11 June 2024

Did monetarism work?

By Tim Congdon

The piece below is Tim Congdon’s chapter from ‘Conservative Revolution: The Centre for Policy Studies at 50’, published on June 4. It can be purchased here

The economic policies of Margaret Thatcher, then and at the time, were presented as a dangerous innovation. The Centre for Policy Studies, from which many of those policies emerged, was accused by The Guardian of being a ‘Potala of monetarism manned by fanatical lamas’. But the key to understanding that emblematic policy of monetarism is that it was not revolutionary at all.

For Thatcher, Joseph and others – myself included – it was above all a restoration of a lost tradition.

In the 18th and 19th centuries, Britain was the home of classical liberalism. Admittedly, the phrase has more than one potential meaning, but it certainly included such notions as the freedom of the individual under the law and respect for private property. Thatcher and Keith Joseph were unusual politicians, in that they both had a strong and lively interest in political ideas, even – dare one say? – in political philosophy. They certainly believed that Britain’s classical liberalism had contributed to its historical achievement.

So when they set up the Centre for Policy Studies in 1974, they wanted – as freedom-loving Conservatives – to restore a tradition of political thinking and practice, and to make it relevant to the future. I was lucky, as a young economist at the start of my career, to help in the Centre’s work updating and refreshing this heritage. A central part of the agenda was to defeat inflation and to stabilise the public finances. I advocated, in particular, control over growth of the quantity of money and systematic reductions in the budget deficit, a policy approach which came to be known as ‘monetarism’.

In a classically liberal society, the state’s tasks were limited to defenceand the provision of law and order, while key functions of the law were to define and protect private property. In a society of this kind, freedom in the economic sphere was, above all, freedom from government intervention. As Adam Smith explained in his 1776 Wealth of Nations, prices should be set by supply and demand in what he termed ‘a system of natural liberty’. Were such ‘natural liberty’ to prevail, the state would have little to do.

Emphatically, the role of the state was not to meddle in the setting of wages and prices by private agents. All the same, it was supposed to honour its financial promises. In particular, the Government’s bank – the Bank of England – was to ensure that the value of the pound sterling was to be kept stable relative to that of gold. This arrangement was part of a larger commitment to public morality and economic stability, with the Government’s own budget to be balanced or in a small surplus.

Through the 20th century, classical liberalism went into retreat, in Britain as elsewhere. The leaders of thought and opinion moved towards ‘the left’, where the extreme left was represented by Marxism. According to Marx in his 1848 Communist Manifesto, the ultimate destination of all polities was Communism, when

Society will take all forces of production and means of commerce, as well as the exchange and distribution of products, out of the hands of private capitalists and will manage them in accordance with a plan based on the availability of resources and the needs of the whole society. In this way, most important of all, the evil consequences which are now associated with the conduct of big industry will be abolished. There will be no more crises…

‘Crises’ meant here the cyclical crises, the boom–bust cycles already evident in the mid-19th century when Marx was writing. He recommended that in the Communist ‘new social order’, money – like the institution of private property – would be abolished. Cyclical crises could not then be caused by the antics of the banking system, and related upheavals in credit and money.

The emergence and failure of the post-war economic consensus
References to Karl Marx may seem anachronistic and rather shrill in the early 21st century, but matters were different 50 years ago. By the 1960s and early 1970s the leftward shift of elite thinking had created an existential problem for the many British traditions and institutions which had originated in the liberal culture of earlier centuries. One aspect of this problem was serious economic failure.

The growth of national output had through the post-war years been slower than in other advanced countries. The Conservative government of 1970–4, under Edward Heath as Prime Minister, with Anthony Barber as Chancellor of the Exchequer, engineered a big boom in ‘a dash for growth’. But in 1974, when the CPS began, it was clear that the boom had provoked rapid inflation and would be followed by a bust.

In the year to August 1975, the retail price index rose by 26.9%, the highest number in peacetime history. Indeed, the pound’s loss of value in that one year was more than had been typical in the lifetimes of British people in the Hanoverian and Victorian eras.

Why had so much gone wrong with British economic policymaking? The leftward shift of high-level opinion had undoubtedly affected Britain’s economists in the middle decades of the 20th century. Many of those approaching their career peaks had reached adulthood or were in their early career in the 1930s and during the Second World War.

They had been saddened and alienated by the sorry spectacle of the American economy in the Great Depression of the early 1930s; they were impressed, by contrast, with the much-trumpeted and widely believed-in triumph of Soviet planning at the same time, and by Russia’s contribution to the Allied victory in the Second World War.

In the immediate post-war decades, most British economists believed in ‘planning’. Taken to its logical conclusion, the state was to specify production targets for particular sectors, and to direct the allocation of labour and capital accordingly. Some prominent figures – notably Joan Robinson, variously associated in her career with Girton College, Newnham College and King’s College at Cambridge, and a fellow of the British Academy from 1958 – were indeed Marxists.

A clear majority of the economics profession despised money and monetary policy. Even if they did not go as far as Marx in recommending that the use of money be forbidden, they scoffed at once standard views on the role of money in the inflationary process. In a book on the British economy in the 1950s, Charles Kennedy, who was an economics don at Queen’s College, Oxford, from 1948 to 1961, described the quantity theory of money as a ‘doctrinal monster, which one [had] thought and hoped [was] extinct’.

The best way to deal with inflation – in Kennedy’s view and that of hundreds of other university economics teachers – was for the Government to set limits on increases in wages and prices, regardless of any resulting microeconomic inefficiency. The free market was scorned as ineffective and old-fashioned. Like sound money and a balanced budget, it was mocked as other fuddy-duddy Victorian orthodoxies had been in the early 20th century by Lytton Strachey and the rest of the Bloomsbury Group.

Any reference to the Bloomsbury Group of course raises the subject of one of its members – John Maynard Keynes, who is often regarded as the greatest economist of all time. A discussion of Keynes’ role in British policy thinking and making is complex because he was something of an intellectual chameleon. In any case, his successors – particularly a number of self-described ‘Keynesians’ at Cambridge University (who included Nicholas Kaldor and Richard Kahn as well as Mrs Robinson) – propounded a set of doctrines which they claimed would have carried Keynes’ imprimatur.

The Cambridge Keynesians of the 1950s and 1960s thought that the Government’s job was to secure full employment by the management of aggregate demand, where the management of aggregate demand involved variations in government spending and taxation, and hence in the budget balance.

An increase in the budget deficit stimulated demand, according to the Cambridge Keynesians and their many acolytes; a reduction in the deficit reduced it. Kaldor – like Kennedy – was dismissive of monetary policy and rude about the quantity theory of money. Adjustments to the budget balance constituted ‘fiscal policy’, and fiscal policy was to have pride of place in macroeconomic strategy and action.

And so we come back to the Heath–Barber boom of the early 1970s. At the Bretton Woods conference of 1944, Britain agreed to participate in the post-war system of fixed exchanges rates. This system was ostensibly a dollar standard, but the risk of inflationary policies in the United States of America was cramped by its obligation to redeem official dollar liabilities in gold at a fixed price of $35 an ounce.

In 1971 the USA broke the link with gold, and in 1971 and 1972 the United Kingdom moved, with many other countries, to float its exchange rate. From 1945 to 1971 the Bretton Woods system had imposed an external constraint on fiscal and monetary irresponsibility in the UK. The breakdown of the system removed this constraint.

The Keynesians took the opportunity to go on the rampage. From late 1971, macroeconomic policymaking became wildly expansionary. The 1972 Budget increased the budget deficit by over £3 billion, the equivalent of 5% of gross domestic product. The need to finance the deficit partly from the banking system, in conjunction with overdue measures of financial liberalisation and an associated surge in bank credit, led to an explosion in the quantity of money. Money growth on the then widely tracked M3 measure was 26.8% in the year to the fourth quarter 1972 and 27.1% in the year to the fourth quarter 1973.

In other words, the quantity of money soared by over 60% in a mere two years. This pace of money expansion caused dramatic rises in asset prices and a vigorous upturn in aggregate demand. As so often in these cycles, asset price inflation spread to product and labour markets, and inflation at factory gates and in the shops started to accelerate.

On 6 November 1972 Heath announced an immediate freeze on all increases in wages and prices. According to the BBC in an ‘On This Day’ history comment, the ‘controls on income and expenditure’ were introduced ‘after talks between the government, the Trades Unions Council and the Confederation of British Industry… failed to produce an anti-inflationary deal’. In a statement to the House of Commons, ‘Prime Minister Edward Heath told MPs the government had decided to bring in laws enforcing… controls.’

The Heath–Barber boom was Keynesianism run amok. But the intellectual context must be remembered. A clear majority of those economists with influence on the government of the day believed both that fiscal policy was the best tool for managing aggregate demand, with growth ambitions justifying so-called ‘expansionary fiscal policy’, and that inflation could be controlled – quite properly and very effectively – by the enactment of laws against it.

Moreover, their assessment was that these laws would work regardless of the rate of money growth. After all, the quantity theory of money was an extinct doctrinal monster, wasn’t it?

The 1981 Budget and overturning the economic consensus
After coming down from Oxford in summer 1973, I started my first job – on the economics staff of The Times – in October 1973. My main tasks were reportage, to write news stories on the monthly statistics which reflected the shambles of the UK economy and its policymaking, as well as daily summaries of the gilt and money markets, and the foreign exchanges. But of course I had views on the major economic developments and what might be done to improve the situation.

My direct boss, Peter Jay, had already warned that ‘the Barber boom’ would end in a bust and was even worried that out-of-control inflation threatened Britain’s democratic way of life.

One of his friends was Samuel Brittan, who was the main economics columnist on The Financial Times for much of the period from 1966 to his retirement in 2014. Both had met and come to admire Milton Friedman, the main supporter of the quantity theory of money in the late 20th century. For a few years Brittan and Jay were known as ‘the monetarist twins’, or even ‘the terrible monetarist twins’, because of their preparedness to cite money growth changes in their critiques of official policymaking.

I was influenced by these two brilliant and outstanding commentators. But I had done much reading on my own both before and during my four years at Oxford. I had, for example, dipped into Keynes’ 1923 Tract on Monetary Reform and his 1931 volume of collected journalism, ‘Essays in Persuasion’. They showed me that Keynes was an admirer of market mechanisms, who wanted people to enjoy a private sphere and freedom of choice, and who deplored Marxism and the Soviet Union. I also could not fail to notice that the index of his 1936 General Theory had a mere two references to ‘fiscal policy’, but 26 to ‘money, quantity of’ and six to ‘money, quantity theory of’.

It seemed to me that the Cambridge Keynesians were involved in dishonest fabrication. They purported to have the right to mint ideas as if they were Keynes’, but their real game was intellectual counterfeiting. I wrote an article for the April 1975 issue of Encounter magazine in protest against their practices.

As described elsewhere in this essay collection, Alfred Sherman was instrumental in establishing the Centre for Policy Studies with Sir Keith Joseph, and was its first Director. He contacted me about my Encounter article, and invited me to participate in CPS study groups and to publish under the CPS banner. I agreed to write a pamphlet called ‘Monetarism: An Essay in Definition’. We deemed this to be worthwhile, as many people were not sure what monetarism meant.

The pamphlet duly appeared in 1978, in both soft and hard covers, with the hard covers apparently causing some in-house controversy over cost. (I was a conceited young man who wanted to be able to say he had written a book. There are worse offences against good taste.)

The pamphlet was well timed, and had a worthwhile impact on the debates of the late 1970s and early 1980s. Politicians and journalists even used the phrase ‘Thatcherite monetarism’ to define the economic agenda of the Conservative government elected in 1979.

This agenda was undoubtedly very different from that of the 1970–4 Heath government. Prices and incomes policies backed by the law were dropped as a means of combating inflation. Instead the job was to be done by monetary restraint. Fiscal policy was subordinated to a money target regime formalised from 1980 in a ‘Medium Term Financial Strategy (MTFS)’.

Along with such notables as Alan Budd and Terry Burns of the London Business School, I had for some years favoured an MTFS programme with quantified forward numbers on money growth and the budget deficit. And it was the existence of the MTFS that led to perhaps the most contentious episode in British economic policymaking, the 1981 Budget.

Partly because a recession dented tax revenues and increased certain kinds of public expenditure, projections in early 1981 were for the budget deficit to be well above the figure envisaged in the MTFS. To maintain credibility, the then Chancellor of the Exchequer – Sir Geoffrey Howe, later Lord Howe – decided that taxes should be increased in order to keep the deficit within the prescribed limits.

This seemed to breach textbook Keynesian economics, which said that taxes should be cut and the deficit raised in a recession. Two economics professors at Cambridge University organised a letter to The Times to condemn the Budget decisions, and indeed monetarism, and managed to secure the signatures of 364 university teachers of economics.

Here was an outright and very public confrontation between the predominantly Keynesian university-based UK economics profession and the ‘Thatcherite monetarists’. On the face of it, the contest was very uneven, as the monetarists were markedly fewer in number, and often – like myself – mere journalists or worked in the City of London.

The outcome of the confrontation may itself still be controversial. All the same, the 364 were wrong in one crucial respect. They forecast that the fiscal contraction – as they saw it – would lead to an intensification of the economic downturn. On the contrary, in the weeks following their letter the economy began to show signs of recovery. Roughly trend growth was sustained for a few quarters, while 1984 enjoyed above-trend growth.

Another weakness of the letter was its assertion that ‘alternative policies’ were available, without saying what they were. If the 364 understood the ‘alternative policies’ to be prices and incomes controls plus fiscal activism, they were policies that had already been discredited. Admittedly, the monetary side of the MTFS had a somewhat chequered record, and was ultimately abandoned.

Happily, however, the Conservative government persevered with the fiscal component of the MTFS, with a balanced budget being the objective in its final decade. Apart from Norway – an oil-rich country with a small population – the UK was the only advanced nation to have a lower ratio of public debt to gross domestic product at the end of the 18 years to 1997.

Moreover, fiscal rectitude was not accompanied by ever-deteriorating demand and employment. Employment was one and a half million higher in 1997 than in 1979, and gains in productivity and living standards were good by historical levels. Further, by 1997 inflation had been defeated, and prices and incomes controls had not been used at all.

This primacy of monetary policy was recognised by Blair’s New Labour government from 1997. It gave the Bank of England operational independence to set interest rates and to meet an inflation
target, which – at least for a time – consolidated the Conservatives’ progress on inflation.

Whatever else is to be said about the episode, the intensity of the debate over the 1981 Budget evidenced the major policy shift that had occurred in the preceding decade. In the 1960s and early 1970s Keynesianism had lost its moorings in Keynes’ original work, and had moved too far left in its enthusiasm for planning, including direct government interference in wage- and price-setting, and its fiscal adventurism.

Monetarism proved to be a better approach – however much most British economists are reluctant to admit it. Similarly, the excellent macroeconomic results in the Great Moderation from 1992 to 2007, with its ‘NICE’ years of Non-Inflationary Consistent Expansion, can be explained by fiscal probity and steady growth of the quantity of money at much lower rates than in the 20 years before 1992. The once fashionable panaceas of the university Keynesians – prices and incomes policies, and fiscal stimulus and fine-tuning – had nothing to do with it.

Unfinished business?
I was fortunate to be involved with the Centre for Policy Studies almost from the start. The debates about economic policy in those years were occasionally too bitter, but they were exciting and important. So much was at stake.

I will always be grateful to Keith Joseph and Margaret Thatcher for creating the Centre at a crucial moment in British economic policymaking, and to Alfred Sherman for inviting me – as a young man – to play a role in the evolution of high-level thinking about macroeconomics.

Although my later role in actual policymaking was marginal, my commentary and writing did have an impact on decisions through the 1980s and 1990s, during my time as a member of the Treasury Panel, for example. This impact was undoubtedly enhanced by the scope to use the Centre as an outlet for monetarist ideas and proposals.

The Centre for Policy Studies may not (yet) have restored a classically liberal Britain, and industrial policy, price controls and protectionism might be in vogue once more. But the success of its work is one reason that hardly anyone nowadays considers the future to be a world in which money and private property will have been banned, and where every important feature of production and income distribution will be planned by the state.

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Tim Congdon is one of the world’s leading monetary analysts and authors on monetarist theory. He advised the 1979–97 Conservative government on economic policy, serving as a member of the Treasury Panel from 1992 to 1997.

Columns are the author's own opinion and do not necessarily reflect the views of CapX.