The home economy.

Anderton, Bob ; Britton, Andrew ; Gregg, Paul 等

CHAPTER 1. THE HOME ECONOMY

The forecasts were prepared by Bob Anderton, Andrew Britton and Paul Gregg, but they draw on the work of the whole team engaged in macroeconomic analysis and modelbuilding at the Institute.

PART 1 RECENT DEVELOPMENTS AND SUMMARY OF THE MAIN FORECAST

The upper turning point of the UK trade cycle was apparently in the spring or early summer of last year. That was when the coincident index of cyclical indicators compiled by the Central Statistical Office reached its (provisional) peak. At the time of writing, more than a year after that peak, the downturn still seems mild at least compared with the abrupt ones that followed the summers of 1973 and 1979.

The downturn is most obvious in the housing sector where starts in the second quarter of this year are 22 per cent down on last year, with completions down by 15 per cent. Industrial investment on the other hand may still be rising. The growth in the volume of consumer spending has slowed down considerably, but not altogether stopped. Employment still seems to be rising and unemployment is still falling, although not as fast as it fell last year.

From one point of view a clear cyclical downturn would now be welcome, since it should moderate the pressure for wage and price increases. Since our last Review settlements have increased a little and there have been more industrial disputes. The rise in producer prices has been rather less than we expected, but on the other hand the exchange rate has depreciated more. In May we took the view that short term interest rates would rise from 13 to 14 per cent in response to the more rapid rate of inflation in prospect. In fact events happened faster than we expected and the rise in interest rates coincided with our publication.

A reduction in the rate of inflation is now the first priority of the Government's economic policy. This means that interest rates will be set mainly in response to indicators of actual or potential inflation, not with an eye to exchange rate stability. By next year, if not earlier, the government may be beginning to take some credit for the fact that inflation has passed its peak, and may use the opportunity to cut interest rates by a small amount, say one percentage point. But, since the progress in moderating inflation will be slow, the reduction in interest rates will be no more than slight, with the possibility of a renewed rise remaining throughout the forecast period.

The Chancellor has suggested that the need to cut inflation will prevent him from making large cuts in taxation next year. He will also be urging his colleagues, for the same reason, to be content with very small increases in public spending. We have retained the same assumptions as in May on the conduct of fiscal policy. There are income tax cuts worth about 2 billion [pounds] a year (as well as indexation of allowances and specific duties), and public authorities' consumption rises by only 1 per cent a year in volume. The implication is that the public sector accounts remain in large surplus. Debt repayment for the current financial year is still forecast at about 14 billion [pounds].

In the main forecasts we assume that Britain stays outside the exchange rate mechanism of the EMS, the implications of full membership being explored in a variant forecast described in Part 2. Our main exchange rate forecast is based on an interpretation of current interest differentials and the assumption of consistent expectations. The short-term interest rate for sterling is now some 4 1/2 per cent higher than comparable rates on the currencies which make up the effective exchange rate index. This then is the rate of exchange depreciation the market is deemed to expect over the next twelve months. Similar calculations for successive years, based on the forecast of world interest rates described in Chapter II, lead to the conclusion that sterling will continue to depreciate at around this rate during the early 1990s.

This assumption about the exchange rate is crucial to our forecasts especially of the rate of inflation in the medium term. Depreciation implies a UK rate of inflation persistently above that of the rest of the world, in this case a rate of around 5 to 6 1/2 per cent. For the short term we have slightly reduced our forecast of the increase in wholesale prices in the light of the unexpectedly low figure for the second quarter. The 12-month rise in retail prices by the fourth quarter nevertheless seems likely to be about 7 1/2 per cent, a little above the forecast we made in May. Interpretation of the trade figures for a few months will be obscured by the dock strike, but the underlying deficit on current account is likely to be reduced a little in the latter half of the year. For 1989 as a whole we are now expecting a deficit of about 18 billions [pounds], with only a slight reduction in 1990. Provided that the rate of growth is very low, and provided that the exchange rate depreciates as we expect, the current account deficit should have fallen to about 1 per cent of GDP by the end of our medium-term forecast period in 1993.

PART 2 THE CONSEQUENCES OF FULL EMS MEMBERSHIP

The United Kingdom has been a member of the European Monetary System since its beginnings in 1979, and has undertaken to join the exchange rate mechanism `when the time is ripe'. Membership of the exchange rate mechanism would involve keeping the exchange rate for the pound within narrow margins relative to currencies of the other members, subject to mutually-agreed realignments if that proves impossible. The Delors Report, published in April outlines a programme for transforming the EMS into a currency union such that exchange rates are fixed `irrevocably'. It is unlikely that the UK will join the exchange rate mechanism this year, but the option is still open next year or later.

In this part of the chapter we look at the possible consequences of full EMS membership using the Institute's macroeconomic model. First we describe what might have happened between 1979 and 1988 had the UK been a full member from the start. Secondly we construct a variant on our main forecast to explore what the consequences of full membership would be now or in the future.

In using an estimated model to address these questions we have to assume that the change of policy `regime' would not alter the underlying behavior of the economy. This is a simplification: fixing the exchange rate would most probably increase the volume of trade between Britain and the rest of Europe, because one element of uncertainty would be removed; there is also some indication that EMS membership has changed the behaviour of wages and prices in both France and Italy and a similar response could occur in this country. Changes of this kind might make the transition to full membership easier than our model suggests, but we have no way of quantifying them. We also assume that a commitment to a fixed exchange rate would be believed by the market, and that therefore the resolve of the authorities to defend that rate by raising interest rates is never tested. For that reason short-term interest rates in the UK are set equal to rates of interest in other European countries. This is, of course, to ignore important problems of maintaining confidence, especially in the transition period. Up to now full EMS membership has not brought into line the interest rates in, for example, France, Germany and Italy, but as the system evolves towards monetary union it seems inevitable that they will converge. We discuss below the relationship between credibility and the outlook for the balance of payments.

Finally, we simplify the analysis by assuming no change in the policies of other European countries as a result of the UK decision. Thus the rates of interest in Germany, France, Italy are all unaffected and so are the cross exchange rates of all currencies other than sterling. In practice full membership would give the UK authorities some influence on interest rates in these countries. It is not easy to judge what effect, if any, a British voice in collective decisions would make. It is possible, however, that had Britain been a full member of the EMS in the early 1980s when sterling was being strengthened by its status as a `petro-currency', then all other European currencies might have been rather stronger against the dollar than they were in fact. By a similar argument the UK current account deficit could now weaken any currency to which sterling was tied. These arguments would make it slightly easier for the UK to participate in the exchange rate mechanism, but they are ignored in the calculations we have carried out.

Full EMS Membership 1979 to 1988

The results of the retrospective simulation(1) are shown in table A below. It happens, by chance, that the average exchange rate in 1988 is almost exactly unchanged in the simulation as compared with `real life'. The path for the exchange rate was calculated as follows: the EMS exchange rate index against the dollar is a weighted average of the actual rates for the DM, the franc and the lira. The weights (0.67, 0.22 and 0.11 respectively) are based on their shares in the (old) ECU, with the weights of the Benelux countries and Denmark allocated to the DM and the weights of the rest, including that of the pound, allocated proportionately. Sterling is then assumed to move in line with this EMS currency index against the dollar (or any other non-member currency). The level of short-term interest rates is calculated in a similar way.

As the table shows, had the UK joined the ERM from the start, sterling would have been lower in effective exchange rate terms for most of the period, by as much as 20 per cent in the first quarter of 1981. The only period when sterling would have been higher was from the third quarter of 1986 to the first quarter of 1988. Interest rates, on the assumption described above, would have been much lower in 1979 and 1980, and again from 1985 to 1988, being relatively little changed in the years in between.

The effect on output is to moderate the severity of the recession in 1980 and 1981, but the effects on GDP are never large. Output in the early 1980s is increased by the better performance of exports and by a higher level of investment, but this is partly offset by a lower level of consumer spending. From 1983 the level of output is lower in the simulation, and the recovery from the recession is slowed down. Manufacturing benefits in the simulation more than other sectors of GDP, with output more than 3 per cent above the actual path in 1981 and little different even in the mid-1980s. The capacity of the manufacturing sector is greater throughout, rising to 2 1/2 per cent above actuality by 1988.

The balance of payments surplus on current account is on average larger in the simulation, although not greatly so. By the end of the period, that is as we approach the present day, the deterioration of the current balance is more marked in the simulation. Although the cumulated net asset position of the UK would have been stronger, as a result of larger surpluses in the past, the prospects for the current balance beyond 1988 might have been even more disquieting than they are in fact.

Had we joined the exchange rate mechanism in 1979 the balance of payments position of the UK would not have threatened our commitment to it during the years of large oil surplus. The assumption of a lower interest rate than we had in fact over those years does not seem at all implausible on that account. The difficulties, if there had been any, might have arisen around 1987 or 1988 when the balance of payments moved into deficit and other members were keeping their interest rates relatively low. It is possible therefore that, to maintain the credibility of the UK commitment, the Budgets of those years would have had to be more contractionary, or interest rates might have been raised somewhat above the rate on other European currencies.

Perhaps the most striking result from the simulation concerns the rate of inflation. This would have been higher at the peak in 1980 and slower to fall in subsequent years. On the other hand, it would have actually turned negative in 1987 (at the time when the German rate was close to zero). The level of the price indices in 1988 is much the same in the simulation as it was in fact. This is understandable, since the main influence on the price level in the long run must be the exchange rate if that is treated as exogenous; and the exchange rate happens to be much the same in 1988 with or without full membership of the EMS. The point to emphasise, however, is that the variation of inflation from year to year is clearly greater in the simulation than it was in fact. The authorities under a floating rate system were able to influence the exchange rate so as to reduce the variation in the rate of inflation. Full EMS membership would have increased our rate of inflation when it was in any case high, and would have reduced it when it was already low.

Full EMS Membership 1989 to 1993

The forecast variant was calculated, as far as possible in the same way as the retrospective, using our main forecast as the base. It begins in the fourth quarter of 1989. Again we assume that sterling moves in line with a weighted average of the DM, the French franc and the lira relative to non-EMS currencies. This means that the sterling effective exchange rate appreciates especially in 1990 because the dollar is forecast to fall against European currencies.

We also assume that UK short-term interest rates fall into line with the average of continental rates, but in this case we assume that the transition takes place gradually over a period of two years. It seems unrealistic to suppose that full membership of the EMS would, in current circumstances, give full `credibility' to a commitment to fix exchange rates. If the enterprise was successful for several years, and if in the meantime the EMS itself evolved towards monetary union so that realignments became less likely, then equality of interest rates would gradually be achieved. Compared with the main case the path for interest rates in the UK is much lower. This adds to the level of domestic demand, to both private consumption and fixed investment.

If fiscal policy were assumed to be the same in the variant as in the main forecast then the growth of demand and of output would be considerably faster and there would be no prospect for a return to equilibrium on the balance of payments. Both the main forecast and the variant were computed up to 1997. In the main case the current account in that year was in balance, but in the exchange rate mechanism variant with unchanged fiscal policy there was still a deficit equal to some 3 1/2 per cent of GDP with little sign of improvement. This is unlikely to be a sustainable outcome. The results we report in table B are taken therefore from a simulation in which fiscal policy is much tighter.

It is assumed that income tax is raised by 2 billion [pounds] in the Budget each year and also that the growth rate of public authorities' consumption is cut by 1/2 per cent. The implication is that the surplus of the public sector (the PSDR) stabilises at 6 per cent of GDP (as against 3 per cent in the main case). Having lost control of monetary policy by becoming full members of the EMS, the UK authorities must use their remaining fiscal instruments to hold back domestic demand and to restore external balance. In the simulation as reported in table B the current account is still in large deficit in 1993, but it is heading for a position close to balance by the end of the solution period in 1997.

As the table shows, the effects on the level of aggregate economic activity in this case are small. But there are changes in the composition of expenditure. Lower interest rates, lower import prices and lower inflation all help to stimulate consumption. The growth of export volume is held back, and the growth of imports is accelerated. Because of this shift in the pattern of demand, manufacturing industry is more adversely affected than the rest of the economy. The effects on employment and unemployment are both small.

As in the retrospective simulation, the dramatic result concerns the rate of inflation. Instead of running on in the region of 5 to 6 1/2 per cent as in the main forecast, the growth of the consumer price index falls by about a percentage point a year, almost reaching zero. The retail price index, because it includes the mortgage interest rate, would actually fall in 1992 and 1993.

A year or so of falling prices is a possible outcome if this mix of policies were adopted. It is unlikely, however, that falling prices, or even price stability would be maintained in the long run. In the mid 1990s, according to this simulation the rate of inflation would settle at about 2 per cent a year in line with that which we are forecasting for Germany. As the EMS evolves towards a monetary union, the rate of inflation must tend towards rough equality across member states.

PART 3. THE MAIN FORECAST IN DETAIL

Tables 1 to 9 give details of the short-term forecast with the outlook for the medium-term to 1993 shown in Table 10.

Forecasts of Expenditure and Output (table 1)

Output seems to have been very flat in the first half of this year. This is partly due to production problems in the oil sector which we expect to be rectified in the latter part of 1989 thus allowing GDP growth of just under 2 1/2 per cent for the year. Next year we expect GDP growth to decline to below 2 per cent, beginning a protracted period of slow growth with signs of a recovery possibly not emerging until the end of the medium-term forecast period. A slow-down in both consumers' expenditure and total fixed investment, becoming apparent at the end of this year, will probably lead the way into the growth down-turn. Very low consumption growth--combined with perhaps slightly negative total investment growth--is likely to persist well into the medium term.

A good trade performance will probably begin to reduce the current balance deficit next year with strong export growth and subdued import growth bringing further improvements in the early 1990s to at least 1993. However, a somewhat worrying prospect may materialise around the end of the medium-term period, given the especially good performance in manufacturing exports and continued low investment. First, manufacturing capacity utilisation may soon reach fairly high levels again as output growth begins to rise, even though growth rates may be below 3 per cent per year. Second, manufacturing productivity growth may fail to reach even our `pessimistic' estimated underlying trend rate of 3 per cent, partly because of low rates of investment in the next few years.

Personal Income and Expenditure (table 2)

Since our last forecast, the data for personal incomes have been revised upwards for both last year and the beginning of this year resulting in an upward revision in the savings ratio to approximately 5 per cent. Last year real consumers' expenditure grew by almost 6 1/2 per cent and real personal disposable income by almost 4 3/4 per cent; hence the savings ratio fell. This year most indicators point to a slowdown in consumers' expenditure. The expenditure data for the first part of this year, as well as figures for retail sales, provide some evidence that this is already occurring. Conversely, some categories such as passenger motor cars, which should show some sensitivity to high interest rates, have not shown any decline in sales growth. Similarly, non-mortgage borrowing has continued to grow with borrowers to a large extent ignoring high interest rates, although borrowing for house purchase has experienced a decline.

For 1989 our forecast for year-on-year real personal disposal income growth is almost 5 per cent which is virtually the same as 1988. This is higher than our previous forecast and partly reflects our more optimistic view on consumer price inflation for this year and partly the rapid rise in property income. Next year should see a substantial slow-down in real incomes growth to around 1 per cent (year-on-year) as average earnings growth starts decelerating, employment growth comes to a halt and the mortgage rate rises again.

Our model equation explains total consumers' expenditure in terms of movements in wealth, liquidity, real incomes and a one-for-one effect from consumer credit. We forecast real consumers' expenditure to grow less rapidly than real incomes in 1989, as the high level of interest rates is expected eventually to slow down the growth in consumer credit. Compared to the high consumption growth rate of 1988, the higher interest rates of this year will depress sales of the more interest sensitive consumer durables and substantially discourage mortgage equity withdrawal, because of the stagnation of the housing market. Recent warnings by the Chancellor may discourage some people from spending in anticipation of large tax cuts in the future. Next year sees the growth of real total consumption decreasing again in response to the beginning of a prolonged period of depressed real income growth. This is actually negative for much of the medium term forecast, and only begins to pick up at the end of 1993. Real consumption in the medium term grows at only about 1/2 per cent per year, with the savings ratio continuing to decline as consumers continue to take advantage of the liberalisation of credit markets.

Fixed Investment and Stockbuilding (tables 3 and 4)

The figures are uncertain but the CSO estimates suggest a strong investment boom in both manufacturing and other sectors occurred last year. There were large investment increases in rapidly growing export market sectors such as chemicals and pharmaceuticals, which already show a strong export performance (see the appendix at the end of the chapter). However, there are some doubts as to whether this recent manufacturing investment growth was strong enough, and sustained for long enough, when we consider that manufacturing investment in constant prices in 1988 was only marginally higher than investment in 1979. By contrast, investment in 1988 by distribution and financial and business services was more than double its 1979 value at constant prices.

The provisional data for the first quarter of 1989 suggest that manufacturing investment is already slowing down although investment by the construction, distribution and financial industries was still showing strong growth at this stage. The July CBI survey indicates this is the beginning of a slow-down as only 3 per cent of manufacturing firms expect to raise investment over the next year--compared with a much higher 19 per cent in the previous survey--with larger firms in particular showing a substantial decline in the growth rate of future investment. Our forecast arrives at a similar conclusion: manufacturing investment begins to flatten out in the latter half of 1989 as manufacturing capacity utilisation and output begin to fall. Manufacturing investment remains low in 1990, adding to the slowdown in this sector, with virtually no growth throughout the medium term as capacity utilisation grows slacker and persistently high interest rates maintain a high cost of capital. Investment in distribution etc. falls in 1990 and goes on falling through the medium term. With the exception of the financial sector, distribution and service industries' investment may be cut back more sharply than manufacturing investment because there is less short-lived plant and machinery to renew and replace, and because they are not pressurised to the same extent into constantly investing in order to remain competitive in world markets.

Total stockbuilding reached a high level last year, which is usually what happens at the peak of the output cycle. This year will also probably see high levels of stockbuilding as output is not expected to slow down as much as demand. However, de-stocking is likely next year as firms attempt to achieve more normal stock/output ratios. The medium term sees a continuation of the past trend decline in stock/output ratios.

Exports and Imports of Goods and Services (table 5)

Recent trade data seem to indicate that the rapid deterioration in the UK current balance stopped in the final quarter of last year. Since then--even though a further fall in oil production has depressed net exports of oil even more--the current account has registered lower quarterly deficits suggesting that the underlying decline has been arrested. Consumer goods import volumes were virtually flat in the first half of 1989. Capital goods imports however have showed robust growth of 10 per cent in volume terms since the final quarter of 1988. The 1988 increase of around 20 per cent in import volumes of capital goods is not necessarily the result of exceptionally high pressure of demand. Similar growth occurred in 1982 to 1984.

Exports of manufactures have continued to grow strongly in the first half of 1989, and there are also signs that exports of food, beverages and tobacco are recovering from their depressed levels of 1988. Our forecast is optimistic on both manufacturing and non-manufacturing exports: we have added a positive residual to our manufacturing exports equation so that, apart from relative price and profitability effects, these grow in line with world trade growth (see appendix at end of chapter) and we follow our equations for exports of non-manufactures, even though they have recently been over-predicting. Of the latter, exports of services have probably been temporarily less buoyant because the overseas earnings of the financial sector, which provide the largest part of the trade surplus in services, have fallen for the past two years. This seems to be due to particular earnings declines in insurance and banking; underwriting earnings were lower because of higher claims (e.g Piper Alpha) and writing-off of Third World debt reduced the net revenue of banks. However, we expect the earnings of this sector to continue to grow strongly, benefiting from more open capital markets in Europe as we approach 1992. We forecast a healthy and growing surplus on services especially in the medium-term.

Our forecasts of a current balance deficit of around 18 billion [pounds] for 1989 and 16 billion [pounds] for 1990 are a little higher than last time, primarily due to the `J-curve' effects of the recent sterling depreciation and a more delayed slow-down in manufacturing. But the prolonged slower demand growth, largely imposed upon the economy by the size of the present trade deficit, and an improved oil surplus begin to turn the current account towards balance; by 1991 the deficit is reduced to 2 per cent of GDP (compared to 3.3 per cent for last year) and by 1993 it is below 1 per cent of GDP with the visible deficit improving by almost 10 billion [pounds] compared with its expected 1989 nadir. Although much of this improvement is due to strong manufacturing export growth, imports of manufactures are also subdued. Our model's manufacturing imports equation has a unit elasticity with respect to total demand for manufactures combined with capacity utilization effects which in the forecast period are also reducing imports.

Output and the Labour Market (table 6)

It now seems that manufacturing output growth peaked in the last quarter of 1988. The latest figures for May 1989 suggest that the year on year growth rate for this sector is now 1 1/2 per cent lower than the fourth quarter of 1988. Total production industries experienced a greater output slow-down, as the output of the energy sector was adversely affected by both the unusually warm weather and the production problems of the oil sector.

Although we begin the forecast with the official unemployment count at its lowest level since the fourth quarter of 1980 at 1.8 million, the monthly declines in unemployment seem to be decelerating to well below the average of the previous six months. Recent employment falls in manufacturing--although services employment is still growing--add further confirmation that the process of slow-down is now underway. The forecast continues this trend: as demand falls, manufacturing output leads the downturn in the latter part of 1989 and actually registers negative growth year on year in 1990. This fall could have

been more severe given the current high level of interest rates, but a strong manufacturing export performance responding to fairly buoyant world trade growth helps to lessen the impact upon manufacturing. Total GDP growth slows down a little later, and to a lesser extent. Unemployment remains low in 1990 before its lagged response to slower output growth causes it to begin rising in the medium term.

One consequence of the decline in output growth is that productivity growth falls. Changes to more flexible working practices--for example, the CBI's Pay Databank suggests that sixty per cent of all manufacturing establishments had at least one flexibility accord in the four years from 1981--may have caused a step up in sustainable productivity growth. In contrast, our estimated equation suggests that manufacturing can only sustain around 3 per cent productivity growth, but given the constraints upon output even this rate is unattainable until beyond the medium term.

Wage and Price Inflation (tables 2 and 7)

At the moment, average earnings are growing at an underlying rate of 9 1/4 per cent. The latest CBI survey shows that pay settlements are running at 7.5 per cent in manufacturing (the highest for eight years) and 8.3 per cent in services. In addition some higher wage settlements around 10 per cent, such as ICI and Post Office parcels staff, combined with more frequent industrial action in support of pay claims (171,000 working days lost through industrial disputes in May) suggest that there could be further rises in earnings growth. Our model equation is currently underpredicting average earnings--possibly because of skilled labour shortages which, according to the latest CBI survey, seem to be affecting 24 per cent of companies--and we have decided to follow the equation's predictions, with the addition of a small positive residual. This forecasts earnings growth to decelerate from 9 1/4 per cent this year to about 8 per cent in 1990. This is not sufficient to avoid acceleration in unit labour cost increases in both 1989 and 1990. The steady fall in unemployment of recent years gradually comes to an end in 1990 and also helps ease wage pressure. Recent figures are also showing that the falls in unemployment in the South may be over and that the North is now accounting for most of the total fall. If this regional discrepancy continues it may also help reduce wage inflation, as the South is usually perceived as the leading region in wage setting.

Bad news about recent growing wage pressure has been tempered by cautious optimism concerning price inflation, as factory gate prices have shown a slow-down in their rate of increase, suggesting that profit margins could be narrowing. The extent to which profit margins continue to narrow in response to our forecast of rising unit labour costs will have a key effect upon inflation. Compared to the May Review our forecast for consumer and wholesale prices is now more optimistic (especially in 1989) because of the new data on prices and also because import prices again seem to be holding back inflation in 1989. In 1988 import prices actually fell, through the combination of a rising exchange rate and stagnant world prices, and helped to restrain UK inflation. We are forecasting import prices to rise this year, but again they are helping to contain inflation by rising by only a small percentage. This may seem surprising given that the exchange rate is forecast to depreciate more now in 1989, but this has been off-set by more optimistic forecasts for the oil price and some commodity prices. Our view is that 1990 will probably see a further increase in price inflation because import prices will rise faster as the exchange rate continues to depreciate. The increase in the retail price index will probably be just below 8 per cent for this year and will then fall by a percentage point in 1990 as most of this year's mortgage rate increases drop out of the calculation.

In the medium term (1991-1993), average earnings increase at just below 6 per cent per year rising slightly at the end as both productivity and output begin to show signs of recovery. With earnings growth slowing down over this period, and with an extended period of slow growth substantially easing demand pressures, consumer price inflation slows down to about 5 per cent (with wholesale prices a little higher). Inflation never falls below that because of continued exchange rate depreciation in line with the uncovered interest rate differential between the UK and overseas.

Public Sector Finance (table 9)

The first quarter figures for the 1989/90 financial year actually showed a small amount of public sector borrowing rather than the expected surplus. However, we still predict a large public sector debt repayment for both this year and next. Robust earnings and employment growth, combined with growing inflation, continue to increase revenue in 1989/90 while cash limits restrain spending. These effects are less strong in 1990/91 as the economy begins to experience slower growth and this keeps the PSDR flat. It is possible that over this short-term period there may be lower income from national insurance contributions, due to employees taking up private pensions, but we have assumed there will be no increase in subsidies arising from attempts to soften the effects of introducing the Poll Tax.

The Chancellor points to a balanced budget as the best guide to fiscal policy in the medium term. However, our forecast is that the PSDR will remain substantial to at least 1992/93. The strong possibility of depressed consumers' expenditure throughout the medium term should slightly reduce the surplus over the period, but given the strict public spending controls, even very slow growth in economic activity is likely to produce a continuing surplus.

APPENDIX: EXPORTS OF MANUFACTURES

The current NIESR model equation explains exports of manufactures in terms of world trade, relative export prices, export profitability and a time trend. In order to capture the past secular decline in the UK export share of world trade the time trend is negative and the world trade elasticity is less than unity. As in other recent NIESR forecasts, this equation is subject to a residual adjustment designed to approximate the effects of imposing a world trade elasticity of unity and eliminating the negative time trend. Justification for this optimistic view of UK manufacturing exports is provided by the export equations estimated by Anderton (1988).

Recent work by A. Gurney (1989) investigates the degree to which this improved trade performance is evident among the different categories of UK manufacturing exports. This throws light on two issues: first we can look for evidence of improved performance within each category; and second we can see whether changes in the composition of exports have contributed to the improvement of performance in aggregate. The analysis is based upon the results of aggregate and disaggregate exports of manufactures demand functions estimated over the whole sample period (71Q1-87Q4) and then re-estimated over the two subsample periods (71Q1-79Q4 and 80Q1-87Q4). Predictive failure tests and parameter stability tests, combined with comparisons of the elasticities between the two sub sample periods, are used in order to ascertain whether UK export performance has improved in the 1980s. The long run elasticities for world trade (WT) and relative prices (RP) are shown in Table A1 below.

The aggregate exports equations support our optimistic view of the world trade elasticity; the estimated elasticities suggest that a 1 per cent increase in world trade in the 1980s causes a 1.1 per cent increase in UK exports compared to a much smaller 0.64 per cent export increase in the 1970s. There is also some evidence that the aggregate RP elasticity has also risen in the 1980s. A further indication that some structural shift has occurred between the 1970s and 1980s is the failure of the aggregate equation in the parameter stability test.

In all but one of the disaggregated equations the WT elasticity is higher in the 1980s than in the 1970s. Only three of the disaggregated categories failed to pass all of the stability tests. Of these three, the road vehicles category provides the strongest evidence that the instability is due to an increased world trade elasticity. The other unstable categories--mechanical machinery and electrical machinery--may owe their instability to volatile RP elasticities in addition to increased world trade elasticities.

The three stable categories have quite different (whole sample) world trade elasticities; the elasticities for chemicals and miscellaneous manufactures (scientific instruments, photographic apparatus, etc.) substantially exceed unity whereas for the manufactures classified by material (textiles, iron and steel, metal manufactures etc.) the elasticity is considerably below unity. These different elasticities may also help explain the observed improvement in the aggregate manufactures world trade elasticity. Over time the aggregate WT elasticity will tend towards that of the UK's fastest growing export categories. Therefore the aggregate elasticity will increase as an increasing proportion of total manufacturing exports is accounted for by high elasticity categories such as chemicals and miscellaneous manufactures. Table A2 below shows the export values of the categories as a percentage of total UK manufacturing exports and supports this proposition. High WT elasticity categories have, in general, increased their proportionate contribution to total UK exports.

As world trade grows it is only to be expected that the UK (and all other countries as well) will find a larger proportion of their exports accounted for by categories which have relatively high WT elasticities. But in fact what has happened recently in the UK may be rather more significant than that. As the same WT variable is used for the estimation of all the disaggregated equations it is possible that a high/low WT elasticity could be estimated merely because world trade in the particular category is growing faster/slower relative to other categories. But Chart A1 shows that this is not the whole explanation. The chart plots separately the UK's high and low elasticity category exports to the OECD expressed as a percentage of the OECD's imports of these particular categories (in dollar value terms). It is clear that the estimated UK high elasticity sectors have lost share (of total OECD imports of their category) less rapidly then the low elasticity categories. Thus one part of the explanation of the UK aggregate exports in the 1980s is that our performance has been relatively good in categories like chemicals for which world demand has been growing relatively fast. [Tabular Data A and B, 1 to 10, A1 and A2 Omitted] [Chart A1 Omitted]

(1)A retrospective simulation using a model that assumes `consistent' expectations is not altogether the same in character as a similar exercise with a `backward-looking' model. We are comparing two cases: in one full EMS membership, with all its implications, was maintained and was expected to be maintained; in the other the policies actually followed were expected. To the extent that any forecasting errors were in fact made, those errors are unrealistically assumed to be the same in both cases and thus unrelated to the different outturns. In the case reported here, however, the exchange rate is treated as exogenous and the `forward-looking' behaviour of the model is therefore much less important to the results. Some issues involved in counterfactual simulations under rational expectations are discussed in P.G.Fisher and K.F.Wallis `The Historical Trading Performance of UK Macroeconomic Models 1978-85.' ESRC Macroeconomic Modelling Bureau Discussion Paper No. 17.