Macroeconomic Policy Constraints
Greece and the UK

At a lunchtime meeting on 14 October, George Alogoskoufis and Charles Bean discussed the results and implications of recent research into external constraints on macroeconomic policy-making in Greece and the UK. Alogoskoufis is Reader in Economics at Birkbeck College, London, Professor of Economics at the Athens School of Economics and a Research Fellow in the International Macroeconomics programme of the Centre for Economic Policy Research. Bean is Professor of Economics at the London School of Economics and a Research Fellow in CEPR's International Macroeconomics programme. Their remarks were based in part on their contributions to External Constraints on Macroeconomic Policy: The European Experience, which reports the proceedings of a CEPR May 1990 joint conference with the Bank of Greece. The present meeting formed part of the Centre's research programme on Financial and Monetary Integration in Europe, supported by the Commission of the European Communities under its SPES programme and by the Ford Foundation; additional financial support was provided by Cambridge University Press. The views expressed by the speakers were their own, however, not those of any of the above organizations nor of CEPR, which takes no institutional policy positions.
Alogoskoufis noted the spectacular rise in the Greek external debt from $5.1 billion to $20.6 billion (from 13% to 40% of GDP) during 1979-89. Together with other unfavourable macroeconomic developments, this justifies the common observation that the 1980s was a `lost decade' for the Greek economy. Average consumer price inflation rose from about 12% in the 1970s to 20% in the 1980s, average GDP growth fell from 5.5% to about 1.5%, average unemployment more than doubled to 6.6%, and business investment fell. Underlying these developments was an enormous expansion of the public sector under the socialist governments: total public expenditure rose from some 30% of GDP in 1980 to more than 50% in 1990, while public debt rose from about 40% to 110% of GDP.
The conservative New Democracy government is now trying to bring public expenditure under control and prepare Greece for Europe's economic and monetary union. There is widespread concern that the fiscal adjustment programme it agreed with the Community in February 1991 supported by a 2.2 billion ecu loan will not work: the current financial year's deficit reduction targets can be met only by a miracle; and the `crawling-peg' exchange rate policy has successfully contained inflation only at a cost of a loss of competitiveness.
Stabilizing Greece's public debt as a percentage of GDP should also suffice to stabilize its external debt, since the private sector can stabilize the ratio of its own assets to GDP through consumption smoothing. The agreement with the EC required that the `primary deficit' the public sector borrowing requirement net of interest payments be set to zero; but many of the revenues forecast in the November 1990 budget failed to materialize. Its revenue projections were far too optimistic, and the 1991 budget should relaunch the adjustment programme by reducing public expenditure instead of relying solely on tax increases and other revenueenhancing measures, which also reduce private savings. Greece also needs to rethink its exchange rate policy, since comparing unit labour costs with the OECD average indicates a real appreciation of 18% during 1987-90, while comparing GDP deflators indicates an appreciation of only 12%. He estimated the drachma's current overvaluation at some 10%.
Alogoskoufis proposed two measures for a new stabilization programme: credibly setting the primary deficit to zero in the November 1991 budget preferably through expenditure cuts to stabilize the public and external debts; and joining the Exchange Rate Mechanism of the EMS. The latter should be accompanied by a correction of the exchange rate to overshoot its estimated overvaluation to prevent Greece's persistent inflation differential from undoing the initial adjustment and enhance the credibility of its parity at entry and by a one-year wage freeze to ensure that the nominal correction is translated into a real correction and to minimize its initial inflationary effects.
In conclusion, Alogoskoufis noted that a similar package had succeeded in reducing Greece's macroeconomic imbalances in the past. In 1953, following World War II and a destructive civil war, when the government halved the value of the drachma and entered the Bretton Woods system, the economy boomed and Greek inflation converged to the industrial countries' average within two years. These measures provided the springboard for an impressive period of non-inflationary growth that lasted until the demise of Bretton Woods. Economic and monetary union offers a similar opportunity, if Greece can once again put its house in order.
Charles Bean first noted that the balance of payments has had a major influence on UK policy-makers since World War II, but the nature of the `constraint' it implies remains far from clear. His calculations indicated that the UK could maintain a trade deficit of 0.25-0.5% of GDP indefinitely with its current level of foreign assets. It could run even higher deficits for a while by matching them with lower deficits (or surpluses) in the future. Many have cited the strong positive relationship between domestic savings and investment across countries as a sign that access to foreign funds is limited and financing a large trade deficit difficult. In such cases, however, a deteriorating trade balance should also raise domestic vis-à-vis foreign real interest rates, but Bean's calculations on UK data over a century indicated little evidence of such an effect.
He also disputed the general consensus that trade deficits indicate economic failure: international trade allows households to smooth consumption over time in the face of fluctuations to national income; it is quite natural for a country to finance an investment boom by foreign rather than domestic borrowing; and such trade deficits are in any case self-correcting. Turning to the recent consumer boom and bust in the UK, he attributed the original expansion to increased optimism about future income growth. Increased consumption was met initially by increased borrowing, and it was ultimately to be met and the debt repaid out of the expected higher income. The counterpart to this process was to be an initial worsening and subsequent improvement of the trade deficit. Consumers' over-optimistic expectations in fact led to a collapse of spending as they ran down their high debt levels; but while their initial over-optimism was unfortunate with hindsight, it in no way justifies measures to increase restrictions on consumers' borrowing in the future.
Bean noted that government concerns about savings levels and the trade deficit may be justified in one respect, however, since reductions in savings tend to raise the real exchange rate and reduce the size of the manufacturing sector. Many argue that `learning-by-doing' is much more important in manufacturing than elsewhere and that such advances in knowledge have beneficial effects beyond the industry in which they occur; but the European Community's rules forbid direct subsidies to manufacturing. Fiscal action to promote the UK's domestic (public and private) savings may therefore play a role in promoting the UK manufacturing sector once the economy recovers from its current recession.

External Constraints on Macroeconomic Policy: The European Experience, George Alogoskoufis, Lucas Papademos and Richard Portes (eds.),
Cambridge University Press for CEPR, £30.00/$59.50.