EC-111 British EconomyRecent UK Macroeconomic

TrendsDr Catherine Robinson

F35, Richard Price BuildingOffice Hours: Mondays 10:30-11:30 and Thursdays 9.30-10.30

Appointments: c.robinson@swansea.ac.uk

IntroductionAim of today

To consider what happened to macro policy in the 1980s and 1990sThe “Great Moderation”

The Thatcher administrationWhat was its impact on macro policyand the wider economic impact?

What caused Thatcher’s departure?The role of Europe

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But first…Who listened to the budget yesterday??

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The political landscapeGovernment Prime Minister(s)

Conservative (70-74) Heath

Labour (74-79) Wilson, Callaghan

Conservative (79-97) Thatcher, Major

Labour (97-2010) Blair, Brown

Conservative-Liberal coalition (2010-)

Cameron

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Chancellors since 1979Geoffrey Howe (1979-1983)

Nigel Lawson (83-89)

John Major (89-90)

Norman Lamont (90-93)

Kenneth Clarke (93-97)

Gordon Brown (97- 2007)

Alistair Darling (2007-2010)

George Osborne (2010 - )

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The main players

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The Economic legacy of 1979The 1970s were a period of economic turbulence

unprecedented since the 1930s.

Persistent US trade deficit (caused partly by spending on the Vietnam War) led to the breakdown of the Bretton Woods fixed exchange rate system between 1971 and 1973.

The ‘oil price shocks’ of 1973-4 (triggered by the Arab-Israeli War)

and again in 1979-80 (triggered by the Iranian revolution) helped create inflation and recession simultaneously.

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The Economic legacy of 1979Labour market conditions

workers’ increasing aspirations, and a chaotic Trade Union structure contributed to industrial unrest and inflationary pressures.

IMF loan (Autumn 1976) Labour government committed to deflationary macroeconomic

policies.

By 1979, some success had been achieved in reducing inflation, and re-kindling economic growth.

But unemployment remained high.

The ‘Winter of Discontent’ (1978-9) paved the way for Tory success under Margaret Thatcher in the May 1979 General Election.

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Key macroeconomic policiesTwo main ‘themes’ influenced the subsequent (post-1979)

development of macroeconomic policy:Much more prominent role for monetary policy.A shift of emphasis in the 1980s away from monetary policy

towards exchange rate policy

These were fundamental changesFiscal policy was out of fashionAny attempt at stimulus was achieved through supply side

policies

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Monetary policyMonetary policy had been used passively

To keep interest rates steady to create a stable climate for investment

After 1976, monetary policy became the main macro policy instrument in pursuit of inflationary controlFiscal policy played a subservient role

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Monetarist policiesPretty simple - the equation of exchange

MV=PTWhere M=money supply, V=velocity of circulation, P=prices and

T=transactionsIf V and T are fixed (or known) ΔM=ΔP

Output and employment are determined by microeconomic factors that affect aggregate supply

In the long run they may change, but in the short to medium term, they have a ‘natural’ level

Controlling the money supply is the key to controlling inflation Controlling inflation would change wage and price expectations and

therefore reduce unemployment

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Traditional monetarismExpected to cause recession in the short-term

Workers would continue to push for inflationary pay increases, and ‘price themselves out of jobs’. These are movements along a downward sloping short run Phillips curve.

But in the long-term, as people’s inflationary expectations adjusted downwards, pay claims would moderate and market forces would push the economy back to its ‘natural’ levels of output and employment there shouldn’t be any significant long-term damage.

The long run Phillips curve is vertical.

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Monetary Policy and Fiscal Policya relationship exists between the budget deficit

and the money supply. If the government cannot borrow enough money to

meet the deficit it has to increase the money supply.

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Types of MoneyOnly 2 figures are published:

M0 – narrow money; wide monetary baseCash outside the Bank of England, PLUS banks operational deposits within the Bank of EnglandNo longer published

M4Cash outside banksPLUS private sector retail bank and building society deposits PLUS private sector wholesale bank and building society

deposits

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The Monetarist phase: 1979-1985The new Government announced a Medium Term

Financial Strategy to eradicate inflation

MTFS-1 (1979-1981)Targets set for M4 as a reliable indicator of spendingBut, controlling M4 meant that interest rates had to be set at

17%And even this didn’t work

The 1980s were characterised by high interest rates

At the same time, a global recession had set inManufacturing output fell by 19.6 % in 2 yearsManufacturing employment fell by 23%

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Rational Expectations A more optimistic view arose from the “rational expectations”

school of monetarists (notably, in the UK, Patrick Minford).

They argued that expectations were forward looking.

there was a unique natural rate of unemployment and hence that inflation was determined by money supply growth would form their expectations on the basis of what was believed to be future government policy.

Provided that the government could persuade people it meant what it said about monetary targets, therefore expectations of future inflation could come down without having to increase unemployment.

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What happened?The exchange rate also rose dramatically, partly due

to North Sea Oil

Double squeeze on manufacturing due to high borrowing costs and a loss of competitiveness in export markets

in 1978 unit labour costs in manufacturing measured in dollars rose by 26.4%, in 1979 by 30.5% and in 1980 by 34.1%, well above the increases in the UK’s major trading partners.

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Exchange Rate movements

Sterling effective exchange rate 1975-2005, monthly average

0

20

40

60

80

100

120

140

160

Jan-7

5

Jan-7

7

Jan-7

9

Jan-8

1

Jan-8

3

Jan-8

5

Jan-8

7

Jan-8

9

Jan-9

1

Jan-9

3

Jan-9

5

Jan-9

7

Jan-9

9

Jan-0

1

Jan-0

3

Jan-0

5

month

exch

ang

e ra

te in

dex

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What happened?Unemployment rose sharply, and the economy fell into

the (global) recession

Growth in M4 failed to stay within targets Individuals shifted their money between accounts

and whilst the overall supply of money showed little signs of changing, actual spending was falling

The monetarist experiment failed as other policies had, because of conflicting objectivesThe high interest rates decreased industrial investment which

led to a fall in UK exports

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Money SupplyGrowth of M4

-5

0

5

10

15

20

25

30

Jun

-63

Jun

-65

Jun

-67

Jun

-69

Jun

-71

Jun

-73

Jun

-75

Jun

-77

Jun

-79

Jun

-81

Jun

-83

Jun

-85

Jun

-87

Jun

-89

Jun

-91

Jun

-93

Jun

-95

Jun

-97

Jun

-99

Jun

-01

Jun

-03

Jun

-05

date

grw

th r

ate

per

cen

t

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MTFS 2 Successive conservative governments, led by Thatcher and then Major,

persisted with the MTFS but by the second phase, abandoned the attempt to control a single definition of the money supply

The doubling of unemployment in the 1979-1982 weakened the governments resolve to control inflation

Interest rates fell at the beginning of MTFS2

Lawson cut taxes from 1983 onwards (stimulating AD)

Expenditure and earnings rose faster than inflation In part funded through a credit boom…

By 1984, zero inflation was perceived as unattainable, 5% becoming an accepted target

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MTFS 3Exchange rate crisis of 1985Loss of confidence in sterling (faced with a strong

dollar, rising inflation and continued unemployment)Exchange rate need to be ‘pegged’ to a strong currency

– the DMA global phenomenon – the Plaza Accord (1985) and

the Louvre Accord (1987) saw major trading nations coordinating their economic policies to achieve stability

PRIMARY FOCUS NOW THE EXCHANGE RATE

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MTFS 4A resurgence in inflation towards the end of phase 3 meant government had to deal with the contractionary phase, 1988-1992Caused by

low interest ratesFinancial liberalisationMortgage leak

Interest rates rose sharplyAffected consumer spending and house prices

dramaticallyNecessary for ERM entry in October 1990

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The ERMThe 1980s shift of emphasis away from monetary

policy towards exchange rate policy, led up to Britain’s 1990 entry into the EU’s Exchange Rate Mechanism (ERM)To keep import costs low Thus easing inflationary pressure

An attempt to go back to a fixed exchange rate system like the failed Bretton Woods system

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Entry to the ERMthe UK entered the EU’s Exchange Rate

Mechanism, committing the UK to an exchange rate within a 6% margin on either side of £1=DM2.95.

Exchange rate management was now the centrepiece of macroeconomic policy

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Inflation and unemployment again

inflation and unemployment 1981-1993

0

2

4

6

8

10

12

14

0.0% 2.0% 4.0% 6.0% 8.0% 10.0% 12.0%

unemployment

infl

atio

n

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Lessons from the Monetarist experiment

Tight monetary policy (1979-81) did not achieve control over the money supply, due to:distress borrowing by ailing firmsfinancial deregulationerratic behaviour of M3 target

But the Monetarist squeeze did achieve a permanent dampening of the inflationary psychology of the 1970s the cost was the most severe recession since the

1930s with a particularly damaging effect on UK

manufacturingWeek 3:1 27

Post Monetarist policyUnder ‘pure’ Monetarism, the exchange rate was

irrelevant for the conduct of macro policy, all that mattered were money supply targets.

After 1985 this view was untenable; Monetarism was ‘dead’

Alternative ideas about the control of inflation centred on the role of the exchange rate

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