Philip Pilkington: The New Monetarism Part I – The British Experience
By Philip Pilkington, a writer and journalist based in Dublin, Ireland. You can follow him on Twitter at @pilkingtonphil
While there are pretty stark dissimilarities between the current quantitative easing (QE) policies of many governments and the old monetarism that prevailed in the late-70s and early-80s, the reason that these both policies were ineffective is because they were based on the same flawed ideas. The key difference between the two is that where monetarism was implemented as a deflationary and contractionary policy, QE is currently being implemented as an inflationary and expansionary policy. As a result, examining the failure of monetarist policies thirty years ago provides important lessons considering QE and its offshoots.
Before looking at the similarities between these two doctrines, we will explore the actual historical trial of monetarism. We will focus on the British experience since the doctrine was applied there with far more zeal than in the United States. Indeed, Paul Volcker – Fed chairman at the time of the monetarist experiment in the US – has recently stated that he never believed in the doctrine and simply used the monetarist ‘fad’ of the day to push for unpopular interest rate hikes. By contrast, those working in the Bank of England at the time were true followers of the monetarist faith.
Maggie Thatcher’s Legacy: Monetarism in Britain
Margaret Thatcher was elected as Prime Minister in Britain in 1979. She was voted into office at a time when the British economy was undergoing an inflationary crisis that was mainly due to oil price hikes by the Saudis in response to political instability in the Middle East coupled with unions demanding that their wages keep pace with inflation. However, to paint this in such drab terms would be to illustrate the era poorly. The wage-bargaining process had become deeply inflexible and entrenched in Britain at this time. Unions were coming to be seen by many as a cancerous growth on British society and on British industry.
In 1978, one year before Thatcher was elected, Anthony Burgess wrote a short novel entitled ‘1985’. It was a poor piece of writing, as so much of Burgess’ output was – ‘A Clockwork Orange’ being a notable exception. Burgess grew up in a working class family and much of his work reflects his hatred of his origins. In his books the working class are usually portrayed either as hopeless dullards conditioned by the social system in which they live or as violent anti-social rebels who wreak havoc upon society. However, poor though it was Burgess’ ‘1985’ – which was supposedly an ‘update’ of Orwell’s excellent ‘1984’ – articulated what many in Britain had come to feel toward the trade union movement.
The story follows Bev, a man who had recently lost his wife to the callousness of the unionised staff at the state-run hospital service who were striking for a pay increase and neglected to treat her. In a moment of outrage that was soon to get him fired due to its anti-union tone Bev indicts the system of unionised work as a tremendous evil:
“My rage,” said Bev, “as you rightly term it, is the mere emotional culmination of a long-growing belief that the closed shop is evil, that it’s unjust to force men into being mere cells in a gross fat body that combines the torpid and the predatory, that a man has a right to work if he wants to work without having to jump at the shop steward’s whistle, and that, given certain circumstances, a man has a duty to work. A duty to put out a fire, if that’s his trade. A duty to –” He was going to say: drop nuts on chocolate creams, but he saw the absurdity of it. And then he did not see the absurdity of it. A child dying and wanting only one thing: a box of Penn’s Assorted. And everybody on strike and not a box left in the world, and the defiant worker, braving the threats and the blows, going to the machine–
Burgess’ ‘argument’ – if we dare use that term – is rather weak. Its striking workers that deny a dying woman healthcare is little beyond the caricature found in some of the more vulgar tabloid newspapers. (It, of course, being infinitely more likely in today’s world that a person will go untreated due to an inadequately funded healthcare system). However, due to the troubles taking place in Britain at this time such a view of unions resonated with much of the British public who could not see that the inflationary push underlying much of the strikes and the discontent were partially due to circumstances outside of the British government’s control. It is in this context that we must understand why the disastrous monetarist experiment was allowed to be carried out by the British public.
The aim of Thatcher’s monetarist policies was to attempt to control the rate at which the overall money supply grew. Thatcher and her advisers – relying on the work of Milton Friedman which will be considered in what follows – believed that it was the expansion of the money supply pure and simple that caused inflation. This was appealing to the Thatcher government for a number of different reasons. It provided them with an ostensibly scientific theory that told them that despite the fact they had no influence on the OPEC oil price and little direct influence over the unions and their wage bargaining, they could nevertheless simply order the Bank of England to target the amount of money allowed to be created and this would bring down inflation. The monetarists essentially allowed the Thatcher government to pretend that the inflation Britain was facing had nothing to do with either international or class politics and was simply a technocratic problem with a technocratic solution.
Traditionally central banks use interest rate policy to regulate the level of demand and hence inflation in the economy. However, in the post war years the use of interest rate policy as an effective means to regulate the economy had fallen into disfavour – especially after the British government had launched a detailed investigation into monetary policy in the early 1950s named the Radcliffe Committee (to be discussed in more detail when we consider the theory as opposed to the practice of monetarism). The monetarists claimed that the British government need no longer use straightforward interest rate targeting to get inflation under control. Instead they would simply target the supply of money and let interest rates fall where they may.
But in Practice…
The monetarist experiment proved disastrous. The Bank of England failed completely to control the money supply and succeeded only in causing interest rates to spiral out of control. This threw the economy into a deep recession. Between the last quarter of 1978 and the last quarter of 1980 the M3 measure of the money supply – the target of the monetarists – rose by some 32.8%; this was significantly faster than in the years before the targets had been initiated. Meanwhile unemployment skyrocketed and businesses shut their doors.
The British filmmaker Adam Curtis made an excellent film entitled ‘The League of Gentlemen’ [http://www.youtube.com/watch?v=BRu4SnBz7TY] as part of his series ‘Pandora’s Box’ [http://en.wikipedia.org/wiki/Pandora%27s_Box_%28television_documentary_series%29] which dealt extensively with Britain during the monetarist years. Here is a clip from that film describing the situation in Britain as the monetarists tried to target their monetary aggregates:
Nevertheless, despite the fact that the experiment was a complete failure, the Thatcher government clung onto the policy with a determination that bordered on zealousness. Thatcher and others had put so much stock in the monetarist doctrine and its supposed scientificity that to abandon it would have been an enormous embarrassment to the government and its champions.
Note the resemblance to today’s QE program. Many in the markets and the media have succumbed to a sort of ‘QE fatigue’ as it is obvious that the policy has not produced the desired effect. Nevertheless, QE continues to live on as a sort of undead policy tool. A great deal of the reason for this is that those engaged in the markets can still trade on QE. For example, if another round of QE is announced by a central bank an investor can short the currency of that country, buy their government bond or throw money at the stock market. The brief increase or decrease, generated mostly by self-fulfilling expectations, can then give their portfolios a boost. Economists and commentators also cling to QE because it gives them something to talk about which they can use to enhance their prestige – this even though QE, stripped of its aura, is a straightforward asset swap program that a child could understand.
Back to the early 1980s. Something eventually had to give. And, not surprisingly given the absurdity of the monetarist policies, the Thatcher government eventually folded. However, Mrs. Thatcher never admitted that she had been wrong. Instead she pretended that her government had never subscribed to the policy. Here is a wonderful interview with Thatcher taken from Curtis’ documentary where she flat out denies that she was ever an enthusiast of monetarist.
By the mid-1980s the inflation in Britain was coming down. One of the main reasons for this was the fall in oil prices as the OPEC cartel drew back their price rises. But another reason was that Thatcher’s policies had, through the massive recession that the monetarist policies had induced, hollowed out the British trade union movement – and with it a good portion of British industry.
The recession was brought about mainly through the chaotically high interest rates of the period – which remained at double digits through most of the monetarist era – together with tax rises and cuts to government spending that were ostensibly taken to meet the monetary targets. The channel through which this affected the economy was mainly that producers became extremely nervous about the future as they saw sales fall – a good deal of the effectiveness of this policy was due to self-reinforcing expectations. The high interest rates also strengthened the British pound which led to exports falling and domestic goods being outcompeted by the now cheaper foreign goods. All this, coupled with the high and unstable rates of interest they had to pay on loans, led British businesses to cut investment rapidly. As investment fell so too did employment and a depressionary spiral ensued. Much of British industry crumbled and went bankrupt; those industries that did survive were much smaller than they had previously been.
This is a point lost on many who look back on the era. These policies did not have the effect of redistributing income from the workers of the factories to the owners, but rather they simply destroyed large segments of British industry. As the British economist Nicholas Kaldor wrote in his book ‘The Scourge of Monetarism’:
[Monetarism] is not, therefore, a viable method of restoring a ‘broad balance of power in a framework of collective bargaining’ [as the Thatcher government had claimed]. It is a method of ruining both sides of industry at the same time, and not of strengthening one side at the expense of the other.
Some of the more reflective civil servants who took part in the monetarist experiments later became dimly aware of what they had engaged in. Here is yet another short clip from Curtis’ documentary in which a government banker reflects on what had taken place in the during the reign of monetarism.
Whether the government or segments of the government were conscious of what they were doing is unclear. Kaldor, for one, thought that they really did believe in the monetarist doctrine. However, Paul Volcker’s admission that he effectively used monetarism as a smokescreen cited at the beginning of this piece casts some doubt on this. Regardless, the effects of monetarism are now crystal clear.
One more of these effects should briefly be considered before in the next part of this series we move on. Monetarist policies, as Curtis alluded to in his documentary, greatly benefited the finance community in the City of London. Again this was not due to monetarist mysticism or money supply targets, but simply that the objective effect of the policy was to greatly strengthen the value of the British pound through persistently high interest rates. This attracted much foreign capital to the City of London – including the capital that was being paid out to the oil sheiks as they price-gouged British consumers. This, together with the light-touch regulation that the Thatcher government favoured, led to financial servicesbecoming a mainstay of the British economy. No longer would the interests of British manufacturing dominate debates over economic policy in Britain. Monetarism was, in a very real sense, the harbinger of a new dawn for Big Finance in Britain.