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Summary and appraisal.

The crisis in the Middle East could damage the prospects for world growth and price stability. The possibility obviously cannot be ruled out, given the similarities which exist between the pattern of events now unfolding and the circumstances of the oil shocks' in 1973 and 1979. In preparing our forecasts, (in the first week of August) however, we have assumed that the effect of oil prices is relatively minor, and relatively short-lived. The possibility of a larger and more sustained rise is discussed in an annex to the chapter on the world economy.

Even a substantial oil price increase, back say to the pre-1 986 level in real terms, need not be followed by such a disastrous outcome for the world economy as those experienced in 1974 and 1980. The inflationary pressure in commodity markets is a great deal less now than it was on either of those occasions. The economies of the oil producers themselves have been developed and integrated better into the international economy, so a transfer of income from oil consumers to oil producers no longer has such a major effect on world trade and activity.

The implications of higher oil prices for the UK economy are a rather special case, as we are net exporters. We would not expect on this occasion, however, that sterling will be buoyed up in the market as it was in 1979. What happened to sterling at that time was due to the change of government, and of macroeconomic policy, rather than to the oil price rise on its own. As it happens, on this occasion our forecasts for the UK economy have been significantly affected by a rise in sterling which took place in the early summer months, unconnected with subsequent events in the Middle East. The outlook for the UK economy The higher level of sterling probably reflects a market view that UK interest rates will stay higher, for longer, than had earlier seemed probable. We have in fact changed our own assumptions about monetary policy on this occasion: we now see base rates staying at about their present level well into next year even if the UK joins the exchange-rate mechanism of the EMS in the meantime.

The higher level of both interest rates and the exchange rate next year means that the recovery of output growth is also now expected to be quite modest, although an actual recession is not very likely. Unemployment is now rising slightly, and is unlikely to turn down again until about the summer of next year.

The higher exchange rate on its own would suggest a lower rate of inflation, but other new information is not so encouraging. The actual outturns for price inflation are running above forecast, and will be raised over the 1 0 per cent mark by the very prompt rise in petrol prices at the pump. The size of wage settlements remains very worrying. Thus our forecasts of underlying inflation are raised rather than lowered. Our forecasts for the 'headline' retail prices index are also raised by the delay we assume in getting interest rates down next year. It seems we may have to wait until 1992 for a really substantial fall in the rate of inflation.

Similarly the prospect for the balance of payments has deteriorated despite the slower growth we foresee next year. The sharp cutback in demand, and especially in stockbuilding, has not so far materialised, and neither has the hoped-for fall in import volume. The higher exchange rate will make UK goods less competitive in domestic markets and overseas-a matter which is now causing industry increasing anxiety, shown for example in the latest CBI survey responses.

If our interpretation of its effects is correct, the recent rise in sterling is unwelcome. It has damaged the prospects for output and the balance of payments, without producing an early or pronounced improvement in the prospects for inflation. It has also made the transition to full membership of the exchange-rate mechanism more difficult.

The differential between UK and German interest rates implies a market expectation that sterling will depreciate against the D-Mark. In our forecasts we assume that this expectation is correct. Yet if the UK joins the exchange-rate mechanism, at the current level of sterling, with a narrow band, this could be understood as a commitment to prevent the expected depreciation taking place. In our forecast such a commitment would not be credible. The result could be greater uncertainty, not less, about the future course of the exchange rate and interest rates.

The irony is that our interest rates can only be held at their present level relative to other EC countries if sterling is expected to depreciate in the future. If the authorities are serious about exchange-rate stability, they should make it clear to the markets that they expect and intend interest rates to fall. They should also make it clear that fiscal policy will be tightened to the extent appropriate to manage domestic demand. The markets might then judge that the exchange rate should be lower in view of this clarification of policy intentions. If so it would be better for the exchange-rate adjustment to come before full EMS membership, rather than to take the form of an early realignment downwards within the ERM.

The outlook for the world economy

Our central forecast for the world economy is more hedged about with uncertainty than it has been for many years. The Iraqi invasion of Kuwait has raised the world price of oil. We take the view, however, that the rise will be relatively short-lived. The combination of excess capacity elsewhere in the world with stocks of oil at twice the 1979 level should put downward pressure on prices by next year. More general hostilities in the Gulf, however, could of course alter the situation altogether.

The rise in oil prices has revived talk of a recession in the United States, but in our view such fears are exaggerated. The US economy is responding to the earlier tightening of monetary policy, and growth this year should be about 11/2 per cent. This easing in the growth rate has allowed some easing in monetary policy, which should be enough to keep output rising at, or rather below, the growth of capacity. Even after allowing for the rise in oil prices, US inflation should be slowing down gradually.

The cessation of the Cold War is likely to provide a considerable peace dividend to the US in the long run. The prospects for lower government spending have reduced pressure on both Administration and Congress to agree a budget within the guidelines, so that in the short run fiscal policy may be expansionary.

Meanwhile the Japanese economy is benefitting from the fall in the Yen, which makes Japanese goods even more competitive in world markets. Output growth in that country will be reinforced by a strong rise in domestic demand. Japanese, import markets have become more open over the last year, and Japanese factories producing for export are relocating elsewhere in the Pacific rim. We are expecting the Japanese current account surplus (as a percentage of GNP) to decline slowly over the next decade.

In Europe, the unification of West and East Germany is providing a stimulus to growth. In West Germany itself the migration of labour from the East should help to limit the potential for inflationary wage increases. The German growth rate in the 1990s should be about 1 percentage point above that of the 1980s. This will be associated with a decline in the German current account surplus as more investment opportunities become available in the united Germany. Further progress towards the creation of a single European market will add to trade flows as well as investment.

It now seems likely that agreement on the form of an economic and monetary union in Europe will be reached next year. As a result we assume that France, Germany and the Benelux countries operate a system of fully-fixed exchange rates from 1995. Because it takes time for the necessary adjustments to be made, the other countries including Britain are assumed to join rather later, in 1997. The disadvantages of such a 'two speed' solution are discussed below. LESSONS FROM RECENT HISTORY In the home economy chapter we look back at the boom of 1987 and 1988, and ask whether anything could have been done to prevent it. The episode is an important one in any assessment of what macroeconomic policy can, and cannot, do.

It' is doubtful whether the authorities were in fact aiming to control domestic demand at the time. In the MTFS they said that they would 'aim to avoid departures in the medium term' from a target path for money GDP. In the event they were prepared to tolerate an overshoot because the division of money GDP between output growth and inflation was better than forecast, a further sign of improvement in the supply performance of the economy'. It is unclear therefore whether their real objective was stability in the growth of nominal incomes, real incomes, or neither. If we look at what they did rather than what they said, their monetary policy seems to have been directed at exchange-rate stability, and their fiscal policy guided by a longer-term aim for budget balance.

It is unlikely that they could have prevented a boom occuring even if there had been no ambiguity as to their intentions. There are two distinct reasons for saying this. The scale of the boom was not anticipated in time for remedial action to be taken; and the scale of the measures required to offset that boom (using conventional policy instruments) would have been impractical or disruptive.

In 1987 and 1988 taxes were actually cut. This was a mistake for two reasons: the tax cuts added directly to consumer demand; they also gave the signal that further tax cuts could be expected in the future encouraging the euphoria which so often goes with a cyclical boom. We take some pride in recalling that we argued against tax cuts in the latter year, but no one was recommending tax increases of the scale necessary to offset the boom. The main problem was not with the data provided by the CSO; the mistake made by the Treasury (and by ourselves) was to forecast that the growth of demand would slow down of its own accord, when in fact it was growing faster and faster each year.

The Bank and the Treasury have suggested, with the wisdom of hindsight, that interest rates should have been raised earlier when the boom was still in its infancy. it would indeed have been better for the world economy if interest rates in general could have been higher in 1987 and 1988. But, taking world interest rates as given, it is not clear that the UK authorities could have done much better than they did. Higher UK interest rates would have encouraged sterling to rise more than it did in 1987 and in 1988, but the result would have been an even worse outcome for the balance of payments, with the likelihood of an even sharper fall in the exchange rate than actually occurred in 1989.

This illustrates the main problem with the use of interest rates as an instrument of demand management. It is true that they have more leverage' on domestic demand than they had when credit was regulated; it is also true that they can be changed quickly when the need arises; but unexpected interest-rate changes also cause' jumps' in the exchange rate which are subsequently reversed. These' jumps' do not offer a lasting cure for inflation, and they are highly disruptive for trade and investment. It is for these reasons (amongst others) that opinion in this country now favours full membership of the exchange-rate mechanism. The corollary is that the management of domestic demand rests on the active use of fiscal policy.

It is instructive to compare UK fiscal policy with fiscal policies adopted in other countries at this time. The expansion of demand was a worldwide phenomenon, although the boom was particularly strong in this country. Whilst the UK government was cutting taxes, the general response was a tightening of fiscal policy, notably in Germany and in France.

Calculations we have done show what the effect might have been of a really tough fiscal policy in the UK in the late 1980s. In the 'variant' shown on page 9, the volume of public spending actually falls for four years in a row and the basic rate of income tax is raised in three successive Budgets. The boom is not altogether flattened out, and inflation still accelerates, but the balance of payments deficit is almost eliminated. It is difficult to imagine measures on a larger scale than this being enacted in response to the forecast of a boom, doubly so in 1987 which was an election year. We conclude that the boom could have been moderated by a timely and determined use of fiscal policy but that it could not have been eliminated altogether.

A similar situation to that of the late 1980s could certainly arise again. The recent deregulation of the economy has made macroeconomic forecasting more difficult, because it has changed the established relationships (like that between incomes and consumer spending) on which forecasting must depend. Moreover, deregulation of consumer credit has removed one of the most reliable of the traditional levers of stabilisation policy. The economy may as a result have a 'rougher ride' in the future.

Within the limits set by their forecasting ability and the instruments at their disposal the authorities can still exercise a stabilising influence on domestic demand. In the late 1980s that influence should have been used to restrict demand, just as in the early 1980s it should have been used to stimulate demand. But the authorities have to weigh the benefits of stabilising output and prices against the costs of destabilising tax rates or public spending programmes. They cannot prevent episodes of boom or slump occuring, which may last for a year or more.

This makes it all the more important to set guidelines for the medium-term growth of domestic demand, and to use fiscal policy vigorously if there is a sustained departure from that trend. The present economic problems, especially the large deficit on the balance of payments, are the result of a failure to observe that rule.

In the May number of the Review we discussed the proposals of the EC Commission for implementing economic and monetary union. Since then the British Treasury has published its suggestions which are along very different lines. (They are summarised in the Treasury Bulletin, Summer 1990, page 14.)

The Treasury approach would 'retain control of monetary policies firmly in national hands'. The move to a single currency for Europe would take place only if peoples and governments so choose' some time 'in the very long term'. Meanwhile the ECU would be changed from a currency basket into a new international currency controlled by a European Monetary Fund. In future realignments within the exchange-rate mechanism the new 'hard ECU' would never be devalued.

It is argued that this new currency would be more attractive than the ECU in its present form. Thus a common European currency could emerge by a process which was 'market-driven' rather than policydriven'. By moving to a currency which was at least as strong as any of the existing national currencies, the process should converge on a rate of inflation at least as low as the lowest rate amongst member states.

The response to the Treasury proposals suggests that they are unlikely to be adopted as they stand. It is possible nevertheless that they may influence the outcome of the negotiations which will begin in December. One of the problems at these negotiations will be to find a way of accommodating the position of the British government, whilst allowing the rest of the community to go ahead with a relatively rapid transition to monetary union on broadly the lines set out by the EC Commission.

The upshot could be that the ECU in some shape or form is adopted as a community currency: in most countries it replaces the national currency more or less straightaway, whilst in Britain (and perhaps in some other countries) it is introduced alongside the national currency, so that the changeover (if it takes place at all) can be much more protracted. It would be difficult for the Treasury to oppose such a solution on the basis of the arguments it has itself put forward.

Yet this could be for Britain the worst of both worlds. Monetary policy would not really be autonomous. Realignments, and speculation over possible realignments, would be especially disruptive if the ECU had a wide circulation in Britain alongside the pound. In any realignments which did take place the pound would never rise against the ECU; thus monetary policy would only be independent to the extent that the UK monetary authorities were prepared to see the pound devalued. That is a freedom they would themselves be reluctant to use.

Moreover, dealing in two currencies at once within the domestic market would add greatly to the cost of transactions. Far from improving the efficiency with which everyday business is conducted, a dual currency system would be highly inefficient-and perhaps ultimately unstable. It is difficult to judge how far the use of the ECU in Britain would develop in these circumstances. Perhaps it would still be confined mainly to financial markets and international trade. it seems unlikely that it would ever effectively replace sterling, unless the changeover were actively encouraged by the UK authorities. (Their attitude, for example, to the payment of taxes in ECU could prove very important.) It would seem that in 'the very long term' the pound might eventually disappear as a result of a choice made by the public and the markets', but it could be a protracted and troublesome business.

The best outcome from the talks due to begin in December would be a clear announcement of a date for EMU sufficiently far in the future for nearly all member states, including Britain, to participate. That outcome is unlikely so long as the British government remains opposed to the outline of institutional change now taking shape in discussions amongst the other countries. The second best outcome would be an early move to EMU for some countries, with a transition period of a few years before the 'slow movers' including Britain, joined as well. The objection to using the Treasury approach in this period of transition is that no timetable for full UK participation could be laid down in advance. It would be like the ERM all over again, with the UK waiting for the time to be ripe.
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Title Annotation:British and world economies
Publication:National Institute Economic Review
Date:Aug 1, 1990
Previous Article:Comparative levels of labour productivity in Dutch and British manufacturing.
Next Article:Chapter I. The home economy.

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