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The UK economy

The recession in the UK is coming to an end, with a gradual recovery expected in the second half of the year. It now seems that stocks of goods and materials were run down sharply in the first half of the year. This is a common occurrence at the low point of the economic cycle, leading to a spontaneous upturn once the stock adjustment is complete.

This time the recovery is being helped by a rise in exports. Looking ahead to the first half of next year we expect the recovery to be reinforced by renewed growth in consumer spending, but we may have to wait rather longer for fixed investment to pick up as well.

The rate of inflation, as measured by the retail prices index has fallen sharply during the year, from about 10 per cent to about 4 per cent although the reduction in the underlying rate (excluding housing costs and the effect of the poll tax) has been much less. The rise in earnings is also moderating significantly, partly because of shorter hours and the loss of bonus payments. Provided the exchange rate remains stable we expect the rate of inflation to remain low during the recovery next year.

After just a year in the exchange-rate mechanism it is difficult to say what effect membership has had on the British economy. The credibility of the exchange-rate band itself seems to be well established and sterling has never come under really heavy attack. This reflects the cautious approach of the Government to the reduction of interest rates, which has been managed with some tactical skill. It also reflects the commitment of the Labour leadership to a fixed exchange rate, a factor of no little importance in the run-up to a general election. Interest-rate differentials between sterling and the D-Mark imply market expectations of little change in the exchange rate for the next year at least.

Membership of the ERM may also have eased the reduction in wage and price inflation. it seems that the commitment to a fixed exchange rate contributed to the realisation earlier this year that inflation must come down sharply if the UK was not to lose competitiveness. The expectation of lower price inflation helped to reduce the size of some wage settlements. There is no evidence so far, however, that ERM membership has made real wages more flexible. It must not be forgotten that the fall in inflation has been accompanied by a rise of some 750,000 in unemployment.

We expect that unemployment will continue to rise for most of next year, reaching about 2 3/4 million. The average duration of unemployment at this stage in the cycle is likely to lengthen considerably, with the risk of creating once again a special problem of long-term unemployment as a legacy of the recession for several years to come. It is surprising, and regrettable, that special measures to retrain the unemployment should be cut back at this time (see the note on page 45).

The Autumn Statement this year confirmed that the total of public spending will be allowed to increase as a proportion of GDP, and that the PSBR for this year is to be larger than expected at Budget time. Setting aside the politics of the decision, this can be welcomed as a contribution to aggregate demand in the recovery phase of the cycle. Ideally it would have been better timed if the increase had been put in place a year ago, but of course at that time the severity of the recession was not foreseen.

The question remains what scale of public sector borrowing will be appropriate in a 'normal' year, once the recession is over. In the Autumn Statement the PSBR implied for 1992/3 is about 3 per cent of GDP; but this may not be a normal year as unemployment will still be high and tax revenue still low following the recession. Our forecasts show a PSBR of about that scale in both 1992 and 1993, but with a reduction in prospect further ahead. (These figures include the effects of privatisation; the public sector financial balance in those two years is forecast to be about 3 1/2 per cent of GDP.)

In a protocol to the draft treaty for discussion at the Maastricht Summit it is proposed that the ceiling on government deficits should be 3 per cent of GDP. We would argue that the scale of borrowing which is judged prudent must depend on a whole range of factors, including the trend of endebtedness, the stage of the cycle and the scale of public investment. If nevertheless a ceiling is to be set, it should be set at a level which would be imprudent in any country. Such a ceiling would be much higher than 3 per cent of GDP. We do not think that a PSBR of 3 or 4 per cent of GDP in the UK for the next few years would necessarily be excessive.

Despite the recession the balance of payments is still in deficit on current account and the figure is likely to rise again next year. This is not a reason for immediate concern, but it does suggest that UK industry is still not as competitive as it eventually must be if the recovery is to be sustained. With the exchange rate fixed, competitiveness can only be improved (and unemployment reduced) by raising productivity or by holding back the increase in pay and prices.

Despite this, we would not recommend a devaluation of the pound either now or after the election-whichever party wins. We see the best framework for economic policy in the medium term as being provided by full membership of a European economic and monetary union. The Uk's standing as a prospective member of that union would be greatly weakened if the pound were to be devalued even by a small amount. The credibility of policy under a possible future Labour government would now be as much bound up with maintaining a fixed exchange rate as would the credibility of a Conservative government if it is re-elected. Moreover, in these circumstances, a devaluation could raise interest rates rather than lower them, making it doubtful whether even a temporary reduction in unemployment could be achieved that way.

Our forecasts suggest that (in the absence of unforeseen shocks) the UK economy will reach a sufficient degree of convergence with the economies of the rest of Europe for full membership of an economic and monetary union to be a realistic aim by about 1997. Our inflation rate is already in line with the rate in Germany, but that is in part because the German rate is high at the present, mainly because of unification. Looking further ahead convergence means getting inflation even lower than it is now and preventing government borrowing from rising too fast. This will clearly limit the scope for fiscal expansion, whether through higher spending or through curring taxes. But the difficulties facing the UK are a good deal less severe than those of some other European states, for example, Italy (see the note on page 51). To maintain convergence in the longer run there should be structural changes in all the European economies so that they become more closely integrated, and respond to shocks in a similar way.

in December the summit meeting at Maastricht will meet to decide the form of political, as well as economic and monetary, union in Europe. The UK government is no longer trying to stop the progress towards unification taking place at all. But it has yet to be decided what part the UK itself will play. There seems now to be broad support for full UK participation over a wide range of opinion from centre left to centre right. For several years now we have encouraged the view that British industry and commerce would benefit from closer European integration. We have also argued that independent monetary policy in this country is unlikely to achieve a better outcome than monetary policy conducted by the proposed European central banking system.

Economic and monetary union

Successive drafts of the treaty on economic and monetary union have been released since the summer. The form of the proposals has now become clear, although a number of issues have still to be settled. EMU, as it has emerged from these discussions, is very different from the sort of union imagined by many of those who advocated closer European integration in the 1980s. The idea then was that the strength of a more united Europe would be harnessed by active government from the centre, so as to combat the competitive 'challenge' from across the Atlantic or from the Far East. Now, on the contrary, the economic union being negotiated is characterised by non-intervention; economic policy action at the centre will be kept to the minimum. A central bank (or central banking system) will be established, and it is certainly intended that this body should keep a firm grip on monetary conditions throughout Europe. But its responsibilities are limited by the draft treaty to the maintenance of price stability. It will not be responsible for economic policy more widely defined and it will not be obliged to cooperate with the policies of governments, individually or collectively, if those policies seem to it to threaten price stability. (If the aim is zero inflation for Europen as a whole, this will sometimes involve negative inflation in some countries to offset positive inflation elsewhere.)

For the rest, macroeconomic policy is to be coordinated between member states, rather than directed from the centre. The real substance of that cooperation can only become clear as a result of experience. The only rules that are being set in advance are rules to prevent individual countries borrowing too much and so undermining the good work of the central bankers. When the unexpected happens, the appropriate policy response will not be the same in all member states, yet it will be necessary to ensure that the responses are consistent. Moreover, we are especially concerned that there is no clear account in the draft Treaty of how the community as a whole could act together to offset Europe-wide booms and slumps. in normal times perhaps it will be best for finance ministers to set fiscal policy in each member state, with just a friendly exchange of views as to how their decisions affect each other at the level of the community as a whole. But times will not always be normal, and more than a friendly exchange of ideas may be needed in an emergency.

In much the same way the initiative on industrial policy will probably remain with member states. They may still be able to embark on 'supply-side' policies of an active, even an 'interventionist' kind, but their freedom of manoeuvre will be considerably more restricted than it has been in the past. The borderline between acceptable policies and covert protection is not well defined, but the commitment to 'an open market with free competition' in the draft treaty is to be taken seriously; it is an indication of the direction in which it is intended to move.

Over the years it is likely, and desirable, that the most interventionist of all community policies, the CAP, will gradually narrow its scope, and hence use up less resources. A good use for those resources could be found by an expansion of the regional and social funds (see the note on page 63). This would provide little, if any, help to the UK in particular (apart from Northern Ireland) as the regions most in need are in Greece, Spain, Portugal and Ireland. Well-targeted schemes could make a useful contribution to economic development and the relief of poverty in those regions. Nevertheless, the extent of redistribution between regions will remain very small as compared to that undertaken by existing federal countries, such as Germany or the USA. In this respect too, the role of government f rom the centre in the proposed European union will be kept very small indeed. The union will be very heterogeneous in character, with no guarantee that income levels in different regions or member states will not diverge.

The character of the economic union is bound to change as further countries are admitted to membership of the EC. The transition period for several of the EFTA countries is likely to be brief. By the time that EMU is planned, Sweden and Austria may already be members, with perhaps Norway, Finland and even Switzerland on the threshold as well. A community of 17 members cannot be run on the principle of unanimity. Given the weak form of federalism proposed, however, it will sometimes be impossible to 'impose' a common economic policy on countries which want to go their own way. The result could well be to reinforce the case for minimal government--a kind of liberalism by default.

It remains to be seen what kind of economic system will prevail to the east of the European economic union. For the present it is difficult to exaggerate the extent of disruption and backwardness in the USSR (see the papers on pages 84 to 97). it now seems that expectations of an easy transition to a market economy in the countries of Central Europe were also too optimistic (see the note on page 75).

Minimal government is not likely to provide the right answer for the acute development problems of the ex-communist world. For Poland, Czechoslovakia or Hungary the natural aim is eventual membership of the EC, but they face a lengthy period of transition before such a step could be contemplated. For the republics of the Soviet Union the prospect is less clear. Their first need is to establish political legitimacy, effective government and the rule of law. it is only in such a context that the market system is likely to flourish.

Thus Europe faces continuing political and economic uncertainty. The treaties drawn up to be signed at the Maastricht Summit would represent an important step forward, but they leave important questions undecided. The impression is given of a set timetable leading to a clear objective with the future mapped out in advance, but in practice no-one can know how events will shape themselves even a year or two ahead. The fundamental question for this country is the extent to which we need to preserve our ability to conduct an economic policy in this uncertain environment independent of, and different from, that of the rest of Europe. The option of being completely independent is already in effect closed off. Little would be gained from a reluctant and half-hearted involvement. The best outcome now would be a clear decision from the UK government, giving full support to economic and monetary union.
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Title Annotation:British economy in the face of European economic union
Publication:National Institute Economic Review
Date:Nov 1, 1991
Previous Article:Deregulation, debt and downturn in the UK economy.
Next Article:The home economy.

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