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Policies for Achieving Sustainable Growth in the Industrial Countries

Author(s):
International Monetary Fund. External Relations Dept.
Published Date:
January 1995
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PROSPECTS for sustained economic growth in the industrial countries are generally good, especially because inflation rates have remained well contained—in many cases, close to their lowest levels since the early 1960s. However, large budget deficits and high structural unemployment rates are hobbling economic expansion in many countries, according to the IMF’s World Economic Outlook, October 1995 (WEO). To foster stronger, sustainable growth, industrial countries should pursue fiscal consolidation and labor market reforms more boldly.

Benefits of bolder adjustment

Lowering fiscal deficits would reduce demands on world saving and stimulate private investment, and making labor markets more flexible would lower structural unemployment rates and contribute to fiscal consolidation. Today’s climate of growth with subdued inflation (see chart) provides an excellent opportunity to pursue these policy efforts more vigorously, which would improve productivity and raise real incomes.

Unsustainable pension plans, rising healthcare costs, distortionary subsidies, and overly generous indexing schemes have contributed to fiscal deficits in a number of countries. Governments need to restrain spending; some may also need to increase tax revenues. These efforts at fiscal consolidation should help stimulate private investment and other interest-sensitive components of demand. Industrial countries that successfully tackle their budget deficits should be able to ease monetary conditions gradually without triggering more rapid inflation, and long-term interest rates should decline. Labor market reforms should include the reduction of payroll taxes and unemployment compensation benefits and elimination of other labor market rigidities.

Long-term interest rates and consumer price inflation in the major industrial countries Recent swings in long-term interest rates contrast with generally subdued inflation

Source: IMF. World Economic Outlook. October 1995

GDP-weighted average of ten-year (or nearest maturity) govemment bond rates for Canada, France, Germany, Italy, Japan, the United Kingdom, and the united Stales.

Percent change from four quarters earlier.

If governments manage by the year 2000 to balance their budgets and reduce structural unemployment rates by 1-2 percentage points, the outlook would be considerably brighter, as shown in Table 1. Long-term interest rates could drop by 1-2 percent; short-term interest rates would also likely decline as monetary policies reflected the improved fiscal environment. Investment would therefore be stimulated, and the capital stock would grow faster, improving productivity and tending to reduce inflation. This tendency toward lower inflation, even with higher output, would be reinforced by more flexible labor markets, bringing about a decrease in unemployment rates, which would improve fiscal positions. GDP would be permanently higher. The short-term costs of fiscal consolidation would be small, the long-term gains substantial.

Costs of policy slippages

A less attractive outcome, shown in Table 2, is possible, however, if policymakers overreact to the recent softening of growth by inappropriately relaxing both fiscal and monetary policies. Signs of sluggish growth have already led to monetary easing in some countries; there is also a risk of fiscal backsliding in several countries. The benefits of this approach would be fleeting, while the long- term costs would be high. GDP might rise at first, but inflation would soon pick up, requiring severe monetary tightening, while larger budget deficits would boost long-term interest rates. Investment would thus be dampened. Higher interest rates in the industrial countries could provoke capital outflows from developing countries and slow economic expansion worldwide.

A switch to more expansionary policies is not justified by the current economic outlook for the industrial countries. The risk of recession or persistently sluggish growth in North America or Europe is small, and Japan should be on the path to recovery in 1996. There are few signs of inflationary pressures. By putting their fiscal houses in order and improving the functioning of their labor markets, the industrial countries could, in the next few years, embark on a path of stronger and more durable economic growth.

Table 1.Benefits of policy reform in the industrial countries Soft landing: balanced government budgets in five years and reduced structural unemployment rates(percentage deviation trom baseline unless otherwise noted)
1996-971998-992000-2001Long run
Real GDP-0.41.51.22.3
Capital stock0.20.92.15.5
Inflation (GDP deflator)10.5-0.5-1.02
Unemployment rate0.2-0.6-0.9-1.0
Short-term interest rate 1-0.3-1.2-2.2-0.4
Long-term interest rate 1-0.1-1.9-1.9-0.4
Real long-term interest rate 1-0.1-1.5-2.0-0.4
General government balance/GDP 10.81.93.40.9
Government debt/GDP1-1.7-4.5-9.3-17.9
Contribution to real GDP
Real government spending 1-0.6-1.4-2.22
Real consumption 121.51.41.3
Real investment10.21.31.91.0
Real net exports1220.10.1
Source: IMF, World Economic Outlook, October 1995.Note: The simulation assumes that a gradual reduction in public debt stocks is achieved through cuts in real spending and nondistortionary transfers. The fiscal consolidation is enough to achieve fiscal balance by 2000 but is not credibly viewed as permanent until 1998. in addition, it is assumed that revenue-neutral cuts in unemployment compensation and labor taxes reduce the natural rate of unemployment by approximately 1.5 percent in Europe, more than 2 percent in Canada, and 1 percent in the United States.

In percentage points.

Indicates zero.

Source: IMF, World Economic Outlook, October 1995.Note: The simulation assumes that a gradual reduction in public debt stocks is achieved through cuts in real spending and nondistortionary transfers. The fiscal consolidation is enough to achieve fiscal balance by 2000 but is not credibly viewed as permanent until 1998. in addition, it is assumed that revenue-neutral cuts in unemployment compensation and labor taxes reduce the natural rate of unemployment by approximately 1.5 percent in Europe, more than 2 percent in Canada, and 1 percent in the United States.

In percentage points.

Indicates zero.

Table 2.Costs of policy slippages in the industrial countries Hard landing: easing of fiscal and monetary policies(percentage deviation from baseline unless otherwise noted)
1996-971998-992000-2001Long run
Real GDP0.8-0.5-1.0-1.7
Capital stock-0.2-0.8-1.5-5.3
Inflation (GDP deflator) 11.90.9-0.1--
Unemployment rate-0.6-0.20.4--
Short-term interest rate 1--1.21.40.3
Long-term interest rate 10.91.00.60.3
Real long-term interest rate 10.51.20.70.3
General government balance/GDP 11.4-2.5-2.1-0.5
Government debt/GDP 10.54.58.89.9
Contribution to real GDP
Real government spending 10.61.01.01.0
Real consumption 10.4-0.5-0.9-1.6
Real investment1-0.3-1.0-1.1-1.0
Real net exports 1-----0.1--
Source: IMF, World Economic Outlook, October 1995.Note: The simulation assumes that the growth rate of money increases by approximately 2 percent a year in 1996 and 1997 before returning to its baseline rate of growth. It is also assumed that fiscal policy is eased so as to increase debt stocks by about 10 percent of GDP, phased in gradually over five years. It is assumed that these policy changes are known in 1996 and consequently are reflected in expectations. The estimates for the long run represent the permanent effects of the shocks.

In percentage points.

Indicates zero.

Source: IMF, World Economic Outlook, October 1995.Note: The simulation assumes that the growth rate of money increases by approximately 2 percent a year in 1996 and 1997 before returning to its baseline rate of growth. It is also assumed that fiscal policy is eased so as to increase debt stocks by about 10 percent of GDP, phased in gradually over five years. It is assumed that these policy changes are known in 1996 and consequently are reflected in expectations. The estimates for the long run represent the permanent effects of the shocks.

In percentage points.

Indicates zero.

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