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The economic situation.


The Economic Situation

The new Chancellor, John Major, has taken office at a difficult time for the conduct of economic policy. The boom of the late 1980s has spent its force, but as yet there is no sign of the improvement in the balance of payments, or the reduction in inflation one might expect as a consequence.

In our main forecasts we show output growth in 1990 of just over 1 1/2 per cent, less than 1 per cent excluding North Sea oil production. Consumer spending, which gave the main impetus to the early stages of the boom, will hardly rise next year and stock building is expected to turn negative. Fixed investment is unlikely to contribute much to the growth of demand year-on-year. The fall in the exchange rate during this year will help to sustain export growth next year, although world markets will not be as buoyant as they have been in 1989.

From the end of this year we should see a very gradual improvement in the trade figures, but the deficit on the current account of the balance of payments will remain very large next year. Inflation, measured by the retail prices index, will be reduced, but the fall in the exchange rate and the continuation of high wage settlements imply that the improvement will be a slow process.

Our forecasts were completed before the publication of the Autumn Statement, but they do not need any revision on that account. The Treasury forecasts are, on this occasion, a little more pessimistic than our main case, with respect to output growth and retail price inflation, but less pessimistic on the balance of payments.

The time is now past, in our view, for tightening policy to reduce domestic demand. The growth of the economy has already slowed down and the pressure of demand is falling. If that tendency were now reinforced by yet higher interest rates the outcome could well be a recession rather than merely a pause in expansion. We argued at Budget time in 1988, and again earlier this year, that fiscal policy should have been tighter. The overheating of the economy has confirmed our judgment. But that phase now seems to have ended, and it would no longer be appropriate to advocate deflationary measures.

A similar point applies to control of personal sector credit. In August 1988 we argued that direct restrictions on mortgage borrowing, although they might be administratively feasible, should not be preferred to tax increases as a means of curbing consumer spending. That was against a background of a consumer boom, and at a time when the housing market was still relatively strong. In the present economic climate the introduction of controls of this sort would be inopportune.

Our main forecast could be said to present the new Chancellor with a sombre outlook, but not with a critical one. Recent signs of weakening in demand have indeed been welcomed as showing that the tightening of monetary policy has produced its intended result. There is, however, a significant risk that the slowdown is becoming a recession, with output actually falling. The extension of credit, which has fuelled the spending of companies as well as households, could become an abrupt contraction. The recent pattern of financial flows is a very unusual one, with the personal sector and the company sector both in deficit. We do not know whether that pattern is sustainable. For that reason we have presented a variant forecast in which company spending in particular is sharply reined back. The consequence is a short-lived recession, but half of the reduction of domestic demand is absorbed by lower imports and there is a more speedy correction of the trade balance. In this scenario 1991 is a year of good recovery in output, but the trade balance again looks troublesome.

The change of Chancellor may mean that fiscal policy will resume a more explicit role as a second instrument in the management of demand. We would certainly recommend that the excessive reliance on high interest rates be abandoned. There should be a progressive shift in the policy mix over the next few years towards relatively tighter fiscal policy and a relatively less tight monetary policy. Such a shift would be necessary if Britain became a full member of the EMS, but we would recommend it in any case.

The issue of full EMS membership, which provoked the political crisis, has yet to be resolved. In our forecasts we assume that the time will be declared `ripe' at the end of next year, but it is almost as likely that the issue will not be faced this side of the next general election. Meanwhile we are forecasting that interest rates will be reduced with extreme caution, amounting perhaps to no more than one percentage point over the next twelve months.

We continue to support full UK membership of the EMS. The best time to join may be in the summer of next year, rather earlier than we have assumed in the forecast. By then the political row over the issue should have died down, and the balance of payments should be moving in the right direction. There seems little merit in waiting for any other conditions to be fulfilled.

Economic and Monetary Union

In the August issue of the REVIEW we commented on the proposals for European economic and monetary union set out in the Delors Report. The British Treasury has now published its own critique. It accepts that Stage One of the Delors proposals will go ahead, including full participation by the UK in the European Monetary System. But it argues against Steps Two and Three, preferring an `evolutionary approach which allows currencies to compete to provide the non-inflationary anchor in the European Monetary System', and which `could evolve into a system of more or less fixed exchange rates'. It also rejects the proposals for binding rules set by the Community on the size of budget deficits, as proposed by Delors.

On this last point we are in agreement with the Treasury paper. There is no need to lay down a common Community fiscal policy. There is indeed a case for `competition' between Governments to gain and hold a reputation for fiscal prudence. The more `prudent' Governments will be able to borrow at a lower rate of interest. On the issue of fiscal policy there is reported to be some disquiet with the Delors Report in many member states. The UK Government would have done well to concentrate its fire on this point where the Delors Report offers a vulnerable target.

So far as monetary policy is concerned, the proposals in the Treasury paper are unlikely to win support, since they would not secure the benefits to be expected from monetary union and a common currency. There is no guarantee that competition between currencies would in fact result in `more or less fixed exchange rates'. What might well happen is that a clear league table of currencies would be established, in which holders of the currencies most likely to depreciate would be compensated by higher interest rates. That is how the EMS works now, and the Treasury proposals for making capital more mobile could simply reinforce the existing pattern. Competition between currencies could even result in `competitive' interest rate increases.

The Treasury paper seems to contemplate a kind of competition between currencies which has featured in recent academic debate, but which is seldom observed in practice. In circumstances of very high and variable inflation rates it is true that a shift into the use of foreign currencies for domestic transactions can be observed; this happens now for example in Poland on a significant scale. It is very difficult to imagine it happening in Britain or elsewhere in Western Europe in the foreseeable future.

There is, moreover, a great difference between a system of `more or less fixed exchange rates' and a monetary union. A monetary union removes altogether one major uncertainty inhibiting trade and capital flows between member countries. That uncertainty and the inhibition will remain so long as any possibility remains that currencies will be realigned. It is, of course, in precisely the circumstances when realignment is attractive to Governments that a monetary union provides the reassurance ordinary traders would like to have. This is true even if the Treasury is right in arguing that there will be a continuing tendency for realignments to become less frequent.

The paper refers to the evidence of convergence of inflation rates already taking place within the existing EMS. But the experience of France and Italy for example in recent years has been influenced by the growing possibility of a move to monetary union, as well as by the dismantling of exchange controls. If the Community now took a decision to halt the process at the end of Stage One, or to stretch out the timetable into the remote future, the process of convergence could be set back. It must surely make some difference to behaviour, not only in financial markets, whether the final aim is understood to be monetary union or not. To that extent it would be helpful if Governments took decisions now about the future of the system beyond Stage One, even if those decisions will not be implemented for some time.

There is another important difference between the proposals of the UK Treasury and a true monetary union. In a monetary union the use of a common currency would facilitate trade by eliminating the cost and inconvenience of transactions in the exchange markets. The Treasury proposals actually involve a greater use of a variety of different currencies, and hence involve greater cost and inconvenience for individual traders. As with any issue of standardisation the benefits of using a particular currency depend on the number of other users with whom one expects to do business. There is thus an `externality' argument for policy intervention to bring about the use of the same currency by many traders. This is a common benefit which will not necessarily be realised as a result of market forces. (If one were to follow the route suggested by the Treasury paper, there might be a case for official encouragement of the use of the ECU in all countries rather than the use of a multiplicity of different units.)

We feel, however, that the Treasury counter-proposals miss the essential point of a monetary union. We would judge, moreover, that their critique of the Delors Report will in practice prove ineffective. It would have been better to address constructively the real political difficulties which monetary union involves. Clearly some arrangement is required for the political accountability of the central banking system which would be responsible for the common monetary policy of the Community.

The Treasury paper says that the only acceptable solution would be to create a Treasury on a European scale. That is not a widely-shared view. A balance has to be struck between the need for independence, and the enhanced `credibility' that goes with it, on the one hand, and the ultimate responsibility of any central bank to the democracy it serves on the other. The way these issues have been resolved in the UK is not necessarily the best model for Europe. On the contrary the constitution of the Bundesbank or that of the Federal Reserve System in America is much more likely to be the starting point.

The EC Social Charter

The British Government appears to be in a minority of one in opposing the draft Charter of Fundamental Social Rights drawn up by the European Commission. The Charter is a statement of general principles, which, if it is adopted, will be followed by more explicit legislation or agreements at community level, or within the individual member states. The British Government's objections are of two kinds: that the Community is seeking to extend its authority into areas which are not properly its concern; and that the proposed approach to social policy is inimical to the free market.

It is inevitable that the creation of a single European market should have implications for the labour market as well as for the markets for capital or for goods and services. Some of the clauses in the draft Charter may be included for no reason except that the member states share some common social values or ideals. Most of the clauses, however, can be attributed to one or other of two issues that properly concern the regulation of economic relations between the states. The first issue is labour mobility and the migration of workers within the Community. The second is the effect of relative labour costs in the different member states on their competitiveness in trade. In our view these are both issues that need to be addressed at a European level, and the Commission was right to bring forward proposals for consideration that address them.

The right of movement by citizens between member states is already established. It is limited, as it always will be by differences in language and culture, and migration flows remain small relative to the size of the labour force in most member states. The removal of any remaining administrative obstacles would almost certainly represent a gain in economic efficiency, although it could no doubt be against the interests of some particular groups of workers, those for example who now enjoy a local monopoly of particular skills.

An increase in migration between member states will bring to public attention many of the social issues covered by the charter, the rights of migrants to social security benefits being an obvious example. Moreover, a greater mobility of capital between member states would raise similar questions. Employment regulations and social security contributions must be among the considerations firms have in mind in choosing the locations for their production units in Europe.

The issue of relative labour costs is a serious and contentious one. The Charter foreshadows an attempt to improve conditions of work in a variety of ways throughout the Community, moving towards the `best practice' of the richest member states. If this is done, goods produced in the poorer member states must become less competitive in terms of price unless one of the following happens: profit margins are cut, productivity growth is accelerated or the growth of wages is held back. This is simply a matter of arithmetic, but it explains why the social charter proposals could be regarded with suspicion in some of the less wealthy member states of the Community. On the other hand it is understandable that workers in the most wealthy member states should want to see their terms and conditions of employment applied throughout the Community. It is partly, no doubt, an altruistic concern for the welfare of the less fortunate. It may also be a concern that their own position could be undermined by unrestricted trade with countries in which labour costs are lower.

The UK Government position seems to be that British industry will compete most successfully in Europe if it is able to keep its labour costs down by offering less favourable conditions of employment, as well as lower pay. On this view, trying to achieve minimum standards set in agreement with other member states would damage employment prospects, especially in this country. This is in keeping with the familiar message coming from the Department of Employment that pay restraint is the key to job creation.

Recent experience in the UK itself suggests that the message is incomplete, if not misleading. The recovery of output and employment in this country since the mid-1980s has been associated with a rapid increase in real wages and with improvements in non-pay benefits for many workers, made possible by gains in productivity. It is true that the pay and conditions of some groups of workers have deteriorated, but these are not in general the leading sectors of the economy.

As competition within Europe becomes more intense, British industry could adopt the approach of cutting labour costs and winning market share on the basis of relative price. Such a strategy would indeed be hampered by the kind of legislation suggested by the draft social charter. It is unlikely, however, that the strategy would succeed for many British firms, given the competition likely from Southern Europe and, increasingly, from Eastern Europe as well.

A different, and more optimistic, approach would be to attempt to emulate the productivity levels achieved in such countries as Germany, the Netherlands and France. Some firms, at least, have demonstrated that this can be done. In order to win the co-operation of the workforce in making the necessary changes in technology and working practices, pay and conditions of work would be improved on the Continental model. If the approach is successful this would be done without reducing profitability. There is no guarantee that this approach will work, but in our view it stands a better chance of working than the alternative with lower pay and productivity, and poorer conditions of employment.

One theme of the draft charter that calls for special comment is vocational training. It proposes a right to two years' training after leaving school, and a right to retraining at later stages of a worker's career. Training should not, in our opinion, be seen only as a benefit to the individual worker but also as a benefit to the economy as a whole, and as such the cost should be shared. The Charter requires countries to do something which it is in their own best interests to do, something which they should be doing already. It is, indeed, closely in line with recent developments in training policy in this country. More and better vocational training must be central to the approach to industrial competitiveness which we recommend, based on higher productivity rather than lower pay or less favourable conditions of work.

The implementation of the principles laid down in the Charter cannot be identical in every member state. For example, it is right that workers everywhere should be paid `a decent wage', but it would be unrealistic, given the present differences in productivity, for the same minimum to be set in every member state. On the other hand there are clauses which confirm the right to a basic level of provision or entitlement which should indeed be the same everywhere.

The draft charter is not, of course, above criticism on may points. There are a number of issues on which the British Government, amongst others, has been right to press for amendment. But the Charter, taken as a whole, is a useful initiative, deserving support. [Tabular Omitted]
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Title Annotation:Great Britain
Publication:National Institute Economic Review
Date:Nov 1, 1989
Previous Article:Comparative properties of models of the UK economy.
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