Saturday, 4 May 2013

The Thatcher and Major Years

In 1979 Margaret Thatcher came to power in Britain - the first female Prime Minister. It was seen as a turning point for Britain, not just for this reason, but because of the effect it could have on economic policy. She was a radical woman, and her policies echoed her personality. Brutal. Defeating inflation was the key to her policies. In the run up to the election the Conservatives rethink their philosophy and come up with their "New Approach". They'd place greater emphasis on market forces, preferring small government intervention in the economy. This wouldn't be possible with the inflation problem, however. This needed to be defeated because it was distorting price signals and angering voters.

This period saw the rise of the Monetarists. They were born out of the "Chicago School" with Milton Friedman a figurehead of sorts. Their argument was fairly simple. They felt using demand management would be shooting ourselves in the foot - more demand meant more inflation and not higher output. Inflation was a monetary phenomenon, the money supply had to be cut to control it - tight financial policy was needed. In 1980, the Conservatives follow this line of thought. They raise interest rates and VAT while lowering their public borrowing. What's the result?

Well, in 1981 the economy is in recession - yet the Budget of this year sees policy tightened even further. It was a bold move, it showed that the Conservatives were really trying to tackle inflation. And it works. Inflation falls rapidly from 18% to a more acceptable 4.3% from 1980-1983. Interest rates are increased further after this and growth starts to pick up. It was a step in the right direction, but unemployment was remaining high and inflation was still higher and more volatile than other major economies.

The policy still struggled, however. They know that responding to the headline inflation rate was pointless because of the time lags in policy taking effect. They somehow needed to find an effective framework that could predict inflation in the future and respond to that level now. This indicator for when to change policy came in the form of the Medium Term Financial Strategy (1980). It was a framework that targeted the money supply - targets would be made and the broad money supply would not be allowed to rise above them. Interest rates and lower public borrowing would be used to control the money supply and keep it within the desired range. It had risks, tightening policy always carried the risk of bringing a recession.

It could have worked, but it had its problems. The targets weren't met - the money supply consistently grew faster than it was meant to and public borrowing wasn't cut enough. The policy wasn't tight enough, yet the real economy suggested the policy was too tight - domestic demand was being curbed by the interest rates and the pound soared. Britain entered a bad recession not long after. Why does this happen? A recession shouldn't really mean the money supply rises. Yet it did. This is the same period that the banks are being deregulated and firms were struggling and needing to borrow more to stay afloat. Lending controls were abolished, which means more loans were now showing on the official statistics. Overall, the money supply figures weren't an accurate guide to the economic conditions.

The Medium Term Financial Strategy is gradually abandoned because of its weaknesses - the government starts to slowly target the exchange rate by keeping the pound steady with the German mark. The pound starts at too low a level against the mark and the economy overheats in 1988. The government try and raise interest rates but it's too late as we enter recession again and end the 1980s with rising inflation. Britain needed help - and this came in the form of the European Exchange Rate Mechanism. This mechanism pinned the pound to the strong Mark allowing it to fluctuate 6% either side - Britain joined at a rate of 2.95 DM. The advantages were that it would supposedly improve fiscal discipline and therefore curb the inflation problem. It didn't. In 1992, on a day known as 'Black Wednesday' we see that it didn't. Britain finds it needing to lower its interest rates because the initial rate it joined the ERM with was over-valued. Other countries in the ERM had high interest rates which meant Britain couldn't realistically lower theirs. Speculators begin to see the pound falling and start to sell, a run on the pound starts. The aftermath of this was that the pound had to be devalued in 1992 and the credibility of the John Major government was ruined. Improvements do follow, but they can't restore the governments political position. An inflation target rate is set and interest rate decisions are given to the Bank of England who based their changes on a range of economic variables and not just the one. 

1 comment:

  1. Do you think that harmonisation with the EU preparatory to Euro membership may have been involved in the steady increase in government spending? If you look at graph 7 in this article it looks probable that this was involved.