Academic journal article National Institute Economic Review

The World Economy

Academic journal article National Institute Economic Review

The World Economy

Article excerpt

part of the renewed commitment of the Italian government to curtail the country's budget deficit and reduce the level of debt. The stock of outstanding debt has reached the record level of L1,700,000bn (over 110 per cent of GDP), rising 1.8 per TABULAR DATA OMITTED cent from February to March and 13.5 per cent in a year. Only around 4 per cent of public debt is held by foreign investors.

Shortly after the appointment of Mr Antonio Fazio as the new governor of the Bank of Italy, a plan made by the central bank to modify the banking system has been approved by the cabinet. It will allow commercial banks to own up to 15 per cent of The short-term outlook

The deepening recession in Europe during the first half of 1993 has resulted in increasing pressure on the stability of exchange rates. The Exchange Rate Mechanism went through a crisis in late-July/early-August, and very wide fluctuation bands were adopted on the 2nd of August. Table 1 presents our forecast for output and inflation, which helps put the turmoil on the exchanges in context. Output is expected to fall in Germany and France in 1993, but the causes and consequences differ considerably. The recession in the former country may just take output back to a little below capacity whereas in France there has been a good deal of spare capacity for some time.

We are expecting the West German economy to contract by around 2 per cent this year, the largest fall since the war. This is in part a reflection of the slow growth in activity elsewhere, but it is mainly driven by domestic events. German unification in 1990 was accompanied by a loosening of fiscal policy and a sharp increase in investment spending. Both factors increased demand and put upward pressure on inflation. The Bundesbank kept to its monetary targets, and interest rates rose sharply in Germany. As a result the D-Mark appreciated against the dollar. The commitment to the ERM on the part of France, Italy, Belgium and (for a time) the UK meant that interest rates in those countries were higher than they otherwise would have been.

There was a strong case for an upward revaluation of the D-Mark as early as 1990. The Institute believed in 1990(1) that the Bundesbank's policy would cut growth throughout Europe, and might well lead to a recession. In the August 1991 Review John Williamson(2) argued that unification was a once and for all shock and should have been accompanied by a revaluation of the D-Mark, and we calculated that sterling and the lira were 10-15 per cent overvalued.(3) We have seen little reason to change our judgment over the last few years, except that the success of the anti-inflation strategy in France, at least when compared to Germany, has probably reduced the potential overvaluation to at most 5 per cent.(4)

Our central forecast suggests that growth will continue to be slow in Germany for some time, but that this is in part a reflection of the rapid growth experienced through until 1991. Output was above normal levels of capacity utilisation for several years, and is probably not much below it even now. The difference between the French and German positions is clear from Chart 1. We have argued elsewhere that(5) the sustainable level of unemployment is around 7 to 8 per cent in France, and just below this in Germany. Unemployment has been held above the sustainable level in France throughout the 1980s, and as a result inflation has come down, albeit slowly. In the upturn around 1989 French unemployment stayed above the sustainable rate and inflation did not rise very much. On the other hand Germany was clearly operating above capacity and inflationary pressures emerged. Our research suggests that there is a considerable degree of nominal inertia in the process of adjustment in the labour markets of Europe.(6)

The franc was overvalued for much of the early ERM period. Such overvaluations in the real exchange rate can be dealt with either by depreciation or by deflation, that is a reduction in the rate of inflation brought about by a period of low pressure of demand. …

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