Cutting interest rates is just the job

Economics

THE PAST 18 months have been very disappointing for the world economy. After a sharp burst of economic activity in 1994 growth has faded, and by early 1996 the world economy was close to stagnation. Consequently in the third year of economic recovery, unemployment in the world's biggest seven economies has started to shift back up after falling sharply in 1994. Last week's G7 jobs conference set out with the laudable aim of achieving job-creating economic growth but, as is usual with such meetings, the final communique was bland, contained no practical measures and its rhetoric served to reinforce the conventional policy wisdom of the day.

Much of the micro-economic debate was over the deregulation of labour markets, which the US sees as the main solution to Europe's woes, whereas Europe's worry is about the impact of greater labour flexibility on job insecurity - the fashionable explanation for the anaemic nature of the current economic recovery. It is, however, interesting to note that it is the deregulated US that accounts for virtually all of the increase in G7 employment between 1992 and 1995. There was also a good deal of debate about whether trade should be used as a vehicle to enhance core labour standards around the world. Both the US and France, with their inherently protectionist bias, argued that trade union freedoms and the prevention of child employment should be high on the agenda at the next meeting of the World Trade organisation. This back-door attempt to drive up labour costs in the developing world was opposed by those with a stronger commitment to free markets such as the UK. While the G7 countries found it difficult to agree on these important but longer-term issues there was a strong and unanimous commitment to fiscal rectitude: "The G7 countries must endeavour to control public spending more effectively in order to reduce their deficits ... Reducing deficits will help to create a more favourable climate for private investment and income growth against a background of moderate interest rates."

There is a profound danger that G7 are missing the point. The world has just been through a period of sustained fiscal consolidation, prices are stable and have been for some time and interest rates are low by historical standards. Despite this apparently favourable economic background and strongly rising profit shares in a number of G7 economies, economic growth has faltered and unemployment has started to rise. The real reason the world economy has failed to sustain its momentum is that macroeconomic policy is far too tight, especially in continental Europe.

How can this be so when the headlines show budget deficits overshooting and interest rates so low? The first point is that the tightness or looseness of economic policy is not an absolute concept but a relative one. Arguably the fact that the G7 countries have found it very difficult to sustain even trend growth is in itself an argument that policy is tight.

A vital part of this argument is that fiscal consolidation is actively restraining the pace of economic expansion. Structural budget deficits, ie after allowing for the economic cycle, have been cut from 3.6 per cent of potential GDP in 1992 to 2.3 per cent in 1996. This, however, is to understate the full extent of the fiscal squeeze. If you exclude Japan, which has eased throughout the period, the tightening is closer to 1.6 per cent of potential GDP.

In a recent study at HSBC James Capel, we looked at the impact of fiscal consolidations on economic activity and interest rates. A successful fiscal adjustment, defined as a discretionary tightening of fiscal policy that reduces the debt/GDP ratio by 5 per cent over the following three years, has virtually always occurred against a background of strong GDP growth. The average growth rate at the point of tightening was 4.5 per cent. Over the next three years growth slowed on average by nearly 2 percentage points. It is not surprising, given the intensity of the fiscal squeeze and the starting point, that fiscal consolidation is restraining the pace of the economic recovery.

Theory would argue that the quid pro quo for tighter fiscal policy is easier money policy and lower interest rates. However, this is not borne out by history. In the twelve episodes we examined, monetary policy was actually tightened, through both a rise in short term interest rates of around 1 percentage point after three years and an appreciation of the effective exchange rate by around 3.5 percentage points; this in itself is equivalent to a 1 point rise in rates for a small open economy. The message appears to be that one cannot expect an economy to be rewarded for tightening fiscal policy with lower interest rates.

This is a worrisome message for any European economy that wishes to take part in monetary union. Fiscal policy is the biggest barrier to a common currency, albeit for very different reasons. If one uses the Maastricht criteria as a yardstick then fiscal policy is deemed to be too loose. Both Germany and France are likely to record deficits of over 4 per cent of GDP this year, well in excess of the 3 per cent required by the Maastricht treaty and nearly double their structural deficits. The difference between the actual and structural deficit is in part explained by the high level of unemployment. As the policy prescription from both the Maastricht treaty and the G7 communique is to tighten fiscal policy further, there is a real danger of a vicious circle developing in which tighter fiscal policy impacts on growth which pushes up unemployment and therefore the budget deficit, which in turn results in calls for further fiscal austerity. Unless there is a compensating easing in money policy to offset the impact of the fiscal consolidation the net result will be slow growth and a further rise in unemployment. We have already seen that history suggests that a fiscal squeeze is not necessarily rewarded with a monetary easing, but the 1990s do have the considerable advantage of a very low inflation environment.

G7's call for fiscal restraint to create jobs could still be justified if it is seen as part of a policy aimed at keeping inflation low. Here economic theory would suggest that interest rates should adjust to the lower inflation environment and help generate sustainable economic growth. Empirical evidence of this is very difficult to come by. We have analysed the link between inflation and interest rates in the US, Germany, France and the UK over the last hundred years. Despite using the latest statistical techniques we have found no evidence of a strong link. Where a link does exist it is both weak and is only present over the long run of at least ten years.

If there is no clear monetary reward for either fiscal consolidation or lowering inflation, this raises grave doubts about the current policy implicit in the G7 communique and the Maastricht treaty. If the industrial world persists with tightening policy without putting in place much lower interest rates, we will remain stuck in a slow-growth, high-unemployment rut. The US broke out of its slow growth phase by keeping its short rates very low for several years in the early 1990s. Japan is likely to be the fastest growing of the G7 economies in 1996, partly as a result of a radical easing in monetary and fiscal policy.

There are very good medium-term reasons for maintaining a tight fiscal policy but it is unlikely to generate growth strong enough to stimulate sustainable employment. Microeconomic measures to deregulate labour markets will help, but sustained employment growth is unlikely unless macro policy is eased through further cuts in interest rates around the world and the central banks accept that the inflation risks are minimal.

o Keith Skeoch is director of economics and strategy at HSBC James Capel. Hamish McRae is on holiday.