UN BODY CAUTION ON MONETARY TIGHTENING IN EURO-ZONE

by Chakravarthi Raghavan

Geneva, 2 May 2000 -- For the first time since 1990, average GDP growth this year in western Europe is likely to exceed three percent, but a crash in the overvalued US stock prices or rise in euro interest rates could jeopardise this, the UN regional body said Monday.

The UN Economic Commission for Europe (ECE) said that the transition economies of eastern Europe would return to an average growth rate of four percent or more, the Baltic economies would emerge from recession with an average three percent growth.

But despite the slight improvement in the short-run outlook for many of them, the transition economies of south-east Europe, would continue to fall further behind western or eastern Europe, and pose "a constant but unpredictable threat to economic and political stability in the European region as a whole". The ECE's chief economist, Paul Rayment, said the ECE did not use any 'model' of its own to make projections, but looked through the various national government projections and that of other institutions. Careful examination of these showed that more or less the same data and same models were used by all, but the individual variations were due to the subjective assessments and assumptions.

The ECE went through all these in detail and came to its own judgements of these assumptions and assessments.

And for the first time since 1990, Rayment said, the ECE felt optimistic about the prospects for growth in the ECE region, but there are some downside risks - particularly, over whether the United States would have a 'soft-landing' or much harder one. Much would depend on the stock-market. It was clear there would be adjustment, but how big and how fast, was the uncertainty.

Another related to the euro-zone and interest rates - whether rates should go up to promote structural change or whether structural change would come about as a result of growth, as the ECE believed. If monetary policy is tightened too quickly on the basis of monthly inflation rates it would lead to a lot of uncertainty and keep back investments.

On the implications of the ECE views about the 'new economy' in the US, the role of information technology and computers in increasing productivity, the ECE economists note that while there has been significant productivity increase in the durables sector of manufacturing in the US, it has not been so evident in the non-durables and even less in the non-farm business sector.

Much of the productivity increase in the introduction of computers and information technology has been in computer manufacturing itself, while in the financial sector it has also helped speculation.

Asked about these data and implications in relation to the advice from the United Nations as well as the World Bank and others, to developing countries and others to invest in information technology, internet and other short-cuts, Rayment said that development economics had been studied intensely over the last 40-50 years. If there were short-cuts to development, these would have been "discovered".

Development and structural change depended on a number of elements: new technology, whether they are appropriate to real factor endowments and relative stages of development of the economy. The view that a new technology would provide some magic formula for development was unrealistic.

In its 'Economic Survey of Europe 2000 No.1', the ECE said that there was a clear potential for catch-up investment (capacity-increasing investment) in Europe (just as in the US in early 1990s), and this should not be discouraged by rise in interest rates or talk of need to raise interest rates, whenever output picks up, without reference to estimates of capacity utilization,

The ECE report, published Monday, based on data till late March, was written before last week's action of the European Central Bank (ECB) raising euro-zone interest rates by a quarter percentage point - but failing to shore up the value of the Euro.

The ECE underlined that though the annual inflation rate in the euro-zone in Feb 2000 was 2 percent, the upper limit of the ECB target, most forecasts expect inflation impulses from higher import prices to die away in coming months. The consensus forecast is that average inflation will remain below the 2% ceiling in 2000 and 2001, a view that was shared by the ECB in late 1999. Core inflation is still very low; there is ample slack in labour markets and intense competitive pressures are still putting downward pressures on profit margins and prices.

But the ECB still appears more concerned about possibility of second-round effects of a sharp rise in oil prices. Though monetary conditions are still seen to be accommodative, an "overly cautious" orientation of monetary policy risks placing unnecessary restraint on the cyclical upturn.

The main inflation problem before the ECB is the dispersion of inflation rates (1.5 percent to 4.6 percent) within the euro-zone and the difficulty this raises, in combination with divergent cyclical positions, for the ECB's "one-policy-fits-all," the ECE said.

The report also brings out that after 1973, per capita incomes in western Europe was failing to catch-up with that of the United States, and the transition economies are falling further behind, and it would take many decades for them to narrow the gap.

The ECE analysis of growth, convergence and catch-up shows that the policy advice to developing and transition economies from mainstream neo-classical economists, based on their convergence hypothesis, namely, that there would be steady economic growth and convergence of income by allowing market forces to operate as freely as possible, is not working out.

The empirical estimates of long-term growth prospects of countries, based on the Solow output model, should be treated with scepticism, especially as they assume technology is similar across countries.

The process of catch-up is not an automatic process to be triggered by market liberalization, and economic policy measures, domestic and international, are needed to stimulate the catch-up process.

The negative effects of the financial crisis in Asia in 1997 and in Russia in 1998 had depressed economic activity in much of the ECE during early 1999, but fears of world recession had now receded - by the temporary easing of monetary policy in the US and the "harsh adjustment measures" in Asia and other developing countries, with the costs borne by domestic populations rather than foreign investors.

There was widespread improvement in the economic situation in the second half of 1999, and current forecasts are for a 3% growth in western Europe and 4% in the transition economies of eastern Europe. And while the balance of forces is more favourable for growth in Europe, the downside risks are not negligible, the ECE cautioned.

These risks flow from the possibility of a crash in the over-valued equity prices in the United States, uncertainties over the course of oil prices and of the monetary policy in the European Monetary Union (EMU). Also, not all economies in the region enjoy the same prospects and there are large differences among the transition economies.

Though there is a rise in output, and fall in unemployment rates (from 9.1 to 8.4 percent) in western Europe, unemployment is still the greatest blot on the west European landscape and a major challenge for policy-makers.

And despite a rise in import prices in 1999, due to higher oil prices and weakness of the euro, the impact on west European inflation rates have been quite modest. Intense competition has forced absorption of higher producer prices in lower margins. Labour cost pressures too have remained mild. Though annual inflation in February 2000 at 2 percent was at the upper limit of the ECB target, most forecasts expect inflation impulses from higher import prices to die away in coming months.

The main problem of inflation for the euro area is more the dispersion of rates within the euro-area and the difficulty this raises, in combination with divergent cyclical positions, for the ECB's "one-policy-fits-all."

A major concern of analysts and policy makers in western Europe has been the relatively weak performance of European economies over the past decade in comparison with the US, raising the question whether the "new economy" of the US -- eight years of sustained growth, with GDP growth rate double the west European average, inflation at 2.2 percent, just a fraction higher than ECB upper limit target, and unemployment at 4.2 percent.

That the west European economies have been performing less well than the US is also reflected in the slowing down of the process of convergence with US, with real incomes in western Europe by 1990 being some 35% lower than in the US. In the 1990s, western Europe has fallen behind rather than continuing to close the gap, albeit slowly.

The ECE report is slightly sceptic about all the claims about the "New Economy" in the United States.

The underlying argument, it notes, is that micro-economic combination of new information technology and market liberalization has transformed the key macro-economic relationships between output growth and productivity, inflation and employment.

Mastery over information flows, increased competition as a result of ability of consumers to compare prices on the internet, and more sophisticated methods of stock-control as a result of new technologies -- all these are claimed to tend to raise corporate profits and economic growth; and rising productivity in a highly competitive environment keeps inflation at bay.

Some descriptions of the new economy as "weightless", "knowledge-driven" or "service dominated", are trying to encapsulate two related tendencies: the continued rise in value added to output ratio in industrial economies and the major shift in output and employment from industry to services.

But some of the descriptions of the new economy, the ECE says, are just new labels for old ideas and tendencies that have been around for a long time.

However, since the mid-1990s there has been a sharp acceleration in US productivity growth - though almost entirely in the durables sector of manufacturing.

Output per hour in US manufacturing sector as a whole was 3.3 between 1990-1995 and 5.1 between 1995-1999, compared to 2.4 between 1973-1990 and 3.0 between 1960 to 1973. For the non-farm business sector the figures were respectively 1.6, 2.6, 1.4 and 3.0. Within the manufacturing sector, output per hour between 1990-1995 and 1995-1999 in the durables sector was respectively 4.3 and 7.6; and in the non-durables respectively 2.3 and 2.3.

As for unit labour costs per hour, between 1990-1995 it rose by 0.2 percent and fell by 1.2 percent between 1995-1999. Within the durables manufacturing sector, unit labour costs per hour fell respectively by 0.7 and 3.9 percent, while in the non-farm business sector it rose by 1.7 percent and 1.6 percent respectively.

One reason labour is more productive in the US is that it has more and better capital to work with - or capital/labour ration has risen. Changes in labour productivity are also influenced by technical change, organizational efficiency and economies of scale - changes that can't be directly attributed to changes in combined services of capital and labour.

Some studies in the US have challenged the view that computers have played an important part in rise of labour productivity: of the 2.2 percent rise in output per hour in non-farm business sector between the fourth quarter of 1995 and the first quarter of 1999, only 0.3 percent reflects a structural acceleration, while the reminder is due to cyclical effect, improved statistical methods of measuring price deflators, and the underlying trend.

The marked rise in the US in the incarceration rate, from 0.2 percent of adult population in 1970 to 0.9 percent in 1999, would explain as much as one-fifth of unemployment reduction over the period.

There have also been other factors: a fall in share of young workers in the working age population, improvements in education level of labour force over recent decades has increased employability of workers, fading trade union power has contributed to wage moderation, labour reallocation between sectors due to exogenous shocks and increased worker mobility.

As a result of these several factors, the Nairu concept ("non-accelerating inflation rate of unemployment", reflecting the negative relationship between unemployment and inflation or the Phillips curve), has not proved very useful for conduct of monetary policy over the last decade or so and "there is need for more research to better understand the determinants of inflation over the short term". (SUNS4659)

The above article first appeared in the South-North Development Monitor (SUNS) of which Chakravarthi Raghavan is the Chief Editor.

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