The world economy.

Barrell, R. ; Anderton, R. ; Vaughan, N. 等

The Overall Outlook

The OECD as a whole is experiencing below capacity growth for the third year in succession, and output in the EC and in Europe may actually fall this year after growing by less than 1 per cent in aggregate in 1992. Inflation in the OECD area has been falling since it reached a peak in 1990, and it should fall below 3 per cent this year. OECD output growth reached its peak in the late-1980s, and activity slowed first in North America, with the US entering recession in 1991. At this time demand remained strong in Europe, in part because of the stimulus imparted by German reunification. As a result the cycles in output in Europe and North America have been less coordinated than in the early-1980s. Overall activity began to slow down in Europe in 1991 and 1992. This slowdown in activity appears to be the consequence of tight monetary policy in the ERM, and strains began to emerge in the system.

The ERM saw a major realignment in September 1992 when speculative pressures forced the UK and Italy out of the system. Although it might have been possible to defend existing parities, the manifest economic problems in both economies, along with a lack of political will to take the painful measures necessary to maintain parities, combined to make the speculative pressures overwhelming. The subsequent adjustment of the operating rules of the ERM in the summer of 1993 appeared to signal the demise of the system, but it has had little effect on the pattern of exchange rates and interest rates. Although wide fluctuation bands were adopted they have not so far led to a particularly noticeable increase in the volatility of intra-European exchange rates, although this possibility cannot be ruled out. The pressures on the franc in the summer of 1993 stemmed in part from the rather hesitant behaviour of the newly elected French authorities in relation to both their fiscal plans and the nature of the potential privatisation programme, and also from the increasingly obvious problems facing the French economy. The prospects for growth in Europe now look even less good than they did three months ago, and there have been further revisions to forecasts for growth, especially in France. The authorities in that country have not followed the UK and loosened monetary policy independently of Germany, and hence so far they have not experienced a substantial devaluation.

The European problems that began to develop in 1991 and 1992 can be seen as largely the result of previously tight monetary policy, with high interest rates and the consequent high exchange rate causing the growth rate of output to slow down in Europe and to speed up in North America. The continuation of this policy has led to a situation where most Continental European countries appear to have entered a recession in 1993. The Japanese economy is enduring its lowest growth of the post restoration period, and output has fallen in recent quarters. The slowdown is in part the consequence of a sharp increase in the real exchange rate over the last year, and it has also been influenced by the monetary tightening that took place in 1990 and 1991. Overvalued exchange rates in Continental Europe and Japan imply undervalued exchange rates elsewhere, and hence they should not be a major cause of slow growth in the world economy.(1)

There can be many causes for an overvalued exchange rate, but they are frequently the result of high interest rates. In the early-1980s the US undertook a fiscal expansion, and the associated monetary policy raised interest rates, and hence the dollar appreciated. The overall impact on the world economy was expansionary. In the early-1990s German unification raised demand in that country, and the Bundesbank allowed interest rates to rise. The commitment to the ERM on the part of the other European countries meant that they also had to tighten their monetary policies, and the ECU appreciated. The overall effects of this tight monetary stance were probably contractionary for the world economy. It could be claimed that monetary policy in Europe is still inappropriately tight, and even in Japan real interest rates facing producers are still around 4-5 to 5-0 per cent. It may, however, be difficult to cut real rates further in Japan as nominal rates are currently very low, and producer prices are likely to continue to fall as a consequence of the recent appreciation of the yen.

As can be seen from Table 1 and from our UK Forecast chapter, growth in the English speaking world is likely to be considerably stronger than elsewhere in the OECD. This reflects the fact that the UK, the US, and Canada all entered the recession earlier and began to loosen their monetary policies somewhat earlier than either Japan or Continental Europe. Simulations using our world model, NiGEM, suggest that the effects of monetary policy feed through to activity only slowly, with the response being slowest in Japan. These differences depend upon the estimated structure of the model which in turn reflects the institutional structures of the economies concerned. Wealth appears to have a greater effect on consumption in the UK, the US and Canada(2) than elsewhere, in part because the personal sector has larger holdings of financial assets, and especially equities, than in Continental Europe. As a result monetary policy is a stronger tool in the former group of countries. Although interest rates TABULAR DATA OMITTED have continued to fall in Europe, we do not expect that the effects will be felt for a year or more, and further cuts in interest rates cannot be expected to be a major force for recovery before the end of 1994.

It is common to compare patterns across economic cycles, but we should be careful not to expect them to be similar. Different forces drive recoveries at different times, and private sector reactions to a given impulse may change over time as, for instance, balance sheets and liquidity constraints evolve. The recovery in the US in 1982 was helped by a strong fiscal impulse, whilst the recovery experienced in the early-1990s has largely driven the change in the budgetary position. A similar pattern emerges in Japan, where a gradually tightened fiscal stance has been a major factor behind the slowdown in activity. Recent fiscal packages in that country have been large, but the stimulatory content has not always been clear.

Prospects for inflation appear to be good. The recovery in the US has until now not been excessively rapid, and so far the authorities have made it clear that they will raise interest rates as soon as is necessary. If this pattern is continued then we believe that inflation is unlikely to rise much above 3 per cent in the next few years. The Japanese appreciation has cut imported costs and, as a result, producer prices have been falling. Labour markets have also been slack and, as a consequence of these factors, consumer price inflation is likely to be about 1 per cent a year for several years. We are projecting that German monetary policy will continue to dictate events in much of Europe, even if the formation of a monetary union is somewhat delayed. As a consequence we expect that inflation in the core European countries is unlikely to rise above its recent peak, and our model based forecasts indicate that it should fall in the medium term. We expect that inflation in Italy and some of the other peripheral countries will remain above German levels for the foreseeable future.

Interest Rates and Exchange Rates

The rather stately progress towards monetary union in Europe seems to have been set back lately by speculative pressures that were in part driven by sustained real misalignments. However, the move to wide fluctuation bands in the ERM has not as yet been accompanied by a significant change in monetary policy. Short-term interest rates have fallen less in France than we anticipated in August, whilst they have fallen marginally more than we expected in Germany. The franc-D-Mark parity has not altered very much in the last few months, although it is now below the bottom of the old band. The Bank of France appears to be committed to a relatively fixed franc-D-Mark parity and, as can be seen from Table 2, we expect that they will continue to be relatively successful in achieving this aim, and hence we do not expect a major realignment in the foreseeable future.

Our central exchange-rate forecast depends in part on our projections for interest rates, and these are given in Table 3. Forward markets had been suggesting that short-term interest rates outside of North America would fall in the third and fourth quarters, and they have done so. Short rates in the US, Germany and especially Japan are now very slightly lower than we had anticipated in August, whilst long-term rates have fallen everywhere rather more than we had been expecting. The last few months appear to have seen a major revision to expectations of the prospects for short-term interest rates over the medium term. As we can see no major event causing a revision to projections of the medium-term real rate of return to capital we can only surmise that there have been downward revisions to expectations of the average rate of inflation over the medium term. We have reduced our projection for short rates in 1997 by around 0.3 per cent, TABULAR DATA OMITTED TABULAR DATA OMITTED TABULAR DATA OMITTED reflecting almost fully the fall in long-term rates in the US. However, the prospects for slower growth in Europe over the next two years has led to larger falls in long rates, and we believe that there are now further substantial reductions in short rates to come in Europe in the next six months.

Our forecast for real exchange rates is given in Table 4. The last two years have seen substantial real appreciations of both the yen and D-Mark real exchange rates. We have argued in a number of places that these currencies were below their Fundamental Equilibrium Exchange Rates for much of the 1980s(3) and the recent appreciations are likely to be sustained for some time. The undervaluation of exchange rates leads to the accumulation of foreign assets, and hence national wealth rises. Eventually the accumulation of wealth raises domestic spending, putting upward pressure on prices and eventually removing the undervaluation. This process is likely to be extended, and the undervaluations of the yen and the D-Mark would have been removed only slowly by market forces, especially given the inflation aversion displayed by the authorities in both countries. A rapid change in the exchange rate removes the problem, but requires a major shift of productive resources away from orientation to foreign markets. We are forecasting that real exchange rates will stay at around their current levels for the next few years, reflecting both our belief that Germany and perhaps Japan are closer to their FEERs and the fact that the appreciations do not set off significant deflationary pressures on our model.(4)

World Trade and Commodity Prices

Trade growth normally declines significantly during recessions, yet over the last three years it appears to have been remarkably strong. The North American Free Trade Agreement raised trade on that Continent, and strengthening links between China and Japan have also led to strong trade growth. Trade within Europe has been, however, rather weaker than overall trade, and this weakness may well have been increased in the last nine months. However, underlying trends may have been obscured by changes to the method of collecting statistics. All the countries of the EC moved over to a new method of collecting intra-EC trade statistics based on VAT returns rather than on Customs documents. In the first half of 1993 it appears that imports into France fell by 5 1/2 per cent compared to the same period in the previous year whilst German imports fell by 9 per cent. Chart 1 plots the growth of European exports in the last eighteen months, whilst Chart 2 does the same for imports. Falls of this magnitude could reflect a major downturn in economic activity in Europe, or they could just be a consequence of the new recording system.

In order to construct our forecast of trade and GDP in Europe we have to be able to judge the proportion of signal to noise in the new trade statistics. Our estimated trade equations suggest that recorded trade is unexpectedly low. However, if we have reached a genuine turning point then it is not useful to judge the accuracy of the statistics by inspecting the residuals on estimated trade equations. These could be off track either because there are problems with the data or because established relationships have changed. Although opinion is divided on the quality of the statistics there is some anecdotal evidence that trade volumes have genuinely fallen, and we have taken this on board in our forecast. It fortunately has less effect in a model based forecast of the world than might be anticipated. If both exports and imports fall everywhere then GDP is generally unaffected, and hence our output forecast will be unchanged. However, in Europe imports have fallen more than exports, suggesting a genuine decline in the rate of growth of economic activity.

There are a number of reasons why the new recording system could change trade statistics; some of them would suggest a change in the recorded level of trade, some would change the value-volume split, and some would change the timing of records of trade. The new recording system would reduce recorded trade for at least two reasons. First, entrepot trade between, say, London and Rotterdam would have previously entered the trade statistics, but it would not enter VAT returns in both countries. Second, small firms do not have to enter VAT returns if they are below the VAT threshold, and although some allowance can be made for this omission it may well reduce the level of recorded trade. This effect will also vary between countries as the VAT threshold is not the same everywhere. It is also suggested that importers are generally smaller firms than are exporters, and hence more imports than exports will have dropped below the palisade. This could indeed help explain the more marked drop in imports than exports throughout Europe. VAT returns are based on invoices, but it is common practice for importers to make their returns when they pay invoices, whilst exporters make them when they issue the invoice. If this is the major factor behind the decline in recorded trade then it not only explains why imports have dropped more than exports but also suggests that, as returns are made, recorded trade will rise back towards historical levels. It does not yet appear to be possible to quantify any of these explanations at present. Table 1 contains our forecast for world trade, and we are now expecting recorded trade in manufactures between the OECD countries to display a decline in 1993, but to recover relatively strongly thereafter. This recovery reflects our view that some of the downturn is the consequence of unanticipated changes in the recording of trade within Europe. Overall world trade growth is expected to slow down. This reflects both problems in Europe and the very weak state of demand in Japan, which will cut trade with China and the Pacific Rim. However, overall world trade should still be supported by growth in the LDCs, and we expect it to recover into 1994.

The weak state of demand in Europe and Japan is reflected in recent commodity prices. Our forecast of commodity prices is given in Table 5, and the Institute's indices of commodity prices are plotted in Chart 3. Developing country food prices have been weak, despite some strength in coffee prices, whilst developed country food prices have been relatively stable. Floods in the mid-West of the US have caused some shortfall in the coarse grain harvest, and soy-meal supplies have dropped. Soybean prices rose by 25 per cent in the first week of August, but the floods have had less effect on output than had been initially anticipated. However, weak demand has keep prices moderate. Metals prices have been depressed by exports from the former Soviet Union, which has meant that the growth in demand in TABULAR DATA OMITTED China and the Far East has not been sufficient to offset falling demand from elsewhere. Aluminum prices are only 40 per cent of their 1988 level, and inventories are high. The London Metal Exchange experienced a speculative bubble in the copper market in August. Prices rose from around $1,600 a tonne in early July to almost $3,000 in late August. Since then they have fallen back, but remain above levels seen earlier in the year. However, as can be seen from the chart, overall metals prices remain weak. Our forecast suggests that commodity prices will fall in dollar terms in the short run, and in the longer term real prices will continue to fall.

United States

The US recovery gathered strength in the third quarter. Real GDP grew by 0.7 per cent compared with 0.5 per cent in the second quarter and 0.2 per cent in the first. Without the negative impact of the recent flooding in the mid-West, growth would have been closer to 1 per cent in the last quarter. Consumers' expenditure grew by just above 1 per cent in the third quarter compared to 0.9 per cent in the second and 0.2 per cent in the first. Spending grew faster than incomes and the savings ratio fell to 3.7 per cent from almost 4.5 per cent in the second quarter. Total real investment rose by just over 1 per cent in the third quarter. Investment growth was dominated by the more interest-rate sensitive categories such as housing investment and producers' durable equipment investment. Both categories grew by around 2.5 per cent in the third quarter. The major negative contribution to real GDP in the third quarter was net exports of goods and services which registered the largest deficit for five years. Export volumes declined slightly in the third quarter, reflecting weakening world demand, whereas import volumes increased as the recovery in US demand continued.

The unemployment rate was 6.7 per cent in September compared with 7.0 per cent in June. The downwards trend in unemployment from 7.5 per cent in 1992 can be accounted for by fairly strong non-agricultural employment growth. Most of the recent growth in jobs has been in the service sector, but overtime working and average weekly hours are also reaching high levels in manufacturing, suggesting that recovery in industrial employment may soon occur. The recent growth in employment and output has not pushed up consumer price inflation, which fell slightly in September to an annual rate of 2.7 per cent. This partly reflects strong productivity growth in the first half of this year which has not yet been reflected in average earnings.

Futures markets imply a path of rising short-term interest rates, and this is embodied in our forecast and its effects are reflected in Table 6. We expect GDP to grow by less than 3 per cent this year and next and then slow thereafter as short rates gradually rise. Although we are expecting strong domestic demand in the fourth quarter of this year, external demand will be subdued and net exports will make a negative contribution to GDP in the last quarter of 1993. Demand will also be adversely affected by fiscal policy next year. The finally agreed deficit reduction package will reduce demand by approximately 26 billion dollars with higher taxes and lower spending. In addition, given that the household savings ratio is already low, we do not expect consumption to provide a major stimulus to growth next year. External demand will also remain fairly subdued in 1994. We believe that strong profits growth, due to the good productivity performance, should encourage some investment growth in 1994 in spite of the expected rise in interest rates. Moreover, the predicted monetary tightening will still leave real interest rates close to zero.

Our forecast for the US balance of payments is given in Table 7. The current balance deficit is steadily deteriorating as US demand recovers. The visible trade deficit widened to 96 billion dollars last year even though GDP was not growing more rapidly than potential. Strong growth this year will probably result in a further deterioration to over 130 billion dollars. However, the current balance deficit will be reduced by the large surplus on TABULAR DATA OMITTED trade in services and will probably be of the order of 1.5 per cent of GDP. Our forecast of a rising dollar, in line with interest-rate differentials, will reduce competitiveness in 1994, but this will be offset somewhat by the relatively low growth of US unit labour costs. However, demand effects, particularly among the import sensitive expenditure categories of consumption and investment, will once again dominate and we expect the deficit to increase to almost 2 per cent of GDP next year.

In contrast to the trade deficit, the Federal budget deficit is improving in line with the recovery. The deficit TABULAR DATA OMITTED for fiscal year 92/93 was 255 billion dollars compared with 290 billion in the previous year. This is due to a period of sustained lower interest rates and lower defence expenditure in addition to falling unemployment. The prospects for the future deficit are also improved now that President Clinton's deficit reduction package has been passed by Congress. (The effects of this package were analysed using our model in the February 1993 Institute Review where we demonstrated that the package would have a negative impact on growth.) However, this makes little difference to our forecast compared to TABULAR DATA OMITTED August, as we previously assumed that the fiscal package would be successfully implemented.

Table 8 shows the Federal deficit on a calendar basis. After peaking in 1992 at about 4.5 per cent of GDP, we expect the deficit to decline by around 1 per cent over both 1993 and 1994. In the longer term we expect that the deficit will settle to around 1.5 per cent of GDP. The combination of low private and public sector savings partially explains the external imbalance and the upward pressure on interest rates.

Japan

Real GNP fell by 0.5 per cent in the second quarter of the year after rising by 0.5 per cent in the first quarter. The signs are that the current downturn is deeper and much more prolonged than was initially envisaged. The Japanese economy grew by 1.5 per cent in 1992, which was the slowest growth rate since 1974, but the prospects for this year are even bleaker. In the second quarter both consumer spending and total investment fell, by 0.6 and 0 per cent respectively. Business investment continued to decline and fell by 3.7 per cent.

The Bank of Japan's quarterly survey showed business confidence falling to the lowest level since 1975 with expectations for the fourth quarter worsening. However, the index of leading indicators provides no clear evidence of a further contraction in the next half year or an expansion thereafter. Retail sales in department stores and supermarkets continue to fall and were 3.7 per cent lower than a year ago, as consumer confidence is depressed by lower incomes growth and higher unemployment. The economic downturn has reduced wage growth and both over-time working and bonus payments have declined.

For this year wage increases agreed in the annual wage negotiations are expected to average 3.5-4.0 per cent. This would be a further decline from the 4.9 per cent increase in 1992, which was the smallest for many years. But more importantly, there has been a considerable cut in bonus payments, which are traditionally a significant component of total earnings in Japan. Bonuses fell this summer for the first time in ten years. In September the unemployment rate rose to 2.6 per cent. Although this may seem low by international standards, it represents a 5-year high. This official figure is not comparable to that in other countries as institutions differ significantly. In particular, many employees are guaranteed lifetime employment by Japanese firms and this leads to a significant reduction in the volatility of unemployment.

In September the Bank of Japan responded to the worsening economic situation with a reduction in the official discount rate of 3/4 of a percentage point to 1.75 per cent. This cut should not only be beneficial in boosting the sluggish economy but it should also help to curb the strength of the yen, which has appreciated by 15 per cent in dollar terms in the last twelve months. One of the effects of the strength of the yen is that it has reinforced the process of disinflation. Import prices have fallen by more than 15 per cent in the last year, and this has been reflected in a fall in wholesale prices, which are now 3.7 per cent lower than a year ago. Consumer price inflation stands currently at 1.4 per cent, but is expected to fall gradually over the next few months when the delayed effects of the appreciation feed through in consumer prices.

Our forecast for GNP is set out in Table 9. We are now more pessimistic about the Japanese economy and expect virtually no economic growth this year. This is reflected TABULAR DATA OMITTED in all expenditure components of GNP, with a large fall occurring in investment in machinery and equipment. That will mean that for the first time since the recession at the beginning of the 1970s, business investment will have fallen in two consecutive years. Reduced wage rises and bonuses and rising unemployment have made people more cautious about spending and we expect no strong growth in consumption. The only boost can come from government investment, as the delayed investment plans announced in earlier fiscal packages slowly come through. The prospects for a recovery next year look bleak as by then the delayed effects of the appreciation of the yen will have taken an effect on exports.

So far, the appreciation of the yen has not had the desired effect of reducing Japan's current account surplus. The trade surplus in dollar terms is still rising as the dollar value of exports has been boosted by the appreciation of the yen. In addition there has been strong growth in Japan's export markets in the Far East, in particular in China. On the other hand, imports have been depressed by lower domestic demand. But in yen terms the rise in the trade surplus seems to have come to a halt. Our forecast for Japanese trade is set out in Table 10. We expect export volumes to fall by 1 per cent next year, mainly as a result of the delayed effects of the 15 per cent appreciation of the yen in dollar terms. Despite the worsening of Japan's competitiveness and the expected fall in the trade surplus, there is still concern that the high trade surplus will exacerbate trade friction with the US and the EC. It is unlikely that Japan's trading partners will reduce the pressure on Japan to open up its domestic market to foreign imports and remove some of its trade barriers.

In September, the new coalition government announced a new fiscal package of Y6,000 bn. The main features of the plan are additional spending on public works, expansion of housing loans and loans to small firms and many new deregulatory measures and investment tax credits. Most of these measures will not be implemented until next year. This latest package was widely considered to be disappointing as it did not include a reduction in tax rates. It is the second stimulatory package that has been announced this fiscal year, as it follows the Y13,200 bn package that was presented by the LDP government in April. These packages supplement the 0.2 per cent increase in government expenditure that was budgeted for the fiscal year 1993/94, starting in April, which was the smallest planned increase for six years.

The experience with earlier stimulatory packages has been rather disappointing. The actual stimulating effect of the extra spending is highly uncertain. A large proportion of the plans are not really new spending, but loans or expenditure growth in line with inflation. These packages are announced by politicians, but are subsequently trimmed heavily by the Ministry of Finance. There is considerable pressure from other countries to give a real boost to domestic demand. The coalition government is divided on the use of tax cuts, and has appointed an official panel to study a general reform of TABULAR DATA OMITTED the tax system. Japan's public finances are, by international comparison, in a healthy state. The forecast deterioration in the position of the public sector should still leave the economy with only a very small overall public sector deficit.

Germany

West German real GDP rose by 1/2 per cent in the second quarter of 1993. It is unlikely that this small increase signalled the beginning of a recovery. GDP fell by 1.6 per cent in the first quarter and the upturn in the second quarter was entirely due to increased stockbuilding. This may indeed be a sign of unexpectedly low demand as all other components of GDP fell further in the second quarter. Consumption declined by 0.4 per cent, while total investment fell by 3.8 per cent, as investment in machinery and equipment fell by more than 5 per cent. Exports of goods and services were depressed by a stronger D-Mark and fell by 2.1 per cent, but imports fell even further as domestic demand weakened.

Capacity utilisation in manufacturing has fallen sharply and is now the lowest for over eight years. Domestic orders have dropped as domestic demand has weakened, while export orders have been depressed by slower growth in Germany's export markets as well as by a loss of competitiveness after the strengthening of the D-Mark. In the first half of this year, sales fell sharply, due to the increase in VAT in January 1993. Since then sales have recovered slightly, but in the absence of a significant boost to consumption, they are not expected to pick up rapidly as real incomes growth has declined, due to lower wage increases and persistently high consumer price inflation.

Unemployment in west Germany rose to 2.38 million in September, and the rate of unemployment is now, at 8.6 per cent, the highest since 1988. Many large companies have announced big job cuts, whilst others have introduced shorter working hours and longer holidays. The number of people on short-rime working in west Germany has increased again to 600,000 in September. Moreover, half a million people are on job creation or training schemes. The rise in unemployment has reduced wage pressure, and wage inflation is beginning to moderate. The two largest public sector unions accepted a 3 per cent wage rise for 1993. The demands of the IG Metall engineering union for a 6 per cent pay increase and a freeze on job cuts have been rejected by the employers.

In east Germany, unemployment rose in the third quarter to 16 per cent of the workforce, and 1.16 million people are now out of work. These figures do not reflect the true situation of the east German labour market. It is estimated that the unemployment rate would be closer to 35 per cent when all people who have retired early, or are employed on training and job creation schemes, were included in the figure. With subsidies removed, east German firms can hardly compete with western companies as productivity in the east is much lower. A contract agreed in 1991 to raise wages to west German levels by April 1994 was renegotiated as employers claimed that such a large wage increase would be disastrous for the restructuring process in the eastern Lander. As a compromise a smaller wage increase was agreed with the unions and the v|cents~age parity with the west was postponed until 1996. Current pay rises average 15 per cent and far exceed what could be justified in terms of productivity. Inflation in the east is currently around 9 per cent.

The headline figure for inflation in the west has fallen slightly over the last months to 3.9 per cent in October. Wholesale prices were 0.5 per cent lower than a year ago in September. The fall in producer prices and wholesale prices reflects weakening domestic demand pressure and falling import prices. Despite these price falls, consumer prices continue to rise due to increases in services prices and in rents. Moreover, it is estimated that over a third of the rise in consumer prices is based on state-induced inflation. There have been sharp price rises for services whose prices are administered by public bodies, such as charges for public transport, postal charges, and prescription charges.

The Bundesbank has cut its official interest rates gradually over the last months. On October 22nd, the Bundesbank lowered its discount rate by 0.5 of a percentage point to 5.75 per cent and its Lombard rate to 6.75 per cent. This was the second cut in a relatively short period of time as on September 10th the Bank had also lowered its official rates by 0.5 points. By the end of October the repurchase rate had fallen to 6.4 per cent. It has come down more than 3 per cent since September last TABULAR DATA OMITTED year, when it reached its record high of 9.7 per cent. As the prospects for a recovery look bleak, the Bundesbank may well decide to reduce rates further in the medium term. Money supply growth (M3) has fallen to 6.8 per cent, and moved closer to the target range of 4.5-6.5 per cent for 1993. During the summer months the Bundesbank had been obliged to intervene on behalf of its partners in the ERM and these interventions led to an increase in liquidity into the market. Since then M3 growth has slowed, and now further massive interventions have become highly unlikely, money supply growth could move closer to the target range again. Our forecast for interest rates is shown in Table 3. We expect interest rates to come down slowly in the next half year to around 5 per cent by mid-1994. Long-term interest rates have fallen considerably over the last months.

Our forecast for (west) German GDP is set out in Table 11. We expect GDP to fall by 2 per cent this year. The largest fall is in investment. Consumers' spending is also set to fall as real personal disposable income has declined, due to inflation exceeding incomes growth. For 1994, we expect no strong recovery with GDP growing by only 1 1/2 per cent. Various tax increases and higher charges for public services will depress the purchasing power of consumers. In addition, the government has announced sharp cuts in social spending and unemployment benefits as well as a public sector pay freeze, and this makes a strong recovery highly unlikely. We expect domestic demand to remain weak in the coming years as consumer spending will be adversely affected by the reimposition of the solidarity surcharge on income tax of 7.5 per cent in 1995.

Germany's trade account has shown a small improvement this year. Exports of goods and services have fallen, TABULAR DATA OMITTED but imports have fallen more due to the weakening of domestic demand. It seems that the effects of the strengthening of the D-Mark against most other European currencies has been partly mitigated by a depreciation against the dollar. As this trend has recently been reversed, German exports have become less competitive and this is likely to depress exports further. Table 12 shows our forecast for German trade. There has been a continuing trend towards a widening of the deficit on services. In addition, Germany's overseas assets position has been eroded by recent current balance deficits. We expect the current account deficit to be around 1 per cent of GDP this year and foresee only a small improvement next year.

The budget deficit of the federal government is expected to rise from D-Mark 39 bn in 1992 to D-Mark 70 bn in this year, whilst the total public sector deficit will be close to D-Mark 160 bn. When one includes the deficits of the Treuhandanstalt, and public companies such as the railways and the Post Office, the total deficit is around D-Mark 230 bn, or 7.5 per cent of GDP. The government is facing a sharp increase in the costs of servicing the growing debt stock. Government debt has risen to almost 50 per cent of GDP, with the vast bulk of the new debt attributable to the enormous budgetary burden deriving from German unification. The debt will exceed D-Mark 2,000 bn, over 60 per cent, by 1995 when the government must take on the debt of the of the Treuhandanstalt and the former GDR. This will lead to higher interest payments and become an additional burden on the public finances. The share of interest expenditure in total spending is likely to increase from 11 per cent in 1989 to 16 per cent in 1994, and it is expected to reach 23 per cent in 1997.

Our forecast, set out in Table 13, shows the total public sector deficit, on a national account basis and including the social security funds. With tax revenues adversely affected by the recession, we expect no significant improvement in the total deficit next year despite the numerous spending cuts. The government has announced more spending cuts for 1995 and 1996, and various tax increases have been proposed. One of the measures included in the 'solidarity pact' with employers and trade unions was the reintroduction of the solidarity surcharge of 7.5 per cent on income tax and increased wealth taxes from January 1995. All these measures will reduce the growth prospects for the German economy in the medium term even further.

TABULAR DATA OMITTED

France

Although real GDP fell in the second quarter of 1993 it declined only marginally compared with the 0.7 per cent and 0.3 per cent falls of the previous two quarters. Both consumers' expenditure and exports grew slightly after falling in the previous quarter. In contrast, investment has declined in every quarter for the past two years, but only by just over 1 per cent in the second quarter compared with almost 3.5 per cent in the first quarter. A considerable amount of de-stocking in the first half of the year has also played a considerable part in the downturn. In the second quarter business investment declined by almost 2 per cent but this was a substantial deceleration compared with a 5 per cent fall in the previous quarter. Residential investment fell by around 0.5 per cent in the second quarter after a 2.5 per cent decline in the first. The widening of the ERM fluctuation bands to 15 per cent (from 2.5 per cent) has given the authorities room to relax monetary policy. However, the decline in short-term interest rates has generally followed German rates. The latest reduction was the 0.5 per cent cut in the repurchase rate to 7.25 per cent in the latter part of October. This cautious approach seems to have persuaded the financial markets that the French authorities are still determined to maintain the value of the franc. Hence, partly as a result, the franc has only fallen by about 2.5 per cent relative to its previous floor against the D-Mark.

The government budget deficit is still deteriorating. The rapid rise in unemployment has obviously increased state benefit payments and both corporate and private sector tax revenues have been depressed by low or falling activity. The deficit would have been considerably larger without the estimated privatisation receipts of around 350 billion in both this year and next. The deficit for this year will probably be around 350 billion francs with only a small improvement expected in 1994. In May a deficit reduction package was announced which consisted of increases in both indirect and direct taxes in addition to spending cuts. The unemployment rate has risen by 1.3 per cent over the last year to 11.7 per cent in August. Redundancies for prime-age workers are 33 per cent higher than a year ago. However, the slack labour market has had an effect on earnings. Hourly wage rates in manufacturing in the second quarter were 2.6 per cent higher than a year ago, considerably less than the 3.4 per cent of the first quarter.

The French authorities clearly feel that they have more scope to stimulate activity via monetary policy than any further loosening of fiscal policy. However, this depends on the future path of German interest rates as France will probably not allow any further depreciation of the franc. The forward short-term interest rate suggests that three-month rates will have fallen to aroused 5-5.5 per cent by the end of next year. Although we expect that most of this decline will occur over the next six months, the opportunities for further cuts this year are limited. Apart from the automatic stabilisers, we do not expect that government spending will be used to stimulate activity because of worries about the growing size of the public sector deficit. There is little evidence that the private sector could lead a recovery in the near future. Both confidence and expectations will play a large part in determining the response of both consumption and investment to past, and anticipated, declines in interest rates. The inexorable rise in unemployment will dissuade those in employment from spending. Excess capacity in the French production industries will also put downward pressure on TABULAR DATA OMITTED investment. The prospects for French GDP and its components are summarised in Table 14. We are now more pessimistic about growth for both this year and next than we were in August. Both domestic and, more recently, external demand have deteriorated. The former has been adversely affected by high real interest rates and the latter has been depressed by the effective appreciation of the franc and the decline in German activity. The combination of these will result in approximately a 1 per cent decline in GDP this year followed by a subdued recovery in 1994.

The major expenditure category driving the recession this year is our predicted fall in all investment. Profit margins have been squeezed as domestic producers have tried to remain competitive after the franc appreciation reduced the price of foreign goods, and this may have reduced investment. However, our predicted interest rate reductions should cause investment to grow in 1994 for TABULAR DATA OMITTED the first time in almost two and a half years. The path of interest rates and wage inflation over the forecast period imply that the relative cost of capital will remain fairly high, and hence we cannot expect strong investment growth. We are expecting consumption to grow by around 1/2 per cent this year which is a little slower than real personal disposable income. Slower growth would have been likely if not for the lagged effects of wealth revaluations arising from the recent period of falling interest rates.

Both the continued rise in unemployment and its high level will keep wage inflation around 4-5 per cent for 1993 and next year. Consumer price inflation will be further restrained over this period due to a deceleration in import prices and the implied squeeze on profit margins. The relatively low inflation performance will offset some of the adverse effects of the franc appreciation upon competitiveness. In addition, the strength of the French recession will offset some of the effects of lower external demand upon net trade. Hence, export and import volumes will probably fall by similar amounts this year. Given the higher franc a small J-curve effect may also help improve the current balance. As Table 15 shows, we expect a current balance surplus of around 3/4-1 per cent of GDP in both 1993 and 1994. Both exports and imports should recover strongly next year.

Italy

Despite the depreciation of the lira the growth in the Italian economy has slowed. In the second quarter real GDP growth was 0.7 per cent, helped by a strong growth in exports of 5 per cent. Although imports increased by 3.5 per cent this follows a fall of 12.8 per cent in the first quarter whereas exports only fell by 2.5 per cent in the same period. Investment continues to fall, but the rate is slowing, with a fall of 1.5 per cent in the second quarter following 4 per cent in the first quarter. It is likely that industry, showing a fall in production of 3 per cent, is waiting for an improvement in domestic demand, which grew by only 0.5 per cent, to take up spare capacity before undertaking any new investment. Consumption remained unchanged in the second quarter reflecting a lack of consumer confidence prompted by a high rate of unemployment.

Despite growing unemployment the government recently announced a tough austerity budget for 1994 with plans to reduce spending and restrain any growth in the government debt. Specific measures include total spending cuts of L27.2 trillion with planned reductions in budgets by 3 per cent for every ministry with the TABULAR DATA OMITTED possibility of further cuts especially in health, welfare and education. A freeze on civil service recruitment has been imposed and government departments are to be rationalised and given performance targets.

An important factor in reducing the government deficit is the recent fall in short-term interest rates. In Italy over 80 per cent of public debt is held in 3-month bills. We estimate that a 1 per cent cut in short-term rates reduces the public sector borrowing requirement by approximately L15,000 bn which is around 1 per cent of GDP.

Inflationary pressures remain low despite the depreciation of the lira and it is expected that the effect of higher import prices will continue to be mitigated by a fall in profit margins. Recent data on prices for the third quarter show wholesale prices rising by 6.5 per cent but this increase in costs was not passed fully on to the consumer since consumer prices only rose by 4.4 per cent. A wage agreement reached in July this year between the government, employers and unions restricts wage increases over the next four years to the projected inflation rate. Any additional wage increases will also be linked to improvements in productivity. Currently hourly wage settlements are running at just 3 per cent per annum and this, along with continued high unemployment should keep inflation to around 5 1/2 per cent in 1994.

Faced with weak domestic demand and the recent collapse in investment, Italian industry has been calling for further interest rate cuts, even though the discount rate was cut to 8 per cent in October, its lowest level since 1976. The effects of recent falls in market interest rates on investment by companies in the private sector have TABULAR DATA OMITTED been rather small, as borrowing costs facing the private sector have been little affected. The discount on government borrowing has recently increased with the political and institutional changes which have lent the government more creditability. The depreciation of the lira and the accompanying exchange rate independence has allowed Italian short-term rates to fall considerably over 1993. This reduction in short rates will only be maintained if the government can maintain a tight fiscal policy which, at present, is realistic and attainable. It is unlikely that short-term interest rates will have to be raised to defend the lira as long as Italy's strong growth in exports continues.

The prospects for recovery lie with with the continued growth in exports initiated by the devaluation and a pickup in private sector industrial investment commensurate with the falls in interest rates. Capacity utilisation has been at the lowest level for seven years, and this along with high interest rates, were the main reasons for the sharp fall in investment over 1993. In the first half of this year exports were already up 10.7 per cent on the fourth quarter of 1992 while imports have fallen by 1 per cent. The 20 per cent devaluation of the lira impacted on revenues immediately leading to a short-term decrease in the current account, but export volumes have been unusually quick to increase, and this should lead to a prolonged increase in the current account balance through 1994. Growth prospects for 1993 have been revised firmly downwards with little or no change in GDP now expected. Although the depreciation has helped to produce a strong export performance, these gains are more than offset by weak domestic demand, which is primarily due to a projected fall in investment along with depressed private consumption. Looking ahead to 1994 we expect reasonable growth in GDP with a recovery in investment, fuelled by lower interest rates. We believe that consumers will remain cautious with the proposed new government policies coming into force and, combined with high unemployment, this will mean that consumption will remain weak.

Canada

After an extended downturn the economic recovery has got firmly under way with real GDP growth of 0.9 per cent in the second quarter after a similar gain in the first quarter, the third consecutive quarter of significant economic growth. This strong growth was due in large part to inventory accumulation since real GDP excluding inventories produced a modest 0.5 per cent growth and domestic demand remained subdued with consumption gaining only 0.4 per cent. Consumer price inflation at 1.6 per cent remains around its lowest for thirty years despite an appreciable decline in the value of the Canadian dollar over the past year. The implicit GDP deflator reflecting the prices of all goods and services produced in Canada is up only 1.1 per cent on a year ago. However, labour demand has not increased in line with the robust recovery and unemployment currently stands at 11.4 per cent with employment increasing by only 0.8 per cent in the second quarter and falling in July and August. Over the past four quarters labour costs per unit of output have increased by only 0.3 per cent, whereas in 1989 and 1990 they grew at over 5 per cent per year. In contrast, US labour costs are rising and if the lower Canadian dollar is taken into account then Canadian unit labour costs have fallen 7.6 per cent relative to the US over the last four quarters. This improvement in cost performance reflects both lower wage growth, on average less than 1 per cent for large collective agreements in the private sector, and productivity which increased by 4.1 per cent in the second quarter.

Corporate profits have increased to 5.6 per cent of GDP but remain well below pre-recession and historical levels of around 10 per cent. For the second consecutive quarter an increase in inventories was the driving force behind growth in real GDP. Manufacturing inventories TABULAR DATA OMITTED registered their first increase for thirteen quarters, reflecting improved profitability and a climate of confidence in the business sector. Improved business confidence was evident in the Conference Board of Canada's second quarter Survey of Business attitudes; with confidence increasing by 2.3 per cent to its highest level in four years.

The buoyant attitude of the business sector is not matched by the household sector which remains cautious. Consumer spending increased 0.9 per cent in real terms in the second quarter, led by spending on durable and semi-durable goods and prompted by a 1.1 per cent gain in disposable income. However, this gain in personal disposable income was not caused by an increase in labour income but rather by the one-off effects of changes in the processing of tax refunds which were returned more quickly than is usual. The cautious mood of consumers was highlighted by the fact that much of this gain in disposable income was added to savings; the household sector savings rate increased from 10.9 per cent in the first quarter to 12.6 per cent in the second. While the Conference Board of Canada reported increased optimism in the business sector its index of consumer attitudes fell 12.6 per cent in the second quarter.

The unemployment rate is expected to remain flat or even increase over the medium term and this, along with the rise in regional parities, was a major issue in the recent election. The newly elected Liberal government promised during the election campaign to reduce the unemployment rate and commentators are therefore expecting some expansionary fiscal measures. The perception of the Liberal government as an inflation risk may be exaggerated, but in August the currency came under significant downward pressure due to sales of Canadian dollar denominated short-term assets. Although the previous government professed a strong commitment to deficit reduction, the Canadian fiscal position has deteriorated from 6.3 per cent of GDP in 1992 to nearly 7.2 per cent in 1993 leaving little room for manoeuvre. It is expected that the election promises for higher spending may be offset by higher taxes or cuts in other areas, a recent large defence order has been cut and it is thought that the social security programme, which is about 60 per cent of federal spending, could also be a target.

Concerns about the high budget deficit have prevented real long-term rates from declining significantly and these remain well above the corresponding US rates and it is expected that short-term interest rates will rise in the near future. There is a possibility that the new government will try to circumscribe the independence of the Bank of Canada or renege on inflation reduction targets set jointly with the previous government. The new government has to decide whether to reappoint the Governor of the Bank of Canada for a second term.

Spain

Spain has experienced a slow-down in the rate of growth of demand for a sustained period. Real GDP growth peaked in 1989 at almost 5 per cent and has been falling steadily each year since then, reaching around 1.0 per cent last year. The effects upon unemployment have been dramatic. The unemployment rate was around 16 per cent in 1990 and has risen to over 22 per cent by the middle of this year. In contrast, largely because of structural rigidities in both price and wage setting, consumer inflation has not responded adequately to the decline in activity, remaining at approximately 6 per cent for both 1991 and 1992.

Over the past few months the disruptions to the ERM have actually helped to decelerate the slide into recession. The 20 per cent accumulated devaluation of the peseta effective exchange rate over the past year, combined with some cautious cuts in interest rates, have raised hopes that the 1 per cent fall in GDP in the first quarter represents the turning point in the recession. This is largely because it appears that Spanish trade performance seems to respond very strongly to improvements in competitiveness. Spain is now roughly back to the same competitive position as in 1988, and this has stimulated the economy. Over the past twelve months to the second quarter of this year, employment fell by more than half a million. Most of this occurred in the last quarter of 1992 and first quarter of 1993, but in the second quarter there was only a 14,000 decline in employment.

Most categories of expenditure are still declining. Gross fixed capital formation has made the largest contribution to the decline in domestic demand. The fall in TABULAR DATA OMITTED the cost of borrowing, along with the effects of improved competitiveness, should help investment to recover in the latter part of this year. Consumers' expenditure has declined in response to the fall in incomes but has retained some buoyancy due to the continued strong growth in wages. Our research suggests that consumption is quite responsive to interest rate cuts; we expect that the rise in unemployment will also have a strong negative effect upon expenditure.

The downturn has added to the problems of the structural public sector deficit. The deficit was around 5.25 per cent of GDP in the first quarter of 1993. This is in spite of the severe measures announced in last year's budget. Further corrective measures were implemented in July 1992, with a further 2 percentage point rise in both personal income tax and VAT. Most of the initial impact of these increases will be felt this year. The 1993 budget was also quite restrictive and should reduce the structural deficit, with employee social security revenues rising as the tax base is widened, privatisation revenues remaining high, and defence expenditures being sharply reduced.

Futures market suggest that short-term interest rates will remain around 9 per cent over the next twelve months. Although monetary policy has been relaxed in recent months, the prospects for future cuts in interest rates are limited. First, the large and rising public sector deficit is putting upward pressure on borrowing rates. Second, after the recent bout of devaluations the Spanish authorities are keen to make clear their commitment to both a stable exchange rate and low inflation.

Our forecast for Spain is given in Tables 19 and 20. TABULAR DATA OMITTED Export volumes of goods and services should grow quite rapidly in both this year and next, despite subdued demand in Spain's major European markets, because of the recent gains in competitiveness resulting from the depreciation of the peseta. In addition, the tendency for goods to be diverted to foreign markets when Spanish domestic demand is slack may be further encouraged by the increasing role of multinational corporations in Spanish production. Import volumes are also subdued over the forecast period due to higher import prices and weak domestic demand. The latter is dominated by our forecast of a further considerable decline in investment in 1993. Our forecast includes government investment, which is still increasing, and therefore implies that private sector investment will experience an even greater decline. The prolonged fall in investment should come to a halt next year due to higher activity and a lagged response to the reduction in interest rates.

We are expecting consumers' expenditure to fall this year followed by a slight rise in 1994. The recent decline in employment and the resulting path for real personal disposable incomes explains most of the decline this year. Taking all of the above factors into account, we expect real GDP to fall this year followed by a strong recovery in 1994

Given the path of output we predict that Spanish unemployment will rise above 23 per cent next year. Although recent increases in both direct and indirect tax rates and cuts in spending will boost government net revenues, these effects will be more than offset by cyclical factors such as unemployment benefits. Hence we expect the government deficit as a percentage of GDP to reach 7 per cent this year with only a slight fall next year. The Spanish government is currently trying to negotiate a wage accord which would limit the growth in average earnings to 2.5 per cent next year. Our forecast assumes that some wage agreement will be reached but that price inflation will not respond strongly to the deflationary conditions. We are predicting that inflation will remain stubbornly high both this year and in 1994. This is partly due to some of the structural rigidities of the labour market. Given the relative ease with which temporary workers can be fired, it is probable that these workers will experience the majority of the job losses. As most of the temporary work is in low-paid service sector jobs, this will tend to raise the average wage. Hence this will partially offset the decline in wage inflation caused by rising unemployment. Other factors keeping inflation high are the lack of competitive pressures in the service sector and the stronger growth in import prices resulting from devaluation of the peseta.

NOTES

(1) We have argued elsewhere (Anderton, Bartell and in't Veld, 1993) that realignments might initially raise output in aggregate in Europe, and hence may not be zero sum games in the short run, although they must be in the longer term. For instance the 1992 realignment in Europe could have led to an overall acceleration in the growth of activity. Output in the devaluers, the UK and Italy, has in the past reacted more rapidly to exchange rate changes than it has in the revaluers, France and Germany. However, this appears not to have been the case in the current conjuncture.

(2) Our comparative work on consumption makes this relatively clear, as can be seen in Barrell and in't Veld (1992) and Barrell, Gurney and in't Veld (1992).

(3) We see no reason to make substantial changes to the analysis in Barrell and in't Veld (1991) where we calculated FEERs for the G7. The concept of FEERs (or DEERs) has recently achieved some attention from the IMF (Artis and Taylor, 1993).

(4) We have rebased our model to 1987 (the base year for US GDP), and we have revised our trade matrices. As a result our effective exchange rate indices are more comprehensive than they were. We now include separate exchange rate and price equations and forecasts for Spain, the Netherlands, Belgium, the rest of the EC, the EFTA countries and the rest of the OECD. As a result our projections have changed somewhat. Both our effective and real effective exchange rates depend on the trade between these thirteen countries or blocks. We have used bilateral trade flows to produce country specific weights, adding exports to and imports from competitor countries and dividing by the total of exports and imports. Our real exchange rate measures use consumer rather than producer prices, and hence may be affected by changes in indirect taxes.

REFERENCES

Anderton R., R. Bartell and J. W. in't Veld, (1993a), 'Forward looking wages, nominal inertia and the analysis of monetary union', National Institute Discussion Paper no. 42. Paper given at the ESEM Brussels, August 1992.

Artis, M. and Taylor, M, (1993), 'DEER hunting: misalignment, debt accumulation and desired equilibrium exchange rates', IMF Working Paper W/P 93/48, June 1993.

Barrell, R. and J. W. in't Veld, (1991), FEERs and the path to EMU', National Institute Economic Review, August, no. 137, pp. 51-58.

Barrell, R., Gurney, A. and J. W. in't Veld, (1992), 'Fiscal policy, the real exchange rate and the role of wealth', Journal of Forecasting, August 1992.

Barrell, R. and J. W. in't Veld, (1991), 'Consumption and models of the world economy', Vierteljahrsheffe zur Wirtschafts-forschung, DIW, Berlin pp. 121-130.