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.
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.
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