The outlook for the world economy is, on balance, probably more favourable than when we last reported in November: a further significant deterioration in equity prices has been avoided and business confidence appears to be holding up well. World economic growth will be lower in 1988 than would have been the case but there appears a good chance that recession can be avoided. The key to future exchange rate stability and the maintenance of business confidence in the world economy rests on the progress being made in the US, Japan and West Germany in introducing domestic macro-economic policies to remove the continuing financial imbalances. West Germany's weakening resolve in this connection is a major cause for concern

Ashcroft, Brian

Boyle, Stephen

Draper, Paul

Dunlop, Stewart

Jenkins, Iain

Lockyer, Cliff

Love, Jim

McGregor, Peter

McNicolI, Iain

Pearlman, Mike

Simpson, David

Stevens, Jim

University of Strathclyde Institutional Repository

Strathprints Institutional RepositoryAshcroft, Brian and Love, Jim and Boyle, Stephen and Draper, Paul and Dunlop, Stewart and Jenkins, Iain and Lockyer, Cliff and McGregor, Peter and McNicolI, Iain and Pearlman, Mike and Simpson, David and Stevens, Jim (1988) The world economy [March 1988]. Quarterly Economic Commentary, 13 (3). pp. 4-7. ISSN 2046-5378 , This version is available at http://strathprints.strath.ac.uk/53213/Strathprints is  designed  to  allow  users  to  access  the  research  output  of  the  University  of Strathclyde. Unless otherwise explicitly stated on the manuscript, Copyright © and Moral Rights for the papers on this site are retained by the individual authors and/or other copyright owners. Please check the manuscript for details of any other licences that may have been applied. You may  not  engage  in  further  distribution  of  the  material  for  any  profitmaking  activities  or  any commercial gain. You may freely distribute both the url (http://strathprints.strath.ac.uk/) and the content of this paper for research or private study, educational, or not-for-profit purposes without prior permission or charge. Any  correspondence  concerning  this  service  should  be  sent  to  Strathprints  administrator: strathprints@strath.ac.ukThe World Economy MACROECONOMIC TRENDS OVERVIEW The outlook for the world economy i s , on balance, probably more favourable than when we l a s t reported in November: a further s i g n i f i c a n t d e t e r i o r a t i o n in equi ty p r i c e s has been avoided and business confidence appears to be holding up well . World economic growth w i l l be lower in 1988 than would have been the case but there appears a good chance that recession can be avoided. The key to future exchange ra te s t a b i l i t y and the maintenance of business confidence in the world economy rests on the progress being made in the US, Japan and West Germany in in t roduc ing domest ic macro-economic p o l i c i e s to remove the cont inuing financial imbalances. West Germany's weakening resolve in this connection i s a major cause for concern. In the thi rd quarter of 1987, industrial production in the OECD countries rose by 1.6% compared with increases of 1.2% and 0.5? respectively, during the f i r s t two q u a r t e r s of the year . West German production rose by just under 1% following a 2% increase in the second quarter and a f a l l of 1.9% in the f i r s t q u a r t e r . Japanese production increased markedly, r i s ing by 3.6% after remaining unchanged between the f i r s t and second quarters of the year. The US and the UK continued to experience posi t ive growth rates in the t h i r d q u a r t e r , a t 2% and 1.6% respectively. I t a ly , on the other hand, experienced a drop in production of 2.8% after successive increases in the f i r s t two quarters of the year. In the twelve months to October, OECD production was 4.9% higher, with US production rising by 5.4% (12 months to November), Japanese production increasing by 7.9%, and West German production r i s ing by 1.2%. The other major i n d u s t r i a l c o u n t r i e s a l l experienced positive growth over the year to October, with Canada, France, Italy and the UK, increasing production by 8.1%, 1.2%, 7.6%, and 3.8% respectively. I n d i c e s oF i n d u s t r i a l p r o d u c t i o n S e a s o n a l l y a d j u s t e d C19B0 = ! 0 8 > 130 -, 120 -110 -100 -1? . JAPAN _ / ^ ~ V ^ USA i t i 80 1983 1986 1989 Key developments in the t h r ee main indus t r ia l economies during the l a s t quarter were as follows: 4 United States Provisional figures for real GNP show that the US economy was growing at an annual ra te of 4.2? in the fourth quarter of 1987. Th i s can be compared w i t h annualised r a t e s of growth of 4.1?, 2.5? and 3.8? in the f i r s t , second and thi rd quar ters , respectively. The apparent buoyancy of the US economy in the post stock market crash period i s less clearly supported once the components of GNP growth are examined. Real consumer spending f e l l more sharply in the fourth quarter than in any period since 1980. A c c o r d i n g l y , s t o c k b u i l d i n g r o s e s ignif icant ly during the period, leading many analysts to expect that growth will be much lower in the f i r s t quarter of 1988 as firms move to a more optimal balance of stocks. A reduction in domestic US demand can be viewed as a necessary step towards raising the US domestic saving r a t i o and so reducing the savings shor t fa l l that underlies the deficit on current account -see ea r l i e r Commentaries. In the fourth quarter the personal saving ratio rose to 4.9? from 2.8? in the third quarter and th i s must in part be accounted for by the wealth effect of the stock market crash with investors seeking to rebuild t he i r a sse t s , as predicted in the November Commentary. The main point a t i ssue , however, i s whether the switch from domestic to ex t e rna l demand can be accomplished smoothly. A too rapid cut back in domestic demand could of course be the prelude to recession. In the third quarter of 1987, the US trade deficit widened to a seasonally adjusted US$39.83bn, which is the highest quarterly de f ic i t on record. Nevertheless, trade volumes have been moving in favour of the US for most of 1987, but with the dol lar falling during the year the effect on the external accounts of the improvement in net export volumes has been swamped by a terms of trade effect. To the extent that the d o l l a r s t a b i l i s e s around present rates, the underlying conditions suggest t h a t t h e r e should be a f a i r l y rapid improvement in the trade and current accounts. The November Commentary reported that the US inf la t ion ra te was giving some cause for concern. Retail prices rose by 0.5? in August 1987, 4.3? above the level in August 1986, and representing an annual r a t e of 5.8?. However, p re l iminary figures for the fourth quarter were more favourable than expected suggesting an annual ra te of only 2.7?. Despite agreement between Congress and the Administration on measures to cut the Budget de f i c i t in l ine with the ta rge ts set by the Gramm-Rudman Budget reform law for fiscal 1988, current forecasts suggest that the de f i c i t could be some US$30bn above the outturn for f i sca l 1987.The Congressional Budget Office forecast in February tha t in the absence of further f iscal action the 1988 def ic i t would be US$176bn, compared with US$148bn in 1987. This i s due to the e f f e c t of higher interest rates and lower economic growth on net revenues. Further cuts of around US$30bn are therefore required to bring the outturn into l i ne with the revised Gramm-Rudman target of US$144bn for fiscal 1988. The prospects for agreement on such cuts appears to be limited in an election year. And in the short term at l ea s t , adjustment in the US external accounts wi l l depend more heavily on the savings behaviour of the domestic private sector. Japan In the third quarter of 1987 real GNP grew by 2.1? over the preceding q u a r t e r , equivalent to an annual rate of 8.6?. The slowdown of growth in the second quarter, when real GNP f e l l s l igh t ly , has clearly been reversed in the second half of the year. In November, Industrial production had increased by 10.7? over November 1986. The favourable performance of the Japanese economy re f l ec t s the strong growth in domestic demand which appears to have been l i t t l e affected by the events of l a s t October. In 1986 the surplus on current account stood a t the record level of US$85.8bn. During 1987 the surplus has, on revised f i g u r e s , been f a l l i n g to US$24.9bn, US$21.1bn and US$19.9bn, in the f i r s t , second and third quarters , respectively. On a monthly basis , the surplus f e l l p rogress ive ly during 1987, reaching US$5.9bn in August compared with US$7.1 bn in August 1986. However, in September and October the surplus rose again to US$7.7bn 5 and US$6bn, respect ively, although to lower levels than those recorded during the same periods in 1986. For 1987 as a whole Japan's overal l trade surplus f e l l to US$79.8bn, a reduction of 3.5% on 1986 and the f i rs t fa l l in five years. Further reductions depend on the significance of the J -curve e f f e c t s of the fu r t he r appreciation of the Yen during the la t t e r pa r t of 1986, the r a t e of growth of domestic demand, and the comparative performance of Japanese and foreign firms in taking advantage of, or adjusting to , the exchange rate movements. The f i sca l policy stance continues to be favourable to the stimulation of domestic demand and the removal of the t r ade i m b a l a n c e s in t h e wor ld economy. Following the US$25.4bn package of spending and tax cuts announced last May, the budget for the 1988/9 f i sca l year represents an overal l net increase in spending of 4.3%. Monetary policy remains re la t ive ly lax in order to res t ra in the appreciation of the Yen. The growth of the money supply (M2) during 1987 stood at 10.4%, compared with 8.7% in 1986. West Germany The performance of the German economy continues to be sluggish. In the third quarter fo 1987 real GNP rose by 1.3%, compared with an increase of 1.1% in the second quarter and a f a l l of 0.8% in the f i r s t three months of the year. Between the third quarters of 1986 and 1987 real GNP rose by 2.1% and for 1987 as a whole the increase in real GNP i s estimated to be only 1.7%. The most recent forecasts by the country's five leading economic research inst i tutes suggests that real GNP wi l l grow by 2% in 1988, while other forecasts predict that the growth ra te could be as low as 0.75%. While there are now clear signs that domestic industry i s adjusting to the high D-Mark/dollar rate, the impact on the e x t e r n a l accounts remains small. In the f i r s t eleven months of 1987 the surplus on current account stood at DM70.5bn, compared with DM80.6bn for the whole of 1986. Current forecasts suggest that the surplus i s unlikely to fall below DM65bn in 1988. The government cont inues to r e j e c t suggestions that i t do more to st imulate the economy. Indeed in January the government decided to cut i t s borrowing by a t l eas t DM1Obn in the next f i sca l year via increases in consumer taxes and a reduction in public expenditure. This move followed evidence of a sharp rise in the federal de f i c i t t h i s year to around DM40bn, compared with the original target of DM29.5bn. The growth in the s ize of the d e f i c i t r e f l e c t s in p a r t h igher contributions to the EEC, and the failure of the Bundesbank to gene ra t e DM6bn profits which the government had expected to be earned and paid over during the year. The central bank has had to wri te off up to DM15bn tax cuts which became effective at the beginning of the year and because of the slower than predicted growth of the economy. There i s now considerable doubt whether the government will be able to continue with i t s proposed tax cuts of DM20bn scheduled for 1990. 170 -160 -150 -140 -130 -120 -110 -100 - j 1980 Consumer p r i c e i n d i c e s <1980 - 108> ' ' J^^ r 1 1983 , ' ^_ S ^ 1 1 9 8 6 EUROPE OECO USA 1 1 9 8 9 LABOUR MARKET Standardised ra tes of unemployment have not been published by the 0ECD fr the aggregate of member countries since the fourth quarter of 1986. The ser ies i s no longer being updated pending receipt of new data based on EEC Labour Force Surveys. However, on the basis of data tha t are available for key countries, i t appears t h a t unemployment again f e l l s l igh t ly in the third quarter of 1987. The US standardised rate of unemployment f e l l , on revised figures, from 6.1% to 5.9%, fa l l ing further to 5.8% in November of l a s t year. Japan's unemployment f e l l by 0.2% points to 2.8%, after r is ing by 0.1 percent po in t s during the second quarter of the year. By November the rate had fallen further to 2.7%. Unemployment in France f e l l by 0.1% points to 10.8% after r i s ing by 0.1% points in the second 6 quarter. And in Canada and the UK, unemployment fell by 0.2% points in the former and 0.5% points in the latter bringing their rates to 8.8% and 9.8% respectively. West Germany, in contrast to almost every other major country, experienced a further increase with the rate rising from 6.9% to 7%. PROGNOSIS I t i s too early to say whether the world economy has successfully negotiated the more extreme recessionary poss ib i l i t e s r e s u l t i n g from the upheavals in the world's financial markets during the final quarter of l a s t year. The outlook i s on balance probably more favourable than when we l a s t reported in November: a further significant deterioration in equity prices has been avoided and business confidence appears to be holding up well. World economic growth will be lower in 1988 than would have been the case but there appears a good chance t h a t r ecess ion can be avoided. Following the G7 statement in December i t appears t h a t the a u t h o r i t i e s have e f f e c t i v e l y aba ndqned t h e i r e a r l i e r attempts to set rigid ceilings and floors for the Yen and the D-Mark on the one hand and the d o l l a r on the o ther . There appears to have been a recognition tha t d i r e c t i n t e r v e n t i o n in the fore ign exchange markets and monetary policy changes may not be the a p p r o p r i a t e approach to the removal of the trade and financial imbalances in the world economy. Indeed, i t i s arguable that the exchange ra te s t ab i l i s a t ion policy adopted led to interest rate volati l i ty which contibuted to the stock market crash. There seems a greater wil l ingness now than before to adopt the domestic macroeconomic policies that many, including this Commentary, have urged for some time, The expansionary measures adopted in Japan can be taken as symptomatic of th i s change, while in the US some, a l l be i t l imi ted, progress i s being made in reducing the Budget deficit. An in tens i f ica t ion of these effor ts in both countries i s s t i l l desirable. But what i s worrying, is the weakening resolve of West Germany to introduce expansionary measures. This coupled with the need for the US trade de f i c i t to be seen to be improving i s the key to future exchange ra te s t a b i l i t y and the maintenance of business confidence in the world economy. 7 

The world economy [March 1988]

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The world economy [March 1988]

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