The world economy.

Barrell, Ray ; Anderton, Robert ; Vaughan, Nicholas 等

The overall outlook

Output growth in the OECD as a whole is likely to be around 2 per cent in 1994, the fourth year in succession when it has been below estimates of potential growth. A number of economies were growing very rapidly in 1990 and 1991, and capacity was stretched in both Germany and Japan. However, subsequent recession has taken these economies to levels of capacity utilisation and unemployment that have resulted in downward pressure being put on wage and price inflation. Inflation generally falls in recessions, and the fall from an OECD average inflation rate of 4.5 per cent in 1990 to around the 2.5 per cent projected for 1994 is not without precedent. However, the prospects for inflation over the next few years look a little better than one might expect in an upturn, and we are forecasting that OECD consumer price inflation will stay around 3 per cent for the next few years.

Inflation pressures are likely to be low for this year partly because of a lack of synchronisation in the world business cycle: the US, which still represents around 40 per cent of OECD GDP, and the other English speaking countries have only just emerged from a recession whilst Continental Europe and Japan are still experiencing stagnant or declining output. It appears likely that EC GDP fell in 1993, and the same may well have happened in Japan, although the signals from that country are mixed. Capacity utilisation in both Germany and Japan was at historically high levels in the recent boom, as can be seen from Chart 1, and it has only returned to levels seen in the early 1980s. However, some output gap has emerged in both countries(1), and more resources are available for serving export markets than one would expect in a concerted upturn. Capacity utilisation has been rising in North America, but the availability of excess foreign capacity, along with intensifying price competition from the newly industrialising economies in South East Asia, should prevent any bottlenecks in the US economy from leading to an increase in inflationary pressure in the short term.

Over the medium term we are expecting inflation in the OECD as a whole to average just over 3 per cent, with inflation for the EC averaging 3 3/4 per cent. Both are relatively low by historical standards, although they are close to the averages seen through the upturn of the mid-1980s. Over the same period we are expecting that GDP growth will also be somewhat below levels experienced in the 1980s, after a relatively weak recovery, especially in Europe, but also in the US and Japan. This slow growth is not the consequence of the tendency of a model based forecast to 'revert to the mean', but rather the result of our understanding of the future restrictive path of fiscal policy in a number of economies, and the consequential effect on unemployment and the pressure of demand and hence on inflation.

During the 1980s fiscal policy was expansionary in the US, and as a result debt and deficit both rose, as can be seen from Chart 2. The recession of the early-1980s raised both unemployment and budget deficits in Europe, and although contractionary policies were adopted they worked more through high real interest rates than through reductions in primary government budget balances. As a result, debt stocks rose throughout much of Europe, and even in fiscally prudent France and Germany TABULAR DATA OMITTED debt stocks were 10 per cent higher, as a per cent of GDP, in 1990 than they were in 1980, with the sharp upturn in the 1990s in Germany displayed in Chart 3 being driven by the effects of the budgetary costs of German reunification.

Serious worries have emerged about the sustainability of the trajectory for the debt stock in Europe. One would expect debt stocks to rise during wars and recessions, but to decline, at least as a per cent of GDP, in booms. This did not happen in Continental Europe during the 1980s, and the worries that have emerged have been enshrined in the debt and deficit targets spelled out in the Maastricht Treaty. The Continental countries appear to take these targets seriously, and indeed as they have signed the Treaty they are constitutionally bound to do so. As a result we expect that the fiscal policy stance will be restrictive throughout Europe for much of the 1990s. If we lived in a world where consumers discounted their future tax liabilities at the same rate as the government, or if there were no nominal inertia in Europe's wage and price system, then this tight fiscal stance would have little effect. However we do not feel that we observe such a world(2): consumers in aggregate are myopic, and forward-looking labour markets still work slowly. As a consequence our forecast contains an extended period of slow growth, high unemployment and low inflation, especially in Europe, but also elsewhere in the OECD.

The prospects for growth and inflation in Japan are dominated by the effects of the 20 per cent real appreciation of the yen experienced over the last year. Although Japanese exporters have always shown a willingness to cut margins to ensure that they maintain market share, an appreciation of this magnitude inevitably puts pressure on domestic output. Growth had been low in 1992, and with three quarters of GDP figures available there appears to be little evidence of any output growth in 1993. The combination of excess capacity and declining import prices is likely to keep Japanese inflation very low over the next few years, and it could even be negative for several years to come. The prospects for a more rapid recovery driven by a substantial fiscal package look more bleak now than they did a few months ago. The Diet and the bureaucracy appear divided over the necessity for a fiscal stimulus, and unless one is administered growth will remain low.

Interest rates and exchange rates

Long-term interest rates have continued to fall throughout the OECD. This in part reflects lower than anticipated short-term rates, especially in Japan, Canada and Italy. However, the fall in long rates, plotted in Chart 4 for the US and Japan, has been largely driven by revisions to expectations of future short-term rates. This revision appears to be based on a belief that inflation will in future be lower than had been previously anticipated. Our inflation forecast reflects this view, and although we have revised down our projection of short-term interest rates, our projection for real interest rates is largely unchanged.

Our forecast for exchange rates in Table 2 reflects our interest-rate assumptions in Table 3. The turmoil on the European exchanges appears to have abated, and French, Belgian and Danish exchange rates have now all joined the Dutch in the narrow band around the ecu. This in part reflects the relative weakness of the D-Mark against the US dollar, but it is also the consequence of a strengthening of the franc as confidence has returned. The appointment of the Council of the newly independent Bank of France was well received, and interest rates eased somewhat whilst the franc strengthened. The European Central Banks have recently been intervening to re-establish their reserve positions, and as a consequence of their timing they have avoided the exchange losses that they would have suffered if the franc had permanently devalued.

The sharp appreciation of the yen in the last year has taken the real effective rate to levels that in the long run may be unsustainable. However, we have argued that through much of the 1980s the yen was undervalued, at least in terms of its FEER(3). The re-adjustment of the level of net exports to the new level of competitiveness is likely to be prolonged, and it will have a depressing effect on the economy. The pattern of real exchange rates in our forecast in Table 4 seems to us to be much closer to a sustainable set than has been seen for sometime.

We expect that short-term interest rates will continue to fall in Europe for the next nine months or so, reaching a trough of 5.0 per cent in Germany in the last quarter of 1994. Thereafter we expect that the European economies will have begun to emerge from the recession, and the Bundesbank will ensure that interest rates will rise. The position is somewhat different in North America, where interest rates reached a nadir during 1993. Short-term market rates began rising in the fourth quarter of 1993 and in February 1994 the Federal Reserve raised the discount rate in response to the emerging signs of a strong recovery. We expect that US interest rates will continue to rise for the next two years until they return to around 6 per cent at the end of 1996.

Table 2. Exchange-rate forecasts for the major six

 Percentage change in effective
rate

 US Japan Germany France Italy
Canada

1990 -4.2 -8.4 4.2 4.0 1.5 0.2
1991 -1.5 8.2 -0.5 -1.4 -1.2 1.7
1992 -1.0 5.7 3.2 3.3 -2.9 -5.8
1993 3.6 19.1 4.8 4.2 -15.3 -5.6
1994 2.2 3.5 -1.1 0.6 -3.8 -2.7
1995 0.3 1.9 0.1 0.2 -1.8 -0.4
1996 -0.1 2.7 0.0 0.2 -1.3 -0.5

 Yen D-Mark Franc Lira Franc
Lira per Dollar per
D-Mark

Nominal cross rates, year average

1990 144.8 1.62 5.44 1197.8 3.37
741.7 1991 134.5 1.66 5.64 1240.0 3.40
 747.7 1992 126.7 1.56 5.29 1231.1 3.39
 789.4 1993 111.2 1.65 5.67 1570.8 3.43
 950.0 1994 108.8 1.74 5.90 1695.7
3.39 975.9 1995 107.3 1.76 5.97 1744.1
 3.40 993.4 1996 104.7 1.77 6.01 1779.6
 3.40 1005.6

It is difficult to conceive of Japanese short-term interest rates falling much further, as they are now just below 2 per cent. With inflation likely to be negative during this year real interest rates are still around 3 per cent, and they are likely to stay that high. Long-term interest rates are well below those in other countries, and we expect them to stay so. However, at 3.2 per cent they do suggest that short-term rates will rise in the future.

Long-term interest rates in Europe have been falling, as can be seen from Chart 5 and 6, and they have also been converging. The falls in long-term rates are most marked in Spain and Italy, and short-term rates have fallen in both countries. The Spanish authorities had kept interest rates high in order to maintain a potentially overvalued exchange rate that was also protected by capital controls. The devaluations and the move to a freer exchange rate have allowed monetary policy to be loosened. The situation in Italy is different, and more interesting. Short-term interest rates on government debt have fallen from 14.7 per cent in the fourth quarter of 1992 to around 8 1/2 per cent now. Long-term rates on government debt have also fallen markedly, although this is a relatively thin market. The falls reflect both a loosening of monetary policy and a decline in the relative risk premium on government debt, which seems to have followed from recent electoral reforms. However, we feel that markets may have over-reacted to the changes in Italian politics, and in such a thin market this means that long rates have probably fallen too far. In the medium term we expect short rates to settle at around 8 per cent, and long rates to be around 8 1/2 per cent, almost a full point above their current level. We are expecting inflation in these two countries to remain low, but not as low as in the rest of Europe. We are projecting that short-term rates will stay around 2 per cent higher than in Germany for the next few years, and hence exchange rates will continue to change in line with the uncovered arbitrage condition for portfolio equilibrium in foreign exchange markets.

Table 3. Short-term interest rates

 Per cent

 US Japan Germany France Italy

1990 8.1 7.7 8.4 10.2 12.4
1991 5.8 7.4 9.2 9.7 12.2
1992 3.7 4.5 9.5 10.5 14.0
1993 3.2 3.0 7.3 8.4 10.2
1994 3.7 2.0 5.3 5.6 8.3
1995 4.6 2.3 5.6 5.6 8.0
1996 5.6 2.9 6.0 6.0 8.0
1997-2001 6.0 4.3 6.0 6.0 8.0

1992 I 4.1 5.2 9.6 10.2 12.2
II 3.9 4.7 9.7 10.3 12.7
III 3.3 4.1 9.7 10.6 16.3
IV 3.4 3.8 9.1 10.7 14.7
1993 I 3.1 3.4 8.3 11.6 11.9
II 3.1 3.2 7.6 8.1 10.8
III 3.1 3.0 6.8 7.3 9.3
IV 3.3 2.3 6.3 6.7 8.7
1994 I 3.4 2.0 5.8 6.1 8.5
II 3.4 1.9 5.4 5.5 8.3
IlI 3.8 2.0 5.0 5.4 8.2
IV 4.1 2.1 5.0 5.2 8.1
1995 I 4.3 2.2 5.3 5.3 8.0
II 4.5 2.3 5.5 5.5 8.0
III 4.8 2.4 5.8 5.8 8.0
IV 5.0 2.5 6.0 6.0 8.0
Table 4. Real effective exchange rates

year average US Japan Germany France Italy

1990 95.4 87.3 96.9 97.7 106.0
1991 94.0 92.6 95.1 94.3 107.0
1992 93.8 96.7 98.5 95.8 105.8
1993 97.5 113.3 103.5 98.3 90.7
1994 100.1 114.3 102.4 97.6 88.5
1995 101.8 112.4 100.8 96.5 88.3
1996 102.5 111.8 98.9 95.5 88.8

World trade and commodity prices

Much of Continental Europe is caught in a recession, and output growth is weak in Japan. However, North America is recovering strongly, and that area produces almost half of the OECD's output. This is putting upward pressure on commodity prices, and it is strengthening world trade. Output and trade are also very buoyant in Latin America, the Pacific Rim and China, partly financed by capital flows from the US and Japan, but also because some of the economies in South East Asia have developed their own dynamic. Indeed some of the weakness of output in Japan is the result of the relocation of sources of Japanese firms' production to outside of the OECD.

We expect that total world trade in all goods will rise by around 6 1/2 per cent in 1994, after growing by 2 1/2 per cent in 1993. However, its growth is concentrated away for Europe, and we expect that the export markets facing French, German and British firms will only grow by 4 1/2 to 5 1/2 per cent in 1994. North American trade is still buoyed up by the effects of the Free Trade Agreement, and we expect US import volumes to grow by more than 10 per cent in 1994, much as they did in 1993 and 1992.

Commodity prices are sometimes a good forward indicator of impending inflation, although they can sometimes be misleading. For instance, a 'bubble' appeared in copper prices in the late summer of 1993, and this pushed up overall commodity indices. It is always possible to find particular stories to explain why a particular commodity price has risen. For instance the floods in the US in the summer has led to a shortage of coarse grains, and prices of wheat and maize have risen. However, it is sometimes useful to stand back and look at indices which take account of a range of individual price movements. Chart 7 TABULAR DATA OMITTED plots our commodity price indices on a monthly basis. Almost half of our commodity price indices (wheat, maize, copper, tin, zinc and nickel) were significantly higher in January than they were in October, and none of our indices for other foods or metals were significantly lower. Gold prices have also risen, as can be seen from Chart 8 (a longer series is available in the Appendix), and rising commodity prices may have been one factor behind the US Federal Reserve Board's decision to raise interest rates in early February.

The inflation signal in these prices is partly obscured by the effects of lower oil prices. Output has been high, with OPEC producing above quota and although production from the former Russian republics fell 14 per cent in 1993, exports have stayed high. North Sea output has also been unexpectedly buoyant, and as a result the Brent Crude marker price for low sulphur crudes has been very weak at around $14 per barrel in December and January. Although short-term oil futures are weak, we do not expect oil prices to fall further, as the Russian Federation is introducing an oil export licensing system, and the surge in North Sea output is unlikely to be repeated. In the medium term we expect oil prices to rise in real terms, in line with real interest rates.

The United States

The US recovery is promising the possibility of strong growth combined with low inflation. Real GDP grew by 1.5 per cent in the fourth quarter of last year, the strongest quarterly growth for six years, but the GDP deflator only rose by 0.3 per cent (compared with 0.4 per cent in the third quarter and 0.6 per cent in the second). Both equity and bond prices moved upwards in response to the prospect of continued weak inflationary pressures and strong growth. All of the monetary indicators are currently close to the floor of their target range. The sharp increase in real GDP in the fourth quarter followed the upward trend of the second and third quarter growth rates. Demand was strongest in the expenditure categories most likely to respond to sustained low borrowing costs, such as business and residential investment and spending on consumer durables. Although export volumes grew by 4.6 per cent in the final quarter of 1993 the contribution of net trade to GDP was actually negative as import volumes rose by almost 4.9 per cent. Real GDP grew by 2.9 per cent last year after increasing by 2.6 per cent in 1992. However, the composition of growth now seems better balanced compared to the end of 1992 as business investment rather than consumers' expenditure is now leading the recovery.

Residential investment grew by more than 7.0 per cent and business investment in machinery and equipment grew almost as strongly at 6.25 per cent in the fourth quarter. These figures reflect a growing confidence among both consumers and corporations. Companies have begun to respond to robust growth in profits which, by the third quarter, were at levels 20 per cent higher than a year earlier. The Conference Board's index of consumer confidence rose again at the start of this year reaching its highest level since September 1990. Most of the improvement in confidence has occurred since the middle of last year. This seems to be related to the upturn in employment. Around 1/2 a million jobs were created in the last three months of 1993 with most of the new employment concentrated in the service sector. By the end of 1993 the unemployment rate had declined to below 6.5 per cent which is the lowest level for three years.

Table 6. United States GDP

 Percentage
change

 1990 1991 1992 1993 1994 1995
1996-2000

Consumption 1.5 -0.4 2.6 3.3 3.1 2.1 1.8
Investment: housing -9.2 -12.8 16.3 8.7 7.4 2.5 8.4
business 1.2 -5.9 2.9 11.7 7.3 5.5 5.6
Government expenditure 3.1 1.5 -0.1 -0.7 1.1 2.3 2.4
Stockbuilding(a) -0.5 -0.3 0.3 0.2 0.1 0.1 0.0
Total domestic demand 0.8 -1.4 2.9 3.8 3.5 2.7 2.7

Net export(a) 0.4 0.7 -0.3 -0.9 -0.2 -0.2 0.0
GDP 1.2 -0.7 2.6 2.9 3.3 2.4 2.7

Savings ratio 7.1 7.7 8.0 6.7 6.3 6.2 7.1
Average earnings 5.6 3.5 5.0 2.3 4.9 4.3 4.6
Consumer prices(b) 5.2 4.3 3.3 2.7 2.4 2.8 2.9
RPDI 1.8 0.1 3.0 1.8 2.4 1.8 2.0
Unemployment, % 5.5 6.7 7.4 6.8 6.4 6.5 6.4

(a) Change as a percentage of GDP.
(b) Consumers' expenditure deflator.

The growth in employment helps to explain the strong rise in real personal disposable incomes in the fourth quarter of 1993. However, the recent fall in oil prices has also increased real incomes by reducing gasoline prices and the cost of heating. Although consumption was fairly buoyant in the final quarter the strength of the growth in incomes resulted in a rise in the savings ratio. However, the tighter labour market is not putting much upward pressure on wages. Average weekly earnings hardly rose in December and by the end of 1993 were only about 3 per cent higher than a year ago. Growth in producer prices has also been surprisingly restrained given that capacity utilisation in manufacturing rose to its highest level for four years at the end of last year. The increase in the consumers' expenditure deflator was also low in 1993 at 2.7 per cent which is around 1/2 a percentage point lower than the previous year.

The momentum behind the GDP growth is likely to decelerate in the near future. More than a third of last quarter's growth can be accounted for by a large increase in motor vehicle assembly. The other major contributor to growth, residential investment, is also rising very rapidly as the level of housing starts at the end of 1993 is the highest for 15 years. These trends are unsustainable and are indicative of future inflationary pressures. Until recently the authorities have been reluctant to suggest any tightening of monetary policy as the recovery in growth has been the major priority. In fact, the decline in inflation and the planned reductions in the budget deficit, confirmed by the signing in August of the Omnibus Budget Reconciliation Act of 1993, have helped to cause a decline in long-term bond yields. However, the potential inflationary impact of strong growth led the Federal Reserve into raising interest rates in February for the first time in five years. The bank overnight lending rate was increased from 3 per cent to 3 1/4 per cent. We believe that further tightening will take place and that short rates, which started to rise in the fourth quarter of 1993, will increase by a percentage point during this year and next, reaching around 6 per cent by the end of 1996.

We expect GDP growth to increase further to above 3 per cent this year and then slow down to around 2 1/2 per cent in 1995. Domestic demand this year will probably grow less rapidly than in 1993 as the interest-rate sensitive categories, such as investment and consumption, begin to respond to the tighter monetary conditions. However, external demand should be stronger this year, and net exports will not depress GDP as much as in 1993. Growth in consumers' expenditure will probably decelerate to just above 2 per cent and housing and business investment will slow down rapidly. Business investment will be primarily influenced by lower activity because long-term interest rates, which are the major determinant of capital expenditure by business, already embody the TABULAR DATA OMITTED expectation of higher short-term interest rates and will therefore remain stable over the next two years. In contrast, the tightening of short rates will feed through into higher mortgage rates and more expensive consumer credit.

The projected path for fiscal policy also explains some of the deceleration in domestic demand over the short term. The 4-year deficit reduction package includes an income tax increase which raises the top rate of tax from 31 per cent to almost 40 per cent. The increase is back-dated to the beginning of 1993 but the retroactive element can be paid over the next three years. In addition, the ceiling for social security payroll tax has been increased taking the effective top rate of tax to 42 per cent. Government spending cuts will also decrease demand. The 14 per cent cut in nominal defence spending from 1993 expenditure levels (spread over four years) and the loss of 100,000 jobs in the public sector will have the largest impact.

Higher activity this year will allow productivity growth to remain robust and push unemployment downwards. Both of these effects will help wage bargainers incorporate productivity increases into pay settlements. Hence average earnings will probably grow by around S per cent this year but as most of this occurs in the latter part of 1994 the inflationary impact upon prices will be more evident next year. We do not expect that consumer inflation will be above 3 per cent in 1995 as the projected decline in the rate of growth in activity will moderate demand pressure in both the goods and labour markets.

Recent strong growth has resulted in the noticeable deterioration in the US current account which can be seen in Table 7. The deficit as a percentage of GDP increased from around I per cent in 1992 to almost 1 3/4 per cent last year. A 3 1/2 per cent increase in the US effective exchange rate since the third quarter of 1992 explains some of this deterioration but strong US demand relative to the rest of the world has also increased net imports. However, US export markets have been more buoyant than those facing the European economies as a higher proportion of US goods go to Canada, the Far East and Latin America. Although the growth of external demand should increase this year we still expect the US current account to deteriorate further by the end of next year. This is largely the result of further losses in competitiveness as we are assuming that the dollar will appreciate in line with the US interest-rate differential. As a result, both net export volumes and net interest, profits and dividend income will be lower.

The Federal deficit for the first three months of the 93/94 fiscal year declined to $92bn compared to $120bn a year earlier. Higher economic activity, lower defence spending and sales of the assets of the savings and loan associations explain much of the decline in the deficit. Furthermore, efforts have been made to reduce the average maturity of public debt in order to reduce interest payments by taking advantage of the steepness of the yield curve. In addition to the measures mentioned above the deficit reduction package will increase the corporate tax rate to 35 per cent, reduce health spending and TABULAR DATA OMITTED increase the efficiency of the public sector. There are further plans to curb health spending such as the draft legislation to require employers to contribute up to four fifths of their employees health insurance.

Japan

The Japanese economy is in one of the sharpest down-turns since the war. GNP grew by 1.4 per cent in 1992, which was the lowest growth rate since the early-1970s, but provisional estimates suggest that GNP showed no growth in 1993. Real GNP grew slightly in the third quarter of the year by 0.4 per cent, but it had fallen by 0.6 TABULAR DATA OMITTED per cent in the second quarter. All domestic expenditure components showed a modest growth in the third quarter, but early indications suggest that this could well be reversed in the final quarter of the year. The current downturn can be seen as a slow and protracted correction to structural imbalances that had built up during the boom years of the late-1980s. It has been aggravated by the strong appreciation of the yen at the beginning of 1993, which reduced export growth in volume terms.

In response to this downturn, the Bank of Japan has reduced the official discount rate to a historical low of 1.75 per cent, with the intention not only to boost the economy but also to reduce the strength of the yen. The government has announced several additional spending packages designed to raise economic growth, and they involve more government investment in public infrastructure. Despite these stimuli, leading indicators show that no strong recovery can be expected. The Bank of Japan's quarterly survey showed business confidence falling and expectations for the first quarter of 1994 deteriorating. Other surveys indicate that large finns plan further cuts in investment.

Sales in department stores continue to fall and retail sales in 1993 were 3.2 per cent lower than a year ago. Consumer confidence is depressed by low wage growth and rising unemployment. The consumer confidence index ebbed to a 19-year low in the fourth quarter of 1993. The combination of lower wage increases agreed in the annual spring wage round in 1993, less overtime working and declining bonus payments, which traditionally amount to over a quarter of total earnings, meant that average earnings have been squeezed. Confidence has been further depressed by the rise in unemployment to 2.9 per cent by the end of 1993. Although this seems low by international standards, the rise is in some respects alarming. Unemployment among the under 25s is around 7 per cent and the old Japanese tradition of guaranteed lifetime employment seems to be changing. Many companies used to hold on to excess labour and it TABULAR DATA OMITTED is estimated that 3 to 4 million people are kept on by firms even though there is no work for them. This would imply that the true rate of unemployment is around 11 per cent of the workforce.

The problem the government faces is to encourage consumers' spending in the current climate. For months, the coalition government has deliberated the introduction of a new economic stimulus package that would include income tax reductions. The Ministry of Finance has long resisted such tax cuts and argued that these should be paid for by an accompanying rise in the sales tax, which the socialists, the largest party in the coalition, are strongly opposed to. At the time of writing the package was still under discussion. It is not clear what the effect of the government plans will be on the economy. The package includes annual tax cuts of Y6,000bn in income and residence taxes for three years. The other Y9,100bn is for additional government spending and loans, including about Y3,000bn on public works.

Our forecast for the Japanese economy is set out in Table 9. We have changed our headline output measure for Japan from GNP to GDP, and this is now consistent with the other major economies. We forecast very modest growth for 1994, mainly due to increased government spending and a modest recovery of consumption. We are now much more pessimistic about business investment and expect this to fall for the third consecutive year, followed by a modest recovery next year. We also revised down our forecast of the stimulatory fiscal packages and we now expect less fiscal expenditure growth and less substantial tax cuts than we had assumed in earlier forecasts. Consumption growth will remain relatively low due to low income growth and rising unemployment. Inflation averaged 1.2 per cent in 1993. Import prices rose somewhat at the end of the year as the yen weakened slightly, but they were still 13 per cent down on a year previously. At the end of the year wholesale prices were more than 3 per cent down compared to a year ago. We expect consumer price inflation to fall further this year. Model simulations using our world model NiGEM suggest that after a 20 per cent appreciation of the yen, consumer prices fall as much as 2 per cent in two years. Although the yen appreciated by 20 per cent in the beginning of 1993, it has since then weakened somewhat and currently stands 17 per cent above its level a year ago in effective terms. We forecast that as a result of this, inflation will fall to around zero for this year and next year could be negative.

In the fourth quarter, exports fell by 3 per cent in volume terms, while imports grew by 1 per cent. This suggests that the appreciation of the yen has started to take its effect on Japan's trade position. However, we forecast no sharp fall in Japan's trade surplus for this year despite the loss in competitiveness. Japanese imports are depressed due to lack of demand at home, while stronger growth in the US will boost exports. This, in combination with continuing strong growth in China, currently Japan's second largest trading partner, means that export market growth can partly offset the negative effect of the loss of competitiveness in exports. We expect Japan's current account surplus to remain between 2 and 3 per cent of GDP for this year and 1995.

For the first year since 1986 the government probably ran a small deficit in 1993, at least as measured on a national accounts basis over a calendar year. This was largely due to cyclical factors, as lower growth reduced tax revenues. Although some significant fiscal packages have been announced over the last two years, these have to a large extent been front loading of existing plans, or merely spending growth in line with inflation. Given the uncertain political situation at the moment, it is hard to predict future spending. We expect to see a widening of the deficit to around 3 per cent this year if the planned tax cuts are implemented, as the current downturn will continue to depress tax revenues.

Germany

Real west German GDP is estimated to have fallen by 1.9 per cent in 1993. After a sharp fall of 1.6 per cent in the first quarter of the year, GDP grew by 0.6 per cent in both the second and third quarter. Although there are some signs of a further stagnation, it seems more likely that the current recovery has merely paused and will pick up this year.

Consumption stagnated last year, as a result of large falls in disposable incomes. After declining in the first half of the year, it picked up again in the second half. Total investment plummeted, largely due to a huge fall in business investment. Even construction, which held up relatively well in 1992, was affected by the recession and fell slightly last year. Exports were down as growth in Germany's main export markets slowed, but imports fell even more as a result of the fall in domestic demand. The recession is taking its toll on the labour market. The rate of unemployment had risen to 9.0 per cent by the end of 1993 and 2.5 million workers are now unemployed in the Western Lander. In addition, half a million people are on short time working as reduced working hours are introduced to avoid massive job losses. The rate of unemployment in the east has risen to over 16 per cent and almost 1.2 million people are out of work. In addition it is estimated that around 1.5 million people have retired early or are on training and job creation schemes. High unemployment has helped to keep wage demands down. A 2 per cent wage increase has been agreed in the chemical industry and while the main public sector union has demanded a 4 per cent pay increase, it is expected they will settle for less in return for some guarantee that new jobs will be created for the unemployed. IG Metall, the engineering workers' union, has demanded a 6 per cent rise, but it is expected that they will accept a lower offer. The employers, Gesamtmetall, have demanded a pay freeze and abolition of holiday pay, constituting a 10 per cent cut in costs. With rising productivity in many sectors, a slowdown in the increase of unit labour costs is required to improve the competitiveness of German firms.

Lower wage increases will also help to bring inflation down. Consumer price inflation fell to 3.4 per cent in January, despite a new surtax on petrol, after averaging 3.6 per cent in 1993, when it was buoyed up by higher charges for public services. Administered prices, such as public transport fares and rents in social housing, have increased sharply since 1992 and account for almost a third of total consumer price inflation. By the end of 1993 import prices were 1.3 per cent down on a year ago, while wholesale prices were unchanged.

It is widely expected that inflation will ease further in the course of 1994 and this may lead to a further relaxation of the Bundesbank's restrictive monetary policy. Inflation is the most important determinant in the bank's interest-rate policy and has prevented a reduction in official rates since the last cuts in October. In the course TABULAR DATA OMITTED of 1993, interest rates have fallen significantly from the high levels the year before, and the Bundesbank's repurchase rate fell more than 3 percentage points over the year. In the beginning of February the Bundesbank's council decided to keep its official rates unchanged after publication of money supply growth figures. In December M3 was 8.2 per cent higher than in the fourth quarter of 1992 and was thus well above the official target range of 4.5 to 6.5 per cent for 1993. The Council has set the target range for 1994 slightly lower at 4 to 6 per cent. Our interest-rate forecast is set out in detail in Table 3 above. We base our forecast on the current forward rates in money markets and these seem to have already discounted further interest-rate cuts this year.

TABULAR DATA OMITTED

Our forecast for west German GDP is set out in Table 11. This is based on published seasonally adjusted quarterly figures and could therefore differ slightly from some annual figures. We expect GDP to grow by around 1 per cent in 1994, despite a further fall in consumption. Consumers' spending will be depressed this year as disposable incomes will fall in real terms because of low wage settlements. Spending will be further hit by the introduction of the solidarity tax in 1995. A positive contribution from net exports will boost GDP further next year. Foreign demand is expected to grow and the recent depreciation of the D-Mark, as well as the reduced unit labour costs growth, should help to improve Germany's competitiveness. We are pessimistic about the prospects TABULAR DATA OMITTED for the labour market and foresee a higher rate of unemployment for this and next year of between 9 and 9.5 per cent.

The margin of uncertainty surrounding our trade forecast is somewhat larger than usual because of the introduction of the new method of collecting trade statistics, which are now based on VAT returns rather than customs documents. As a result of this, trade volumes data for 1993 are still somewhat uncertain. What has become clear is that the invisibles deficit continued to increase. We expect the deficit on services to widen and the deterioration in Germany's external assets position will mean an increasing deficit on investment revenue.

Our forecast for the German public sector finances is set out in Table 13. This shows the deficit on a national accounts basis and includes the social security fund. The deficit of the federal government rose to DM 67bn in 1993 or more than 2 per cent of GDP. Despite spending cuts totalling DM26bn for this year, the federal deficit is planned to remain at this level in 1994. The fiscal measures for this year include cuts in social spending, such as unemployment benefits, a public sector wage freeze and higher pension contributions. From January 1995, a 7.5 per cent surcharge will be levied on income taxes and this is expected to raise an additional DM26bn in tax revenues to be used to finance increased transfers to the eastern Lander. In January 1995, the government will have to take on the outstanding debts of the Treuhandanstalt and the GDR Debt Fund. As a result of this, we expect that the debt to GDP ratio will rise to over 60 per cent, the criterion mentioned in the Maastricht Treaty. The costs of servicing this debt will be a heavy burden on German public finances. We expect an only gradual reduction in the budget deficit to around 3 per cent of GDP in 1995.

France

Real GDP increased by 0.3 per cent in the third quarter of 1993 compared to only a 0.1 per cent increase in the second and considerable declines in the previous two quarters. The major expenditure categories causing this small expansion were consumers' expenditure and exports. The slowdown in the prolonged decline in investment also helped to support activity. Consumption increased by 0.7 per cent, the same as in the previous quarter, and exports grew by more than 2 per cent, a good performance given the depressed state of demand in Europe. Total investment fell only marginally in the third quarter, which is a substantial improvement on the 1 1/2 per cent decline in the previous quarter and 3 per cent fall in the first three months of 1993.

Preliminary data for the final quarter of 1993 suggest that the recovery is fragile. Industrial production was flat in October and November while manufacturing output declined over this period. Manufacturing production actually dropped by almost 2 per cent in the three months to November compared to a 0.2 per cent decline in the previous three months. As a result, capacity utilisation in the fourth quarter fell by 1/2 a percentage point to 80.2 per cent, the lowest level since 1986, and considerably below the peak of 86.3 per cent in the first half of 1990. In contrast, the rise in unemployment came to a halt in the final months of last year leaving it around 12 per cent.

The decline in activity in the the last quarter of 1993 was largely due to poor consumer demand. Car sales were particularly depressed and were 3.5 per cent lower than in the previous quarter. The government has now announced several measures designed to stimulate car sales. Household consumption of manufactured goods fell by almost 1 per cent in both October and November. Weak import growth and a rapidly deteriorating budget TABULAR DATA OMITTED deficit provide further evidence that demand was rather subdued in the fourth quarter of 1993. Hourly wage rates in manufacturing rose by 2.6 per cent in 1993 compared to 3.6 per cent the previous year. In contrast, consumer price inflation only dropped marginally from 2.3 per cent in 1992 to 2.0 per cent last year. High and rising unemployment has depressed wage settlements whereas the introduction of higher indirect taxes on petrol and alcohol in July 1993 has prevented a further deceleration in inflation. Although the revaluation of the franc, due to the ERM devaluations triggered by the events of September 1992, depressed prices somewhat, this has been partially reversed by a decline in the French effective exchange rate since April because of a depreciation of the franc against both the dollar and the yen.

The government has introduced several policy changes in response to the recession. First, a long-term plan to cut unemployment was announced in September. In order to create jobs for the young, employers will be allowed to pay 18-26 year olds 90 per cent of the minimum wage if training is provided. In addition, the state will compensate people taking on jobs which pay less than the unemployment benefit rate. Second, the government has announced its intention to reduce the budget deficit to 2 1/2 per cent of GDP by 1997. The draft 1994 Budget begins the process by concentrating on expenditure restraint. Government investment will fall sharply and civil servants' wages will only rise by around 5 per cent between 1993 and 1995. Future pension payments will also be cut and efficiency savings in the health care system will save about FF30bn. In an attempt to reduce the costs of high unemployment, the contribution to unemployment insurance has been increased along with some reductions in unemployment benefit. Government revenue will also benefit from a rise in privatisation receipts to FF55bn from FF43bn last year. In contrast, income tax reform will cut tax payments by about FF20bn which may indicate that the authorities are perhaps more concerned about economic recovery than the deficit.

Monetary policy has been eased since the height of currency turmoil in 1992, but the approach has been very cautious following the widening of the ERM bands to 15 per cent in August. However, short-term interest rates at the end of last year were 6 percentage points lower than in the first quarter of 1992. In contrast, long-term interest rates only fell by 2 1/2 percentage points over the same period.

Table 14 gives our forecast for French GDP. We expect the recovery to continue modestly this year but to accelerate next. GDP will probably only grow by around 1 per cent this year followed by around 2 1/2 per cent growth next year. Activity has received a major stimulus from fiscal expansion in addition to benefitting from the effects of interest-rate cuts. In contrast, although depressed external demand explains some of the slide into recession we do not see net exports providing a major source of growth over the short-term horizon.

In 1994 consumers' expenditure should respond to the cheaper borrowing costs and upward revaluations of wealth caused by the decline in interest rates. Furthermore, the upward trend in savings should be dampened by the stabilisation of the unemployment rate and the reduced return on savings. Real personal disposable income will also benefit from the effective cut in income tax. Hence we expect consumption to grow by around 1.5 per cent in 1994 and to accelerate next year as both TABULAR DATA OMITTED consumer confidence and employment begin to rise. However, we do not expect capital expenditure to rise this year. This is primarily due to very low levels of capacity utilisation, but long-term interest rates may not have fallen sufficiently to offset uncertainty over future output. Stronger growth next year will improve profitability and push capacity utilisation upwards thereby stimulating investment growth of around 4 per cent. Both earnings and consumer inflation will remain subdued given our projected unemployment rate of around 12 1/2 per cent for this year and next. Inflation should be around 2 per cent in 1994 and may fall slightly next year. Given that GDP growth will remain below potential over the short-term forecast we do not expect any rapid improvement in the fiscal deficit unless further expenditure cuts are announced for next year. Therefore, we are projecting budget deficits of around 6 per cent of GDP for the short term which will push up the government debt to GDP ratio to around 60 per cent.

It is difficult to forecast the French current account position given the new method of trade data collection following the completion of the EEC Single Market in January 1993. Table 15 shows that both import and export volumes declined substantially in 1993 indicating considerable falls in French internal and external demand. Obviously some decline in activity did occur but not to the degree suggested by the trade figures which are expected to be heavily revised in the near future. We are predicting that export volume growth will add to French production this year. This arises from renewed growth in major French export markets, such as Germany and Italy, as well as gains in competitiveness resulting from relatively low French inflation. However, imports will also grow strongly in response to the renewal of growth in activity, and the balance on services, particularly tourism, will deteriorate because of the effects of the high level of the franc. Given these factors we expect the French current account to register a surplus of around 1 per cent of GDP this year and stabilize around this level in the medium term.

Italy

We are forecasting that in 1993 Italy will have experienced negative growth for the first time since 1975 with a fall in Gross Domestic Product of 0.4 per cent. This continues the recession which began in the third quarter of 1992. Recent data for the third quarter of 1993 showed a fall of 0.5 per cent in GDP after an unexpected rise of 0.7 per cent in the second quarter. Only a strong performance by exports in 1993 overall, for example, 6.2 per cent growth in the first quarter, prevented a sharper decline in output. The price of Italy's exports fell sharply after leaving the European Exchange Rate Mechanism (ERM) in September 1992. Exports and imports both grew by about 1.5 per cent in the third quarter, however while exports are 8.2 per cent up on a year ago imports are 10 per cent down producing a predicted current account surplus of 0.1 per cent of GDP in 1993.

The weak growth in imports in the third quarter and falls earlier in 1993 reflect the weakness of domestic demand. This was initially prompted by a collapse in consumer and business confidence which began early in 1992: faced with cuts in real wages households began to reduce spending while firms reduced investment because of low expectations about future demand. Consumption in the third quarter was 1.9 per cent below the level a year previously. Consumption growth was flat in the third quarter after 4 successive negative growth rates averaging 0.5 per cent per quarter.

Investment fell by 1.8 per cent in the third quarter marking the seventh consecutive fall. While in the ERM firms faced weak demand for exports and this, along with lower consumer spending, meant that output prospects were bleak which initiated a decline in investment. The extent to which firms have reduced output is shown by the low level of capacity utilisation which has remained at 64-65 per cent since the third quarter in 1992, its lowest level for seven years and this is likely to exert a further retarding influence on investment. Firms have also been running down their stocks of goods to historically unprecedented levels. In the first three quarters of 1993 stock building was negative and in volume equalled 1.5 per cent of GDP over the same period.

Inflationary pressures remain weak within the Italian economy. Consumer prices grew by just over 1 per cent per quarter in 1993 while the growth in nominal wages has been even slower. The annual rate of inflation of consumer prices in the fourth quarter was just over 1 per cent while the hourly wage rate index increased by only 0.5 per cent. Wage increases are being restrained by a slack labour market with unemployment running at 10.2 per cent in the third quarter of 1993. Although domestic inflationary pressures are weak, the depreciation of the lira could put upward pressure on import prices, but increases have been lower than expected. It is suggested that foreign suppliers have been willing to lower their price in order to maintain market share in Italy. Domestic firms, facing weak demand, have also not fully increased prices in line with the price of imports, preferring instead to lower their profit margins.

With these excellent inflation prospects, both short and long-term interest rates continued to fall in the fourth quarter to around 8.7 per cent and 7.6 per cent respectively. The fall in interest rates will have a direct effect on public finances by lowering interest payments on the debt stock. The discount rate was cut to 8.5 per cent and the rate on fixed-term advances to 9.5 per cent in September TABULAR DATA OMITTED and again in October to 8 per cent and 9.5 per cent respectively. Expectations of future inflation are low but this does not entirely explain the fall in interest rates. The other major factor is a commitment by government to reduce not only the budget deficit but the debt stock itself. The government is tackling the problem on both fronts, for example, indirect taxes have recently been raised and spending is being cut, government consumption actually fell by 0.6 per cent in the 3rd quarter of 1993 and is projected by the OECD to remain flat throughout 1994.

Our forecast for 1994 is detailed in Table 16. We expect to see a modest export-led recovery of around 2.4 per cent growth in GDP with consumption recovering from a 1.6 per cent fall in 1993 to 0.8 per cent growth in 1994. We expect consumers to remain cautious and increase their savings rate to about 20 per cent in 1994. The savings rate has been rising since 1990-91 despite the recent falls in interest rates. Investment, which fell in 1993 by 8.7 per cent, should also recover in response to lower interest rates to show 0.7 per cent growth in 1994. The most important factor in the predicted recovery in 1994 is exports which are predicted to increase by around 8 per cent in 1994 on top of a 5.8 per cent increase in 1993.

The turnaround in Italy's trade performance is almost entirely due to the devaluation of the lira after leaving the ERM. Table 17 details recent data and our forecast for Italian trade. While export volumes are predicted to grow by 14 per cent in total over 1993 and 1994, market growth is only expected to be 5 per cent. Italy has increased its market share of exports by the change in its relative price of its exports.

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For 1993 we are forecasting a small current account surplus of around 0.1 per cent of GDP and in the long-run this surplus may settle down to around 3/4 of a per cent. We expect the improvement in Italy's fiscal position to continue with the government debt to GDP ratio peaking at around 110 per cent in 1994 and 1995 with a deficit of under 9 per cent. There is a risk that interest rates will have to be raised to reduce inflation which we forecast at 4.4 per cent for 1994. However, continuing high levels of unemployment will put downward pressure on wages.

Canada

The Canadian economy suffered more severely in the recent recession than did the US. Growth also began to recover somewhat after that in the US, and the strength of US imports has been a mainstay of the recovery. Indeed, net exports contributed around 3/4 of a per cent to GDP growth in both 1992 and 1993. However, not all of this gain is the result of strong market growth, as the Canadian dollar depreciated by over 10 per cent in effective terms between 1991 and 1993. The existence of spare capacity and high unemployment has prevented this devaluation from feeding strongly into domestic prices. However, as the economy recovers some inflationary pressures may emerge.

Output growth in 1992 and 1993 was below the growth of productive potential, and as a result unemployment rose from 8.1 per cent in 1990 to over 11 per cent in 1992 and 1993. Unemployment fell in the first quarter of 1993, but then rose again over the summer. In October and November employment grew by 0.8 per cent on average, and unemployment has fallen from its peak of 11.6 per cent to 11.2 per cent in December. However, the labour force has also shrunk slightly over this period, and the fall in unemployment has not been continuous. The high level of unemployment reflects the slow speed of recovery. Real GDP rose in each of the last four quarters, but growth was only 0.6 per cent in the fourth quarter after 0.9 per cent in the third, and GDP is only 3 per cent higher than a year previously.

Consumer spending was subdued with a 0.33 per cent increase in the fourth quarter reflecting low consumer confidence. This lack of confidence was also reflected in the housing market where residential investment fell by 2 per cent leaving the level 5.7 per cent down on the third quarter of 1992. This is in spite of the fact that mortgage rates have fallen to record lows with major lenders prepared to offer households one year interest rates of 5.75 per cent and five year rates of 7.25 per cent. This weak spending on housing investment is in contrast to the number of housing starts which rose by 3.1 per cent in November to 171,300 as opposed to a demographic demand of 200,000.

The business sector is more optimistic about output prospects and is taking advantage of low interest rates to initiate a pickup in investment with a growth rate of 2 per cent in the third quarter of 1993 following a similar rise in the second quarter. Ten year bond yields of 7.0 per cent are the lowest since the early-1970s and 3-month interest rates are at their lowest for 20 years.

The Liberal government clearly regards deficit reduction as its primary goal and although more weight is to be given to unemployment the inflation targets of 1-3 per cent are unlikely to come under pressure in 1994. The consumer price index (CPI) rose by 0.74 per cent in the fourth quarter of 1993 but this was largely driven by higher import prices since the implicit GDP deflator has remained largely unchanged. Unit labour costs were unchanged in the third quarter of 1993 and 2 per cent down on those in 1992 which reflects both a moderate growth in wages of 0.7 per cent in the third quarter and growth in productivity of 1.4 per cent. The prime minister, Jean Chretien, announced the government's legislative and fiscal agenda on January 18th. There will be a fiscal boost of 6 billion Canadian dollars TABULAR DATA OMITTED to fund a public works programme to improve infrastructure which is likely to create 120,000 jobs. The government is also concerned with the public debt equal to about 85 per cent of GDP in 1993 with a corresponding budget deficit ratio of about 7.5 per cent. Although spending targets were met in 1992/93 with higher than expected transfers to the provinces outweighed by reductions in expenditure elsewhere and lower debt charges via interest rates, the fiscal position in Canada has worsened due to lower than predicted revenues.

Our forecast for the Canadian economy is set out in Table 18. We expect that GDP growth will be 2 1/2 per cent in 1993, and it will rise to around 3 1/2 per cent in 1994 and 1995. We expect that both business and housing investment will grow moderately over this period, and unemployment will fall slightly. The slow nature of the recovery will keep inflation moderate in these two years, but as the economy returns to full capacity later in the decade some inflationary pressures will temporarily emerge. The Canadian government faces a major problem with its high stock of debt, but a combination of low interest rates along with the deficit reduction package recently announced should ensure that the deficit does not grow excessively. The depreciation of the Canadian dollar over the last two years, along with a strengthening US recovery, should mean that GDP growth exceeds domestic demand for at least the next two years, but eventually the rise in inflation that we are projecting will eat into the recently gained competitive advantage. The Canadian current balance is likely to stay in deficit despite a strong trade surplus because of the income payments to abroad associated with the large negative stock of overseas assets.

Spain

Recent data suggest that the Spanish recession came to an end in the middle of 1993. Real GDP grew marginally in the third quarter of 1993 after declining by 1 per cent over the previous 12 months. The recovery has been generated by the external sector which has benefited from the 20 per cent effective depreciation of the peseta that has taken place since August 1992. The gain in competitiveness has been associated with a 14 per cent increase in Spanish export volumes last year while import volumes have declined by more than 6 per cent. In contrast internal demand continued to decline. Both consumption and total investment fell in the third quarter and were respectively 2.5 per cent and 10 per cent lower than a year ago. The recession has put downward pressure on prices, which has not yet been offset by the inflationary impact of the devaluations. By the third quarter of last year consumer price inflation was about 1 percentage point lower than the previous year but average earnings growth remained high given that the TABULAR DATA OMITTED unemployment rate is now above 23 per cent. It seems that part of the high labour costs and import price rises have been absorbed by companies in the form of lower profit margins. Low profitability also probably accounts for some of the recent fall in capital expenditure.

The recession has caused the government budget deficit to deteriorate to around 7 per cent of GDP. This is in spite of restrictive budgets which have substantially increased both direct and indirect taxes. Public spending is also being curtailed, particularly defence expenditure, and increases in privatisation revenues are already planned. These measures will help reduce the structural deficit, but the cyclical part of the deficit accounts for most of the recent deterioration in government finances, and the latter will only be improved by higher activity.

Spanish short-term interest rates have come down from a peak of 14 per cent in the fourth quarter of 1992 to around 9 per cent. Long-term rates have also fallen by about 5 percentage points over this period. The forward markets indicate that 3-month interest rates will be more than a percentage point lower by the end of this year. This implies that monetary policy will become more independent of Germany in the near future as the Spanish authorities will probably put greater emphasis on reducing unemployment. We adopt this interest-rate profile for our forecast and in the longer run assume a 2 per cent interest-rate differential vis-a-vis Germany. Assuming that the open arbitrage condition holds we expect that the peseta will depreciate by 2 per cent per annum against the D-Mark in the medium term.

Table 19 shows that we are predicting GDP growth of around 2 per cent this year which is quite optimistic compared to other forecasters. The major source of growth is net trade. Our econometric model incorporates quite large competitiveness elasticities for both import and export volumes which take some time to feed through. As a consequence, we expect net trade to add about 2 per cent to GDP this year. Capital expenditure will probably decline by around 2 per cent and consumers' expenditure will remain fairly flat. The very low level of capacity utilisation, combined with weak profitability, will deter investment this year. If our forecast of an unemployment rate of around 24 per cent in 1993 is correct this will discourage consumption by reducing personal incomes and damaging consumer confidence. The increase in the number of people without jobs will cause a further deterioration in the budget deficit which may well exceed 8 per cent of GDP in 1994. We are projecting that inflation will fall to around 4 per cent this year largely as a result of a rapid slow-down in wage growth. Although high unemployment explains some of the wage moderation we have also assumed that some wage accord, or wage ceiling, will complement the virtual wage freeze in the public sector.

We expect that both consumption and investment will begin growing again next year in response to the recent and projected declines in interest rates. Investment will provide the largest boost to output whilst growth in consumption will be more sluggish than investment as high unemployment will continue to depress both incomes and confidence. Net trade should again add to GDP in 1995 as Spanish industry will retain its competitive advantage. Our assumption of a continued tough approach to public sector wages, which also helps to discipline the private sector, should continue to put downward pressure on wages in addition to the slackness of the labour market. It is likely that there may be a small increase in consumer price inflation as the final effects of the peseta devaluation feed through but we expect inflation to be subdued and it should be around 4 1/2 per cent next year. Wage inflation may also decelerate further if unemployment continues to rise in 1995.

Table 20 shows our forecast for Spain's current account. The effects of the devaluation are clear in terms of the strong growth in export volumes and considerable decline in import volumes in 1993. This combination of gains in competitiveness and weak domestic demand TABULAR DATA OMITTED resulted in an improvement in the current account deficit from 3 1/4 per cent to 2 1/2 per cent of GDP in 1993. We expect the improvement to continue both this year and next as a result of competitiveness gains and sluggish domestic activity. However, the devaluation will affect import price competitiveness more than relative export prices as Spanish exporters tend to follow competitors' prices as much as possible. The current account deficit as a per cent of GDP will probably improve by a percentage point in both 1994 and 1995.

NOTES

(1) The OECD estimates that the gap between current and capacity output in 1993 was 4.4 per cent in Japan and 0.6 per cent in Germany. See OECD Economic Outlook, no. 54. December 1993, p.2.

(2) There is, however, evidence that consumers look forward to some extent, and our work in this area is set out in Sefton and In't Veld (1994), 'Consumption and Wealth', and we also believe that, at least in Europe, nominal inertia is persuasive. The consequences for our policy advice are discussed in Barrell (1994), 'Solvency and Cycles'.

(3) See Barrell and In't Veld (1991) and National Institute Economic Review, November 1992 p. 42-43.

REFERENCES

Barrell, R. (forthcoming), 'Solvency and cycles', paper to be presented at the Royal Economic Society conference, Exeter, April 1994.

Barrell, R. and In't Veld, J.W. (1991), 'FEERs and the path to EMU', National Institute Economic Review, no. 137, August.

Sefton, J. and In't Veld, J.W. (forthcoming), 'Consumption and wealth', paper to be presented at the Royal Economic Society conference, Exeter, April 1994.