The G7: Economic Outlook and Policy

Nicholas Staines

Introduction

It is a pleasure to be here in Colorado and to have the opportunity to talk about the G7. My goal is threefold: to outline what I believe to be the primary problem facing the G7, where the economy stands and to make some comments on policy.

The problem

Let me start with an outline of what I believe to be the primary problem facing the G7.

The first ingredient is that output growth for the G7 has been declining steadily: averaging 3.6% in the 1970s, 2.8% in the 1980s and 2% in the 1990s. In part, this has been because of the slower growth in resources available, but it has also been because of slower growth in output per worker. The result is that annual growth in output per capita - the only macro economic indicator that ultimately counts - has also been declining: from an average of 2.8% in the 1970s to 2.1% in the 1980s to about 1% in the 1990s.

The second ingredient is that the G7 population is aging fast. In 1990, the old age dependency ratio was around 13%. In 2000, it will have risen to around 15% and by 2020 it will rise to 20% - with enormous implications for pensions (and a topic that will be addressed in Denver).

The upshot is that under currents trends a smaller proportion of people with productivity growth decelerating will be obliged to assume the burden of an increasingly large proportion of the population in retirement. This will only exacerbate the decline in the growth of output per capita already evident.

The key is the growth of what economists call potential output. This is what the economy can produce under 'normal' or 'full' employment of resources. There are three components : labour, capital and gains in productivity that can arise from technological improvements or from the better usage of those resources. At the moment, the growth of potential output in the G7 is in the 2-2.5% range. In Canada, at least, this has declined from 3.4% in the 1970s and 2.9% in the 1980s. The divergence between the level of actual and potential output is called the output gap. This is an important concept because of the policy debate over whether the closure of the output gap can be entrusted to the market or requires government intervention.

At the risk of gross simplification, the central objective of G7 economic policy this decade has been to increase the growth of potential (or sustainable growth). Further simplifying, the role of macroeconomic policies (fiscal and monetary) is to provide the appropriate environment within which markets can operate. The job of microeconomic policies is to devise the rules that increase the growth of potential by enhancing the supply and more efficient use of resources including technological innovation.

To address this issue, G7 policy making this decade has been dominated by profound structural policy changes. At the macroeconomic level we have had dis-inflation and fiscal consolidation. At the microeconomic level we have had a sleuth of policies: liberalization of commerce- aimed not only at international trade but also at domestic product and labour markets as well as financial markets; policies aimed to promote R&D, technological innovation and entrepreneurship; and deregulation and regulatory reform. It is still too early to know whether the G7 has been successful in increasing potential growth, though the anecdotal is positive. But it is quite evident that these policies have been associated with the emergence of a large output gap.

Economic Performance

The decade opened up with a mix of tight monetary and loose fiscal policy. While the US Federal Reserve moved to ward off inflation, the G7 fiscal authorities moved to offset the impact on the economy. But by 1993, the impact of high interest rates on debt service charges and Maastricht led to a reversal in fiscal policy (except in Japan where fiscal policy remained stimulative till this year).

This bout of dis-inflation has been a success. Consumer price inflation, assisted by vigilant monetary policy and a weak economy has now declined from an average of 6-7% in the 1980s to a mere 2.2% over the past three years- well within the bounds considered to be price stability. And we are now starting to see the benefits with the sort of low interest rates not seen in thirty years: in 1996, G7 10-year government bond rates averaged 6%.

Fiscal consolidation has also been successful, but perhaps less so. This is because consolidation has been hampered by high real interest rates (at the long end) from the dis-inflation and by the negative impact of a weakened economy on tax revenues and social security payments. Even so, the general government deficit has declined 2.2 percentage points since its 4.3% peak in 1993 to a projected 2.1% in 1997.

The G7 economy has not responded altogether well to the double shock of dis-inflation and fiscal contraction. Indeed, output growth since 1990 has averaged only 2.0%, somewhat below potential. And as a result, the level of activity has now been below potential since 1992, in 1996 the output gap was 1.4%. A large part of the problem has been that labour and product markets have not had the flexibility to adjust: indeed at 7%, the unemployment rate in 1996 is where it was in 1992. From 1991 to 1996, cumulative employment gains were only 7 million or 2.3%.

There are obviously variations in policy and performance across the G7. But, in my view, the central variation has been in how their labour and product markets have responded. The process of structural adjustment has been significantly faster in the Anglo-Saxon trio which have more flexible markets than does continental Europe or Japan. This has been reflected in the variation in unemployment rates which range from 5% and 6% in the US and UK all the way up to 12% in France and Italy. While the US is probably at potential, other economies are about 3% below with the UK and Canada in between.

The good news is that the G7 economy is clearly strengthening and growth is now expected to accelerate from 2.2% in 1996 to 2.6% in both 1997 and 1998. This is ahead of potential so that the output gap is expected to drop to 0.7% in 1998. Monetary policy has been considerably easier for over a year and lower rates have started to have an impact, especially on residential investment and consumer durables expenditures. But with the economy picking up, monetary policy has already moved to neutral and some tightening can be expected in 1998. Fiscal policy is likely to remain generally tight for another year. Only limited further structural cuts are expected from 1998 once the Maastricht targets in Europe have been met and once a stronger economy and low interest rates start to work their magic on the deficit numbers. This should spell good news for unemployment, but progress is expected to be slow since, although employment growth will rise, so will labour force growth.

Growth is expected to rise in 1997 in all the G7 economies, except Japan which is being hit by fiscal tightening. It is the Anglo-Saxon economies which will have the strongest growth, topping 3% and will be the first to close their output gaps and move ahead of potential. But except for the US, output gaps can be expected to linger till the turn of the decade. It is at this point that inflationary pressures can be expected to start building up. But the US is probably already there. And with inflation already near 3%, both the US and UK have already moved to raise interest rates. The cycle draws to a close. There are two major risks. The first is that - Greenspan's goldilocks tight-rope walk not withstanding - he may raise rates too little too late. This may force a major rate hike later this year and perhaps a recession the next. The indications are otherwise. The second risk, which can only be compounded by a rate hike, is that the European economies miss their fiscal targets, are unable to agree on a compromise or to accept further fiscal cuts, and that the EMU project collapses. In this scenario, all bets are off.

Comments on policy

If the preliminary meetings and statements are any guide, economic policy will not be a large part of the Denver agenda, though selected microeconomic topics like pensions, labour markets and trade will probably be addressed. What I am looking for is the re-affirmation of the trends in economic policy direction that seems to have evolved over the past decade. However, with the recent leftward shift of the political guard, we may well be in for some surprises. What I am looking for is the re-affirmation of two strands of thought, if only implicitly:

The first is the recognition that, although macroeconomic policy does have an important influence, the long term rate of economic growth has more to do with 'potential' and supply side factors that are more appropriately handled by microeconomic policies. Faulty macroeconomic policies can certainly impede long term growth, but ultimately, growth is driven by the determinants of potential. Raising sustainable growth is a micro-policy issue.

The second is a continued leaning against the view that problems can be solved by discretionary (i.e. one off) government intervention. The alternative is the view that economic policy should instead provide the appropriate environment in which individual economic agents can make their own decisions: policy should set the rules of the game rather than become a player in the game. This does not preclude intervention – if the objective is long term and aimed to increase potential. But once the rules have been set, markets should be left alone to resolve imbalances – output gaps, trade imbalances or unemployment.

Monetary policy

Denver is likely to do little more than repeat Lyons and re-affirm that monetary policy should continue to be directed towards price-stability. To a large extent, the G7 has been very faithful to and successful in meeting this commitment. However, holding inflation down when the economy is weak is one thing, keeping it there when the economy recovers is another. And, in my view, both the US and the UK have not only been suspect of using monetary policy for output stabilization but they have also allowed inflation to rise a little to far this past year.

Though completely unlikely, I would like to see Denver go farther than Lyons and institutionalize price stability as the goal of G7 monetary policy. This might entail endorsing: (i) that central banks be given complete autonomy from central government and the explicit mandate to maintain price stability; (ii) the definition of price stability and setting of explicit targets across the G7; (iii) the issuance of real index bonds in all G7 so that market inflationary expectations can be used to evaluate the credibility of the central bank.

Fiscal policy

Denver is also unlikely to do little more than reiterate the Lyons commitment to fiscal consolidation. And the G7 has been quite successful in fiscal consolidation. However, the air has not been completely cleared of the counter-cyclical impulse. Japan is the obvious exception with five years of stimulative policy, and it has now shifted fiscal gear to restrictive. Neither is the US immune. Although the recent budget agreement did negotiate a long-term elimination of the deficit it also included a tax cuts with a net stimulative impact in 1998. And the most recent example is Jospin in France. The danger is that once deficit reduction has been achieved, government will again return to previous habits. Canada is almost there already and has already started to consider policy options for the fiscal dividend. Though rather unlikely, I would again like to see the G7 commitment to fiscal consolidation more formalized.

Exchange Rates

One area where interventionist thinking lingers concerns currency markets, prompted by the low value of the Yen, the gyrations of the European currencies and the prospect of even stronger gyrations should Maastricht collapse. While there is an argument to be made for central banks to enter markets to smooth short-term volatility, I see little basis for central banks to counter the larger swings – if at all they can. Currency markets are reasonably efficient are reflect fundamentals and if those fundamentals shift then punters should be allowed to change their bets. But perhaps more to the point, it is not all clear that central banks can indeed control currencies in an age of global capital markets – that is, if they simultaneously also wanted to target inflation and allow capital to be mobile. Though unlikely, I would be happy to see Denver confirm a non-interventionist stance in currency markets.

Labour markets

Labour markets and the high unemployment rates in Europe are likely to be a focus of discussion in Denver and the policies suggested in the 1994 OECD Job Strategy and endorsed at Lyons are likely to be endorsed again. This focused on changing the institutional structure of labour markets so as to reduce structural unemployment and enhancing the ability of business to create jobs. As our compliance study suggests, the G7 has had measured success in implementing these policies – though at least outside the Anglo-Saxon trio, the benefits have yet to be seen. I think the strategy and Lyons were correct to eschew large-scale government funded make-work projects of the sort Jospin is now calling for.

But the unemployment rate is a curious number that hides a great deal. Indeed, if the labour force participation rate is low, it is quite possible to have a low unemployment rate but also low employment rate too – as in Japan. Or look at Germany. It has a high unemployment rate despite also a high employment rate – because, it also has a relatively higher labour force participation rate.

From the perspective of boosting growth of potential, it is not the unemployment rate per se that matters, but the proportion of labour resources made available to the economy and then employed: the participation and employment rates. But boosting the participation rate to any significant extent will require the consideration of social policy towards contentious areas like the family or retirement. And this is unlikely in Denver.

Conclusion

In conclusion, the G7 has made considerable strides in implementing macro and micro policies supportive of an increased growth of potential. However, although some of the benefits are starting to arrive, the short-term costs to the economy have been quite large especially in continental Europe and primarily because of rigid labour and product markets. Denver is expected to confirm and continue the policy direction. But with the passing of the conservative old guard, we might at least expect a shift in nuance.