Our success in bringing down inflation in our first term from a rate of 10 per cent (and rising) to under 4 per cent (and falling) had been achieved by controlling the money supply. ‘Monetarism’ – or the belief that inflation is a monetary phenomenon, i.e., ‘too much money chasing too few goods’ – had been buttressed by a fiscal policy which reduced government borrowing, freeing resources for private investment and getting the interest rate down. This combined approach had been expressed through the Medium Term Financial Strategy – in large measure Nigel Lawson’s brainchild. Its implementation depended heavily on monitoring the monetary indicators. These, as I have noted, were often distorted, confusing and volatile. So, before the end of Geoffrey Howe’s Chancellorship, the value of the pound against other currencies – the exchange rate – was also being taken into account.
It is important to understand what the relationship between the exchange rate and the money supply is – and what it is not. First consider the effect of an increase in the exchange rate; that is, one pound sterling is worth more in foreign currency. Because most import and export prices are fixed in foreign currencies, the sterling prices of these tradeable goods will fall. But this only applies to goods and services which are readily imported and exported, like oil or textiles. Many of the goods and services that comprise our national income are not of this sort: for example, we cannot export our houses or the services provided in our restaurants. The prices of these things are not directly affected by the exchange rate, and the indirect effect – passed on via wages – will be limited. What does more or less determine the prices of houses and other ‘non-tradeables’, however, is the money supply.
If the money supply rises too fast, the prices of non-tradeable domestic goods will rise accordingly, and a strong pound will not prevent that. But the interaction of a strong pound and a loose money supply causes the export sector to be depressed, resources to flow to houses, restaurants and the like. The balance of trade will then go into larger and larger deficits, which have to be financed by borrowing from foreigners. This kind of distortion just cannot last. Either the exchange rate has to come down, or monetary growth has to be curtailed, or both.
This result is of the utmost importance. Either one chooses to hold an exchange rate to a particular level, whatever monetary policy is needed to maintain that rate. Or one sets a monetary target, allowing the exchange rate to be determined by market forces. It is, therefore, quite impossible to control both the exchange rate and monetary policy.
A free exchange rate, however, is fundamentally influenced by monetary policy. The reason is simple. If a lot more pounds are put into circulation, then the value of the pound will tend to fall – just as a glut of strawberries will cause their value to go down. So a falling pound may indicate that monetary policy has been too loose.
But it may not. There are many factors other than the money supply which have a great influence on a free exchange rate. The most important of these are international capital flows. If a country reforms its tax, regulatory and trade union arrangements so that its after-tax rate of return on capital rises well above that of other countries, then there will be a net inflow of capital and its currency will be in considerable demand. Under a free exchange rate, it would appreciate. But this would not be a sign of monetary stringency: indeed, as in Britain in 1987 to mid-1988, a high exchange rate may well be associated with a considerable monetary expansion.
It follows from this that if the exchange rate becomes an objective in itself, ‘monetarism’ itself has been abandoned.
The only effective way to control inflation is by using interest rates to control the money supply. If, on the contrary, you set interest rates in order to stick at a particular exchange rate you are steering by a different and potentially more wayward star. As we have now seen twice – once when, during my time, Nigel shadowed the deutschmark outside the ERM and interest rates stayed too low; once when, under John Major, we tried to hold to an unrealistic parity inside the ERM and interest rates stayed too high – the result of plotting a course by this particular star is that you steer straight onto the reefs.
These questions went to the very heart of economic policy, which itself lies at the heart of democratic politics. But there was an even more important issue which was raised first by argument about whether sterling should join the ERM and then, in a more acute form, about whether we should accept European Community proposals for Economic and Monetary Union (EMU). This was the issue of sovereignty. Sterling’s participation in the ERM was seen partly as proof that we were ‘good Europeans’. But it was also seen as a way of abdicating control over our own monetary policy, in order to have it determined by the German Bundesbank. This was what was meant when people said we would gain credibility for our policies if we were ‘anchored’ to the deutschmark. Actually, if the tide changes and you are anchored, the only option to letting out more chain as your ship rises is to sink by the bows; and in an ERM where revaluations were ever more frowned upon there was no more chain to let out. Which leads on to EMU.
EMU – which involves the loss of the power to issue your own currency and acceptance of one European currency, one central bank and one set of interest rates – means the end of a country’s economic independence and thus the increasing irrelevance of its parliamentary democracy. Control of its economy is transferred from the elected government, answerable to Parliament and the electorate, to unaccountable supranational institutions. In our opposition to EMU, Nigel Lawson and I were at one. But, alas, by his pursuit of a policy that allowed British inflation to rise, which itself almost certainly flowed from his passionate wish to take sterling into the ERM, Nigel so undermined confidence in my government that EMU was brought that much nearer.
I made Nigel Lawson Chancellor in 1983. At this time the exchange rate was just one factor being taken into account in order to assess monetary conditions. It was the monetary aggregates which were crucial. The wider measure of money – £M3 – which we had originally chosen in the MTFS had become heavily distorted. A large proportion of it was in reality a form of savings, invested for the interest it earned. In Nigel’s first budget (1984) he set out different target ranges for narrow as well as broad money. The former – Mo – had been moving upward a good deal more slowly and this was taken into account in plotting the future course. But at this stage M3 and Mo were formally given equal importance in the conduct of policy. Other monetary indicators, including the exchange rate, were also taken into account. Our critics, who had until now denounced our policy as a rigid adherence to a statistical formula, began to denounce our rootless and arbitrary pragmatism. And indeed this was to mark the beginning of a process by which the clarity of the MTFS became muddied. This in turn, I suspect, caused Nigel, as the years went by, to search with increasing desperation for an alternative standard which he finally thought he had found in the exchange rate.
Events in January 1985 brought the ERM back into discussion. The dollar was soaring and there was intense pressure on sterling. I agreed with Nigel that our interest rates should be raised sharply. I also agreed with Nigel’s view that there should be co-ordinated international intervention in the exchange rates to achieve greater stability, and I sent a message to this effect to President Reagan. This policy was formalized by Nigel and other Finance ministers under the so-called ‘Plaza Agreement’ in September. In retrospect, I believe that this was a mistake. The Plaza Agreement gave Finance ministers – Nigel above all perhaps – the mistaken idea that they had it in their power to defy the markets indefinitely. This was to have serious consequences for all of us.
Sterling’s problems prompted Nigel to raise with me in February the issue of the ERM. He said that in his view controlling inflation required acceptance of a financial discipline which could be provided either by monetary targets or by a fixed exchange rate. New factors, argued Nigel, favoured the ERM. First, it was proving difficult to get financial markets to understand what the Government’s policy towards the exchange
rate really was: the ERM would provide much clearer rules of the game. There was also a political consideration. Many Conservative MPs were in favour of joining. Entry into the ERM would also move the focus of attention away from the value of the pound against the dollar – where, of course, the problem at this particular moment lay. Finally, £M3 was becoming increasingly suspect as a monetary indicator because its control depended increasingly on ‘overfunding’, with the resulting rise in the so-called ‘bill mountain’.* I was not convinced on any of these counts, with the possible exception of the last. But I agreed that there should be a seminar involving the Treasury, the Bank of England and the Foreign Office to discuss it all.
Alan Walters could not attend the seminar and let me have his views separately. He put his finger on the key issue. Would membership of the ERM reduce the speculative pressure on sterling? In fact, it would probably make it worse. That was the lesson to be drawn from what had happened to other ERM currencies.
At my seminar Nigel repeated the general argument in favour of joining which he had put to me earlier. Perhaps the most significant intervention, however, was that of Geoffrey Howe who had now been converted to the Foreign Office’s departmental enthusiasm for the ERM and thought that we should be looking for an appropriate opportunity to join – though he, like Nigel, did not think the circumstances at the moment were right. It became clear that we would need to build up foreign exchange reserves if we wanted to be in a position to enter. I agreed that the Treasury and the Bank of England should consider how this should be done and the meeting ended amicably enough.
During the summer of 1985 I started to become concerned about the inflation prospect. £M3 was rising rather fast. Property prices were increasing, always a dangerous sign. The ‘bill mountain’ was worrying too – not because it suggested anything about inflation (indeed, the overfunding which led to it was in part the result of the Bank’s attempt to control £M3). Rather, since we had decided against a policy of overfunding as far back as 1981, the fact that it had been resumed on such a scale without authorization did not increase my confidence in the way policy in general was being implemented.
Even now it is unclear whether my misgivings were justified. Some analysts – notably the perceptive Tim Congdon – would argue that the rise in £M3 now and later did cause inflationary problems. By contrast, Alan Walters reckoned that monetary policy was sufficiently tight, as did the rest of my advisers. The important thing is that when clear evidence appears that things are slipping you take action fast. Certainly, I do not believe that monetary policy in 1985 – or 1986 – was the main cause of the problems we were later to face.
Nigel now returned to the charge on the ERM. I agreed to hold a further seminar at the end of September though by now I was more convinced than ever of the disadvantages of the ERM. I could see no particular reason to allow British monetary policy to be determined largely by the Bundesbank rather than by the British Treasury, unless we had no confidence in our own ability to control inflation. I was extremely sceptical about whether the industrial lobby, which was pressing us so hard to join the ERM, would maintain its enthusiasm once they came to see that it was making their goods uncompetitive. I doubted whether the public would welcome what might turn out to be the huge cost of defending sterling within the ERM – which, indeed, might well prove to be impossible in the run-up to a general election and so be compounded by a forced devaluation. Looking back over the last few years it was clear that sterling had not tracked other European currencies in a stable way. In 1980, sterling rose 20 per cent against the European Currency Unit (ecu). In 1981 it fell by 15 per cent from peak to trough. In 1982 it did the same. In 1983 it rose by as much as 10 per cent. In 1984 it was somewhat more stable. But in 1985 it had risen by more than 10 per cent. To control such movements, we would have needed recourse to huge quantities of international reserves and to a very tough interest rate policy.
There was nothing secret about these facts. But nothing is more obstinate than a fashionable consensus. Nor is it without influence on Cabinet committees. I had no support at the seminar at the end of September.
Nor did my arguments budge Nigel and Geoffrey. There was no point in continuing the discussion. I said that I was not convinced that the balance of argument had shifted in favour of joining.
Until 1987, when Nigel made the exchange rate the overriding objective of policy, there was no fundamental difference between us, although Nigel apparently now thinks I was ‘soft’ on interest rates. Anyone who recalls our decisions from 1979 to 1981 will find that implausible. It would also surprise anyone who considers that one of the main arguments advanced for joining the ERM, which Nigel so passionately wanted, was that it would lead to lower interest rates. And, as I shall show subsequently, there were occasions when I thought that he was soft on interest rates and wanted to raise them more quickly. The two of us were equally opposed to inflation but it was my constant refrain that much as I might admire his fiscal reforms, he had made no further progress in getting down the underlying inflation rate.
But we did have rather different starting points. I was always more sensitive to the political implications of interest rate rises – particularly their timing – than was Nigel. Prime Ministers have to be. I was also acutely conscious of what interest rate changes meant for those with mortgages whose prospects – even lives – can be shattered overnight by higher interest rates. My economic policy was also intended to be a social policy. It was a way to a property-owning democracy. And so the needs of home owners must never be forgotten. A low interest rate economy is far healthier than a high interest rate economy.
High real interest rates* do ensure that there is a high real reward for saving. But they discourage risk-taking and self-improvement. In the long run, they are a force for stagnation rather than enterprise. For these reasons I was cautious about putting up interest rates unless it was necessary.
Another reason for caution was the difficulty of judging precisely what the monetary and fiscal position was. The Mo figures were volatile from month to month. The other aggregates were worse. In these circumstances, making the right judgement about when and whether to cut or raise interest rates was indeed difficult. So at the meetings I had with Nigel, the Bank and Treasury officials to decide on what must be done I would generally cross-examine those involved, give my own reaction and then – when I was sure all the factors had been considered – go along with what Nigel wanted. There were exceptions. But they were very few.
It was only from March 1987 – though I did not know it at the time – that Nigel began to follow a new policy, different from mine, different from that to which the Cabinet had agreed, and different from that to which the Government was publicly committed. Its origins lay in the ambitious policy of international exchange rate stabilization. In February Nigel and other Finance ministers agreed on intervention to stabilize the dollar against the deutschmark and the yen by the ‘Louvre Accord’ agreed in Paris. I received reports of the massive intervention this required which made me uneasy.
In July Nigel raised again with me the question of whether sterling should join the ERM. I was not unprepared for this and had earlier talked the subject through with Alan Walters and Brian Griffiths, the head of my Policy Unit who in an earlier incarnation had been Director of the Centre for Banking and International Finance at the City University. I said to Nigel that the Government had built up over the last eight years a well-founded reputation for prudence. By joining the ERM we would in effect be saying that we could not discipline ourselves. ERM membership would reduce the room for manoeuvre on interest rates which would, at times of pressure, be higher than they would be if we were outside. Overall, when things were going smoothly membership of the ERM would add nothing to our economic policy-making, and when things were going badly membership would make things worse. Nigel completely rejected this. He said he would want to discuss it all again with me in the autumn. I said that I would not wish to hold a further discussion on th
e subject until the New Year.
By now there was some evidence that the economy might be growing at a rate too strong to be sustainable. In August 1987 Nigel proposed a 1 per cent rise in interest rates on the grounds that this was required to defeat inflation by the next election. I accepted the proposal. That was the position when on ‘Black Monday’ (19 October 1987) there was a sharp fall in the Stock Market, precipitated by a fall in Wall Street. These developments were, in retrospect, no more than a market correction of overvalued stocks, made worse by ‘programmed selling’. But they raised the question of whether, far from overheating, we might now be facing a recession.
I was in the United States when I learned about the Stock Market collapse. I dined that evening with some of America’s leading businessmen and they put what had happened in perspective, saying that, contrary to some of the more alarmist reports, we were not about to see a meltdown of the world economy. Still, I thought it best to make assurance doubly sure, and I agreed to Nigel’s request for two successive half percentage point cuts in interest rates in response to help restore business confidence.
What I did not know was that Nigel was setting interest rates according to the exchange rate so as to keep the pound at or below DM3. It may be asked how he could have pursued this policy since March without it becoming clear to me. But the fact that sterling tracks the deutschmark (or the dollar) over a particular period does not necessarily mean that the pursuit of a particular exchange rate is determining policy. There are so many factors involved in making judgements about interest rates and intervention that it is almost impossible at any particular time to know which factor has been decisive for whoever is in day-to-day charge.
Margaret Thatcher: The Autobiography Page 82