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Recent developments and prospects for the UK economy The timing and the speed of the economic recovery are still issues of great interest and uncertainty. Our view is essentially unchanged since February: the upturn is beginning in the first half of the year and will gather pace in the second half; but even next year the speed of the recovery will be barely sufficient to stop unemployment from rising.

Relative to previous experience, as summarised in our model of the economy, we could say that the recovery is already running late.The downturn began as long ago as 1988 and intensified into a recession in the later part of 1990, producing an exceptionally long period of contraction. It is now well over a year since the interest rate reductions began, but the response of expenditure is still hesitant. The most likely explanation for the delay is the accumulation of debt from earlier periods of excessive spending in the late-1980s. We remain cautiously optimistic, and now see reason to believe that the worst phase of the cycle is over. For 1992 we are forecasting growth of about 1 per cent, followed by 2 1/2 to 3 per cent in 1993.

As well as our main forecast, constructed in the usual way using our model of the economy, this Review includes an alternative view based on a much more simple statistical analysis of leading indicators (see page 13 below). The underlying behaviour of the economy appears to have changed significantly since the mid-198 Os as a result of financial liberalisation and other structural changes. Nevertheless it is possible to estimate a relationship between output growth and a number of leading indicators which is stable through the 1970s and 1980s. Indeed, it would have been possible to estimate such a relationship up to the mid-1980s and use it since then to forecast both the boom of the late-1980s and the subsequent recession. If the same equation is used to project forward from current data, it suggests a rather stronger upturn than we show in our main forecasts.

Our forecasts show inflation falling slightly, despite the upturn, and then continuing at around 3V2 per cent for the foreseeable future. The balance of payments deficit is likely to widen this year--there is already evidence of a sharp rise in import volume--but given the modest pace of recovery that we predict, there should be no reason for alarm on that account. A more substantial worry concerns the level of unemployment which we see rising to 3 million next year, with little hope of much reduction even in the medium term.

Our short-term forecasts are similar to those published by the Treasury at Budget time, but we expect significantly less growth in later years than is assumed in the Medium-Term Financial Strategy. We agree with the Treasury that capacity utilisation is now relatively low and that growth is determined by supply factors in the long run. But we take a more cautious view of the scope for rapid growth accompanied by low inflation. In this context it may be useful to reflect on the experience of the 1980s. For much of that decade the Treasury was correct in anticipating year after year of growth above trend; but in the longer term the result was renewed inflation and, an excessive balance of payments deficit. Now that the exchange rate is fixed in the ERM the day of reckoning would probably come much sooner.

One implication of our lower forecast for medium-term growth than the Treasury is that we are less confident that the public sector accounts will return to balance. However, even in our projections the UK meets the Maastricht criteria in time to be a full member of EMU in the late-1990s.

Real interest rates and monetary policy in Europe

The contrast with America

Short-term interest rates in Europe (averaging Germany, France and the UK) are currently around 9 1/2 to 10 per cent and it is a cause for celebration when the UK and French authorities are able to shave off a half percentage point. With inflation rates (in the same three countries) averaging just 3 1/2 to 4 per cent and expected if anything to fall, a reasonable estimate of the average real rate of interest in Europe would be around 6 per cent. This contrasts with a short-term real interest rate in the United States of around 1 per cent. This difference between real rates in Europe and America is exceptionally large by historical standards and suggests important differences in economic prospects and policies on the two sides of the Atlantic. (For the 1980s as a whole real interest rates were 4.5 per cent in America, 3-8 per cent in Germany and 5.1 per cent in Britain.)

The difference in nominal interest rates should give an indication of market expectations of exchange rate movements. Thus the present differential implies that the dollar is expected to rise relative to European currencies over the next year or so (see the forecast of the world economy on page 26 below). It is more difficult to interpret a difference in real interest rates in terms of market expectations, since we do not know what rates of inflation the market is anticipating, and expected real rates of return in different parts of the world may in any case diverge (especially on a short-term comparison) because of market imperfections. It would seem appropriate therefore to look in the first instance at differences in monetary policy in Europe and America for an explanation of the contrast in real rates which we now observe.

Short-term interest rates in America have been reduced quite sharply in response to the recession and are rather lower than one would expect to be sustainable in the long term. Certainly the yield on longer-term US bonds implies a market expectation of higher short-term nominal interest rates in the future, which may not be entirely accounted for by expectations of higher inflation. The US authorities have allowed a moderate relaxation of monetary policy as a means of maintaining demand. This is the way that monetary authorities have behaved in most countries for most of the postwar period. It involves giving some weight to output stabilisation as well as reducing inflation.

The situation in Europe is quite different, and out of line with most historical experience. Nominal interest rates were raised sharply in Germany in 1989 in response to an increase in inflation from under 1 per cent in 1987 to about 3 per cent in 1989. The rise in nominal rates exceeded the rise in inflation in that year, and it has continued for two more years even though inflation has not risen much further. Meanwhile in France nominal interest rates have risen despite a fall in inflation; and in the United Kingdom over the past year nominal interest rates have remained high despite a long and deep recession. Longer-term bond yields suggest that the market expects European nominal interest rates generally to fall to 6 or 7 per cent in a few years' time. If Europe achieved or even approached price stability the resulting real interest rate would still be very high indeed by historical standards.

Why are real interest rates so high in Europe? Several conventional explanations could be put forward, but they do not explain the contrast with rates in America. Public sector borrowing might be to blame, but this hardly fits the history of fiscal tightening in Europe, notably France and the UK in the 1980s (see the note on page 69 below). The scale of public borrowing in the United States has been very worrying to financial markets, but this has not prevented a fall in US short-term interest rates.

Credit liberalisation in the 1980s may have contributed to the rise in real interest rates in Britain, and possibly in France. Higher real interest rates might be seen as substituting for credit rationing. But again this plausible explanation founders on the contrast with America, where liberalisation has gone further, but apparently without the need for an upward shift in real interest rates. Moreover credit liberalisation has, as yet, had relatively little impact in Germany.

The timing of the rise in real interest rates suggests another explanation. Has the demand for borrowing in Eastern Europe had a disproportionate effect on financial markets in Western Europe? Are real interest rates rising in anticipation of high returns to be made in that region some time in the future? The scale of lending or transfers to Central and Eastern Europe seems hardly sufficient as an explanation, except in the case of the eastern lander of of Germany. This explanation of high real interest rates in Europe is, in effect, an explanation in terms of German unification and the way in which its economic aspects have been handled by the German authorities. To understand this argument therefore, we need also to look at the special role that the Bundesbank plays in the setting of European monetary policy.

The special role o[the Bundesbank

The Bundesbank has established a leadership position such that the monetary authorities in other member states of the ERM behave as if they were pegging their exchange rates against the D-Mark. At the present time it is almost taken for granted that the French or British interest rate cannot be reduced further unless the German rate is cut first. If German rates were to rise, it is assumed that the French and British rates would have to rise too. But there is nothing in the constitution of the EMS which gives leadership to one country; neither is it necessary to concede it in practice. (The foreign exchange markets may tend to quote the D-Mark against the dollar and some other European currencies against the D-Mark, but this convention has no real significance, since the markets must necessarily determine all cross-rates consistently. ) If the other member states of the ERM all agreed to cut their interest rates now simultaneously by a significant amount, the Bundesbank might in fact have to follow their example. One could imagine a situation in which France or even Britain took over the leadership role, but that is not the most appropriate solution. Obviously it would be much better for joint decisions to be taken by the monetary authorities in all the countries of the EMS, taking account of the situation of Europe as a whole--not just the situation in Germany.

The Bundesbank has established its position of leadership in part because of the size and importance of Germany, and because the D-Mark has been a relatively strong currency for much of the postwar period. During the evolution of the ERM in the 1980s it may have been appropriate for France or Italy (or latterly the UK) to think of the D-Mark as the 'anchor' of the system. But that is no longer so appropriate today, when Germany no longer has the lowest inflation rate in Europe. The Bundesbank may also enjoy special prestige because it is constitutionally independent of government. An independent Banque de France and an independent Bank of England would probably carry rather more weight in a conclave of central bankers, than can be the case under the present regimes. Certainly it would be easier for the Committee of Central Bank Governors to coordinate their policies effectively if they all enjoyed the same freedom to negotiate. Their policy commitments would enjoy more credibility if they were freed from electoral anxieties--a significant factor now in relation to France.

Since this is the direction which institutional change must take under the terms of the Maastricht Treaty the sooner that all the central banks are freed from political control the better. It would mean foregoing headlines to the effect that 'Lamont cuts Home Loan Rates', but that would be a small price to pay.

If these constitutional changes were made it would be possible to anticipate much more closely the kind of European monetary policy which will be in operation during the second stage of progress towards EMU, a stage which should be reached in any case by 1994. The dilemma created by high real interest rates at the present time would be more easily resolved in that setting.

A monetary policy for Europe as a whole

The objective of European monetary policy under the Maastricht Treaty is price stability. Currently the rate of inflation in the countries participating in the ERM averages about 4 per cent. The objective of price stability might be consistent with, given the known biases in the compilation of price statistics, measured inflation up to about 2 per cent a year. It would be consistent with the aims agreed at Maastricht therefore for monetary policy to be restrictive, although not necessarily as restrictive as it is now. The Maastricht Treaty makes no mention of steady growth as an aim of monetary policy, but in practice no central banker would be so foolish as to ignore the state of the real economy entirely when setting interest rates. The first annual report of the Committee of European Central Bank Governors indicates that the growth rate of output is a factor that at least deserves a mention when the setting of monetary policy is being discussed.

Europe as a whole showed economic growth of about 1 per cent in 1991, compared with minus 1 per cent in the United States. This year we expect growth of about 1 1/2 per cent in Europe. There is no need then for the stance of monetary policy in Europe to be as relaxed as it is in the US. We cannot expect the special circumstances of the UK to be given more than their proportionate weight.

Real interest rates are so high mainly because the pressure of demand arising from lending and transfers to the East is concentrated in Germany. The other member states of the Community have been much less affected--the UK hardly at all. Moreover the German government has been reluctant to finance the costs of supporting or developing the recovery of the East by raising taxation or cutting other forms of spending. Fiscal policy is too lax in Germany, as would be evident if real interest rates were reduced. If monetary policy was being conducted with a view to balancing the advantages and disadvantages to all the member states of the EMS then interest rates everywhere in Europe would be lower than they are now, and the German government might well be obliged to tighten its fiscal policy. (The effects of a policy switch of this type are set out on page 28 below.) Nominal income in Germany is reduced and hence the growth rate of the wider monetary aggregates in Germany might be reduced as well, despite the cut in interest rates. If the tightening of fiscal policy could not be achieved then Germany would have to realign its exchange rate or else tolerate for a few years a rate of inflation a little higher than the European average.

The disadvantages of high real interest rates are well-understood and generally acknowledged. They have their main impact on the private sector, by restraining consumption to some extent, but principally by reducing investment. Our world model suggests that these effects are strongest in Germany, less so in Italy and in France. Thus they may sacrifice the potential for longer-term growth in the interests of maintaining current spending either by taxpayers or by government. High real interest rates also transfer income from borrowers to lenders, risking the solvency of otherwise sound businesses and making the task of fiscal stabilisation more difficult for governments which inherit a large stock of public sector debt.

The appropriate stance of monetary policy is always a matter of judgement, but we would conclude that real interest rates as high as 6 per cent for Europe as a whole at the present time are clearly excessive.

The alternative of a realignment

Since we are still in fact in the first stage of transition to EMU, the alternative is still available of an exchange rate realignment within Europe. It is important to recognise however that the rate of all European currencies together against the dollar and other world currencies is determined by market forces. If the currencies of Europe realigned without any change in average interest rates then we would not necessarily expect the ECU basket of currencies to change its dollar value. Thus the overall level of real interest rates in Europe might not be altered at all by changes in the parities of national European currencies.

If the D-Mark was revalued against the Franc and the pound, German inflation would be reduced and French and British inflation increased for a year or so (see World economy forecast variant on page 30 below). The main point of the realignment would be to ease the anxieties of the Bundesbank, allowing it to behave in its preferred traditional way. This might win its support for a general reduction in European interest rates. It could be presented as a final and once-for-all adjustment prior to 'really' fixing exchange rates, or as a once-for-all adjustment (rather a belated one) to the unique event of unification. It is an attractive option, because it is the way in which similar tensions have been resolved in the past. But it may nevertheless be the wrong option to follow this time.

The ERM is a difficult monetary regime to analyse formally since it is neither a fixed-rate system nor a floating-rate system. It is a hybrid with characteristics of both. The rules of the game allow realignments, but do not make clear the circumstances in which they would be appropriate. It is of the essence of the system that realignments should be unexpected, and hence to some degree should appear arbitrary. This is not an attractive feature of a monetary regime and may help to explain why the EMS has been evolving towards a fixed-rate system.

It is very uncertain how the markets would interpret another realignment now. Relative interest rates suggest that the market would be taken by surprise. The note on page 86 below discusses how markets may revise their expectations in the face of a policy 'shock'. The conclusion might well be that a margin for expected depreciation had to be put back into the interest rates on franc or sterling assets. The effect of the realignment could then actually be perverse, requiring higher interest rates in France and in Britain, together with lower interest rates in Germany. We have discussed exchange rate policy in terms of a D-Mark revaluation. The case of a devaluation of sterling and/or the French franc would be very similar--the presentational objections would be of the same kind, but stronger.

Any kind of realignment would now represent a serious setback to hopes of an early move to EMU. A revaluation of the D-Mark relative to the franc and the pound would appear as a failure of the economic policy of the German government. It would confirm that the Bundesbank still cares about the objective of price stability in Germany, whilst the monetary authorities in the other member states have different objectives or different understandings of the way that monetary policy works. A realignment would also suggest that the attempt to coordinate monetary policy in Europe had failed. That would cast doubt on the possibility of ever conducting such a common policy within a monetary union.

The prospects for EMU

The path to ratification of the Maastricht Treaty is not quite as smooth as had been hoped. Most of the political leaders who signed the Treaty have run into domestic opposition. Nevertheless the aims of the Treaty still have widespread support across the spectrum in all member states and universal ratification is still probable.

The alternative to EMLJ would not necessarily be a continuation of the EMS in the present form. It would not be possible to abandon the aim of EMU without a serious disruption to expectations. The stability of exchange rates in Europe since the late 1980s may be largely due to the perceived political momentum towards EMU. If that goal were to be abandoned now exchange rate changes might well become larger and more frequent. The combination of free capital mobility with frequent realignments would result in higher and more volatile interest rates. The convergence of inflation rates might also be reversed.

But the present high level of real interest rates must be seen as inimical to the transition to EMU. As mentioned above it makes the process of fiscal convergence more difficult. More fundamentally, it suggests to public opinion throughout Europe that a common monetary policy will be a harsh one, bearing down unnecessarily hard on both households and firms. This is not the way to win political support.

The Maastricht Treaty is supposed to apply the principle of subsidiarity to economic policymaking. Monetary policy is to be conducted in the interests of Europe as a whole; fiscal policy is left to the member states, subject to certain restrictions, and should be set in a fashion appropriate to the special conditions at the national level. If that principle were applied now, monetary policy in Europe would not be so tight and real interest rates would be substantially lower. Fiscal policy in Germany, and perhaps some other member states, would be substantially tighter.
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Title Annotation:United Kingdom's economic recovery and European monetary policy
Publication:National Institute Economic Review
Date:May 1, 1992
Previous Article:Social policy: the UK and Maastricht.
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