into question the sustainability and credibility of fiscal policies, contributing to large risk premiums on interest rates in some countries. Third, aging populations and the existence of large unfunded liabilities in public pension systems risk exacerbating public finances in the future in the absence of reforms aimed at controlling the level and growth of public expenditures. Finally, the present cyclical situation presents the best possible circumstances to make significant inroads into the large deficits. Postponing the necessary actions until the next economic slowdown would exacerbate any short-term loss of output and employment associated with a withdrawal of fiscal stimulus. In some countries, fiscal retrenchment may actually help to strengthen economic performance even in the short run (Box 2).

Table 5.

Industrial Countries: Medium-Term Fiscal Objectives

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The United States has made substantial progress in the past two years toward the medium-term objective of fiscal consolidation. The August 1993 budget legislation, the robust economic expansion, and net sales of assets of failed thrift institutions have helped reduce the deficit of the federal government on a unified basis. However, the administration’s February budget proposal implies little further progress toward deficit reduction in the foreseeable future. The staff’s projections suggest that the federal deficit and the debt-to-GDP ratio will begin to rise again after FY 1995. Even assuming that effective measures to curtail health care costs and other entitlements are adopted, it would be difficult to achieve the necessary further improvement in the fiscal balance in the medium term. Fiscal policy should focus on measures to contain the growth of spending, and also on measures to raise federal revenues as expenditure restraint alone is unlikely to bring about the needed consolidation. The relatively low saving rate in the United States underscores the need for strengthened efforts at fiscal consolidation so that the burden of adjustment of the external imbalance does not fall on investment.

Can Fiscal Contraction Be Expansionary in the Short Run?

Policymakers are often reluctant to implement significant reductions in government deficits because of a perception that withdrawing fiscal stimulus might lower aggregate demand and jeopardize growth. This view is rooted in the standard fiscal multiplier analysis that has influenced economic policy thinking in many countries during the postwar period. According to this analysis, increases in government expenditures are transmitted through a positive fiscal multiplier into increases in aggregate demand, at least for a year or two after the fiscal expansion. Beyond the initial positive impact, many models, including the staff’s multicountry econometric model MULTIMOD, which incorporates forward-looking expectations, show a declining multiplier that eventually turns negative because of crowding out effects on investment and on the capital stock. The standard analysis also suggests that the effects of a fiscal contraction would be broadly symmetric to those of a fiscal expansion.

This traditional view concerning the effects of reductions in budget deficits may not apply to countries with very large budgetary imbalances, especially if financial markets are internationally integrated. In such economies, the multiplier may be negative even in the short run—that is, a fiscal contraction may increase economic activity in both the short and the longer run. The possibility of a negative short-run multiplier rests on the central role played by expectations about future policy actions and interest rates. The basic argument is as follows. Suppose that the government in a country with a very large and rapidly growing budget deficit and a high level of government debt makes a firm commitment to significantly reduce its budget deficit. Provided that financial market participants regard the policy measures as fully credible, the pressure on long-term interest rates is likely to abate very quickly. The reason is that a credible policy announcement will be viewed as reducing the danger of rising inflation and of future financial instability. As a result, the risk premium in long-term interest rates will tend to decline, perhaps significantly.

In such a scenario, the reduction in long-term interest rates would have expansionary effects on both demand and supply. It would lower the cost of capital and increase investment and the capital stock. The debt-servicing burden of households, firms, and the public sector would ease, particularly in economies with large public and private debt overhangs, and the adjustment of balance sheets would be facilitated. Diminished uncertainty about the sustainability of the budgetary situation should also help to boost confidence of investors and consumers. To the extent that the reduction in public debtservicing payments would lower budgetary pressures and expected future tax rates, consumption and investment would be further stimulated. These expansionary effects might well outweigh the traditional negative short-term impulse from fiscal consolidation.1

There is evidence of a negative fiscal multiplier from the experience of the 1983–86 Danish stabilization program and the 1987–89 Irish stabilization.2 In both cases, the fiscal imbalances before the intensification of consolidation efforts were clearly unsustainable, and risk premiums on interest rates were extremely high. Following the adoption of front-loaded fiscal consolidation programs, which relied on expenditure reductions, both countries rapidly experienced an improvement in economic performance, with stronger growth and declining unemployment (see chart).3

uch02fig01

Denmark and Ireland: GDP Growth and General Government Structural Balance1

(In percent and percent of potential GDP, respectively)

1 The structural budget balance is the budgetary position that would be observed if output was at its potential level. For Ireland, it is based on the public sector borrowing requirement. Blue shaded areas indicate fiscal consolidation periods.

The views and responses of investors have come to play a crucial role in countries with large budget deficits and public debts. This is illustrated by the sharp widening of interest differentials among the industrial countries during the past year and by the downward pressure on the exchange rates of some currencies. By requiring higher yields on government debt, financial markets have frequently signaled that the lack of credible fiscal austerity programs is economically costly. At least for some countries, the “macroeconomic model” used by market participants appears to be consistent with the existence of a negative multiplier. Governments need to exploit these market sentiments in a constructive way. Under current circumstances, this would seem to apply particularly to Italy, Greece, and Sweden. For other countries with large fiscal imbalances and high levels of public debt, such as Canada, Belgium, Finland, and Spain, the economic outlook would also be strengthened, even in the relatively near term, by the adoption of stronger deficit reduction measures. In all cases, the credibility of the fiscal adjustment program would be enhanced by front-loaded action to achieve the necessary degree of medium-term fiscal consolidation.

1For a theoretical derivation of the negative multiplier, see Giuseppe Bertola and Allan Drazen, “Trigger Points and Budget Cuts: Explaining the Effects of Fiscal Austerity,” American Economic Review, Vol. 83 (March 1993), pp. 11–26. For a survey, see Frank Barry and Michael Devereux, “The Macroeconomics of Government Budget Cuts: Can Fiscal Contractions Be Expansionary?” in Deficit Reduction: What Pain, What Gain? ed. by William Robson and William Scarth (Toronto: C.D. Howe Institute, 1994).2Ireland had undertaken an earlier, less successful, fiscal adjustment program in 1982–84 that had relied mainly on higher discretionary taxes, rather than on lower government expenditures, and did not go far enough in reducing budgetary imbalances to reverse the rising trend in the debt-to-GDP ratio. The coexistence of robust growth during periods of fiscal contraction in a number of developing and transition countries also suggests the possibility of a negative fiscal multiplier.3The growth in output cannot be ascribed solely to fiscal retrenchment; other factors such as favorable real wage developments, robust external demand, and the effects of exchange rate policy on interest risk premiums, also contributed. The experience of Denmark and Ireland is analyzed in Francesco Giavazzi and Marco Pagano, “Can Severe Fiscal Contractions Be Expansionary? Tales of Two Small European Countries,” in NBER Macroeconomics Annual, ed. by Olivier Blanchard and Stanley Fischer (Cambridge, Massachusetts: MIT Press, 1990).

Germany and the United Kingdom have begun to reduce large underlying deficits through expenditure restraint and higher taxes, and are in a good position to achieve their medium-term fiscal consolidation objectives if the announced medium-term plans are fully carried out. In Germany, the general government budget deficit is projected to decline as a proportion of GDP for the second successive year in 1995 and should be within the target of less than 2 percent in 1996. In the United Kingdom, current policies, if fully implemented, would stabilize the debt-to-GDP ratio in 1995/96 and eliminate the structural deficit by the end of the decade, mainly through expenditure restraint. However, lower-than-anticipated inflation in 1994 resulted in less real spending restraint than initially envisaged, and much of the planned spending restraint lies in the future.

A number of other countries, including Australia, France, Denmark, the Netherlands, Norway, Spain, and Switzerland, have also announced fiscal objectives that should result in some improvement over the medium term. Some progress has been made in containing the growth of public expenditures, but further measures will be necessary in most cases. In France, the fiscal situation is improving mainly as a result of the recovery, and it will be important to put in place specific measures also to achieve a reduction of the underlying fiscal deficit in 1996/97. Further reform of social security is needed to contain the growth of outlays, even though deficits are expected to decline in the next few years as revenues recover. Australia has announced that measures will be introduced in the 1995/96 Commonwealth budget to move the budget into surplus in 1996/97, although the exact measures are as yet unspecified. In Denmark, much of the improvement in the fiscal balance aimed at over the medium term hinges on an optimistic assumption of a decline in structural unemployment.

In Canada, Greece, Italy, and Sweden, the high levels of public debt make fiscal adjustment programs very susceptible to derailment by adverse shocks, including higher-than-anticipated interest rates. In Belgium, the very high debt-to-GDP ratio also constitutes an element of vulnerability. In all of these countries, and most urgently in Italy and Sweden, there is a need for more ambitious fiscal adjustment plans and efforts. In Italy, despite a robust recovery and some progress in deficit reduction, the large structural fiscal imbalance has resulted in a rapid buildup of public debt. In combination with political uncertainties, this has tended to undermine confidence in the lira and push up the level of interest rates. To correct the situation, the government of Prime Minister Dini introduced a supplementary budget at the end of February. But much stronger measures are required in coming years to substantially reduce the budget deficit and place the debt-to-GDP ratio on a clearly declining trend. In Canada, the federal government tabled a budget for the 1995/96 fiscal year at the end of February that is set to achieve its medium-term target of limiting the federal deficit to 3 percent of GDP by 1996/97. However, additional efforts are necessary to lower the high debt-to-GDP ratio over the medium term and to lessen the vulnerability of the fiscal position to a cyclical downturn and financial market disturbances. Sweden’s fiscal position has also deteriorated rapidly in the past few years. Gross public debt to GDP has doubled from 45 percent of GDP in 1990 to 92 percent of GDP in 1994. The 1995/96 budget presented in January proposed new savings geared to the medium-term objective of stabilizing the debt ratio by 1998. But the budget was not well received in financial markets and stronger efforts are likely to be necessary to restore confidence of financial investors and improve the fiscal and overall economic outlook.

In Japan, a succession of fiscal packages has provided desirable support to economic activity. Supplementary spending for reconstruction following the earthquake will provide further support to activity this year. However, the flexible use of fiscal policy has led to a marked deterioration in the fiscal position. Starting in 1996, there will be a need to resume fiscal consolidation. The government has passed a tax reform package and approved a pension reform bill that should go some way toward deficit reduction, but further significant measures appear necessary to achieve long-run fiscal sustainability.

Structural Policies to Strengthen Employment and Productivity

The importance of broad-based structural reforms for improving economic performance is clearly illustrated by the impressive recent and prospective performance of New Zealand, the country that has made most progress in implementing such reforms (Box 3). In Europe and Canada, the most pressing structural problem is the high level of unemployment. In Australia and New Zealand, unemployment also remains at the top of the political agenda, although the recovery has already made substantial inroads into cyclical unemployment, especially in New Zealand. Double-digit unemployment rates are now the norm in Europe. The recent recessions have played a part, but the bulk of unemployment appears to be structural, implying enormous economic and social costs that will persist beyond the cyclical recovery.

Most economists and policymakers have more or less the same diagnosis of the structural unemployment problem, although specific causes vary from country to country.5 Many would agree, for example, that unemployment benefit systems as currently structured discourage people from seeking work and contribute to high levels of long-duration unemployment; that high payroll taxes and social insurance contributions discourage employers from seeking employees, particularly low-wage employees; that school systems generally do not adequately prepare students for the requirements of the labor market and that public sector training programs are inadequate and often ineffective; that insufficiently competitive product and housing markets restrain the demand for workers and reduce mobility; and that union power, collective bargaining systems, minimum wages, job security legislation, and barriers to labor mobility insulate incumbent employees from the forces of demand and supply, make wages less responsive to market forces, prevent wage differentials from reflecting productivity differentials, and encourage the substitution of capital for labor (Box 4).

Reflecting the broad consensus about the structural nature of the unemployment problem, most governments have made attempts at labor market reform during the 1980s and early 1990s.6 These reforms do not appear to have had much of an impact on unemployment, however, except perhaps in the United Kingdom and New Zealand, where changes in the system of industrial relations appear to have led to more flexible wages and employment. There are three factors suggesting that broad-based, fundamental labor and product market reforms, as opposed to the relatively modest reforms adopted in the past, will be needed if European unemployment is to be reduced on a durable basis.

  • First, there is no single, well-defined cause of the dramatic rise of European unemployment from the early 1970s to the early 1980s, or of the current high level. If reform is to succeed, it will have to address the myriad of institutions and policies that contribute to high unemployment.

  • Second, rigidities can be mutually reinforcing. Re-forms that allow real wages to better reflect differences in productivity across regions, for example, would be more effective if accompanied by reforms to housing markets to improve geographic mobility and reforms to enhance the portability of pensions.

  • Third, high levels of unemployment have become such a standard feature of the economic landscape in many countries that only a regime change is likely to change entrenched practices and reduce unemployment substantially.

New Zealand’s Structural Reforms and Economic Revival

New Zealand has been enjoying rapid economic growth accompanied by low inflation and strong employment growth since 1993. This success has followed a decade of far-reaching structural reforms. The reforms followed mounting frustration over poor economic performance in the wake of a long-term decline in the country’s terms of trade and inadequate policy responses. The reforms radically reversed past policies, simultaneously improving microeconomic efficiency and restoring macroeconomic balance.1 The general approach was a rapid launch of reforms across a wide front, with sequencing decided both by economic imperatives and political feasibility.

Immediately upon taking office in 1984, an exchange market crisis forced the Labor Government to turn its attention to financial reforms, accelerating the reform program generally. The New Zealand dollar was devalued by 20 percent in July 1984 before it was set on a free float in March 1985. At the same time, the capital account was completely liberalized and the foreign exchange market deregulated. Monetary control was simplified by replacing reserve requirements, interest rate controls, and credit guidelines with a market-based system for limiting banking system liquidity. Competition in banking was promoted by equalizing the legal status of financial institutions, lifting ownership limitations, and allowing free entry for foreign banks. Bank supervision was introduced in 1985 and recently underwent an innovative reform aimed at allowing market discipline to play a greater role. Financial liberalization together with tight monetary but relaxed fiscal policies contributed to a 25 percent real appreciation of the currency between 1984 and 1988.

By 1987, price stability became the overriding objective of monetary policy, after more than a decade of double-digit inflation. This was formalized with the passage of the Reserve Bank Act 1989, which stipulated that price stability was the Reserve Bank of New Zealand’s sole monetary policy objective. The act granted the Bank complete independence in the use of its instruments, enhanced monetary policy transparency, and placed accountability with its Governor. In recognition of the government’s ultimate responsibility for monetary policy, the act provided for a Policy Targets Agreement between the Minister of Finance and the Governor of the Reserve Bank to define price stability. The current agreement, signed in December 1992 and valid through 1998, obliges the Bank to maintain 12-month increases in the CPI within zero and 2 percent, inflation having been brought down to that range already by the end of 1991. The policy target agreement allows inflation to depart temporarily from its target zone to accommodate relative price movements resulting from specific shocks defined in the agreement. The Bank is obliged to submit to Parliament a Monetary Policy Statement twice a year that contains, inter alia, the two-year inflation forecast, which plays a central role in guiding monetary policy.

Public sector reforms came in two waves, the first directed at eliminating the role of Government in the provision of commercial goods and services, and the second at raising the efficiency of the “core government.” Government commercial activities, which were equivalent to about 12 percent of GDP in 1984, were first organized in state-owned enterprises. These enterprises and other government-owned industries (mostly in the utility, transport, and finance sectors) were then corporatized by restructuring them into limited liability companies to be run on a commercial basis. Usually, the privileges these enterprises had enjoyed in legislation (monopoly powers) or practice (subsidies) were removed. Finally, many of these enterprises were privatized with the proceeds from the asset sales largely used to repay public sector debt.

To improve the efficiency of core government functions, a financial management reform was launched in 1988 that introduced “performance contracting” deep into the civil service. Department heads became responsible for the delivery of well-defined “outputs,” such as vehicle inspections, with ministers retaining responsibility for “outcomes,” such as traffic safety. To accomplish this, department heads were given large discretion in the management of budgets and labor inputs. The accounting system was shifted from a cash to an accruals basis in line with generally accepted accounting practice to provide the information needed under the new management system.

The core government reforms culminated in 1994 in the Fiscal Responsibility Act. Without setting specific fiscal targets, the act codified disclosure and accounting practices that had gradually been introduced, aiming for maximum transparency about fiscal strategies, outcomes, and forecasts. It prescribed “principles” for responsible fiscal management, such as the requirement to reduce debt to “prudent levels” and, once achieved, to keep it there by balancing operating expenditures and expenses “over a reasonable period of time.” Temporary departures from these principles were permitted, provided that the government explain why and how it plans to return to the principles. For maximum transparency, the Fiscal Responsibility Act imposed generally accepted accounting practices for all budget statements and introduced a series of new disclosure requirements.

The tax system in New Zealand prior to 1985 was highly distortionary and inequitable. It relied heavily on taxation of labor (60 percent of revenues), with high marginal rates and many tax incentives and expenditures. A comprehensive package of tax reforms, announced in 1984, set out to broaden the tax base, lower marginal rates, generate more revenue, and shift the tax mix from income to consumption. Reform of the personal income tax between 1984 and 1990 reduced the number of tax brackets from five, with rates ranging from 20 to 66 percent, to two of 24 and 33 percent, with the top rate aligned with the company tax rate. In 1986, a 10 percent flat-rate value-added tax on all goods and services replaced the wholesale tax and a range of other indirect taxes; the rate was raised to 12½ percent in 1989.

Tax reforms were followed in 1991 by complementary reforms of the welfare system to cut costs and improve financial incentives to beneficiaries. By 1994, expenditures on social welfare had been reduced by 2 percent of GDP by paring down most welfare programs, including unemployment benefits, and lowering superannuation payments. Moreover, the eligibility age for superannuation was raised from 60 to 65 phased in over ten years starting in 1992.

Trade liberalization had perhaps the largest immediate impact of all the reforms. New Zealand had developed a system of import licenses and tariffs that implied an average effective rate of protection for the manufacturing sector estimated at 60 to 70 percent. While intended to shelter domestic production, the high level of protection seriously distorted resource allocation, impeded productivity, and hampered external competitiveness. Although trade liberalization had started already in the 1970s and a free trade agreement with Australia was concluded in 1983, the pace of liberalization quickened after 1984 as trade policy sought to derive the maximum benefit for the domestic economy from world competition. By 1988, all import licenses had been abolished and, by 1992, a unilateral program had reduced tariffs to a nominal average rate of 10 percent (compared with 27 percent in the mid-1980s). All export incentives were abolished, including subsidies to agriculture, which had reached the equivalent of 33 percent of output in 1985. Present policies call for a further one-third reduction in tariffs by 1996, at which time protection in New Zealand would be at a level comparable with the average among industrial countries, leaving only a few sectors, such as textiles, footwear, and motor vehicles, with high effective protection. Further tariff reductions have already been announced for after 1996. The initial effect on manufacturing of the removal of trade protection, along with the real appreciation of the currency, was a sharp decline in manufacturing output and employment. However, international competitiveness has since improved, and manufacturing output and exports have been strong since 1992.

Industrial relations were reformed radically in 1991 with the Employment Contracts Act.2 The old system was rigid and complex, dominated by “occupational awards” that comprehensively set working conditions for specific occupations across whole industries. Although compulsory arbitration was abolished in 1985, government intervention in the wage bargaining process was still pervasive. The act introduced the legal framework for a highly decentralized, enterprise-level bargaining system. It abolished all awards by turning them into individual employment contracts. This had a profound impact on both unions and employers: the former saw their role reduced to that of freely chosen bargaining agents, and the latter were forced to take responsibility for wage negotiations and labor management generally. Early indications are that the Employment Contracts Act has brought more flexibility in working hours and patterns, and in remuneration practices, while the impact on the level of wages has been limited to a reduction in overtime and weekend pay.

There are a number of reasons for the success of New Zealand’s reform program: a strong, popular mandate for change, an exchange market crisis that catalyzed the reform process, strong political support and vision, a coherent agenda, a rapid and comprehensive approach that thwarted opposition from vested interests, and a political system and tradition prone to quick decision taking.3 The positive supply effects of the reforms took quite a number of years to materialize, but as illustrated by the recent excellent economic performance, the reforms together with the attainment of macroeconomic stability have positioned New Zealand well for sustained, high growth over the medium term.

1For a summary of the reforms, including their “new microeconomic” theoretical foundations, see Alan Bollard, New Zealand: Economic Reforms, 1984–1991, Country Studies No. 10 (San Francisco, California: International Center for Economic Growth, 1992).2For an analysis of the genesis and implications of the act, see Raymond Harbridge, ed., Employment Contracts: New Zealand Experiences (Wellington: Victoria University Press, 1993).3See Alan Bollard’s chapter on New Zealand in The Political Economy of Policy Reform, ed. by John Williamson (Washington: Institute for International Economics, 1994).

Progress in this important area of public policy will require a greater willingness to tackle sensitive issues and acknowledgment that some social policies and labor market practices that were intended to protect economically vulnerable groups have had the unacceptable side effect of excluding large segments of the population from productive activity. Despite the broad consensus about the causes of high and persistent unemployment, however, social concerns continue to delay the adoption of appropriate reforms. To address such concerns, and to the extent that labor market reforms have unfavorable distributional consequences, the reforms should be complemented with appropriately designed, well-targeted transfer programs operating through the tax system in the short run, and with improvements in training and education to increase labor productivity and real wages in the medium to long run.

Capital Formation and Employment

The increase in real GDP in the United States and in the European Union since 1970 has been remarkably similar, as has the increase in the capital stock (see chart). The growth of employment, on the other hand, has been very different. Employment in the United States was about 60 percent higher in 1994 than in 1970. In the European Union, by contrast, employment was essentially stagnant in the two decades after 1970, and the uptick in 1991 was mainly due to the inclusion of the eastern Lander into unified Germany.

This combination of developments suggests that the relatively poor employment performance of the European Union compared with the United States cannot be blamed on insufficient demand or on “capital shortage.”1 A more plausible explanation is to be found in the types of investment in the two regions. In Europe, investment was capital deepening as indicated by the sharp rise in the capital-labor ratio. With more capital for each worker, the increase in output came about primarily through higher labor productivity rather than through higher employment. In this sense, investment appears to have been primarily directed toward substituting increases in capital for increases in employment. In the United States, on the other hand, the growth of the capital-labor ratio was much more modest, indicating that investment was more capital widening.2

The relatively small rise in the capital-labor ratio in the United States, and the smaller increase in labor productivity, resulted in increases in employment that kept pace with the growth of the labor supply, and hence the equilibrium level of unemployment was largely unchanged from 1970 to 1994.3 This was not, however, the case in Europe. The much larger increases in the capital-labor ratio and in labor productivity in Europe were reflected in only modest gains in employment that did not keep pace with the growth in labor supply. Abstracting from cyclical effects, the equilibrium unemployment rate appears to have increased by a staggering 7 or 8 percentage points in Europe.4 The contrast is even more striking given the relatively modest increase in the labor force in Europe compared with the United States.

Increases in real wages in Europe and the United States were broadly consistent with developments in capital intensity, productivity, and employment. Compared with the United States, the larger increases in capital-labor ratios and labor productivity in Europe supported a bigger rise in real wages. The higher real wages, of course, benefited a declining share of the European labor force. Indeed, many low-paying jobs have effectively disappeared in Europe, which helps to explain the heavy concentration of unemployment among unskilled, low-productivity workers.5 Average real wages grew much less in the United States, which encouraged the larger increase in employment. The much smaller rise in average real wages in the United States than in Europe also reflected, of course, the fact that much, but not all, of the increase in U. S. employment was for jobs that paid relatively low wages, many of which were in the service sector. The increase in wage inequality in the United States compared with Europe partly reflects this larger increase in employment at the low end of the wage distribution.

Entrepreneurs’ investment decisions are based on many factors, including existing and prospective labor market regulations and institutions. Relatively rigid labor markets in Europe have encouraged capital deepening investments that have effectively substituted more capital for labor. Relatively flexible labor markets in the United States, on the other hand, have encouraged much less substitution of capital for labor, and the equilibrium level of unemployment has remained broadly stable. This suggests an urgent need for European governments to adopt fundamental structural reforms to increase labor market flexibility and reduce the cost of labor—broadly defined to include, for example, the costs of hiring and firing—and thereby encourage investments consistent with higher levels of employment. In addition, both the United States and Europe need to strengthen education and training to boost productivity and real wages at the lower end of the skill and income distributions.

uch02fig02

The European Union and the United States: Output, Capital, Employment, and Wages

(1970 = 100, unless noted otherwise)

Sources: OECD, analytical data base; and IMF staff estimates.1Excluding Luxembourg and Portugal. Real GDP, capital stocks, and real wages are calculated using PPP-based weights.2National accounts compensation per employee deflated by the GDP deflator.
1See Charles Bean, “Capital Shortage and Persistent Unemployment,” Economic Policy, Vol. 8 (April 1989), pp. 11–53.2Capital widening refers to an increase in the capital stock with an unchanged capital-labor ratio.3The equilibrium level of unemployment was also relatively stable in Japan, although the 1970–94 increase in output, capital, and capital-labor ratios were far higher than in the United States or Europe.4See the May 1994 World Economic Outlook, pp. 34–41.5See Jacques Dreze and Edmond Malinvaud, “Growth and Employment: The Scope of a European Initiative,” European Economic Review, Vol. 38 (April 1994), pp. 489–504.

In the United States, the level of structural unemployment has been relatively stable. The most pressing structural issues are to increase the productivity of unskilled or displaced workers through better training and education, and to increase the efficiency of the health care sector in order to reduce fiscal pressures and to improve equity in the supply of medical services. Reforms to contain the costs of health care and alleviate future fiscal pressures associated with population aging are also necessary in most other industrial countries. The principal structural issues in Japan are deregulation of the distribution system, telecommunications, finance, housing, and land. Greater progress in these areas would help to increase economic efficiency and allow consumers to benefit fully from their strong purchasing power in world markets.

Convergence in the European Union

The second stage of Economic and Monetary Union (EMU) came into force on January 1, 1994. According to the Treaty on European Union (The Maastricht Treaty), it must be determined not later than the end of December 1996 whether a majority of member states of the European Union (EU) meet the conditions for participation in the third, and final, stage of EMU.7 To qualify for the third stage, countries must meet convergence criteria for inflation, government budget deficits and debt, long-term interest rates, and exchange rate stability within the ERM. Although most countries meet or are close to meeting the inflation and long-term interest rate criteria, significant reductions in government budget deficits and debt-to-GDP ratios, or both, are needed in most EU members to meet the fiscal criteria (see Table 6, p. 29). The latter will pose a serious obstacle for a number of countries. Fiscal consolidation has not proceeded at a fast enough pace, and countries risk taking insufficient advantage of the recovery to reduce their fiscal imbalances. In 1996, EU budget deficits are expected to average over 4 percent of GDP on current policies, well above the Maastricht reference value of 3 percent, while the gross debt-to-GDP ratio is projected to exceed the 60 percent criterion in all but four or five countries.

Table 6.

European Union: Convergence Indicators for 1995 and 1996

(In percent)

article image
Sources: National sources; and IMF staff projections.Note: The table shows the convergence indicators mentioned in the Maastricht Treaty. The relevant convergence criteria are (1) consumer price inflation must not exceed that of the three best performing countries by more than 1½ percentage points; (2) interest rates on long-term government securities must not be more than 2 percentage points higher than those in the same three member states; (3) the currency must have been held within the normal fluctuation margins of the ERM for two years without a realignment at the initiative of the member state in question; and (4) the financial position must be sustainable, which is defined as a general government deficit no greater than 3 percent of GDP and a public debt-to-GDP ratio of not more than 60 percent. For countries that do not satisfy the fiscal criteria, the Treaty requires a substantial and continuous decline of fiscal deficits toward the reference value, and the debt-to-GDP ratio must be approaching the benchmark at a “satisfactory pace.” See “The Maastricht Agreement on Economic and Monetary Union,” Annex II in the May 1992 World Economic Outlook, pp. 52–55. The fiscal projections are based on current policies and do not take into account further consolidation measures that are planned in accordance with countries’ convergence programs.

The GDP shares are based on the purchasing power parity (PPP) valuation of country GDPs.

Debt data refer to end of year. They relate to general government but may not be consistent with the definition agreed at Maastricht.

Ten-year government bond yield or nearest maturity.

Retail price index excluding mortgage interest.

Average weighted by 1994 GDP shares.

The debt-to-GDP ratio would be below 60 percent if certain items acknowledged by ECOFIN as warranting separate consideration are deducted.

General government balance includes capitalized interest; long-term interest rate is 12-month treasury bill rate.

According to the Treaty, the debt criterion may be considered satisfied, however, if the debt ratio is sufficiently diminishing and approaching the reference value at a satisfactory pace. On this basis, the EU Council of Ministers has taken the position that Ireland meets the debt criterion, even though Ireland’s debt-to-GDP ratio is still relatively high. On current policies, only Germany, the United Kingdom, Denmark, Ireland, Luxembourg, and the Netherlands are likely to meet the deficit criterion in 1996. However, France would be within striking distance (½ of 1 percent of GDP), while Belgium, Austria, and Finland would need a somewhat larger, though still feasible, effort (on the order of 1 to 1¼ percent of GDP). Portugal and Spain, which are committed to reducing their fiscal deficits substantially during the period ahead, face more significant adjustment needs. Italy, Sweden, and Greece are still a long way from meeting the deficit criterion. Although it would seem possible for a majority to satisfy the deficit convergence criterion by 1996, and probably also most other criteria, the slow pace of fiscal consolidation may delay the third stage of EMU until 1999.8

The convergence criteria set out in the Maastricht Treaty were conceived as minimum requirements aimed at ensuring a high degree of financial discipline and stability in the monetary union. In light of recent EU surveillance activities, including the first excessive budget deficit procedure in the fall of 1994, it appears that the EU intends to apply the convergence requirements strictly. However, beyond meeting the agreed ceilings on budget deficits, a broader question concerns the appropriate degree of fiscal balance that members of the EU should strive for over the medium term. Simply meeting the 3 percent deficit target by the latter part of this decade would still leave significant underlying imbalances, since it might well coincide with a relatively high level of capacity utilization as the current expansion matures. Both the Council and the Commission have stressed that deficits will need to be much lower than the Maastricht reference value, and perhaps close to balance by the end of the century. Nevertheless, existing deficit reduction plans of most member states remain relatively unambitious.

There is also reason for concern about the aggregate stance of fiscal policy across the members of the monetary union. A bias toward easy fiscal policy and tight monetary conditions would hamper growth and complicate external exchange rate policy vis-à-vis other major currency areas. In order to ensure the highest possible degree of macroeconomic balance and an appropriate macroeconomic policy mix, it will be important for the members of the prospective monetary union to pursue more stringent objectives for fiscal deficits than seem to be required by the provisions of the Maastricht Treaty.

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Cover World Economic Outlook, May 1995
World Economic Outlook, May 1995
Global Saving
Author: International Monetary Fund. Research Dept.
ISBN:
9781557754684
ISSN:
0256-6877
Publication Date:
30 May 1995
Publisher:
International Monetary Fund
DOI:
https://doi.org/10.5089/9781557754684.081
Pages:
205
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    Major Industrial Countries: Real GDP1

    (Percent change from four quarters earlier)

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    Major Industrial Countries: Output Gaps1

    (Actual less potential, as a percent of potential)

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    Selected Industrial Countries: Policy-Related Interest Rates and Ten-Year Government Bond Rates1

    (In percent a year)

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    Selected Industrial Countries: Short-Term Interest Rates and Yield Curves1

    (In percent)

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    Major Industrial Countries: Nominal and Real Effective Exchange Rates

    (1980 = 100; logarithmic scale)

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    Selected Industrial Countries: Exchange Rates and Long-Term Interest Rate Differentials

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    Selected Industrial Countries: Inflation and Real Short-Term Interest Rates in the Recovery

    (Horizontal scale indicates number of quarters from cyclical trough for GDP)

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    Major Industrial Countries: General Government Budget Balances1

    (In percent of GDP)

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    Denmark and Ireland: GDP Growth and General Government Structural Balance1

    (In percent and percent of potential GDP, respectively)

  • View in gallery

    The European Union and the United States: Output, Capital, Employment, and Wages

    (1970 = 100, unless noted otherwise)

Major Industrial Countries: Real GDP1

(Percent change from four quarters earlier)

Major Industrial Countries: Output Gaps1

(Actual less potential, as a percent of potential)

Selected Industrial Countries: Policy-Related Interest Rates and Ten-Year Government Bond Rates1

(In percent a year)

Selected Industrial Countries: Short-Term Interest Rates and Yield Curves1

(In percent)

Selected Industrial Countries: Short-Term Interest Rates and Yield Curves1

(In percent)

Selected Industrial Countries: Short-Term Interest Rates and Yield Curves1

(In percent)

Major Industrial Countries: Nominal and Real Effective Exchange Rates

(1980 = 100; logarithmic scale)

Selected Industrial Countries: Exchange Rates and Long-Term Interest Rate Differentials