The revolution in economic policy; how Thatcher’s legacy has been overturned
Forty years ago, it was widely assumed that high interest rates were the only responsible policy to deal with the economic problems of the day. Now it is widely assumed that only low interest rates can suffice. Clearly the decline of high inflation has played a large part in this change. But it is not the only factor. There has also been a change in mindset about the importance of government debt (and deficits), the relative merits of savers and borrowers, and the role of the financial markets. It has amounted to a revolution in economic policy.
Margaret Thatcher was associated with many policies, but one of her basic instincts was the need to fight inflation. As such in the mid-1970s, she adopted the ideas of monetarist economists, led by Milton Friedman. Restrict money supply growth, such economists believed, and inflation would sort itself out.
But there was one aspect of the policy which caused Mrs Thatcher to hesitate. The standard tool for limiting money supply growth was to push up interest rates; if rates were high, people would be reluctant to borrow so commercial banks (which create money) would not lend as much. However, higher interest rates meant, of course, higher mortgage rates which adversely affected the middle classes — “our people” as Mrs Thatcher referred to them. She even considered capping the mortgage rate banks could charge, a significant intervention in the “free market” she otherwise supported.
Nowadays, the same middle classes are deemed to be hurt by too low interest rates on their savings. In Britain, the requirement for pensioners to buy annuities has been dropped because there were so many complaints about low returns. This illustrates a dilemma at the heart of monetary policy; that people are both savers and borrowers, usually at different points in their lives, but occasionally at the same time. In theory, interest rates are the price at which savers and borrowers come together; in practice, governments are reluctant to see the price determined by the market because of the political consequences.
To understand why policy has switched, we must go back to the assumptions on which the Thatcher policy toolbox was built.
Budget deficits led to higher inflation. In a sense, this was standard Keynesianism in that the great economist favoured governments running deficits in a recession so as to reflate an economy. But Thatcherites also believed that…
Higher government spending crowded out private sector investment. This view arose from the long period of state expansion that began with the Second World War. The European social democracies had imposed high taxes and nationalised some industries. The Thatcherites argued that these taxes were bad for incentives and that government intervention in industry kept “lame ducks” in business and prevented resources from being reallocated to new, growing industries. In turn, this explained why the strong growth performance of the 1950s and 1960s had dissipated. They also believed that…
If capital were able to flow freely, it would be allocated to the most attractive investment opportunities. The Bretton Woods system that prevailed after the Second World War had fixed currencies against the dollar. This required tight controls on capital movement to stop speculators from forcing countries off their currency pegs. But when the Bretton Woods system collapsed, exchange rates floated and thus, by implication, the need for exchange rate controls disappeared. Milton Friedman believed that the markets would be better at setting the correct level for the exchange rate than politicians or central bankers. He also believed that…
Government should focus on the rate of inflation, rather than the level of unemployment. In the post-war era, economists and policymakers believed there was a trade-off between inflation and unemployment — the so-called Phillips curve. But Friedman argued that this trade-off disappeared if policymakers tried to force unemployment below its “natural” level. This level existed because employees needed to move from one job, or industry to another, and there would always be a period when they were temporarily out of work. Trying to suppress unemployment further would only push up inflation without creating any more jobs. The best way of reducing unemployment would be to pursue “supply side” reforms which made it easier for the economy to grow faster. And the final assumption was that..
The money supply could be defined and measured and had a reliable relationship with the rate of consumer inflation. A fact that dogged Mrs Thatcher was that broad money supply growth in the 1980s was very rapid, something that was seen as a sign of incipient inflationary pressure. Under monetarist theories, this necessitated sky-high interest rates. But the Thatcher government had also reduced many of the controls on the financial sector that had been imposed in the 1960s and 1970s. This liberalisation was driving the rapid money supply growth; very high rates were probably unneccesary. For a while, monetarists debated whether to focus on narrow money supply measures (notes and coins) rather than broad measures (bank accounts etc) but none seemed to be reliable.
Dropping the pilot
By the mid-1980s, central banks started to drop money supply targets because of the problems just described. That was the first of the Thatcherite assumptions to be abandoned. Another assumption that was weakened as the idea that budget deficits lead to inflation and higher interest rates; in the US, Ronald Reagan’s tax cuts led to a surge in the budget deficit in the 1980s. But from June 1984 onwards, there was a steady decline in the 10-year bond yield from 13.6% to 7% in 1987. The market did not punish the government’s “profligacy”. Each successive cycle seemed to have lower yields: 5.4% in 1993, 4.5% in 1998, 3.3% in 2003, 2.4% in 2008 and 0.7% last year.
So what was going on? Why was inflation falling? One reason for the inflationary surge of the 1970s was higher oil prices but these fell sharply in the 1980s. Another factor was the declining power of trade unions for which the Thatcher/Reagan government can take credit (or blame, depending on your point of view). Another issue was the ageing of the baby boomer generation which stepped up its savings in preparation for retirement. But the main cause may have been the computer revolution, which improved efficiency and lowered prices, along with the emergence of China (and in the 1990s, eastern Europe) as low-cost producers.
In short, none of this was much to do with monetary policy at all. But the other changes introduced by Thatcher and Reagan did have enormous consequences. The financial sector was liberalised just as interest rates and inflation were falling; this caused an enormous bull market in bonds and equities and meant that many people involved in finance became rich. The level of debt in the economy shot up; consumers and companies, as well as government, borrowed more.
This created a huge constituency in favour of lower rates. A high level of debt created the potential for severe economic damage at times of crisis, so central banks reacted by cutting rates when markets wobbled; in 1987 and 1998, for example. Over time, investors learned the lesson that asset prices would always go up in the long run and borrowing costs would always fall. Sure enough, this encouraged them to take on more risk. The end result was the 2007 and 2008 crisis, the worst since the Great Depression.
Caught by surprise
At this point, I (along with many others) thought that a new order would be established. In my book “Paper Promises”, I wrote of the 40-year cycles where the system was remade. The 1930s depression led to Keynesianism, the 1970s to floating exchange rates and monetarism and the 2010s might lead to a deal between the US and China on exchange rate management.
It didn’t happen. Remarkably, for more than 10 years, we have got by on ultra-low interest rates. A calamitous debt crisis has been avoided because central banks have bought up government debt in the process called quantitative easing (QE). And none of this has resulted in high inflation.
Savers have learned to take more risks, moving out of low-yielding cash and into equities. At the most extreme, this has been seen in the trading in individual shares that has occurred on platforms like Robinhood.
And it is very hard to envisage how this will change. Inflation may edge up a bit because of the pandemic, and the massive stimulus governments have applied. But globalisation and technological change still bear down on the cost of goods and services. Central banks dare not unwind QE or raise interest rates too quickly for fear of the pain they will inflict.
We have ended up with a world that Margaret Thatcher could not imagine; a Conservative government is set to borrow £350bn this year, or 17% of GDP. But inflation is just 0.7% and the markets are quiescent; 10-year bond yields are just 0.7% too. In forty years, many of the core beliefs of Thatcherites have been overturned. But she is still seen as one of history’s victors.