Inside Thatcher’s Monetarism Experiment: The Promise, the Failure the Legacy

By Tim Lankester - a book that inadvertently shows how British civil service economic thinking needed to change: at its best in 1979 the Treasury was part of the problem rather than a solution

Sir Timothy Lankester is a quintessential member of the contemporary British establishment. A former Treasury official who studied economics at two bastions of the Keynesian tradition. He benefited by being taught by Joan Robinson at Cambridge and by James Tobin at Yale. Between leaving school and going up to St John’s College, Cambridge he undertook voluntary service overseas. Before joining the HM Treasury in 1973 he worked for the World Bank in Washington DC and in India. He served later as the permanent secretary at the Overseas Development Administration for five years before leaving to work in academia first as the Director of SOAS and then as President of Corpus Christi College, Oxford. 

The kind of civil servant who did not like the change of government in 1979

In short Sir Timothy is precisely the kind of Whitehall official whose professional life was uncomfortably disturbed by the election of Mrs Margaret Thatcher. At that point in his career he was the prime minister’s economic private secretary at No 10 Downing Street, on secondment from HM Treasury. Sir Timothy had gone to Number 10 to work for the Labour Prime Minister, Mr James Callaghan as one of the prime minister’s private secretaries, in October 1978. Mrs Thatcher inherited Tim Lankester as her economic private secretary in the normal way in May 1979. He was part of the permanent politically neutral civil service that serves ministers in all governments regardless of party.

A distinctive special genre of bureaucratic literature 

Sir Tim Lankester has, after a lapse of forty or more years, witten an insider’s account of Mrs Thatcher’s economic policy. In doing so he has made an interesting contribution to a distinctive genre of bureaucratic history. That is a well informed eye witness account that pulls no punches and spells out things that outsiders might have thought were going on, but could not always put their finger on with confidence. 

The candid inside account that is also revealing and exposes an author’s prejudices 

Good examples of the category of literature are Sir Nicholas Henderson’s Britain’s Decline; Its Causes and Consequences - a Foreign Office Valedictory Ambassadorial Dispatch from the Paris Embassy in March 1979 that was leaked in full to The Economist; Peirre Arbour’s book Quebec Inc : And the Temptation of State Capitalism a first hand account of the investment policy of the Province of Quebec’s state pension fund, the Caisse de Québec, written by its former chief investment officer; and Bernard Connolly’s book The Rotten Heart of Europe: The Dirty War for Europe's Money an account of the working of the European Exchange Rate Mechanism, a critique from an economist who headed the European Commission’s Economic Unit. Each of these provides an interesting perspective that is in no way diminished by their vivid and tendentious manner. The direct approach of each of these insider accounts offers a transparent guide to each author's political and analytical prejudices. Guile does not stand in the way of them exposing their instinctive reflexes and their blind spots.

It is good that Sir Timothy has written this account of his time as Mrs Thatcher's first economic private secretary at No 10. He is intellectually candid, arguably unguarded and interesting. He is scrupulous in his personal treatment of Mrs Thatcher as an employer and person to work for. He exhibits great courtesy to her and offers pleasant memories of his time working for her. In this he corroborates the memories of other officials that worked directly for the Prime Minister, such as Caroline Slocock who worked as one of her private secretaries, at the end of the Prime Minister’s time in office. He recalls Mrs Thatchers as kind and generous. The Prime Minister regularly invited him for supper or a drink with her and her husband Denis in the private flat at No 10. They got on and had an enjoyable working relationship. Over a two and a half year period she ‘never once spoke out in irritation or anger against me’. 

Inside Thatcher's Monetarism Experiment : The Promise,The Failure, the Legacy concentrates on the early years of Margaret Thatcher’s first administration between 1979 and 1981. The Conservative Party under Margaret Thatcher took office in exceptionally difficult circumstances. Trade union power had destroyed the political authority of James Callaghan’s Labour Government. A sustained prices and incomes policy that had repressed inflation between 1976 and 1978 had been broken by the Winter of Discontent. The measures of fiscal and monetary disinflation that had been put in place by Denis Healey and the IMF between 1975 and 1978 had been abandoned. Denis Healey the Labour Chancellor had deflated demand in the economy and at the same time there was a second rise in international oil prices in 1979 that reignited international inflation.

Why business as usual - incomes policy and the rest was not possible in May 1979

Received official opinion was that if inflation was to be controlled there would have to be an incomes policy. A workable incomes policy would only be effective with the consent of the trade unions. Given that Labour ministers had not been able to secure trade union consent to a workable and sustained pay policy to control inflation, a Conservative government after the Winter of Discontent was hardly likely to be able to get union support for one. Mrs Thatcher and her ministers knew that they had to construct macro-economic policy to control inflation that was not dependent on trade union cooperation. Moreover, badly needed structural reforms to improve the working of product and labour markets would involve necessary radical changes to trade union law and the immunities from the law of tort that industrial action that the Trade Union and Labour Relations Act 1976 had extended. 

In opposition between 1975 and 1979 Mrs Thatcher and her colleagues set about constructing an alternative macro-economic policy framework that would return the country to financial stability and would not be dependent on trade union co-operation. It was an essentially political project. Its purpose was to answer the question - how can a Conservative Government govern without the unions. Margaret Thatcher, her Shadow Chancellor Sir Geoffrey Howe, Nigel Lawson as well as Sir Keith Joseph and Nicholas Ridley searched for an alternative policy to post-war Keynesian demand management with periodic price and wage controls to contain inflation. They were helped by the academic monetarist counter-reformation led by Milton Friedman and Anna Schwartz. This provided a convenient set of analytical propositions and policy prescriptions. Broadly there was a reliable relationship between money that could be measured, and related to national income. If money increased faster than the rate of growth in national output, there would be inflation. A set of published targets that would set monetary growth to that of the trend rate of growth of output, taking account of the demand for money and would ensure a rough approximation of price stability. To get from a period of high or rapid inflation to low inflation a gradual reduction in monetary growth would bring this about, without huge or permanent losses of output and employment. By publishing a series of projected targets the credibility of the policy would be further enforced offering clarity to financial markets and economic agents more widely.

The problem of adapting the Friedman framework to the UK 

This broad analytical and set of policy propositions had largely been worked up in relation to the US economy in the 1960s. It was predicated on a measure of the money supply that did not include interest bearing bank deposits. In 1979 this approach was applied to the UK economy and formalised in the Medium Term Financial Strategy in 1980. There was a practical difficulty in making it work in a UK context. Most of the first work on monetary relationships and national income in the UK had been done by applied economists working in research departments at stockbrokers in the City of London. Economists led by Mr Gorden Pepper found the best fit between money, economic activity, national income and prices was for a broader measure of money £M3 that included interest bearing bank deposits.

This meant that when interest rates were raised to tighten monetary conditions and contain growth of the money supply, it raised the return on cash and resulted in portfolio effects where the desire to hold money increased. The result was that more money was placed in interest bearing deposit accounts scored as part of £M3. This resulted in £M3 exceeding its target, and, initially, in the Treasury tightening monetary conditions further by raising interest rates further. In the particular circumstances of the early 1980s this process had a pronounced dynamic. For most of the 1970 while nominal rates were high and rising, they were significantly negative in terms of real interest rates. 1979 changed that. A government determined to give inflation priority over all other macro-economic objectives, raised nominal interest rates, sustained them at a high level to ensure that inflation fell. This resulted in sustained high positive real rates for the first time in years. The result was that even more cash was parked in interest bearing deposit accounts that formed part of £M3. 

A very tight domestic monetary policy amplified by a strong and rising exchange rate

The overall effect of this was to impose a very tight monetary squeeze on the British economy. It was made tighter by the impact of North Sea Oil on the balance of payments and the exchange rate. The development of North Sea Oil led to a significant strengthening of the UK’s traded goods sector. This drove an increase in the sterling exchange rate when for a period of about three or four years sterling took on some of the characteristics of so-called petro-currency. Very tight domestic monetary conditions amplified the effects of North Sea Oil. The combination of a strong and rising exchange rate and very tight domestic monetary conditions imposed a powerful and necessary disinflation on the British economy.

The monetary disinflation was much more severe than British ministers understood it to be - and it was necessary

Neither British ministers nor their official advisers at the Treasury or the Bank of England fully grasped what was going on. If Conservative ministers had really understood what was happening they would almost certainly have resiled from the policy. While the Government’s official advisers would not have been able to clarify the policy choice and carry through the disinflation. As Edmund Dell, a former Labour Treasury Minister in his book The Chancellors spelt out, inflation could only be properly reduced by giving disinflation absolute priority over all other macro-economic objectives such as economic activity, employment and low unemployment. This is not a criticism of the officials involved but a recognition that making the choice is inherently political. 

A disinflation that worked

The policy was a great success in terms of its ultimate purpose to reduce inflation and return Britain to an approximation of financial stability. From a peak of 21.8 per cent in June 1980 the Retail Prices Index fell to 10.9 per cent in July 1981, 6.3 per cent in November 1982 3.7 per cent in May 1983.As output recovered it settled at around 5 per cent in the mid-1980s.

This was a dramatic fall in the rate of inflation brought about by an exceptionally tight monetary squeeze and involved significant social and economic costs. The superficial glosses that monetarist economists sometimes made suggesting that a successful monetary disinflation could be brought about gradually with little significant social and economic cost were embraced was naive. The economic costs of the policy were inevitable and necessary. 

The unavoidable costs of disinflation and the necessary reckoning with delayed structure change 

Moreover in 1979 the costs of a successful disinflation In the UK were going to be greater than in other economies. This reflected the structural features of the economy. They included a labour market that was dysfunctional, exhibiting malign institutional features such as excessive trade union power. A combination of subsidies and a devaluing exchange rate had protected manufacturing businesses long after they had lost their commercial rationale. The combination of inflation and squeezed profitability arising from price controls and wage growth made company balance sheets vulnerable. De-industrialisation by 1975 had become an established economic process in the British economy. For close to a generation inevitable economic change had been put off. The anxieties about the future of employment and manufacturing industry can be seen in Maurice Scott’s book Can We Get Back to Full Employment and The National Instittute’s collection of conference papers De-Indistorialisation edited by Frank Blackaby. What happened after 1979 was unavoidable if inflation was to be reduced. Edmund Dell quotes Christopher Johnson in his book the Chancellors who argued that an excessive amount of capacity was lost in the 1980-81 recession. Sir Timothy takes the same view. Edmund Dell is unflinching and direct in his rebuttal of this. He wrote ‘much of the capacity lost in the early 1980s was soon for the scrap heap in any case. There is no evidence that a wiser Chancellor could have more sensitively modulated the severity of his action if he was serious in his attack on inflation. That such methods had to be employed to deal with inflation was a tragedy that had its roots long in the past.’

Micro-economic structural reform inevitably took time 

If the micro-economic measures that Mrs Thatcher’s administrations eventually enacted - trade union reform, reform of the law relating to the working of employment protection, the structure of unemployment benefit, properly applying the availability for work test through Restart, the addition of the actively seeking work test, and wider changes to the tax system to improve incentives to work and save as well as creating a more neutral fiscal system that was less biassed against saving and employment - these structural changes would improve the working of labour and product markets and reduce the costs of adjusting to changing circumstances and economic shocks. 

But they took time to carry out and work out. The Conservative Government’s first steps to reform trade union immunities were initially hesitant and tentative. The experts on industrial relations, such as Professor Hugh Clegg, whom Sir Timothy describes as a ‘courtly academic closely connected to the Labour Party and his colleagues in the Nuffield College Oxford industrial relations school’, dismissed them as unworkable and irrelevant. Privatiatisation took time to develop. A systematic attempt comprehensively to improve the working of labour market institutions through tax, benefits and an understanding of the role of wages and non wage costs in determining employment and unemployment did not take place until 1985. The change of gear in labour market policy was marked by the publication of the Treasury’s paper The Relationship between Employment and Wages: Empirical Evidence for the UK published in January1985.. 

Sir Timothy in his book draws attention to the 1984 Employment White Paper. This was inspired by the then recently appointed permanent secretary at the Department of Employment, Sir Michael Quinlan a charming classicist who had spent most of his time in ‘the public service’ working at the Ministry of Defence. Much of his career had involved thinking about the nature of nuclear deterrence. As a practising Catholic he also had explored notions of a just war. Michael Quinlan’s idea was to publish a White Paper to mark the fortieth anniversary of the 1944 Employment White Paper. It was a bit of a disaster, devoid of analytical rigour couched in the sort of rhetoric used by James Ramsay Macdonald when he spoke of an economic blizzard. The 1984 Employment White Paper made little or no contribution to structural reform of the labour market.

Conservative ministers had little practical help from the civil service in developing a theory and agenda of micro-economic structural reform

Sir Timothy notes that much of the micro-economic measures taken by Mrs Thatcher’s governments such as the ending of industrial subsidies and trade union reform were beneficial. Yet it took time to work out what needed to be done and how to do it. Moreover, neither the mainstream civil service machine nor the Government Economic Service had much to offer in terms of a coherent programme of measures of structural reform. The Treasury could just about help with discretionary cuts to public expenditure, the improvement in public expenditure control represented by ending the Plowden system of volume spending plans and cuts to the Public Sector Borrowing Requirement. Yet beyond these Treasury housekeeping policies its senior officials offered little to ministers in terms of new or radical ideas. For example Sir Timothy suggests that Mrs Thatcher made a mistake in agreeing to honour Clegg public sector pay comparability recommendations. This was a pledge made in the heat of the 1979 general election campaign. It represented an expensive public expenditure commitment that Treasury officials would happily advise against. A contemporary of Sir Timothy’s in the Government Economic Service at the time recalls that senior officials regarded Mrs Thatcher and her Treasury ministers as a sort of aberration that would pass. As they saw it their job was to avoid as little disturbance to the usual conduct of administration until she was gone.This reflected in the attitude of Sir Douglas Wass. He tried to carry out the new Chancellor Sir Geoffrey Howe’s policies yet his main interest was in persuading Sir Geoffrey to set up a Treasury working group on ‘competitiveness’ under Wass’s direction. Nigel Lawson, the then Financial Secretary to the Treasury, in his memoirs The View From No 11 described the resulting Treasury Paper as offering no policy advice and offered an analysis that implied open advocacy of devaluation. In short a return to the best practice of the post-war years.

The need for fresh thinking outside the Government Economic Service and Oxbridge - the London Business School

That is why macro-economic policy was swiftly dominated by the Financial Secretary Nigel Lawson and the newly appointed chief economist. Terry Burns was brought in from the London Business School. Terry Burns had developed a distinctive international monetarist macro-economic model for the British economy. Its distinctive feature was that it took account of the open character of the UK economy and the important role of the exchange rate in determining UK prices. Terry Burns and Nigel Lawson wrote the MTFS with its targets to lower growth in £M3, the PSBR, published in the 1980 Budget Redbook. In 1979 the political imperative was to act. Mrs Thatcher and her Treasury needed to disinflate the economy and have a plausible account to offer financial markets. 

The combination of monetary targets, very high nominal interest rates and the movement to rising positive real interest rates disinflated the economy and lowered inflation. Yet it swiftly involved a presentational problem for Sir Geoffrey Howe and Nigel Lawson. Yes there was tough medicine, yes inflation fell, but the chosen monetary aggregate rose sharply. Mrs Thatcher and her Treasury ministers had political and intellectual egg all over their faces. Yet the key thing was that the policy worked. Sir Timothy as so many other people involved in making and describing policy at this time gets lost in the weeds of detail. The big thing was there was successful disinflation. 

1981 Budget - putting up taxes and cutting public borrowing at the trough of the recession

Sir Timothy discusses the 1981 Budget. To reduce the structural budget deficit, and to reduce the PSBR that had risen in part because of the depth of the recession and the structural unemployment that had resulted from the shake out of employment in the manufacturing sector, fiscal policy was tightened in March 1981. On an indexed basis, the budget raised taxes by £4.5 billion, and over £5 billion when changes to employee national insurance changes were included These measures represented about 2 per cent of GDP.This was anathema to the Keynesian economic establishment in Whitehall and in academia. A former Labour adviser worked up a round robin letter signed by 364 economists and published in The Times. The gravemen of the letter was that there could be no recovery in output with such a fiscal policy. 

The letter was unfortunate for the economists that signed, because there was a recovery in output. Not only was there a recovery in output but it started in the second quarter of 1981. The economy then grew at an annual rate of around 3 per cent for eight years. Nigel Lawson in his memoirs noted that ‘their timing was exquisite. The economy embarked on a prolonged phase of vigorous growth,almost from the moment the letter was published. So far from launching the economy on a self-perpetuating downward spiral, the Budget left our economic critics bewildered and discredited’.The recovery started in the second quarter of 1981.

When Denis Healey chose to tighten fiscal policy as unemployment rose in 1975 it represented the first repudiation of Keynesian demand management since Sir Kingsley Wood’s budget in 1941.Yet it did not elicit a comparable response from academic economists. They seemed able to accommodate that episode of procyclical fiscal policy tightening.

This recovery was the result of two things. The first was a relaxation in domestic monetary conditions that started with interest rates being lowered. The second was a lower sterling exchange rate arising from the overshooting of sterling on the upside as a result of the effects of North Sea Oil starting to be unwound and a strengthening of the dollar at sterling’s expense. The strength of the dollar reflected market confidence in the new Reagan administration, the tightness of the monetary policy being run by the Federal Reserve under Paul Volker’s policy of ‘practical monetarism and the deficits that the Reagan administration started to run as a result of tax cuts, increased defence spending while at the same time as maintaining domestic spending. The New Republic dubbed this War Keynesianism’. There was a further factor stimulating demand and output in the British economy. This arose from powerful real balance effects. Unexpectedly lower inflation left economic agents with more real cash balances that were available to spend.

Thatcher and Reagan both radical Conservatives : Thatcher eliminated a deficit, Reagan created deficits

The 1981 Budget has acquired something of a mythic status Conservative ministers involved in economic policy. The fact the economy recovered from the early part of 1981, because of monetary loosening, did not mean that the tightening in fiscal policy and the cut to borrowing was necessary. There was a marked difference between the Reagan and Thatcher governments. In Britain deficits were progressively cut over the 1980s, and the Public Sector Borrowing Requirement was replaced by a Public Sector Debt Repayment. In contrast the US Treasury continued to run large deficits throughout the 1980s. In the US they fell a bit as the Reagan economic expansion got under way, but they were a permanent feature of the Federal Government’s fiscal landscape.

Towards the end of the 1980s two radical conservative market orientated governments were in place. They had successfully disinflated their economies in the early 1980s. They both enjoyed long and sustained periods of economic expansion. As the 1980s progressed there was a debate about whether above trend growth would lead to inflation and an unambiguously hard landing. In the columns of newspapers, such as The Financial Times and The Economist this commentary took on an element of schadenfreude. The American economy with all its federal government debt and continuing deficits at the peak of the economic cycle was considered to be riding for a fall. The US fiscal policy would be America’s Achilles Heel. In contrast the UK had eliminated its deficits and monetary policy was supported by a surplus.

In the end it was the UK that was riding for a fall and a hard landing with the RPI reaching 10 per cent in 1990 and interest rates returning to 15 per cent. This was because throughout the 1980s the Federal Reserve maintained suitable monetary conditions and a monetary policy that was more appropriate than the monetary policy run by Nigel Lawson, the British Chancellor of the Exchequer, between 1983 and 1989.

Nigel was clever enough to get himself out of monetarism?

Given the technical difficulties of operating formal targets for broad money in a context of technical innovation and a financial environment where a measure of the money supply was likely to include deposits that earned interest, Nigel Lawson backed away from formal monetary targets. As Harold Lever noted to me at the time ‘Nigel was clever enough to get himself into monetarism and he will be clever enough to get himself out of it’. In the 1985 Mansion House speech - at the traditional banquet hosted by the Lord Mayor of London for the merchants and bankers of the City of London where the Chancellor speaks on economic policy - Nigel Lawson abandoned monetary targets and memorably said that there would still have to be judgements made about monetary policy and that inflation would be judge and jury of those judgements. It was a wholly discretionary policy of demand management.

The Bundesbank and the Deutsche Mark 

Monetary policy became discretionary; there were no intermediate targets to guide policy. Interest rates were decided on evidence from economic data. There was, however, a sort of parallel exchange rate policy. Nigel Lawson preferred to have an anchor for monetary policy. He came to the view that linking sterling to the Deutsche Mark would offer a route to a reliable non-inflationary anchor. It would enable the UK to benefit from the admirable record of the Bundesbank in relation to inflation and price stability. The success of the Bundesabank was a hallmark of the success of the old West German Federal Republic. Nigel Lawson thought that the best way of doing this would be for sterling to join the Exchange Rate Mechanism of the European Monetary System that had been launched in April 1979.

Mrs Thatcher and Nigel Lawson did not agree on this. Denis Healey had considered the proposition in 1979. He was Chancellor at the time of the launch of the EMS. The more Healey looked at it, and examined how it would work in practice, the more sceptical he became. Nigel Lawson could not get Mrs Thatcher to agree to enter the ERM, so in his eyes he did the next best thing. He decided that sterling should shadow the Deutsche Mark as though it were part of the ERM. This episode of exchange rate targeting exposed an important property in exchange rate targeting regimes. This is the potential for an incompatibility between the necessary domestic monetary policy to maintain internal price stability and the interest rate and other policies, such as unsterilised intervention in the foreign exchange markets to either contract or expand the money supply of the currency involved. 

An exchange rate target as a device to import inflation - shadowing the Deutschmark 

By 1986 what became known as the Lawson Boom was in full swing: strong economic growth; a booming equity market; a booming commercial property market; rising house prices; strong bank lending; strong growth in broad money; and a deteriorating balance of payments. The strength of this expansionary phase of the economic cycle was reflected in tax receipts and a budget surplus that much vaunted PSDR. There were several occasions when sterling rose sharply against the Deutiche Mark and to meet his de facto exchange rate target against it Nigel Lawson loosened UK monetary conditions lowering interest rates in 1987 for example and using foreign exchange intervention to lower sterling against the mark. This was the classic case of an exchange rate target resulting in inappropriate domestic monetary conditions with decisions made to meet the external target. It was West Germany’s refusal to import inflation from the USA in the 1960s in similar circumstances that contributed to the breakdown of the Bretton Woods fixed parity regime against the dollar. Later in the early 1990s, when the inflationary consequences of the one for one German monetary union in 1990 became apparent, the Bundesbank tightened German monetary conditions in and in the process destroyed the functioning of the narrow bands of the ERM in 1993.

The Lawson Boom where inflation was to be judge and jury of the success of monetary conditions

The episode of shadowing the Deutschmark aggravated inflation in an economy that was overheating. Domestic monetary policy was too loose. All the economic signals were clearly pointing in that direction. Board money and bank lending were growing rapidly. The Treasury and the Bank of England produced ingenious intellectual explanations of reassurance. The first was that there was no evidence from price indexes that inflation was rising. Charles Goodhart, the monetary adviser to the Bank of England went to the Surrey University Monetary Conference and spoke. He made two interesting points. The first was that while the UK may be exhibiting ‘asset price inflation’ there were no signs of general inflation. The other was that while bank lending had expanded rapidly, the lending was matched by the private sector acquiring matching assets, with the result that the monetary effects both for banks and the wider economy netted off, and had no inflationary implications. The Governor of the Bank of England at the House of Commons Treasury select committee spoke of a ‘glacier of liquidity’ that was prevented from melting by interest rates. The question was how high should the interest rate be raised to prevent the melting.

The fact prices indices remained reassuring was an artefact of the leads and lags in monetary conditions and the fact that inflation is a lagging indicator. The asset price inflation - rising equity, property and house prices - with no apparent rise in overall inflation was the working of the transmission mechanism that takes place before a general inflation. White the netting-off of assets against liabilities, illustrates how balance sheet analysis can offer a misleading impression of the economic effects of financial transactions.

Mrs Thatcher repeatedly complained to Nigel Lawson about loose monetary conditions and growth in board money that was too fast. She did not like exchange rate targets and preferred sterling to float memorably saying that ‘you cannot buck the market’. While the Prime Minister riled against growth in broad money and bank lending, she herself was of course reluctant to agree to increases in interest rates to tighten monetary conditions.

In the period between 1984 and 1988 after the deep and costly recession of the early 1980s Conservative ministers exhibited some hubris. They had got inflation down and they now had a steadily growing economy and falling borrowing. With inflation around 5 per cent they were not minded to make further progress in lowering it, especially if that meant sacrificing economic growth.

Sir Timothy returned to the Treasury after a spell in Washington. He was then involved in an unfortunate episode where the Treasury and the Foreign Office attempted in 1989, at the Madrid European Summit, to get Mrs Thatcher to commit to allow sterling to enter the ERM. 

The ERM fiasco 1990 to 1992

When sterling went into the ERM choosing an appropriate exchange rate was important. A rate that was too low, but easy to sustain against the Deutsche Mark would result in domestic monetary conditions that would be too loose to lower inflation. It is, moreover, important to remember that in 1990 the UK had an inflation problem that was being managed by a tight domestic disinflation where interest rates were 15 per cent. Over the next two years the combination of high and rising real interest rates along with a fixed target against the Deutsche Mark that constrained the loosening of domestic monetary conditions reduced inflation and resulted in a long recession. At this stage of the economic cycle another artefact of an exchange rate target regime was exemplified. 

There can be a protracted clash between what is needed to stimulate the domestic economy with what is needed to meet the external target. In the summer of 1992 sterling started to weaken against the Deutsche Mark. That would have required a tightening in UK monetary conditions, yet the economy was in the trough of a long recession. Not only did the UK economy not need a further tightening in monetary policy, the overall trade weighted sterling index was rising and sterling was rising against the dollar. Sterling was only weakening against the Deutsche Mark. It would have been perverse in these circumstances to tighten policy. Yet that is what happened MLR - Minimum Lending Rate was raised to 15 per cent. Sterling left the ERM. The following morning on my screen at the Royal Bank of Scotland, I commented that Mrs Thatcher’s judgement had been vindicated in the face of that of her three Chancellors Sir Geoffey Howe, Nigel Lawson and John Major. The following summer in 1993 the whole of the ERM narrow band regime against the deutsche mark, not least the French ‘francfort’ policy, fell apart. While Sir Timothy supported sterling’s entry into the ERM he recognises ‘joining the ERM didn’t work out well’

The book concentrates on the early difficult years of Mrs Thatcher’s monetary policies. It does not explore these later issues other than in passing. The big issue that his book does not get into is an exploration of why, having reduced inflation to around 4 to 5 per cent, and having achieved a steadily expanding economy, how did it go wrong in the second half of the 1980s? Why did interest rates end up at 15 per cent?. Why did inflation peak at over 10 per cent in 1990? Sir Timothy’s book is liberal in commenting on later developments in policy, such as the collapse of the ERM, inflation targets, Rishi Sunak’s fiscal policy, Liz Truss’s short lived administration and the Bank of England’s monetary tightening in September 2022, yet it displays an unusual reticence in relation to what turned out to be a first class episode of monetary and macro-economic error between 1985 and 1990.

In a wide ranging book Sir Timothy appears reticent about exploring what went wrong between 1985 and 1990?

Sir Timothy suggests that the decision to cut taxes in the 1988 budget was central to the overheating economy and the rise in inflation in the late 1980s. When Joe Grice, Charles Goodhart and I were at the Surrey University Monetary Conference in the spring of 1987 the issues related to an overheating economy that resulted from excessive monetary stimulus, were very much alive then. The Lawson boom was well under way before the 1988 Budget’s tax cuts. The full year effect of all the tax changes in the 1988 Budget was £6.1 billion about 1.3 per cent of GDP. The overall impact of the cash cost of the tax cuts were modest in relation to the size of the economy. The overall fiscal stance was continuing to tighten. The Public Sector Debt Repayment turned out not just to be rising, but the numbers for the surplus turned out to three times greater than the figures set out in cash and as a ratio of GDP in the 1988 Budget Redbook. The PSDR for example turned out to rise from 0.8 per cent of GDP to 3 per cent of GDP between 1987-88 and 1988-89. 

In terms of an overstimulated economy and higher inflation the problem lay with monetary conditions. The effect of interest rates that were too low was the key driver of money GDP and inflation. Interest rates touched every economic decision that economic agents engaged in: consumption, saving and investment. As the Treasury Weekly Brief at this time argued, monetary conditions were supported by an ‘exceptionally tight fiscal stance’, as exemplified by rising Public Sector Debt Repayment. The candid truth is that interest rates were too low and indicators such as money abroad and bank lending were ignored. One of the few ministers at the top of the government who intuitively understood this was Margaret Thatcher, another was probably Nicholas Ridley.

Abolition of Foreign Exchange Controls in 1979

There are several observations in Sir Timothy’s book that have caught my attention and in one instance puzzle me. For me the puzzle is Sir Timothy’s comment on the abolition of foreign exchange controls in September 1979. This was widely welcomed in the City and an overdue change for example supported by Lord Lever, the former Labour Chancellor of the Duchy of Lancaster saying in the House of Lords that ‘In the end of this exchange control, which has served no useful purpose, and the abolition of which could be a considerable encouragement to a great trading, insurance and banking nation like our own.’ 

In 1979 one of the problems of the UK economy was the adjustment of the traded goods sector resulting from revenue from the export of North Sea Oil and its effect on the balance of payments and the exchange rate. The abolition of exchange controls enabled investors and holders of UK sterling based assets to adjust their portfolios and invest abroad. This had the potential to dampen the rise in the sterling exchange rate. Sir Timothy’s offers an interesting yet counter intuitive observation that the ‘abolition of controls increase the upward pressure on sterling which manufacturing industry could well have done without’ It is possible that a fully liberal capital account may have made investors more attracted to sterling, because they knew that if they changed their mind they could get their money out. Yet after forty years the portfolio adjustment effect might have been thought likely to possibly dampen the trade invoicing effect of the oil exports. 

I find Edmund Dell’s take on the matter more persuasive. As he recalled in his book The Chancellors. Dell had argued in the Labour Cabinet about the ‘need to relax or abolish exchange control as the oil came on stream. It would provide some offset to the upward pressure on the exchange rate that all might otherwise cause. It would ease outward investment and thereby enable UK companies to build up assets abroad . It would, at least in theory, compel investment in Britain to show a return comparable with that available abroad’.

Money Base Control 

One of the debates in monetary policy in the 1970s surrounded money base control. The normal framework for central bank operations to influence monetary conditions is changes in interest rates that are given effect by open market operations in the money market. In the US this is the Federal Reserve’s Open Market Committee’s decision on rates, that is then given effect by the Open Market Desk at the Federal Reserve Bank of New York. In the UK the Bank of England managed money market liquidity by setting the dealing rates at which it would lend to the market. The policy is a decision about interest rates, the cost of money and what price should be to either increase the demand for money or reduce it. It is a process that operates on the demand for money rather than on the supply of money.

Bundesbank - home of monetary targets and money base control

In the 1970s after the collapse of Bretton Woods all central banks were free to adopt whatever arrangements for monetary control that they wanted. As the Keynesian macro-economic policy paradigm collapsed the West German central bank the Bundesbank absorbed the intellectual critique, mounted by Milton Friedman and his colleagues, better than other central banks. The Bundesbank announced monetary targets to control inflation and performed in difficult circumstances, relatively better than other central banks, such as their counterparts in France, the UK and US.. As well as monetary targets the Bundesabnk used minimum reserve requirements not just as a tool of prudential control but as an instrument to control the supply of money to the banking system.

Milton Friedman and many monetarist economists were attracted to monetary base control as a means of directly working on the supply of money. By 1979 the US had a serious inflation problem and Paul Volker was appointed to sort it out. In October 1979, Paul Volker not only announced monetary targets but a wholly new monetary operating procedure. He introduced a version of money base control. The Federal Reserve ceased to set a formal interest rate but instead targeted the supply of non-borrowed reserves to the banking system through the Federal Funds Market. He called this ‘practical monetarism’ This led to high and volatile interest rates and the desired monetary squeeze. 

Inflation fell yet the M1 target was not met, because of developments such as checking accounts starting to pay interest.. As Milton Friedman’s biographer Jennnifer Burns commented, by the late 1970s, the structure of the US economy that he, and his collaborator Anna Schwartz, had studied began to change in its structure and interest on your checking account was one of the changes. Paul Volcker’s policy worked. There was a deflationary shock and fall in inflation. This was then followed by a long period of sustained economic expansion. Once the deflation was accomplished in the summer of 1982, Paul Volcker reverted to setting a target for the Fed Funds rate achieved through the previously conventional open market operations of the New York Federal Reserve.

While Sir Timothy writes warmly of Paul Volcker and explores the setting of targets for M1 and the difficulties of meeting the target, yet still seeing inflation fall, he does not explore the Federal Reserve's changed operating procedures announced in October 1979. It would have been interesting to learn how the success of the US deflation and the interesting change in the Fed’s operating procedures were perceived by UK policy makers in their assessment of the issues involved in money base control. The UK’s 1980 Green Paper on Monetary Control can be best described as a study in muddled ambiguity that yields little benefit to a reader trying to obtain a purchase on the salient issues involved.

Money Base Control would have meant the demise of the Discount Market

One dimension of the discussion on money base control that Sir Timothy draws attention to, was the Bank of England’s concern that it would involve in abandoning the Discount Market, as its instrument for domestic open market operations in sterling money markets, as the means of setting interest rates. This may well explain what Nigel Lawson refers to, in his memoirs, as ‘the Bank’s abhorrence’ of money base control, which Nigel Lawson did not share. Neither did he see it as an alternative way of getting inflation down that did not involve high interest rates. 

It is worth exploring the British central bank's attachment to the Discount Market,because it illustrates how ministers were poorly served by its advice and institutional attitudes. In the case of the Discount Market the Bank’s institutional reflexes did significant damage to the conduct of monetary policy in difficult and sensitive circumstances in 1992..The Bank of England was wedded to using the Discount Market for reasons buried deep in its institutional history. In the 19th century the Bank of England began to take on the functions of being a central bank, such as that of being a lender of last resort to stabilise the money market. This story is vividly told in Walter Bagehot’s famous book Lombard Street: A Description of the Money Market published in 1873.The Bank of England was, however, a private profit making bank with shareholders to satisfy. It did not like giving money to its commercial competitors. So it preferred to supply liquidity to the money market through the City’s specialist bill brokers, the Discount Houses. The London Discount Market acted as an intermediary between the Bank and the commercial joint stock banks. When the Bank of England was nationalised in 1945, it had no shareholders and was a public body. Yet still it preferred to carry out open market operations through the Discount Market. This was despite the fact that it was a redundant operating procedure and an expensive one. Harold Lever as a young Labour MP explained to a House of Commons Select Committee in 1949 that the Discount Houses only have a function, in the sense that the Life Guards protect the King, and that the Discount Houses were much less aesthetically pleasing, and many times more expensive than the Life Guards.

Growing Practical Problems with operating through the Discount Houses 

By the late 1980s the Discount Market was becoming a progressively less convenient institutional arrangement for the London money market. The Bank of England from one day to another mediated its operations through the discount houses instead of dealing directly with the banks. This often meant that guidance and messages about technical operations were often blunted - passed from the central bank to the discount broker and then on to the real money market - the banks. Both the central bank’s operating procedures and the working conventions of the money market were opaque and rooted in folk memory that was difficult for even for money market technicians to get a purchase on or to follow its working with confidence. As more American, European and Japanese banks opened in London this opacity became an increasing problem. What was more, there was only a limited range of money market instruments used as collateral for the Bank of England’s open market operations and the balance sheets of the discount houses were not large enough to expand to the increasing liquidity needs of the money market. The shortage of collateral sometimes meant that the central bank could not ‘relieve’ shortages of cash in the money market. This resulted in periodic higher overnight money market rates, often to be followed by lower overnight rates. Money market interest rates were regularly becoming detached from the central bank’s policy rate. Large commercial banks with big balance sheets in relation to the collateral available in the discount market, knew how to play the system. They were able to corner the market in bills and prevent the central bank from relieving the shortage, positioning their own trading books to take advantage of it. Smaller players such as new banks, foreign banks and the Scottish clearing banks found themselves at a disadvantage in this institutional arrangement.

Failing Discount Market made managing sterling in the ERM more difficult in the summer of 1992

In the summer of 1992 these issues came to a head in the Discount Market. One Friday the Bank of England could not relieve the money market shortage. To tempt holders of bills to part with their paper, the Bank cut its dealing rates in band three bills. The foreign exchange market interpreted this to mean that the central bank was testing the water to see whether there was any selling of sterling in response to this before policy interest rates, bank base rate was cut. There was a recession, the domestic economy needed stimulating, but the ERM exchange rate target against the Deutsche Mark made lowering interest rates difficult. The foreign exchange market was hyper vigilant in watching for any weakening in the commitment of the monetary authorities to maintaining sterling within the agreed trading bands against the Deutsche Mark.

 In fact the Bank was carrying out a technical manavore to try to get the money market to work. Foreign exchange traders did not believe the convoluted technical explanation given by their colleagues on sterling money market desks. Sterling started its slide that carried on throughout the summer until John Major’s government abandoned ERM in September.

The Bank of England’s historic insistence on using the Discount Market and refusal to accept growing evidence of its defects played a direct part in making the managing of an exchange rate target more difficult. This episode offers a serious indictment of the Bank of England as an official UK monetary institution. It made it more difficult to carry out an exchange rate policy that was central to the Government’s economic policy at that time. If perhaps the discussion over money base control had involved a proper interrogation of the merits of the Discount Market, the Bank’s operating procedures would have been changed and modernised removing one set of headaches from exchange rate policy in the summer of 1992.

The dust jacket of SIr Timothy’s book describes him as an ‘impartial Treasury official’. Having carefully read his book it would appear to me to be the work of a candid figure who is tendentiously parti pris. He is an economist rooted in the Keynesian supervisions given to him by Joan Robinson in Cambridge and the lectures he attended delivered by James Tobin in Yale in the 1960s. When Mrs Thatcher told him to read up on the American economist Arthur Laffer, Sir Timothy was dismissive. He writes that Laffer ‘had the dubious reputation of being Ronald Reagan's favourite economist. His famous Laffer Curve purported to demonstrate how raising the tax rate, when tax rates were already high, would reduce rather than increase government revenue. Whether this was of any relevance to the UK, except quite possibly in respect of the highest income tax band which had a top rate of 83 per cent was questionable to say the least.’ 

Given that the top marginal tax rate in the UK in May 1979 was 83 per cent and 98 per cent when the investment income surcharge was applied to income from savings and investment, I would have thought that interrogating what Laffer had to say was pertinent. Moreover, the powerful illustrative device that Laffer apparently drew on a restaurant napkin, would be interesting to look at, if only to see how a complex point could be explained to a politician. Of course Arthur Laffer was not just President Reagan’s favourite economist he had also served as a senior economist in the Nixon and Ford administrations in the 1970’s. Why Sir Timothy would choose to be so dismissive of Ronald Reagan is odd - a very successful US President, a successful Governor of California and an outstanding economic communicator both as an early television journalist in the 1950s and as a President broadcasting from the Oval Office. One might think that we could all learn something by being curious about things and examining them in their own terms rather than dismissing them.

Conclusion

Sir Timothy’s book is interesting as a contribution to the genre of ‘insider bureaucrat says his piece’, form of history. He provides us with a cogent reminder of the perspective of the British establishment on Mrs Thatcher’s radical Conservative Government. His vignettes of meetings and the encomia he offers to the careers of officials, such as Sir Douglas Wass, illustrate why things had to change. In many respects the intellectual instincts and intuitions of civil servants like Sir Timothy were the problem that needed to be changed.

He has chosen to focus on the period between 1979 and 1981. This was when Mrs Thatcher faced her greatest difficulty. She inherited a collapse of industrial relations order. Trade unions, through the immunity given to people organising strike action under the 1906 Trade Disputes Act, as extended by the Trade Union and Labour Relations Act 1976, were exempt from the normal law of tort. The previous Labour Government had reflated the economy in 1978. The second increase in international oil prices posed an immediate inflationary risk. Sir Timothy appears to think that the appropriate response of British macro-economic policy and monetary policy should have been to accommodate this in 1979. To repeat what the Treasury did in practice in 1974, against the Labour Chancellor Denis Healey’s better judgement. The combination of wage and price controls had repressed prices, and the collapse of the wage policy was bound to see this price repression being unwound.

To return to an approximation of tolerable levels of inflation required a decisive and unyielding monetary disinflation. One way or another this would involve high nominal and rising real interest rates. It would involve short term losses of output and employment. Sir Timothy believes that the Government should have given less priority to inflation and more priority to unemployment. Yet the experience of the 1960s and 1970s was that policy makers could not frame macro-economic demand management to trade a given level of unemployment, for a chosen level of inflation. 

Sir Timothy’s book does not explore how British post-war policy got to the position in 1979. The candid judgement has to be that the loss of control of inflation in the 1970s arose from the policy instincts and the Keyensian intellectual prejudices of economists and Treasury officials, like Sir Timothy. Inflation in 1979 could only be successfully reduced by giving disinflation unflinching priority within macro-economic management, even if that resulted in rising unemployment. If Mrs Thatcher's ministers had been guided by Sir Timothy and Sir Douglas Wass, the Treasury’s Permanent Secretary, the Government would have failed to control inflation.

Sir Timothy skates lightly over the period between 1983 and 1989 when Nigel Lawson was Chancellor, commending him for getting out of monetarism. Given the institutional challenges of having targets for the £M3, the monetary indicator that appeared to have the best correlation with nominal GDP and prices in the UK, that made the operation of formal monetary targets difficult. Nigel Lawson honourably tried to identify a reliable monetary anchor that would be an improvement on discretion. He looked at other monetary indicators and the scope of using an exchange rate target tied to a currency with formal monetary targets and a stable demand for money function, the Deutsche Mark. Yet in practice he operated - especially after the 1985 Mansion House Speech - a discretionary demand management policy. This judgement ignored and downplayed awkward and bad news such as : strong broad money growth; strong growth in bank lending; strong growth in asset prices - equities, commercial property and housing; and a deteriorating balance of payments deficit. This resulted in an unsustainable boom where output grew above its trend rate of growth and inflation returned to 10 per cent. 

In his memoirs Nigel Lawson accepts the blame for misreading the economy. He understandably also invites credit for taking the measures needed to correct his error: a tight domestic monetary deflation with interest rates raised to 15 per cent in 1989. This resulted in a protracted recession, losses of employment and higher unemployment. If Nigel Lawson and his successors John Major and Norman Lamont had flinched from the necessary measures and social and economic costs that accompanied them, the UK’s acute inflation problem would not have been remedied.

In many respects Sir Timothy’s book reads as the exploration of the candid recollections of a man whose framework of thinking is stuck in the late 1960s. This is in itself a useful contribution to the history of the period. Having these intellectual and policy prejudices spelt out with clarity and guileless elan, serves a purpose, in terms of helping us to understand what had gone wrong before 1979 and why there had to be such a radical departure in policy. Lord Annan in 1990 published a book Our Age: Portrait of a Generation. It explored why his generation of distinguished urbane public intellectuals, academics and civil servants presided over a collapse of British power and prosperity after 1945. Noel Annan was every bit as much a quintessential member of the British establishment as Sir Timothy. At various times, Provost of King's College, Cambridge and University College London, Vice-Chancellor of London University and Chairman of the Royal Commission on Broadcasting, the Annan Committee reported in 1977. Yet Noel Annan was able to step out of his comfort zone of intellectual prejudice to pick apart the failings of his generation, in a manner that Sir Timothy appears unable to do.

Warwick Lightfoot

27 October 20124

Warwick Lightfoot is an economist and was Special Adviser to the Chancellor of the Exchequer between 1989 and 1992, he worked for Nigel Lawson, John Major and Norman Lamont.