Abstract

The April 1993 Declaration by the IMF Interim Committee on a cooperative effort to strengthen global activity called on the industrial countries to adhere to a strategy of low inflation, deficit reduction, and structural reform to reduce unemployment (see the May 1993 World Economic Outlook, p. x). Similar medium-term objectives have been pursued by most countries at least since the early 1980s. However, although substantial progress has been made during the past decade in reducing inflation, little, if any, progress has been made in tackling fiscal imbalances or unemployment.

The April 1993 Declaration by the IMF Interim Committee on a cooperative effort to strengthen global activity called on the industrial countries to adhere to a strategy of low inflation, deficit reduction, and structural reform to reduce unemployment (see the May 1993 World Economic Outlook, p. x). Similar medium-term objectives have been pursued by most countries at least since the early 1980s. However, although substantial progress has been made during the past decade in reducing inflation, little, if any, progress has been made in tackling fiscal imbalances or unemployment.

For many countries, the failure to consolidate fiscal positions during the 1980s means that budgetary situations have become unsustainable. Public debt burdens have risen sharply, and most countries have all but lost the ability to use fiscal policy as a stabilization tool. Several governments recently have announced or adopted new deficit-reduction plans, despite the difficulties of doing so during a period of cyclical weakness. The baseline projections imply, however, that current policies—including these new measures—will lead to only modest reductions of the underlying deficits for most countries, and that levels of public debt will continue to rise rapidly. Major additional efforts are therefore necessary to achieve fiscal sustainability as well as broader economic objectives, particularly the restoration of adequate national saving rates and higher growth.

The large fiscal deficits need to be addressed with a considerable degree of urgency. Rather than providing support to activity, the large fiscal imbalances in Europe and North America—and markets' expectations that these will persist in the medium term—are a principal cause of the high levels of real long-term interest rates seen since the early 1980s and the lackluster growth performance seen recently. Because of widespread uncertainty about future policies, the large deficits are undoubtedly also a major factor behind the depressed levels of consumer and business confidence in many countries. And in Europe, the large deficits have resulted in an unsustainable policy mix, which has generated a deep recession and provoked unprecedented turmoil in the EMS.

Over the medium to longer run the large fiscal imbalances, and the persistent diversion of resources from investment to consumption that they imply, threaten to reduce the growth of potential output and jeopardize future improvements in living standards. At the same time, pressures on government budgets will continue to increase as populations in industrial countries age. Unless credible actions and reforms are implemented in the near term to contain prospective deficits, future generations will not only face a substantial increase in taxes to support a growing share of pensioners and to service the public debt, they will also experience a marked decline in productivity and real income growth because of insufficient capital formation. These problems are already visible. In the United States, stagnating or falling real wages for some categories of the labor force have resulted in the phenomenon of the working poor; in Europe, high real interest rates and low rates of investment have contributed to inadequate new job creation.

There is also an urgent need for structural reform in labor markets. The persistence of high rates of unemployment in many countries over the past two decades suggests that in the absence of substantial and broadly based labor market reforms there is a risk that unemployment will not be reduced sufficiently when growth recovers. In addition to unacceptable social, economic, and budgetary costs, the high levels of unemployment have contributed to heightened protectionist sentiment in a number of countries.

The Stance of Monetary Policies

Although the relative emphasis differs across countries, the principal goals of monetary policy are to achieve and maintain a high degree of price stability and to alleviate fluctuations in output and employment over the business cycle.18 These goals are consistent if monetary policy follows a “nonaccommodating” policy stance over the cycle, which provides scope for interest rates to ease during recessions and, symmetrically, to rise in order to dampen inflationary pressures as recoveries mature. The task of pursuing these two goals, however, was complicated in the 1980s by relatively high inflationary expectations following the acceleration of inflation during the 1970s, by high structural fiscal deficits in some countries, and by financial innovation and deregulation and an apparent breakdown of the relationship between money and credit growth and economic activity in many countries. Muchreduced inflationary expectations following the largely successful disinflation of the 1980s, as well as fulfillment of fiscal consolidation programs, should significantly reduce the risk of a resurgence of inflationary pressures in the short term and provide room for short-term interest rates to remain relatively low during the period ahead in most industrial countries.

Because of the relative success in achieving the low-inflation objective, monetary conditions have been eased substantially to support economic recovery in the United States, Canada, the United Kingdom, and Japan. Of course, as economic slack is reduced in each of these countries, monetary policy will need to be adjusted to safeguard the substantial progress that has been achieved in reducing inflation and to help lower underlying inflation further over the medium term. In continental Europe, nominal interest rates have declined markedly in recent months, but monetary conditions are still tight given the weakness of activity and recent and prospective inflation trends. In many countries, the scope for interest rates to decline further depends on actions to reverse recent deteriorations in fiscal positions.

In the United States, both the discount rate and the federal funds rate have remained at low levels of about 3 percent as mixed signals about the strength of the recovery and generally moderate inflation indicators have justified a relatively easy policy stance. Long-term interest rates have continued to decline and are now at their lowest level since the late 1970s, which is evidence of market expectations of lower inflation (Chart 20). Even though households and businesses have significantly lowered their debt-service payments and financial intermediaries have improved their financial position, monetary growth, at least for the broader aggregates, has remained relatively weak for this stage of the economic recovery.

Chart 20.
Chart 20.

United States: Monetary Indicators

(In percent unless otherwise noted)

In Japan, in response to the economic downturn, the Bank of Japan lowered the discount rate in six steps between June 1991 and February 1993, from 6 percent to 2½ percent. Both the three-month certificate of deposit rate and the ten-year government bond rate declined considerably and are now well below previous cyclical lows (Chart 21). Growth of the monetary aggregates has remained modest because of a combination of weak income growth, the continuing adverse consequences on wealth of asset price deflation, and a shift of deposits into the postal saving system. Given the absence of inflationary pressures in goods, labor, and asset markets, and the recent strength of the yen, there would seem to be room for further interest rate reductions.

Chart 21.
Chart 21.

Japan: Monetary Indicators

(In percent unless otherwise noted)

1 CD, certificate of deposit.

Monetary conditions in Germany have continued to ease as the Bundesbank has responded to the weakening economy, improved prospects for lower inflation, and the recent agreement on a fiscal consolidation program (Chart 22). Since the beginning of this year both the discount rate and the Lombard rate have been reduced in several steps, the latest on September 10, from 8¼ percent to 6¼ percent, and from 9½ percent to 7¼ percent, respectively. Both short- and long-term market interest rates have declined considerably from their peaks in 1992, with the yield curve in Germany remaining inverted. Nevertheless, using World Economic Outlook projections of inflation as an estimate of expected inflation, both short-term and long-term real interest rates are still high for this stage of the business cycle. Cost inflation has declined significantly, and new wage contracts are now generally consistent with the 2 percent normative inflation objective of the Bundesbank. Although underlying consumer price inflation has begun to moderate, monetary growth remains above the top end of the target range owing to a rapid expansion of credit to the public sector.

Chart 22.
Chart 22.

Germany: Monetary Indicators

(In percent unless otherwise noted)

In the other major European countries, shortterm interest rates generally declined during the first half of 1993 as the tensions within the ERM earlier in the year diminished (see Chart 18). In France, three-month money market rates had fallen below those in Germany, from about 12 percent in January 1993 to less than 7 percent at end-June, as the Banque de France reduced its official interest rate, but in July interest rates were raised again to support the franc. Long-term rates in France have declined considerably since the beginning of the year, but, as in Germany, the yield curve has remained inverted. In Italy, short-term interest rates have continued to ease, particularly at the short end, although rates have remained high in real terms. In the United Kingdom, short-term rates have remained at 6 percent; a further easing to support economic recovery may depend on progress in reducing the fiscal imbalance. As in France, the reemergence of tensions in the ERM in July led to renewed increases in short-term official interest rates in several ERM countries and a widening of interest differentials vis-à-vis the deutsche mark. At the time of writing, the impact on interest rate differentials has again eased since the widening of the ERM band on August 2, and the cuts in German official rates on September 10, and financial markets appear to be anticipating further reductions of interest rates in most ERM countries.

Many smaller European countries have recently seen increases in unemployment rates as a result of the severe slowdown in growth and trade, and structural rigidities. Some countries, such as Finland and Sweden, which are still experiencing an unwinding of recessionary forces, have very large structural budget deficits. Measures that would ensure substantial improvements in public sector financial positions over the medium term would increase the scope for interest rates to decline and would improve prospects for recovery.

Structural Budget Positions and Current Fiscal Policies

In the period 1983-89, government budget deficits generally declined (Table 6), but in many countries the improvement reflected mainly cyclical factors rather than a correction of underlying fiscal imbalances. Among the major industrial countries, structural imbalances—the deficits that result after adjusting for the effects of cyclical developmentsremained high in the United States, France, Italy, the United Kingdom, and Canada (Chart 23).19 Greater progress was made during this period in reducing both actual and structural budget deficits of the general government sector in Japan and Germany. In the early 1990s, however, fiscal positions in most countries again deteriorated considerably with the economic downturns. The cost of unification in Germany, and policy slippages in many other countries—particularly France, the United Kingdom, Finland, and Sweden—also contributed, and structural budget deficits in 1992 were generally larger than they had been in the early 1980s.

Table 6.

Industrial Countries: General Government Financial Balances Including and Excluding Social Insurance

(In percent of GDP)

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The projections are based on the assumptions of unchanged policies and constant real exchange rates, except for the bilateral exchange rates among the ERM currencies.

In percent of GNP.

Includes interest payments on tax refund liabilities.

Central government only; excludes the proceeds from asset sales.

This concept is less meaningful for the United Kingdom, where a significant proportion of social security outlays is financed through general revenues.

Chart 23.
Chart 23.

Major Industrial Countries: Actual and Structural General Government Budget Balances1

(In percent of GDP)

1 Blue shaded areas indicate staff projections.

There are a number of important qualifications that should be kept in mind in interpreting the structural budget indicator. Because of the margin of uncertainty that attaches to tax and expenditure elasticities and to estimates of cyclical gaps, indicators of structural budget positions should be interpreted as broad orders of magnitude. The uncertainties surrounding the estimates of revenue and expenditure elasticities and of output gaps are broadly balanced, however. On the one hand, tax and expenditure elasticities may vary over the business cycle and may be somewhat larger during recessions than during periods of normal capacity utilization. On the other hand, to the extent that persistence effects may further increase structural unemployment rates following a cyclical slowdown, the calculated output gaps may prove to exaggerate the available margin of slack in the economy, especially following a relatively deep and prolonged recession. In addition, it is important to note that changes in structural budget balances are not necessarily attributable to policy changes but and some have recently adopted, significant deficitmay reflect the built-in momentum of existing ex- reduction measures. In most cases, however, these penditure programs. Nonetheless, even with these efforts will not be sufficient to restore fiscal susqualifications, estimates of structural budget bal- tainability over the medium term. The failure to ances provide useful indications of fiscal trends and seize the opportunity to reduce structural deficits policy requirements in individual countries.

Despite the difficulties of consolidating fiscal positions during a period of cyclical weakness, there conis growing awareness of the detrimental effects for confidence and growth of persistently large fiscal imbalances, and many countries have proposed, and some have recently adopted, significant deficit-reduction measures. In most cases, however, these efforts will not be sufficient to restore fiscal sustainability over the medium term. The failure to seize the opportunity to reduce structural deficits during the long expansion of the 1980s has clearly made the overall task more difficult, but also more urgent. Nevertheless, in one important respect conditions for substantial deficit cuts are better now than in the early 1980s: inflation rates are generally quite low, and monetary policy now has the flexibility—missing in the early 1980s—to support economic growth. Consolidation efforts will also be facilitated by worldwide intentions to scale back military expenditures in the period ahead (see Annex II).

There are good reasons to believe that gradual, but cumulatively substantial, deficit reductions are possible without jeopardizing the global economic recovery. As discussed in the May 1993 World Economic Outlook, cooperative actions to achieve more appropriate policy mixes in all countries—with fiscal consolidation in most countries matched by reductions in short-term interest rates in Europe, in particular—would reduce long-term interest rates immediately, strengthen confidence, stimulate investment in the industrial countries in the short term, and raise potential output in the medium term. Intensified fiscal consolidation in the period of cyclical recovery that is projected therefore is likely to cause only a moderate and temporary reduction in growth in the industrial countries; at the same time it will encourage stronger growth in the indebted developing countries through significantly lower international interest rates.20 Thus, the shortterm costs of coordinated fiscal adjustments are likely to be outweighed by the medium-term gains from the crowding in of private investment. Before reviewing the requirements for restoring sustainability, it is useful first to take stock of the fiscal situation and outlook in each of the major countries on the basis of current policies.

In the United States, despite earlier efforts to tackle the deficit problem, the period of slow growth and recession in the early 1990s and other noncyclical factors—including the cost of the savings and loan crisis and the rapid rise in healthrelated outlays—led to a further deterioration in the budget, and in FY 1992 the federal unified deficit reached 5 percent of GDP (5¾ percent when social security is excluded). The fiscal consolidation package recently adopted—which is broadly consistent with the objectives proposed in the administration's budget—implies progressive deficit cuts, reaching 1¾ percent of GDP by FY 1998, through measures including tax increases and expenditure cuts in the areas of defense, Medicare, and net interest payments by the end of the five-year budget projection horizon (Table 7). Achievement of the administration's broad objectives would represent a considerable effort but would still leave the structural federal budget deficit at 2¾ percent of GDP in FY 1998 (3 ¾ percent of GDP excluding social security)—about where it was in FY 1989. The administration also is planning to reform the health care system. Reform could potentially reduce longterm pressures on federal finances, particularly if it introduces new cost-control mechanisms, but the adoption of universal health care coverage would risk increasing expenditures. It would be necessary to ensure that health care reform is designed and implemented with the objectives of avoiding an increase in the deficit in the short term and providing a substantial contribution to deficit reduction in the longer run.

Table 7.

United States: Estimates of the Federal Budget Balance

(In billions of U.S. dollars unless otherwise noted; fiscal years)

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Based on figures contained in Mid-Session Review of the 1994 Budget (Washington: Government Printing Office, September 1, 1993). The economic assumptions underlying the administration's fiscal projections do not incorporate August 1993 benchmark revisions of the U.S. national income and product accounts.

The IMF staff estimates are based on the U.S. administration's estimates but assume lower inflation, slower growth, and higher interest rates. The IMF estimates do not reflect differences in the level of GDP arising from the August 1993 benchmark revisions of the U.S. national income and product accounts.

During the 1980s, Japan made considerable progress in consolidating the government financial position, in part through reform of the social security system. However, although the overall budget balance has remained in surplus, the budget position excluding social security moved from an approximate balance to a deficit in 1992 as a result of the recession and the stimulative measures taken to support economic activity and to restore financial stability. The September 1993 fiscal stimulus package amounted to 6 trillion yen (1¼ percent of GDP)—compared with 13½ trillion yen in the April 1993 package—and included measures to ease regulatory constraints and support public spending; about one-fourth of these new measures would represent new public investment spending.21 The carryover from last year's stimulus package and the actions taken this year are expected to raise the structural deficit (excluding social security) to 2 ¼ percent of GDP in 1993. Under current policies, this structural deficit is projected to decline slightly to 2 percent of GDP in 1994 and is expected to remain there over the medium term. Including social security, the overall structural budget balance is expected to decline from a surplus of1¾ percent of GDP in 1994 to a budget balance in 1998.

In Germany, the higher-than-expected costs of unification and the recent recession led to a sudden and considerable deterioration in the general government financial position following earlier success at consolidation (Table 8). The deficit of the territorial authorities widened sharply, and total public borrowing, including the borrowing of the Treuhandanstalt and the investment needs of the post office and railways, reached 5½ percent of GDP in 1992 on an administrative basis. The Solidarity Pact, agreed in March 1993, aimed to reduce the deficit of the territorial authorities to 2 percent of GDP by 1996, mainly through new revenue measures, but this target was based on economic assumptions that have turned out to be optimistic. In July, the Cabinet approved a package of new measures, in connection with the 1994 budget, intended to limit the federal deficit to 2½ percent of GDP in 1994, mainly through social and labor-market-related expenditure cuts. Because of the projected weak economic recovery total public borrowing is projected to remain at a historically high level through 1994 but the structural balance should improve markedly and this would be reflected more clearly in the actual fiscal accounts once the economy returns to more normal levels of resource utilization.

Table 8.

Germany: Fiscal Indicators

(In percent of GDP)

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Source: Federal Ministry of Finance; and staff estimates and projections for 1992-94.

National accounts basis.

Administrative basis.

Other levels of government and special funds.

Territorial authorities' balance, adjusted for changes in cash reserves, plus borrowing of the Treuhand, the postal service, and the railways.

During the period 1989-92, the general government deficit in France increased from 1¼ percent of GDP to 4 percent of GDP, with a further widening of the deficit to 6 percent expected this year. Only half of this deterioration is attributable to the weak economic conditions, however. Budgetary overruns, including the introduction of employment subsidies, and reductions in VAT and corporate tax rates contributed to raise the general government structural deficit to3½ percent of GDP in 1992. There was also a significant deterioration in social security accounts, which was only partly related to cyclical factors. In 1993, measures were taken to raise income tax rates, effective this July, and the government committed itself to curtailing real expenditures in the budget beginning in 1994. However, some supplementary expenditure measures have been announced that will contribute to the general government deficit—without adding to the central government budget—and the overall deficit is projected to remain at 6 percent of GDP next year. The structural component is projected to average about3½ percent of GDP in 1993-94 and is expected to remain close to 2 percent of GDP over the medium term. The government is committed to a five-year plan to reduce the budget deficit to 2 ½ percent of GDP by 1997, in part by establishing a norm of zero real growth in government expenditure, and to privatize its holdings of 21financialand industrial companies. The government will also strive to balance the social security system by 1996.

The underlying fiscal situation in Italy has improved markedly in recent years, but much remains to be accomplished. Despite a significant reduction in 1990-92, mainly reflecting an increase in revenues, the structural deficit was 8¾ percent of GDP in 1992 (or a surplus of 2¾ percent of GDP excluding interest payments). Because of measures adopted in the 1993 budget (and the subsequent mini-budget in May 1993), the structural deficit will be further reduced this year. The general government structural deficit is projected to amount to 7 percent of GDP in 1994 and to average 5 percent of GDP over the medium term in the absence of further adjustments. The cyclical component of the deficit also is projected to remain high, partly reflecting the impact of the structural imbalance on long-term interest rates, confidence, and economic growth.

In the United Kingdom, the general government budget balance has moved from a surplus of 1 percent of GDP in 1989 to a deficit of more than 6 percent in 1992 and 8½ percent of GDP in 1993, owing both to the recession and to a marked deterioration in the underlying position. During the past decade, the overall aim of fiscal policy has been to reduce both the tax burden and the growth of public expenditure, but earlier progress in reducing the share of expenditures in relation to GDP has been substantially reversed. During the next few years the structural deficit is projected to decline by more than 2 percent of GDP, in part due to tax increases in 1994-95 as well as to expenditure restraint, but it is expected to average3½ percent of GDP over the medium term.

The government in Canada has reinforced its commitment, first undertaken in the mid-1980s, to balancing the budget over the medium term by extending and deepening the budget cuts announced in December 1992. New expenditure-reduction measures were introduced in this spring's budget to ensure the achievement of the original fiscal targets for 1993/94 and to eliminate federal borrowing requirements by 1997/98. Much of the current fiscal imbalance is the result of cyclical weakness, and both the actual and the structural budget deficit of the federal government is projected to decline to about 1 percent of GDP by 1997/98. The actual and the structural deficit of the general government, which includes provincial governments, is projected to decline to 2 percent of GDP by 1997/98.

Among the smaller industrial countries, the general government financial balance in Sweden moved from a surplus of about 5½ percent of GDP in 1989 to an estimated deficit of 13½ percent of GDP in 1993. More than half of this deterioration can be attributed to tax reform and a cut in payroll taxes, higher expenditures due to the lagged indexation of transfer payments, and financial assistance to the banking system, and the remaining deterioration to cyclical weakness. The Swedish government has implemented medium-term budget saving of about 5 percent of GDP, through both higher revenues and lower expenditures, and there are plans for further additional saving of about the same magnitude. In Finland, the general government deficit is expected to rise to 12¼ percent of GDP in 1993, owing to the severe recession, increases in public expenditures on investment and employment promotion, and reductions in income and corporate tax rates. The government intends to reduce the deficit by 1995 by limiting spending to its 1991 level in real terms; it has recently taken measures—including the indexation of income tax brackets, a “temporary” employment tax, and lower expenditure on education and health—to stabilize the public debt-GDP ratio below 70 percent by 1997. In Australia, the commonwealth budget balance moved from a surplus in 1990 to an estimated deficit of 5 percent of GDP in 1993, reflecting both cyclical developments and discretionary policies. The Australian government intends to reduce the deficit to 1 percent of GDP by 1996/97 and is expected to outline its plan in the 1993/94 budget.

Requirements for Medium-TERM Budgetary Sustainability

Because of the repeated failures of past consolidation efforts, public debt levels in many industrial countries have increased substantially in relation to GDP (in both gross and net terms) during the past twenty years. Moreover, under current policies, public debt is expected to grow further in relation to GDP in most countries (Table 9). Higher levels of debt have absorbed growing shares of government resources in debt-servicing costs, and public sector financial imbalances have severely limited, if not eliminated, the scope for fiscal policy to support economic activity. This reduced scope for action has been evident during the current recession and is likely to constrain governments further in the future. In view of the historically high levels of public debt in many countries, the restoration of fiscal sustainability implies that it is not sufficient to stabilize current levels of public debt-GDP ratios, and that it would be necessary to aim for a gradual reduction in debt ratios over time (Box 4).

Table 9.

Major Industrial Countries: General Government Debt and Budget Balances1

(In percent of GDP)

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Net debt is defined as gross debt less financial assets, which includes assets held by the social security insurance system.

Figure for 1980-84 is average of 1983-84.

Gross and net debt include tax refund liabilities. Net interest payments and budget balance include interest payments on tax refund liabilities. Net debt figure for 1980-84 is for 1984.

However, measures of government indebtedness considerably understate the extent of the problem, mainly because the future entitlements of populations insured in public pension schemes are not included in conventional measures of government debt. All of the major industrial countries except the United States and Japan rely primarily or exclusively on pay-as-you-go public pension systems, which are either already incurring large deficits—as in Italy, the United Kingdom, and Canada—or are expected to do so soon—as in Germany and France. The United States and Japan have reformed their social security systems and are seeking to implement partially funded systems. However, even though both systems have accumulated large reserves of assets, these assets are held in the form of government bonds and are thus indirectly used to finance other government activities. When social insurance assets are drawn down—to fulfill pension obligations—it will be necessary to increase market borrowing or to raise taxes to service the public debt to the social security system.

Future liabilities depend on the number of retired people relative to the number of people of working age—the so-called old-age dependency ratio. This ratio declined in the major industrial countries from an average of about 58 percent in 1965 to about 48 percent in 1985, but it is expected to rise to 53 percent over the next twenty years and to be even higher thereafter.22 The strains that higher dependency ratios will impose on budget policies in the future can be seen by examining the present value of future net liabilities of the pension systems in the major industrial countries (Table 10). In all the major industrial countries, regardless of the system in operation, the present values of net pension liabilities are estimated to be at least as large as current debt levels, even under favorable assumptions. In the absence of policy adjustments—possibly including increases in retirement age—existing debt levels and unfunded liabilities will continue to grow and will require costly policy adjustments in the future when benefits are paid, in the form of either higher taxes or sharp cuts in expenditures and benefit levels. The projected need for many governments to borrow heavily in the future to fulfill pension obligations clearly reinforces the perception that current budgetary trends are unsustainable.

Table 10.

Major Industrial Countries: Estimated Net Pension Liabilities—Present Value of Current and Future Rights and Future Contributions1

(In percent of 1990 GDP)

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Source: OECD, “Pension Liabilities in the Seven Major Industrial Countries,” Economics and Statistics Department Working Paper (Paris, 1993, forthcoming). The estimates are based on projections for various parameters (including dependency, eligibility, and employment ratios), real GDP growth, and the discount rate. In the United States and Japan, where pension contributions exceed pension expenditures the contribution rates are assumed to remain constant at the 1990 ratio of actual pension contributions to GDP. In the remaining major industrial countries, the contribution rate is assumed to remain constant at the 1990 ratio of pension contributions to expenditures.

Gross liabilities less net liabilities.

Assumes the full implementation of the announced increase in retirement age by five years.

In addition to fiscal sustainability, there are broader economic objectives that are important in formulating fiscal policies. The IMF Interim Committee declaration of April 1993 called for a reorientation of economic policies in the major industrial countries to achieve stronger and sustainable noninflationary growth and to reduce external imbalances and trade tensions. National saving rates and rates of capital formation have declined considerably during the past two decades, and there is growing concern that they have reached levels that cannot support adequate rates of growth in productive capacity and employment in the medium term (Table 11). Low national saving rates also reflect inadequate private saving, which can be traced in part to tax policies (and government subsidies) and other disincentives for private saving. Large and growing amounts of government debt have also tended to reduce private investment by raising the average cost of funds required to finance investment outlays. An improvement in potential growth rates will require higher rates of capital formation, which will need to be financed by increases in both private and public saving. Changes in the structure of public spending toward productive investment—in education, health care, and infrastructure—and the elimination of subsidies and taxes that discourage saving and investment also would significantly improve the prospects for higher sustainable rates of growth. Productivity may also have been adversely affected by the disincentives associated with the high income tax rates on the current generation of workers that have been necessary to finance current pension entitlements. These intertemporal imbalances and equity considerations will need to be taken into account in establishing budget priorities in the period ahead.

Table 11.

Major Industrial Countries: Gross Saving and Investment

(In percent of GDP)

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The projections are consistent with the assumptions underlying both the short-term and medium-term projections discussed in Annex III and the Statistical Appendix.

Data are constructed from unpublished estimates supplied by the Bureau of Economic Analysis, U.S. Department of Commerce, and are not based on the U.S. national accounts.

includes interest payments on tax refund liabilities.

The Sustainability of Fiscal Policy

There is no generally accepted definition of what constitutes a sustainable fiscal policy. There is, however, broad agreement that fiscal policies are not sustainable if present and planned revenues and expenditures result in a persistent and rapid increase in public debt-GDP ratios. In this case, financial markets will expect that, sooner or later, these policies will have to be revised—implying higher taxes, lower spending, or, in the absence of the policies, the risk of higher inflation from monetization of the deficits. In the early 1980s, when the industrial countries became concerned about medium-term fiscal trends, public debt was already high, and there was a growing concern that it would continue to rise rapidly unless fiscal policies were changed.1 Nevertheless, fiscal imbalances persisted in the 1980s—and in some cases worsened considerably—and there is now an even greater need for policy adjustments: debt-GDP ratios are much higher; interest payments are a significant share of GDP and government expenditure; and policy flexibility has been reduced, if not eliminated, in most industrial countries (see Tables 9 and 11). In some countries, it may also be necessary to lower debt-GDP ratios in the short run in anticipation of future fiscal demands that will increase debt-GDP ratios in the medium term.

Economic theory generally provides little guidance about optimal or desirable debt-GDP ratios. There are, however, various ways of establishing benchmarks for budget balances that would stabilize or reduce the public debt-GDP ratio. As recent experiences in the industrial countries indicate, persistently high and rising government debt-GDP ratios are costly and eventually unsustainable because of the associated debt-service payments and pressures on interest rates. The fiscal adjustment necessary in individual countries depends on many factors, but in all of trie major industrial countries—and in most of the others—the restoration of fiscal sustainability would call for significant reductions in debt-GDP ratios from current levels.

Whether a policy is sustainable depends on factors that the fiscal authorities control, such as revenue and spending programs, as well as on factors that are beyond their direct control, such as the rate of interest on government obligations, the long-run growth rate of the economy, and demographic trends. Expressed as a ratio to GDP and separating interest payments from the total deficit, changes in the public debt-GDP ratio (d) depend on the primary balance (pb, the ratio of noninterest expenditures less revenues to GDP), the difference between the nominal interest rate on public debt (r) and the growth of nominal GDP (g), and the initial debt-GDP ratio, according to the following budget identity:2

Δd=pb+[(r-g)/(1+g)]g-d-1.

where Δ indicates the change from the previous period.

The second term on the right-hand side of the equation represents the “built-in momentum” of the debt GDP ratio: when the interest rate exceeds the growth rate, interest payments add more to public debt than growth adds to GDP; hence the public debt-GDP ratio will increase unless there is a primary surplus (that is, unless pb is negative). Because interest rates have remained above growth rates (in both real and nominal terms) in many industrial countries, a primary surplus is required to stabilize the debt-GDP ratio.

There are two conventional measures of public debt: general government gross liabilities and the corresponding net liabilities.3 Gross debt includes all outstanding liabilities of the general government sector and plays an important role in financial markets in many countries. Net debt adjusts these figures for government financial assets—including cash, bank deposits, loans to the private sector, holdings in public corporations, foreign exchange reserves, and other assets. The general government definition of the public sector is most often used because its broad coverage of government activities makes it comparable across countries. The proper measure of debt for the government budget identity is net debt, because it corresponds most closely to the overall, or general, government deficit. The general government deficit captures net government financial flows, and net debt properly subtracts government financial assets from gross debt. Thus, net debt comes close to measuring the net worth of the government, although it records financial assets at book value and does not adjust for unfunded liabilities and nonfinancial assets.4

The government budget identity can be used to calculate budget targets that would achieve specific debt objectives such as debt-GDP stabilization or specific reductions in the debt ratio (see table). Debt-GDP stabilization requires that the deficit-GDP ratio, inclusive of interest payments on the debt, must equal the initial debt-GDP ratio multiplied by nominal GDP growth. For example, with public net debt in the United States at about 55 percent of GDP in 1992, a deficit of 2¾ percent of GDP in 1993 would have stabilized the net debt-GDP ratio at this level, given a nominal growth rate of 5 percent. With nominal interest rates on public debt of 6 percent, this would imply a primary deficit of about 0.5 percent of GDP. A deficit of ¾ of 1 percent of GDP, or a primary surplus of 1.5 percent of GDP, would have reduced the debt GDP ratio by 2 percentage points.5

Major Industrial Countries: Budget Targets to Achieve Three Debt Rules1

(General government financialbalance as percent of GDP)

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The calculations are based on 1992 public net debt-GDP ratios and on the projected nominal the growth rates shown in Table 9 of Chapter IV.

For the United States, the figures correspond to the staff projections but are adjusted for financial flows related to asset sales and government employee pension fund contributions. This adjustment, which adds½ to 1 percentage point to the projections, reconciles the deficit figures (which are on a national accounts basis) with the debt figures (which are on a flow-of-funds basis).

Figures in brackets indicate the budget balance needed to achieve a reduction in the debt ratio of 4 percentage points a year.

In the United States, notwithstanding the recently adopted deficit reduction measures, projected deficits are consistent with continued increases in the debt GDP ratio, and further significant reductions would therefore be required to stabilize the ratio at its 1992 level, let alone permit the ratio to decline. In Japan, the projected balances imply a stable net debt-GDP ratio, but a budget surplus would be required to reduce the ratio by 2 percentage points a year. In all of the major European countries, considerable deficit reductions are necessary just to stabilize the debt-GDP ratio; Germany, France, and the United Kingdom would all need budget surpluses in order to reduce the ratio by 2 percentage points a year. Although debt reduction does not appear to require very low budget deficits in Italy, it does require a significant primary budget surplus because the current debt-GDP ratio is very high and interest rates are higher than the growth rate. Moreover, because of the very high debt-GDP ratio in Italy, it would be desirable to reduce the debt ratio by more than 2 percentage points a year, at least initially. To achieve a reduction in the debt ratio by 4 percentage points a year, Italy's budget deficit would need to be reduced to about 1½ percent of GDP from 1994.

1 See communiques from OECD Ministerial Council meetings, June 17, 1981 and May 11, 1982; and the Supplementary Note on “Sustainability of Fiscal Policy in the Major Industrial Countries” in the October 1990 World Economic Outlook, pp. 88-93.2 Over time, the government's (intertemporal) budget constraint requires the present value of revenues to be not less than the present value of expenditures (including interest on the public debt) plus repayments of the debt. The budget identity holds whether the variables are in real or nominal terms and assumes that there is no monetary financing of deficits.3 The general government is broadly defined to include, for example, local governments, the monetary authorities, social security system, and other trust funds; it does not include public enterprises.4 For a further discussion of the various measurement and conceptual issues, see Jean-Claude Chouraqui, Brian Jones, and Robert Bruce Montador, “Public Debt in a Mediumterm Context and Its Implications for Fiscal Policy,” Economics and Statistics Department Working Paper No. 30, (Paris: OECD, May 1986), pp. 5-12; and IMF, A Manual on Government Financial Statistics (1986).5 These calculations assume that interest rates and economic activity remain unchanged.

There is also a global dimension to domestic imbalances. External imbalances and the associated trade tensions among the major industrial countries are the direct consequence of large, persistent imbalances between domestic saving and private domestic investment in many countries. In the United States, as the public sector has increasingly absorbed financial resources, there has been a corresponding shortage of domestic saving available to finance domestic investment opportunities. These investment opportunities have attracted a persistent net inflow of foreign investment—the necessary counterpart to the U.S. current account deficit. In Japan, total domestic saving has remained above domestic investment, and the corresponding surplus has been invested abroad. An increase in public and private saving in the United States would increase the supply of funds available to finance investment and would reduce net foreign capital inflows. Similarly, an increase in domestic investment relative to saving in Japan would tend to reduce the current account surplus.23

The achievement of a broader set of objectives for fiscal policy that takes due account of domestic as well as external considerations will require profound structural changes in budgetary trends to strengthen the financial position of the public sector. On the basis of current policies, sharp increases in tax rates will be necessary in the future if governments are to meet their pension obligations and other financial commitments. In most industrial countries, however, government revenues are already high in relation to GDP, and further increases would raise tax rates to levels that would be likely to damage incentives, reduce potential growth, and threaten living standards. In most cases, budgetary consolidation will therefore need to be achieved primarily through expenditure restraint. Even where future net liabilities are relatively small, the achievement of fiscal sustainability requires going beyond reducing fiscal deficits to levels that would stabilize public debt-GDP ratios. In countries having a large pool of unfunded net liabilities, budget surpluses may be required to achieve a sound financial position by the end of this decade.24

In the United States, notwithstanding recent significant steps toward addressing the fiscal problem, there is a need for a more stringent fiscal objective for the long term, in order to raise the national saving rate, to restore earlier rates of capital formation, and to promote stronger sustainable medium-term growth of living standards. Government net debt is projected to rise from 53¾ percent of GDP in 1992 to 57¾ percent of GDP by the end of FY 1998, and it would continue on an upward trend without further measures. Because unfunded liabilities appear to be manageable, fiscal sustainability—defined as a gradual reduction in the debt-GDP ratio—could be achieved through further consolidation efforts aimed at reducing the federal unified fiscal deficit to about 1 percent of GDP (see Box 4). However, to achieve the broader objectives of significantly strengthening national saving and investment performance, it may be necessary to aim for a small surplus in the federal budget (or to balance the budget excluding social security).

In the other major industrial countries, unfunded net liabilities are much higher than in the United States. As growth recovers, it would be appropriate for each of these countries to resume medium-term fiscal consolidation efforts in order to increase public saving and to reduce public debt in relation to GDP. In Japan, budget policies that would maintain an overall budget surplus would be desirable and would be consistent with a gradual but marked increase in social security assets. Such a policy would allow Japan to maintain the necessary degree of flexibility in the future to manage the financing of pension entitlements.

Substantial efforts at fiscal consolidation over the medium term will be required in Germany, France, Italy, the United Kingdom, Canada, and most of the smaller industrial countries in order to establish sustainable budgetary positions as economic recovery gains momentum. In most cases, these efforts will need to eliminate the structural imbalances or even to generate fiscal surpluses. In addition to confronting the need to stabilize and gradually reduce visible debt burdens, governments will have to address the future needs of aging populations while limiting the burden on future taxpayers. These concerns can be met by a variety of means: limitation of the growth of health care costs (for all countries); increases in the age for qualification for full benefits (especially in countries with relatively low age limits); scaling back of some benefits (especially in countries with very generous benefits); increases in social contribution rates; and funding from general revenues. However, because tax rates are already high in many of these countries, changes in pension benefits and retirement ages may be unavoidable. In Italy, an increase in the retirement age and a reduction of entitlements (in the 1993 budget) should help to substantially reduce the net unfunded liabilities of the pension system, but considerable further fiscal consolidation efforts are necessary to reduce both visible and invisible liabilities to sustainable levels.

Where there is genuine scope to improve productivity through increases in public investment—such as investment in education, job training, and physical infrastructure—it may be appropriate to set an intermediate objective for the structural deficit that reduces the debt-GDP ratio more gradually. Provided that the structural deficit is associated with a restructuring of public expenditure in favor of productive public investment that creates tangible long-term benefits, such investments will be selffinancing if they raise the level of output by more than they increase the debt service associated with the “marginal” additional government debt. Budgetary discipline is required, however, to increase expenditures exclusively in those areas where the long-term benefits are commensurate with the short- and long-term costs.

Unemployment, Trade, and Protectionism

Unemployment has once again risen to intolerable levels in the industrial countries (Chart 24). In 1993 unemployment in the industrial countries is expected to surpass 32 million—equivalent to the working-age populations of Spain and Sweden combined—9 million more than in 1990 and 3 million more than in 1982, the trough of the previous recession. These numbers undoubtably understate the size of the problem because they do not reflect the number of discouraged workers or involuntary part-time workers, which has recently been estimated by the Organization for Economic Corporation and Development (OECD) to be 13 million.25

The cost of unemployment in the industrial countries is enormous. In terms of forgone output, GDP in the industrial countries could be as much as 3 ½ percent higher in 1993 than now expected—or about $600 billion—if unemployment were reduced to 5 percent in those countries where it now exceeds 5 percent.26 The cost to government budgets is also large. Unemployment benefits are estimated to have accounted for about3½ percent of total government expenditures in the industrial countries in 1991,27 and this has increased substantially with the recent rise in unemployment. If unemployment could be reduced to 5 percent of the labor force, budget positions for the industrial countries as a whole might be improved by as much as 4¾ percent of GDP.28

The broader social costs of unemployment are also unacceptably high. Chronic unemployment is disrupting the social fabric in many countries, regions, and communities. The recent cyclical increase in unemployment has also coincided with a rise in xenophobia and protectionist sentiment. Even some traditional champions of free trade have suggested that protectionist measures may be necessary to protect workers in the industrial countries from the effects of “globalization”—that is, from increased international competition from developing countries or countries in transition—which is being blamed for job losses or pressures on living standards. These concerns, and the related fear that jobs are being destroyed by rapid technological progress, reflect a very short-run view of economic growth and employment creation. They also suggest a profound misunderstanding of the historical role of trade and economic integration as engines of growth in all countries.29

During the global recession of the early 1970s until the mid-1980s, there was a sharp increase in unemployment in the industrial countries, especially in the 12 members of the EC. This seemingly inexorable rise in unemployment coincided neither with an increased pace of technological change nor with a pickup in the growth of world trade. Indeed, the rise in unemployment followed the widespread slowdown in trend productivity growth and the slowdown in the growth of world trade (Chart 25). Moreover, trade between the industrial countries and the nonindustrial countries as a percent of industrial countries' GDP—which broadly indicates the degree of competition from the rest of the world—was more or less stable from the mid-1970s to the mid-1980s. These facts suggest that high and rising unemployment is not due to too much competition or too rapid technological change. It seems more likely that it reflects inflexible labor markets and insufficient technological progress and competition in sectors protected from market forces, whether domestic or international.

Chart 25.
Chart 25.

Industrial Countries: Unemployment, Trade, and Productivity1

(In percent)

1 Blue shaded areas indicate staff projections.

Competitive labor market forces in the United States, Japan, and Canada have been sufficiently strong to ensure that cyclical increases in unemployment have been subsequently reduced, although the reductions have typically taken somewhat longer than the increases. As a result, the equilibrium unemployment rate has remained broadly stable over the past three decades (except in Canada, where it may have increased by a few percentage points in the early 1980s). Even in North America, however, the level of unemployment implies significant losses of economic and social welfare. Among the industrial countries, only Japan has been fully successful in maintaining low and stable unemployment.

The contrast between North America and Japan and the other industrial countries is striking. From 1960 until the early 1970s, unemployment in Europe, Australia, and New Zealand averaged less than 3 percent, considerably lower than in North America. In the recessions of 1973-74 and the early 1980s, cyclical increases in unemployment in many countries interacted with inflexible labor markets and appeared to be translated one-for-one into structural unemployment. Moreover, not only did unemployment not fall during periods of economic recovery, it continued to increase in the late 1970s and in the early 1980s, when it reached 11 percent. Unemployment in most European countries and Australia gradually declined in the late 1980s, before rising once again in 1991-93. It is estimated that 40 percent of the currently unemployed in the EC have been out of work for a year or longer, suggesting the marginalization of a large part of the labor force and a substantial deterioration in human capital.30 The recent large increases in unemployment in Finland, Norway, Sweden, and Switzerland are reminiscent of the rise in unemployment in other European countries in the 1970s.

The problem of high structural unemployment, and the policies needed to reduce unemployment, have been intensively discussed since the early 1980s. Although the current recession in industrial countries has raised cyclical unemployment, the solution to persistently high unemployment is to be found primarily in the area of structural policies. Reforms are needed to increase the flexibility of workers and of markets—particularly of labor markets—so that the private sector is better able to adapt to the process of dynamic change by creating new jobs as others are lost. The importance of flexible labor markets is suggested by the fact that in the EC, where labor markets are generally considered to be relatively inflexible, total employment increased only 7¾A percent in the two decades from 1972 to 1992; in the United States, Japan, and Canada, where labor markets are more flexible, the increase was 37 percent.

Broadly based labor market reforms are required in virtually all industrial countries, although the importance of reform in specific areas will vary from country to country. There is an urgent need in almost all countries to re-examine both the financing and the overall generosity of social insurance schemes with the aim of eliminating those features that discourage employment creation by increasing employers' labor costs relative to employees' wages and that reduce the incentives for the unemployed to take jobs. In many countries, the generosity of social insurance is a significant disincentive to work because after-tax labor income is in some cases only marginally higher than available transfer payments. Disincentives to hiring include taxes, charges, and costly regulations, particularly those that are of a lump-sum nature and that, therefore, fall especially heavily on the employment of lowwage workers, such as the young or inexperienced. Unduly high statutory minimum wages and overly rigid employment-protection regulations have a similar effect. In some countries, there is a need to increase the flexibility of work arrangements by removing restrictions on working hours and part-time work, and to change regulations that limit the portability of pensions and health insurance, in order to enhance labor mobility. Wage bargaining systems need to be reformed in some countries to increase wage flexibility so that real wages in different sectors reflect productivity differences, which would allow expanding industries to attract labor rapidly. The market power of the currently employed—the insiders—should not be so great as to result in real wage levels that are too high to allow the unemployed—the outsiders—to find work. Finally, in many countries, governments' labor market expenditures need to be reoriented away from passive income-support programs to more active labor market policies that encourage job search and improve incentives for education and training, particularly for the long-term unemployed.

Macroeconomic policies also have an important role to play in the reduction of unemployment. Particularly in those countries where persistence mechanisms and slow adjustment have in the past tended to transform cyclical rises in unemployment into higher structural unemployment, macroeconomic policies should seek to minimize cyclical increases in unemployment, so long as this does not jeopardize the attainment of other medium-term objectives. The recent cyclical increase in unemployment is, of course, directly related to the failure to correct macroeconomic imbalances during the long expansion of the 1980s. As emphasized in the previous section, macroeconomic policies should encourage saving and capital formation, especially through budgetary consolidation, and should create the conditions for sustained growth, including lower real rates of interest. In those countries where government deficits are unsustainably high, a credible commitment to fiscal consolidation can reduce long-term interest rates, bolster confidence, and increase private sector investment and job opportunities. If governments have credibility, fiscal stimulus can be an effective offset to cyclical weakness. Moreover, good microeconomic policiessuch as reductions in cross-border trade protection and labor market reforms—can restrain inflation and increase potential output, and thus make fiscal stimulus feasible.

The argument is sometimes made that the hardwon social gains of workers in industrial countries—for example, in terms of employment protection or high wages—must be protected from competition from countries where workers do not enjoy such benefits. However, it is not clear that all such social gains represent an increase in welfare for the population as a whole. To the extent that policies such as minimum wage legislation, which are ostensibly directed toward social or distributional objectives, have the perverse effect of increasing unemployment, they may reduce rather than improve social welfare. Policies such as these often represent “social gains” only for the employed, who are shielded from competition from the unemployed, not for society as a whole. Trade restrictions improve the welfare of workers and entrepreneurs (or shareholders) in the protected sectors, but they do so at the expense of higher prices to everyone else and, in the longer term, reduced flexibility and long-term growth. The goals of lower unemployment, improved welfare of low-wage workers, and higher incomes for all would be better served if social and distributional objectives were pursued through the tax and transfer system and through active labor market policies rather than through measures that reduce the efficiency and flexibility of markets.

In some countries there is also a growing perception that competition from developing countries and from countries in transition is “unfair.” This view ignores that the gains from trade that benefit all countries stem primarily from each country's exploitation of its comparative advantage; countries develop and improve their standards of living by producing those goods for which their advantage in terms of productive efficiency is the greatest. Moreover, low wages and low social standards do not confer an advantage in international trade if they reflect low productivity and inadequate investment; but even if they did, it would not necessarily imply unfair competition. Concerns about the adequacy of social and environmental standards—which need to be seen in relation to countries' levels of economic development—should be addressed without resort to trade-distorting measures.

In the medium term, it is clearly in the interest of workers in industrial countries that poorer countries develop as rapidly as possible, since this will result in expanding markets and increased demand for industrial countries' exports, thereby increasing employment and incomes in industrial countries. Indeed, developing countries—which are already major markets for industrial country exports—were the industrial countries' fastest growing export market in 1991 and 1992: for example, U.S. merchandise exports to Western Europe increased by an annual average of 2½ percent, but U.S. exports to China and the developing countries in the Middle East and the Western Hemisphere increased by an average of 22 percent; merchandise exports from Japan to North America rose 3 percent, whereas Japan's exports to the same group of developing countries increased 29 percent; and EC merchandise exports to Japan and North America fell by an average of 3½ and 1 percent a year, respectively, while exports to the same group of developing countries increased 13 percent. Moreover, jobs in the export sector of industrial countries tend to generate higher incomes than those in sectors threatened by imports from lower-wage countries. More rapid development in nonindustrial countries, and the expectation of improved standards of living in the future, will also reduce the incentive for immigration from the developing countries and countries in transition and will result in improved social and environmental standards in those countries.

In the short term, however, it is necessary to recognize that technological progress and heightened competition from developing countries may result in job losses in some sectors of the industrial economies. The increase in unemployment may be concentrated in certain industries or regions or among low-skilled workers, and this will—not surprisingly—be reflected in calls for governments to do something to protect jobs. Despite possible job losses in some sectors in the short run, however, governments must promote free trade and technological progress in order to avoid jeopardizing employment creation in those sectors benefiting from expanded trade and to improve economic performance in the medium term as labor and capital resources shift into more productive sectors. For this reason, it is important that trade and labor market policies—like macroeconomic policies—be formulated in a medium-term context. Policies that attempt to resist change and shield workers and industries from competition in the short run in an attempt to protect jobs will only reduce the medium-term competitiveness of economies and the private sector's ability to create job opportunities. Indeed, the focus on “preserving jobs” is misplaced; preserving jobs in technologically outdated and declining industries—whether through tariff or nontariff barriers or through industrial subsidieswill eventually lead to fewer jobs in other more efficient industries, thereby reducing productivity growth and impairing the medium-term employment prospects for the economy as a whole. Government policies should instead be directed toward preserving and enhancing workers' employ ability and toward encouraging entrepreneurship by increasing the flexibility of markets. The only durable solution to the problem of low-skill workers and the working poor is to increase the productivity of workers through better education, training, and job opportunities in growing industries.

Policies that resist change and reduce competition make it more difficult for macroeconomic policies to achieve their medium-term objectives. Tariffs and nontariff barriers, managed trade arrangements, and subsidies tend to increase mediumterm inflationary pressures and, in the case of subsidies, to increase fiscal deficits. Similarly, overly generous unemployment insurance systems—whether in terms of the level of benefits, the duration of benefits, or the qualification for benefitshave been very costly to government budgets and have reduced the inflation-restraining influence of unemployment. To the extent that these policies raise the natural rate of unemployment or reduce productive potential, they make it more difficult to implement appropriate monetary and fiscal policies.

In summary, since the early 1980s governments have recognized the importance of medium-term policies aimed at low inflation, fiscal consolidation, and structural reform. Substantial progress has, however, been made only in the area of inflation reduction. It now seems more likely that governments will implement medium-term fiscal consolidation programs, and prospects have recently improved for a successful conclusion of the Uruguay Round. Now is also a propitious time for governments to demonstrate that they are capable of adopting policies to reduce unemployment and to increase the employment content of growth. Particularly during the expansion phase of the business cycle, properly designed macroeconomic, trade, and structural policies can be mutually reinforcing, thereby bolstering confidence, increasing growth and employment, and safeguarding low inflation.