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Summary and appraisal.

The Domestic Economy

The recession, by which we mean the fall in gross domestic product, seems now to be coming to an end. The low point may well have been in the second quarter of this year. But the recovery is likely to be slow and hesitant. The usual way of identifying turning points in the cycle is by comparing the growth of GDP with its trend of about 2 1/2 per cent a year. On that basis the turning point is not expected until about the second quarter of next year. Such precise statements are, as always, subject to a wide margin of error: a rapid recovery next year is quite possible, but so is a year of no growth at all.

Short-term interest rates have now been reduced by some 4 percentage points since the UK joined the exchange rate mechanism. They are now not much higher than German rates, leaving little room for further reductions. In line with the market expectations implied by the structure of rates, we are forecasting only a further 1 percentage point reduction next year. This would seem a cautious policy for the monetary authorities to follow, but it is understandable if they share our view of the economic outlook. A small reduction from the present level would certainly be welcome. A further sharp cut in interest rates would be appropriate if the recession were continuing to intensify (and in those circumstances should be possible without upsetting the exchange market) but that is not the direction in which the evidence points at the present time.

The aftermath of the recession will be with us for most of next year, even though output is rising. Employment will continue to fall in most industries and unemployment will continue to rise. Bankruptcies, repossessions and bad debts will remain at very high levels. Some industries, especially those dependent on building or fixed investment will see the recession intensify, although others, especially those with good export opportunities, should see a return of relative prosperity.

Looking further ahead two aspects of our medium-term forecasts merit special mention. The first concerns prices. We still expect the rate of inflation to be down to about 4 per cent by the end of the year, which is similar to the present rate in Germany. For several years in the medium term we project the rate of inflation in this country as slightly lower than that in Germany. Our analysis suggests that this will be necessary to bring our price level into a sustainable relationship with prices in Germany. (The argument is spell out in the note by Ray Barrell and Jan Willem in't Veld on page 51 below.) This seems a difficult adjustment to make, and it will probably require that the rate of unemployment in this country remains a good deal higher than that in (west) Germany for the foreseeable future.

Another feature of our medium-term forecasts is a return to a sustained period of public sector borrowing. This is true even although we make no allowance for cuts in rates of taxation or for growth in public spending as a share of GDP. (The effects of raising benefits in line with earnings are shown in a variant forecast.) There is, in our view, no special merit in a precisely balanced budget. Indeed a more natural requirement would be that the growth of public sector debt should, over a run of years, be broadly in line with the growth of the tax base. In our forecasts the growth of GDP at current prices slows down to some 6 per cent a year; growth of public sector debt at 6 per cent a year would be consistent with borrowing of about the level shown in our forecasts for the mid-1990s. This does not leave scope however, for tax cuts or for extra spending. The World Economy In the last 12 months the economic cycle in the major economies of the world has been out of phase. The United States and Canada have experienced recession, and reacted by lowering interest rates. Japan and Germany have continued to experience strong demand growth, with attendant inflationary pressures, and have maintained a tight monetary policy stance. The other major continental European countries have generally avoided recession, but experienced slower growth because of constraints imposed on them by the Exchange Rate Mechanism. These constraints have limited the extent to which monetary policy can be relaxed in European countries. The strength of the D-Mark and high German interest rates have inevitably slowed growth throughout Europe, but strong growth in Germany has offset some of the slower growth in other European countries' domestic demand.

Our forecast suggests that the major economies will move back towards trend growth-rates in the next 12 months. The US and Canadian recessions appear to be at an end, although we expect that recovery in the second half of the year will be weak. Cyclical recovery in domestic demand should ensure that both economies grow by 2.5-3 per cent in 1992. Indeed the US recovery will probably have to be restrained by increases in US interest rates, Since inflation in the US could easily accelerate if demand grew too rapidly.

The Japanese economy continued to grow strongly in the first quarter of 1991, but a tight monetary policy should ensure that domestic demand grows more slowly in the second half of the year. In the last 12 months Japanese GNP growth has been sustained by strong net exports, following the 14 per cent depreciation of the yen between 1988 and 1990. Although the yen has appreciated somewhat recently we would expect the continued undervaluation of the yen to cause the current balance to improve and growth should not fall far below trend productivity in the near future.

We discuss the medium term prospects for the European economies and the possible road to eventual monetary union. A note in this Review suggests that the D-Mark may be undervalued against other European currencies by between 5 to 15 per cent. This misalignment cannot persist permanently, and if nominal exchange rates do not change then eventually relative price levels will adjust. This is a lengthy process, and we are forecasting that French inflation will remain below that in Germany for much of the next decade. The inflation differential is small however, and should be maintained without changes in fiscal and monetary policy.

The path to monetary union with Germany will be relatively smooth for the French, Dutch, Belgians, Danes and even the Austrians. The same cannot be said of the Italians. We are forecasting that their sustained positive inflation differential against Germany will make unavoidable at least one realignment before monetary union, and growth will have to be held below capacity for several years.


Unemployment has risen very sharply so far this year. Although the rate of increase should now slow down, the total may keep on rising for at least another year, heading back towards 3 million or about 10 per cent of the labour force. The issue deserves to be at the top of the policy agenda. The plight of the unemployed attracts most public attention during recessions as the numbers rise, but the underlying problem will not be solved simply by a cyclical recovery.

The history of unemployment shows a rise from one cycle to the next for much of the post-war period. Until the end of the 1960s the rate was 3 per cent or lower: by the end of the 1970s it had risen to about 6 per cent. Then during the recession of the early 1980s and for some years thereafter it rose very strongly to a peak of nearly 12 per cent. Having turned down in 1986 however it fell for some years, and it was reasonable to hope that a rate somewhere around 6 per cent or a little higher might prove sustainable. The prospect now seems to be, as illustrated by our own medium-term forecasts, that the rate of unemployment in this country for the next few years will not be far below 10 per cent.

The theoretical framework now commonly used in this country to explain trends in unemployment is provided by the NAIRU (or non-accelerating inflation rate of unemployment), an approach developed since the 1970s and now embodied in several macroeconomic models including our own. in contrast with the neoclassical framework generally adopted by American economists, this approach assumes imperfect competition in both goods and labour markets, with emphasis on wage bargaining between firms and trade unions. Briefly the idea is that some slack in the economy is needed to prevent a wage-price spiral, caused by bids for real wages or profit margins in excess of what the economy can produce. The NAIRU will not in general correspond with full employment as the term is popularly understood. Individual workers will be out of work through no choice, or fault, of their own. The system needs some involuntary unemployment as a pressure for wage restraint balancing the pressure of unrealized aspirations for a higher standard of living. The outcome is not a full equilibrium in which all these pressures are resolved: it is a point of balance with one pressure matched against another.

Various attempts have been made to explain the rise in UK unemployment since the 1970s using this framework. Some calculations give most weight to the rise of trade union power in the 1970s, others to mismatch' between the skills needed and those available in the workforce. Our own model of the economy suggests a shortage of spare capacity in the latter part of the 1980s is also an important reason for the current rise in unemployment. if there had been a higher rate of fixed investment, or less scrapping, during the early 1980s it would have been possible to produce more output in the boom years with less inflation, and hence with less need for the subsequent recession.

Although the NAIRU explanation of unemployment adopts a wage-bargaining framework there can be no suggestion that the present rise in unemployment is due to more 'aggressive' behaviour by trade unions. On the contrary the late 1980s saw a substantial weakening of union influence, with many examples of derecognition. The 'mark-up' of pay in unionised firms compared with similar non-unionised firms has been decreasing. increasingly pay is being set to reflect the performance of individual production units, rather than resulting from national settlements. This greater flexibility may assist the allocation of resources in the economy, but it does not seem to be doing much to reduce unemployment.

The labour market has also become more flexible in that fewer workers enjoy security of tenure. There is more part-time working, more seff-employment and more short-term employment contracts. Firms themselves are less secure, more at risk of bankruptcy. The effect of these changes on unemployment is ambiguous. it makes it easier for employers to lay off workers-as can be seen in the present recession-but it may also make them more willing to take on new workers-as we hope to see when the recovery gets under way. The variation in unemployment over the cycle is likely to increase in a more flexible labour market. One might also hope that the average duration of unemployment would be lower.

The NAIRU framework is a useful one for the explanation of unemployment trends in the medium term, but it has its limitations. As a theory of wage bargaining behaviour it remains incomplete and perhaps inconsistent. It is generally assumed for example that wage bargains take account of productivity changes in a 'rational' way so that the sustainable level of unemployment is not affected one way or the other. Why should not a similar 'rational' bargain be reached when lasting changes take place in tax rates or the real exchange rate? Is it really true that a higher rate of income tax or a lower real exchange rate will raise the margin of slack required in the economy for ever?

The history of this country and many others also suggests quite strongly that the experience of a period of high unemployment makes it permanently more difficult to restore full employment. institutional or behaviour changes have taken place which have shifted the relationships on which the NAIRU analysis rests. it is more than likely that the attitudes of firms to job security changed irreversibly some time in the 1980s as a result of tight monetary conditions and enhanced competition. It is also very probable that attitudes in the workforce and the community were irreversibly changed, and the social stigma' associated with a spell of unemployment was reduced. Both these changes of attitude could contribute to a permanent increase in the sustainable level of unemployment.

The experience of other countries may show that an upward trend in unemployment is not universal or inevitable. The table below shows unemployment on the standardised ILO definition for a variety of countries in 1971 and in 1991.

In most countries unemployment is now substantially higher than it was 20years ago. in none of those shown is it lower; there are several examples nevertheless of countries where the increase is very small; this is true of the United States, of Japan and of Sweden. The great variety of experience across countries suggests that the significance of these numbers for unemployment may be different in different countries, even after the statisticians have done their best to standardise them. In some countries there is more short-time working as an alternative to unemployment. Some countries rely more than others on migrant workers as a labour reserve. in some countries there are relatively large numbers engaged in retraining but not classified as unemployed.

It would be too simple therefore to conclude from this table that because unemployment is still under 3 per cent in Japan or in Sweden it could, and should, again be under 3 per cent in the UK. Nevertheless the arguments for full employment as a policy objective remain compelling. The case rests on two foundations, economic efficiency and social justice. The only economic benefit of unemployment is the better allocation of resources which results from retraining, relocation or a more protracted search for the right job. But job searching can be quite effectively undertaken whilst working full-time at an existing job or alongside short-term employment. Retraining and relocation usually take place after a new job has been secured. involuntary unemployment is, almost by definition, economically inefficient. it is in the interests of society as a whole to organise job changes in such away as to minimize unemployment. This point is perhaps especially relevant at the present time to the spectacular rises in unemployment being experienced in eastern Europe and the Soviet Union but it is relevant to this country as well.

The social case for full employment is difficult to fit into the familiar forms of economic accounting. It is most relevant to long-term unemployment. The predominantly short-term unemployment experienced for example in the United States is a different phenomenon to the more wide-spread long-term unemployment seen in Europe. The argument is that individuals have, or should have, a right to participate in the economic life of the community to which they belong as producers as well as consumers. The 'stigma' of unemployment may be less than it was, but is is still an alienating experience, painful for most of those it affects. It is this argument, more than the wish to realize the last few percentage points of potential output, which explains the place which full employment has occupied as a policy objective in most Western countries since the war.

Traditionally full employment has been an objective of macroeconomic policy, influencing the setting of interest rates or the scale of government borrowing. Gradually over the next few years the conduct of macroeconomic policy of this kind will become more and more a matter of decision by the European Community rather than by national governments. This does not mean however, that unemployment has become a purely European rather than a national problem. The labour markets of the member states are far less closely integrated than the markets for goods and services. Unemployment will not be equalised in all European countries by migration. There are policy measures of a microeconomic kind which can be taken at the national or regional level. Indeed the efficient operation of labour markets, and the achievement of full employment, may from now on be seen as the main task facing economic policymakers in most European countries.

We argued in the February issue of the Review-that the cost in terms of unemployment of reducing inflation could be kept at a minimum if all current wage settlements and administered price increases reflected the outlook for European inflation. This required some leadership from the TUC and the CBI. Others have argued for greater coordination of wage bargaining, perhaps with a concentration of settlements at one point in the year. We remain convinced that this approach is a valuable one. If successful it would reduce the severity and duration of the recession needed to bring inflation in this country into line with the rest of Europe. in fact the fall in inflation has been abrupt, as we hoped, but unemployment has risen sharply, as we feared. The problem we now face is not so much one of reducing inflation, as one of reducing unemployment without causing inflation to speed up again. Reforms which change expectations of inflation or increase the coordination of wage settlements may reduce the extent to which unemployment has to remain above the NAIRU. But now the main issue is that the NAIRU itself is too high.

We have two specific suggestions to propose, one familiar, the other less so. Both should help to reduce the average duration of unemployment. The familiar one is that the administration of benefits should be combined with help to the unemployed in retraining, relocating and finding work. Some part of the fall in unemployment between 1986 and 1990 was the result of increased efforts of this kind. It is difficult to achieve a great deal by these methods during a cyclical downturn, but the policy should pay off once the recovery gets under way. in the 1980s this approach was neglected until the latter part of the decade. Unemployment might never have risen so high if schemes like the Job Clubs or Restart had been in place earlier.

The less familiar proposal is that help should be given to those at risk of unemployment before they actually lose their jobs. This help should not take the form of a subsidy to their old job, but of help in moving directly to a new one. The financial help, whether given by tax allowance or cash payment, could extend to any of the expenses associated with job changes. Examples would include retraining or relocation expenses. Training in job search might be made available free to those still in employment. We would not wish to exaggerate the extent to which the problem of unemployment can be solved by spending public money in this way. The point is mainly to signal to individuals that they need to plan ahead, so as to avoid an unnecessary spell of unemployment.

We have identified some of the changes over the past twenty years which may have contributed to the rise in unemployment in this country. This is interesting as a historical exercise, but it is certainly not intended as a guide to policy. We mentioned, for example, that keener competition between firms may have reduced overmanning; this is a step towards greater economic efficiency which we would not wish to see reversed. We also suggest that the social 'stigma' of unemployment had been reduced-something which we must welcome even if it makes it more difficult to secure full employment.

The Government has, in its response to the European Social Charter, put great emphasis on the reduction of unemployment as a policy aim. It is surely right that all proposals for labour market regulation, or deregulation, should be scrutinised to see what their effects would be on unemployment, and that this should be one of the main criteria for decision. There may be some presumption against measures which restrict the efficient working of the market. It should be noted, however, that the free market' outcome of unemployment will not correspond to the economically efficient or 'optimum' rate. The payment of unemployment benefit and the taxation of employment income necessarily involve 'distortions'. A case for policy intervention to secure full employment can therefore be established from the most elementary principles of welfare economics.
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Title Annotation:Great Britain's economy vis-a-vis the world economy
Publication:National Institute Economic Review
Date:Aug 1, 1991
Previous Article:European integration and external constraints on social policy: is a social charter necessary?
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