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

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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 popula- tion, 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 pro- viding 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. 48 ©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 in- dustrial countries. Because of the relative success in achieving the low-inflation objective, monetary conditions have been eased substantially to support economic recov- ery 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 infla- tion and to help lower underlying inflation further over the medium term. In continental Europe, nom- inal interest rates have declined markedly in recent months, but monetary conditions are still tight given the weakness of activity and recent and pro- spective 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 in- dicators 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 expecta- tions of lower inflation (Chart 20). Even though households and businesses have significantly low- ered their debt-service payments and financial inter- mediaries have improved their financial position, monetary growth, at least for the broader aggre- gates, 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 1/2 percent. 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 be- cause 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- 49 ©International Monetary Fund. Not for Redistribution IV INDUSTRIAL COUNTRIES: FISCAL ADJUSTMENT AND LABOR MARKET REFORM tionary pressures in goods, labor, and asset mar- kets, 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 con- solidation 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 de- clined considerably from their peaks in 1992, with the yield curve in Germany remaining inverted. Nevertheless, using World Economic Outlook pro- jections of inflation as an estimate of expected infla- tion, 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 re- mained 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 sup- port economic recovery may depend on progress in reducing the fiscal imbalance.
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