The world economy.

Barrell, R.J. ; Gurney, Andrew ; Darby, Julia 等

CHAPTER II. THE WORLD ECONOMY

The overall outlook

Our recent forecasts have warned of growing inflationary pressures in the world economy. The policy response to these has been robust, and interest rates have risen markedly over the last year; consequently there are now signs that inflationary pressures are receding. Chart 1 illustrates the recent interest-rate developments, and chart 2 recent and prospective inflation rates for the major 4 economies. Oil prices have weakened over the last three months, and commodity prices, especially those for metals and minerals, have been falling.

The rise in interest rates in the US along with better than anticipated US trade figures early in the year, has led to a strengthening of the dollar which would, if maintained, export US inflation to other economies. The US effective rate in the second quarter was 8 1/2 per cent higher than a year previously, reversing a little of its continuous fall from its peak in the first quarter of 1985. The reasons for the dollar's recent strength are discussed further below.

Our forecast is summarised in table 1. Consumer price inflation in the major 4 economies has accelerated considerably during 1988 and 1989, and we are anticipating that the inflation rate in 1989 will be almost 2 per cent above that of the previous year. However the rise in interest rates, along with a projection of a generally more restrictive fiscal stance, is expected to reverse this rise. Output growth in the major 4 during 1987 and 1988 has been well above the average for the preceding five years, and has probably outstripped the growth in underlying capacity. Most industrial countries have been operating with a degree of spare capacity during much of the 1980s, and although rates of capacity utilisation are high, business survey indicators may be misleading when they suggest that conditions are tighter then they have been since the early 1970s.

Both OECD industrial production and exports of manufactures have grown very strongly in the recent past after sluggish growth in the early 1980s. Some of this volume growth may be associated with a temporary improvement in the terms of trade faced by primary producers, allowing them to import more manufactures, but this effect is likely to be reversed in the coming year. Manufacturing trade volumes, as measured by OECD exports of manufactures are estimated to have grown by over 9 per cent last year. Although this is 1 1/2 per cent lower than we estimated in our last forecast, we are now projecting higher growth in 1989, leaving the total for the two years virtually unchanged. In the longer run we are projecting trade growth to be around 5 3/4 per cent a year, reflecting the slightly stronger prospects for OECD growth over our forecast period. Total world trade in all commodities by all countries is expected to grow slightly more rapidly than this in future, at around 6 1/2 per cent a year, after strong growth of 9 1/2 per cent in 1988.

Table 2 gives our commodity price forecast and it shows that oil prices have weakened considerably in the last few months, as production has increased in the Gulf. We are projecting that these prices will remain around these levels during the rest of 1989 and into 1990 as the relative slowdown in activity reduces demand growth. Metals and minerals prices have been falling recently after stock shortage induced rises at the end of 1989. Food prices fell during much of the early 1980s, but have again started to rise. This has been partly a consequence of last year's poor grain crop in the US, but can also be attributed to the fact that free market food prices have strengthened due to the decline in surplus production of food in the EC. We are expecting this trend to continue, and thus we believe free market real food prices will rise despite the easing of general inflationary pressures.

Exchange rates and interest rates

Normally when constructing a forecast we assume that financial markets are `rational', and that if exchange rates change in line with interest differentials then eventually the current balances (or current balance to GDP ratios) produced in the forecast will reach `sustainable' levels. In such a case the deficits or surpluses would have to be offset by long-term, stable, capital flows. However, it is difficult to justify the recent strength of the dollar on these grounds. Annex I to this chapter sets out an alternative forecast using the open arbitrage condition for the exchange rate, and has fiscal and monetary policies set in line with announced objectives. The level of capital flows required to make this projection sustainable in the late 1990s seem to be implausibly large. We do not see the exchange-rate paths given by our normal forecasting rules as sustainable. In particular we feel that the dollar is currently too strong, and consequently must fall by more than is implied by risk adjusted interest differentials.

Our main case forecast is constructed with an extra 10 per cent fall in the dollar against the yen and members of the European Exchange Rate Mechanism. We feel that the market has reacted too strongly to the good US current balance performance in recent months, and has projected the rise in US interest rates too far into the future. Box A summarises some of our recent work on exchange rates, which gives some support to our belief that it takes the market some time to accept that interest rates will stay higher and therefore the initial impact on the exchange rate of an interest-rate rise is spread over time.

Table 3 sets out our forecast for interest rates. Short rates rose in the US, Germany and Japan during the second quarter of this year, and in Germany they are currently 2 per cent higher than a year ago. Japanese rates have risen much less, but the interest rate which we use, the Gensaki rate, exhibits little variability and a 1 per cent rise can be described as sharp. In our estimated model of Japan output is sensitive to small interest rate changes, so we expect the effects of this rise will be noticable. These interest-rate rises have been induced by fears of rising inflation which have in turn been conditioned on the depreciation of Japanese and German exchange rates. Chart 3 gives recent and forecast exchange-rate developments. The rise in US interest rates has been spurred by fears of domestically generated inflation, but the (unintended) consequence has been the strengthening of the dollar. This has been so sharp that the authorities have recently been nudging down US prime rates. Our presumed 10 per cent extra dollar depreciation takes place between the fourth quarters of 1989 and 1990, and it will raise inflationary pressures in the US and lower them elsewhere. As a consequence we project that the US authorities will have to raise interest rates again in the last quarter of 1989, whilst other countries will be given space for making interest-rate reductions.

Recent exchange-rate developments must be kept in historical perspective. Chart 4 plots the course of the dollar and the yen over the 1980s, and recent movements seem small in comparison. Table 4 sets out our projections for nominal and effective rates through to 1991, and includes our paths for real exchange rates through to the end of the forecast period. Japanese, German and French real exchange rates are projected to appreciate (and hence the US depreciates). This pattern of real rates will, we believe, produce an orderly, albeit slow, progression toward a sustainable set of current balances. Chart 5 plots the current balance to GDP ratios implied by our main case forecast, and although these still imply considerable deficits and surpluses even by 1997, we feel they are probably sustainable by capital flows generated by differences in real rates of return and by portfolio preferences.

Our sharp decline in the dollar puts some pressure on the EMS, as inflation in Germany is reduced more than in France, and the Italian current balance deteriorates markedly because of a loss in competitiveness. EMS exchange rates have only been realigned five times since 1982. We assume that in future there will be only small periodic realignments, the first taking place towards the end of 1991. The removal of capital controls will make the EMS more integrated, and interest-rate differentials, especially between Germany and Italy are expected to decline from the recent ex-post 4 per cent in excess of the change in the exchange rate. Charts 6a and 6b plot the exchange-rate change and interest differentials between Germany and Italy and Germany and France. The movement toward monetary union as advocated in the Delors report may in and of itself reduce interest differentials, because the risk of significant exchange-rate realignment is reduced. The Delors committee recommends a move toward the centralisation of macro policymaking in Europe, in part because they fear the adverse effects of competitive government deficit financing in a decentralised federal system. Annex II to this chapter analyses the grounds for these fears in some detail.

The United States

There are clear signs in the US of a slowdown in both production and demand despite an improving net trade position. Construction spending has been growing very slowly in real terms, and in January-May 1989 it was 0.1 per cent above that of the same period a year previously. In May housing starts reached their lowest level since 1982. Preliminary estimates of real GNP suggest that growth had slowed from an annual rate of 3.7 per cent in the first quarter to 1.7 percent in the second quarter of 1989. First estimates of consumer expenditure for the quarter also suggest a reduction in demand growth has taken place. Retail sales fell 0.1 per cent in May and 0.2 per cent in June, the first sequence of falls for three years. Industrial production has been falling in both May and June after very strong increases during 1988, and industrial capacity utilisation, as measured by business surveys, has fallen.

These clear signs of a slowdown have not been reflected in the labour market or in the rate of increase in prices. Although unemployment rose to 5.3 per cent in June from 5.2 per cent in May total civilian employment continued to grow rapidly, and in June it was 2.7 per cent higher than in December 1988. Consumer price inflation has accelerated from around 4 per cent in the middle of 1988 to 5 1/4 to 5 1/2 per cent in May and June. Wholesale price inflation has moderated, and prices fell in June, but this was largely due to falling energy and food prices. Other producer prices rose sharply in the month despite the strength of the dollar.

Our assumption that the dollar will have to fall significantly, and that interest rates will have to rise to reduce the resulting inflationary pressures colour our forecast for US domestic developments. The forecast is set out in table 5. We anticipate that output growth will continue to slow down, and that by the first quarter of 1990 output will be only 1.1 per cent above the same quarter of 1989. The effects on growth in 1990 of the slowdown of the economy during 1989 are augmented by a noticeable fiscal tightening. This is partly the temporary consequence of the timing of government expenditure programmes. In particular some postponements in the B-2 bomber programme help reduce military spending in 1990, and there are likely to be changes in the timing of other military and farm support programmes. We are still also assuming a package of $40 billion increases in taxes will be implemented by the end of 1990, in part because there appear to be great difficulties in persuading Congress to reduce expenditure programmes on a permanent basis. The effects of this package were analysed in our February Review no. 127.

In the longer term we project that US growth will return to our estimate of its potential, which is around 2 1/2 per cent a year. The combination of higher taxes and a declining path for interest rates is expected to shift demand from consumption to investment in both business and in housing. The delayed effects of the recent rise in the dollar will reduce output growth relative to domestic demand in 1990, but our assumption that the dollar has to fall sharply and then continue to fall in line with interest-rate differentials has a positive effect on our forecast for GNP. Our trade and payments forecast is set out in table 6. US export performance has been very strong recently, with a 10 per cent gain in market share during 1988. This is likely to be the delayed consequence of the improvement in competitiveness achieved in 1986. Our equation for US exports, which was estimated in 1987, suggests that all the effects of an improvement in competitiveness should come through in eighteen months, but it appears that the large scale gains in 1986 and 1987 have taken longer than that to come through. Chart 7 plots the residuals on our export and import equations. The loss of competitiveness consequent on the rise of the dollar during 1989 affects our forecast of export growth in 1990, and our presumed rapid fall in the effective rate during 1990 raises export growth in subsequent years.

The visible balance has improved during 1989, and we are forecasting that this will continue, with a balance of only --$116 billion for the year as a whole, or just under --$10 billion per month. However, some of this improvement is the result of the J curve effect of the appreciation in mid-1989, and we anticipate a deterioration in both 1990 and 1991 before the effects of the devaluation come through. The non-factor services balance is forecast to improve further over the future as the strong, estimated, competitiveness effects raise our forecast of exports and reduce that of imports. The balance on property income (IPD) will continue to be positive into 1992 as the fall in the dollar raises the value of credits. However, we expect that some time in 1992 the US will become a genuine net debtor as the cumulating effects of a decade of deficits have increased the scale of US debts to overseas residents.

Table 7 sets out our forecast for the US government's budget position. In no year do we expect the Balanced Budget Act Targets to be achieved, but sequestration will not be triggered because the ex ante government forecasts are likely to remain optimistic. The public sector as a whole has a much smaller deficit than the federal government because many states run budget surpluses, as does the public sector pension scheme. Public sector deficits are likely to fall to around 1/4 per cent of GDP in the mid-1990s, and this will lead to a sustained fall in the government debt to GDP ratio. As inflation is expected to fall there may be little political support for this rather restrictive fiscal stance and by 1997 the public sector deficit may be sufficiently large to ensure a stable debt to GDP ratio. This will require some easing of the fiscal stance in the US during the 1990s, and should mean that bond rates will rise relative to short rates, reversing the current negative yield gap.

Japan

The analysis of short to medium-term prospects for the Japanese economy has been made more difficult by the recent electoral success of the Japanese Socialist Party in the elections for the upper house. Although the JSP has only blocking power, and cannot form a government, the shock to the Liberal Democrats hegemony may change the style and scope of Japanese government. For many years the LDP has acted at a distance from both the bureaucracy and from business, and either a reformed LDP government or a JSP government may be more interventionist. In particular, in the short term, commentators in Japan suggest that Japanese trade liberalisation initiatives will be delayed. One major reason for LDP losses was the unpopularity of farm reforms, and progress on trade liberalisation in this area in particular is likely to be set back.

The future of the tax reform introduced in April may also be in doubt, as it is unpopular even in the ruling LDP and the opposition JSP is likely to introduce a bill to repeal the indirect tax increases. The tax reform, which had been mooted for several years, involved the introduction of a 3 per cent value added tax and the reduction and simplification of both income and corporation tax. As a result of the value added tax the consumer price index rose by 1.3 per cent more than it would have otherwise done in April and May. The abolition of the tax would reduce short-term inflationary pressures, but would be likely to increase the government deficit and hence raise inflation in the long run. We have constructed our forecast on the assumption that the tax reform will not be altered.

The weakness of the yen against the dollar has been a major factor in causing wholesale price inflation to rise, albeit to only 3.7 per cent in May. Strong oil prices were also a factor in wholesale price rises, and the recent fall, along with the projected weakness, should enable the rise in the wholesale price index to moderate in the near future. However, there are clear signs of inflationary pressures building up in Japan. The job offers to applicants ratio has continued to rise, and in April stood at 1.16, and unemployment has continued to fall, and reached 2.2 per cent in June. Employment has also been rising, and in April was 3 1/2 per cent above a year previously, and in the last few months overtime hours worked have also been rising.

Japanese output growth in 1988 was the highest for over a decade, with a very strong rise in investment. The investment to GDP ratio was at its highest level of the 1980s and the growth of private residential construction was 13 1/2 per cent. Although the Japanese economy had some spare capacity in the mid-1980s, the level of measured utilisation is now higher than at any time since the first oil shock. The inflationary response has been muted, mainly because the yen has appreciated by more than 50 per cent since the beginning of 1985. Despite the political uncertainties and the emergence of capacity constraints we expect strong Japanese growth to continue through 1989 into 1990, albeit at a somewhat reduced rate. Investment in business has been around 20 per cent of GDP for several years, and capacity must be significantly increasing. According to the `Short Term Economic Survey of Enterprises', undertaken by the Bank of Japan in May, manufacturers planned to increase their investment by 17.6 per cent in 1989/90 after what appears to have been very strong investment performance in the first quarter of 1989.

Table 8 gives our forecast for the Japanese economy. We anticipate that consumption growth will moderate somewhat in 1989 as inflation reduces the growth of real personal disposable income, and we expect business investment to slowdown into 1990 as the slightly higher interest rate begins to have an effect in this very interest sensitive sector. We have revised up our projections for housing investment in the short run as it appears that repair and extension activity has taken up a lot of the slack in the construction industry that has resulted from recent declines in the number of housing starts.

In the longer run we expect Japanese output growth to settle at around 4 1/2 per cent a year, and hence we do not expect inflationary pressures to be sustained, as this growth is around our estimate of underlying capacity increase. In the short term we expect the yen-dollar rate to appreciate by 10 per cent more than the interest differential would suggest. This would reduce export growth and raise imports as well as moderate inflation. The effect on output is enhanced by the effects of fiscal consolidation on government expenditure growth in 1989 and 1990. The current Liberal Democrat government wishes to reduce the ratio of government debt to GDP, and expenditure plans imply that there will be a decline in the ratio of government spending to GDP. The combination of external political pressures, and the need to maintain a neutral fiscal policy in the long run will, we feel, lead to a rise in expenditure growth in the early 1990s. We forecast that from 1991 onwards both taxation receipts and expenditure will grow in line with GDP, giving the government the ability to maintain a stable, but lower, ratio of debt to GDP. This fiscal projection helps maintain domestic demand growth in the longer run, as does our belief that the authorities will allow interest rates to decline more than in line with inflation.

Table 9 sets out our forecast for the Japanese current account. The combination of high oil prices early in 1989, with high oil imports, and the J curve effect from the appreciation of the yen, has led to relatively low current balance surpluses in the first half of the year. The reversal of these factors should raise the current balance in the rest of 1989, and we anticipate an overall surplus of $76 billion or 2.6 per cent of GDP. The projected rise in the yen, along with strong consumption growth, is expected to produce import growth of around 8 per cent. The appreciation of the yen is likely to lead to a slight loss of Japanese export market share, but despite the fact that we expect Japanese exports to grow more slowly than imports, the sheer size of exports relative to imports, along with weak oil prices, imply that the visible trade surplus will continue to increase.

We do expect the current balance to decline in the medium term, however. This is the result of two factors. Firstly the continuing appreciation of the yen reduces the IPD surplus by raising the dollar value of debits, and this largely offsets the flows from cumulating current balance surpluses. Secondly we expect the services deficit to continue to expand. Services imports (especially tourism) rose by over 30 per cent in each of 1987 and 1988, and we expect this rate of growth to be repeated in 1990. The number of Japanese who went abroad rose by 23 per cent to 8.4 million in 1988, and Japan ran a tourist deficit of $19.4 billion, up from $11.3 billion in 1987. Trips abroad have continued to rise rapidly despite the weaker yen, and per capita spending by tourists has also been rising. The appreciation of the yen along with the increasing openness of Japanese society has also increased the demand for other foreign produced services.

Germany

The latest data for German GNP indicate that the strong economic growth experienced in 1988 was maintained in the first quarter of 1989. GNP was up 4 per cent on the first quarter of 1988, and was higher than we were anticipating. Most of this was due to better net export performance, split equally between visibles and invisibles. Domestic demand was 2.4 per cent higher than a year before. Consumers' expenditure growth was a modest 1.3 per cent but investment demand remained strong, especially in the construction sector, which benefitted from the mild winter.

Business surveys reflect both the recent strength of demand for German goods and the expectation that demand will remain high in the near future. New orders for manufacturing goods continue to rise, with an increase in domestic orders compensating for a decline in the growth-rate of orders from abroad (see chart 8). The orders figures also show that the demand for investment goods is especially strong. This is consistent with the IFO survey evidence which indicates that the rate of capacity utilisation is high, while business confidence also remains high (see chart 9). High investment growth should raise available capacity, allowing Germany more space for non-inflationary growth.

Labour market figures indicate a degree of tightening in the second half of 1988, but that this has not increased in the early months of this year. Seasonally adjusted unemployment fell from 8.9 per cent in June 1988 to 8.0 per cent in January, and 7.9 per cent in April, while unfilled vacancies rose from 186,000 in June to 216,000 in January and 223,000 in April. Hourly earnings in manufacturing continue to grow at around 4.5 per cent, but unit labour costs in mining and manufacturing remained stable through 1987 and 1988.

Producer prices rose by 4.3 per cent in the year to April and consumer prices by 3 per cent. The main element of price pressure continues to be the cost of imported goods, following the decline in the exchange rate since the end of 1987. The increase in indirect taxes in January has also increased consumer price rises by around 1/2 per cent. In the year to March the cost of domestically produced inputs to manufacturing industry rose by 6 per cent, while the cost of imported inputs rose by 11.5 per cent. The recovery of oil prices has also contributed to rising costs.

The Bundesbank has continued to operate a tight monetary policy in order to head off potential inflationary developments. The latest increase of 0.5 per cent on 30 June means that German interest rates have risen by 2.5 percentage points since the beginning of 1988. A particular concern has been to stem the period of DM weakness. In early June the DM fell to 2 DM/$ for the first time since December 1986. Since then actual and anticipated responses of the German and US authorities have led to an appreciation of the DM which will be especially welcome to the German authorities. However it is unlikely that monetary policy will be loosened until they are satisfied that the currency is firmly supported. Domestic considerations also point to continued monetary tightness as demand for German goods is expected to remain high at a time when activity appears to be close to capacity levels. A final consideration is the rate of growth of broad money which currently exceeds the Bundesbank's 5 per cent target. Our expectation is that interest rates will remain at around 7 per cent until well into the Autumn. We assume that the DM will appreciate in line with the interest parity condition in the long run after our assumed 10 per cent excess appreciation against the dollar in 1989/90. This should ease some of the inflationary pressures and may allow the Bundesbank to reduce interest-rates in the fourth quarter, with further reductions likely in 1990.

German fiscal policy continues to follow the programme set out for 1986-90. This programme led to a degree of fiscal tightening as indirect taxes were raised at the start of this year. This, along with the extra revenues generated by recent economic growth, has helped the process of budget consolidation. The most recent OECD Economic Outlook forecasts that the general government deficit will fall from DM 42 billion in 1988 to around DM 15 billion this year. The final stage of the fiscal programme is a reduction in income tax costing around DM 20 billion at the start of next year. This measure should stimulate consumers' expenditure, and thus help sustain domestic demand. The current strength of business confidence must be in part due to anticipation of this domestic stimulus. Government expenditure has been closely controlled in 1988 aided by low civil service wage settlements and a reform affecting health expenditure. It is expected that the government will continue to constrain the growth of expenditures in order to further the budget consolidation process, but a general election is due at the end of 1990, and the government will no doubt wish to see that economic activity remains strong in the intervening period.

Table 10 reports our forecast for German GNP. As a result of the strong first quarter performance we expect growth in 1989 to be 3.5 per cent. We expect that investment will be the main component of domestic demand growth, with net exports contributing 1 percentage point of the overall growth rate. Consumption is likely to be relatively subdued, partly in response to the increase in indirect taxes at the start of the year.

Next year consumption growth should increase, aided by the proposed reduction in income tax. Export growth is likely to decrease in response to declining activity abroad, and to the appreciating exchange rate. Investment growth is also likely to decline, mainly in response to the slower growth rate, but also because favourable first quarter conditions are unlikely to be repeated next year. The decline in investment and net exports outweigh the stimulus to consumption leading to a decline in GNP growth to 2 per cent.

The rise in inflation in the early months of this year should be reversed in response to the tightening of monetary policy that has already occurred, and to our assumed appreciation of the DM. In addition the increase in indirect taxes at the start of 1989 will cease to contribute to the annual inflation rate at the start of 1990. In the absence of widespread capacity constraints, cost pressures should remain muted. Consumer price inflation is therefore expected to fall from 3.2 per cent this year to 1.7 per cent next year.

In the medium term we anticipate that the German economy can continue to grow by 2.5-3 per cent per year, with inflation of just under 2 per cent per year. The mainstay of this growth is likely to be consumption, buoyed by real earnings growth of 2.5-3 per cent. Further appreciation of the DM means that imported inflation will remain low, but will also lead to net exports reducing GNP growth by around 0.5 percentage points a year. However the current balance is likely to remain in surplus, although gradually declining as a proportion of GDP. Continuing surpluses should generate additional property income inflows which will partly offset the decline in the balance earned on goods and services. Our forecast for the German current account is set out in table 11.

France

GNP figures for the first quarter of 1989 show growth of 3.1 per cent compared with a year earlier. Domestic demand grew by 3.4 per cent, with investment especially strong, while net exports made a small negative contribution to GNP. The first quarter information therefore suggests a continuation of the strong investment-led growth that prevailed in 1988.

Inflation in the first half of the year averaged 3.8 per cent, up from 2.7 per cent for 1988 as a whole. This increase has been led by increases in imported inflation, as increased world demand has resulted in higher commodity prices. This tendency has been aggravated by the depreciation of the franc in the latter part of last year. Domestic price pressures remain relatively weak despite the strong economic growth experienced over the past eighteen months.

Survey evidence shows considerable confidence that the current favourable conditions will persist. Questions relating to prospects for the industrial sector and to the future tendency of production reveal that firms are more optimistic this year than they were last year. Furthermore the rate of capacity utilisation in manufacturing, which increased throughout 1987 and 1988, fell marginally in the first quarter of 1989, which perhaps indicates that investment has been sufficiently strong to allow industry to supply the increased demand for its products.

Labour market evidence also suggests that strong growth is not yet threatened by imminent capacity constraints. Employment in industry continued to fall in 1988, whilst unemployment in March 1989 stood at 10 per cent of the total labour force, unchanged from a year earlier. The trade deficit appears to have worsened in the second quarter of 1989, but this followed an improvement in the first quarter: the decline compared to the second half of last year is minimal. Again the implication is that the French economy is coping well with the recent strength of demand.

French monetary policy continues to be driven by the desire to maintain the existing EMS parities. As noted in the last Review, the increasing credibility of this strategy has enabled a reduction in the interest-rate differential between France and Germany. Since publication of the last Review German rates have been raised by 0.5 percentage points. This increase was matched by the French authorities, who presumably judged that the markets were not yet ready to see the differential narrow further. Indeed after strengthening against the DM in the first quarter of the year, the franc has since weakened slightly, although it remains comfortably inside its EMS band.

The commitment of the French authorities to further development of the EMS provides the rationale for our monetary policy assumption. This has French interest-rates declining a little faster than German rates, as continued commitment to maintaining the present parity against the DM leads to further gains in credibility and hence a further narrowing of the interest-rate differential. We assume that the franc will weaken further against the DM, entailing a realignment of EMS parities sometime in the early 1990s. This assumption is sensitive to developments towards greater monetary union. We have assumed that the proposed abolition of capital controls in 1990 has already been largely discounted and hence should not generate a marked exchange-rate response when it finally occurs, although it will be a force further reducing interest-rate differentials.

The French authorities also remain committed to their target of FF 100.5 billion for the public sector deficit. This has entailed the recent freezing of around FF 10 billion of proposed expenditure. For 1990 the preliminary deficit target is FF 90 to FF 95 billion. Continued economic growth should ensure strong revenue growth, but expenditure pressures remain strong.

Table 12 presents our forecast. We expect that GDP growth in 1989 will again exceed 3 per cent. Domestic demand growth is forecast to slow to 3.1 per cent due to less rapid growth in consumption, investment and government expenditure. Consumption growth is likely to fall in response to lower growth in real personal disposable income this year. Last year's strong growth in RPDI was mainly due to cuts in income tax. Lower investment expenditure occurs mainly because of the expected decline of economic growth both within France and abroad. Net exports are likely to have a negligible effect on overall GDP growth as both exports and imports are projected to grow by 7.5-8 per cent. Preliminary figures for the first quarter suggest that exports performed especially well, and export markets are expected to continue to grow strongly in the early part of the year, although probably slowing thereafter. Import growth is likely to decelerate this year in response to slower growth within the French economy.

In 1990 we expect domestic demand will again grow by around 3 per cent, but GDP growth may slow to 2.7 per cent due to a deterioration in trade. The latter is primarily caused by lower export growth, due to a combination of lower market growth as the world economy slows, and to a deterioration in competitiveness caused by appreciation of the EMS currencies.

The longer-term prospects for France depend on whether it succeeds in adapting itself into a flexible, low-inflation economy. Failure to do so will put strains on the EMS and could leave the government of the 1990s struggling to maintain a counter-inflationary reputation. A successful transition will smooth the path to monetary union which the current government is keen to follow. It is now over two years since the last EMS realignment. During this time French inflation has declined towards German levels without requiring a deceleration in GDP growth. Our forecast projects inflation at under 3 per cent through the early 1990s with GDP growth continuing at 2.5--3 per cent per annum. We anticipate that a slight deterioration in the visible trade balance will be compensated by an improvement in the services balance, leaving the current account balance little changed. There is a risk that greater upward pressure on the DM could cause strains on the EMS which future governments would be tempted not to resist. If that were to occur the basis of the current anti-inflationary strategy would be threatened with likely adverse consequences for inflation itself and for the stable environment which encourages growth of economic activity.

Italy

The most recent figures available for Italian GDP and its composition are those for the third quarter of last year. These indicate that demand was then growing steadily in Italy as elsewhere in the world. Fourth quarter figures for industrial production suggest that demand remained strong at the end of the year. Business survey evidence indicates considerable confidence that a strong economic performance will be maintained in 1989. Questions relating to the future tendency of production and of order books showed rising optimism in the early months of the year. This followed a high level of orders placed in manufacturing industry in the fourth quarter of 1988. Consumer price inflation remained at around 5 per cent through much of last year, but picked up in the fourth quarter, mainly because of increases in indirect taxation. These increases will continue to boost the annual inflation rate in the early months of this year, but provided they do not trigger a wage-price spiral, it is likely that inflation will again decline towards the end of the year.

For much of the last three months Italy has been without a government. The previous coalition has now reformed under a new Prime Minister, Giulio Andreotti. The main economic concern continues to be the need to reduce the government budget deficit, which is one reason why Italian interest rates remain five to six points higher than German rates, despite Italy's achievement of a low inflation rate and a high degree of currency stability. The budget deficit now seems likely to exceed its initial target of 117400 billion lira following the added costs of higher interest rates, and difficulties in implementing additional fiscal measured proposed in March.

Our forecast for Italy is shown in table 14. We expect GDP growth of 3.1 per cent this year. Domestic demand growth should be similar to that of 1988, despite slower growth in consumption, investment and government expenditure, because we do not expect stockbuilding to decline by as much as in 1988. Net exports will however subract from GDP growth. In 1990 and beyond we expect growth of 3--3.5 per cent per annum, sustained by consumption growth of around 3 per cent and investment growth of 4--5 per cent. Net exports are expected to remain approximately constant as a proportion of GDP. The inflation outlook is favourable, provided wage settlements do not respond to what we perceive as a temporary increase in inflation this year. The abandonment of the `Scala Mobile' has changed the wage-price behaviour of the Italian economy. Our equations reflect this instant indexation of wages to prices, and produce rather more rapid responses to shocks than we think are now likely. As with France a continued commitment to currency stability remains the most important counter-inflationary measure. Our forecast is predicated on a belief that Italy will remain within EMS, and that steps will be taken to avoid continuous realignments. But there will be several infrequent realignments nevertheless. As a consequence we expect output growth to be held below that of potential capacity, and inflation will fall. However, the strictures of EMS membership will lead to a balance of payments deficit of around 1 to 1 1/2 per cent of GDP. We do, however, feel that this is sustainable, as Italian growth and real rates of return are still likely to be above those of the rest of the community, and this should be sufficient to attract long-term capital inflows, especially from Germany.

Canada

Output growth in Canada over the last three years has been very strong, and inflationary pressures are beginning to emerge. The Canadian authorities' response has been sharper than in the rest of the major seven economies, and their response to inflationary pressures began earlier. Short term interest rates have risen by 4 1/2 percentage points since the first quarter of 1988, and are now around 3 points higher than the rate on ten year bonds. Canadian short rates have not eased with US rates recently, emphasising the strong stance of both the Conservative government and of Mr Crow, the Governor of the Bank of Canada. Their tight monetary stance appears to be having some impact on Canadian growth.

Canadian output grew by under 3 per cent at an annual rate in the first quarter (after adjusting for the large increase in farm inventories that the statisticians have included on the assumption that drought affected farm output returns to normal in 1989). Both business and residential investment continued their strong growth, but consumer spending slowed in response to the sharp rise in interest rates. Real personal disposable income grew at an annual rate of 7.1 per cent in the quarter, whilst consumption rose only by 1.8 per cent at an annual rate, and the personal savings rate rose sharply. The rise in interest rates appears to be affecting residential investment, and housing starts fell in April and May.

However, the rise in interest rates and falling output growth have as yet had little impact on employment and inflation. Full-time employment has continued to grow during 1989, albeit at a slower rate than in 1988, and unemployment has fallen to around 7 3/4 per cent, its lowest level since 1981. Inflation has risen during 1989, and consumer price inflation reached 5 per cent by the middle of the year. This was, however, partly affected by indirect tax increases in the 1989 budget, and the underlying rate is about 4 1/2 per cent.

We anticipate that Canadian growth will slow from 4 1/2 per cent in 1988 to 3 per cent in 1989, and will average 2 1/2 per cent in 1990 and 1991. Our forecast is given in detail in table 15. This is in large part a response to a very restrictive fiscal stance that is now being adopted after the re-election of the government at the end of 1988. The declared intention is to reduce the government debt to GDP ratio well below its current 56 per cent, and as a consequence we foresee that real government expenditure will grow at only 1 per cent per annum for the next three years. It will, we anticipate, take some time before the anti-inflationary stance shows clear signs of success. The deterioration of the Canadian current balance during 1988 and 1989 will have to be corrected and we have assumed that the Canadian dollar will have to depreciate along with the US. This affects our inflation forecast because Canada is a very open economy, and rising import prices feed into domestic inflation.

The Canadian current balance has deteriorated markedly in the first half of 1989. Although part of this is the result of temporarily high property income debits, it is mainly the result of a strong appreciation combined with high demand growth, both raising imports. The Canadian balance of payments deficit is likely to exceed 3 per cent of GDP in 1989. We feel that this is not sustainable by long-term capital flows, but partly because Canada is a primary producer exporting to the US we do expect long-term capital inflows directed to this sector to be maintained at about 1 per cent of GDP. In our forecast we do have the deficit returning to this level, and by the mid-1990s Canadian growth is also expected to return to its trend level of 3 1/2 to 4 per cent.

ANNEX I. THE OPEN ARBITRAGE FORECAST: OR WHY THE DOLLAR MUST DROP

We have adopted the practice of constructing our forecasts by assuming:

(1) Exchange rates follow the open arbitrage path,

with some allowance for risk factors which may

change over time.

(2) Our model is an adequate description of the

world economy, and that the views embedded

in it are shared by participants in the market.

Our forecast is made over a nine year period, and government policy and the evolution of real interest rates also have an impact on the outcome, as do our residual settings. Our short-run fiscal policy assumptions generally follow the declared objectives of governments, which are almost always that expenditure should fall as a per cent of GDP, as should the public sector deficit. This unrealistic assumption of a continually restrictive fiscal stance would affect the structure of our projections, and we generally assume that in the long run governments adopt a neutral fiscal stance. This requires that expenditure and taxes grow in line with GDP, and that the public sector deficit to GDP ratio is sufficiently small to maintain a constant debt to GDP ratio.

We assume that in the short run monetary policy follows announced targets or meets agreed objectives and is set to reduce the rate of inflation, without in the US, at least, causing a recession. In the long run real interest rates are allowed to stabilise at around 3 per cent. Finally we also assume that countries that run persistent balance of payments surpluses, such as Japan and Germany, eventually settle on lower real interest rates than do persistent deficit countries such as Canada, Italy and the UK.

We applied these rules to the structure of exchange rates and interest rates observed at the end of July 1989, and the resulting long-run forecast did not seem to us to produce a sustainable equilibrium. Table A1 gives the growth rates and inflation rates for the US, Germany and Japan, and table A2 gives the current account to GDP ratios for the major 4. The forecast summarised in table A1 would be reasonable if it were not for the scale of flows implied by table A2.

As our forecast, as normally constructed, did not produce what we would consider an equilibrium in the long run, we felt constrained to make clear our disagreement with the markets. We believe that the dollar must fall, and we have constructed our main forecast on this presumption. The US current account improves by 1/2 a per cent of GDP in response to an extra 10 per cent nominal devaluation of the dollar, and the Japanese current balance surplus declines slightly. The German surplus as a per cent of GDP declines by 1 3/4 per cent of GDP, whilst the Italian deficit worsens. Our judgement is that flows on this scale would be sustainable, whereas those implied by our traditional forecast techniques may not be. If they were not, and if our model is an adequate description of the world, either more depreciation would have to take place or some other adjustments, such as increased protectionism, would be necessary.

ANNEX II. FISCAL POLICY IN EUROPE

The Delors report on European Economic and Monetary Union proposed that fiscal as well as monetary policy should be subject to centralised control. The committee is concerned that individual governments would not feel constrained to observe fiscal prudence, and that some of the consequences of a fiscal expansion would fall on other members of the Community. In particular, if exchange rates between member states were fixed and interest rates on equivalent assets were the same everywhere, a fiscal expansion in one country would lead to a rise in prices everywhere, and some of the financial cost would be paid by the rest of the Community because the home country's balance of payments would deteriorate.

We have investigated the likely impact of fiscal expansions in individual Community members with fixed interest rates and exchange rates using our world econometric model, GEM. Our model, which is more fully described in the manual available from the Institute, has sectors for Germany, France, Italy, the Netherlands and Belgium (as well as the UK). The characteristics of the individual countries are described in box B. A note of caution is needed: the equations have been estimated over the past, and the behaviour of the economies could well change if a monetary union was formed. But these simulations may nevertheless be a useful contribution to the debate.

In the simulations we have assumed that exchange rates and interest rates are fixed both within the Community, and between the Community and the rest of the world. A fiscal expansion in any one country will lead to a deterioration in the balance of payments in the Community as a whole. In a monetary union this would probably put downward pressure on the ECU exchange rate against the dollar and other non-European currencies, but we do not attempt to quantify what the exchange rate and interest rate effects would be.

We carried out three simulations: government expenditure was raised by 1 per cent of GDP in each of Germany, France and Italy.

Germany

There is very little GDP spillover from Germany to the rest of the Community in response to a 1 per cent of GDP increase in government expenditure. By the end of the first year German GDP rises by 0.88 per cent, whilst after 5 years this has fallen to 0.65 per cent. Over the same time the effect on GDP in both France and Italy at least doubles (see table A1). The spillover increases not only because of the slow build up of the effects of increased activity on imports, but also because Germany gradually loses competitiveness. The German price level is raised considerably more than prices elsewhere. Both German and French inflation peak after four years, and subsequently falls and the two inflation rates converge. Our model suggests that price effects in Italy rise over time as the effects of the increased pressure of demand feed through to wages and prices.

After five years the German current balance has worsened by $3.2 billion, whilst the total balance of the Community countries included in our model has deteriorated by $2.2 billion. This has two implications. Firstly the German fiscal expansion would put upward pressure on all interest rates in the Community or downward pressure on the ECU, and if the ECU fell then inflation would be higher throughout the Community, and the output gains would be less. Secondly, there is a transfer of resources from the rest of the Community to Germany of initially around $1 billion a year as the current balances of the other countries improve.

France

A fiscal expansion in France initially has less effect on GDP then does an equivalent expansion in Germany. One year after a one per cent of GDP increase in spending French output is only 0.57 per cent above base. French output falls from its peak above base after two years as the effects of worsening competitiveness raises imports, lowers exports and cuts domestic output. Table A2 gives these figures, along with the activity spillover effects on Germany and Italy. There is a noticeable deterioration in German/French competitiveness, as can be judged by the relative size of the changes in the CEDs, and this, along with the fact that 30 per cent of French imports come from Germany, produces a 0.15 rise in German GDP after five years.

The French current balance deteriorates by $1.9 bn. after five years, and the current balance of the five economies together deteriorates by $1.2 billion. There is a resource transfer of $0.7 bn. to France from the rest of the group. French inflation rises initially in response to the increased pressure of demand, but eventually returns to base. German inflation rises slightly throughout in response to higher demand, but as in the previous simulation, Italian inflation is still rising relative to base after eight years.

Italy

The effects of a one per cent of GDP increase in government spending build up slowly in Italy rising from 0.67 per cent after one year to 0.89 per cent after five. Initially German GNP is affected considerably more than that in France because of the greater importance of the former as a source of imports (32 per cent of Italian imports are sourced from Germany compared to 23 per cent from France). However, in the longer run both economies benefit as the loss of Italian competitiveness raises imports from both sources. Our model suggests that, unlike German and French output, Italian output is rising continually after the government expenditure shock. The effects on French and especially German output rise over time.

In response to the expenditure shock consumer prices rise more markedly in Italy than in Germany. The inflation spreads to the other countries, but much less than it does when the Germans raise their expenditure. Because the expenditure effects do not spread to the rest of Europe as much as for the other countries, and because prices rise significantly, the Italian balance of payments deteriorates significantly. After five years it is $2.6 billion worse, whilst that of our five EMS countries is $1.7 billion worse. More importantly, our path of continually rising output in Italy produces a continually rising level of inflation and Italian inflation is one per cent above base levels after eight years. This result may follow from our model, but it is one area where we might expect a monetary union to have a significant impact. Our Italian wage-price system is very responsive to shocks, and this is a valid description of Italian experience in the 1970s and early 1980s. However, the abandonment of the instantaneous indexing of Italian wages in the mid 1980s may have changed the structure of Italian wage-price behaviour in ways that we are unable to discover using time series econometric modelling.

Conclusion Fiscal expansions are most attractive to Governments in individual countries within a monetary union if the benefits of the expansion stay at home but the costs are spread abroad. Our model suggests that it is the Germans who most closely fit this description because of the importance of their trade prices in determining prices in the rest of Europe. Their fiscal expansion raises prices in France and Italy by around half of German increases. The fiscal expansions in France and Italy raise prices by four to six times as much at home as abroad. The German fiscal expansion raises German output by four to eight times as much as elsewhere whilst that in France raises output by four to five times as much as elsewhere, and that in Italy raises output at home by six to ten times as much as abroad. Both the Germans and Italians make significant relative output gains, but only the Germans are able to force the others to share increased inflation. The rather surprising result is that the French and the Italians should be less tempted than the Germans to adopt expansionary fiscal policies within a monetary union. How the various governments would actually behave would also depend of course on the relative priorities they each give to inflation, output and other objectives of policy in their own countries. [Tabular Data A1 to A3, 1 to 15 Omitted] [Box Data A and B Omitted] [Charts 1 to 9 Omitted]