The main slogan of the Conservative Party during the 1997 general election campaign has been ‘Britain is booming: don't let Labour blow it’. In our analysis of the UK economy, we discuss the extent to which Britain is indeed booming and how we expect it to develop once the election is over. Given their lead in the opinion polls, we have assumed that Labour will win the election and have built some of their policies into the forecast. This therefore provides some means of assessing whether Labour will ‘blow it’, although this will obviously depend on how they actually behave in office.

The new government will inherit an unhealthy fiscal position, with public sector borrowing higher than would normally be expected at this stage of the economic cycle. Chart 1 shows the public sector financial deficit as a proportion of GDP when compared with an estimate of the cyclically adjusted deficit. This shows for each date an estimate of what the deficit would have been if the economy had been operating at full capacity, as in early 1973 and late 1988, and achieved a level of output higher than has been normal over the past twenty five years.(1) In cyclically adjusted terms, the budget was in surplus throughout the 1980s but went strongly into deficit around the time of the 1992 election. Since this also coincided with the recession, the actual budget deficit deteriorated sharply around this time, reaching a peak at the beginning of 1994. Since then there has been a decline in both the actual and the cyclically adjusted deficit.

It is increasingly clear that the world economy has been recovering relatively strongly from a pause in activity at the end of 1995. The recovery has also been relatively well spread around the globe, with Japan displaying the strongest growth amongst the larger economies, in part because of the effects of the depreciation of the yen, but also because government policy was expansionary throughout last year. Although growth rates in Europe appear low in 1996, with Germany and France both recording growth of less than 1½ per cent, growth through the year has generally been strong. It appears there is still some spare capacity in Europe, and hence growth can be expected to strengthen further into 1998, at least within continental Europe. The US economy has been growing at or above capacity for several years; in the fourth quarter of last year output rose by a further 1 per cent, with growth through the year of over 3 per cent. Domestic demand also rose strongly in Canada and Mexico in the latter half of last year. Growth in the NAFTA economies is expected to strengthen in 1997, but to slow into 1998 in the aftermath of moves to tighten monetary policy. Overall, as can be seen from Table 1, we expect a period of above trend growth and low inflation in the majority of the OECD countries.

Increasing attention has been paid in Europe in recent years to the question of why firms invest abroad. This reflects both the rapid growth in foreign direct investment within Europe, along with recent improvements in the quality and availability of data. At the heart of the debate is a focus on the costs and benefits of foreign investment, such as whether inward investment affects employment and economic growth and whether outward investment is simply ‘job exporting‘, with firms moving to low-cost, labour-abundant locations. An understanding of the motives behind firms’ decisions to invest overseas is of particular importance for the UK, whose aggregate stocks of outward and inward foreign direct investment reached 30 per cent and 21 per cent of GDP respectively at the end of 1995.

Foreign direct investment (FDI) has played a crucial role in the overall development of the Irish economy over the past three decades, as the Republic of Ireland, hereafter referred to as Ireland, has pursued an industrial strategy characterised by (i) promoting export-led-growth in Irish manufacturing through various financial supports and fiscal incentives, and (ii) encouraging foreign companies to establish manufacturing plants in Ireland, producing specifically for export markets. The significance of FDI for the Irish economy is now reflected in, inter alia, the significant gap between GNP and GDP; in 1994, GNP was roughly 88 per cent of GDP in Ireland. As regards the manufacturing sector, the high shares of output and employment in foreign-owned companies in Ireland also indicate the importance of foreign firms. As we discuss in some detail in Section 3, foreign companies produced roughly 69 per cent of total net output and accounted for 45 per cent of employment in Irish manufacturing industries in 1993.

The European Economic Community originally came into existence following the Treaty of Rome in 1957. Member states planned to harmonise their tariffs, pursue a common trade policy and liberalise intra-Community trade. All internal customs duties and quantitative restrictions on trade were successfully removed by 1968. However it subsequently became clear that this had not resulted in the full integration of product markets in Europe, with capital movements and trade continuing to be restricted by capital controls and non-tariff barriers. In the mid-1980s the European Commission identified around 300 areas in which legislative action could be taken to help the free flow of goods, services, capital and labour within the community. This led to the Single European Act in 1986 which aimed to complete the internal market by the end of 1992.

Since the mid-1980s foreign direct investment (FDI) outflows from Germany have increased considerably. Germany ranks after the US, UK and Japan as the fourth-most important global investor. The most rapid expansion of German FDI in the eighties occurred in the EU; now it is happening in Central Europe (Czech Republic, Hungary, Poland, Slovakia and Slovenia). The question arises whether economic integration is a major stimulant of German FDI. The Single Market programme was introduced in the EU in the eighties and it increased the degree of integration of the markets of member countries. This was particularly important for the service industries which had hitherto been heavily protected from foreign competition. Now the economic integration of the Central European countries with the EU is likely. They have already applied for EU membership. It is not clear when this will take place but during the interim phase, some of the advantages of economic integration (free trade, capital movement, economic aid) are available through ‘Europe Agreements’ between the EU and Central European countries (Langhammer 1992), and through CEFTA among the latter.