In the industrial countries, there are promising signs that economic activity will turn out to be stronger in 1997 than during the past year, when growth slowed sharply in many countries.¹ At the same time, inflation is likely to remain subdued while external imbalances are expected to diminish further in a number of cases. For the United States, the slowdown in 1995 was needed to reduce the risk of overheating after the strong performance of 1994, which brought the economy to a high rate of resource utilization. More recently, activity has again picked up, partly in response to the easing of monetary conditions that began in mid-1995. In Europe—with the main exception of the United Kingdom, where growth had also been above trend—the slowdown in growth was decidedly unwelcome as recoveries from the trough of the 1992–93 recession were incomplete and unemployment had remained high. Since the beginning of 1996, however, conditions for a renewed strengthening of activity have improved as monetary conditions have generally eased, as long-term interest rates remain well below their levels in late 1994 and the first half of 1995, and as overstocking appears to have been corrected somewhat. Moreover, with greater convergence of economic and policy fundamentals within Europe, exchange rates have returned to levels more consistent with balanced growth following the misalignments that arose in the spring of 1995 when the deutsche mark (together with the yen) appreciated sharply against the U.S. dollar and several other currencies. In Japan, in contrast to the moderation of growth elsewhere in 1995, the recovery has gained momentum, with confidence gradually recovering as the yen depreciated from the excessively high values reached in the early part of last year.

Inflation in the industrial world has been generally well contained in recent years and is no immediate threat to sustained growth in most countries. But as discussed further, monetary authorities will, of course, need to remain vigilant to incipient price pressures as growth continues or strengthens. (The monetary and fiscal policy assumptions underlying the projections are summarized in Box 1.) Of continuing concern, however, is the need shared by most industrial countries to make further progress toward substantially reducing their fiscal imbalances over the medium term. Structural (i.e., cyclically adjusted) deficits have only been brought down from 3 ¹/₂ percent of GDP in 1992 to 2 ¹/₂ percent of GDP in 1995 for the industrial countries as a group, and the financing of fiscal deficits remains a source of pressure on world real interest rates, keeping the level of private investment and potential future growth below what otherwise could be achieved. A growing number of countries, however, are setting targets for substantially eliminating their fiscal shortfalls over the medium term. These consolidation efforts appropriately are focused on the need to contain the level and growth of public expenditure, which may ultimately permit reductions in tax burdens. There is also increased awareness of the need to address early on the problem of unfunded pension liabilities, which threaten to exacerbate pressures on public finances as populations age in coming decades (see Chapter III of the May 1996 World Economic Outlook). In many countries, however, the debate about pension reform and the search for solutions has only just begun.

Most of the largest fiscal imbalances are suffered by members of the European Union (EU), including some of those countries that have experienced the highest unemployment rates and the weakest growth performance in recent years. It is generally recognized that progressive elimination of fiscal imbalances is necessary for an improvement in growth performance over the medium term. The priority that has now been given to fiscal consolidation has already begun to yield benefits in reducing risk premiums in long-term interest rates, in improving confidence, and in strengthening medium-term growth prospects, particularly in those countries where financial markets previously indicated some lack of confidence in government policies. The attention being given to fiscal consolidation also reflects the desire to meet the objective of keeping fiscal deficits within the Maastricht Treaty reference value of 3 percent of GDP by 1997, the test year for deciding which member countries meet the criteria for participation in the third and final stage of EMU beginning in 1999.

While the weakness of activity in early 1996 would appear to militate against the pursuit of specific fiscal targets defined in actual rather than cyclically adjusted or structural terms, the legacy of excessive fiscal imbalances in many European countries suggests that any significant backsliding from announced consolidation efforts could have severe implications for interest rates and financial market confidence, especially since it might derail the EMU process. Not only does the maintenance of an adequate pace of consolidation offer the best prospect for a sustained improvement in economic performance over the medium term, but also the short-term costs may be smaller than those arising from failure to address adequately the persistently large deficits. At the same time, it is important to avoid aggravating a difficult situation through unduly procyclical fiscal policies. If recent economic weakness were to be prolonged, it would be necessary to allow fiscal policy to provide automatic stabilizers for activity, but only in those countries that are making convincing and adequate progress in reducing structural imbalances (Chart 2). To foster greater fiscal discipline in Stage 3 of EMU, it is encouraging that the EU is considering an agreement whereby countries would aim for a budgetary position close to balance over the medium term. This should provide a basis for allowing automatic stabilizers to operate without budget deficits exceeding 3 percent of GDP during a normal business cycle.

For many countries, particularly in Europe, fiscal imbalances are related to shortcomings in the functioning of labor markets, which have resulted in a dramatic upward trend in unemployment over the past twenty-five years. As much as 8 to 9 percentage points of the EU's current unemployment rate of over 11 percent is widely considered to be structural in the sense that it is unlikely that it could be absorbed through cyclical recovery alone, without significant inflationary risks. Together with discouraged job seekers and heavy resort to early retirement, these high rates of unemployment represent a considerable underutilization of labor resources, which has reduced potential output and exacerbated budgetary pressures through revenue losses and outlays for income support. Clearly, a substantial reduction in this underutilization through appropriate labor market reforms would go a long way toward addressing Europe's fiscal shortfalls.

Many economists and policymakers agree on the root causes of rising structural unemployment and on the types of reform that are needed to reverse it. Much remains to be done to tackle the problem, however, and it has proved extremely difficult to mobilize public support for the necessary reforms. In many countries, there is great reluctance to modify labor market regulations, benefits, and privileges that are widely perceived to be social achievements, but which contribute to persistently high unemployment and social exclusion by keeping labor costs above warranted levels for low-productivity workers and by reducing incentives to work and to create jobs. New Zealand and the United Kingdom are the most prominent examples of countries that have begun to reduce their structural unemployment rates. Most other countries have introduced some reforms aimed at reducing overly generous levels of unemployment compensation, tightening eligibility criteria, reducing taxes on employment, restraining increases in minimum wages, or facilitating restructurings and layoffs—and thereby hirings. The reforms in many countries, however, have been mostly piecemeal, and the beneficial effects of progress in one area have often been hampered by new or deeply ingrained distortions in other areas.

The essential aim of labor market reforms must be to allow market forces a greater role in helping to clear the labor market at much lower levels of unemployment. Since this may well result in lower real wages for some skill categories, governments, in Europe and Canada, in particular, are faced with the challenge of also reforming tax and transfer systems so that they may better meet equity objectives and safeguard a reasonable level of social protection without the negative implications for incentives and employment that are associated with present arrangements. Enhanced training and education are also needed in all countries to alleviate poverty and social exclusion. In Europe, as emphasized in earlier issues of the World Economic Outlook, labor market reforms are not only needed to address the problems of unemployment and fiscal imbalances, but are also essential for the success of the planned monetary union: increased labor market flexibility will be needed to substitute for the loss of the exchange rate instrument when countries are faced with exceptional adjustment needs.

In contrast to the continued difficulties in the fiscal area and in labor markets, monetary authorities in the industrial countries have been highly successful in achieving reasonable price stability, the primary objective for monetary policy. The industrial countries are now enjoying the lowest inflation rates in thirty years with price increases well within official target ranges and generally at very low levels in most cases. It is through the achievement and maintenance of a high degree of price stability that monetary policy can make its most important contribution to both supporting the highest sustainable growth paths for output and employment and minimizing cyclical fluctuations around these growth paths. When monetary policy fails to contain inflationary pressure, thereby necessitating stronger tightening at a later date, the eventual effects on the stability of output and employment and on the sustainable growth rate are likely to be negative.

Success on the inflation front has enhanced the credibility of the anti-inflationary commitment of monetary authorities and thereby reduced inflation premiums in interest rates in many countries, as indicated by the trend declines in nominal and real long-term interest rates since the early 1980s. Credibility has also provided some room for monetary policies to respond to other macroeconomic concerns, such as the stability of output, without raising doubts in financial markets about the commitment and ability to contain inflation. This is fully consistent with the normal cyclical movement of monetary conditions needed to achieve and maintain reasonable price stability. Thus, in situations when inflation objectives would not be jeopardized, it is appropriate to guide short-term interest rates lower to help counter recessionary forces or to facilitate the absorption of slack. But it is essential that such a posture be consistent with the overriding need for monetary policy to safeguard a high degree of price stability. And, because of the lags with which changes in monetary conditions affect the economy, monetary policy must necessarily be forward looking: this implies that preemptive tightening is needed when inflationary pressures are in prospect and before they become apparent.

A complication in the conduct of monetary policy, at least for countries that are not using the exchange rate as an intermediate target, is the need to rely on a broad set of indicators to judge the appropriate stance of monetary conditions. This became clear following the unsatisfactory experiences with monetary targets in many countries. Greater reliance on broader indicators does not appear to have been an obstacle to achieving and maintaining reasonable price stability and seems if anything to have enhanced the credibility of monetary authorities. Still, in a number of cases, credibility has not yet been fully established and will require a solid track record over a long period. In this context, the emphasis on meeting explicit inflation targets in many countries should be helpful, even though it will be difficult in practice to keep inflation within the narrow ranges defined by these targets in all circumstances.

The United States has been particularly successful in recent years in achieving a high level of employment and maintaining growth at close to its potential rate with low inflation. These achievements can be partly attributed to an exceptionally dynamic and flexible labor market that has accommodated a growing labor force and facilitated macroeconomic management. The authorities have also made good progress on the fiscal front—after more than a decade of excessive deficits—while the soft landing achieved in 1995 testifies to the success of monetary policy in preempting inflationary pressures at a mature stage of the expansion.

Despite these achievements, significant challenges remain in both the monetary and fiscal areas. Following the moderation of growth in 1995, the U.S. economy rebounded in early 1996 and is now again threatening to exceed the level of output consistent with low and stable inflation. So far, the underlying inflation rate has remained fairly stable at about 3 percent or less throughout this expansion. However, margins of unused resources in the economy appear to be virtually exhausted and the unemployment rate has fallen to a level that in the past has been associated with rising wage and price pressures. In these circumstances, some tightening of monetary conditions would seem appropriate to reduce the risk of a pickup in inflation that would require more severe and potentially more disruptive policy actions at a later stage, the effects of which would be felt beyond the United States. In the fiscal area, further efforts are needed to progressively balance the budget over the medium term and to avert a renewed deterioration in the fiscal situation in the long run due to the rapid growth expected in spending on pensions and medical care for the elderly.

Japan's economic recovery has gained momentum since mid-1995 after a protracted slowdown. A broad range of supportive policy actions have helped to counteract the deflationary forces stemming from falling asset prices and difficulties in the banking sector and to correct the excessive appreciation of the yen in the early part of 1995. The authorities are now faced with the challenge of gradually withdrawing stimulus without undermining prospects for continued recovery. Eventually, short-term interest rates will need to be raised from the low levels seen recently, but the large output gap, a virtually stationary price level, exchange market considerations, and the need to facilitate the workout from the nonperforming loan problems all underscore the appropriateness of maintaining the current supportive monetary stance for the time being. Fiscal consolidation will need to proceed at a sustained pace as the recovery gains momentum and the authorities appropriately are planning to unwind the recent stimulus packages and to increase revenues. Over the medium term, the need to prepare for future budgetary outlays associated with the aging of the population suggests that Japan should aim at reestablishing a surplus in its overall budgetary position (for general government), although perhaps not as large as in the early 1990s when it reached almost 3 percent of GDP. Further deregulation to strengthen the role of market forces is essential to support the recovery.

Although Germany has already made progress in reducing the large unification-related structural budget deficit that emerged in 1990–91, the actual deficit is projected to widen to about 4 percent in 1996 partly as a result of the renewed cyclical slowdown during the past year. The latest fiscal consolidation package, which also contains important measures to enhance labor market flexibility, is projected to reduce the deficit to 3 percent of GDP in 1997, provided activity continues to pick up as expected during the period ahead, following the rebound in the second quarter. But major fiscal challenges remain to be addressed, including the need to ensure the financial sustainability of public pension plans and to reduce the eastern Länder's dependence on transfers and subsidies.

Inflation in Germany is well under control, and this allowed short-term interest rates to be lowered significantly in late 1995 and early 1996 in response to growing signs that the recovery was faltering. In August, short-term market rates were eased further, triggering corresponding reductions in many of Germany's partner countries (Chart 3). Real long-term interest rates increased somewhat in the opening months of 1996, partly under the influence of higher bond yields in the United States, but more recently exchange market developments and the slack in the economy have allowed German rates to decouple to a large extent from U.S. rates. The growth of M3, the principal monetary aggregate monitored by the Bundesbank, has decelerated in recent months although it is still above its target range; the rise in M3 in 1996 follows very subdued money growth in 1995. The easing of monetary conditions over the past year should help to secure the prospective recovery and was appropriate in view of the absence of inflationary pressure, the continuing efforts at fiscal consolidation, and the strength of the exchange rate. However, it is still too early to conclude that the recent round of interest rate reductions has fully run its course.

In France, growth has also been weak since early 1995, raising doubts, as in many other countries, about the ability to meet fiscal targets. The authorities have stood firm, however, on their intention to meet by 1997 the 3 percent fiscal deficit criterion stipulated in the Maastricht Treaty. This firm approach and the subdued inflation picture have contributed to a significant narrowing of interest differentials vis-à-vis Germany; the easing of monetary conditions over the past year should also assist recovery. The 3 percent deficit goal seems within reach provided activity strengthens during the period ahead as envisaged in the staff's projections. But it will be difficult to restore adequate balance in the public finances over the medium term and lower the tax burden without fundamental reforms aimed at better containing public expenditures and at enhancing incentives to create and seek jobs in order to reduce the high level of unemployment. Recent measures to lower social security contributions for workers at or near the minimum wage and to stimulate part-time work are welcome steps but should be followed up by more far-reaching measures that address the root causes of high and persistent unemployment. A comprehensive program of fiscal and labor market reform is necessary to create a basis for robust noninflationary growth over the medium term, which would facilitate other reforms, including measures to address the problem of unfunded liabilities in the public pension system.

In the United Kingdom, where the recent economic slowdown has been much less severe than in Germany and France, underlying inflation has been running slightly above the 2 ¹/₂ percent ceiling of the authorities' inflation target range, but is expected to drop below the ceiling by early 1997. Unemployment has declined steadily since the start of the recovery in 1993 and there may still be room for some further reduction without undue inflationary risks. On the fiscal side, recent revenue shortfalls suggest that government borrowing will be higher than expected in last November's budget and that corrective measures are needed to put the public finances back on track toward the authorities' goal of balance over the medium term. Growth is expected to pick up in the second half of 1996 and to be sustained at a pace higher than the growth of potential next year. There is some risk, however, that financial market confidence and long-term interest rates, which already appear to reflect concerns over the fiscal outlook, could be more adversely affected by continuing fiscal slippage, especially if the authorities were to introduce significant tax cuts before the next general election.

Following a relatively strong performance in 1995, Italy's recovery lost momentum in the first half of 1996 as growth in key export markets slowed, as the correction of the earlier undervaluation of the lira continued, and as domestic demand remained subdued. Progress in reducing the large fiscal deficit and in lowering inflation has helped to reduce interest differentials further vis-à-vis Germany, but real interest rates remain among the highest in Europe. Despite the slowdown in growth, the new government's three-year program confirms the previous plan's targets, centered on achieving the Maastricht objectives by 1998. Furthermore, it does not rule out accelerating adjustment later this year, if growth and interest rate developments turn out better than currently expected. Achievement of the plan's targets is essential for safeguarding stability in financial markets and achieving better balanced economic growth. It is, however, likely to require action in sensitive areas, including the public payroll, health expenditures, and pensions. The 1997 budget will constitute an important test of the government's resolve in this respect.

In Canada, efforts at fiscal consolidation since 1993 have reduced the fiscal deficit from over 7 percent of GDP to an estimated 2 ¹/₂ percent of GDP in 1996, which has helped to narrow the long-term interest rate differential vis-à-vis the United States in recent months. Meanwhile, weak growth, subdued inflationary pressures, and a firmer exchange rate have led to a decline in short-term rates well below U.S. levels. Lower domestic interest rates, combined with the strength of the U.S. expansion in 1996, should lead to a significant pickup in growth this year. Achievement of the official objective of balancing the budget is within reach, which would help to reduce real long-term interest rates further and strengthen the basis for sustained economic expansion. With substantial gains of export market shares in recent years, the external current account, which has been in significant deficit during the past decade, is expected to be close to balance in 1996.

Among the smaller industrial countries, economic conditions vary considerably. Australia and New Zealand have experienced buoyant growth in recent years with emerging inflationary pressures being met by monetary tightening. Norway and Ireland also continue to enjoy robust growth, so far with low inflation. While activity has been relatively strong in the Netherlands, growth in Austria and Belgium moderated in 1995 but should gradually firm as their main export markets in Germany and France begin to recover; Spain, Sweden, and Finland have experienced a slowing of their export-led recoveries but with inflation remaining well within official targets and fiscal consolidation proceeding, interest differentials vis-à-vis Germany have narrowed considerably, and confidence is improving. All of these countries are pursuing relatively tight fiscal policies aimed at fulfilling by 1997 the conditions for participation in the final stage of EMU. (Denmark, Ireland, and Luxembourg are the only countries that are currently considered to meet the Maastricht fiscal criterion.) Economic activity in Switzerland remains sluggish, in large part because of the persistent strength of its currency. Relatively easy monetary conditions, deregulation, and other structural reforms are needed to facilitate recovery, to reduce the large external surplus, and to promote further realignment of the exchange rate.

1. The average annual growth rate for the industrial countries shown in Table 1 of about 2 percent in 1995 masks the extent of last year's slowdown. On a fourth-quarter-to-fourth-quarter basis, growth in the major seven countries slowed to only 1.5 percent in 1995 (from 3.1 percent in 1994) but is projected to pick up to 2.5 percent in 1996.