Bang!: A History of Britain in the 1980s (12 page)

If Denis Healey and his successors did not understand the counterproductive consequences of maintaining exchange controls for the competitiveness of the currency, then Sir Geoffrey Howe appeared
not to have foreseen the extent to which his bold initiative was at odds with his commitment to the strict control of the money supply. Allowing banks to move their sterling lending overseas
without restriction effectively made redundant efforts to control the amount of credit they lent within the domestic economy. As Edmund Dell put it: ‘Vast flows of capital, far exceeding the
value of trade, destabilized exchange rates, forced movements in interest rates, and deprived
governments of much of their remaining control over their domestic
economies.’
⁵
In doing so, the UK moved in the opposite direction from its closest continental neighbour. In 1981, France’s incoming
socialist president, François Mitterrand, introduced sweeping new exchange controls in order to insulate his country from global money markets. For the City of London, the liberalization
came as an immediate and sustained boost which helped strengthen its role in the world order of capitalism, which had been threatened since the abandonment of capital controls by the United States
in 1974.
^EN5
Now, the fetters had been removed from British pension fund managers and insurance companies that wanted to expand and diversify their
international investment portfolios. Efforts were made to ensure the revolution was permanent. The Treasury’s files on exchange controls were destroyed, supposedly in order to hamper a future
administration that might try to reimpose them.
⁶

The Pain of Monetarism

Whatever the promises of eventual salvation, the early consequences of the new economic policy were appalling. With strong underlying drivers of inflation such as rising oil
prices and a high public sector wage settlement, controlling the money supply was easier said than done. Inflation continued to climb. The response was to borrow more. This created a spiral in
which the further inflation rose, the more the money supply swelled. Howe had established a guideline growth for Sterling M3 of 8 per cent in 1980–1. Instead, it grew by 19 per cent. The
onset of a recession triggered by the soaring price of oil pushed up unemployment. This diminished tax returns, increased benefit pay-outs and unbalanced the budget, thereby ensuring more
government borrowing. In November 1979, with inflation running at 17.4 per cent, Howe responded by raising interest rates (set by the minimum lending rate) to 17 per cent. The rate had never been
higher. Thus Howe and Thatcher found themselves faced with only unpalatable choices. They could not long sustain interest rates at such a level without crippling the economy, and the worse the
recession became the greater would be the ensuing budget deficit. The projected PSBR for 1981–2 of £7.5 billion (3 per cent of GDP) was heading towards £14 billion. The need to
finance such a debt by attracting the necessary loans reduced the scope for reducing interest rates. It was a vicious circle.

To the Chancellor and prime minister’s way of thinking, it seemed the only way to bring interest rates down was first to reduce the borrowing requirement. This could be done by putting
taxes up. However, reversing
the tax cuts of the June 1979 budget would be politically humiliating, and businesses would not be greatly helped if the consequence of lopping a
few per cent off interest rates was to put a few per cent on their and their employees’ tax bills. This left the Cabinet with a grim alternative: cut public spending further. Higher education
and local government were hit, as was defence spending, which the Tories had gone into the general election promising to increase by 3 per cent per year. A minor reshuffle in January 1981 removed
Francis Pym, who was resisting the cuts, from the Ministry of Defence and installed John Nott, who was prepared to wield the axe. Defence analysts pondered what consequences this would have for the
country’s role in NATO, particularly for the Royal Navy’s role in guarding the North Sea and for the British Army of the Rhine. It was actually in the South Atlantic that the
retrenchment would have the greatest consequences. Argentina’s military junta made their plans accordingly.
^EN6

Cripplingly high interest rates encouraged foreign investors to buy sterling. The result sent the value of the pound soaring, to the detriment of British industry. In the second half of 1980,
the pound’s value averaged around $2.40. This was close to where it had been at the start of the 1970s, before the collapse of the fixed exchange rate system. Placed in more recent
perspective, though, it represented a steep acceleration from nearer $2 in 1979 and was far up from its historic trough of $1.57 during the IMF crisis of 1976. The new, punishing, rate of $2.40
brought about the first blink from the Treasury via the Bank of England. In November 1980, the minimum lending rate fell back to the (still extraordinarily high) level of 14 per cent. This minor
cut provided scant and short-term relief. The primacy given to the money supply and the curtailment of borrowing had come at the expense of trying to manage the exchange rate for sterling. The
consequences were calamitous for the export market.

The predicament was later set out by Nigel Lawson, who was at that time Financial Secretary to the Treasury: ‘We had come to office at a time when the UK economic cycle had peaked and was
about to turn down – as for that matter was the world economy – and it would have been much easier to have deferred our attack on the deficit (and indeed on inflation via higher
interest rates). But we consciously decided to press ahead, because deferment can become a way of life.’
⁷
This was, according to taste, either
brave or callous. However, the decision to press on with it demonstrated the deepness of the psychological scars left by the Heath government’s decision to run away at the first signs of
trouble. Even so, many of Lawson’s colleagues felt the new determination was foolhardy and that history would have to repeat itself. Indeed, perhaps as much as a majority of the Cabinet
believed that the
only possibility of salvation would come from executing a humiliating U-turn. They now wanted to prioritize staving off the collapse of British industry
ahead of controlling inflation. This meant dropping high interest rates so that the exchange rate, rather than the money supply, became the central tool of recovery.

There were historical parallels in Britain’s once almost theological commitment to the gold standard. In the nineteenth century, there was an orthodoxy that the currency ought to remain
worth a fixed amount in gold. Policy was therefore aimed at not devaluing the currency by increasing supply. This was monetarism Victorian-style. After sterling was forced off the gold standard in
the world recession of 1931, governments looked for new ways to manage the exchange rate. From the end of the Second World War until 1971, sterling’s value was fixed against the dollar. This
proved a tough test in obedience, hence the repeated ‘sterling crises’ that afflicted post-war British governments, which found that keeping sterling fixed at a particular rate acted as
a tail wagging the dog of the rest of economic policy. Freedom from this discipline came in 1972 when, the fixed exchange rate system having collapsed, the decision was taken to let the currency
float and find its natural level. For politicians, no longer having to maintain the exchange rate by regular intervention to keep the balance of payments in check proved heady. Sizeable budget
deficits were quickly run up in pursuit of boosting demand and increasing welfare funding. Borrowing soared and economic growth faltered. It was at this moment that control of the money supply
stepped in to fill the anarchic gap created by the ending of fixed exchange rates. The new discipline seemed even harsher than the old one in terms of cripplingly high exchange rates and interest
rates. Indeed, the centrality now given to the interest rate encouraged an unceasing desire to fiddle with it. In 1982, the rate was altered thirty-six times.
⁸
Nevertheless, when Howe’s successor as Chancellor, Nigel Lawson, began the process of shifting the focus of discipline from the money supply back to the exchange rate,
first by shadowing the Deutschmark in 1987, which brought back inflation, and three years later through John Major’s decision to peg sterling to the European Exchange Rate Mechanism, the
resulting recession demonstrated that managing the exchange rate was not necessarily a painless way to squeeze inflation out of the British economy, nor to boost employment.

The clear moment to announce that the monetarist experiment had failed came – and passed – during the length of time it took Sir Geoffrey Howe to deliver his third budget to the
House of Commons on 10 March 1981. It took either great self-confidence or reckless insensitivity to stand by the decisions that had been taken and to affirm that they were to be persevered with
despite all the evidence pointing to their consequences. The first two years of the Thatcher government had witnessed the greatest fall in industrial
production since 1921.
Unemployment, which had stood at 1.4 million claimants when the Conservatives came to power, had reached 2.7 million by October 1981 and showed no sign of tailing off. The prospect of three million
out of work was a question not of ‘if’, but ‘when’. And ‘when’ proved to be January 1982. This tally of human despondency created fresh pressures on the national
accounts, reducing the scope for interventionist public works projects – even had the Treasury approved of such projects, which it did not. Capital expenditure (spending on the stock and
infrastructure of the state), which had represented one fifth of all public spending in 1974, now represented only one tenth. Indeed, for all the cuts Howe and his Treasury team forced through, the
exploding cost of supporting the unemployed ensured that total public spending was actually still increasing. It had represented 44 per cent of GDP in 1979 and stood at 47.5 per cent by 1981.

The previous Conservative government had lasted two years before Heath had signalled a full-scale retreat. But Thatcher had so pinned her leadership on not flinching in the face of tough
conditions that to repeat her predecessor’s surrender could have been as fatal to her survival as standing firm. At her party conference in October 1980, she had delivered the lines,
suggested to her by her speechwriter Ronald Millar: ‘To those waiting with bated breath for that favourite media catchphrase, the “U-turn”, I have only one thing to say. You turn
if you want to. The lady’s not for turning.’
^9
EN7
This was too memorable a catchphrase to
permit room for manoeuvre. She was fortunate that, crucially, her Chancellor was equally determined not to flinch. Their only disagreement was over how further fiscal tightening could be achieved
during 1981 without putting income tax rates back up. The answer was a sleight of hand, keeping tax rates the same but omitting to raise the thresholds at which they were paid. Given that inflation
had nudged 20 per cent in the intervening year, and was still running at 13 per cent in the spring of 1981, this made a significant difference. Higher taxes on alcohol, cigarettes, oil producers
and the banks provided the rest of the increase. Much as the 1981 budget was most vigorously attacked for continuing with monetarism, in fact Howe’s statement revealed a slight slackening of
monetary control, with the increasing grab from tax revenues providing the deflationary discipline.

Twenty days later, 364 economists sent a letter to
The Times
denouncing government policy. They claimed there was ‘no basis in economic theory or supporting evidence for the
government’s belief that by deflating demand they will bring inflation permanently under control’ or ensure economic
recovery. By ignoring alternatives to
monetarism: ‘Present policies will deepen the depression.’
¹⁰

In order to keep the 364 economists in agreement – a historic achievement in itself – the precise alternative course to be followed was not prescribed. Nevertheless, so resounding a
refutation could not easily be brushed aside or attributed purely to the self-interest of lecturers whose university budgets were among the targets of the spending squeeze. Initiated by two
Cambridge professors, Frank Hahn and Robert Nield, the declaration attracted the support of academics from thirty-six universities and included the signatures of seventy-six present or past
professors and five former chief economic advisers to the government. In contrast, the prime minister could not even marshal the support of half of the twenty-two members of her Cabinet.

In reality, Thatcher did not need to listen to her critics to discover that the obsessive focus on the money supply was mistaken. Her new personal economic adviser, Alan Walters, told her as
much. ‘Bugger Sterling M3!’ he supposedly exclaimed, pointing out that ‘Sterling is obviously far too high. That can only mean that sterling is scarce.’
¹¹
The 1981 budget succeeded in bringing the PSBR back towards £10 billion, thereby facilitating a welcome depreciation in the value of sterling. Indeed,
the day after the budget, interest rates fell by 2 per cent, to 12 per cent. Unfortunately, the relief was a mirage. By October, there was a run on the pound and, in the panic, interest rates were
hiked up to 16 per cent. This seemed like a crippling blow to companies still limping along.

The declaration by the 364 economists seemed a withering verdict, delivered at a critical juncture. However, with hindsight, the spring of 1981 proved an inopportune moment to forecast that
government policy would ‘deepen the depression’. As Nigel Lawson later noted with undisguised glee: ‘Their timing was exquisite. The economy embarked on a prolonged phase of
vigorous growth almost from the moment the letter was published.’
¹²
Indeed, the decline in GDP had reached its bottom in the first quarter of
1981, after which recovery – albeit not at a rate to dent the jobless queues – began. Even before this turnaround was evident, the critique of the 364 had been challenged by Patrick
Minford, professor of economics at Liverpool University, whose rebuttal in
The Times
earned him a note of thanks from the prime minister.
¹³
He argued that the eminent academics were more Keynesian than John Maynard Keynes. For while it was true that Keynes had advocated reflation, that was at a time (1932) when the rate of inflation
was below zero and the money supply was growing at less than 1 per cent. Thus he had merely been calling for price stability, which was also the Thatcher government’s goal – to be
achieved through reducing government borrowing. While it was undeniable that the least productive parts of British industry
had gone to the wall, the outlook for the survivors
was not as bleak as the 364 imagined, for the stock market, sniffing out opportunity before the theorists could, was again increasing the capitalization of even the hardest-hit
sectors.
¹⁴
Along a particularly dark tunnel, there was a far-off glimmer of light.