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The world economy.

* A 10 per cent surtax on Taxpayers earning more than $250,000.

* An increase in corporation tax from 34 per cent to 36 per cent.

* A new energy tax amounting to $22 bn extra revenue per year.

* Income tax charged on 85 per cent of social security retirement payments instead of 50 per cent.

Growth rates of output amongst the major seven economies during 1992 appear to have accelerated a little on average, with an increase in the rate of growth in the US and a decline the rate of growth in Japan, Germany and Italy. Inflation has decelerated or remained roughly constant in all these countries. However, the prospects for 1993 look distinctly less good now than they did six months ago. Table 1 reports our current forecast, and Chart 1 plots recent and prospective growth rates in the major four economies.

We are expecting the German economy to contract by more than 1 per cent this year, which is 1/2 a point greater than in our last forecast.(1) Our forecast for Japan has also been revised down sharply, with growth now expected to be around 1/2 a per cent. This would be the lowest outturn since 1974, when output fell for the only time since the war. Both countries could use traditional Keynesian policies, and introduce a fiscal expansion. However, their budgetary positions are very different. Chart 2 plots the general government budget deficits for these countries, along with our forecast. German unification caused the West German government budget deficit to rise sharply, and there appears to be little room for manoeuvre. The Japanese, on the other hand, have been running government budget surpluses for some years, and they do appear to have both the room and the will to introduce an expansionary package.(2) We are assuming that the impact of the recently announced fiscal package will be greater than that introduced last year, and the surplus will fall. The fall in the growth of tax revenues that will result from the slowdown in the growth of income will also reduce the surplus.

First quarter figures for the US suggest that a recovery is still under way, but that it is not over strong. The Clinton administration has announced a deficit reduction package, and the markets appear to have taken it seriously, as both short-term and long-term interest rates fell after its publication. The package, which is analyzed in Box A below, will eventually be TABULAR DATA OMITTED contractionary, but as our analysis shows the initial effects could easily help the recovery. However, the consequences of a reduction in interest rates will not be apparent in the output figures for the first quarter.

Our forecast draws a strong distinction between the English speaking world on the one hand and continental Europe and Japan on the other. Recovery, albeit hesitant, is clearly under way in Canada, the US and now in the UK, whilst growth is slowing, or recession accelerating, in much of Europe. Financial liberalization proceeded faster and further in the former countries and the associated increase in borrowing and debt in the 1980s fuelled the upturn, and exaggerated the downturn. The rise in real interest rates that followed from German unification helped push these countries into recession. These contractionary effects were offset in much of Europe by the associated expansionary effects on demand. As growth has slowed in Germany the contractionary effects of real interest rates have begun to be evident throughout Europe. We expect the recession in continental Europe to be short lived, rather as it was in the US. This is in part because the Bundesbank will be able to react by cutting interest rates, a strategy that was not easily adopted by the UK authorities in 1991. Our forecast also reflects the smaller amplitude of past cycles in Europe. Charts 3 and 4 plot the growth of output and the level of inflation over the last twenty five years in the UK, the US, France and Germany. The former two countries have been more volatile, and we expect this difference to continue.

The recovery in Europe is expected to be quite strong, but the same cannot be said of Japan. Over the ten years up to 1991 Japanese growth averaged 4.6 per cent. The current slowdown in the growth of activity is the most severe since 1974. It has been led by a decline in investment, that has in part been produced by the recent collapse in asset prices. The fall in land and equity prices between late-1990 and early-1993 has had a depressing effect on the Japanese banking system and on large firms. Recent fiscal measures and rescue packages and the recent substantial rise in equity prices should help alleviate the recession. However, business confidence and investment intentions are weak, and the appreciation of the yen that took place in March and April is likely to have a contractionary impact.

Interest rates and exchange rates

Exchange rates within Europe changed markedly in the period after the exit of the UK and Italy from the ERM. The lira has fallen by around 25 per cent in effective terms since September 1992, with almost half that fall coming in the last few months, with increasing political uncertainty. The dollar has also fallen recently, but only as a consequence of previously unanticipated interest-rate reductions at both the long and short end. The combination of a near contemporaneous announcement of an expansionary fiscal package in Japan and a contractionary one in the US has caused the yen to rise sharply to its highest ever level against the US dollar.

Our exchange-rate forecasts are set out in Table 2. Our forecast is usually based on the assumption that exchange rates follow the interest arbitrage path. However, in this forecast we have decided not to adopt this assumption for the lira during 1993. Recent political uncertainties appear to have raised the risk premium on the lira, but we do not think the currency will depreciate further. Instead, we have assumed that the lira rises to 1460 against the dollar in the last quarter of the year, having fallen to 1580 in recent months.

The election of a new government in France, and its commitment to the franc-D-Mark parity, has meant that interest rates have fallen a little in France since our last forecast. German rates have stayed higher for longer than we had anticipated, but the forward market suggests that interest rates will fall to around 6 per cent by the end of the year before rising thereafter. Our interest-rate forecasts are set out in Table 3. We use three, six and twelve month forward rates to inform our forecast, as well as the profile of long rates to set our medium-term projections. Long rates suggest that French and German short-term rates will converge within two years. Chart 5 plots recent and projected long-term rates for the four major European economies, whilst Chart 6 plots them for the US, Canada and Japan. We expect that nominal long-term rates will continue to be lower in Japan than elsewhere, and that this will be reflected in a continually appreciating yen and a lower inflation rate than in the US.
Table 2. Exchange-rate forecasts for the major six

 Percentage change in effective rate

 US Japan Germany France Italy Canada

1988 -5.5 11.2 -0.6 -1.9 -3.4 6.1
1989 4.8 -4.2 -2.1 -2.1 0.0 6.4
1990 -6.8 -10.7 8.1 7.9 4.7 -1.7
1991 -0.7 8.6 -2.1 -2.7 -2.5 1.9
1992 -2.9 4.0 3.0 3.4 -3.2 -6.7
1993 2.1 14.8 0.4 1.7 -16.6 -4.5
1994 0.8 3.3 -1.4 -0.9 0.3 -2.9
1995 1.5 1.8 0.0 0.0 -4.4 -1.8
1996 0.7 1.5 0.1 0.2 -3.4 -0.9

 Yen D-Mark Franc Lira Franc Lira
 per Dollar per D-Mark

Nominal cross rates, year average

1988 128.1 1.76 5.96 1301.2 3.39 741.1
1989 137.9 1.88 6.37 1370.9 3.39 729.7
1990 144.8 1.62 5.44 1197.8 3.37 741.7
1991 134.5 1.66 5.64 1240.0 3.40 747.7
1992 126.7 1.56 5.29 1231.1 3.39 789.4
1993 113.6 1.60 5.41 1488.5 3.37 927.7
1994 110.8 1.63 5.50 1496.4 3.37 916.3
1995 109.9 1.66 5.58 1579.2 3.37 953.3
1996 108.8 1.67 5.62 1640.2 3.37 983.4

In the longer term we expect real interest rates to settle at around 4 per cent, a little higher than the average of the last 25 years. This is not out of line with historical experience(3). It also reflects our long standing view that the opening up of East and Central Europe will raise the rate of return to investment for some time to come. Real exchange rates in our forecast mirror current and prospective real interest-rate developments. Table 4 sets out our forecast for real exchange rates, whilst Chart 7 plots real interest-rate developments. Real exchange rates appear to have reached more sustainable levels than those seen in the recent past. Nominal realignments may have no real long-run effects on output and unemployment(4) but they can alter (indeed reduce) the cost of achieving a given real equilibrium exchange rate.
Table 3. Short-term interest rates

 Per cent

 US Japan Germany France Italy

1988 7.7 4.5 4.2 7.9 11.3
1989 9.1 5.4 7.1 9.3 12.7
1990 8.1 7.7 8.4 10.2 12.4
1991 5.8 7.4 9.2 9.7 12.2
1992 3.7 4.5 9.5 10.5 13.9
1993 3.3 3.3 7.5 8.8 11.9
1994 4.4 3.7 6.1 6.8 11.9
1995 5.6 4.8 6.8 6.8 11.1
1996 6.6 5.2 6.8 6.8 11.0
1997-2001 6.8 5.2 6.8 6.8 11.0

1992 I 4.1 5.2 9.6 10.2 12.2
 II 3.9 4.7 9.7 10.3 12.7
 III 3.3 4.1 9.7 10.6 16.4
 IV 3.4 3.8 9.1 10.7 14.2

1993 I 3.1 3.4 8.4 11.8 11.6
 II 3.2 3.3 7.8 8.4 11.8
 III 3.2 3.1 7.1 7.8 12.0
 IV 3.6 3.2 6.5 7.3 12.0

1994 I 3.8 3.3 5.9 6.8 12.0
 II 4.2 3.6 6.0 6.8 12.0
 III 4.6 3.8 6.2 6.8 11.8
 IV 5.0 4.0 6.4 6.8 11.6

1995 I 5.1 4.3 6.6 6.8 11.4
 II 5.5 4.6 6.8 6.8 11.2
 III 5.8 4.9 6.8 6.8 11.0
 IV 6.1 5.2 6.8 6.8 11.0

World trade and commodity prices

World trade growth has been slowing for some time now, but as is clear from Table 1, it has remained quite strong. We are forecasting that the exports of manufactures of the 13 largest OECD countries will grow by 3 per cent in 1993, below the 3 1/2 to 4 per cent seen in 1991 and 1992, but still relatively robust given that OECD industrial production appears to have been falling for two years. Chart 8 plots the annual percentage growth rates for OECD industrial production and OECD exports of manufactures. The recent episode is the first time (at least since 1970) that industrial production has fallen whilst world trade has continued to rise. There has clearly been some change in the relationship between these two variables, and if there had not been, then we would have expected world trade growth to be up to 3 per cent lower in 1992.
Table 4. Real effective exchange rates

year average US Japan Germany France Italy

1988 97.2 149.6 84.9 81.9 109.2
1989 102.9 138.8 80.9 78.8 111.7
1990 98.0 121.8 88.7 85.9 121.8
1991 97.4 130.3 85.7 81.7 122.8
1992 94.9 134.3 90.3 84.5 121.6
1993 97.3 151.8 90.7 84.6 103.8
1994 99.1 153.6 87.9 83.4 106.0
1995 101.5 152.8 86.0 82.9 103.7
1996 102.5 152.0 85.0 82.4 102.5

World trade has risen more rapidly than world output for some time, and this is in part the result of the continual process of the reduction of trade barriers and the development of new markets. The EC's 1992 programme and the growth of the small countries on the Pacific rim are good examples. Over the last two years there have been two major developments, and they should permanently affect the observed level of world trade (but not its growth in the long run). The North American Free Trade Area has been in effective operation for about a year, but it has already led to a considerable increase in US--Mexican trade, especially in manufactures. Much of this cross border trade consists of exports and then reimports of manufactures, with some processing taking place in Mexico. This rise in two way trade helps account for much of the buoyancy of US imports and exports over the last 18 months. The other major factor affecting world trade has been the rapid growth in output in, and imports into, mainland China. In particular, Japan has benefitted from this rapid growth. Neither of these developments is likely to have had much effect on European exports.

Commodity prices have been weak in the last six months. Table 5 presents our forecast for commodity prices, and Chart 9 plots recent developments for a number of groups of commodities. These indices are based on the Institute's disaggregated weekly commodity database. Prices of agricultural raw materials have been weak, in part because of low demand from the housing sector. Wool prices have remained low because of poor demand, especially from Eastern Europe. Food prices have also been weak because of low grain prices. These have resulted from falling demand from Eastern Europe as livestock slaughtering has risen. This in turn has depressed meat prices. It is, however, felt that excess TABULAR DATA OMITTED slaughtering has come to an end and prices may stop falling.

Metals and fuels markets have also been influenced by developments in the former Communist states. The CIS increased its exports of aluminium in 1992, and as a result stocks in the industrial world were 300,000 tonnes higher than they would otherwise have been, causing prices to fall. The CIS has also been selling large amounts of copper, and prices have fallen as a result. These pressures have to be added to low demand, and all prices have generally been weak. Fuel prices have fallen a little in recent months. The CIS have managed to maintain their oil exports despite falling production, and steam coal deliveries have been stepped up significantly. Real prices for coal have fallen by more than 10 per cent in the last year, but stocks (at least outside the UK) are relatively low, and prices may well stop falling. Low steam coal prices have affected the oil market, and in combination with high OPEC output the pressure of excess supply has meant that prices have fallen from $20 per barrel to $18 per barrel in recent months.

The United States

Real GDP only grew by 1/2 per cent in the first quarter of 1993 compared to 1.2 per cent in the fourth quarter of 1992. Both consumers' expenditure and exports' growth weakened substantially. Consumer spending growth decelerated to a quarter of its fourth quarter increase, rising by only 0.3 per cent and the savings ratio actually increased after falling throughout the second half of last year. Export volumes declined by 1 3/4 per cent in the first quarter compared to a 2 1/4 per cent increase in the previous quarter. Gross private domestic investment provided the major impetus to GDP, increasing by almost 5 per cent in the first quarter compared to 2 1/2 per cent and 1 1/2 per cent in the fourth and third quarters respectively. However, most of the increase was accounted for by stockbuilding as growth in the other investment categories decelerated. Residential investment remained flat after rising by 6 1/4 per cent in the fourth quarter. Capital expenditure on producers' durable equipment only rose by 2 per cent compared with 3 1/2 per cent in the final quarter of 1992.

It is not a complete surprise that consumption growth decelerated in the first quarter as the Conference Board index of consumer confidence has now declined from its December peak of 78.1 to 67.7 in April of this year. A sustainable consumption-led recovery requires a more substantial improvement in real incomes and job prospects. Although the unemployment rate has fallen from its peak of 7.7 per cent in June it remained unchanged in March compared with February at 7 per cent. Growth in employment has been weak compared with previous recoveries but non-farm payrolls did expand strongly in the first two months of this year before falling slightly in March. Much of the employment increase was part-time, although there has been a significant increase in average weekly working hours in manufacturing. This suggests that firms are seeking to become more flexible by changing hours worked rather than staffing levels. Perhaps both consumers and employers are not totally convinced that the US recovery is firmly established. In a similar fashion to consumer confidence, the National Association of Purchasing Managers (NAPM) index fell in both February and March of this year.

Industrial output rose by around 1/2 per cent in both January and February but remained unchanged in March. Manufacturing capacity utilisation also rose slightly over the same period. The Commerce Department survey in March showed that industry plans to raise real capital expenditure by more than 8 per cent in 1993 which is significantly higher than the 5 1/2 per cent increase indicated by the previous survey conducted at the end of the last year. Increased profitability and lower long-term interest rates accounts for some of this increase in intended investment. Post-tax corporate profits rose by almost 9 per cent in the fourth quarter ending 1992 16 per cent higher than a year ago. The recovery in output, combined with subdued employment, has resulted in strong productivity growth and, for the moment, this has increased profits rather wages.

Although average weekly earnings increased strongly in January they slowed down rapidly over the next two months and by the end of March were less than 2 per cent higher than a year ago. Earnings are currently growing less rapidly than consumer prices. Annual growth in producer prices, excluding food and energy, declined to less than 2 per cent in March, helped by the fall in import prices in the early part of the year.

US three-month interest rates have declined by approximately 7 percentage points since the middle of 1989. The twelve-month interest rate suggests that three-month rates are now expected to rise by about 1/2 a percentage point by the first quarter of next year. However, given the slow growth recorded for the first quarter, combined with monetary growth substantially below the target range for both M2 and M3, monetary tightening may be delayed until a strong recovery is firmly established. Furthermore, long rates have fallen by about 1/2 a percentage point since the announcement of President Clinton's plan for budget deficit reduction. The Federal deficit increased to a record $290 bn in 1991/2 compared to $220 bn in the previous fiscal year. Much of the rise in the deficit is cyclical and there are signs that the upward trend is coming to a halt as the first five months of fiscal year 92/93 registered a deficit of $138 bn compared to $149 bn over the same period a year ago.

Past data and our forecast for US GDP are shown in Table 6. The recovery in 1992 was actually fairly robust and rapid. GDP rose by 2.1 per cent compared with a fall of 1.2 per cent in 1991. In addition, the unemployment rate, which began rising in 1990, has now begun to decline. However, the first quarter figures for 1993 have caused us to revise our forecast downwards, and we now expect GDP growth of around 2 3/4 per cent for 1993. Consumption will probably grow by a similar amount, in line with real personal disposable income. The expected stronger growth in real personal disposable income relative to last year is largely due to higher earnings' growth which, in turn, is the result of our assumption that recent strong productivity growth will feed into wages. We are forecasting a continuation of the recovery in housing and business investment in 1993. The recent poor figures for construction activity are mainly the result of bad weather and we therefore expect the upward trend in housing starts, which began in the second half of 1992, to resume during the next few quarters. However, some investment projects may be delayed until after the planned investment tax credits come into operation in 1994. Growth in 1993 should also benefit from a rebuilding of stocks, but strong relative US demand, particularly vis-a-vis Europe, will probably result in net exports making a negative contribution to GDP growth this year.

GDP growth next year will probably decelerate slightly to around 2 1/2 per cent. This is partly the result of the effects of our forecast of higher short-term interest rates. The anticipated interest-rate increase is consistent with the past profile of long rates, which only fell by a fraction of the decline in short rates, indicating that some of the monetary loosening was perceived as temporary. Although real personal disposable income growth will probably slow down next year, as higher wages feed into prices, consumption will probably continue growing at around 2 1/2 per cent.

Table 7 shows our forecast for the US balance of payments. The visible trade deficit deteriorated from $77 bn in 1991 to almost $100 bn last year. This occurred even though the US gained competitiveness and increased its export market share. Much of the increase in the deficit can be explained by the high marginal import propensity of the US. Even though growth was below potential last year, import volumes still grew by almost 11 per cent compared to 6 per cent for exports. TABULAR DATA OMITTED (However, both exports and import growth rose as trade in intermediates between the US and Mexico increased as a result of the reduction of trade barriers produced by the Free Trade Agreement). Net export volumes will be adversely affected by strong growth of domestic demand and by our projected appreciation of the US dollar in line with the US interest-rate differential. The invisibles balance has deteriorated since 1991 as that year benefitted from the large one-off transfers of war payments from the Gulf War allies. The current balance deficit will probably continue to deteriorate to around 1 1/2 per cent of GDP this year. This is due not only to visible trade but also because the surplus on interest profits and dividends will be lower than in recent years and eventually develop into a deficit. This is partly due to the appreciation of the dollar but also the result of the deterioration in US overseas net assets caused by the accumulation of current balance deficits in the 1980s.

Recession and subdued growth explain most of the increase in the government deficit/GDP ratio to around 5 per cent in 1992 compared to 3 per cent in 1990. Transfers rose sharply last year and tax revenues over the past two years have grown considerably less rapidly compared to the late 1980s. However, even after allowing for the recessions the figures indicate a structural federal deficit of around 3 per cent of GDP. Our previous forecasts have always embodied a reduction in the deficit to an approximate sustainable level of around 2 per cent of GDP by the end of the decade. Hence the new long-term deficit reduction plan, which is discussed in detail in Box A, does not substantially change our forecast from the February Review.


In the short term, we expect the Federal deficit to decline to about 4 1/2 per cent this calendar year. Projected falls in both long-term interest rates and the unemployment rate will reduce debt interest and transfer payments and boost tax revenue. From next year the fiscal package will come into operation and bring the deficit ratio down more rapidly.


The Japanese economy grew by only 1.5 per cent in 1992, the slowest growth rate since 1974. The current slowdown is in part a reaction to the excessively high growth rates in the late-1980s, in particular in housing and business investment, which was accompanied by spiralling asset prices. This led ultimately to the adjustment pressures that materialized in the bursting of the bubble economy, with dramatic falls in asset prices and the recent economic downturn.

Consumer spending grew by 1.8 per cent last year, but there was a dramatic fall in investment. Business investment dropped by 4.1 per cent, while housing investment fell for the second year in a row. Government investment, which accounts for less than 20 per cent of total investment, was the only category that showed a positive growth rate, due to the August fiscal package of |yen~10,700 bn. As the bulk of the projects announced in the August emergency package will be started this spring, the effects have yet to be fully felt. Although there are signs that the downturn has bottomed out, recent economic indicators give conflicting evidence. The Bank of Japan's quarterly survey showed business confidence has fallen further to the lowest level for over ten years. The official index of leading economic indicators has, however, pointed to renewed growth for two consecutive months now in part in response to the cut in official discount rates in February. Major companies expect an upturn in profits. The recovery of the stock market in the first quarter of this year was remarkable. After three years of sharp falls, share prices rose by more than 20 per cent in the first months of this year. This could help Japanese banks and companies to recover some of the earlier losses on their portfolios and to finance new investment, but the recent sharp appreciation of the yen could jeopardise any prospects of a recovery, as Japanese exporters become less competitive.

In April, the government responded to wide ranging pressure to boost the economy by announcing a fiscal package that incorporates |yen~13,200 bn of public spending. The government had previously set expenditure only 0.2 per cent higher than in the previous year, which was the smallest increase for six years. The additional package consists of public investment and tax concessions, and the government forecasts it will raise nominal GNP by 2.6 per cent. However, this is widely seen as far too optimistic, as the contents of the package involve, at least in part, the front loading of existing plans. Some of the announced spending is simply a commitment to bring forward public works that were already budgeted, and this will have little effect in the long run. Box B discusses the effects of a fiscal expansion in our model.

Consumer confidence remains low, as reduced wage increases and bonuses make consumers more cautious. Retail sales have fallen sharply recently. Wage increases averaged 5 per cent in 1992. It is expected that the wage increase to be agreed in the annual spring negotiations, the 'Shunto', will be even lower, at 3.5 to 4 per cent. Bonus payments traditionally form a large share of total earnings, but recently they have hardly risen in real terms. Inflation, already low at 2.1 per cent, is expected to fall further after the recent appreciation of the yen, as import prices fall sharply.

Our forecast is set out in Table 9. We expect GNP to grow by 0.4 per cent this year, mainly due to a fall in business investment of 5.8 per cent. Last year net exports formed the main positive contribution to growth, but this is much less likely this year. Simulations on our model suggest that a 10 per cent appreciation of the yen against the dollar can lower GNP by 0.5 per cent for three years before the effects fade out. This means the recent appreciation could have a significant effect on output at a time when the Japanese economy is already seriously weakened. These simulations also suggest that inflation could be 0.16 percentage points lower in the first years, and 0.4 per cent lower in the following three years with TABULAR DATA OMITTED the price level falling by 10 per cent in the long run.

The trade balance has continued to improve. Exports grew by 3.4 per cent in the first quarter of the year, as the recovery in Japan's export markets continued. Imports rose less, by 2.8 per cent, reflecting the slowdown in the domestic demand. Table 10 shows our forecast for Japanese trade. The yen has recently appreciated sharply against the dollar. Although it is argued that the short-term effect of the recent appreciation will be to raise export revenues, and further improve the surplus in the long run it will inevitably lead to a reduction in Japan's trade balance.



The recession in West Germany has deepened considerably. After a relatively buoyant first quarter last year, output fell in the three following quarters. For the year as a whole, real GDP grew by 1.1 per cent, while real GNP, which includes net factor income from abroad, rose by only 0.5 per cent. Consumer spending grew by 0.8 per cent. Construction investment rose by 4.9 per cent, reflecting the continuously high demand for housing due to the inflow of foreigners from eastern Europe, but business investment, which accounts for over 60 per cent of total investment, fell by 3.6 per cent.

Recent economic indicators show the economy is sliding further into recession. Industrial production, which dropped by 1.6 per cent in 1992, fell further in the first quarter of 1993 as did total output. Capacity utilisation is now at the lowest level for eight years. Order books are weakening, reflecting the downturn in domestic demand, and retail sales were also very low in the first months of this year, after a relatively strong second half of last year. Consumer spending grew by 1.4 per cent in the fourth quarter of last year, as spending was brought forward in advance of the increase in VAT in January 1993. Consumer confidence is also affected by rising unemployment. The unemployment rate is west Germany rose to 7.8 per cent in March. In addition, more than a million people are on short-term working, compared to 266,000 a year ago, while another 500,000 are on job creation or training schemes.

Rising unemployment has helped to curb wage inflation. Negotiated wage increases in the west are significantly smaller than a year ago. The public sector unions have recently accepted a pay increase of 3 per cent, much lower than the 5.5 per cent initially demanded. These developments ultimately help to bring price inflation down. Wholesale prices are around 1.5 per cent higher than a year ago, in part because import prices have fallen as a result of last year's appreciation. Consumer prices are rising by more than the 2 per cent long-term target of the Bundesbank. Annual consumer price inflation was 3.7 per cent at the end of last year, but inflation rose to around 4.2 per cent in the first quarter of this year, as a result of the VAT rate increase.

The rise in inflation has not prevented the Bundesbank making further small cuts in its official interest rates. In March the Bank cut its discount rate to 7.5 per cent, and in April the discount rate was lowered by another 1/4 percentage point to 7.25 per cent. The Lombard rate, the ceiling at which banks can obtain emergency funds, was also cut to 8.5 per cent. These cuts followed the gradual reductions in the Bank's money market rate, the repurchase rate, which has fallen by 2 percentage points since it reached its peak of 9.7 per cent in September 1992. The Bundesbank argues that the recent cuts in interest rates are justified as the money supply is again under control. In March, the M3 measure of the money supply grew at an annualised rate of 3.2 per cent. Although this was higher than expected, it was well below the target range set by the Bank for 1993, of 4.5 to 6.5 per cent. It is generally expected that the target range will be met this year, and that no repeat of last year will occur, when M3 grew by 8.7 per cent in the year to December, well above last year's target range of 3.5 to 5.5 per cent. The recent cuts in interest rates are also an indication that the Bundesbank is worried about the severity of the recession.

Our forecast for (west) Germany is set out in Table 11. We are less pessimistic about the German economy than many other observers. Recently, the six German economic institutes published their joint forecast predicting a fall in west German GDP of 2.0 per cent and 5.5 per cent growth in east Germany. Our forecast is model-based and our interest-rate and exchange-rate assumptions are in line with current forward rates. On that basis, such a strong fall in predicted west German GDP cannot be justified. Forward rates suggest further cuts in interest rates and this should moderate the recession. Rising demand for housing for new immigrants should stimulate the construction sector, while growth in Germany's exports markets should also contribute to west German output. We project a deepening of the recession in the first half of this year and a recovery later this year and next year. We expect business investment to fall by 4.3 per cent this year, but are more optimistic for other, non-manufacturing sectors of the economy. The east German economy is expected to grow by 5-7 per cent in 1993, and west German producers should benefit most from the higher demand. We also forecast housing investment to rise by 1.1 per cent in 1993. As the contribution of net exports will be modest this year, we forecast real TABULAR DATA OMITTED GDP will fall by 1.1 per cent this year. For 1994 we expect a recovery to 2.1 per cent growth.

Our inflation forecast is set out in the bottom half of Table 11. When the D-Mark appreciated against other European countries in September last year and indicators suggested the onset of the recession, we predicted a fall in inflation that, at least at consumer level, has not so far occurred so far. Import prices and wholesale prices have fallen, but consumer prices rose by 4.3 per cent at an annual basis in the first quarter of this year. Besides the increase in the VAT rate to 15 per cent in January, it seems that special factors relating to services have been responsible for this. Prices of various state services have risen as an attempt was made to reduce deficits. Housing costs and related rent expenditure have also risen sharply in the first months of the year. This increasing divergence of price developments in the traded and non-traded goods sectors has meant that the anticipated reduction in inflation has failed to materialise in the first months of the year. As the deepening recession will ease inflationary pressures, we forecast inflation to fall later this year and average around 3.4 per cent this year and 2.1 per cent in 1994.

Imports fell last year by 1.0 per cent, reflecting lower domestic demand. Exports were hampered by lower demand in Germany's main export markets and grew by only 0.7 per cent. Markets for capital goods were particularly weak reflecting the slowdown in investment activity elsewhere in Europe. The trade surplus grew to DM 33 bn in 1992, compared with DM 22 bn in 1991, when imports were boosted by high demand after unification. Despite the improvement in the trade balance, the current account worsened in 1992, due to the deterioration in the deficit on invisibles. The trend towards growing deficits on foreign travel continued, while investment income TABULAR DATA OMITTED also fell sharply. The latter is a reflection of the deterioration of Germany's external assets position, due to current account deficits in recent years, but it was also affected by the interest-rate differential between the dollar, in which most of Germany's external assets are denominated, and the D-Mark, in which most liabilities are denominated. The current account showed a DM 39.1 bn deficit in 1992, compared with a DM 32.9 bn deficit in 1991. Table 12 shows our forecast for German trade. The appreciation of the D-Mark last year has worsened Germany's export competitiveness, and we expect no strong recovery of exports. But imports will be equally depressed, due to the deepening recession. The current account will remain in deficit at around 1.3 per cent of GDP.


The government has warned that the federal deficit could widen to DM 65-70 bn this year. This is much higher than the DM 55 bn deficit initially estimated. The higher deficit reflects the lower than projected tax revenues due to the recession and rising unemployment benefit payments. Last year, the deficit of the federal government was DM 38.6 bn. Our forecast for the German public sector is set out in Table 13. This relates to the deficit of the total German public sector and is on a national accounts basis. It differs from other published sources. For 1993, we expect the total deficit to rise to DM 130 bn, and to fall only slowly in the following years. Transfers to the east are an increasing expenditure category and these are expected to remain high in the medium term. When the outstanding debts of the Treuhandanstalt and the GDR Debt Fund are taken over by the government in 1995, the debt to GDP ratio will rise to over 60 per cent. It was agreed, as part of the 'solidarity pact' with employers, unions and federal states, that a 7.5 per cent surcharge on income tax will be introduced from January 1995, but this will only cover part of the additional debt servicing costs. To control the budget deficit, further expenditure cuts and/or tax increases will be unavoidable.


The major event in France since our February forecast has been the anticipated overwhelming election defeat of the ruling Socialists in the March election. The coalition of the two main conservative parties accounts for 484 of the total 577 constituencies in the National Assembly. The new Prime Minister, Edouard Balladur, has already announced his intention to reduce the rising budget deficit by cutting government spending by FFr 20 bn and raising indirect taxes. Edmond Alphandery, a former economics professor, has been appointed Finance Minister and favours both monetary union in Europe and the franc parity within the ERM.

Recent data suggest that the short-term growth prospects for France have deteriorated. Real GDP declined by 1/2 per cent in the final quarter of 1992 after registering small gains in the previous two quarters. Export volumes actually fell, real consumers' expenditure decelerated and the decline in investment accelerated. The severity of the downturn in Germany, combined with the recent appreciation of the franc, partly explain why French exports declined by around 1 1/2 per cent in the fourth quarter. Consumer confidence weakened as unemployment continued to rise, reaching 10.4 per cent in the fourth quarter. In the same quarter investment fell by almost 1 per cent after falling by 1/2 per cent in the previous quarter. Residential investment fell by 1 per cent and business investment declined by almost 1 1/2 per cent.

Capacity utilisation remained low in the fourth quarter at 78 per cent which is 8 percentage points lower than the peak reached in the second quarter of 1990. Industrial production fell by almost 1 1/4 per cent in December to its lowest level for four years but recovered in both January and particularly February. Over the three months to February industrial output declined by 3 per cent. This was consistent with the March INSEE survey which showed a substantial deterioration in business optimism in the latter part of last year. At the same time, consumer confidence has been weakened by the rise in unemployment. Although tighter benefit procedures have been adopted, the number of unemployed rose above 3 million in February resulting in an unemployment rate of 10.6 per cent which is the highest for five years. The number of unfilled vacancies declined further in February falling to 20 per cent below that of a year ago.

GDP growth decelerated to 1 per cent in 1991 before accelerating to 1.8 per cent last year. The decline in GDP growth had actually come to a halt in the middle of last year, largely because of buoyant exports arising from strong German demand. However, in the second half of last year, as the stimulus of German reunification eventually subsided, the less transitory effects of ERM membership once again became apparent. The uncertainly over the Maastricht treaty and then the French elections in March pushed already high interest rates further upwards.

The recent behaviour of investment shows that expectations concerning the medium-term outlook for French activity remain pessimistic. Total investment has been falling since 1991, declining by 2 1/4 per cent last year. Business investment registered the largest fall of almost 6 per cent compared to a 1/2 per cent decrease in residential investment. However, recent data probably suggest a more pessimistic outlook than is actually the case as the figures also reflect uncertainty over ERM membership. The election result has allowed a substantial easing in money market rates as the new government made clear its intention of maintaining the ERM parity. Before the election in January, after the currency turmoil following the referendum on Maastricht, the Bank of France raised the 5-10 day securities repurchase rate to 12 per cent from 10 per cent as the franc reached its ERM floor. After the election, in early-April, the rate was cut by 2 per cent and reduced again on 23rd April to 9.5 per cent. The latest cut was associated with an appreciation of the franc presumably because growth prospects for France now seem brighter.

High unemployment and depressed activity in the goods market has put substantial downward pressure on inflation. In the third and fourth quarters hourly wage rates edged towards a lower growth rate of around 3 1/2 per cent, a percentage point lower than the 1991 average. Wage inflation may slow down further in 1993 as the government hopes to restrict public sector wage settlements to around 2 1/2 per cent this year. In comparison, consumer prices have started to grow a little faster, rising by 1/2 per cent in March resulting in an annual rate of inflation of 2.2 per cent compared to 1.6 per cent in November of last year.

Our forecast for French GDP is given in Table 14. The outlook is dominated by the path of real interest rates. Our profile for three month rates is in line with the forward markets and hence we expect interest rates to be below 7 per cent by the beginning of next year. However, we expect very little GDP growth for France this year. We TABULAR DATA OMITTED believe that previously high real interest rates will continue to depress both consumption and particularly investment in 1993. Poor prospects for output growth, partly caused by last year's appreciation of the franc, will probably encourage a further decline in business investment. However, the expected rapid fall in the French interest rate, which will probably be perceived as more permanent than the recent increases, will cause upward revaluations of wealth and encourage consumers' expenditure. Real personal disposable income will probably only grow by around 1 1/4 per cent in 1993, largely in response to a deceleration in compensation. This is partly the result of excess supply in the labour market. However, direct and indirect net interest receipts of the personal sector will rise as interest rates fall as many assets attract a fixed long rate. Expectations of inflation will also probably fall as the French authorities have made clear their determination to maintain low inflation by raising interest rates and allowing the franc to appreciate during a period of slow growth. GDP growth in 1993 will also be decreased by negative net exports. This arises partly because of the franc appreciation but also because export markets particularly among France's main European trading partners will be depressed.

The government budget deficit rose to above FFr 226 bn in 1992 or about 3 1/4 per cent of GDP which is in excess of the target set out by the Maastricht Treaty. The reduction in the top rate of VAT in April 1992 has depressed receipts but high debt interest payments and declining activity have been the major factors explaining the growth in the deficit. The new government intends to embark on a policy of deficit reduction but the poor short-term prospects for activity will make this difficult. However, we expect indirect taxes to be increased by about 1 per cent over this year and next, along with reductions in the growth of government consumption and investment. Without this fiscal tightening, the deficit target of 3 per cent of GDP outlined by the Maastricht Treaty would be virtually impossible to achieve by the end of the decade.

The substantial reduction in interest rates projected for this year should provide a considerable boost to GDP growth in 1994. However, employment growth will remain subdued, restraining growth in personal income and hence limiting the recovery in consumption. Growth will also be restrained by the fiscal tightening which should contain the government budget deficit at around 4 1/4 per cent of GDP in 1994. Given all of the above factors, GDP should grow by above 1 3/4 per cent next year but this will not be enough to stop unemployment rising to above 11 per cent. The increase in activity will be reflected in a rise in inflation to around 3 per cent in 1994 rising from about 2 1/4 per cent for this year. The acceleration in inflation next year is also a consequence of faster growth in import prices and a rise in indirect taxes.

Our forecast for the French current account is shown in Table 15. The visible balance moved to a surplus of just over FFr 30 bn last year compared to a deficit of the same amount in 1991. This improved trade performance reflects weak domestic demand and improvements in French price competitiveness arising from relatively low inflation. The current account also improved but not by so much. The overall surplus of almost FFr 15 bn compares favourably with the deficits of 33.4 bn and 52.5 bn in 1991 and 1990 respectively. The impact of the franc appreciation is quite clear in terms of the projected decrease in export volume growth and increased growth of import volumes in 1993.



The Italian economy is beginning to show the first modest signs of recovery, according to Confindustria, the industrialists' association, although industrial production fell by 7.7 per cent in the first two months of 1993 against the same period last year. Order books have begun to improve and exports to surge as a result of the devaluation of the lira. The export sector, is the most buoyant: in December foreign orders rose by 33.5 per cent, whilst domestic orders declined by 17.8 per cent. An additional stimulus to the economy has come from the government, which has approved a L7,000 bn jobs package which includes a L1,650 bn national employment fund to create new jobs in the next three years, and L3,500 bn to be spent on re-industrialisation projects.

The state of the public finances remains a crucial issue in Italy. The stock of outstanding debt now amounts to 107 per cent of GDP, and the government's deficit forecast of L155,000 bn in 1993 appears to be optimistic, as it is predicated on the assumption that L93,000 bn (about 5.8 per cent of GDP) will be raised in taxes and extra revenue. In 1992 the budget deficit totalled L163,150 bn, overshooting by L11,000 bn earlier estimates, and reaching 11 per cent of GDP. This is partly attributable to a slower than expected pace of privatisation, which raised much less than the scheduled L7,000 bn. According to the government the same amount should be raised this year.

Interest payments are still a heavy burden, because the political turmoil has not enabled Italy to cut interest rates substantially after withdrawing from the ERM. In 1990 the yield differential between 10-year Italian and German bonds was 4 per cent, the same as the inflation differential. Currently, Italian bonds yield 12.85 per cent gross, 6.3 percentage points more than German securities, whilst the inflation differential has narrowed. A 1 per cent cut in short-term interest rates reduces the borrowing requirement by approximately L15,000 bn a year; a further reduction of the order of L10,000 bn could be achieved for each extra point of GDP growth. The cost of foreign borrowing has also been increased by a fall in Italy's credit ratings, which are currently double-A by Standard & Poor's and A1 by Moody's. Nevertheless, the government has recently raised DM 5 bn in the Eurobond market, and obtained a Ecu 8 bn loan from the European Community.

Share prices have generally been rising in 1993, despite the involvement of some of the biggest companies, such as FIAT, in the corruption scandal. The main reasons appear to be the expectations of lower interest rates, the abolition of the wage indexation system (scala mobile) and the competitiveness gains resulting from the depreciation of the lira since last September. The Italian currency has devalued almost 30 per cent against the D-Mark and even more against the dollar, which is seen as excessive by the Italian authorities. It reached a record low against the D-Mark at the end of March, as the corruption scandal kept spreading, involving many prominent politicians, such as cabinet ministers and the former Prime Minister Giulio Andreotti. A further weakening of the currency could compromise the objective of low inflation. Although the rate of growth of consumer prices slowed down in March, dropping from an annualised rate of 4.8 per cent in February to 4.3 per cent, the lowest in more than five years, there are signs that higher import prices are starting to feed through, despite the slack in economic activity and the government policies to keep prices down.

The Bank of Italy was able to cut its discount rate in February from 12 to 11.5 per cent, which is 3.5 percentage points below the level reached in September. Banks' reserve requirements, i.e. the ratio of their deposits which has to be placed with the central bank, have been lowered by the government from 22.5 to 17.5 per cent, with the aim of further reducing the cost of borrowing. Another TABULAR DATA OMITTED injection of liquidity into the system is expected to come from an even bigger reduction for certificates of deposit of over 18 months' maturity. New legislation will allow the central bank to set reserve requirements and grant it more independence by closing the Treasury's account with the Bank of Italy which was used to finance public spending.

In April Italians voted overwhelmingly in favour of a first-past-the-post system for electing the majority of the upper house. This can be considered as the effective end of the Italian First Republic, which was based on coalition governments revolving around the dominant Christian Democrats. After the resignation of Mr Giuliano Amato, the governor of the Bank of Italy has been invited to form Italy's 52nd post-war government. The new cabinet was meant to be broadly-based and to include members of the former Communist Party of the Democratic Left (PDS) for the first time since 1947. TABULAR DATA OMITTED However, the three PDS ministers and one minister from the Green Party have resigned after the Chamber of Deputies' vote to bar prosecution of the former Socialist leader Mr Bettino Craxi. If the new administration can weather this crisis, it should last until a new polling system is introduced on which to hold another general election, maybe as early as the autumn. The recent decision to present the 1994 budget by July instead of the end of September would make this possible.

Our forecast for Italian GDP and trade is set out in Tables 16 and 17. We expect the recovery to be export-led, thanks to the competitiveness gains generated by the depreciation of the lira. The strong performance of the export sector and the fall in imports, which reflects the weakness in domestic demand due to the squeeze in personable disposable income resulting from a much tighter budgetary stance, will lead to an improvement in the current account as a percentage of GDP. Domestic demand as a whole is projected to fall in 1993. Private consumption in particular will be affected by the L13,000 bn package of spending cuts and increased taxes to prevent the budget deficit running too far over its target. Although the deficit-to-GDP ratio is forecast to fall, the stock of debt will keep rising until 1994, before stabilising at above 104 per cent. Inflation will edge up as higher import prices eventually feed through, and the weakness of the lira will be reflected in high short-term interest rates in the next few quarters.


The latest data indicate that Spain has moved into recession. GDP grew by 1 per cent last year but the annual rate of growth declined to -0.2 per cent in the final quarter of 1992. Investment fell by 3 per cent last year but consumers' expenditure grew by almost 2 1/2 per cent. Government consumption rose by 4 per cent in real terms in 1992 and prevented GDP decelerating further. The slowdown in activity has caused employment to fall and the unemployment rate has increased rapidly reaching 20 per cent at the end of last year.

The annual growth in consumer prices has fallen from 5 1/2 per cent at the end of last year to 4 per cent in February. This shows the extent of the decline in activity given the upward pressure on prices from the peseta devaluation of 10 per cent in October and the VAT increase of 2 percentage points in August of last year. The uncertainty surrounding the ERM towards the end of last year also put upward pressure on Spanish short term interest rates. The three month interbank rate was 14 1/2 per cent at the end of April but they fell to 12 per cent after the 8 per cent realignment in early May. The lower exchange rate has reduced the overvaluation of the peseta and should ameliorate the deflationary pressures in the economy.

ERM membership was associated with an anti-inflationary policy based on a high real exchange rate. However, in addition to a strong peseta and high real interest rates tight fiscal policy also accounts for some of the recent slowdown in activity. The general government deficit actually fell from 4.9 per cent in 1991 to 4.4 per cent last year. The largest items of expenditure were transfers and interest on debt. Given the high cost of borrowing and decline in activity these costs are difficult to control. The main thrust of deficit reduction has concentrated on decreasing government consumption and investment and both categories fell last year. The increase in VAT also increased revenues. The target deficit for this year is 3.7 per cent of GDP. However, the forthcoming election. We expect real GDP to fall by about 1 1/4 per cent this year. Consumption will probably show virtually no growth in 1992 and investment will fall by more than the 3 per cent of last year. However, net exports should make a positive contribution to GDP growth. The recent devaluations will improve competitiveness and weak domestic demand will dampen imports. In addition, Spanish exports tend to grow fairly strongly during recessions as goods are diverted from the home market to abroad. Consumer price inflation should fall to about 4 1/2 per cent this year. The devaluations will cause stronger growth in import prices, but this inflationary impact should be offset by weaker wage inflation as the unemployment rate reaches approximately 22 per cent by the end of 1993.
Spanish GDP and Trade

 1989 1990 1991 1992

Consumption 5.6 3.7 3.1 2.4
Investment 13.8 6.9 1.6 -3.0
Government consumption 8.2 4.3 4.2 4.0
Total domestic demand 7.7 4.7 3.1 1.4
Export volume 3.0 3.3 6.6 6.4
Import volume 17.2 7.8 8.9 6.8
GDP 4.7 3.7 2.3 1.0
Current balance (%GDP) -3.1 -3.2 -3.0 -3.2
Budget deficit (% GDP) -2.8 -4.0 -4.9 -4.4
Consumer prices 6.6 6.4 6.2 6.2
Unemployment 17.3 16.3 16.3 18.4


Economic recovery from the recent recession is still slow. The evidence from the manufacturing sector, in which capacity utilisation is well below its long-term average, suggests that GDP is currently below its potential level, and that it will probably remain below capacity output for some time. The slack in economic activity is equally evident in the labour market. The unemployment rate is considerably above the Bank of Canada's 8 per cent estimate of the NAIRU, and average pay rises have slowed down. At the end of last year, wage settlements averaged 2.1 per cent, down from 3.7 per cent in 1991 and 6.1 per cent in 1990. As a consequence of this decline and of a rise in productivity, unit labour costs growth has been rather subdued, and the competitive position of Canada vis-a-vis the US has improved. The external sector is expected to play an essential role in the recovery, because slow employment growth is likely to continue dampening domestic demand. The trade surplus rose by C$0.9 bn to C$1.9 bn in January, mainly in response to the recovery in demand in the United States and to higher export prices. Price stability remains official policy target of the Bank of Canada, but the recent inflation performance of Canada has been good, which would make an easing in monetary policy possible.

The gap between Canadian and US interest rates and TABULAR DATA OMITTED bond yields has been widening over the last few months, and the exchange rate vis-a-vis the US$ has become more volatile, in part because of increasing federal and provincial budget deficits. Mr Donald Mazankowski, finance minister, left the deficit for the year to March 31, 1994 unchanged from last December's forecast of C$32.6 bn. He forecast that GDP growth would average more than 4 per cent a year from 1994 to 1998 and that the deficit would drop to C$8 bn by then. The combined debt of the federal government and the provinces, which also borrow heavily in the international markets, has risen from 40 per cent of GDP, in 1975, to 80.3 per cent of GDP in 1992. Foreign investors might call into question the long-term sustainability of Canadian fiscal policy and Canadian government bond issues would have to take on an interest premium similar to that in Italy. Stabilising the debt-GDP ratio would involve a substantial reduction of the borrowing requirement over the next few years. Interest payments are such that operational surpluses are required for stability of the debt-GDP ratio. It should be noted, however, that the amount of Canadian issuance is small in the context of the international markets, and the OECD calculates that the cyclically adjusted fiscal stance in Canada is the tightest in the G7. Hence, a crisis in financing the public deficit is not to be expected. Also, the deterioration in public finances appear to reflect mainly lack of discipline at the provincial level, whilst expenditure at the federal level has been rising more or less in line with GDP. Our forecast for the Canadian public sector, which is reported in Table 19, is somewhat less sanguine than that of the government but the debt to GDP ratio is expected to stabilise.

The resignation of Mr Brian Mulroney, Canada's prime minister, as leader of the Progressive Conservative Party, aims to increase his party's chances of retaining power. A new leader will be chosen at the next party convention, probably to be held in June. Mr Mulroney's popularity had been badly dented by the high unemployment level and the record levels of business bankruptcies. Also, slow economic growth, falling tax revenues and higher social security spending have resulted in a failure to curtail the swelling federal budget deficit, now projected to reach C$35.5 bn for the year to March 31, 1993, the highest in the nine years of Conservative administration. The emergence of strong regional parties, e.g. in Alberta and Quebec, could lead to a coalition or minority government. This political uncertainty, and the possibility that a new administration might reduce the independence of the Bank of Canada or be less committed to balancing the public finances, are sources of concern for the financial markets.

Our forecast for the Canadian economy is set out in Table 19. Overall GDP is expected to grow by 3.4 per cent in 1993, reflecting mainly the favourable developments in the external trade sector. The strong growth in exports, though, will not be sufficient to prevent the current balance as a percentage of GDP deteriorating slightly, as import growth is still high, despite slowing down recently. There are signs that domestic demand is picking up (e.g. strong retail sales growth), and we expect this trend to continue. Personal expenditure will not grow as fast as GDP, because the unemployment rate is likely to stay high in 1993, before declining further in the following years. We now expect consumption to grow by no more than 2.5 per cent, partly owing to the implementation of further public expenditure cuts announced in March to curtail the federal deficit. In addition to cuts in subsidies and unemployment benefits, a wage freeze for some public employees is also to be imposed. The inflation outlook remains favourable, but we are forecasting that interest rates will rise in the two years ahead.

Box A. The long-term US budget deficit reduction package

In the state of the Union address in February, President Clinton outlined plans to reduce the US budget deficit by $140 bn by 1997. By fiscal year 1997 the US budget deficit is now planned to be $207 bn (2 1/2 per cent of GDP) compared to the $350 bn previously forecast by the Congressional Budget Office. The four year package consists of roughly $500 bn of tax increases and spending cuts. Taxes will be increased by $240 bn and government spending will be reduced by $250 bn. $160 bn of the savings will be redirected towards a four year public investment plan. The remaining savings in excess of $300 bn will be allocated to deficit reduction. In general the package received a positive response. Long rates declined slightly at the prospect of a smaller future government deficit. The demonstration of the administration's determination to reduce the deficit would have been greatly enhanced if the $160 bn investment programme had been excluded.

The details of the longer-term package are as follows:


* A new top rate of income tax of 36 per cent for couples earning in excess of $140,000 taxable income.
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Author:Barrell, R.; Anderton, R.; CAporale, G.M.; Veld, J.W. in't
Publication:National Institute Economic Review
Date:May 1, 1993
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