The Iron Lady

Inflation again

If the Thatcher Government had one overriding objective in May 1979 it was the conquest of inflation. Conquer inflation, the Prime Minister and her economic advisers believed, by means of sound monetary policy, and everything else would follow. By June 1983 they were able to boast that inflation was conquered – if not in quite the way they had projected – and over the next four years steady growth and rising living standards for the majority duly followed. Unemployment was falling at last, public spending was under control, the balance of payments was in surplus, interest rates were at their lowest for years. By June 1987 Lawson was hailed as the ‘miracle’ Chancellor who had found the holy grail which had eluded all his post-war predecessors. But the control of inflation always remained, as he had once rashly described it, ‘judge and jury’.³⁵ Not content with getting it down to 3 per cent by 1987, he announced that his next ambition was to bring it down to zero.³⁶

Yet within a year the miracle started to go badly wrong. Hubris met its poetic nemesis. A combination of overconfidence, poor forecasting and consequent policy errors fuelled a credit boom which sucked in massive quantities of imports, leading to a runaway trade deficit and an upturn in inflation. Far from the zero Lawson had targeted, by the end of 1989 the figure was pushing 10 per cent, practically back to where it had been in 1979. After ten years of Mrs Thatcher, in other words, inflation was actually higher than it ever was under Harold Macmillan – the supposed father of inflation – while unemployment, though down, was still around two million and likely to rise again as a new recession threatened. This was where the Conservatives had come in. More than the poll tax or divisions over Europe, this central failure of economic management called into question the success of the whole Thatcherite project since 1979. As the huge bonus of North Sea oil began to run out, all the old problems seemed to be returning. As unemployment fell from its 1986 peak, the trade unions were beginning to recover their confidence. Pay was growing faster than productivity which – though much improved – still lagged behind most comparable economies. Manufacturing had never recovered from the previous recession; investment had been low and the national infrastructure was visibly crumbling. Moreover, of particular concern to Mrs Thatcher, the combination of renewed inflation and high interest rates hit particularly hard the new middle class of self-employed small businesspeople, entrepreneurs and new homeowners, whose aspirations she had specifically set out to advance and protect. ‘Good housekeeping’ suddenly seemed a sour joke.

Several factors contributed to this mortifying reversal.Always more cautious than her expansive Chancellor, Mrs Thatcher was already worried that the boom was getting out of hand in the autumn of 1986: Lawson was confident that he could rein it back after the election if necessary. But ‘Big Bang’ and the deregulation of the City had removed from his armoury many of the controls which previous Chancellors had been able to use to cool an overheating economy. Moreover, in the autumn of 1987 Treasury forecasts underestimated how rapidly the economy was already growing. Lawson raised interest rates a point, to 10 per cent, in August. But when the stock market crashed in October, his concern – shared by almost all the City pundits – was to prevent a downturn such as had followed the Wall Street crash of 1929, leading to a world recession. To forestall this threat he cut interest rates again, in three steps between October and December, down to 8.5 per cent. In his defence, Lawson points out that the pundits and the opposition parties were all urging him to do more. Cutting interest rates, however, turned out to be the wrong medicine at the wrong time. The economy was already growing faster than the Treasury realised, and the cuts gave it an additional stimulus which was not needed. Mrs Thatcher was in America at the time of the crash, where the Federal Reserve took the opposite course and tightened credit. Nevertheless she approved Lawson’s strategy, as she wrote in her memoirs, ‘to make assurance double sure’.³⁷

Then Lawson’s first budget of the new Parliament threw further fuel on the fire. Undeterred by warnings that it might be the wrong moment, he was determined to crown his reputation as a great reforming Chancellor with another spectacular tax-cutting package. With revenues buoyant, he was able to balance the books with a surplus for 1988 – 9 and plan for zero public borrowing in 1989 – 90, while leaving himself ?4.2 billion to give away. Not only was he able to trim the standard rate of income tax by another two pence to twenty-five pence in the pound, while announcing his ambition to cut it eventually to twenty pence; but he simultaneously slashed the top rate – which Howe had cut to 60 per cent back in 1979 – down to 40 per cent, one of the lowest rates in the world. All intermediate tax bands were abolished. At the same time Capital Gains Tax was reformed and simplified, and married women were at last assessed separately from their husbands – an equalisation which Mrs Thatcher strenuously opposed.

This was Lawson’s apogee. The opposition parties – and some Tories – denounced the budget for blatantly favouring the rich, at the very moment when social-security reforms were withdrawing many benefits from the poor. ‘It’s tax cuts galore but not if you’re poor’ was the Daily Mirror’s headline. Executives earning ?70,000 a year gained an extra ?150 a week, while families struggling on that much a week had their income cut.³⁸ Mrs Thatcher privately had her doubts: she would have settled for a top rate of 50 per cent, and she thought announcing a 20 per cent target an unnecessary hostage to fortune.³⁹ But most Tory MPs were ecstatic, and she could not fail to join in the general enthusiasm. ‘Nigel’s budget,’ she told the Conservative Central Council four days later, was ‘a humdinger’ which wrote ‘the obituary for the doctrine of high taxation… It was the epitaph for Socialism.’⁴⁰

But 1988 was a classic instance of the maxim that the morning-after verdict on budgets is usually wrong. Lawson’s tax cuts, whether or not they were equitable, were fatally mistimed.They were followed the next day by yet another cut in interest rates. But over the next few months, as consumers rushed to spend their gains, the deficit soared and inflation turned up, the Chancellor was forced into an embarrassing reversal: he was obliged to raise interest rates again repeatedly but without effect, so that by September the base rate was back to 12 per cent, and a year later reached 15 per cent, thus clawing back from home-owners all the benefit given away in March.

But this was not the ground of Mrs Thatcher’s quarrel with Lawson. His real error, for which she could not forgive him, was not the budget but his monetary policy. The rot set in, she believed, when Lawson lost faith in the Medium Term Financial Strategy, which he himself had devised, stopped targeting ?M3 or any other measure of money supply because of the difficulty of measuring it, and started to pay more attention to the sterling exchange rate as a more reliable indicator, until during 1986 he had begun to target a particular rate – between 2.80 and 3.00 Deutschmarks – not as a rough guide, but as a fixed goal. In her memoirs she explained that this was a fundamental error of economic principle. ‘It is… quite impossible to control both the exchange rate and monetary policy…You can either target the money supply or the exchange rate, but not both.’⁴¹

The value of a currency, to a monetarist, is no different from that of any other commodity: it must be allowed to find its level in a free market. All attempts to peg it are futile. By targeting a particular value Lawson unaccountably forgot all the hard-learned lessons of the past decade and went back to the bad old days of HaroldWilson trying to defend the fixed parity of sterling in 1964 – 7. By using monetary policy to target a desired exchange rate, he was obliged first to cut interest rates when he should have raised them, fuelling inflation, and then when the pound began to fall to raise them when the economy (and home-owners) were crying out for them to fall. On this analysis Lawson’s policy – which Mrs Thatcher claimed to have known nothing about in its initial stages – was simply wrong.

But in reality it was not so simple. Her own attitude at the time was not as clear as she later pretended. On the contrary she was, in Lawson’s word, ‘schizoid’ about sterling. Though in theory a good monetarist who was happy to see its value determined by the market, in practice she saw the national currency – ‘our pound’ – as a symbol of national pride and national strength. She liked to see it going up, as an expression of the world’s confidence in Britain, and hated to see it fall.

In fact, between a low exchange rate on the one hand and low interest rates on the other she was ambivalent. She could see the benefit of the low pound between 1983 and 1987, which helped Britain recover from the 1980 – 81 recession. She liked the lower interest rates which that involuntary devaluation made possible and did not want to tie sterling into the Exchange Rate Mechanism of the European Monetary System for fear of having to raise interest rates to protect a fixed parity. She was not initially against the ERM on principle – she had criticised the Callaghan Government for failing to join in 1978 – but increasingly became so from a contradictory mixture of patriotism and free-market economics. She both feared having to defend an unrealistic parity and