Inside a Macroeconomic Policy Blunder

By Simon Wren-Lewis, May 28, 2024

Simon Wren-Lewis is Emeritus Professor of Economics and Fellow of Merton College, University of Oxford.

Already bored with the election? Here is a bit of economic history instead.

To many readers of this blog, 1979-83 will seem like ancient history. To some of us, it was part of our formative history as adults. I joined the Treasury as an economist in 1974, straight after finishing my undergraduate degree. At the time a career in public service rather than academia via a PhD seemed much more interesting and useful. In 1979 the Treasury generously sent me to do a masters degree, on the condition that I worked at least another two years at HMT. While I was doing the masters Mrs Thatcher was elected Prime Minister, and the Treasury I came back to was a rather different place to the one I had left. [1]

Tim Lankester became a Treasury civil servant just one year earlier than me, after working for the World Bank. His talents obviously shone, and he became private secretary to Jim Callaghan in 1978, and then private secretary for economic affairs to Mrs Thatcher in 1979. He therefore had a particularly interesting vantage point in which to view the brief but highly significant UK monetarist experiment. He went on to have a very distinguished career as a civil servant (becoming permanent secretary at the Overseas Development Administration) and then in education. This helps explain why it took a pandemic and associated lockdowns for him to get around to writing about those events some fifty years earlier.

Being a civil servant Lankester was no true believer in either Thatcher or monetarism in 1979. Partly as a result his book, which relies on a lot of very good research as well as personal memories, is a pretty objective account of the monetarist period, as well as covering what came before and ending almost at the present day. It is also very well written and easily accessible to non-economists.

The book starts by setting the scene in the summer 1981 with a cabinet meeting. Unemployment has soared, firms are going bankrupt, inflation is still high and money targets are being missed by miles. Minister after minister asks Thatcher to change her economic course, and she is only saved by Deputy PM William Whitelaw, who tells her restless cabinet to give the policy more time. In reality it was near the end of what Lankester calls ‘hard monetarism’.

The book also begins on a more personal level with a London dinner party around the same time, where Lankester is sitting next to Ben Bradlee, editor of the Washington Post and famous for helping uncover Watergate. After giving a standard defence of Conservative policy to a sceptical Bradlee, a journalist opposite tells Bradlee very loudly that Lankester is Thatcher’s Albert Speer. During a stunned silence Bradlee whispers to Lankester “You either hit him or you have to leave”, and he leaves. As Lankester walks home he wonders to what extent he is complicit in Thatcher’s economic policies. He thinks of Henry Neuberger (a good friend of mine) who left HMT to become an advisor to Labour leader Michael Foot. I think it was Henry who wrote that monetarism was like trying to control how much people ate by regulating the supply of crockery. I too got out exactly when my two years was up to work at the then fiercely anti-monetarist National Institute. Not only did I think monetarism was foolish and dangerous at the time, but I was also beginning to see the value in good academic research. [2]

Of course the monetarist policy failure had nothing to do with civil servants like Lankester and everything to do with Mrs Thatcher and her Treasury ministers. What I personally found most interesting from Lankester’s account, perhaps because I experienced monetarism from a Treasury viewpoint, was how much Thatcher herself was a dedicated monetarist. It is quite fair to describe this episode as Thatcher’s monetarist experiment.

Part of the reason Thatcher adopted monetarism, which was a distinctly minority view among UK academics, was the failure of what went before: politicians trying to override the Phillips curve by using Incomes Policy. Lankester recounts a meeting between Callaghan and union leaders months before he lost the election, when one union leader banged his fist on the table and said “It’s your job, Jim, to get inflation down to 2%; it’s my job to get 18% for my members”.

When Thatcher defeated Heath to become Tory leader, she set up the Economic Research Group (the first ERG!?) chaired by Howe. Although politicians sympathetic to monetarism (including Lawson) were in a majority, it didn’t help that those opposed advocated Incomes Policy instead. But Lankester argues that “monetarism came naturally to” Thatcher. The link between the money supply and prices seemed obvious to her. Although she liked Freidman’s account of monetarism as a ‘scientific doctrine’ akin to the law of gravity, he suggests she was a monetarist by conviction. Lawson called it ‘primitivist’ monetarism. For Thatcher monetarism just had to be true. [3]

Lankester and Thatcher’s views on both economics and society more generally were quite different, but despite this they got on very well, I suspect in part because Lankester was very good at knowing the limits of his private secretary role. Thatcher made it clear that the only advice she wanted from him was on points of interpretation and detail. Lankester admired many of her personal qualities (e.g. her self-belief, her drive and her personal integrity) as well as some of her policy achievements, but he describes monetarism as her biggest mistake. One of the downsides of self-belief is that you can imagine that in areas where you have little knowledge your beliefs are superior to the beliefs of the majority of experts

The mistaken basic concepts of monetarism (the stock of money was a very poor indicator of policy stance, and controlling an intermediate target was inferior to controlling the policy objective) were compounded by tactical errors by ministers. Chancellor Howe decided on a 7-11% target range for the money supply, essentially because it was felt it had to be lower than the 8-12% adopted by the Labour government, even though for Labour these targets were largely cosmetic. Yet wage pressure had increased, oil prices were increasing, and the new government doubled VAT, which meant that this target range was far too tight. Lankester suggests that only Lawson understood this. Indeed he suggests Thatcher didn’t understand the implications of such a tight target for interest rates, which she hated to see going higher.

Interest rates went higher and higher, yet money growth still exceeded its target. As an anti-inflation policy it was a cold turkey strategy, not by design but because the monetary target was sending completely the wrong signals.

The famous 1981 budget was the last major act in the brief monetarist story, and Lankester rightly describes its tax rises as a mistake because they reduced the strength of the subsequent recovery. [4] The 1982 budget raised the targets for monetary growth, as well as introducing additional targets for different definitions of the money supply. When Lawson became Chancellor, he in practice focused more on having an exchange rate target, which he had argued for in the ERG as preferable to money targets. That eventually led to a second major macroeconomic blunder, but that is a different story (although it is covered in this book).

The consequences of the brief monetarist experiment for the real economy are well known. Lankester recounts that his wife’s family-run textile firm was forced into liquidation in late 1980. The combination of high interest rates, and the impact of these together with North Sea Oil on the exchange rate, crippled the traded goods sector. Unemployment rose rapidly and didn’t come down when inflation eventually fell. He argues, correctly in my view, that a more gradualist policy of reducing inflation would have been far more preferable, because it would have avoided such a large and long lasting increase in unemployment, albeit with a more gradual reduction in inflation. In addition my own view is that deflation early on using fiscal rather than monetary policy would have avoided such a big hit to the traded sector.

One mistake some opponents of Thatcherism often make is that high unemployment was all part of the plan, and in particular a means to reduce union power. In fact few of those advocating monetarism before it happened believed it would have such devastating effects. Lankester writes that “Thatcher was undoubtedly surprised and upset by the rise in unemployment in the early 1980s”. Interestingly he also thinks that if she had been told about those costs in advance, she would have gone ahead with the policy anyway because she wouldn’t have believed the predictions, because she had this primitivist belief in monetarism and because she would not have been content with a more gradual fall in inflation. She really did believe there was no alternative.

Thatcher’s monetarist experiment was a macroeconomic policy blunder of the highest order, because it ruined so many people’s lives and because there was a better alternative. For those looking for a detailed and objective account of this blunder, then this is an excellent book. It was probably not the first time a Prime Minister or Chancellor had pursued an economic policy that was opposed by most academic experts and which had ruinous macroeconomic consequences, and unfortunately it would not be the last. Over the last fourteen years we have had two more (austerity and Brexit).

Yet the recent example that reminds me most of Thatcher’s monetarism is Truss’s fiscal event, which involved a Prime Minister’s primitivist belief (for Truss that tax cuts had to be good and might pay for themselves), a small band of economists with unconventional and radical ideas not backed by evidence, a disdain for conventional academic views or civil service advisors and a policy that dramatically increased interest rates. Fortunately for us that fiscal event was quickly reversed and its champion deposed, so it did not create the lasting scars that Thatcher’s monetarism did.

Footnotes

[1] To give one example, my first job in HMT included writing briefs for the Chancellor, Dennis Healey, on other major economies for the international meetings he attended. Healey wanted to know about macro policy in each country, as well as how it was working. With a change in government, where Howe replaced Healey as Chancellor, those briefs now contained personal details about each finance minister, their interests and hobbies etc, and included much less macroeconomics.

[2] To take just one example, the incoming Conservative government chose M3 as their money supply target in part because there seemed to be a close correlation between it and prices two years later. HMT agreed to publish a paper looking at this relationship, written not by HMT but by a named Treasury economist, which turned out to be me under the supervision of Chief Economist Terry Burns. The relationship fell apart the moment it was econometrically interrogated.

[3] For primitivist monetarists, facts and research have little impact on their beliefs. When the Treasury published my research on money to price regressions (see footnote [2]), although there was no attempt to censor what I wrote as the named author of a Treasury Working Paper, I had to focus on the results rather than my interpretation of them. Any objective reading would have quickly understood that my work undermined government policy. Yet a day after publication Tim Congdon, a well known monetarist, wrote a piece in the Times that suggested the opposite.

I was furious at this, and asked to write a letter in response correcting his misinterpretation. HMT said no. But Henry Neuberger, who as I noted earlier was now working for Michael Foot, came to my rescue and wrote a very similar letter to the one I wanted to write. To his credit, Terry Burns also arranged a lunch between him, Congdon and me, where I not only told Congdon why he was wrong but where Terry backed me up. The results were eventually published in an academic journal here.

[4] My own personal story as a Treasury economist in charge of looking at the economic effects of the budget is described here. The story illustrates that most Treasury economists, like the famous 364 academics who wrote the famous letter, thought it was a bad budget.