There is now a general understanding that the effect of increasing government borrowing is to raise interest rates higher than they would otherwise be. This is particularly so if it is expected that the larger deficit will raise future money supply growth and so inflation. In this way, allowing budget deficits to swell arrests rather than accelerates economic growth. The 1981 Budget, which I have described elsewhere, was based on understanding of that truth.[103] The 364 economists who published a statement attacking the strategy we adopted had no doubt that it represented a direct challenge to the prevailing orthodoxy. The challenge succeeded. Economic recovery was heralded by figures in the summer of 1981 and confirmed by others in the following quarter; by 1983 economic conditions were so buoyant that, along with reaction to the successful outcome of the Falklands War, they ensured me my smoothest general election victory.
As with government borrowing, so with inflation. After decades during which governments fine-tuned the economy on the assumption that there was a ‘trade-off’ between inflation and unemployment — the so-called Phillips Curve — it is now widely agreed that in the long run it is micro-economic changes, affecting the structure of the economy — for example, deregulation — rather than macro-economic manipulation, which determines the number of jobs. And hardly anyone now professes to believe that ‘some’ inflation is economically desirable. For whereas in the past governments thought they were sufficiently clever and wage bargainers sufficiently stupid for the former to reduce the latter’s real remuneration by inflation, we now know that the boot has for years been on the other foot. Not only was future inflation discounted by wage bargainers — they frequently overestimated it and increased their demands accordingly. As a result, competitiveness was worsened, not assisted, by the so-called ‘money illusion’. Worse still, those inflationary expectations are immensely difficult to remove from the system, which is why the benefits of low inflation take many years fully to come through.
The great advantage I had over many of my contemporaries in politics was that whereas they had first to be persuaded of the theoretical advantages of monetarism, free trade and deregulation, the technical arguments and insights were so completely in harmony with my fundamental instincts and early experience that I was much more easily convinced — and my convictions helped me to convince others.
BRITAIN IN THE 1980s
As Prime Minister between 1979 and 1990 I had the opportunity to put these convictions into effect in economic policy — and I was fortunate to have three extremely able Chancellors of the Exchequer, Geoffrey Howe, Nigel Lawson and John Major, to assist me. We intended policy in the 1980s to be directed towards fundamentally different goals from those of most of the post-war era. We believed that since jobs (in a free society) did not depend on government but upon satisfying customers, there was no point in setting targets for ‘full’ employment. Instead, government should create the right framework of sound money, low taxes, light regulation and flexible markets (including labour markets) to allow prosperity and employment to grow.
As for government finances, there was, it is true, some limited continuity with the period before 1979. The Labour Chancellor Denis Healey’s £6 billion real cut in public spending between 1976/77 and 1977/78 the terms of the agreement with the IMF in December 1976 which marked the first overt use of monetary targets to guide policy, were significant steps towards the kind of approach in which I believed. But they were implemented from necessity rather than conviction and would have been jettisoned at the first available opportunity. Indeed, that jettisoning had already begun, as public spending was allowed to rise again in Labour’s final year. Moreover, the sound elements of policy pursued under IMF tutelage were not combined with the other crucial, complementary aspects — substantial cuts in marginal income tax rates, reform of trade union law, privatization and deregulation. They were, therefore, only half the remedy, for the vital ingredient of promoting enterprise was missing.
I came into 10 Downing Street with an overall conception of how to put Britain’s economy right, rather than a detailed plan: progress in different areas would depend on circumstances, both economic and political. For example, the priority in our first Budget was cuts in income tax — both because marginal rates, particularly on those with higher incomes, had become a deterrent to work and an incentive to migrate, and because we had made such a firm pledge in our manifesto. But when political and economic imperatives pointed in opposing directions it was the economic requirements which came first — as when we put up personal taxes in order to control the deficit and beat inflation in that unpopular but crucial 1981 Budget.
The economic strategy had four complementary elements. First, in time and in importance, was the fight against inflation. Inflation had become deeply rooted in the British political and economic system and in British psychology. It had risen to successively higher peaks in the post-war years and had, as I have described, come perilously close to hyper-inflation in 1975. As a result, it was all the more difficult to eliminate. Only a sustained policy to reduce monetary growth and change expectations would suffice. So from 1980 onwards monetary policy, supported by a fiscal policy which reduced government borrowing, was conducted within the framework of a Medium Term Financial Strategy (MTFS). Like any strategy worth the name it had to adapt to circumstances. When, for example, problems arose with one particular monetary aggregate as a measure of monetary policy, it was necessary to look to others as well. Again, like any strategy, it did not of itself remove the risk of error. But it limited the scope for such errors and, as it was adhered to in passing years and in spite of difficulties, it gained a credibility which itself inspired wider economic confidence. Between 1981 and 1986, when the MTFS was most consistently at the heart of policy, inflation was brought down from a high point of 21.9 per cent (May 1980) to a low of 2.4 per cent (summer 1986). During the mid-1980s it averaged around 5 per cent, until the shadowing of the Deutschmark in 1987–88, to which I was opposed, set off a sharp increase.[104] It rose rapidly until it peaked at 10.9 per cent in October 1990. It had begun to fall the month I left office, and it came down rapidly during 1991, by which time the high interest rates of 1988–90 had brought monetary growth under control once more. The assessment of domestic monetary conditions remained the final determinant of policy on inflation until I left office.
A month beforehand, however, the MTFS was supplemented by sterling’s membership of the Exchange Rate Mechanism of the EMS. This was intended to demonstrate to the financial markets that our commitment to low inflation was unshakeable. But then maintenance of a parity within the ERM became an end in itself, as the ERM became both a more rigid system and a conveyor belt towards a single currency. This led to a monetary overkill which certainly brought inflation down very rapidly, but at the price of inflicting an unduly severe recession in the British economy. In the end, the policy proved unsustainable and Britain had to leave the ERM.
Since then the Government has pursued a prudent policy to keep down inflation by a return to a sort of domestic monetarism. This is a tribute to the importance which the Government rightly gives to getting as near as possible to price stability. The need now is to re-establish a credible framework much on the lines of the original MTFS, which will be a permanent damper on inflationary expectations. That should not involve sterling’s rejoining even a reformed ERM, since the markets know full well that what you have left once you can leave again. Nor should it entail giving new autonomy to the Bank of England. Ultimately, it is politicians who must be accountable for economic policy. But they have to learn from the mistakes of the past, so that they and their successors are not condemned to repeat them.