Margaret Thatcher’s Four Ages of Monetary Policy

Monetary policy changed dramatically during Margaret Thatcher’s period as prime minister, from hard-line or ‘punk’ monetarism to membership of the European exchange rate mechanism (ERM). This, from my book Free Lunch, explains how her period in office accounted for four of my seven ages of modern UK monetary policy. By comparison, the past 16 years have been remarkably stable.

There are seven ages of man and there are seven ages of modern UK monetary policy. It is a good way of looking at the trials and errors. Other countries have also groped for the ideal monetary policy, although few have done so as ineptly as Britain. If we go back a quarter of a century so, to the 1970s, this was a time of enormous turbulence for the world economy and near-disaster for Britain. It is also my first age of modern UK monetary policy, reluctant monetarism. In 1976 a near-bankrupt government had to call in the International Monetary Fund. This was the occasion for the burying of Keynesian fine-tuning. Peter Jay, sometime British ambassador to Washington, and economics editor of The Times and the BBC, drafted a speech for his father in law James Callaghan for the 1976 Labour party conference, which contained the immortal words ‘I tell you in all candour that you can’t spend your way out of recession’. The IMF’s prescription contained two main elements. It insisted on sharp cuts in public spending – the biggest by any government in the post-war period. And it forced the government to adopt monetary targets, to control the money supply or, more particularly, two measures of ‘money’, sterling M3 and for domestic credit expansion. There is no need to worry about the detail of what these were. The essential point was a simple one. To stabilise the economy, and to control inflation (which had risen above 26 per cent during 1975) it was necessary to control the money supply. There will be more on this when we meet Milton Friedman in the next chapter but the basis of this policy was quite simple – just as you cannot drive a car without petrol, you cannot have inflation without money. The faster that money is printed, and credit allowed to grow, the higher will be inflation. Targeting the money supply was by no means trouble-free. The Labour government found, as many governments have, that it was not possible to control the money supply and the exchange rate at the same time. By the time it lost the 1979 election inflationary pressures were starting to build up strongly. Even so, this ‘reluctant monetarism’ helped to save the economy.

In 1979, we had the second age, willing monetarism, under a Thatcher government philosophically committed to controlling the money supply as a means of limiting inflation.

Despite being acolytes of Friedman, the Conservatives chose a ‘broad’ monetary target, sterling M3, which he would not have recommended. They then proceeded to undertake other policy actions, notably the abolition of exchange controls – limits on the amount of currency and capital that could be taken in and out of the country – and of the Bank of England ‘corset’ (controls on the banks’ lending), which made it impossible to hit the targets for sterling M3. To this day many people think monetarism has something to do with public spending cuts. This was because the Thatcher government’s choice of money supply target was linked to the level of public borrowing, and therefore the amount of government spending. This phase of willing monetarism lasted two or three years, before giving way to third age, pragmatic monetarism.

By the early 1980s Charles Goodhart, then chief monetary adviser to the Bank of England, had come up with Goodhart’s Law, a kind of Murphy’s Law for economics. This did not say that if you drop a piece of toast it is bound to fall buttered side down but, rather, that any measure of the money supply you try to target will automatically become subject to distortions that make it hard to control. So the Conservative government adopted a more relaxed approach, making it clear that they still believed in controlling the money supply but also choosing to target a range of measures and not losing too much sleep if one or more of them missed the target. This approach worked pretty well. From 1982 until 1985 Britain had reasonable economic growth, albeit alongside high unemployment, and low inflation.

Unfortunately, sterling, the traditional Achilles heel of the UK economy, was still subject to periodic crises. In January 1985, not long after I had joined The Times as economics correspondent, the month began with interest rates at 9.5 per cent and ended the month at 14 per cent, sterling having come within a whisker of one-to-one parity with the dollar in the process. These days, we get excited when interest rates change by a quarter of a percentage point in a month and at time of writing they had not changed at all for well over two years. And so, in about 1985, Nigel Lawson, the then chancellor, became rather keen on taking sterling into the European exchange rate mechanism – the system of ‘fixed-but-adjustable’ exchange rates in Europe that had come into being in 1979 as a forerunner to the single currency. When Thatcher rebuffed him, he developed an alternative. Under the cloak of international efforts to stabilise currencies, the so-called G5 (Group of Five) and G7 (Group of Seven) Plaza and Louvre accords, that alternative was unofficial exchange rate targeting – shadowing the D-mark, my fourth age of monetary policy. How much was this responsible for the boom and bust of the late 1980s? Quite a lot, because interest rates were cut to try to hold the pound down. The earlier pragmatism was replaced by dogmatism, with dogma directed at preventing the pound from rising above three D-marks (Germany’s currency before the euro).

My fifth age is official targeting of the exchange rate – the ERM period. John Major was more successful than Lawson in persuading Thatcher of the virtues of joining the ERM, partly because he persuaded her that it was the route to lower interest rates. And so, when in October 1990 it was announced that the pound would be joining the ERM at an exchange rate of DM2.95, it was also announced that interest rates would be reduced at the same time. The problem with ERM membership was, however, the opposite of the one Major suggested, Far from being a route to lower interest rates, it blocked interest rate cuts at the very time they were needed. The combination of what was seen as a high exchange rate and the persistence of high interest rates meant that the period of ERM membership coincided with the 1990-92 recession. There was an additional complication. As a result of the pressures created by the unification of East and West Germany, German interest rates were higher than usual, and they set the pattern for the rest of Europe including, at the time, Britain. By the summer of 1992, the Conservative government, having narrowly won re-election in April 1992 (this time with Major as prime minister) was hanging on for dear life in the ERM. On September 16, 1992 the game was up. ‘Black’ Wednesday to the headline writers, ‘White’ or ‘Golden’ Wednesday to others, this was the day the Bank of England ran out of the reserves needed to prop up the pound within the system (it bought large quantities of sterling with its own foreign currency) but, thanks to George Soros and other speculators, it was to no avail.

The sixth age came after Black Wednesday and sterling’s departure from the ERM, and it can be called quasi Bank of England independence. In putting together a monetary policy framework out of the ruins of the ERM failure, and in doing it both quickly and in an environment where it seemed the government could fall at any moment, the Treasury and the then chancellor, Norman Lamont, performed a minor miracle. That framework, adopting an inflation target instead of money supply or exchange rate targets, requiring the Bank of England to produce a quarterly inflation report, and getting the Bank to advise openly and regularly on interest rate changes (this became the ‘Ken and Eddie show’ after Kenneth Clarke, Lamont’s successor and Eddie George, the Governor of the Bank) was enormously successful. It paved the way for the 1990s to be a period, after the disasters at the start, of non-inflationary growth, the holy grail of economic policy. From there it was a relatively short step to giving the Bank the job.

The seventh age is thus operational independence for the Bank in which the Bank sets rates to meet an inflation target, 2 per cent, set by the government Is this the final resting place for monetary policy? One is tempted to say yes. The possibility of Britain embracing Europe’s monetary union, the euro, under which the governor of the Bank would simply become a voting member of a large European Central Bank council, seems very remote. A question may arise over the Bank’s wider responsibilities, acquired in the wake of the crisis, for supervising the banks and the wider financial system. Errors made in this area could compound criticism of the Bank that emerged before, during and after the crisis. That criticism centred on the Bank’s failure, during a period its governor Mervyn King described as the ‘Nice’ decade (non-inflationary, consistently expansionary), to respond to sharply rising asset prices – mainly property – and rapid credit growth. This criticism, which was also directed at other central banks, and most notably the Federal Reserve, argued that an obsession with achieving low inflation meant that other dangerous developments were ignored. Had central banks adopted a more rounded approach, it was argued, they would have kept interest rates higher and used other methods to restrain credit growth, even if it meant measured inflation was below the official target. Such criticism persisted after the crisis, when soaring commodity prices and in Britain’s case a weak pound, pushed inflation up sharply. The ‘Nice’decade, more generally known as the ‘Great Moderation’, in which central banks seemed all-powerful, appeared to have benefited from considerable good fortune.

This piece is cross-posted from David Smith’s Economics UK with permission.