MIXED RECOVERY, RISING UNEMPLOYMENT IN OECD

5:14 AM Dec 20, 1993

MIXED RECOVERY, RISING UNEMPLOYMENT IN OECD
Geneva 20 Dec (Chakravarthi Raghavan) -- Industrial Economies in the OECD area are projected to have an overall 2.1 percent growth rate in 1994, one percentage point higher than in 1993 -- but with increased unemployment at nearly 35 million people and falling only marginally thereafter, according to the year-end projections of the Paris-based secretariat of the 22-member Organization for Economic Cooperation and Development.

Over the last three years, actual performance in the OECD area have always been much less than the OECD projections which have been explained by the OECD as essentially due to the existing forecasting models not able to take into account the actual response of consumers and enterprises, and their using the increased incomes and profits towards improving their balance-sheets, rather than on spending or on investments.

The current report shows that these elements are still present.

North America, the OECD projects, will continue with the "solid expansion" under way, and there will be "moderate, if unspectacular" recoveries in UK, Australia and New Zealand, and some smaller European countries.

But in most of Europe, the recovery projected (in its spring outlook 53) is still not apparent, though there are indications that with the exception of Germany, the trough might have been reached.

In Japan economic activity has renewed its decline.

The secretariat's OECD Economic Outlook No 54, projects for 1994 for North America a 3.1 percent growth in GDP (against 2.8 in 1993) and falling to 2.7 in 1995; a 0.5 percent growth in Japan (against -0.5 percent in 1993) picking up to 2.3 percent in 1995; and for Europe a 1.5 percent growth (against a -0.2 in 1992) and rising to 2.6 percent in 1995.

Whether Europe can in fact stage a recovery, according to the OECD document, depends greatly on whether Germany can overcome its economic problems: on present policies, the OECD projects a GDP growth in Germany in 1994 of 0.8 percent as against a fall in GDP this year of 1.5 percent, and a 2.2 percent growth in 1995.

As in 1993, growth impulses for the world economy and for the OECD, will come from the faster growth in parts of the non-OECD areas, particularly Asia.

Exports in some OECD countries will get a modest boost by economic developments in non-OECD countries whose imports could grow at an average of nearly eight percent in 1994 and 1995.

But not all OECD countries are expected to benefit from this, because of the differences among their trading partners and the differences in relative competitivity.

World merchandise trade volumes are expected to grow in 1994 by 5.4 percent (compared to the 2.6 percent in 1993, and just a little over the 5.2 percent of 1992) and increasing to 6.4 percent in 1995.

OECD exports and imports are projected to grow by 4.4 and 4.3 percent respectively compared to 1.0 and 0.3 percent respectively in 1993.

OECD exports and imports to non-OECD area is projected at 7.9 percent each.

The projected widespread pickup of activity in the OECD area over the next two years is postulated on the operation of "self-regulating mechanisms" as monetary conditions ease, balance-sheet positions improve and confidence picks up, while inflation remains low.

But these may fail to operate or work too slowly, providing the main risks to the projections.

The report spells these out as: wage and price pressure could fall less rapidly in Germany, and the easing of monetary conditions in much of Europe could occur later; balance-sheet adjustments could remain more serious in some countries and could worsen again, particularly if real estate prices renew their fall; and high unemployment and uncertainty over direction of the economy could retard return of household confidence.

Persisting high, and, in most countries, rising unemployment also poses a wide range of longer-term risks. The most serious of these is that the increase in unemployment resulting from slowdown or fall in activity, the cyclical component, could eventually be added to the already level of structural unemployment -- where skills and professional qualifications get eroded by prolonged unemployment or where the employed are able to prevent real wage adjustment while protecting themselves, effectively marginalising those without jobs.

High and rising unemployment also poses a threat to efforts at consolidation of budget positions over the medium term.

And high unemployment and relatively weak growth also increase difficulties in implementing structural reforms which could be particularly important in terms of labour markets where adjustment may be necessary in politically sensitive areas -- level and duration of unemployment benefits and legislation which operates to protect those with jobs at expense of those searching for jobs.

It will also aggravate the already strong protectionist tendencies. The multilateral trading system has been under pressure and the major trading countries already often use discriminatory means to manage their trade relations.

(While the conclusion of the Uruguay Round of negotiations will have a psychological effect and point to a direction of change, they would not be effective for another 12-18 months and the rules still provide scope for managed trade).

The conclusion of the Uruguay Round (which has come after the report was written) would be particularly important for improving the multilateral trading system.

In this respect, the secretariat adds, efforts to reduce international imbalances by bilateral or regional agreements could pose a particular risk to the open trading system.

"The Japan-US Framework for a New Economic Partnership", announced in July, might be a case in point, the secretariat says.

"The idea of applying 'objective criteria, either quantitatively or qualitatively or both" by which to measure progress in reducing trade imbalances has been the most controversial element of the Framework. If quantitative indicators were to become numerical targets, the framework could carry the danger of a drift towards managed trade, given its emphasis on bilateral Japan-US trade concerns.

"In addition, the new monitoring process could well involve a degree of government surveillance which could result in interference with the market and cold encourage cartel-like behaviour within the industries involved."

Referring in this connection also to the NAFTA (due to go into effect from 1 January), the OECD adds: "regional trade agreements are by their nature discriminatory, and it will be important to ensure that NAFTA evolves in a way that strengthens the multilateral system and neither develops as a regional substitute for it nor impedes the GATT process. This will require it be implemented in a way that enhances the openness and contestability of markets in the participating countries and ensures that for non-participating countries, the benefits in terms of growth of markets in the region outweigh any adverse impact of trade diversion"

The main negative forces responsible for poor economic performance in the OECD area has been the consequences of over-indebtedness of private sector agents in a number of countries.

These, coupled with rising unemployment and uncertainties over employment prospects have exacerbated recession by restraining household earnings and consumer spending. Households and firms have been trying to strengthen their balance sheets and these are still putting a damper on economic activity.

Levels of private indebtedness still remain high and, against the background of efforts to improve balance sheet position, "lower real interest rates than in previous recessions will be necessary to sustain recoveries in countries where the adjustment process has not advanced as far as in the US".

There are also new factors reinforcing the depressive forces over the next two years, OECD says.

Firstly, there is the steep appreciation of the yen, inflicting a further shock to the Japanese economy which is already undergoing financial adjustment -- with negative effects on Japanese competitiveness and profitability, but with offsetting positive effects in trading partners, largely in the non-OECD countries, especially in Asia.

Secondly, fiscal contraction in most of OECD area will have a direct contractionary effect on demand

According to the OECD projections, cumulative reductions in general government financial deficit in the OECD area during 1994-95 could reach to one percent of the GDP and, in cyclically adjusted terms, the fiscal retrenchment will be higher at around 1-1/4 percent of GDP.

In areas where fiscal retrenchment programmes are as ambitious as in Germany, or focused in particular areas as in defence spending in US, they will have adverse effects on activity.

In discussing the policy priorities in major countries, the secretariat argues that there is little scope for expansionary macro-economic action on fiscal side and, in current circumstances, support for recovery must rely largely, if not solely, on monetary policy which while supporting economic activity nevertheless should not compromise control of inflation over the medium term.

A second element is financial market expectations in determining long-term interest rates which have significant consequences on business investment, output and employment over the longer-run. These are influenced by the credibility and consistency of policy -- that governments are in a position to support activity without deleterious consequences for interest and exchange rates.

With a strengthening of recovery under way, additional support to activity is not of concern in US and the medium term deficit reduction package is tuned to medium-term tightening of fiscal policy.

As a result, the stimulus of short-term (low interest) rates is expected to be gradually withdrawn in 1995 in order to slow the economy towards its potential growth rate. Higher levels of employment and real income will be offset by increased federal taxation of income and higher state and local taxation, thus resulting in only moderate growth in real disposal income.

The OECD however suggests that further measures to reduce structural deficits would be needed in coming years and success in this would depend on health care reform not weighing on budget deficits. Any recovery, more rapid than now projected, and the resultant improvement in deficits should be seen as cyclical and not a substitute for further fiscal consolidation.

In Japan, the economy is showing renewed weakness, after the signs of recovery earlier in the year and the stronger yen is eroding corporate profitability, and undermining labour demand and consumer sentiment. The economy has to deal with a new shock of currency appreciation, when it is still recuperating from the effects of previous over-investment and asset-price inflation. 1994 is thus likely to register at best very weak growth.

Within these parameters, the OECD feels a number of countries have room for manoeuvre -- though there may be questions as to how most effectively this room for manoeuvre can be exploited, in terms of cuts in officially-controlled interest rates.

The central issue to be addressed by most countries on the continent, the OECD secretariat says, is the consolidation of "budget positions despite direct negative demand effects" -- meaning reducing or eliminating the gap between revenue and expenditure without damaging the relatively weak recovery in consumer demand.

The OECD notes that among the European countries, Germany, France and Britain have taken or slated to take actions to cut the deficits, and if they do so, their situation should improve.

But others, such as Belgium and Greece, have a particularly high level of both public debt and budget deficit and if they don't take further measures, they would suffer from either increased tax burdens in future or loss of financial market confidence.

On the currency situation, and the aftermath of the collapse of the ERM, the OECD notes that the countries which suspended their participation in the ERM (Italy and UK) or cut their informal links with either the German mark or the European Currency Unit (ECU), have generally witnessed significant reductions in interest rates and the value of their currencies.

The lower interest rates helped them by easing the stresses faced by several of their economic sectors, while the loss in currency values helped more competitive exports and, as a result, "moderate recoveries are either apparent or in prospect" in these countries

Thus the UK is projected to have a 2.9 percent growth in 1994 and 1995. Germany, on the other hand is likely to have a 0.8 percent growth in 1994 and 2.2 percent in 1995 -- as against an estimated fall in growth of 1.5 percent in 1993.

France has a situation similar to Germany, but somewhat better off -- with growth projected to resume at 1.7 percent in 1994 and at 2.7 percent in 1995. It contracted by an estimated 0.1 percent in 1993.

Overall, OECD sees the EC doing slightly worse than the OECD as a whole over the 1993-95 period.

Referring to the problems confronting countries which had exchange rate links with the German mark, the report points out that while Germany's high interest rates were necessary to deal with its own inflation pressures, "they were not always appropriate to domestic conditions in countries whose exchange rates were linked" to the German mark or the ECU.

And although both short term and long term German interest rates have come down in the last 15 months, "in many countries, short term rates are still high relative to inflation", while monetary conditions remain relatively tight.

"Continued economic weakness and declining inflation," the report says, "make further cuts in short term rates likely. The main question is how rapidly this should happen".

The report suggests that further interest rate reductions will be required by Germany's ERM partners who are suffering from weak activity but already have only low inflation.

But "if German inflation remains unsatisfactorily brisk, and German interest rates continue to decline only slowly", then these ERM partners "will face an increasingly difficult situation".