Wednesday, 1 May 2013

Battling Against Inflation, 1970-79

The 70s were a bad decade for the British economy. 'Failure' is probably the most fitting word for the period. From 1974 to 1979 unemployment had crept up to pushing on 5%, growth had fallen to 2% but the real issue was inflation at 16%. Part of the rise in prices can be attributed to the collapse of the Bretton Woods system, this led to a global commodity price rise which saw oil rise four fold in a 2 year period. Domestically, though, the supply side issues discussed in a previous post weren't helping and a lot of errors were made in macroeconomic policy cause partly by confusion over the actual cause of inflation.

The confusion was theorists thinking they understood the tradeoffs between economic objectives, such as inflation and unemployment. Stagflation occurred in the early 70s which shocked theorists - inflation and unemployment was rife at the same time, the government were struggling to achieve any of their objectives.

The government needed to re-think. They put the priority on targeting unemployment in the early 70s. During this period the Barber Boom took place. The chancellor at the time (Barber) injected a large monetary and fiscal stimulus to raise output but not inflation because of the spare capacity in the economy. Sterling was also allowed to float freely to stop a balance of payments crisis choking the growth. Did it work? In the short term - yes. Growth peaks at 7% in 1973. But, over the longer term, the balance of payments deficit soars, inflation starts to runaway and smaller financial institutions collapsed - the three things that really weren't wanted.

Because of the soaring inflation the government makes controlling this the main priority as the 1970s progress. Unemployment falls down the pecking order. Revised Keynesian theory defined the inflation as cost-push. Wages were rising faster than productivity forcing up the prices. Pay rises needed to be checked - were income policies the solution to this? Income policies worked like so: pay rises would be limited by setting a norm that everyone should follow. Some would be voluntary, some would be forced, others would be more complex. It worked for small periods of time, but it always failed eventually as people became dissatisfied and it defied the point of trade unions.

The monetarists attacked the income policies claiming they didn't curb inflation at all they just distorted the labour market. Tighter financial policy was required. This was true, public spending was high and still increasing. It rose faster than national income from 1970-75 and reached 9% of GDP during 1975. This high spending was crowding out private sector investment by pushing up interest rates. In 1976, Labour realise the problem and agree to a deflationary package. Their new budget regime centred around cash limits. 60% of their spending would now be subject to 'cash limits'  and different programmes received a fixed cash sum year on year regardless of inflation. In real terms, this change meant public spending fell and brought inflation down to some extent.

What can we conclude from this then? Was this the end of the Keynesian era? The government were still trying their hardest to adapt Keynesian demand management policies rather than find a new, improved framework. This just resulted in what seemed like aimless policies that didn't solve any problems. Real living standards on the whole were hit, especially the middle income people, which led to a lot of resentment. 

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