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Summary and appraisal.


The European Monetary System and the MTFS

It now seems increasingly likely that Britain will become a full member of the EMS before the next general election, possibly within the next twelve months. This is the assumption on which our forecasts are based this time. If it is true, it requires some fundamental changes to be made in the way in which economic policy is conducted.

Monetary policy will have to be much more closely co-ordinated with the rest of Europe than it has been to date. The present conduct of the EMS does not rule out exchange-rate realignments, but they can only be made in agreement with the other countries concerned and it is hoped that they will become less frequent. It is becoming increasingly clear that the pattern for the co-ordinated monetary policy of the European Community will be monetary policy in the style of the Bundesbank. This means that price stability in Europe will be its only strategic aim. Moreover the co-ordination of policy will be between central banks, rather than between finance ministries. If Britain is to participate fully, the Bank of England will have to be given more independent responsibility than it has now. The setting of interest rates in particular must be the subject to less political control.

With interest rates and exchange rates no longer available as instruments to control the domestic economy, public spending and taxation have a very important role to play. The strategic purpose of fiscal policy has been left unclear in recent Budget Statements. There is need now for a new kind of medium-term financial strategy appropriate to full EMS membership. The original purpose of the MTFS was to show how fiscal and monetary policy could work together consistently to reduce inflation. It would be useful now to demonstrate the consistency of projections for the public sector accounts with lower inflation, lower interest rates and the prospects for the current account of the balance of payments.

An MTFS constructed for this purpose might have the following features: the balance of payments deficit on current account would be greatly reduced by the mid-1990s, since there is no reason to expect a large and persistent net inflow on long-term capital account(see the Note on the Capital Account on page 52). As interest rates come down, personal savings will remain low and private sector investment will rise. The implication is that the public sector will need to stay in financial surplus. One reason for publishing projections of this kind would be to counter the widespread expectation of large-scale tax cuts in the medium-term. This expectation, which is probably unjustified, may be contributing to the low level of savings at the present time.

The economic prospects for Europe and the UK

Increasingly the prospects for the UK economy will be linked to those for the rest of Europe. Our forecasts show German inflation of just 1 1/2 per cent this year and about 2 per cent in 1991; for France the figures are a little higher at about 3 per cent in both years. Interest rates have been raised recently in both countries, but are expected to fall gradually over the next few years. European currencies will remain generally strong, with the deutschemark appreciating against the dollar. The transition to the economic and monetary union of Europe will take many years. with some further small realignments before exchange rates are `irrevocably' fixed.

The first moves towards the reunification of Germany seem likely to take place during this year. We cannot now predict the speed with which the process will go forward, or even the order in which events will occur. In our forecasts we still treat the two Germanys as separate countries, and they will indeed be very different economies for many years to come. whatever political changes take place. In the short term the availability of a large pool of relatively cheap but educated labour will tend to reduce costs in West Germany, making that economy yet more competitive in world markets. Once the process of development gets under way in East Germany, both investment and consumer spending could rise very rapidly, with enlarged markets for products from all over the world. We would expect real interest rates in West Germany to rise; what happens to nominal interest rates and the nominal exchange rate must depend on the arrangements now being considered for monetary union.

For about the next three years we expect growth in West Germany to continue at 3 per cent a year, which is just a little faster than the long-term trend in the past. Growth in France is forecast at about 2 to 2 1/2 per cent. The European economy with which the UK will be more closely associated in the 1990s will be advancing at a steady pace rather than a sprint.

The situation of the EC economies relative to Eastern Europe may be rather like that of America relative to Western Europe and Japan after the war. Capital and technology will flow from West to East providing the opportunity for the East to catch up. Some at least of the EC countries should benefit from the enhanced trade opportunities, but industrial investment within the EC itself may be somewhat curtailed. It is notable that the US did not share in the acceleration of growth experienced by Japan and Western Europe in the 1950s and 1960s. For rather similars reasons we are not forecasting that the development of East Germany, Poland, Hungary or Czechoslovakia will produce greatly accelerated growth in Western Europe.

By the middle of the decade the UK economy should be showing more evidence of convergence with the rest of the EC. The inflation rate in this country should be about 3 per cent a year, which is almost as low as that of West Germany; the growth rate of output should average around 2 1/2 per cent a year. In the next few years, however, there will be serious problems of transition. The problem of wage inflation is discussed at length below. The problem of the balance of payments will only be corrected if the growth of demand and output is held back this year and next.

Since our last forecasts the trade figures have improved more rapidly than we expected; our forecast for the current account deficit this year has been substantially reduced, mainly for this reason. There is a risk that demand and output may rebound sharply next year, however, when there could be a renewed widening of the deficit, which might undermine confidence in sterling.

It is also necessary over the next year or two to reduce the rate of inflation. In our forecasts the growth of consumer prices, now about 5 1/2 per cent, hardly slows down at all until the medium term (although the r.p.i. benefits from assumed cuts in interest rates this year and subsequently). This also argues for a period of `cooling off' in the UK economy with demand kept relatively low. We are forecasting growth of output this year of about 1 1/2 per cent, followed by 2 to 2 1/2 per cent in 1991. Unemployment is likely to rise a little as a result of this period of slower growth and the margin of spare capacity will increase.

We assume in our forecasts that the Budget this year is `neutral'- that is that any tax changes announced leave revenue unchanged relative to an indexed base. In present circumstances this seems the best stance to adopt. A more controversial point, which is worth making well in advance, is that there seems to be no economic justification for any tax cuts in the run-up to the next election.


The growth of wages and salaries per head in Britain last year was over 10 per cent and our forecast for this year is only slightly lower at 9.3 per cent. Increases of this magnitude are bound to raise price inflation, or to raise unemployment - most likely to raise both.

The article contributed by the Clare group (see page 57) describes the industrial relations legislation of the 1980s and assesses its economic impact. One of the aims of this legislation was to reduce the bargaining power of unions, in the hope that this would accelerate the growth of productivity, make labour markets more efficient and make overall price stability easier to achieve. It is a matter for debate whether the legislation has contributed to the improvement of productivity and the growth of output and company profits. It is clear, however, that it has not overcome the long-standing problem of inflationary wage settlements in the UK.

The pattern we have seen in recent years is for wage settlements in industry well above the rate of general price increase, but `paid for' by rapid productivity increases in the firm or plant concerned Other workers, whose productivity has not risen in proportion, then press for high settlements as well, quoting wage comparisons or the growth of the r.p.i.

In a competitive labour market the benefits of improved technology or work organisation would be passed `forward' as lower prices of products rather than `backward' as higher wages. This would increase the sales of the products concerned and direct resources to expand output in the industries concerned. Real wages in the economy as a whole would benefit from the lower price level; wages in the industry where the productivity improvement occured would rise only to the extent that labour of the relevant kind was in short supply. Market determination of wages along those lines would also slow down the growth of consumer prices in this country, encouraging lower rather than higher wage settlements in the rest of the economy. For the economy as a whole the objective should indeed be high real wages earned by high productivity. But to apply that principle rigidly to wage determination in each industry or firm would lead to a misallocation of resources at the national level and to inflationary pressure.

Productivity growth has, in any case, slowed down markedly in the last year, partly for cyclical reasons. We are now at the stage of the cycle when wage settlements based on comparability or on the recent growth in the price level often contribute to an acceleration in inflation. But from now on neither of these indices is appropriate as a norm for wage settlements any more.

Most industrialists, and many trade unionists, are now enthusiastically in favour of fixing the exchange rate for sterling relative to the value of other European currencies, through full UK membership of the EMS. We have, on balance supported this proposal for many years now, and we are basing our forecasts on the assumption that it is adopted. The implications for the rate of wage increase in the UK are serious and urgent. Last year compensation per employee in the business sector rose by 3.7 per cent in Germany, by 4.1 per cent in France, but by 9.1 per cent in this country. Similar figures are forecast for this year. If we are to succeed as full members of the EMS, and share in the European experience of price stability, then that gap must be closed, and closed very soon.

Indeed, it could be argued that closing the gap is not sufficient. To reduce the current account deficit to manageable proportions, without undue loss of output and employment, UK industry must become more competitive in terms of costs and prices, as well as quality of product. Once exchange depreciation is a thing of the past such an improvement in competitiveness relative to the rest of Europe can come about only through a faster growth of productivity or a lower rate of inflation - lower that is even than the French and Germans.

Productivity levels in the UK are still low relative to those in Continental Europe (as the new comparison with the Netherlands reported on page 71 of this number confirms) and it is to be hoped that closer integration of this country with the rest of Europe will lead to a gradual convergence. It would be wrong to count on that convergence taking place, however, when taking a view on the appropriate rate of increase of earnings in this country. Over the decade of the 1980s the growth of GDP per employee was broadly the same in Britain, France, Germany and Italy. Taking one year with another this would be a reasonable (if cautious) assumption for the 1990s as well. Hence the rate of increase of earnings should be broadly the same here as in the rest of Europe. An appropriate `norm' at the present time would be 3 or 4 per cent.

In the 1970s the Institute supported prices and incomes policies, an approach to combating inflation adopted successively by Governments of both the major political parties. In retrospect it is difficult to judge what lasting impact, if any, they had on the rate of inflation in this country, and inevitably they distorted pay relativities and the working of the labour market. In different circumstances they might have worked better, but we are not advocating policies of that kind now. Full membership of the EMS would make such intervention redundant. The UK Government will not be in a position to set a `norm' for prices or incomes; the `norm' must be related to the rate of wage increase elsewhere in Europe.

This does not mean, however, that the Government, the CBI and the TUC should be totally inactive in the process of wage setting. Much could be done to make the public more aware of the rate of wage increase in France and Germany. This, rather than the outturn or prospect for the r.p.i. should be the starting point for all wage negotiations. The Government, the CBI and the TUC, acting separately or together, could do a great deal to shape opinion in this respect. This is not an argument for coercion, but it is an argument for leadership. If the UK does join the exchange rate mechanism, and wages do not respond quickly, the consequence for firms and for their employees could be very serious indeed. The bodies representing both sides of industry at a national level should press their members to take this national interest into account.

Some may read this warning as an argument for staying outside the ERM and relying on exchange-rate depreciation to offset excessive wage inflation. To take that line would be to accept the continuation of price inflation at the present rate or higher. Moreover it would not avoid the implication of higher unemployment, for the reasons spelt out in Chapter One. The tendency of the UK economy to generate excessive wage pressure is endemic; full membership of the EMS forces us to face the issue directly and solve it. [Tabular Data Omitted]
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Title Annotation:Europe and British economies
Publication:National Institute Economic Review
Date:Feb 1, 1990
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