30 July 2010
Black or White According to Taste
David Smith, Economics Editor of the Sunday Times
It was the worst of times but it was also the best of times.
Since September 1992 Britain has enjoyed a recession-free period of economic growth alongside low inflation, the latter averaging around 2.5%, an experience not matched since the "golden age" of the 1950s and early 1960s.
Unemployment has fallen near continuously to close to the full employment levels of that golden age. Base rates, which never fell below 7.5% during the 1980s and averaged 12% during that decade, have not been above 7.5% since soon after the pound crashed out of the ERM and are currently just 4%.
So was it just a question of liberating Britain from a mistaken policy? No, there was more to it than that, and to explain it, it is necessary to go back a little further into our tarnished economic history.
On the afternoon of October 5th 1990, economic journalists were summoned to the Treasury to be briefed by Sir Peter Middleton, then permanent secretary, now chairman of Barclays, and Sir Terry, now Lord, Burns, then chief economic adviser, currently Abbey National chairman.
They handed over a short statement. The first paragraph said that the government - not the Bank of England in those days - was intending to cut interest rates from 15% to 14%. The second contained the more momentous news that from Monday morning, October 8, sterling would enter the ERM at a central rate of DM2.95.
The order was deliberate. Joining the ERM was Thatcher's last significant act of policy - her colleague Nicholas Ridley later said she would go to her grave with the initials engraved on her heart. Within two months she would no longer be prime minister. She had been persuaded by Major, then her chancellor, that joining the ERM would allow reductions in Britain's crucifyingly high interest rates.
It was, it appeared, the last throw of the dice. Since 1985, when Nigel Lawson decided that targeting the pound -"shadowing the D-mark" - offered a better policy than the monetarism that had guided the Thatcher government during its first years. Although Lawson's approach had produced the unsustainable boom of the late 1980s, and the return of 10%-plus inflation, hence those high interest rates, it was argued that this was only because it came a poor second best to the real thing, joining the ERM itself.
The early October announcement was overwhelmingly popular. Business, which had been campaigning long and hard for entry, came out strongly in support. Polls showed more than 80% of companies backed the decision.
As part of Gordon Brown's assessment of whether Britain is ready to join the euro, he recently ordered a search for all the Treasury papers that had informed the decision to join the ERM. The papers were uncovered over the summer but shed little extra light on what was a fatally flawed decision.
On entering the ERM in the autumn of 1990, a goal Major had set himself earlier in the year, ministers and officials either ignored, or were unaware, that by then the economy had embarked on what would turn out to be the longest, if not the deepest, recession in the post-war period. Also ignored were the government's own conditions for entry, one of which was that inflation should have converged with European levels - it was much higher.
They also chose to ignore a momentous event happening elsewhere in Europe - the unification of east and west Germany. This occurred at the precise time, October 3 1990, Major was securing final approval from Thatcher for ERM entry. It also, as economists were warning, made it likely that a period of high interest rates lay ahead for Germany, the ERM's anchor currency.
Most damaging of all, perhaps, Britain decided unilaterally on the DM2.95 entry rate for sterling which other countries, and in particular the German Bundesbank, regarded as ludicrously high.
The initial effects of ERM membership were benign. While the recession continued, it did allow interest rates to be brought down. But then the crunch came. By late in 1991, when Germany was raising interest rates, the ERM offered only pain. The recession, that was to trap 2m people in negative equity and cut a swathe through the small business sector, sending tens of thousands into bankruptcy.
Curiously, as the papers uncovered by Brown reveal, there was no Treasury "plan B" in the event of the ERM startegy coming unstuck. Through 1992, the language signalling the government's determination to stick to its ERM strategy got tougher.
Lamont, in a speech in July, was clear: "The result of leaving the ERM, combined with large cuts in interest rates, would be a fall in the pound probably unprecedented in the last forty years. It's the cut and run option; cut interest rates and a run on the pound. Markets would see that, unlike all our major European competitors, Britain lacked the will to pursue the goal of permanently low inflation. And they would be right."
Major, just days before the September 16 humiliation, was even more forthright. "All my adult life I have seen British governments driven off their pursuit of low inflation by market problems or political pressures," he told a CBI dinner. "The soft option, the devaluer's option, the inflationary option, would be a betrayal of our future."
It was to no avail. Italy was the first to succumb to the pressure, being forced to devalue the lira by 7% on the weekend of September 12-13. The killer blow was struck by Helmut Schlesinger, president of the German Bundesbank - an organisation that had always thought a DM2.95 pound an act of folly - who said in an interview on the evening of Tuesday September 15 that the Italian devaluation did not go far or wide enough to cure the ERM's problems.
When they heard that, speculators like George Soros knew they had a green light to dump the ERM's weaker currencies. The lira droped out along with sterling in the wave of selling on September 16. Other currencies, including the French franc and Irish pound, came under intense pressure in the following weeks and months.
Why did leaving the ERM in such humiliating circumstances not lead to the economic disasters publicly predicted by Lamont and Major but instead result in a prolonged economic triumph?
There are two reasons. The first is that, by accident, Britain timed her entry and exit from the ERM perfectly in one key respect - getting inflation down. The shock treatment forced by ERM membership, that of higher than necessary interest rates and a strong pound, together with the prospect of living permanently with low, German-style inflation levels, transformed inflation expectations. No government, left to its own devices, would have forced the recessionary pain on the economy for as long as ERM membership required.
The second, more important reason, is that while the Treasury had no ready-made plan B to pull out of a filing cabinet, it soon put one in place. Its ineptitude in the period leading up to ERM entry was mirrored by its brilliance in the frenzied weeks immediately after September 16. At a time when the government was in crisis and the chancellor faced daily calls to resign, an enduring and successful policy framework was somehow put together.
When sterling left the ERM, all options appeared closed. Britain had tried Keynesianism, various forms of monetarism and tying the pound to other currencies. All had come unstuck. Then somebody had an idea. Why don't we simply set a target for inflation?
For such a momentous decision, the Treasury records do not reveal who came up with it. It may have been a visiting New Zealander on secondment - such a target was already operating there. Or it could have been Sir Andrew Turnbull, then a senior Treasury official. If so his current job of cabinet secretary - the country's top civil servant - is an appropriate reward. The inflation target, initially 1% to 4%, now 2.5%, has provided the basis for the successful operation of policy over the past decade.
So too has the enhanced role of the Bank of England. The Bank was not made independent in the autumn of 1992, although Lamont now says it should have been, but it was given the task of publishing a quarterly inflation report and publicly advising the chancellor each month on interest rates. After Lamont's sacking by Major in May 1993 these became known as the "Ken [Clarke] and Eddie [George] show".
Without this, Gordon Brown would have struggled to introduce his most important policy innovation, Bank independence in May 1997. Without the framework introduced in the autumn of 1992, Britain would have enjoyed an economic boost from leaving the ERM but it could easily have been frittered away.
The Tories failed to reap the benefits from these changes. Lamont regards the tax increases introduced in 1993 as ranking alongside the inflation target and the Bank's enhanced role in terms of providing the basis for a lasting, low-inflation recovery. But the public only saw a government that had lost control and was making them, the voters, pay for it.
The economy and the Labour party were the beneficiaries. Ten years on, it really has to be White Wednesday.
Prof Patrick Minford CBE Edward Gonner Professor of Applied Economics, Cardiff Business School
The ERM was promoted as a 'nominal anchor'- a way of controlling inflation- that had credibility; it was said that we could not manage our own monetary policies properly. Yet not only had Margaret Thatcher brought inflation down from double digits in the early 1980s; we also went on after 1992 to produce a solid low inflation economy through our won domestic arrangements (now the MPC).
By contrast the ERM was a recipe for instability as not only did our interest rates get set elsewhere but we also had the added instability of speculation about the ERM peg. This instability produced a damaging recession which had the further effect of bringing in a labour government with no real understanding of free markets; its policies have partially reversed free market reforms and threaten worse to come from tax-and-spend. In short the ERM episode was tragic error of demand management policy which paved the way for a worsening of supply-side policy.
The rest of the text from the speech given by Sir Samuel Brittan, Assistant Editor of The Financial Times, is available on www.samualbrittan.co.uk.
The ERM was promoted as a 'nominal anchor'- a way of controlling inflation- that had credibility; it was said that we could not manage our own monetary policies properly. Yet not only had Margaret Thatcher brought inflation down from double digits in the early 1980s; we also went on after 1992 to produce a solid low inflation economy through our won domestic arrangements (now the MPC).
By contrast the ERM was a recipe for instability as not only did our interest rates get set elsewhere but we also had the added instability of speculation about the ERM peg. This instability produced a damaging recession which had the further effect of bringing in a labour government with no real understanding of free markets; its policies have partially reversed free market reforms and threaten worse to come from tax-and-spend. In short the ERM episode was tragic error of demand management policy which paved the way for a worsening of supply-side policy.
Institute of Economic Affairs, 2 Lord North Street, Westminster, London, SW1P 3LB | tel: 020 7799 8900 | fax: 020 7799 2137 | email: iea@iea.org.uk
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