III Using the Recovery Wisely in the Industrial Countries

International Monetary Fund. Research Dept.
Published Date:
October 1994
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Expansions have been under way for some time in the United States, the United Kingdom, Canada, and Australia, and there are firm signs of improving economic growth in most other industrial countries. Inflation is now at the lowest rates in decades in many countries (see Chart 7 in Chapter II). The medium-term prospect for the industrial countries is for growth to proceed at a moderate pace sufficient to diminish margins of slack and to bring, over time, significant reductions in cyclical unemployment and in the cyclical components of large budget deficits. There appears to be no immediate danger of—and under proper policies, no medium-term reason to expect—a general upsurge of inflation. As economic expansion proceeds, however, situations of excess demand may again emerge. Moreover, efforts at fiscal consolidation may flag because the cyclical recovery will give the appearance of an improvement in budget deficits well beyond what actually has been achieved in terms of underlying structural balances. The result, as in the late 1980s in many countries, could be a resurgence of inflationary pressures and the persistence of high real interest rates owing to fiscal crowding out. This risk would be aggravated to the extent that recent increases in unemployment might become entrenched, as has occurred in the past in Europe.

For economic policy, the immediate tasks are to ensure that recovery is firmly established where it is just getting under way and to guard against overheating in those economies where the expansion is already well advanced. For the medium term, the key policy challenge is to promote a durable recovery in the industrial countries that will allow critical structural problems and imbalances to be corrected in an environment of generally rising employment and living standards, while preserving the hard-won gains in reducing inflation. To this end, it is essential to avoid the policy failures of the 1980s by ensuring that monetary policy moves to a neutral stance as the recovery takes hold and by continuing and strengthening deficit-reduction efforts. Following this course would foster sustained economic growth and would help to correct imbalances of the sort that limited policy options during the recent downturn in activity in the industrial countries. These macroeconomic policies to foster medium-term growth must be supported by initiatives to reduce structural rigidities and eliminate impediments to the efficient operation of markets that exist in one form or another in all industrial countries. This combination of policies would lower cyclical and structural unemployment and would increase the rate of sustainable, noninflationary growth in the medium term.

The Business Cycle and the Stance

of Monetary and Fiscal Policy

The origins of the current business cycle and the challenges for economic policy can be traced to the policy successes and failures of the 1980s. To arrest and reverse the run-up in inflation that occurred in many countries during the 1970s, it was necessary to tighten monetary policy sharply, raise interest rates, and slow the pace of economic activity. As output dropped below potential and unemployment rates rose above their natural rates by the early 1980s, inflation began to decline, typically with a lag of about one year (Table 4, Chart 12).6 In Europe, disinflation was also fostered during the 1980s by the increasing coordination of monetary policy within the ERM and, for some non-EU countries, by currency pegs to the deutsche mark. The significant reduction of inflation in most industrial countries was one of the major policy successes of the early 1980s, and it was followed by a sustained expansion of output, which only toward the end of the decade resulted in renewed inflationary pressures in many countries.

Table 4.Major Industrial Countries: Consumer Price Inflation Before and After the Recessions of 1981–82 and 1991–93(In percent)
United States13.
United Kingdom16.
Note: The table compares inflation rates just before the onset of each recession and approximately one year following the trough.

IMF staff projections.

West Germany.

Note: The table compares inflation rates just before the onset of each recession and approximately one year following the trough.

IMF staff projections.

West Germany.

Chart 12.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.

However, progress was limited in the other two key policy areas of fiscal consolidation and structural reform. Although in some countries—especially Japan, but also including France, Germany, and the United Kingdom—considerable strides were made in eliminating fiscal deficits and reducing public debt levels, in many countries structural deficits remained relatively large despite the expansion of output during the decade, and debt-to-GDP ratios rose substantially. The implementation of structural reforms was also uneven during the decade, although there was considerable labor market liberalization in the United Kingdom. Labor market rigidities in many European countries interacted with the business cycle to produce a further ratcheting up of the already high levels of structural unemployment that were the legacy of the 1970s. Trade barriers—often in the form of nontariff and administrative barriers—were maintained and even extended in some cases, and there was only limited success in reducing industrial subsidies that distort trade and burden fiscal policy. An important exception to this limited progress in structural reform was the liberalization of financial markets. Although still incomplete, the reform process that was under way in the 1980s and continued into the 1990s resulted in a remarkable broadening, deepening, and increasing globalization of bond, equity, and foreign exchange markets.

The expansion of the 1980s came to an end as rising inflationary pressures became increasingly evident in several countries late in the decade. Inflation rates began to creep up in North America, the United Kingdom, and in some smaller industrial countries. However, in many countries underlying inflationary pressures were not manifest exclusively, or even chiefly, in consumer and producer prices. Instead, they were reflected in sharply rising asset prices, as real estate and equity markets boomed.7 In retrospect, these asset price run-ups signaled growing imbalances that, ultimately, would be corrected by a tightening of monetary policy and the recession that began in the early 1990s. In turn, the balance sheet restructuring required to correct these imbalances contributed to both the depth and duration of the recession in several countries. In Germany, the monetary and fiscal expansion associated with unification resulted in rising inflation. A sharp monetary tightening followed, which was transmitted throughout the ERM as well as to those countries with currencies linked to the deutsche mark.

With the exception of Japan, the fiscal imbalances that prevailed at the beginning of the current recession limited the use of countercyclical fiscal policy, although there was an increase in fiscal deficits because of the operation of automatic stabilizers and, in some cases, increases in structural deficits. As signs of recession became apparent and as inflationary pressures began to recede, monetary policy was eased, and interest rates fell significantly. In most industrial countries, where margins of slack remain substantial and inflation is low and often still abating, maintenance of an accommodative monetary policy stance remains appropriate to support recovery; but as the recovery gains strength, monetary policy should gradually be returned to a neutral stance. The appropriate path for monetary policy is, however, different across countries. For those that are further advanced in the business cycle, it will be appropriate to shift to a less accommodating stance relatively soon, since allowing excess demand to develop and inflation to rise would eventually necessitate a more severe tightening of monetary policy, as happened in the late 1980s and early 1990s. On the other hand, policy should continue to support the recovery in activity that is just now getting under way in other countries and, in particular, a correction in the stance of policy could be needed if the expansion were to show signs of weakening. But even in these countries, as output expands, monetary policy will need to tighten early enough to prevent overheating. To reconcile the medium-term goal of price stability with the need to adjust monetary policy in the face of business cycle developments, some countries have adopted explicit inflation targets, while others, notably Germany, have implicit but widely understood policies regarding price stability.8 Although explicit inflation targets have yet to be tested in the context of rising inflationary pressures, it is hoped that they will increase the credibility of monetary policy and provide overall guidance to policymakers.

Setting the appropriate stance of monetary policy is complicated by the substantial lag of a year or more between a change in monetary conditions and its effects. Consequently, a wide range of intermediate indicators generally need to be used to assess the stance of monetary policy. For an indicator to be useful, it should have a predictable relationship to macroeconomic variables of concern to policymakers, particularly future output growth and inflation.

  • In the context of central bank monetary targeting, monetary aggregate growth that is within a range consistent with potential output growth and desired inflation indicates a neutral policy stance. However, apparently unpredictable shifts in the relationship between monetary aggregates and output and prices—due in part to structural change in financial markets—have undermined the usefulness of monetary aggregates, and they have therefore been de-emphasized, although not abandoned, in many countries.
  • Private-sector credit growth sufficient to support output growth at potential may also indicate a neutral stance of monetary policy. Credit growth has typically been closely correlated with real output growth, but because the correlation is contemporaneous it is of limited usefulness in predicting the future effects of current monetary policy.
  • Real interest rates, both short- and long-term, at a level that supports an expansion of aggregate demand equal to the growth of potential output would indicate a neutral policy stance. It is, however, difficult to determine with precision what this level is. In the 1970s, measured real rates were extraordinarily low, perhaps because the surge in inflation during the 1970s was not fully anticipated; but they were much higher in the 1980s, partly owing to high budget deficits and declining saving rates in many industrial countries. In the 1990s, projected significant fiscal deficits in almost all industrial countries suggest that a neutral monetary stance may, as in the 1980s, be associated with relatively high real interest rates.
  • Nominal short-term interest rates, because they are essentially determined by central banks, are a direct indicator of the thrust of policy and, in many countries, are highly correlated with real output growth, with about a one-year lead.9 As with real interest rates, it is difficult to assess the nominal short-term rate that is consistent with a neutral policy stance. Moreover, short-term interest rates are generally best conceived of as an indicator of what monetary policy is, rather than as an indicator of what it should be.
  • The shape of the yield curve—proxied by the long-term less the short-term interest rate—also has some predictive power for real output growth in many countries, again with a lead of about one year.10 Because long-term interest rates reflect in part the market’s expectation of future short-term interest rates, a steeply upward-sloped yield curve implies that interest rates are expected to rise over time, as would be typical in a cyclical recovery. The yield curve is normally somewhat upward-sloped on average over the entire business cycle—for example, by about 1½ percentage points in the United States—and such a normal slope would suggest a neutral stance of monetary policy.

As growth picks up and becomes self-sustaining, government budget deficits will begin to shrink through the operation of the automatic stabilizers. At the same time, the opportunity to correct serious structural fiscal imbalances must be seized. Lower public debt levels would free resources for productive investments in the industrial countries themselves as well as in the developing world and the countries in transition. A sustainable reduction of budget deficits would also provide greater room for policy maneuver to support activity in future recessions. The recovery will be an opportunity to implement needed fundamental structural reforms in an atmosphere of buoyant economic activity. These reforms, in turn, can reduce structural unemployment and increase growth of potential output, thereby allowing a greater expansion of incomes and reducing the threat of a resurgence of inflation.

In the United States, virtually all indicators now suggest that little or no slack is left in output and labor markets. Aggregate output trends indicate that real GDP returned to levels of potential during 1994, and capacity utilization has risen above its long-term average and is near the peak reached in the second half of the 1980s, a period characterized by excessive inflationary pressures (Chart 13). In the labor market, the unemployment rate fell to 6 percent in mid-1994, which is at or below the rate at which wage pressures typically build and is near the lows reached in late 1980s.11 Price and wage inflation have nevertheless remained subdued because the cyclical pickup in output and productivity growth reduced unit labor costs, and labor market tightness has yet to translate into higher wage settlements.

Chart 13.Selected Industrial Countries: Unemployment Rates and Capacity Utilization1

1Capacity utilization is an index, with the sample mean equal to 100.

Note that the unemployment rate scale differs for Spain, and that the capacity utilization scales differ for the United Kingdom, Australia, and Denmark.

Given the current cyclical position, there is an increasing need to move U.S. monetary policy to a neutral position consistent with potential growth of about 2½ percent a year by raising interest rates further. This adjustment would help to maintain a favorable inflation performance and thereby sustain the economic expansion. Policy has already been tightened, with the federal funds rate rising by 175 basis points during the first nine months of 1994, and with bond yields also increasing substantially during this period. Nevertheless, it seems likely that a further shift in the stance of monetary policy may be required. Despite the recent increases, both short- and long-term interest rates remain low by comparison with the 1980s as a whole, and even with the mid-1980s (Chart 14). In real terms, short-term rates averaged 4½ percent, and long-term rates averaged 6 percent, in 1985–90, compared with real short and long interest rates of 1½ and 4¼ percent in mid-1994.12 The recent steepening of the yield curve is due to the run-up in long-term rates, which in turn appears partly to reflect market sentiment of increasing inflationary pressures, stronger activity and credit demand, and prospective policy tightening. The signals from monetary aggregates and velocity conflict, but these have in any case become increasingly unreliable as indicators of monetary stance.

Chart 14.Selected Industrial Countries: Short-Term Interest Rates and Yield Curves1

(In percent)
(In percent)
(In percent)

1Both indicators are lagged one year with respect to GDP growth.

A medium-term fiscal adjustment package was approved in August 1993 that aimed to reduce the unified federal deficit relative to a “current services” baseline by about 1¾ percent of GDP by FY 1998.13 As a result of this legislative action and the narrowing of the output gap, the federal unified deficit is projected to fall to 2½ percent of GDP in FY 1995. The deficit would rise gradually thereafter, mainly owing to increasing net interest and health-related outlays, and would reach 2¾ percent of GDP by 1999. Excluding the surplus of the social security trust funds, the deficit would be close to 4 percent of GDP in FY 1999. The structural general government deficit, which is projected to be 2¼ percent of GDP in 1995 (Table 5), is also projected to rise gradually to about 2½ percent of GDP in the medium term.14

Table 5.Industrial Countries: General Government Fiscal Balances and Debt1(As a percent of GDP)
United States
Actual balance-2.5-2.5-3.2-4.3-3.4-2.3-2.1-2.4
Output gap-0.41.9-1.1-1.4-
Structural balance-2.4-3.2-3.0-3.8-3.1-2.4-2.2-2.4
Net debt35.545.849.353.656.456.356.356.6
Gross debt49.359.663.366.768.768.668.669.0
Actual balance-
Output gap0.12.32.1-0.7-3.8-5.6-5.5
Structural balance-
Net debt22.
Gross debt66.369.867.771.175.581.585.687.6
Actual balance excluding
social security-4.4-0.6-0.7-2.0-4.4-6.4-6.1-3.2
Structural balance excluding
social security-4.4-1.3-1.4-1.8-3.0-4.4-4.2-3.2
Actual balance-2.1-1.9-3.2-2.6-3.2-2.6-2.3-0.9
Output gap-
Structural balance-1.5-3.5-5.4-3.9-2.2-1.2-1.0-0.9
Net debt20.718.619.922.526.130.039.535.7
Gross debt39.839.941.143.747.351.260.756.9
Actual balance-2.1-1.6-2.2-3.9-5.8-5.5-4.5-2.2
Output gap-
Structural balance-1.8-2.5-2.4-3.6-4.1-3.6-3.0-2.2
Net debt21.525.
Gross debt29.035.435.439.444.449.251.151.9
Actual balance-11.0-11.4-10.7-10.0-10.0-9.6-8.4-3.9
Output gap0.10.9-1.2-3.8-4.2-3.50.3
Structural balance-11.1-12.0-10.8-9.4-7.7-6.9-6.3-4.1
Net debt79.893.294.7103.3109.4111.8112.6106.8
Gross debt80.3104.9106.6116.3123.2125.8126.7120.2
United Kingdom
Actual balance-2.0-1.2-2.7-6.2-8.1-6.9-5.3-2.3
Output gap-0.92.0-2.2-4.8-4.8-3.7-2.8
Structural balance-1.0-3.7-2.9-3.7-4.5-3.8-3.0-2.0
Net debt25.327.827.228.532.937.640.140.4
Gross debt46.934.633.835.039.344.146.646.9
Actual balance-4.5-4.1-6.6-7.1-7.1-5.8-4.5-1.7
Output gap-0.22.5-2.0-3.9-4.3-2.9-1.9-0.5
Structural balance-5.0-5.9-5.5-4.5-4.3-3.9-3.3-1.4
Net debt28.743.549.757.161.864.965.963.1
Gross debt59.872.780.187.592.296.196.591.1

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 1986–89. 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.

For net debt, the first column refers to 1983–89.

Budget balances include interest payments on tax refund liabilities. Net debt includes tax refund liabilities. For net debt, the first column refers to 1984–89.

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 1986–89. 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.

For net debt, the first column refers to 1983–89.

Budget balances include interest payments on tax refund liabilities. Net debt includes tax refund liabilities. For net debt, the first column refers to 1984–89.

Proposals for health care reform that could help to contain the growth of health-related fiscal outlays in the longer term are currently being considered. However, even if these efforts are successful, reform seems likely to be roughly deficit-neutral in the medium term, and possibly in the longer term. Thus, by 1999 the deficit would still be at a high level, and the debt ratio on an upward trend. The adoption of additional revenue and expenditure measures that would allow the deficit to fall in FY 1996 and beyond is warranted in light of the need to lower the debt-to-GDP ratio and improve U.S. national saving and longer-term growth prospects. Further fiscal consolidation efforts would also help to relieve the burden on monetary policy for containing domestic demand growth.

In the United Kingdom, a recovery has been under way for about two years, but output growth has only recently begun to outpace that of potential. As a consequence the output gap, which reached more than 5 percent in 1992–93, is now estimated at about 4 percent, and it is projected to be eliminated only in the medium term. The unemployment rate, although it has fallen by more than 1 percentage point since early 1993, remains above the standards of the 1980s and above estimates of the structural unemployment rate. On the other hand, capacity utilization rates in manufacturing have returned to trend levels, and there were signs of increasing wage pressures in late 1993 and early 1994; however, the rising trend in average earnings growth has since abated. The stance of monetary policy became clearly expansionary following sterling’s exit from the ERM in September 1992, with short rates falling below levels seen in the 1980s and the slope of the yield curve becoming positive. The stimulative effects of lower short- and long-term interest rates were reinforced by the substantial depreciation of sterling. However, real rates appear to be higher than levels in the 1980s, long-term rates have risen sharply during 1994, and the authorities signaled that the stance of monetary policy was becoming less accommodative by raising base rates by 50 basis points in September.

The structural fiscal deficit in the United Kingdom, which expanded substantially as a percent of GDP between 1989 and 1994, is projected to decline in the years ahead, which should help to keep demand growth to a sustainable pace. The official target is for a zero deficit by the end of the decade; staff estimates suggest that the implementation of the authorities’ consolidation plans would stabilize the ratio of net debt to GDP at about 40 percent by 1997. Although there is probably room for further growth above potential, and despite the expected withdrawal of fiscal stimulus, monetary conditions may need to be adjusted further in due course. The uncertainty about the estimate of the output gap implies a corresponding risk of overshooting as the expansion proceeds and possibly gathers strength. The delivery of timely policy adjustments will be a key test of the new monetary framework, which includes an inflation target range and measures to increase the transparency of the monetary policy process.

Although Canada has also enjoyed a period of sustained growth since early 1991, the preceding recession was very deep, and substantial slack—as judged by the aggregate output gap, capacity utilization, and unemployment—remains; consequently, there appears to be little risk of inflationary pressure in the short term. Despite recent increases in interest rates, most indicators suggest that the stance of monetary policy remains supportive. Short-term nominal interest rates have fallen below levels typical of the 1980s, the yield curve is steeply upward-sloping, growth rates of money aggregates and domestic credit are reasonably strong, and exchange rate depreciation has reinforced the effects of lower interest rates. Fiscal policy was relatively tight in 1989–92, as the increase in the cyclical component of the deficit was largely offset by discretionary deficit-control measures. Current policy calls for medium-term deficit reduction, following the widening of the federal deficit in 1993, although the high level of the debt-to-GDP ratio suggests that still further action may be required. In view of the degree of slack and very low inflation, the continuation of supportive monetary policy is appropriate. If fiscal consolidation is credibly strengthened, such a stance should not cause difficulties in financial markets or jeopardize the achievement of the official inflation-reduction targets.

The other four major industrial countries appear to have reached the trough of the business cycle in late 1993 or in 1994. In Japan, the output gap is estimated to have widened to some 5 percentage points in the course of the recession, and it is projected to increase further in 1994 as actual output growth falls short of potential and capacity utilization remains well below its long-term average. Measured inflation has been very low in terms of consumer prices and negative in terms of producer prices. Moreover, the proliferation of price discounting, which is not properly reflected in the consumer price index, suggests that inflation may be even lower than reported.

In response to the recession, monetary policy in Japan was eased substantially. By mid-1993, short-term interest rates had fallen below even the very expansionary levels reached in 1987–88, which led in part to the bubble economy, and the slope of the yield curve had become positive. However, the impact of the interest rate reductions on aggregate demand has been partly offset by the appreciation of the yen. Growth rates of M2-plus-CDs and domestic credit slowed dramatically, but this reflected continued weakness in activity rather than a tight monetary stance. Fiscal stimulus has also been provided by the introduction of four packages in the past two years designed to support economic activity15. As a result, the structural balance worsened by about 3 percent of GDP between 1991 and 1994, while the actual budget position deteriorated by almost 6 percent of GDP. This deterioration will need to be reversed in the longer term, especially in view of the prospective fiscal burden associated with Japan’s aging population. In view of the tentative nature of the recovery, however, as well as ongoing balance sheet adjustments and the continued effects of the strong yen, both fiscal and monetary policy will need to remain supportive into 1995.

In continental Europe, indicators point to the existence of excess capacity and further downward pressure on inflation in most countries, although in some countries, such as Belgium, Denmark, and the Netherlands, capacity utilization rates have returned close to historical norms. There is, however, significant uncertainty attached to the assessment of margins of slack in Europe because past episodes of high cyclical unemployment have been accompanied by substantial increases in structural unemployment and corresponding declines in the full-employment level of output. If this has occurred during the current recession—and it is too early to say if it has—then the degree of slack may be overestimated.

In Germany, short- and long-term interest rates have fallen substantially since late 1992, and M3 growth has exceeded Bundesbank targets by a wide margin. Nevertheless, judged by real short-term interest rates, which are near historical average levels, a relatively strong deutsche mark, and a yield curve which only recently returned to its more normal slope following the global increase in bond yields, monetary conditions are not excessively easy. Monetary growth has been rather erratic since unification and requires careful interpretation. In particular, the recent high rate of growth of M3 partly reflects the influence of special factors, which appeared to be unwinding to some extent in the second quarter, and M3 velocity, which rose significantly following unification, has recently returned to its trend. On balance, and taking into account the difficulties in interpreting the monetary data, monetary conditions are broadly appropriate at this stage, although there could be some scope for further easing if monetary growth and inflation continue to decline in the months ahead and if the recovery remains hesitant. Fiscal consolidation measures have been put in place, and substantial progress has already been made in reducing the large public borrowing requirement due to unification. With further measures in the pipeline, the deficit is projected to decline over the medium term, although this will not be apparent in the general government deficit figures until after 1995 because of a rise in interest payments associated with the assumption of reconstruction-related debt.

Monetary conditions in ERM countries have been tied to German policy, which has constrained the scope for interest rate reductions. As in Germany, policy has become somewhat more expansionary in the past two years throughout the ERM, bringing monetary conditions more in line with domestic requirements. In France, indicators suggest considerable slack, with an aggregate output gap estimated at about 3½ percent in 1994, an unemployment rate of 12½ percent, and capacity utilization well below its long-term average. The structural deficit deteriorated somewhat in the early 1990s but has since remained roughly constant at about 3½ percent of GDP. Although economic activity is beginning to pick up, estimates of the margin of slack—which appears to be larger than in Germany—would suggest that the stance of monetary policy can be eased further without worsening inflation prospects.

Although Italy left the ERM, real interest rates have remained high by historical standards, in part because of problems of confidence related to large fiscal deficits and public debt levels. The depreciation of the lira provided a substantial boost to export demand in 1993, but there appears to be relatively little scope for further easing of monetary conditions in the short run. In Spain, slow growth, very high unemployment, low inflation relative to historical norms, and low rates of capacity utilization suggest that a relatively accommodative stance for monetary policy would be in order. The peseta was devalued within the ERM, but nominal interest rates have not fallen much relative to levels in the mid-1980s. In Italy and Spain, in contrast to France, there appear to be substantial risk premiums built into interest rates. In the medium term, substantial and sustained programs of deficit reduction will be crucial to reducing these premiums and to permitting lower domestic interest rates. In Denmark, strong output growth fueled by low interest rates and fiscal easing has raised capacity utilization rates back to their long-term average. Although inflation is currently low and legislation is in place to withdraw the fiscal stimulus, there is a risk that inflationary pressures may be building. Growth is also robust in Ireland, but the unemployment rate remains very high, and inflationary pressures seem subdued.

Monetary conditions eased significantly in the Nordic countries following their decision to float their currencies in late 1992. Short-term interest rates in Finland, Norway, and Sweden fell, with differentials vis-à-vis Germany narrowing, and in Finland and Sweden substantial exchange rate depreciations provided further support to activity. Growth has picked up in all three countries, and the degree of slack appears to have narrowed in Norway and, to a lesser extent, in Sweden.16 Prospects for sustained recovery in Sweden will depend critically on a credible program to reduce the fiscal deficit in the medium term, in order to narrow the very large premiums on long-term interest rates. Margins of slack are diminishing in Australia, and the Reserve Bank moved toward a less accommodative monetary stance in August. Although there appears to be substantial excess capacity remaining, judging by unemployment and capacity utilization rates, further interest rate increases may be necessary in the future to shift policy to a neutral stance as margins of slack are eliminated. In New Zealand, the long period of fundamental structural change has set the stage for enhanced noninflationary growth in the medium term.

Structural Reform and Medium-Term Growth and Employment

As the recovery proceeds in the industrial countries, there will be an increasingly urgent need to address the severe underlying structural impediments to higher sustainable growth and employment. In Europe, the principal concern is the high rates of structural unemployment that now prevail in most countries. Unemployment tends to be concentrated among the young and the unskilled, and there is a growing number of long-term unemployed that increasingly appear to be unemployable.17

Although institutions and practices differ from country to country, durable reductions in unemployment will require not only a cyclical recovery in output, but also fundamental, wide-ranging labor market reforms. In some countries, unemployment insurance and related benefits are excessive—both in the replacement rate and in the duration of benefits—and reducing them would raise incentives to seek employment. The budgetary saving from reducing income support could be usefully applied to active labor market programs, including retraining the long-term unemployed and the unskilled, and expanding job-matching services. The latter would be facilitated by eliminating the monopoly position now held in some countries by public sector agencies. Lowering minimum wages and high non-wage labor costs, as well as easing employment restrictions—such as those on hiring and firing, short-time contracts, and part-time work—would increase the incentive for firms to hire and would promote labor market responsiveness. Labor market flexibility would be further enhanced in some countries by decentralizing the bargaining process (or at least permitting more firm-level variation in wages and employment conditions within a centralized bargaining framework) and by abolishing the extension of collective agreements to whole industries. Finally, reducing barriers to competition and market entry would reduce the scope for practices that raise wages for some but restrict the employment opportunities of others.

During the past two decades, there has not been the same ratcheting up of unemployment in North America as there has been in Europe. The structural unemployment rate in the United States is little changed from the early 1970s. In Canada, it has risen by as much as 2½ percentage points in the past twenty-five years, but the bulk of the increase can be traced to substantial expansions of the unemployment insurance system in 1971 and, to a lesser extent, in the mid-1980s. However, underlying productivity growth and, consequently, real wage growth have flagged in both countries. For those at the lower end of the income scale, the widening dispersion of wage incomes has compounded the effects of slow growth in average real wages, especially in the United States. The underlying causes of the productivity slowdown and the widening income distribution remain relatively obscure, but it is clear that raising long-term productivity growth will require more investment in both human and physical capital. Such investment will have to be financed through greater domestic saving, to which the public sector can make a direct contribution by sharply reducing fiscal deficits.

In Japan, economic activity is still overregulated in many sectors, particularly agriculture, construction, transportation, telecommunications, and wholesale and retail trade. Regulatory impediments also reduce the efficiency of land use. As a result, consumers face very high prices for many goods and services, and the innovation that would be spurred by easier entry of new firms is stifled. There has been increasing awareness of the need to reduce regulatory and other barriers in many industries, to increase the efficiency of the distribution sector, and to relax government involvement in many aspects of private sector activity. There have already been efforts at structural reform and the opening of markets to greater foreign competition. These initiatives will need to be broadened and pursued vigorously in the years ahead.

Implementing the needed structural reforms will be difficult in many cases, but it will be easier when economies are growing than during downturns, when income growth falters and structural adjustments are more difficult. Reforms, although justified in the aggregate, may also have side effects that will have to be dealt with as they arise. For example, labor market liberalization may increase the dispersion of wage income, as in North America. Nevertheless, policies that distort labor markets are inefficient mechanisms for redistributing income, because the resulting increase in unemployment reduces potential output and, in some cases, may even increase inequality. Direct methods, such as taxes and transfers, to achieve objectives of income distribution would be more effective. In Japan, liberalization of output markets may require adjustments in the system of lifetime employment and could increase frictional unemployment somewhat. But it should also increase labor productivity—because there will be more scope to match workers to jobs—reduce trade tensions, and increase living standards.

Medium-Term Baseline and Alternative Scenarios

The medium-term baseline projection is conditional on several technical assumptions and therefore does not necessarily represent the most likely outcome. These assumptions include current structural, fiscal, and monetary policy (broadly interpreted to imply that short-term interest rates will respond to cyclical conditions and inflationary pressures); constant real exchange rates (except in the ERM, where constant bilateral nominal exchange rates are assumed); and, in the medium term, stable real commodity prices.18 No attempt is made to incorporate possible future business cycles in the medium-term baseline, although the alternative scenarios illustrate how certain economic policies could induce cyclical movements in output and inflation.

On the basis of these assumptions, real GDP growth in the United States is expected to decline in 1995 and beyond to levels consistent with potential output growth of 2½ percent, and inflation is projected to stabilize at about 3 percent (Table 6). For the other industrial countries as a group, growth is projected to pick up from 2¼ percent in 1994 to more than 3 percent in 1996–99. Fiscal deficits are projected to decline substantially, although most of the improvement reflects the unwinding of automatic stabilizers as output approaches potential. Nevertheless, fiscal consolidation plans and increases in interest rates as the recovery takes hold are assumed to be sufficient to slow growth and to avoid a significant overshooting of output. The relatively sluggish projected growth implies that output gaps will be absorbed only gradually in the years ahead. For many countries, the persistence of margins of slack, even though they are diminishing, will maintain some downward pressure on inflation, which is projected to stabilize at about 2½ percent for the industrial countries as a group in 1996–99.

Table 6.Industrial Countries: Medium-Term Baseline1(Annual percent change unless otherwise noted)
All Industrial countries
Real GDP1.
Real total domestic demand1.
GDP deflator3.
General government balance2-3.8-4.3-3.9-3.5-2.6
Current account balance2-
United States
Real GDP2.
Real total domestic demand2.
GDP deflator2.
General government balance2-4.3-3.4-2.3-2.1-2.3
Current account balance2-1.1-1.6-2.2-2.4-2.4
Real GDP1.
Real total domestic demand0.
GDP deflator1.
General government balance21.8-0.6-2.7-2.7-1.6
Excluding social security2-2.0-4.4-6.4-6.1-4.0
Current account balance23.
Real GDP2.2-
Real total domestic demand3.0-
GDP deflator5.
General government balance2-2.6-3.2-2.6-2.3-1.4
Current account balance2-1.1-1.0-0.8-0.6-0.6
Real GDP1.2-
Real total domestic demand0.2-
GDP deflator2.
General government balance2-3.9-5.8-5.5-4.5-2.7
Current account balance20.
Real GDP0.7-
Real total domestic demand0.8-
GDP deflator4.
General government balance2-10.0-10.0-9.6-8.4-5.4
Current account balance2-
United Kingdom
Real GDP-
Real total domestic demand0.
GDP deflator4.
General government balance2-6.2-8.1-6.9-5.3-3.1
Current account balance2-1.6-1.6-1.3-1.6-2.0
Real GDP0.
Real total domestic demand0.
GDP deflator1.
General government balance2-7.1-7.1-5.8-4.5-2.4
Current account balance2-3.8-4.3-3.9-3.3-2.3
Other industrial countries
Real GDP1.
Real total domestic demand0.7-
GDP deflator4.
General government balance2-4.5-6.0-5.4-4.8-3.4
Current account balance2-
European Union
Real GDP1.1-
Real total domestic demand1.2-
GDP deflator4.
General government balance2-5.3-6.5-5.9-5.1-3.3
Current account balance2-

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

In percent of GDP on a national accounts basis.

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

In percent of GDP on a national accounts basis.

Current account balances are not projected to narrow significantly in most countries in the medium term. There is projected to be little change in the U.S. current account deficit of about 2½ percent of GDP, given the assumption of constant real exchange rates and little change in the fiscal deficit. The recovery of activity in Japan is projected to help narrow its current account surplus to about 2¼ percent of GDP by 1999, assuming that the yen remains unchanged in real effective terms.

As noted, the medium-term projections are based on current policies. A number of alternative scenarios have been constructed to illustrate the possible consequences of improved policies and of policy mistakes. Details of the simulations—which are based on MULTIMOD, the IMF’s macroeconometric model—are presented in Annex II.

A Pessimistic Alternative

The baseline scenario assumes current fiscal policy and a noninflationary monetary stance, but developments could proceed less smoothly. There is a risk that the extent of slack is, or will be, overestimated, especially since there are several mechanisms by which a cyclical downturn could affect the level of potential output (Box 5). In particular, structural unemployment has risen substantially in the past two decades in Europe, and the increased cyclical unemployment in the current recession could again be translated, at least in part, into structural unemployment before the recovery is complete. A related risk, but one affecting all industrial countries, is that monetary policy will not be tightened sufficiently rapidly during the recovery phase of the cycle, either because the amount of slack is overestimated or because the stance of monetary policy is judged to be tighter than is actually the case. In the short term, a monetary stance that is too loose will result in rising inflation. In the longer run, however, central banks will have to react to inflationary pressures by tightening policy substantially in order to ensure the medium-term goal of price stability.

To illustrate the effects of an increase in the structural rate of unemployment in Europe, the natural rate is increased by 2 percentage points above that assumed in the medium-term baseline, approximately the cyclical increase that has been observed to date. Qualitatively, such a development would reduce potential output (because of a lower level of labor input) and would increase inflation (because of much smaller output and labor market gaps). To illustrate the second risk, it is assumed that monetary policy fails to tighten as much as in the baseline scenario for two years, but then tightens more sharply thereafter. Because the United States is currently near potential, the relative easing of monetary conditions—the absence of the tightening that is assumed in the baseline—is assumed to occur in 1995 and 1996, and the subsequent tightening in 1997 and 1998. For other countries, which are not as advanced in the cycle, the easing of policy relative to the baseline is assumed to occur in 1997 and 1998, and the tightening to occur in 1999 and 2000. Qualitatively, this alternative path for monetary policy would result in an initial increase of inflation and output growth, followed by a reduction.

Box 5.Business Cycles and Potential Output

The business cycle can be viewed as fluctuations of actual output around potential output, where potential output is the level of production sustainable at normal rates of capacity utilization and employment of labor. When actual output is equal to potential output, there will be neither upward nor downward demand pressures on inflation; hence, in the absence of pressures from import prices, for example, inflation will tend to be stable. The table shows estimates of potential growth and output gaps—the difference between actual output and potential output as a percent of potential output—for the major industrial countries. During a cyclical downturn, output falls below potential, and this opening of an output gap puts downward pressure on inflation. As output recovers, downward pressure on inflation would be expected to persist so long as the output gap remains, although there may be inflationary pressures stemming from sectoral bottlenecks as the gap narrows. Potential output and structural unemployment are determined largely by noncyclical, structural factors, but there are also mechanisms by which the cycle itself may affect potential. Failure to take such effects into account may result in an overestimation of the output gap and a misperception of underlying inflationary pressures.

The most obvious channel by which the business cycle affects potential is through real fixed capital formation. During a recession, the cumulative shortfall of investment lowers the stock of capital that is available for production and hence causes a decline of potential output. The broad magnitude of the direct effect of reduced investment on potential output during the current recession can be illustrated by comparing actual investment over the cycle with its trend, using an aggregate production function to calculate the effect on potential output. The chart shows the alternative paths for investment as well as the calculated effect on the growth of the capital stock and potential output for the seven major industrial countries in aggregate. In 1993, for example, the cyclical downturn in investment may have reduced the level of potential output in these countries as a group by almost ¾ of 1 percent, and lowered the growth of potential output by⅓ of 1 percentage point. This direct effect would be amplified if the recession also caused an increase in the rate of scrapping of capital, which would further reduce the stock of capital available for production, or if lower investment reduced the rate at which technological advances are incorporated into the production process, thereby retarding productivity growth.

The importance of these factors depends on the depth of the recession. For the United States, where the recent recession was relatively mild, the decline in the level of potential output attributable to the direct effect of lower investment—excluding the induced effect on scrapping and productivity growth—is estimated to have been about ½ of 1 percent in 1993. The recent recession was much more severe and occurred somewhat later in the other major industrial countries, and the decline in the level of potential output in 1995 is estimated to have been of the order of 1½ percent in Japan, and as much as 1¾ percent in the other major industrial countries.

In any case, the effects of the cycle on the capital stock tend to be reversed in the recovery phase of the business cycle, when investment increases at a much more rapid pace than GDP, although usually with a lag. For the United States, which has virtually fully recovered from the recession, the calculations suggest that the effects of cyclically lower investment have been entirely unwound. Indeed, fixed investment in the United States has been much stronger in this recovery than in previous recoveries, which may have raised the growth of potential since 1991.

Another mechanism by which the cycle might affect potential output is by reducing the supply of labor. In many European countries in the past two decades, cyclical increases in unemployment appear to have been transformed into structural unemployment, which has now risen to very high levels. This has been accompanied by substantial increases in the proportion of the unemployed who have been unemployed for long durations. Employers are often reluctant to hire workers who have been unemployed for extended periods, and whose skills may have deteriorated or become obsolete. In addition, some workers who become unemployed during a recession may become discouraged and drop out of the labor force altogether, further reducing available labor input. In the expansionary phase of the business cycle, some of these effects may be reversed as employment opportunities increase, but experience suggests that the reversal may be incomplete in many countries.

The effect of reduced labor input on potential output could in principle also be estimated by using a production function, although it is difficult to assess the extent to which cycles have been responsible for the increases in structural unemployment and the number of discouraged workers. The importance of the increases in unemployment can be illustrated, however, by noting that had the unemployment rate in the 12 countries now in the European Union remained at its 1973 level, employment in 1990 would have been almost 7 percent higher (at full capacity). Using a standard production function suggests that potential output would have been 4½ percent higher in 1990, other things being equal. Furthermore, the extra output that would have been produced in the past twenty years would also have increased investment. Assuming that the capital stock had increased in line with the higher level of employment, potential output would also have been close to 7 percent higher in 1990. These calculations exaggerate the effect of the cycle in potential output to the extent that it is assumed that the entire increase in the unemployment rate during the past twenty years was due to the cumulative effect of business cycles. On the other hand, the calculations take no account of discouraged workers or of the reduced rate of implementation of technical innovations owing to lower investment.

Major Industrial Countries: Potential Growth and Output Gaps1(In percent)
Potential GrowthOutput Gaps
United States2.
United Kingdom2.

Estimates of potential output and, therefore, output gaps are subject to significant margins of uncertainty.

Estimates of potential output and, therefore, output gaps are subject to significant margins of uncertainty.

Business cycles may also have positive effects on potential output by stimulating productivity growth. In particular, recessions may eliminate the weakest, least productive firms as well as force efficiency-enhancing measures on others. But little is known about the importance of such mechanisms, and there is little evidence of a sustained increase in trend aggregate productivity growth following recessions.

Major Industrial Countries: Effect of Business Cycle on Investment and Potential Output

Note: The series are aggregates of calculations for each of the major industrial countries.

The path of output growth and inflation, assuming that both downside risks materialize, is shown in Chart 15. In North America, where only a monetary policy risk is assumed, growth is initially somewhat higher because of the monetary stimulus, and inflation rises sharply, peaking at 6 percent in 1997. The resulting monetary response reduces growth in 1997–99 and brings inflation back to about 3 percent a year. It should be noted that the relatively small slowdown in growth in this simulation reflects in part the forward-looking property of MULTIMOD; experience suggests that the impact on output could be considerably more severe. In Japan, the pattern is similar but delayed by two years, with output growing more strongly beginning in 1997, when monetary conditions are assumed to ease (relative to the baseline projection), and with inflation rising sharply. In 1999, monetary conditions tighten, leading to a significant decline in growth in 1999–2001. In Europe and the other industrial countries, short-term output growth is somewhat less than in the baseline, and inflation is somewhat higher, because the increase in structural unemployment reduces potential output and increases inflationary pressures. By 1997, monetary conditions are assumed to ease (relative to the baseline projection), raising output growth and inflation; after 1999, the subsequent tightening of monetary policy succeeds in reducing inflation, again at the expense of significantly lower output growth.

Chart 15.Industrial Countries: Alternative Medium-Term Scenarios

(In percent)

Using the Expansion Wisely

The recovery also provides an opportunity to implement positive policy initiatives. The most urgent need is for further fiscal consolidation, which in the medium term would reduce interest rates, raise potential output by freeing up resources for the private sector, and position the public sector to better respond to longer-term fiscal challenges, such as future recessions and the aging of the population. It is also important to implement structural policies to reduce structural unemployment in all countries (except Japan, where the unemployment rate has been historically very low).

The consequences of further fiscal consolidation are illustrated by assuming that deficits are reduced sufficiently to yield a decline in the debt-to-GDP ratio of about 2 percent a year by the turn of the century. In general, this does not require actual surpluses in most countries, only smaller deficits than are projected in the medium-term baseline. It is also assumed that policies are put in place to reduce structural unemployment in all countries except Japan. As explained in greater detail in Annex II, this is implemented, first, by reducing labor taxes and raising consumption taxes, while keeping overall revenue constant. In MULTIMOD this substitution away from labor taxation reduces structural unemployment by about 1 percentage point.19 For all countries except the United States and Japan, it is further assumed that some of the labor market reforms outlined above will be implemented, and that this reduces the structural rate of unemployment by another 1 percentage point.

The combined effect on output growth and inflation of these policy initiatives is illustrated in Chart 15. In North America, growth initially falls slightly below the baseline projection as a consequence of the fiscal tightening. The reduction in interest rates spurs investment, however, and leads to higher growth for several years thereafter. Although not shown in the chart, the increase in the capital stock resulting from the deficit cut—the crowding in of investment—yields a permanently higher level of output, even though growth rates fall relative to baseline as the stimulus from lower interest rates wears off.20 At the same time, inflation is little changed because the rise in output reflects an increase in potential. In Japan, output growth and inflation decline initially, reflecting the impact of fiscal tightening, but then rise as investment is stimulated. In Europe and the other industrial countries, output growth is also initially adversely affected by the fiscal contraction, but this effect is offset by the gains from the reduction in structural unemployment. As investment is crowded in and employment expands, output growth rises well above what is projected in the baseline. The net effect on inflation is very small: initially inflation falls, as the assumed reduction in structural unemployment puts downward pressure on wages and prices; inflation subsequently increases slightly, as growth and employment pick up, although the price level is generally lower than in the baseline.

* * *

The industrial countries have the opportunity to build on the policy successes of the 1980s and early 1990s that lowered inflation, liberalized global financial markets, and, with the recent GATT agreement, further reduced trade barriers. The generalized economic recovery that now appears to be in prospect—and that must be supported by macroeconomic policy—will reduce unemployment and ease pressure on government budgets. At the same time, it is crucial that the policy mistakes of the 1980s be avoided. Monetary policy must be shifted to a neutral position well before capacity constraints are reached, to prevent the buildup of demand pressures and imbalances in asset markets. The recovery should be used to redress underlying fiscal imbalances to help to lower interest rates worldwide and to promote productive investments in industrial countries, developing countries, and the countries in transition. Reforms to labor and product markets that increase flexibility and productivity would set the stage for increased prosperity and sustainable non-inflationary growth in the medium term.

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