The Critical Need for Fiscal Adjustment and Labor Market Reform in Industrial Countries

IV The Critical Need for Fiscal Adjustment and Labor Market Reform in Industrial Countries

he April 1993 Declaration by the IMF Interim imply, threaten to reduce the growth of potential T Committee on a cooperative effort to strengthen output and jeopardize future improvements in living global activity called on the industrial countries to standards. At the same time, pressures on govern- adhere to a strategy of low inflation, deficit reduc- ment budgets will continue to increase as population, and structural reform to reduce unemployment tions in industrial countries age. Unless credible (see the May 1993 World Economic Outlook, p. x). actions and reforms are implemented in the near Similar medium-term objectives have been pursued term to contain prospective deficits, future genera- by most countries at least since the early 1980s. tions will not only face a substantial increase in However, although substantial progress has been taxes to support a growing share of pensioners and made during the past decade in reducing inflation, to service the public debt, they will also experience little, if any, progress has been made in tackling a marked decline in productivity and real income fiscal imbalances or unemployment. growth because of insufficient capital formation. For many countries, the failure to consolidate fis- These problems are already visible. In the United cal positions during the 1980s means that budgetary States, stagnating or falling real wages for some situations have become unsustainable. Public debt categories of the labor force have resulted in the burdens have risen sharply, and most countries have phenomenon of the working poor; in Europe, high all but lost the ability to use fiscal policy as a stabi- real interest rates and low rates of investment have lization tool. Several governments recently have contributed to inadequate new job creation. announced or adopted new deficit-reduction plans, There is also an urgent need for structural reform despite the difficulties of doing so during a period of in labor markets. The persistence of high rates of cyclical weakness. The baseline projections imply, unemployment in many countries over the past two however, that current policies—including these new decades suggests that in the absence of substantial measures—will lead to only modest reductions of and broadly based labor market reforms there is a the underlying deficits for most countries, and that risk that unemployment will not be reduced suffi- levels of public debt will continue to rise rapidly. ciently when growth recovers. In addition to unac- Major additional efforts are therefore necessary to ceptable social, economic, and budgetary costs, the achieve fiscal sustainability as well as broader eco- high levels of unemployment have contributed to nomic objectives, particularly the restoration of heightened protectionist sentiment in a number of adequate national saving rates and higher growth. countries. The large fiscal deficits need to be addressed with a considerable degree of urgency. Rather than providing support to activity, the large fiscal imbal- The Stance of Monetary Policies ances in Europe and North America—and markets' expectations that these will persist in the medium Although the relative emphasis differs across term—are a principal cause of the high levels of real countries, the principal goals of monetary policy long-term interest rates seen since the early 1980s are to achieve and maintain a high degree of price stability and to alleviate fluctuations in output and and the lackluster growth performance seen re- 18 cently. Because of widespread uncertainty about fu- employment over the business cycle. These goals ture policies, the large deficits are undoubtedly also are consistent if monetary policy follows a "nonac- a major factor behind the depressed levels of con- commodating" policy stance over the cycle, which sumer and business confidence in many countries. provides scope for interest rates to ease during re- And in Europe, the large deficits have resulted in an cessions and, symmetrically, to rise in order to unsustainable policy mix, which has generated a dampen inflationary pressures as recoveries mature. deep recession and provoked unprecedented turmoil The task of pursuing these two goals, however, was in the EMS. complicated in the 1980s by relatively high infla- Over the medium to longer run the large fiscal imbalances, and the persistent diversion of re- 18See the discussion on price stability in the May 1993 World sources from investment to consumption that they Economic Outlook, Box 2, pp. 24-26.

©International Monetary Fund. Not for Redistribution The Stance of Monetary Policies

tionary expectations following the acceleration of inflation during the 1970s, by high structural fiscal deficits in some countries, and by financial innova- tion and deregulation and an apparent breakdown of the relationship between money and credit growth and economic activity in many countries. Much- reduced inflationary expectations following the largely successful disinflation of the 1980s, as well as fulfillment of fiscal consolidation programs, should significantly reduce the risk of a resurgence of inflationary pressures in the short term and pro- Chart 20. United States: Monetary Indicators vide room for short-term interest rates to remain (In percent unless otherwise noted) relatively low during the period ahead in most industrial countries. Because of the relative success in achieving the low-inflation objective, monetary conditions have been eased substantially to support economic recovery in the United States, Canada, the United King- dom, and Japan. Of course, as economic slack is reduced in each of these countries, monetary policy will need to be adjusted to safeguard the substantial progress that has been achieved in reducing inflation and to help lower underlying inflation further over the medium term. In continental Europe, nominal interest rates have declined markedly in recent months, but monetary conditions are still tight given the weakness of activity and recent and prospective inflation trends. In many countries, the scope for interest rates to decline further depends on actions to reverse recent deteriorations in fiscal positions. In the United States, both the discount rate and the federal funds rate have remained at low levels of about 3 percent as mixed signals about the strength of the recovery and generally moderate inflation indicators have justified a relatively easy policy stance. Long-term interest rates have continued to decline and are now at their lowest level since the late 1970s, which is evidence of market expectations of lower inflation (Chart 20). Even though households and businesses have significantly lowered their debt-service payments and financial inter- mediaries have improved their financial position, monetary growth, at least for the broader aggregates, has remained relatively weak for this stage of the economic recovery. In Japan, in response to the economic downturn, the Bank of Japan lowered the discount rate in six steps between June 1991 and February 1993, from 6 percent to 2 1/2percent . Both the three-month certifi- cate of deposit rate and the ten-year government bond rate declined considerably and are now well below previous cyclical lows (Chart 21). Growth of the monetary aggregates has remained modest because of a combination of weak income growth, the continuing adverse consequences on wealth of asset price deflation, and a shift of deposits into the postal saving system. Given the absence of infla-

©International Monetary Fund. Not for Redistribution IV INDUSTRIAL COUNTRIES: FISCAL ADJUSTMENT AND LABOR MARKET REFORM

tionary pressures in goods, labor, and asset markets, and the recent strength of the yen, there would seem to be room for further interest rate reductions. Monetary conditions in Germany have continued to ease as the Bundesbank has responded to the weakening economy, improved prospects for lower inflation, and the recent agreement on a fiscal consolidation program (Chart 22). Since the beginning of this year both the discount rate and the Lombard rate have been reduced in several steps, the latest on Chart 21. Japan: Monetary Indicators September 10, from 8 1/4 percent to 6 1/4 percent, and (In percent unless otherwise noted) from 9 1/2 percent to 7 1/4 percent, respectively. Both short- and long-term market interest rates have declined considerably from their peaks in 1992, with the yield curve in Germany remaining inverted. Nevertheless, using World Economic Outlook projections of inflation as an estimate of expected inflation, both short-term and long-term real interest rates are still high for this stage of the business cycle. Cost inflation has declined significantly, and new wage contracts are now generally consistent with the 2 percent normative inflation objective of the Bundesbank. Although underlying consumer price inflation has begun to moderate, monetary growth remains above the top end of the target range owing to a rapid expansion of credit to the public sector. In the other major European countries, short- term interest rates generally declined during the first half of 1993 as the tensions within the ERM earlier in the year diminished (see Chart 18). In France, three-month money market rates had fallen below those in Germany, from about 12 percent in January 1993 to less than 7 percent at end-June, as the Banque de France reduced its official interest rate, but in July interest rates were raised again to support the franc. Long-term rates in France have declined considerably since the beginning of the year, but, as in Germany, the yield curve has remained inverted. In Italy, short-term interest rates have continued to ease, particularly at the short end, although rates have remained high in real terms. In the United Kingdom, short-term rates have remained at 6 percent; a further easing to support economic recovery may depend on progress in reducing the fiscal imbalance. As in France, the re- emergence of tensions in the ERM in July led to renewed increases in short-term official interest rates in several ERM countries and a widening of interest differentials vis-a-vis the deutsche mark. At the time of writing, the impact on interest rate differentials has again eased since the widening of the ERM band on August 2, and the cuts in German official rates on September 10, and financial markets appear to be anticipating further reductions of interest rates in most ERM countries. Many smaller European countries have recently seen increases in unemployment rates as a result of

©International Monetary Fund. Not for Redistribution Structural Positions and Current Policies

the severe slowdown in growth and trade, and structural rigidities. Some countries, such as Finland and Sweden, which are still experiencing an unwinding of recessionary forces, have very large structural budget deficits. Measures that would ensure substantial improvements in public sector financial positions over the medium term would increase the scope for interest rates to decline and would improve prospects for recovery.

Chart 22. Germany: Monetary Indicators Structural Budget Positions and Current (In percent unless otherwise noted) Fiscal Policies In the period 1983-89, government budget deficits generally declined (Table 6), but in many countries the improvement reflected mainly cyclical factors rather than a correction of underlying fiscal imbalances. Among the major industrial countries, structural imbalances—the deficits that result after adjusting for the effects of cyclical developments- remained high in the United States, France, Italy, the United Kingdom, and Canada (Chart 23).19 Greater progress was made during this period in reducing both actual and structural budget deficits of the general government sector in Japan and Ger- many. In the early 1990s, however, fiscal positions in most countries again deteriorated considerably with the economic downturns. The cost of unification in Germany, and policy slippages in many other countries—particularly France, the United Kingdom, Finland, and Sweden—also contributed, and structural budget deficits in 1992 were generally larger than they had been in the early 1980s. There are a number of important qualifications that should be kept in mind in interpreting the structural budget indicator. Because of the margin of uncertainty that attaches to tax and expenditure elasticities and to estimates of cyclical gaps, indicators of structural budget positions should be inter- preted as broad orders of magnitude. The uncertainties surrounding the estimates of revenue and expenditure elasticities and of output gaps are broadly balanced, however. On the one hand, tax and expenditure elasticities may vary over the business cycle and may be somewhat larger during recessions than during periods of normal capacity utilization. On the other hand, to the extent that persistence effects may further increase structural unemployment rates following a cyclical slowdown, the calculated output gaps may prove to ex- aggerate the available margin of slack in the economy, especially following a relatively deep and prolonged recession. In addition, it is important to note that changes in structural budget balances are

19Annex I explains how structural balances are defined and estimated.

©International Monetary Fund. Not for Redistribution IV INDUSTRIAL COUNTRIES: FISCAL ADJUSTMENT AND LABOR MARKET REFORM

Table 6. Industrial Countries: General Government Financial Balances Including and Excluding Social Insurance (In percent of GDP) Projections1

1980 1982 1985 1989 1990 1991 1992 1993 1994 1998 Including social insurance All industrial countries ...... -3.5 -1.3 -2.2 -3.0 -4.0 -4.7 -3.9 -2.3 Major industrial countries -2.6 -4.0 -3.4 -1.2 -2.1 -2.8 -3.9 -4.5 -3.7 -2.3 United States -1.3 -3.4 -3.1 -1.5 -2.5 -3.4 -4.4 -4.1 -3.0 -2.2 Japan -4.4 -3.6 -0.8 2.5 2.9 3.0 1,5 -0.3 -0.5 Germany2 -2.9 -3.3 -1.1 0.1 -1.9 -3.1 -2.7 -4.8 -3.5 -2.3 France — -2.8 -2.9 -1.3 -1.5 -2.1 -3.9 -6.0 -5.9 _2.7 Italy3 -8.5 -11.3 -12.5 -10.5 -11.5 -10.7 -10.0 -10.3 -9.2 -5.6 United Kingdom -3.4 -2.5 -2.9 0.9 -1.3 -2.7 -6.2 -8.6 -7.4 -3.9 Canada -2.8 -5.9 -6.8 -2.9 -4.1 -6.3 -6.6 -7.0 -5.8 -2.1 Other industrial countries -4.3 -1.9 -2.5 -3.8 -4.8 -5.9 -5.6 -2.4 Spain -2.6 -5.6 -7.0 -2.8 -3.9 -4.9 -4.4 -6.3 -7.1 Netherlands -3.9 -6.9 -4.6 -4.7 -4.9 -2.5 -3.9 -3.9 -3.9 Belgium -9.3 -11.5 -8.9 -6.4 -5.4 -6.6 -6.9 -6.7 -5.6 Denmark -3.3 -9.1 -2.0 -0.5 -1.5 -2.2 -2.5 -3.5 -4.2 Greece -5.4 -10.1 -16.5 -20.0 -18.9 -15.9 -13.8 -12.9 -13.3 Portugal 3.8 -11.0 -9.6 -4.8 -6.4 -6.8 -5.1 -6.4 -5.4 Ireland -16.6 -18.4 -13.7 -2.7 -2.5 -2.9 -2.9 -3.4 -3.8 Sweden -4.0 -7.0 -3.6 5.4 4.2 -1.2 -7.8 -13.5 -11.5 Switzerland 0.3 0.2 -1.7 -1.8 -2.4 -2.5 Austria -1.7 -3.4 -2.5 -2.8 -2.2 -2.2 -1.9 -3.4 -3.0 Finland 0.3 -0.6 0.1 2.9 1.1 -6.0 -9.0 -12.2 -9.5 Norway 9.4 7.5 10.3 1.4 2.5 -0.2 -2.8 -3.6 -3.4 Iceland 1.7 2.0 -1.4 -2.8 -2.7 -3.2 -2.3 -2.7 -3.5 Australia -1.4 -1.7 -3.0 1.6 0.5 -2.5 -4.5 -4.9 -4.2 New Zealand4 -6.6 -5.6 -4.1 -1.2 -3.2 -3.3 -3.1 -2.8 -2.4 Excluding social insurance Major industrial countries -2.7 -3.7 -3.8 -2.3 -3.1 -3.6 -4.3 -4.9 -4.2 -2.8 United States -1.8 -3.6 -4.5 -3.8 -4.7 -5.3 -6.0 -5.6 -4.5 -3.7 Japan -7.0 -6.3 -3.9 -0.7 -0.6 -0.8 -2.3 -3.8 -3.9 -2.4 Germany2 -3.2 -3.8 -1.4 -0.6 -2.6 -4.0 -2.8 -4.3 -3.6 -2.3 France -0.8 -2.7 -3.2 -1.5 -1.4 -2.0 -3.5 -5.2 -5.4 -2.7 Italy3 -5.5 -7.1 -8.0 -5.9 -6.2 -5.9 -5.0 -5.6 -5.1 -3.1 United Kingdom5 1.1 3.7 2.3 4.5 2.6 2.0 -0.3 -2.8 -2.3 0.7 Canada -1.8 -4.8 -5.1 -0.7 -1.9 -3.8 -3.9 -4.2 -3.0 0.3 1The projections are based on the assumptions of unchanged policies and constant real exchange rates, except for the bilateral exchange rates among the ERM currencies. 2In percent of GNP. 3Includes interest payments on tax refund liabilities. 4Central government only; excludes the proceeds from asset sales. 5This concept is less meaningful for the United Kingdom, where a significant proportion of social security outlays is financed through general revenues.

not necessarily attributable to policy changes but and some have recently adopted, significant deficit- may reflect the built-in momentum of existing ex- reduction measures. In most cases, however, these penditure programs. Nonetheless, even with these efforts will not be sufficient to restore fiscal sus- qualifications, estimates of structural budget bal- tainability over the medium term. The failure to ances provide useful indications of fiscal trends and seize the opportunity to reduce structural deficits policy requirements in individual countries. during the long expansion of the 1980s has clearly Despite the difficulties of consolidating fiscal po- made the overall task more difficult, but also more sitions during a period of cyclical weakness, there urgent. Nevertheless, in one important respect con- is growing awareness of the detrimental effects for ditions for substantial deficit cuts are better now confidence and growth of persistently large fisca n in the early 1980s: inflation rates are generally imbalances, and many countries have proposed, quite low, and monetary policy now has the

©International Monetary Fund. Not for Redistribution Structural Positions and Current Policies

flexibility—missing in the early 1980s—to suppor Chart 23. Major Industrial Countries: Actual and economic growth. Consolidation efforts will also be Structural General Government Budget Balances1 facilitated by worldwide intentions to scale back (In percent of GDP) military expenditures in the period ahead (see An- nex II). There are good reasons to believe that gradual, but cumulatively substantial, deficit reductions are possible without jeopardizing the global economic recovery. As discussed in the May 1993 World Eco nomic Outlook, cooperative actions to achieve more appropriate policy mixes in all countries—with fiscal consolidation in most countries matched by reductions in short-term interest rates in Europe, in particular—would reduce long-term interest rates immediately, strengthen confidence, stimulate investment in the industrial countries in the short term, and raise potential output in the medium term. Intensified fiscal consolidation in the period of cyclical recovery that is projected therefore is likely to cause only a moderate and temporary reduction in growth in the industrial countries; at the same time it will encourage stronger growth in the indebted developing countries through significantly lower international interest rates.20 Thus, the short- term costs of coordinated fiscal adjustments are likely to be outweighed by the medium-term gains from the crowding in of private investment. Before reviewing the requirements for restoring sustainability, it is useful first to take stock of the fiscal situation and outlook in each of the major countries on the basis of current policies. In the United States, despite earlier efforts to tackle the deficit problem, the period of slow growth and recession in the early 1990s and other noncyclical factors—including the cost of the sav- ings and loan crisis and the rapid rise in health- related outlays—led to a further deterioration in the budget, and in FY 1992 the federal unified deficit reached 5 percent of GDP (53/4 percent when social security is excluded). The fiscal consolidation package recently adopted—which is broadly consistent with the objectives proposed in the administration's budget—implies progressive deficit cuts, reaching 1 3/4percen t of GDP by FY 1998, through measure including tax increases and expenditure cuts in the areas of defense, Medicare, and net interest payments by the end of the five-year budget projection horizon (Table 7). Achievement of the administration's broad objectives would represent a considerable effort but would still leave the structural federal budget deficit at 23/4 percen t of GDP in FY 1998 (3 3/4 percent of GDP excluding social security)—about where it was in FY 1989. The ad- 1Blue shaded areas indicate staff projections.

20See the discussion in the January 1993 Interim Assessment of the World Economic Outlook.

©International Monetary Fund. Not for Redistribution IV INDUSTRIAL COUNTRIES: FISCAL ADJUSTMENT AND LABOR MARKET REFORM

Table 7. United States: Estimates of the Federal Budget Balance (In billions of U.S. dollars unless otherwise noted; fiscal years) 1992 1993 1994 1995 1996 1997 1998 U.S. administration estimates1 Unified budget basis -290 -285 -259 -200 -179 -184 -181 In percent of GDP -4.9 -4.5 -3.9 -2.8 -2.4 -2.4 -2.2 Excluding social security -341 -332 -319 -265 -251 -263 -270 In percent of GDP -5.7 -5.3 -4.8 -3.8 -3.4 -3.4 -3.2 IMF estimates2 Unified budget basis -290 -283 -258 -207 -199 -214 -218 In percent of GDP -4.9 -4.5 -3.9 -3.0 -2.7 -2.8 -2.7 Excluding social security -341 -330 -318 -271 -271 -293 -307 In percent of GDP -5.7 -5.2 -4.8 -3.9 -3.7 -3.8 -3.8 Memorandum Social security cash flows 51 47 60 64 72 79 89 Deposit insurance outlays 3 -26 10 -8 -11 -12 -5 1Based on figures contained in Mid-Session Review of the 1994 Budget (Washington: Government Printing Office, September 1, 1993). The economic assumptions underlying the administration's fiscal projections do not incorporate August 1993 benchmark revisions of the U.S. national income and product accounts. 2The IMF staff estimates are based on the U.S. administration's estimates but assume lower inflation, slower growth, and higher interest rates. The IMF estimates do not reflect differences in the level of GDP arising from the August 1993 benchmark revisions of the U.S. national income and product accounts.

ministration also is planning to reform the health percent of GDP in 1993. Under current policies, care system. Reform could potentially reduce long- this structural deficit is projected to decline slightly term pressures on federal finances, particularly if it to 2 percent of GDP in 1994 and is expected to introduces new cost-control mechanisms, but the remain there over the medium term. Including so- adoption of universal health care coverage would cial security, the overall structural budget balance is risk increasing expenditures. It would be necessary expected to decline from a surplus of 1 3/4 percent of to ensure that health care reform is designed and GDP in 1994 to a budget balance in 1998. implemented with the objectives of avoiding an in- In Germany, the higher-than-expected costs of crease in the deficit in the short term and providing unification and the recent recession led to a sudden a substantial contribution to deficit reduction in the and considerable deterioration in the general gov- longer run. ernment financial position following earlier success During the 1980s, Japan made considerable at consolidation (Table 8). The deficit of the terri- progress in consolidating the government financial torial authorities widened sharply, and total public position, in part through reform of the social secu- borrowing, including the borrowing of the Treuhan- rity system. However, although the overall budget danstalt and the investment needs of the post office balance has remained in surplus, the budget posi- and railways, reached 5 1/2 percent of GDP in 1992 tion excluding social security moved from an ap- on an administrative basis. The Solidarity Pact, proximate balance to a deficit in 1992 as a result of agreed in March 1993, aimed to reduce the deficit the recession and the stimulative measures taken to of the territorial authorities to 2 percent of GDP by support economic activity and to restore financial 1996, mainly through new revenue measures, but stability. The September 1993 fiscal stimulus pack- this target was based on economic assumptions that age amounted to 6 trillion yen (1 1/4percen t of have turned out to be optimistic. In July, the Cabi- GDP)—compared with 13 1/2 trillion yen in the April net approved a package of new measures, in con- 1993 package—and included measures to ease regu- nection with the 1994 budget, intended to limit the latory constraints and support public spending; federal deficit to 2 1/2 percent of GDP in 1994, about one-fourth of these new measures would rep- mainly through social and labor-market-related ex- resent new public investment spending.21 The car- penditure cuts. Because of the projected weak eco- ryover from last year's stimulus package and the nomic recovery total public borrowing is projected actions taken this year are expected to raise the to remain at a historically high level through 1994 structural deficit (excluding social security) to 2 1/4 but the structural balance should improve markedly and this would be reflected more clearly in the actual fiscal accounts once the economy returns to 21For a description of the April 1993 economic stimulus package in Japan, see Box 3 in the May 1993 World Economic more normal levels of resource utilization. Outlook, p. 34. During the period 1989-92, the general govern-

©International Monetary Fund. Not for Redistribution Structural Positions and Current Policies

Table 8. Germany: Fiscal Indicators (In percent of GDP) 1990 1991 1992 1993 1994 1995 1996

General government balance1 -1.9 -3.2 -2.8 -4.8 -3.5 -3.1 -3.1 Excluding social security1 -2.6 -4.0 -2.9 -4.4 -3.6 -3.1 -3.0 Territorial authorities' balance2 -3.5 -4.3 -3.8 -5.3 -4.3 -3.6 -3.5 Federal government2 -1.8 — 1 9 -1.3 -2.4 -2.3 -2.1 -2.0 Other2,3 -1.7 -2.4 -2.5 -2.9 -2.0 -1.5 -1.5 Treuhand and other -1.2 -0.8 -1.6 -2.1 -2.1 -0.9 -0.8 Public borrowing2,4 -4.7 -5.1 -5.4 -7.4 -6.4 -4.5 -4.3

Source: Federal Ministry of Finance; and staff estimates and projections for 1992-94. 1National accounts basis. 2Administrative basis. 3Other levels of government and special funds. 4Territorial authorities' balance, adjusted for changes in cash reserves, plus borrowing of the Treuhand, the postal service, and the railways.

merit deficit in France increased from 1 1/4 percent o mini-budget in May 1993), the structural deficit GDP to 4 percent of GDP, with a further widening will be further reduced this year. The general gov- of the deficit to 6 percent expected this year. Only ernment structural deficit is projected to amount to half of this deterioration is attributable to the weak 7 percent of GDP in 1994 and to average 5 percent economic conditions, however. Budgetary over- of GDP over the medium term in the absence of runs, including the introduction of employment further adjustments. The cyclical component of the subsidies, and reductions in VAT and corporate tax deficit also is projected to remain high, partly re- rates contributed to raise the general government flecting the impact of the structural imbalance on structural deficit to 3 1/2 percent of GDP in 1992. long-term interest rates, confidence, and economic There was also a significant deterioration in social growth. security accounts, which was only partly related to In the United Kingdom, the general government cyclical factors. In 1993, measures were taken to budget balance has moved from a surplus of 1 per raise income tax rates, effective this July, and the cent of GDP in 1989 to a deficit of more than 6 government committed itself to curtailing real ex- percent in 1992 and 8 1/2percen t of GDP in 1993, penditures in the budget beginning in 1994. How owing both to the recession and to a marked deterio- ever, some supplementary expenditure measures ration in the underlying position. During the past have been announced that will contribute to the gen- decade, the overall aim of fiscal policy has been to eral government deficit—without adding to the cen reduce both the tax burden and the growth of public tral government budget—and the overall deficit is expenditure, but earlier progress in reducing the projected to remain at 6 percent of GDP next year. share of expenditures in relation to GDP has been The structural component is projected to average substantially reversed. During the next few years about 3 1/2 percent of GDP in 1993-94 and is ex- the structural deficit is projected to decline by more pected to remain close to 2 percent of GDP over the than 2 percent of GDP, in part due to tax increases medium term. The government is committed to a in 1994-95 as well as to expenditure restraint, but it five-year plan to reduce the budget deficit to 2 is expected to average 3 1/2 percent of GDP over the percent of GDP by 1997, in part by establishing a medium term. norm of zero real growth in government expendi- The government in Canada has reinforced its ture, and to privatize its holdings of 21 financial and commitment, first undertaken in the mid-1980s, to industrial companies. The government will also balancing the budget over the medium term by ex- strive to balance the social security system by 1996 tending and deepening the budget cuts announced in The underlying fiscal situation in Italy has im- December 1992. New expenditure-reduction mea- proved markedly in recent years, but much remains sures were introduced in this spring's budget to en- to be accomplished. Despite a significant reduction sure the achievement of the original fiscal targets in 1990-92, mainly reflecting an increase in reve- for 1993/94 and to eliminate federal borrowing re- nues, the structural deficit was 8 3/4 percent of GDP quirements by 1997/98. Much of the current fiscal in 1992 (or a surplus of 23/4 percen t of GDP exclud- imbalance is the result of cyclical weakness, and ing interest payments). Because of measures both the actual and the structural budget deficit of adopted in the 1993 budget (and the subsequent the federal government is projected to decline to

©International Monetary Fund. Not for Redistribution IV INDUSTRIAL COUNTRIES: FISCAL ADJUSTMENT AND LABOR MARKET REFORM

about 1 percent of GDP by 1997/98. The actual an tainability implies that it is not sufficient to stabilize the structural deficit of the general government, current levels of public debt-GDP ratios, and that it which includes provincial governments, is pro- would be necessary to aim for a gradual reduction in jected to decline to 2 percent of GDP by 1997/98. debt ratios over time (Box 4). Among the smaller industrial countries, the gen- However, measures of government indebtedness eral government financial balance in Sweden moved considerably understate the extent of the problem, from a surplus of about 51/2 percent of GDP in 1989 mainly because the future entitlements of popula- to an estimated deficit of 13 1/2 percent of GDP in tions insured in public pension schemes are not in- 1993. More than half of this deterioration can be cluded in conventional measures of government attributed to tax reform and a cut in payroll taxes, debt. All of the major industrial countries except higher expenditures due to the lagged indexation of the United States and Japan rely primarily or exclu- transfer payments, and financial assistance to the sively on pay-as-you-go public pension systems, banking system, and the remaining deterioration to which are either already incurring large deficits—as cyclical weakness. The Swedish government has in Italy, the United Kingdom, and Canada—or are implemented medium-term budget saving of about expected to do so soon—as in Germany and France. 5 percent of GDP, through both higher revenues and The United States and Japan have reformed their lower expenditures, and there are plans for further social security systems and are seeking to imple- additional saving of about the same magnitude. In ment partially funded systems. However, even Finland, the general government deficit is expected though both systems have accumulated large re- to rise to 12 1/4 percent of GDP in 1993, owing to the serves of assets, these assets are held in the form of severe recession, increases in public expenditures government bonds and are thus indirectly used to on investment and employment promotion, and re- finance other government activities. When social ductions in income and corporate tax rates. The insurance assets are drawn down—to fulfill pension government intends to reduce the deficit by 1995 by obligations—it will be necessary to increase market limiting spending to its 1991 level in real terms; it borrowing or to raise taxes to service the public has recently taken measures—including the indexa- debt to the social security system. tion of income tax brackets, a "temporary" em- Future liabilities depend on the number of retired ployment tax, and lower expenditure on education people relative to the number of people of working and health—to stabilize the public debt-GDP ratio age—the so-called old-age dependency ratio. This below 70 percent by 1997. In Australia, the com- ratio declined in the major industrial countries from monwealth budget balance moved from a surplus in an average of about 58 percent in 1965 to about 48 1990 to an estimated deficit of 5 percent of GDP in percent in 1985, but it is expected to rise to 53 1993, reflecting both cyclical developments and percent over the next twenty years and to be even discretionary policies. The Australian government higher thereafter.22 The strains that higher depen- intends to reduce the deficit to 1 percent of GDP b dency ratios will impose on budget policies in the 1996/97 and is expected to outline its plan in the future can be seen by examining the present value 1993/94 budget. of future net liabilities of the pension systems in the major industrial countries (Table 10). In all the major industrial countries, regardless of the system in Requirements for Medium-Term operation, the present values of net pension lia- Budgetary Sustainability bilities are estimated to be at least as large as current debt levels, even under favorable assumptions. Because of the repeated failures of past consol- In the absence of policy adjustments—possibly in- idation efforts, public debt levels in many industrial cluding increases in retirement age—existing debt countries have increased substantially in relation to levels and unfunded liabilities will continue to grow GDP (in both gross and net terms) during the past and will require costly policy adjustments in the twenty years. Moreover, under current policies, future when benefits are paid, in the form of either public debt is expected to grow further in relation to higher taxes or sharp cuts in expenditures and bene- GDP in most countries (Table 9). Higher levels of debt have absorbed growing shares of government 22 resources in debt-servicing costs, and public sector In 1965, the dependency ratio ranged from 48 percent in Japan to 70 percent in Canada, and in 1985 it ranged from 43 financial imbalances have severely limited, if not percent in west Germany to 52 percent in France and the United eliminated, the scope for fiscal policy to support Kingdom. By the year 2025, this ratio is projected to range economic activity. This reduced scope for action from 55 percent in Italy to between 59 and 61 percent in the has been evident during the current recession and is other major industrial countries. For simulations of the economic effects of aging populations, see "Population Aging: An likely to constrain governments further in the fu- Attempt to Quantify the Long-Term Macroeconomic Effects," ture. In view of the historically high levels of public Supplementary Note 3 in the May 1990 World Economic Out- debt in many countries, the restoration of fiscal sus- look,pp. 100-13.

©International Monetary Fund. Not for Redistribution Medium-Term Budgetary Sustainability

Table 9. Major Industrial Countries: General Government Debt and Budget Balances1 (In percent of GDP) Projections 1980-84 1985-89 1990-92 1992 1993 1994 1998 United States Gross debt 43.6 55.6 63.6 66.9 69.6 70.9 71.9 Net debt 30.0 41.5 49.9 53.7 55.9 56.9 57.8 Net interest payments 1.7 2.1 2.3 2.3 2.3 2.5 2.8 Budget balance -2.5 -2.5 -3.5 -4.4 -4.1 -3.0 -2.2 Japan Gross debt 60.8 71.9 69.0 69.1 72.8 75.0 71.9 Net debt 22.8 21.3 6.4 4.0 4.0 4.2 3.4 Net interest payments 1.6 1.4 0.6 0.4 0.4 0.4 0.3 Budget balance -3.5 0.5 2.5 1.5 — -0.3 -0.5 Germany Gross debt 37.5 42.1 41.2 42.5 46.5 48.8 61.9 Net debt -16.6 12.4 21.5 22.8 24.7 26.0 Net interest payments 1.9 2.3 2.3 2.7 2.6 2.8 3.8 Budget balance -2.9 -1.3 -2.6 -2.7 -4.8 -3.5 -2.3 France Gross debt 31.9 46.4 49.2 52.6 57.5 60.6 58.6 Net debt2 14.3 24.4 27.5 30.2 35.4 39.2 41.8 Net interest payments 1.4 2.1 2.6 2.8 2.7 3.0 2.5 Budget balance -2.1 -2.1 -2.5 -3.9 -6.0 -5.9 -2.7

Gross debt 66.0 94.5 109.5 115.1 121.0 123.4 122.3 Net debt 64.7 82.8 97.3 102.3 107.5 109.7 108.7 Net interest payments 7.5 8.1 10.4 11.5 11.9 10.7 8.0 Budget balance -10.7 -11.5 -10.7 -10.0 -10.3 -9.2 -5.6 United Kingdom Gross debt 46.6 47.1 34.5 35.1 39.6 44.4 52.4 Net debt 25.9 24.6 27.9 28.6 33.0 37.9 45.9 Net interest payments 3.0 2.7 2.0 1.9 2.5 2.7 3.4 Budget balance -3.1 -0.9 -3.4 -6.2 -8.6 -7.4 -3.9 Canada Gross debt 51.1 68.5 79.0 85.9 92.4 94.7 90.4 Net debt 19.3 38.4 49.4 55.9 61.0 63.7 62.4 Net interest payments 0.8 2.8 3.8 3.7 3.7 3.5 2.7 Budget balance -4.7 -4.3 -5.7 -6.6 -7.0 -5.8 -2.1 Memorandum Nominal GDP growth United States 8.7 6.8 4.8 5.5 5.5 5.3 5.1 Japan 6.3 5.7 5.5 3.1 1.1 3.3 6.0 Germany 4.8 4.9 11.0 7.4 2.9 4.4 5.6 France 12.0 7.2 4.4 3.7 1.2 3.4 5.9 Italy 18.6 10.4 8.1 5.7 4.0 5.9 6.1 United Kingdom 10.5 9.6 4.9 3.1 3.8 6.7 5.6 Canada 10.1 7.9 1.9 1.9 3.5 5.3 5.3 1Net debt is defined as gross debt less financial assets, which includes assets held by the social security insurance system. 2Figure for 1980-84 is average of 1983-84. 3Gross and net debt include tax refund liabilities. Net interest payments and budget balance include interest payments on tax refund liabilities. Net debt figure for 1980-84 is for 1984.

fit levels. The projected need for many govern- mittee declaration of April 1993 called for a ments to borrow heavily in the future to fulfill reorientation of economic policies in the major in- pension obligations clearly reinforces the percep- dustrial countries to achieve stronger and sustain- tion that current budgetary trends are unsustainable. able noninflationary growth and to reduce external In addition to fiscal sustainability, there are imbalances and trade tensions. National saving broader economic objectives that are important in rates and rates of capital formation have declined formulating fiscal policies. The IMF Interim Com- considerably during the past two decades, and there

©International Monetary Fund. Not for Redistribution IV INDUSTRIAL COUNTRIES: FISCAL ADJUSTMENT AND LABOR MARKET REFORM

Box 4. The Sustainability of Fiscal Policy

There is no generally accepted definition of what and the initial debt-GDP ratio, according to the fol- constitutes a sustainable fiscal policy. There is, how- lowing budget identity:2 ever, broad agreement that fiscal policies are not sustainable if present and planned revenues and Ad=pb + [(r- g)/(1 +g)]d_1, expenditures result in a persistent and rapid increase where A indicates the change from the previous in public debt-GDP ratios. In this case, financial mar- period. kets will expect that, sooner or later, these policies The second term on the right-hand side of the equa- will have to be revised—implying higher taxes, lower tion represents the "built-in momentum" of the debt- spending, or, in the absence of the policies, the risk of GDP ratio: when the interest rate exceeds the growth higher inflation from monetization of the deficits. In rate, interest payments add more to public debt than the early 1980s, when the industrial countries became growth adds to GDP; hence the public debt-GDP ratio concerned about medium-term fiscal trends, public will increase unless there is a primary surplus (that is, debt was already high, and there was a growing con- unless pb is negative). Because interest rates have cern that it would continue to rise rapidly unless fiscal remained above growth rates (in both real and nomi- policies were changed.1 Nevertheless, fiscal imbal- nal terms) in many industrial countries, a primary sur- ances persisted in the 1980s—and in some cases wors- plus is required to stabilize the debt-GDP ratio. ened considerably—and there is now an even greater There are two conventional measures of public need for policy adjustments: debt-GDP ratios are debt: general government gross liabilities and the cor- much higher; interest payments are a significant share responding net liabilities.3 Gross debt includes all of GDP and government expenditure; and policy flex- outstanding liabilities of the general government sec- ibility has been reduced, if not eliminated, in most tor and plays an important role in financial markets in industrial countries (see Tables 9 and 11). In some many countries. Net debt adjusts these figures for countries, it may also be necessary to lower debt-GDP government financial assets—including cash, bank ratios in the short run in anticipation of future fiscal deposits, loans to the private sector, holdings in pub- demands that will increase debt-GDP ratios in the me- lic corporations, foreign exchange reserves, and other dium term. assets. The general government definition of the pub- Economic theory generally provides little guidance lic sector is most often used because its broad cover- about optimal or desirable debt-GDP ratios. There age of government activities makes it comparable are, however, various ways of establishing across countries. The proper measure of debt for the benchmarks for budget balances that would stabilize government budget identity is net debt, because it or reduce the public debt-GDP ratio. As recent experi- corresponds most closely to the overall, or general, ences in the industrial countries indicate, persistently government deficit. The general government deficit high and rising government debt-GDP ratios are captures net government financial flows, and net debt costly and eventually unsustainable because of the as- properly subtracts government financial assets from sociated debt-service payments and pressures on in- gross debt. Thus, net debt comes close to measuring terest rates. The fiscal adjustment necessary in the net worth of the government, although it records individual countries depends on many factors, but in financial assets at book value and does not adjust for all of trie major industrial countries—and in most of unfunded liabilities and nonfinancial assets.4 the others—the restoration of fiscal sustainability The government budget identity can be used to cal- would call for significant reductions in debt-GDP ra- culate budget targets that would achieve specific debt tios from current levels. objectives such as debt-GDP stabilization or specific Whether a policy is sustainable depends on factors that the fiscal authorities control, such as revenue and 2Over time, the government's (intertemporal) budget con- spending programs, as well as on factors that are be- straint requires the present value of revenues to be not less yond their direct control, such as the rate of interest than the present value of expenditures (including interest on on government obligations, the long-run growth rate the public debt) plus repayments of the debt. The budget of the economy, and demographic trends. Expressed identity holds whether the variables are in real or nominal as a ratio to GDP and separating interest payments terms and assumes that there is no monetary financing of from the total deficit, changes in the public debt-GDP deficits. ratio (d) depend on the primary balance (pb, the ratio 3The general government is broadly defined to include, of noninterest expenditures less revenues to GDP), for example, local governments, the monetary authorities, the difference between the nominal interest rate on social security system, and other trust funds; it does not public debt (r) and the growth of nominal GDP (g), include public enterprises. 4For a further discussion of the various measurement and conceptual issues, see Jean-Claude Chouraqui, Brian Jones, 1See communiques from OECD Ministerial Council and Robert Bruce Montador, "Public Debt in a Medium- meetings, June 17, 1981 and May 11, 1982; and the Supple- Term Context and Its Implications for Fiscal Policy," Eco- mentary Note on "Sustainability of Fiscal Policy in the Ma- nomics and Statistics Department Working Paper No. 30, jor Industrial Countries" in the October 1990 World (Paris: OECD, May 1986), pp. 5-12; and IMF, A Manual Economic Outlook, pp. 88-93. on Government Financial Statistics (1986).

©International Monetary Fund. Not for Redistribution Medium-Term Budgetary Sustainability

Major Industrial Countries: Budget Targets to Achieve Three Debt Rules1 (General government financial balance as percent of GDP) Budget Balance Required to Achieve Annual Targets for Public Net Debt-GDP Ratio Reduce by Reduce by Projection Stabilize 1 Percent 2 Percent United States2 1993 -5.0 -2.8 -1.8 -0.8 1994 -3.8 -2.7 -1.7 -0.6 1998 -2.9 -2.6 -1.5 -0.4 Japan 1993 -0.1 0.9 1.9 1994 -0.3 -0.1 0.9 1.9 1998 -0.5 -0.2 0.9 2.0 Germany 1993 -4.8 -0.6 0.4 1.4 1994 -3.5 -1.0 0.1 1.1 1998 -2.3 -1.2 -0.1 1.0 France 1993 -6.0 -0.4 0.6 1.6 1994 -5.9 -1.0 — 1.1 1998 -2.7 -1.7 -0.6 0.5 Italy3 1993 -10.3 -3.9 -2.9 -1.9 [0.1] 1994 -9.2 -5.7 -4.6 -3.6 [-1.5] 1998 -5.6 -5.9 -4.8 -3.7 [-1.4] United Kingdom 1993 -8.6 -1.0 — 1.0 1994 -7.4 -1.8 -0.7 0.3 1998 -3.9 -1.5 -0.4 0.7 Canada 1993 -7.0 -1.9 -0.9 0.1 1994 -5.8 -2.8 -1.8 -0.7 1998 -2.1 -2.8 -1.7 -0.6 1The calculations are based on 1992 public net debt-GDP ratios and on the projected nominal growth rates shown in Table 9 of Chapter IV. 2For the United States, the figures correspond to the staff projections but are adjusted for the financial flows related to asset sales and government employee pension fund contributions. This adjustment, which adds 1/2 to 1 percentage point to the projections, reconciles the deficit figures (which are on a national accounts basis) with the debt figures (which are on a flow-of-funds basis). 3Figures in brackets indicate the budget balance needed to achieve a reduction in the debt ratio of 4 percentage points a year.

reductions in the debt ratio (see table). Debt-GDP therefore be required to stabilize the ratio at its 1992 stabilization requires that the deficit-GDP ratio, inclu- level, let alone permit the ratio to decline. In Japan, sive of interest payments on the debt, must equal the the projected balances imply a stable net debt-GDP initial debt-GDP ratio multiplied by nominal GDP ratio, but a budget surplus would be required to re- growth. For example, with public net debt in the duce the ratio by 2 percentage points a year. In all of United States at about 55 percent of GDP in 1992, a the major European countries, considerable deficit re- deficit of 23/4 percent of GDP in 1993 would have ductions are necessary just to stabilize the debt-GDP stabilized the net debt-GDP ratio at this level, given a ratio; Germany, France, and the United Kingdom nominal growth rate of 5 percent. With nominal inter- would all need budget surpluses in order to reduce the est rates on public debt of 6 percent, this would imply ratio by 2 percentage points a year. Although debt a primary deficit of about 0.5 percent of GDP. A defi- reduction does not appear to require very low budget cit of 3/4 of 1 percent of GDP, or a primary surplus of deficits in Italy, it does require a significant primary 1.5 percent of GDP, would have reduced the debt- budget surplus because the current debt-GDP ratio is GDP ratio by 2 percentage points.5 very high and interest rates are higher than the growth In the United States, notwithstanding the recently rate. Moreover, because of the very high debt-GDP adopted deficit reduction measures, projected deficits ratio in Italy, it would be desirable to reduce the debt are consistent with continued increases in the debt- ratio by more than 2 percentage points a year, at least GDP ratio, and further significant reductions would initially. To achieve a reduction in the debt ratio by 4 percentage points a year, Italy's budget deficit would 5These calculations assume that interest rates and eco- need to be reduced to about 1 1/2percen t of GDP from nomic activity remain unchanged. 1994.

Table 10. Major Industrial Countries: Estimated Net Pension Liabilities—Present Value of Current and Future Rights and Future Contributions1 (In percent of 1990 GDP) United United States Japan Germany France Italy Italy2 Kingdom Canada Gross liabilities 309 496 467 729 742 609 537 482 Accrued rights 113 162 157 216 259 242 156 121 New rights 196 334 310 513 483 367 381 361 Assets 265 296 306 513 508 508 350 231 Existing 23 18 Future contributions 242 278 306 513 508 508 350 231 Net liabilities 43 200 160 216 233 101 186 250 Source: OECD, "Pension Liabilities in the Seven Major Industrial Countries," Economics and Statistics Department Working Paper (Paris, 1993, forthcoming). The estimates are based on projections for various parameters (including dependency, eligibility, and employment ratios), real GDP growth, and the discount rate. In the United States and Japan, where pension contributions exceed pension expenditures the contribution rates are assumed to remain constant at the 1990 ratio of actual pension contributions to GDP. In the remaining major industrial countries, the contribution rate is assumed to remain constant at the 1990 ratio of pension contributions to expenditures. 1Gross liabilities less net liabilities. 2Assumes the full implementation of the announced increase in retirement age by five years. is growing concern that they have reached levels sponding shortage of domestic saving available to that cannot support adequate rates of growth in pro- finance domestic investment opportunities. These ductive capacity and employment in the medium investment opportunities have attracted a persistent term (Table 11). Low national saving rates also re- net inflow of foreign investment—the necessary flect inadequate private saving, which can be traced counterpart to the U.S. current account deficit. In in part to tax policies (and government subsidies) Japan, total domestic saving has remained above and other disincentives for private saving. Large domestic investment, and the corresponding surplus and growing amounts of government debt have also has been invested abroad. An increase in public and tended to reduce private investment by raising the private saving in the United States would increase average cost of funds required to finance investment the supply of funds available to finance investment outlays. An improvement in potential growth rates and would reduce net foreign capital inflows. Sim- will require higher rates of capital formation, which ilarly, an increase in domestic investment relative will need to be financed by increases in both private to saving in Japan would tend to reduce the current and public saving. Changes in the structure of pub- account surplus.23 lic spending toward productive investment—in edu- The achievement of a broader set of objectives cation, health care, and infrastructure—and the for fiscal policy that takes due account of domestic elimination of subsidies and taxes that discourage as well as external considerations will require pro- saving and investment also would significantly im- found structural changes in budgetary trends to prove the prospects for higher sustainable rates of strengthen the financial position of the public sec- growth. Productivity may also have been adversely tor. On the basis of current policies, sharp increases affected by the disincentives associated with the in tax rates will be necessary in the future if govern- high income tax rates on the current generation of ments are to meet their pension obligations and workers that have been necessary to finance current other financial commitments. In most industrial pension entitlements. These intertemporal imbal- countries, however, government revenues are al- ances and equity considerations will need to be ready high in relation to GDP, and further increases taken into account in establishing budget priorities in the period ahead. There is also a global dimension to domestic im- 23Although there is rarely full Ricardian equivalence—in balances. External imbalances and the associated which the effect on national saving of a reduction in taxes today trade tensions among the major industrial countries is completely offset by an increase in private saving to meet are the direct consequence of large, persistent im- future tax liabilities—there is a relationship between public dis- balances between domestic saving and private do- saving and the net flow of foreign capital. An increase in government saving in relation to GDP may not reduce, one-for- mestic investment in many countries. In the United one, a country's reliance on foreign capital—because the bal- States, as the public sector has increasingly ab- ance of private saving and investment can also change—but it sorbed financial resources, there has been a corre- will tend to reduce the need for capital inflows over time.

Table 11. Major Industrial Countries: Gross Saving and Investment (In percent of GDP) Projections1 1970-79 1980-84 1985-89 1990-94 1992 1993 1994 1995 1998 United States Gross saving 20.1 18.9 16.4 14.6 13.9 14.6 14.6 14.7 15.2 Private 18.2 19.2 16.6 15.9 16.0 16.5 15.6 15.4 15.3 Public 1.9 -0.3 -0.2 -1.3 -2.2 -1.9 -1.0 -0.6 -0.1 Gross investment 19.9 19.6 18.9 16.0 15.5 16.2 16.3 16.3 16.5 Private 17.0 17.4 16.6 13.7 13.2 14.0 14.0 14.1 14.4 Public2 2.8 2.3 2.3 2.3 2.3 2.2 2.3 2.3 2.1 Net foreign investment 0.2 -0.7 -2.5 -1.4 -1.6 -1.6 -1.7 -1.6 -1.3 Japan Gross saving 35.2 30.8 32.7 34.0 34.3 33.7 33.3 32.7 32.2 Private 29.6 26.7 26.0 24.5 25.2 24.7 24.3 23.9 24.3 Public 5.6 4.1 6.7 9.4 9.1 9.0 9.0 8.9 7.9 Gross investment 34.5 29.9 29.4 31.4 31.1 30.4 30.2 29.9 29.9 Private 25.0 21.0 22.6 23.7 23.6 21.8 21.8 22.1 22.0 Public 9.5 8.9 6.8 7.6 7.5 8.5 8.4 7.9 7.9 Net foreign investment 0.8 0.9 3.3 2.6 3.2 3.3 3.1 2.8 2.3 Germany Gross saving 24.3 21.1 24.0 22.0 21.8 20.4 21.1 21.5 22.1 Private 20.5 19.5 21.9 22.5 21.7 22.3 21.6 21.5 22.3 Public 3.9 1.6 2.1 -0.5 — -1.9 -0.5 -0.3 Gross investment 23.4 20.9 19.9 22.6 23.0 22.1 22.6 22.9 23.2 Private 19.4 18.0 17.4 19.4 20.3 19.4 19.8 20.0 20.4 Public 4.1 2.9 2.5 3.1 2.8 2.7 2.8 2.9 2.8 Net foreign investment 0.9 0.2 4.1 -0.6 -1.3 -1.7 -1.5 -1.4 -1.1 France Gross saving 25.5 20.4 20.1 19.9 19.8 18.6 18.7 19.0 19.2 Private 21.7 19.0 18.8 19.7 19.7 20.3 20.3 19.4 17.8 Public 3.7 1.5 1.3 0.2 0.1 -1.7 -1.6 -0.4 1.4 Gross investment 25.5 21.4 20.5 20.0 19.6 18.4 18.5 18.6 18.7 Private 21.8 18.3 17.2 16.5 16.3 14.8 14.9 15.1 15.3 Public 3.7 3.1 3.2 3.5 3.3 3.5 3.6 3.6 3.4 Net foreign investment — -0.9 -0.4 -0.1 0.2 0.2 0.3 0.4 0.5 Italy Gross saving 25.9 22.8 20.9 18.3 17.2 17.7 18.1 18.7 20.2 Private 30.0 29.3 27.6 26.1 25.2 27.3 26.4 25.7 25.1 Public3 -4.1 -6.5 -6.6 -7.8 -8.0 -9.6 -8.3 -7.1 -4.9 Gross investment 25.8 24.1 21.5 19.9 19.4 19.1 19.4 19.6 20.6 Private 24.7 19.6 17.0 16.1 15.7 15.4 15.6 15.8 16.6 Public 1.1 4.5 4.5 3.8 3.7 3.7 3.7 3.8 4.0 Net foreign investment 0.1 -1.2 -0.5 -1.6 -2.2 -1.4 -1.3 -0.9 -0.4 United Kingdom Gross saving 19.5 17.7 16.8 13.6 13.6 12.3 12.6 12.8 13.2 Private 15.6 16.2 14.6 15.7 16.8 17.9 16.9 15.5 14.0 Public 4.0 1.5 2.2 -2.0 -3.2 -5.5 -4.3 -2.7 -0.9 Gross investment 19.9 16.3 18.5 15.9 15.1 14.6 15.1 15.5 16.3 Private 12.4 11.7 15.4 13.0 12.3 11.7 12.2 12.5 13.2 Public 7.5 4.5 3.1 2.9 2.8 2.9 3.0 3.0 3.1 Net foreign investment -0.4 1.5 -1.7 -2.3 -1.5 -2.3 -2.6 -2.7 -3.1 Canada Gross saving 22.9 21.3 19.4 15.6 14.5 15.0 16.5 17.4 18.8 Private 21.8 24.9 22.6 20.6 20.2 21.1 21.4 21.2 20.1 Public 1.1 -3.6 -3.3 -5.0 -5.7 -6.1 -5.0 -3.8 -1.3 Gross investment 23.9 21.3 21.6 19.4 18.5 18.7 19.4 20.0 20.2 Private 20.3 18.7 19.0 17.0 16.2 16.2 17.0 17.6 17.7 Public 3.6 2.6 2.6 2.4 2.3 2.4 2.4 2.5 2.5 Net foreign investment -1.0 — -2.2 -3.8 -4.0 -3.7 -2.9 -2.6 -1.3 irThe projections are consistent with the assumptions underlying both the short-term and medium-term projections discussed in Annex III and the Statistical Appendix. 2Data are constructed from unpublished estimates supplied by the Bureau of Economic Analysis, U.S. Department of Commerce, and are not based on the U.S. national accounts, includes interest payments on tax refund liabilities.

would raise tax rates to levels that would be likely ery gains momentum. In most cases, these efforts to damage incentives, reduce potential growth, and will need to eliminate the structural imbalances or threaten living standards. In most cases, budgetary even to generate fiscal surpluses. In addition to con- consolidation will therefore need to be achieved pri- fronting the need to stabilize and gradually reduce marily through expenditure restraint. Even where visible debt burdens, governments will have to ad- future net liabilities are relatively small, the dress the future needs of aging populations while achievement of fiscal sustainability requires going limiting the burden on future taxpayers. These con- beyond reducing fiscal deficits to levels that would cerns can be met by a variety of means: limitation stabilize public debt-GDP ratios. In countries hav- of the growth of health care costs (for all countries); ing a large pool of unfunded net liabilities, budget increases in the age for qualification for full benefits surpluses may be required to achieve a sound finan- (especially in countries with relatively low age cial position by the end of this decade.24 limits); scaling back of some benefits (especially in In the United States, notwithstanding recent sig- countries with very generous benefits); increases in nificant steps toward addressing the fiscal problem, social contribution rates; and funding from general there is a need for a more stringent fiscal objective revenues. However, because tax rates are already for the long term, in order to raise the national sav- high in many of these countries, changes in pension ing rate, to restore earlier rates of capital formation, benefits and retirement ages may be unavoidable. In and to promote stronger sustainable medium-term Italy, an increase in the retirement age and a reduc- growth of living standards. Government net debt is tion of entitlements (in the 1993 budget) should projected to rise from 533/4 percent of GDP in 1992 help to substantially reduce the net unfunded lia- 3 to 57 /4 percent of GDP by the end of FY 1998, and bilities of the pension system, but considerable fur- it would continue on an upward trend without further fiscal consolidation efforts are necessary to ther measures. Because unfunded liabilities appear reduce both visible and invisible liabilities to sus- to be manageable, fiscal sustainability—defined as a tainable levels. gradual reduction in the debt-GDP ratio—could be Where there is genuine scope to improve produc- achieved through further consolidation efforts tivity through increases in public investment—such aimed at reducing the federal unified fiscal deficit to as investment in education, job training, and physi- about 1 percent of GDP (see Box 4). However, to cal infrastructure—it may be appropriate to set an achieve the broader objectives of significantly intermediate objective for the structural deficit that strengthening national saving and investment per- reduces the debt-GDP ratio more gradually. Pro- formance, it may be necessary to aim for a small vided that the structural deficit is associated with a surplus in the federal budget (or to balance the bud- restructuring of public expenditure in favor of pro- get excluding social security). ductive public investment that creates tangible In the other major industrial countries, unfunded long-term benefits, such investments will be self- net liabilities are much higher than in the United financing if they raise the level of output by more States. As growth recovers, it would be appropriate than they increase the debt service associated with for each of these countries to resume medium-term the "marginal" additional government debt. Bud- fiscal consolidation efforts in order to increase pub- getary discipline is required, however, to increase lic saving and to reduce public debt in relation to expenditures exclusively in those areas where the GDP. In Japan, budget policies that would maintain long-term benefits are commensurate with the an overall budget surplus would be desirable and short- and long-term costs. would be consistent with a gradual but marked increase in social security assets. Such a policy would allow Japan to maintain the necessary degree of Unemployment, Trade, flexibility in the future to manage the financing of and Protectionism pension entitlements. Substantial efforts at fiscal consolidation over the Unemployment has once again risen to intoler- medium term will be required in Germany, France, able levels in the industrial countries (Chart 24). In Italy, the United Kingdom, Canada, and most of the 1993 unemployment in the industrial countries is smaller industrial countries in order to establish expected to surpass 32 million—equivalent to the sustainable budgetary positions as economic recov- working-age populations of Spain and Sweden combined—9 million more than in 1990 and 3 million more than in 1982, the trough of the previous recession. These numbers undoubtably understate 24How much a country must reduce its debt in relation to the size of the problem because they do not reflect GDP depends on expected growth, the initial debt-GDP ratio, and the present value of future net liabilities—which itself de- the number of discouraged workers or involuntary pends on factors such as the age structure of the population, part-time workers, which has recently been esti- retirement age, and existing benefit rates. mated by the Organization for Economic Corpora-

tion and Development (OECD) to be 13 million.25 Chart 24. Industrial Countries: Unemployment1 The cost of unemployment in the industrial coun- (In percent of labor force) tries is enormous. In terms of forgone output, GDP in the industrial countries could be as much as 3 1/2 percent higher in 1993 than now expected—or about $600 billion—if unemployment were reduced to 5 percent in those countries where it now exceeds 5 percent.26 The cost to government budgets is also large. Unemployment benefits are estimated to have accounted for about 3 1/2 percent of total government expenditures in the industrial countries in 1991,27 and this has increased substantially with the recent rise in unemployment. If unemployment could be reduced to 5 percent of the labor force, budget positions for the industrial countries as a whole might be improved by as much as 43/4 percent of GDP.28 The broader social costs of unemployment are also unacceptably high. Chronic unemployment is disrupting the social fabric in many countries, regions, and communities. The recent cyclical increase in unemployment has also coincided with a rise in xenophobia and protectionist sentiment. Even some traditional champions of free trade have suggested that protectionist measures may be necessary to protect workers in the industrial countries from the effects of "globalization"—that is, from increased international competition from developing countries or countries in transition—which is being blamed for job losses or pressures on living standards. These concerns, and the related fear that jobs are being destroyed by rapid technological progress, reflect a very short-run view of economic growth and employment creation. They also suggest a profound misunderstanding of the historical role of trade and economic integration as engines of growth in all countries.29 During the global recession of the early 1970s until the mid-1980s, there was a sharp increase in unemployment in the industrial countries, especially in the 12 members of the EC. This seemingly inexorable rise in unemployment coincided neither with an increased pace of technological change nor with a pickup in the growth of world trade. Indeed, the rise in unemployment followed the widespread

25This estimate, which is for 1991, includes workers who were either discouraged from seeking work by poor job prospects or were part-time workers who wanted to work more hours; see OECD Employment Outlook (Paris, July 1993). 26The average unemployment rate in the industrial countries was below 5 percent until 1975. The estimated increase in output is based on 1988-90 average labor productivity levels. 27See OECD Economic Outlook 53 (Paris, June 1993), p. 39. 28Based on the assumptions that the extra employment income would generate tax revenue, and that unemployment insurance outlays would be reduced, in line with the elasticities described in Annex I. Blue shaded areas indicate staff projections. 29See Chapter VI in the May 1993 World Economic Outlook.

slowdown in trend productivity growth and the slowdown in the growth of world trade (Chart 25). Moreover, trade between the industrial countries and the nonindustrial countries as a percent of industrial countries' GDP—which broadly indicates the degree of competition from the rest of the world—was more or less stable from the mid-1970s to the mid-1980s. These facts suggest that high and rising unemployment is not due to too much competition or too rapid technological change. It seems Chart 25. Industrial Countries: Unemployment, more likely that it reflects inflexible labor markets Trade, and Productivity1 and insufficient technological progress and compe- (In percent) tition in sectors protected from market forces, whether domestic or international. Competitive labor market forces in the United States, Japan, and Canada have been sufficiently strong to ensure that cyclical increases in unemployment have been subsequently reduced, although the reductions have typically taken somewhat longer than the increases. As a result, the equilibrium unemployment rate has remained broadly stable over the past three decades (except in Canada, where it may have increased by a few percentage points in the early 1980s). Even in North America, however, the level of unemployment implies significant losses of economic and social welfare. Among the industrial countries, only Japan has been fully successful in maintaining low and stable unemployment. The contrast between North America and Japan and the other industrial countries is striking. From 1960 until the early 1970s, unemployment in Eu- rope, Australia, and New Zealand averaged less than 3 percent, considerably lower than in North America. In the recessions of 1973-74 and the early 1980s, cyclical increases in unemployment in many countries interacted with inflexible labor markets and appeared to be translated one-for-one into structural unemployment. Moreover, not only did unemployment not fall during periods of economic 1Blue shaded areas indicate staff projections. recovery, it continued to increase in the late 1970s and in the early 1980s, when it reached 11 percent. Unemployment in most European countries and Australia gradually declined in the late 1980s, before rising once again in 1991-93. It is estimated that 40 percent of the currently unemployed in the EC have been out of work for a year or longer, suggesting the marginalization of a large part of the labor force and a substantial deterioration in human capital.30 The recent large increases in unemployment in Finland, Norway, Sweden, and Switzerland are reminiscent of the rise in unemployment in other European countries in the 1970s. The problem of high structural unemployment,

30See OECD Employment Outlook (Paris, July 1993).

and the policies needed to reduce unemployment, incentives for education and training, particularly have been intensively discussed since the early for the long-term unemployed. 1980s. Although the current recession in industrial Macroeconomic policies also have an important countries has raised cyclical unemployment, the so- role to play in the reduction of unemployment. Par- lution to persistently high unemployment is to be ticularly in those countries where persistence mech- found primarily in the area of structural policies. anisms and slow adjustment have in the past tended Reforms are needed to increase the flexibility of to transform cyclical rises in unemployment into workers and of markets—particularly of labor higher structural unemployment, macroeconomic markets—so that the private sector is better able to policies should seek to minimize cyclical increases adapt to the process of dynamic change by creating in unemployment, so long as this does not jeopard- new jobs as others are lost. The importance of flex- ize the attainment of other medium-term objectives. ible labor markets is suggested by the fact that in The recent cyclical increase in unemployment is, of the EC, where labor markets are generally consid- course, directly related to the failure to correct mac- ered to be relatively inflexible, total employment roeconomic imbalances during the long expansion increased only 73/4A percent in the two decades from of the 1980s. As emphasized in the previous sec- 1972 to 1992; in the United States, Japan, and Can- tion, macroeconomic policies should encourage ada, where labor markets are more flexible, the in- saving and capital formation, especially through crease was 37 percent. budgetary consolidation, and should create the con- Broadly based labor market reforms are required ditions for sustained growth, including lower real in virtually all industrial countries, although the im- rates of interest. In those countries where govern- portance of reform in specific areas will vary from ment deficits are unsustainably high, a credible country to country. There is an urgent need in al- commitment to fiscal consolidation can reduce most all countries to re-examine both the financing long-term interest rates, bolster confidence, and in- and the overall generosity of social insurance crease private sector investment and job oppor- schemes with the aim of eliminating those features tunities. If governments have credibility, fiscal that discourage employment creation by increasing stimulus can be an effective offset to cyclical weak- employers' labor costs relative to employees' ness. Moreover, good microeconomic policies- wages and that reduce the incentives for the unem- such as reductions in cross-border trade protection ployed to take jobs. In many countries, the gener- and labor market reforms—can restrain inflation osity of social insurance is a significant disincentive and increase potential output, and thus make fiscal to work because after-tax labor income is in some stimulus feasible. cases only marginally higher than available transfer The argument is sometimes made that the hard- payments. Disincentives to hiring include taxes, won social gains of workers in industrial charges, and costly regulations, particularly those countries—for example, in terms of employment that are of a lump-sum nature and that, therefore, protection or high wages—must be protected from fall especially heavily on the employment of low- competition from countries where workers do not wage workers, such as the young or inexperienced. enjoy such benefits. However, it is not clear that all Unduly high statutory minimum wages and overly such social gains represent an increase in welfare rigid employment-protection regulations have a for the population as a whole. To the extent that similar effect. In some countries, there is a need to policies such as minimum wage legislation, which increase the flexibility of work arrangements by re- are ostensibly directed toward social or distribu- moving restrictions on working hours and part-time tional objectives, have the perverse effect of in- work, and to change regulations that limit the por- creasing unemployment, they may reduce rather tability of pensions and health insurance, in order to than improve social welfare. Policies such as these enhance labor mobility. Wage bargaining systems often represent "social gains" only for the em- need to be reformed in some countries to increase ployed, who are shielded from competition from the wage flexibility so that real wages in different sec- unemployed, not for society as a whole. Trade re- tors reflect productivity differences, which would strictions improve the welfare of workers and entre- allow expanding industries to attract labor rapidly. preneurs (or shareholders) in the protected sectors, The market power of the currently employed—the but they do so at the expense of higher prices to insiders—should not be so great as to result in real everyone else and, in the longer term, reduced flex- wage levels that are too high to allow the ibility and long-term growth. The goals of lower unemployed—the outsiders—to find work. Finally, unemployment, improved welfare of low-wage in many countries, governments' labor market ex- workers, and higher incomes for all would be better penditures need to be reoriented away from passive served if social and distributional objectives were income-support programs to more active labor mar- pursued through the tax and transfer system and ket policies that encourage job search and improve through active labor market policies rather than

through measures that reduce the efficiency and low-skilled workers, and this will—not surpris- flexibility of markets. ingly—be reflected in calls for governments to do In some countries there is also a growing percep- something to protect jobs. Despite possible job tion that competition from developing countries and losses in some sectors in the short run, however, from countries in transition is "unfair." This view governments must promote free trade and techno- ignores that the gains from trade that benefit all logical progress in order to avoid jeopardizing em- countries stem primarily from each country's ex- ployment creation in those sectors benefiting from ploitation of its comparative advantage; countries expanded trade and to improve economic perfor- develop and improve their standards of living by mance in the medium term as labor and capital re- producing those goods for which their advantage in sources shift into more productive sectors. For this terms of productive efficiency is the greatest. More- reason, it is important that trade and labor market over, low wages and low social standards do not policies—like macroeconomic policies—be formu- confer an advantage in international trade if they lated in a medium-term context. Policies that at- reflect low productivity and inadequate investment; tempt to resist change and shield workers and but even if they did, it would not necessarily imply industries from competition in the short run in an unfair competition. Concerns about the adequacy of attempt to protect jobs will only reduce the social and environmental standards—which need to medium-term competitiveness of economies and the be seen in relation to countries' levels of economic private sector's ability to create job opportunities. development—should be addressed without resort Indeed, the focus on "preserving jobs" is mis- to trade-distorting measures. placed; preserving jobs in technologically outdated In the medium term, it is clearly in the interest of and declining industries—whether through tariff or workers in industrial countries that poorer countries nontariff barriers or through industrial subsidies- develop as rapidly as possible, since this will result will eventually lead to fewer jobs in other more in expanding markets and increased demand for in- efficient industries, thereby reducing productivity dustrial countries' exports, thereby increasing em- growth and impairing the medium-term employ- ployment and incomes in industrial countries. ment prospects for the economy as a whole. Gov- Indeed, developing countries—which are already ernment policies should instead be directed toward major markets for industrial country exports—were preserving and enhancing workers' employ ability the industrial countries' fastest growing export mar- and toward encouraging entrepreneurship by in- ket in 1991 and 1992: for example, U.S. merchan- creasing the flexibility of markets. The only durable dise exports to Western Europe increased by an solution to the problem of low-skill workers and the annual average of 2 1/2percent , but U.S. exports to working poor is to increase the productivity of China and the developing countries in the Middle workers through better education, training, and job East and the Western Hemisphere increased by an opportunities in growing industries. average of 22 percent; merchandise exports from Policies that resist change and reduce competi- Japan to North America rose 3 percent, whereas tion make it more difficult for macroeconomic poli- Japan's exports to the same group of developing cies to achieve their medium-term objectives. countries increased 29 percent; and EC merchan- Tariffs and nontariff barriers, managed trade ar- dise exports to Japan and North America fell by an rangements, and subsidies tend to increase medium- average of 3 1/2 and 1 percent a year, respectively, term inflationary pressures and, in the case of sub- while exports to the same group of developing sidies, to increase fiscal deficits. Similarly, overly countries increased 13 percent. Moreover, jobs in generous unemployment insurance systems— the export sector of industrial countries tend to gen- whether in terms of the level of benefits, the dura- erate higher incomes than those in sectors threat- tion of benefits, or the qualification for benefits- ened by imports from lower-wage countries. More have been very costly to government budgets and rapid development in nonindustrial countries, and have reduced the inflation-restraining influence of the expectation of improved standards of living in unemployment. To the extent that these policies the future, will also reduce the incentive for immi- raise the natural rate of unemployment or reduce gration from the developing countries and countries productive potential, they make it more difficult to in transition and will result in improved social and implement appropriate monetary and fiscal policies. environmental standards in those countries. In summary, since the early 1980s governments In the short term, however, it is necessary to rec- have recognized the importance of medium-term ognize that technological progress and heightened policies aimed at low inflation, fiscal consolidation, competition from developing countries may result and structural reform. Substantial progress has, in job losses in some sectors of the industrial econ- however, been made only in the area of inflation omies. The increase in unemployment may be con- reduction. It now seems more likely that govern- centrated in certain industries or regions or among ments will implement medium-term fiscal consol-

idation programs, and prospects have recently ticularly during the expansion phase of the business improved for a successful conclusion of the cycle, properly designed macroeconomic, trade, Uruguay Round. Now is also a propitious time for and structural policies can be mutually reinforcing, governments to demonstrate that they are capable of thereby bolstering confidence, increasing growth adopting policies to reduce unemployment and to and employment, and safeguarding low inflation. increase the employment content of growth. Par-