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The Monetary and Fiscal Policies of Early Thatcherism and the Legacy of the Medium Term Financial Strategy

Nathalie Champroux et Nicholas Sowels
p. 135-161

Résumé

This contribution re-examines the Medium Term Financial Strategy which the first Conservative government (1979-1983) adopted as a framework for implementing its monetary and fiscal policies. Conceptually monetarist, the MTFS progressively gave way to more traditional considerations of controlling public spending, though the 1981 Budget sought to combine monetarist zeal and a tight grip on finances in the middle of a major recession. Accordingly, the MTFS and this Budget definitively marked the final break with post-war Keynesian demand management. The MTFS was controversial at the time and its legacy is still disputed. The contribution reviews the MTFS in the light of the release of Cabinet papers and other recent accounts of witnesses who shaped policy. It also looks at what the impact of the MTFS was on monetary policy in the following years, and how even today the memory of the 1981 Budget is still shaping Coalition and Conservative government policy.

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Texte intégral

Introduction

1This contribution looks at the monetary and fiscal policies of early Thatcherism, specifically the Medium Term Financial Strategy (MTFS) which was implemented by the first Thatcher government (1979 to 1983). The period and the MTFS were characterised by the clear break in macroeconomic policy carried out by the Conservatives. To be sure, the policy shift of the time goes back earlier to the previous Labour government: as Britain was forced to borrow money from the IMF in 1976, and when the then Prime Minister Jim Callaghan announced famously at the Labour party conference of the same year that Britain could no longer spend its way out of recession.

2When the Conservatives came to power, however, the switch in macroeconomic policy became far more coherent. Monetarism was adopted as the prime means for fighting inflation, and high employment – the principle objective of economic policy since World War II – was dropped as the main goal of policy. The new approach to economic policy was henceforth to be forward looking, enshrined in the MFTS.

3This article begins by examining the theoretical and ideological underpinnings of this shift in policy. It then presents the impact of the policy and the general performance of the economy under the first Thatcher government, which at the time seemed catastrophic. Next, the contribution examines the politics of implementing such a controversial policy change, drawing on several sources, including Cabinet papers that are now available under the 30-year rule. The contribution moves on to examine the legacy of the MTFS, both during the later years of Conservative government, and with reference to the “austerity” policy of the Coalition government elected in 2010, and beyond.

The Medium Term Financial Strategy Explained

  • 1 Howe, G., 26 March 1980, cc. 1439-90.
  • 2 HM Treasury, 26 March 1980, pp. 16-19.

4The Medium Term Financial Strategy (MTFS) was first publicly presented by Conservative Chancellor of the Exchequer Sir Geoffrey Howe in his Budget speech of 26 March 19801 and detailed in Part II of the 1980 Financial Statement and Budget Report2 known as The Red Book. It had technically been elaborated by then Financial Secretary to the Treasury Nigel Lawson, Chief Economic Adviser Terry Burns and Deputy Secretary Peter Middleton. Yet Margaret Thatcher too had a leading role in its inspiration and promotion.

  • 3 Ibid., p. 16.
  • 4 Double digit figures for the CPI monthly growth rate had been recorded during nearly four years, be (...)
  • 5 Conservative Party, 1979.
  • 6 Figures of Administrative Unemployment Levels: United Kingdom, yearly average, not seasonally adjus (...)

5The MTFS consisted in planning reductions in the money supply and public spending and forecasting GDP growth, public receipts and public borrowing four years into the future (see the tables in the Appendix). Its objectives were “to bring down the rate of inflation and to create conditions for a sustainable growth of output and employment”.3 Inflation had indeed been a long-term issue in Britain, as in most developed countries. In 1978, prices still increased at an annual rate of 8% and a double digit figure was recorded again in April 1979.4 High inflation at the time was part of a vicious circle along with wage rises and currency depreciation: by the beginning of 1979, the pound sterling had lost half of its 1974 value.5 Higher prices also reduced households’ real purchasing power and so led to higher wage claims. These in turn frequently brought on industrial disputes and strikes that culminated in the economic paralysis of the country during the 1979 Winter of Discontent. Moreover, the historical trade-off between inflation and unemployment as suggested by the Phillips curve had clearly broken down. Despite surging inflation in 1975, the number of people unemployed again breached the psychological ceiling of one million, a level reminiscent of the 1930s.6 Even with a slight decrease during 1978, unemployment still affected nearly 1.5 million people at the end of the year.

  • 7 Joseph, K. (Sir), 5 April 1976.
  • 8 Growth rate of Gross domestic product at market prices, revalued at 1995 prices, taken from Governm (...)

6More generally, the rise of stagflation – economic stagnation and inflation – threw into question the recourse to tax cuts and public spending the “pseudo-Keynesians”7 had advocated since the end of World War II as an effective means to boost growth and reach full employment. The fiscal easing that Labour Chancellor of the Exchequer Denis Healey implemented prior to the general election did not prevent GDP growth slowing from 3.4% in 1978 to 2.74% in 1979.8

  • 9 About Labour Chancellor of the Exchequer Denis Healey’s ideology change, see Congdon, T., 2007, p.  (...)
  • 10 About the monetarist experiments prior to Thatcherism, see Smith, D., 1987, pp. 35, 59, 65-66; Need (...)

7With the MTFS, Margaret Thatcher’s first government therefore proposed to sweep away these old recipes that had resulted in economic and social chaos, by focusing only on the control of inflation through reductions in the money supply and public spending. To be sure, these policies were not entirely new. They had been applied by the earlier Labour government of Harold Wilson in 1967, as well as by the Bank of England and the Conservative government of Edward Heath in 1973. In December 1976, they were included more visibly in the two-year adjustment plan put forward by Denis Healey9 in exchange for a substantial loan from the International Monetary Fund (IMF).10

8What rendered Thatcherism original, however, was the determined focus of the strategy. Money supply reduction and spending cuts were no longer targets competing with employment and exchange rate objectives. They were the key targets of government policy, largely to the exclusion of all others. There was no room for the consideration of exchange rate targets, for example. Rather, letting the pound float freely, and hence possibly rise, was perceived as a means to avoid importing inflation. The doors were also closed to other anti-inflationary instruments. In line with its free market philosophy and its rejection of corporatism, the Conservative government dropped all forms of prices and incomes policy both political parties had implemented when they were in power.

  • 11 Hayek, F., 1944.
  • 12 The paradox of heavy monetary and fiscal interventionism from a Conservative government highly in f (...)
  • 13 Howe, G., 26 March 1980.
  • 14 Lawson, N., 4 August 1980.
  • 15 Roberts, M., 26 February 1951.
  • 16 Thatcher, M., 22 May 1975, c. 1638.
  • 17 Joseph, K. (Sir), 5 September 1974.
  • 18 Travers, A.J., 9 February 1975; Rose, D., 11 February 1975.

9The focus on the money supply and public spending reduction stemmed from the belief of the Thatcher team in two main ideologies: Friedrich Hayek’s liberalism and Milton Friedman’s monetarism. Thatcherism found its deepest roots in Hayek’s much-quoted warning about “the danger of tyranny that inevitably results from government control of economic decision-making through central planning”.11 From an economic perspective, the Conservatives had been confirmed in their rejection of communism and socialism by their interpretation of the 1970s’ durable slump as a direct result of post-war interventionism. As a cure to these long-lasting ills, they proposed to reduce state intervention wherever possible. Over time, this would lead to extensive policies of deregulation, privatization and public disinvestment, whereas the government concentrated on monetary and fiscal policies. First, action was needed to curb inflation and make public finances more sustainable.12 Second, these fields were perceived as the only ones “that the Government actually [had] within their power to control”.13 That is how public spending cuts also became a key component of the MTFS. They were justified by the necessity not only to “roll back the frontiers of the state”14 but also to curb inflation, thanks to the alleged contribution of public borrowing to the money supply. Margaret Thatcher had mentioned a clear link between government spending and inflation as soon as 1951.15 In the middle of the 1970s, she had even been of the opinion that inflation was “caused first by Governments, through rapidly rising public expenditure beyond what the taxpayers can bear”16 thus echoing Keith Joseph.17 When, elected leader of the Opposition in February 1975, she started publicly mentioning the control of the money supply as a means to tackle inflation.18

  • 19 Thatcher, M., 10 October 1980; Joseph, K. (Sir), 5 April 1976; Howe, G., 26 March 1980, cc. 1443-14 (...)
  • 20 See Nigel Lawson’s brief for Margaret Thatcher’s meeting with Milton Friedman on 27 February 1980, (...)

10Indeed – this was the other major influence at work – Margaret Thatcher’s team also closely followed the works and policy prescriptions of 1976 economic Nobel Prize winner Milton Friedman, who argued for the strict control of the money supply. In fact, the most obvious representatives of early monetary Thatcherism were reluctant to accept the label of “monetarists”, which was, in the word of the Labour MPs, an accusation of being in favour of unemployment rather than inflation. The Thatcher government therefore tried to rhetorically dampen the label’s adverse connotations as much as possible.19 But, they did their best to comply with Friedman’s technical directives.20

  • 21 Friedman, M., Schwartz, A., 1963.
  • 22 Friedman, M., 1960, pp. 90-91.

11From the empirical study of the link between the monetary policy of the Federal Reserve (Fed) System, prices and growth,21 Friedman had drawn the conclusion that changes in the money supply might have short-run effects on output but, above all, longer-run effects on the price level. He therefore argued categorically that the authorities should increase the money supply “at a fixed rate year-in and year-out without any variation in the rate of increase to meet cyclical needs”.22 By money supply, or the “stock of money”, as he would call it, Friedman referred narrowly to currency plus all commercial bank deposits.

  • 23 £M3 was then composed of the monetary base (notes and coins in circulation with the public) plus th (...)
  • 24 In the 1960s, from his analysis of the American economic situation of the preceding 90 years, Fried (...)
  • 25 Goodhart, C., in The 1981 Budget – Facts and Fallacies, 27 September 2011, p. 11.

12Accordingly, when they came to power, the Conservatives decided to adopt a quantitative money supply target, but they concentrated at first on a broader monetary aggregate called £M3 (sterling M3).23 £M3 had already been identified as the money supply indicator to follow, at the time of the IMF loan. In December 1976, Denis Healey had fixed a 9-to-13% target range of £M3 for 1977-78, and then a 8-to-12% target range for 1978-79.24 £M3 had increased by 16% over the first period but 11% over the second. Drawing on these initial policy experiments, Geoffrey Howe proposed a target range of between 7% and 11%, in June 1979, which he retained in the 1980 Budget. But in the event, the money supply turned out to be far more difficult to control than anticipated. So much so that at the end of the summer of 1980, the Prime Minster summoned the Governor of the Bank of England to monthly meetings when he was “ritually spanked”25 for his failure to meet the £M3 target.

  • 26 Practically speaking, the interest rate instrument can only serve one purpose, that of reducing the (...)
  • 27 Champroux, N., Entre convictions et obligations, 2009.

13Along with money supply targets, a key component of the new policy was the maintenance of a floating exchange rate. Friedman stressed that foregoing any exchange rate policy was a condition to the pursuance of money supply targets. Indeed, in the early 1960s, Robert Mundell and Marcus Fleming had argued that it is impossible to have a stable exchange rate, free movement of capital and an independent monetary policy at the same time.26 The deliberate choice of letting the exchange rate float was therefore a key feature of early Thatcherism, which Margaret Thatcher only gave up in 1990 when she thought she had no other alternative.27

  • 28 Lucas, R., 7 December 1995.
  • 29 HM Treasury, 26 March 1980, p. 16.

14The new policy was also based on the belief that economic agents (households, companies, investors, etc.) have “rational expectations” concerning the real value of money and government policy impacts on the economy and act accordingly to protect their own interests.28 The Conservatives therefore set out the medium term strategy clearly asserting their “firm commitment”29 to curbing inflation, so as to influence economic agents into expecting less inflation, and so obtain quicker adjustments in price and wage behaviour. The concern of commitment and credibility partly explains the government’s later reluctance to change path and publicly accept a U-turn.

  • 30 Ibid.
  • 31 Minimum lending rates had then been pushed at or even above 14% to support the Sterling pound in 19 (...)
  • 32 See chart in appendix for a complete list of the PSBR targets.

15Last but by no means least, the other instruments of the MTFS declared in the 1980 Budget were “public expenditure plans and tax policies and interest rates”. Geoffrey Howe refused “excessive reliance”30 on interest rates, the increase of which was known to strangle the economy, as the past experiences of the end of 1976 and beginning of 1979 had demonstrated.31 A strong emphasis was therefore placed on controlling public expenditure and in particular public deficits, the so-called Public Sector Borrowing Requirement (PSBR). What was ultimately understood and remembered from the MTFS was indeed the fixing of PSBR targets,32 that had to be respected to help reduce the growth of the money supply.

  • 33 Geoffrey Howe himself remained rather vague on this link in his 1980 budget speech.
  • 34 An increase in £M3 is equal to the PSBR less sales of public sector debt to the non-bank sector, pl (...)
  • 35 Friedman, M., “Response to questionnaire on monetary policy”, in HM Treasury, 1980, pp. 55-62.

16However, the link between public spending, PSBR and money supply was not as robust as the government claimed.33 Technically speaking, there was an accounting identity between £M3 and the PSBR.34 But the government presented this as a stronger causality than it really was. As a matter of fact, Friedman himself later denied the importance of the link.35 Nevertheless, the first Thatcher government not only presented the two kinds of monetary and fiscal policies in the same document: they actually designed their own version of monetarism with the inclusion of budget austerity measures. In the collective memory of the British, early Thatcherism is this particular policy mix, especially as its consequences proved dramatic, as we shall see in the following section.

17In terms of inflation, the outcomes were those expected, even if late in coming. After a moderate rise to 11.4% in July 1979, a jump to more than 15% in June, and a steep increase to more than 20% in March 1980, inflation eventually started decreasing from May 1980. It fell to 15% by December 1980, to less than 10% in April 1982 and to below 5% in March 1983. Given that monetary policy is usually considered to act with a time lag of 18 months to two years, other things being equal, all movements prior to late 1980 could be attributed to the previous Labour government. Then, the Thatcher government did arguably achieve its goal. But there were fundamental flaws in the government’s management of the situation, and indeed in the whole pursuit of pure monetarism.

The Flaws and Consequences of the MTFS Experiment

  • 36 Charles Goodhart is a monetary economist who has often worked for the Bank of England. In the mid-1 (...)

18Put most simply, the basic problem with MTFS experiment lay in the fact that the perceived relationship between the money supply and inflation rapidly broke down. Far from being hard and hence capable of being managed, the relationship between the money supply and prices turned out to be very illusive. In its broadest sense this reflects what became known as Goodhart’s law, namely that when an indicator or a measure is used as a target, it stops being a good measure.36 In fact, the application of monetarism was undermined by other policies, including: tax and public spending commitments, financial deregulation, and then the fall-out of the deep recession in the early 1980s.

  • 37 Thatcher, M., 1993, pp. 44-5.

19A key electoral pledge of the Conservative manifesto in 1979 had been to bring down income tax and to finance this by higher VAT: the logic was of taxing what voters spent rather than what they earned. Accordingly, in the June budget immediately following the May election, the basic rate of income tax was cut from 33% to 30% and the top rate brought down from 83% to 60%. These tax cuts were financed by a near-doubling of VAT from 8% to 15%, which directly fed into the Retail Price Index (RPI), the measure of headline inflation used at the time. Similarly, prior to the election, the Conservatives had pledged to honour civil service pay increases proposed by an independent commission set up under the previous Labour government. As it turned out, the commission proposed that civil service pay rise by an average of 26%, with obvious consequences both for public spending and wage inflation. Yet the new government felt obliged to honour its commitment.37 The government’s drive to financial deregulation also rapidly undermined the MTFS. In line with its free-market ideology, the government abolished exchange controls in October 1979, so that capital could flow into and out off the UK freely. This measure, however, very quickly undermined credit rationing which had been implemented by the previous Labour government. British banks henceforth were able to borrow abroad and subsequently repatriate capital to the UK, so the scheme became inoperable, and was scrapped in June 1980.

20Taken together, these factors meant that £M3 largely exceeded the targets the government set out in the MTFS (see Table 1 in the Appendix). In response, the government pushed up interest rates, raising the short term interest rate from 14% to 17% in November 1979, where it stayed until the following July. Such high interest rates in turn, however, had a direct impact on the exchange rate of the pound. Far from falling when exchange controls were ended, the pound actually surged in international markets. As Britain was rapidly becoming an oil exporter, the free-market policy of the government combined with high interest rates caused sterling to rise from an annual average rate of $ 1.75 in 1977, to $ 2.12 in 1979 and on to $ 2.33 in 1980.

  • 38 House of Lords Select Committee on Overseas Trade, 1985, p. 37.

21Not surprisingly, the combination of high interest rates and a high pound had catastrophic consequences for the economy and industry in particular. Industrial production (including oil output) fell by 6.4% between 1979 and 1980, and average unemployment leapt from 1.3 million in 1979 to 1.7 million in 1980, and continued to rise to nearly 3.3 million in 1986. According to a House of Lords report published in 1985, manufacturing output and capacity shrunk by 20% in this recession.38

  • 39 Alan Walters had been an advisor to Margaret Thatcher and her close allies in the mid-1970s, before (...)
  • 40 Keegan, W., 1984, pp. 159-165.

22In the face of the unfolding economic slump, policy did change – a bit. In late 1980, Margaret Thatcher consulted her former advisor in opposition Alan Walters, who suspected that far from being too loose as suggested by the £M3 figures, monetary policy might have been too tight.39 In the ensuing discussions within Margaret Thatcher’s inner circle, it was argued that interest rates should be brought down. However, the government was far from switching policy, and hardly ready to admit that many companies were going bankrupt due to a misunderstood monetary policy. Policy credibility required pursuit of toughness, and Margaret Thatcher was very publicly ruling out a U-turn (see below). As a result, the argument emerged that further squeezes on public spending and reducing the PSBR could prepare the way for interest rate cuts.40

23These further squeezes came in the (in)famous Budget of March 1981, which was in many ways a watershed in economic policy, and which was arguably a reference in terms of the Coalition’s policy of austerity in the early 2010s, and the continuing drive to austerity by the Conservative government elected in May 2015. Coming in the middle of a deep recession, the 1981 Budget specifically sought to bring down the PSBR, even though the deficit was under strong upward pressure due to trends in budgetary “automatic stabilisers”: i.e. the tendency for welfare spending to rise in a recession as more people are unemployed and for tax revenues to fall with weaker activity (the opposite occurring in an upturn). In the event, the government decided to raise the tax take by not increasing the nominal value personal allowances (the untaxed part of income) in line with inflation, which at the time was still running at 13%. Taxes were also increased on alcohol and tobacco. Yet, this fiscal pill was sweetened by a cut in the base interest rate from 14% to 12%

  • 41 Jones, M., 15 March, 1981.
  • 42 The Times, 30 March 1981.

24Such a fiscal contraction in the midst of a substantial recession was, not surprisingly, highly controversial. It was privately criticised strongly within the Conservative party’s own ranks.41 Moreover, one of the more notable public reactions came from a large section of Britain’s economic establishment. In a highly publicised, open letter to The Times, 364 economists roundly denounced the government’s overall policy, noting that: “There is no basis in economic theory or supporting evidence for the Government’s belief that by deflating demand they will bring inflation permanently under control and thereby introduce an automatic recovery in output and employment”.42 In the event, the 1981 Budget did not lead to a further downturn in activity. In fact, it coincided with the slow beginnings of a recovery – though this only become transparent later. Inflation too did then fall, but not until the end of 1981.

25In terms of the MFTS, the events in late 1980 through to the 1981 Budget entailed a shift in policy. The adherence to strict monetarism took a lesser place in government policy, and the targets changed over time, switching from £M3 to narrower definitions of money. Also, control of the money supply gave way to the more traditional Treasury concerns for balancing the public finance books. It was only in retrospect, that this initial episode of the MTFS was interpreted in a more favourable light, as will be discussed below. Also, while the MTFS was still retained in principle, its became significantly less visible public policy.

The Policy Debate at the Time

  • 43 Budd, A. (Sir), in The 1981 Budget – Facts and Fallacies, 27 September 2011, p. 4.
  • 44 Davies, A., October 2012.

26The tenacity with which the first Thatcher government stuck to monetarism and the MTFS may be explained by several factors. Leaving aside Margaret Thatcher’s personality, the shift to what can only be described as dogmatic monetarism follows largely from the economic upheavals of the 1970s. This decade was not only seen as one of stagflation, and indeed absolute economic decline – following years of relative economic decline when Britain’s “stop-go” economic performance lagged behind that of the other major industrialised nations. Moreover, judgement of the previous Conservative government under Edward Heath (1970 to 1974) was particularly harsh: in the words of (Sir) Alan Budd (speaking in 2011), this period “is a strong contender for the worst period of economic management in the post war period. And what it saw was crude Keynesianism to extremes”.43 As a result, the new team around Margaret Thatcher when she became leader of the Conservative party set out to rethink economic policy, along the lines of monetarism which were shaping the overall policy debate internationally.44

27Significantly, these policy changes and the broad outlines of the MTFS had been clearly set out during the Conservatives’ previous years in opposition. Two policy documents stand out in particular: The Right Approach published in 1976, and The Right Approach to the Economy drafted by Sir Geoffrey Howe, Keith Joseph, James Prior and David Howell the following year. Both the intellectual commitment and the electoral commitment to policy change were high, and this surely explains the broad persistence of policy even in the face of the disastrous turn in the economy (see above) and strong attacks from the Conservatives’ key supporters. When Margaret Thatcher famously announced at the Conservative party conference in October 1980 that she was “not for turning”, Terence Beckett, Director General of the Confederation of British Industry (CBI) shot back within weeks at the CBI’s annual conference by calling for a “bare-knuckle fight” with the government to bring down interest rates and the high value of the pound.

28Moreover, despite well-publicised divergences in Cabinet between the so-called “Wets” and “Dries”, the public and private line taken by Sir Geoffrey Howe was remarkably coherent. A review of the main Cabinet records (now available under the 30-year rule) that was undertaken as part of the present research broadly confirms the view that however problematic the implementation of policy was, the government stuck to its line, believing that it had little choice. Thus, a memorandum presented to Cabinet by Sir Geoffrey Howe early on in the government’s life states unambiguously that

  • 45 Howe, G., 10 December 1979.

No compromise is possible on i[nflation]. Otherwise the credibility of any Government’s strategy on inflation would be destroyed. Nor can we compromise on our objective of restoring incentives by reducing taxation. Our weakness on the supply side is still acute and we urgently need to take further measures to remedy this. The single most important contribution we can make is to reduce taxation at all income levels.45

  • 46 This case was made notably in Bacon, R., Eltis, W., 1978.

29Another strand of the government’s policy was also based on the need to reduce state involvement in the economy in order to free up resources available to the private sector. This reflects the monetarist critique that government activity “crowds out” the private sector, usually as public borrowing drives up interest rates making investment more expensive for the private sector. In the 1970s, the “crowding out” argument had also been extended to labour, when it was argued that Britain had “too few producers”.46 Hence, in discussions in Cabinet in June 1981 it was noted that:

  • 47 Cabinet Conclusion on “Economic Strategy”, 17 June 1981.

It would be necessary to look at the options for reductions in programmes which had hitherto been generally immune from cuts but which might have to be reduced in the interest of achieving the objectives of stimulating private sector activity...47

30Significantly, the policy debates during these years remain largely focused on the broader macroeconomic goals set out in the MTFS, in other words, the use of monetary policy to bring down inflation, and the use of fiscal policy to reduce taxes and their alleged, attendant disincentives to work and investment in the private sector. This impression, which admittedly is based on a selective reading of Cabinet papers for the first Thatcher government, does chime with the overall orientation of policy as publicly presented. Other aspects of what became the Conservative agenda of the mid-1980s do indeed seem to be mentioned far less. This is especially so concerning trade union reforms and the substantial policies of public sector deregulation and privatisation.

31And of course as time went by, the Thatcherites felt themselves to be vindicated. By the mid-1980s, the economy was clearly picking up (even if unemployment only peaked in 1986). Industry and manufacturing in particular were slow to recover. But after the 1983 general election, privatisation had emerged as the Conservative’s new policy priority, coupled with other more “microeconomic” areas of reform, including financial market deregulation, and fighting the unions (notably via the miners’ strike of 1984-5). Other areas of policy therefore took centre stage, while the MTFS receded into the background. In terms of the government’s broad objectives it had largely achieved its purpose, by sweeping aside all aspects of the previous Keynesian regime, as neatly summarised by Nigel Lawson as Chancellor of the Exchequer in 1984:

  • 48 Lawson, N., 18 June 1984.

The conventional post-War wisdom was that unemployment was a consequence of inadequate economic growth, and economic growth was to be secured by macro-economic policy – the fiscal stimulus of an enlarged Budget deficit, with monetary policy (to the extent that it could be said to exist at all) on the whole passively following fiscal policy.
Inflation, by contrast, was increasingly seen as a matter to be dealt with by micro-economic policy – the panoply of controls and subsidies associated with the era of incomes policy. The conclusion on which the present Government’s economic policy is based is that there is indeed a proper distinction between the objectives of macro-economic and micro-economic policy, and a need to be concerned with both of them. But the proper role of each is precisely the opposite of that assigned to it by the conventional post-War wisdom. It is the conquest of inflation, and not the pursuit of growth and employment, which is or should be the objective of macro-economic policy. And it is the creation of conditions conducive to growth and employment, and not the suppression of price rises, which is or should be the objective of micro-economic policy.
48

The Legacy of Monetary Policy

  • 49 Friedman, M., in London, S., 6 June 2003.

32It is tempting to declare that nothing remains of early monetary Thatcherism. Monetary aggregates are no longer targeted but used among a battery of other indicators. Strict monetarism, as elaborated at the end of the 1970s in the Chicago school, has worked nowhere. As a result, in 2003, even Friedman himself was led to reckon that “The use of quantity of money as a target [had] not been a success” and added: “I’m not sure I would as of today push it as hard as I once did”.49

  • 50 Champroux, N., Entre convictions et obligations, 2009.

33By the mid-1980s, monetarism had rapidly shown its limits in the UK, since no reliable monetary aggregate could be found that accurately correlated with inflation. The Conservatives then went through a decade of research, hesitation and day-to-day monetary management. Exchange rate policies were tried twice, contradicting Thatcherism. Margaret Thatcher firmly put an end to the shadowing of the Deutschmark (1987-1988) as soon as she realized it was being implemented. In 1990, she only resigned herself to accepting the pound entry into the Exchange Rate Mechanism (ERM) of the European Monetary System when politically forced to do so.50

  • 51 Champroux, N., “La politique monétaire sous les gouvernements Major”, mars 2009, pp. 101-116.
  • 52 Champroux, N., septembre 2011, pp. 59-76.
  • 53 HM Parliament, 1998, Part II, § 11, p. 45-46.
  • 54 Named after the town of Jackson Hole, Wyoming, host of the Federal Reserve Bank of Kansas City’s an (...)
  • 55 Bean, C., et alli, 28 August 2010, Transcript pp. 4-5.

34When the pound left the ERM in 1992, Prime Minister John Major’s government went back to the principles of floating exchange rates and an independent monetary policy focussed on inflation. Direct inflation targeting was adopted, with a symmetrical target of 2.5% growth in the RPIX ± 1%.51 Britain then fully enjoyed its share of the global Great Moderation, with low inflation (around 2-3%) and positive economic growth (between 2% and 4%). In 1997, New Labour reinforced stability, through the operational independence granted to the Bank of England.52 The Bank was actually entrusted with the same objectives attributed to the MTFS eighteen years before, i.e. “to maintain price stability; and subject to that, to support the economic policy of Her Majesty’s Government, including its objectives for growth and employment”.53 At an international level, the Great Moderation saw a consensus emerge on monetary policy, nicknamed the “Jackson Hole Consensus”.54 There was an echo to Thatcherism, which had advocated that monetary policy, through money supply control including spending cuts, had a role to play in the management of aggregate demand (mainly household consumption, government spending, investment and trade). The consensus went further with the belief that monetary policy should be assigned the primary task of short-term aggregate demand management through the manipulation of short-term interest rates, since fiscal policy was perceived as inappropriate to do so. Another link with Thatcherism was the recognition of the need for credibility, transparency and predictability of policies as a means to influence expectations. Yet, there were also differences, especially the rejection of intermediate policy targets in favour of directly targeting consumer price inflation.55

  • 56 “[...] in the sense that it cannot occur without a more rapid increase in the quantity of money tha (...)
  • 57 HM Treasury, March 2013.
  • 58 Osborne, G., 20 March 2013.

35From 2008, the financial crisis and the subsequent Great Recession opened a new era. In Britain, the Bank of England cut interest rates to the zero-lower bound in early 2009, and designed a programme of public and private asset purchases (Quantitative Easing or QE) to help bring down long term interest rates and stimulate bank lending to the economy. Subsequently, in August 2013, the Bank adopted a policy of “forward guidance”, declaring that it conditioned any increase in interest rates to the fall of the unemployment rate to below 7%. This was a real break with pure inflation targeting, as it introduced an intermediary non-monetary threshold in inflation targeting. It was a clear contrast with Thatcherism. From Friedman’s statement that “Inflation is always and everywhere a monetary phenomenon”,56 the early Thatcher team had concluded that monetary policies could only cure monetary issues, while only non-monetary policies should be used to tackle non-monetary issues. But in 2013, in a context of low inflation (2.5%), slow GDP growth (1.7%) and high unemployment, Conservative Chancellor of the Exchequer George Osborne specifically called on monetary policy to address non-monetary issues. While the government pursued its strategy of fiscal austerity in the Budget,57 the recourse to threshold forward guidance was explicitly included in the Chancellor’s Remit to the Bank of England’s Monetary Policy Committee in March 2013.58

  • 59 Conservative Party, 2010.
  • 60 Conservative Party, 2015.
  • 61 Bank of England, 20 May 2015.

36The real dangers of deflation in the 2010s render comparisons between Thatcherism and present Conservative monetary policy convictions difficult. As a matter of fact, since inflation was under control in Britain from 1993 onwards (with the significant exceptions of 2008 and 2011), it has ceased to be an economic and political issue. Thus, in their 2010 General Election manifesto, the Conservatives merely renewed the commitment to the 2% CPI target.59 And even though deflation again became worrying before the 2015 election, with inflation down to 0% in February, the CPI target disappeared altogether from the Conservatives’ manifesto: the inflation rate was just quoted as a benchmark for the calculation of various governmental objectives.60 As it is, the legacy left by Thatcherism, the fundamental purpose of which was the fight against inflation, to today’s Conservatives for their management of a completely reversed situation, seems rather pointless. Yet, it looks like the basics are still valid. Inflation still is considered as a monetary phenomenon, and not an autonomous phenomenon that could be influenced by direct manipulation of prices and incomes. The Conservatives have stuck to their choice of independent monetary policy instead of an exchange rate policy and the pound sterling still is floating. The money supply, as represented now by monetary aggregate M4, is still closely examined. Its increase has justified the non-intensification of the QE programme, while temporary disinflation is accounted for by changes in the labour market and the deflationary cost-effect of the energy price slump.61 So fundamentally, Thatcherism is still present in Britain’s monetary policy.

The Legacy of Fiscal Policy

37In terms of fiscal policy, the legacy of the MFTS and the first Thatcher government has been profound. From an overall policy point of view and in line with macroeconomic policy more generally, the MTFS led to the clear subordination of fiscal policy to monetary policy with a clear end to Keynesian “fine tuning” of aggregate demand, as had occurred before 1979. When New Labour was elected in 1997, for example, fiscal policy was clearly assigned the lesser role of providing resources to finance public services. Although Gordon Brown did indulge in a little fiscal activism at the turn of the millennium – when growth in the United States and Europe was quite weak – the basic approach to macroeconomic policy remained that which was forged in the early Thatcher years.

38Up until the financial crisis and Great Recession beginning in 2007-2008, New Labour also left the Conservatives’ income tax regime largely untouched: notably, the top rate of income tax reduced from 60% to 40% by Nigel Lawson as Chancellor in 1988 remained unchanged. When it wanted extra money, New Labour resorted either to bracket creep (not raising income tax thresholds in line with rising incomes, so that more and more people ended up paying the top 40% rate on part of their income) and to so-called stealth taxes (indirect taxes on petrol, higher national insurance contributions etc.) which were less visible politically than income tax.

  • 62 For a summary of New Labour’s fiscal policy, see Sowels, N., in the Observatoire de la Société Brit (...)

39More generally, New Labour made much of its fiscal prudence, at least in the early years. In the run-up to the 1997 elections, it committed itself to respecting the out-going Conservative government’s spending plans. Furthermore, considerable effort was made – at first at least – to set out rules governing fiscal policy, most notably the New Labour’s “Golden Rule” that over the economic cycle the government would only borrow to invest and not to fund current expenditure. Subsequently, in view of Britain’s strong economic performance between the early 1990s and the financial crisis, and given Gordon Brown’s desire in particular to strengthen public services, public spending did end up breaking this rule. But excesses at the time remained limited.62

  • 63 HM Treasury, 22 June 2010, p1.
  • 64 HM Treasury, October 2010.

40The crisis of course has changed everything. Government intervention to support the banking system was massive, and included substantial extra government spending to inject capital into British banks, a number of which were privatised. At the same time, tax revenue fell markedly, especially given the Treasury’s reliance on tax paid by the financial sector. In 2009, government borrowing topped 11% of GDP, and was still 10% when the Conservative-Liberal Democrat coalition came to office in May 2010. In response, the new Coalition government immediately announced in an Emergency Budget in June that it would strive for substantial cuts in public spending, “unprecedented in the post-war period”.63 These were subsequently detailed in the government’s Spending Review in October 2010, which planned cuts of 19% for all departments (except health and overseas aid) by 2014-15.64

  • 65 A very brief summary of these arguments is given in Sowels, N., in the Observatoire de la Société B (...)
  • 66 Osborne, G., 8 October 2012.

41This sharp switch towards a policy of austerity was echoed elsewhere in Europe, and not surprisingly, the change in policy has been contentious. As the world economy continued to struggle with the fall-out of the financial crisis, quite strong divisions grew up among economists and within the policy-making community about the right path of action to take: essentially whether governments should continue to support growth in a fairly Keynesian way, or whether they should consolidate finances so that rising public debts do not weigh down on growth in the future.65 Britain was therefore not alone in this policy turnaround. But it did differ in so far as there was quite some feeling that the country was re-visiting the 1981 Budget. Thus, in his speech to the Conservative Party conference in October 2012, George Osborne very specifically referred to the 1981 Budget as having paved the way for the British economy to “overcome” its problems at the time, and emphasised that his policies would seek to do the same.66

  • 67 Osborne, G., 18 March 2015.

42In the event, controlling spending and boosting growth turned out to be far more difficult than hoped. For nearly three years through to mid-2013 the UK economy “flat-lined”, while progress made in cutting public deficits proved very hard. There has been much discussion about the causes and effects of these circumstances. Was government austerity responsible for prolonging the recession? Or did the Chancellor in fact act more pragmatically than his austerity pronouncements suggested, allowing quite a substantial deficit to linger? It is beyond the scope of this research to give detailed answers to these questions. However, when growth finally picked up in the second half of 2013, and then continued quite strongly throughout 2014, the government was quick to claim credit for it. In the March Budget of 2015, George Osborne prided himself on his long term plan of using austerity to prepare for growth.67

  • 68 Conservative Party, 2015.
  • 69 Osborne, G., 10 June 2015.
  • 70 Chang, H.-J., et alli, 13 June 2015.

43The surprising election of a Conservative majority government in May 2015 holds out the prospect for further strong cuts in public spending. In its election manifesto, the Conservative party stated its objective of balancing the structural current budget by 2017-18. This is to be achieved through a combination of spending cuts (£ 13 billion in cuts in departmental spending, plus £ 12 billion in welfare cuts), and by generating an extra £ 5 billion in tax revenues by continuing to tackle tax evasion.68 These manifesto pledges were arguably to be bargaining chips in the event of a renewed coalition government with the Liberal-Democrats. But in the wake of their outright victory, the Conservatives have clearly announced that a new emergency budget in July 2015 will begin implementing their electoral pledges. Indeed, the new government has even gone so far as to say that in “normal times” budgets should be in surplus.69 In an ironic twist, 77 leading economists including Thomas Piketty published an open letter in The Guardian in early June 2015 challenging the government’s economic reasoning, and warning that the contraction of public debt is likely to entail a greater private sector debt crisis surpassing that of 2008.70

Conclusions

44This is not really the place to speculate on the likely outcome of the new government’s renewed bout of austerity or the course of the United Kingdom economy over the years ahead. That said, there are causes for concern that the present austerity drive may not only lead to further hardship of those at the bottom of the income ladder but may not be followed by a period of growth in the same way as the 1981 budget (or indeed the tightening of fiscal policy by the Major government in the early 1990s). First, the international economy is more fragile than it was on these two previous occasions. This is especially so for the United-States, where growth has been steady but weak since the technical end of its Great Recession in late 2009/early 2010. The contrast to the Reagan boom of the mid-1980s or the prosperous Clinton years of the 1990s is quite apparent.

  • 71 Cameron, D., in Daily Mail, 11 October 2010.

45Second, by tightening the fiscal screws, the new Conservative government is continuing to place overwhelming confidence in monetary policy to generate growth. In 2010, in line with Thatcherism, David Cameron clearly stated: “I have always believed that actually it is monetary policy that is a better lever in terms of trying to make sure that the economy is progressing and demand is growing [...]. I have always been a fiscal conservative and a monetary activist [...]”.71 Yet monetary policy is a blunt instrument that cannot do everything. Today’s Conservatives recall the early Thatcher team’s belief in the potency of monetary policy, which is essential to controlling inflation and providing the conditions for growth and employment, but is not be sufficient alone. Indeed, a major issue of the United Kingdom economy in the mid-2010s is labour productivity, which has remained flat since the last quarter of 2005 and on which monetary policy has little direct impact.

46Lastly, the policy in the 1970s which began under Labour and continued under the Conservatives, encapsulated in the MTFS, came at a time when the previous instruments of Keynesian macroeconomic management were failing. Today’s world is very different. Neoliberalism and the legacy of the MTFS have been guiding policy for more than three decades, entailing repeated and increasingly violent financial crises. This raises the question of whether today’s unbalanced simplistic economic policy mix may not in fact be the mirror image of the over-blown, simplistic reliance on Keynesianism in the early 1970s.

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Annexe

Table 1 : Money Supply Targets and Outcomes

Table 1 : Money Supply Targets and Outcomes

Table 2 : PSBR Targets and Outcomes

Table 2 : PSBR Targets and Outcomes
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Notes

1 Howe, G., 26 March 1980, cc. 1439-90.

2 HM Treasury, 26 March 1980, pp. 16-19.

3 Ibid., p. 16.

4 Double digit figures for the CPI monthly growth rate had been recorded during nearly four years, between November 1973 and December 1977. Inflation had even exceeded 20% over the 1975-76 fiscal year. A deceleration had been seen from June 1977, bringing inflation down to 7.41% in June 1978, but then inflation had accelerated again (Monthly Consumer Price Index growth rates, calculated on a year-to-year basis).

5 Conservative Party, 1979.

6 Figures of Administrative Unemployment Levels: United Kingdom, yearly average, not seasonally adjusted, taken from “Special Features, Unemployment Statistics from 1881 to the Present”, in Government Statistical Service, Labour Market Trends, 1996, p. 11. Unemployment had already temporarily risen over one million in 1972.

7 Joseph, K. (Sir), 5 April 1976.

8 Growth rate of Gross domestic product at market prices, revalued at 1995 prices, taken from Government Statistical Service, Economic Trends Annual Supplement, Economic Trends Annual Supplement, 2000, p. 11.

9 About Labour Chancellor of the Exchequer Denis Healey’s ideology change, see Congdon, T., 2007, p. 90.

10 About the monetarist experiments prior to Thatcherism, see Smith, D., 1987, pp. 35, 59, 65-66; Needham, D., September 2012; Davies, A., October 2012.

11 Hayek, F., 1944.

12 The paradox of heavy monetary and fiscal interventionism from a Conservative government highly in favour of liberalism was underlined in Gowland, D.H., (1982), 1984, section 10.1.

13 Howe, G., 26 March 1980.

14 Lawson, N., 4 August 1980.

15 Roberts, M., 26 February 1951.

16 Thatcher, M., 22 May 1975, c. 1638.

17 Joseph, K. (Sir), 5 September 1974.

18 Travers, A.J., 9 February 1975; Rose, D., 11 February 1975.

19 Thatcher, M., 10 October 1980; Joseph, K. (Sir), 5 April 1976; Howe, G., 26 March 1980, cc. 1443-1444.

20 See Nigel Lawson’s brief for Margaret Thatcher’s meeting with Milton Friedman on 27 February 1980, in which Lawson identified the various reservations Friedman may express over the British government’s policies and listed all the counter-arguments Margaret Thatcher could present to Friedman. Lawson, N., 22 February 1980.

21 Friedman, M., Schwartz, A., 1963.

22 Friedman, M., 1960, pp. 90-91.

23 £M3 was then composed of the monetary base (notes and coins in circulation with the public) plus the United Kingdom private and public sectors’ sterling and non-sterling deposits held with the country banking sector (added in 1970) excluding foreign currency deposits (since 1977).

24 In the 1960s, from his analysis of the American economic situation of the preceding 90 years, Friedman had advised the Fed to adopt a money supply growth target from 3 to 5%.

25 Goodhart, C., in The 1981 Budget – Facts and Fallacies, 27 September 2011, p. 11.

26 Practically speaking, the interest rate instrument can only serve one purpose, that of reducing the money supply or that of stabilising exchange rates.

27 Champroux, N., Entre convictions et obligations, 2009.

28 Lucas, R., 7 December 1995.

29 HM Treasury, 26 March 1980, p. 16.

30 Ibid.

31 Minimum lending rates had then been pushed at or even above 14% to support the Sterling pound in 1976, and to both support the pound and limit inflation in 1979. In both cases, GDP growth had slowed down.

32 See chart in appendix for a complete list of the PSBR targets.

33 Geoffrey Howe himself remained rather vague on this link in his 1980 budget speech.

34 An increase in £M3 is equal to the PSBR less sales of public sector debt to the non-bank sector, plus the increase in bank lending to the private and overseas sector, plus the net inflow of the private sector.

35 Friedman, M., “Response to questionnaire on monetary policy”, in HM Treasury, 1980, pp. 55-62.

36 Charles Goodhart is a monetary economist who has often worked for the Bank of England. In the mid-1970s, he noted that “any observed statistical regularity will tend to collapse once pressure is placed upon it for control purposes”. (Chrystal, K.A., Mizen, P.D., 15-16 12 November 2001).

37 Thatcher, M., 1993, pp. 44-5.

38 House of Lords Select Committee on Overseas Trade, 1985, p. 37.

39 Alan Walters had been an advisor to Margaret Thatcher and her close allies in the mid-1970s, before going to work in the United States. He was appointed as Downing Street’s economic advisor as of January 1981.

40 Keegan, W., 1984, pp. 159-165.

41 Jones, M., 15 March, 1981.

42 The Times, 30 March 1981.

43 Budd, A. (Sir), in The 1981 Budget – Facts and Fallacies, 27 September 2011, p. 4.

44 Davies, A., October 2012.

45 Howe, G., 10 December 1979.

46 This case was made notably in Bacon, R., Eltis, W., 1978.

47 Cabinet Conclusion on “Economic Strategy”, 17 June 1981.

48 Lawson, N., 18 June 1984.

49 Friedman, M., in London, S., 6 June 2003.

50 Champroux, N., Entre convictions et obligations, 2009.

51 Champroux, N., “La politique monétaire sous les gouvernements Major”, mars 2009, pp. 101-116.

52 Champroux, N., septembre 2011, pp. 59-76.

53 HM Parliament, 1998, Part II, § 11, p. 45-46.

54 Named after the town of Jackson Hole, Wyoming, host of the Federal Reserve Bank of Kansas City’s annual economic policy symposium since 1982.

55 Bean, C., et alli, 28 August 2010, Transcript pp. 4-5.

56 “[...] in the sense that it cannot occur without a more rapid increase in the quantity of money than in output”. Friedman, M., 1974, p. 356.

57 HM Treasury, March 2013.

58 Osborne, G., 20 March 2013.

59 Conservative Party, 2010.

60 Conservative Party, 2015.

61 Bank of England, 20 May 2015.

62 For a summary of New Labour’s fiscal policy, see Sowels, N., in the Observatoire de la Société Britannique, septembre n° 10, pp 77-93.

63 HM Treasury, 22 June 2010, p1.

64 HM Treasury, October 2010.

65 A very brief summary of these arguments is given in Sowels, N., in the Observatoire de la Société Britannique, janvier 2014, p. 165-188.

66 Osborne, G., 8 October 2012.

67 Osborne, G., 18 March 2015.

68 Conservative Party, 2015.

69 Osborne, G., 10 June 2015.

70 Chang, H.-J., et alli, 13 June 2015.

71 Cameron, D., in Daily Mail, 11 October 2010.

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Table des illustrations

Titre Table 1 : Money Supply Targets and Outcomes
URL http://osb.revues.org/docannexe/image/1780/img-1.png
Fichier image/png, 16k
Titre Table 2 : PSBR Targets and Outcomes
URL http://osb.revues.org/docannexe/image/1780/img-2.png
Fichier image/png, 31k
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Nathalie Champroux et Nicholas Sowels, « The Monetary and Fiscal Policies of Early Thatcherism and the Legacy of the Medium Term Financial Strategy », Observatoire de la société britannique, 17 | 2015, 135-161.

Référence électronique

Nathalie Champroux et Nicholas Sowels, « The Monetary and Fiscal Policies of Early Thatcherism and the Legacy of the Medium Term Financial Strategy », Observatoire de la société britannique [En ligne], 17 | 2015, mis en ligne le 01 mai 2016, consulté le 30 avril 2017. URL : http://osb.revues.org/1780 ; DOI : 10.4000/osb.1780

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Auteurs

Nathalie Champroux

Maître de Conférences en Civilisation britannique à l'Université Paris Est-Créteil

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Nicholas Sowels

Maître de Conférences en Civilisation britannique à l'Université Paris Panthéon Sorbonne-Paris 1

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