The dawn of civilisation in the fourth millennium BC was associated with urbanisation and the emergence of writing, and it was made possible by specialisation and the division of labour. People ceased to live only on what they produced, but instead sold some of their produce in order to buy consumables from others. This created a new issue in economic organisation: households and traders had to reach the appropriate ratios between different products in a multiplicity of exchanges.
Societies organised systems of weights and measures, and the ratios – the prices – tended to be expressed in terms of a single standard. Here was the beginning of the concept of ‘money’. Increasingly, metals were used as a measure of money and became its most common constituent. Transactions were conducted in copper, silver and gold, which had the advantages of durability and high value relative to weight.
Fast forward to the early 18th century. In 1717, Sir Isaac Newton set the price of gold at £3.17s.10½d., where the amount (that is, the three pounds, 17 shillings and 10.5 pence) was of the silver coins which circulated as England’s currency. In the next two centuries, the Bank of England – founded in 1694 – issued ever more notes as substitutes for these coins, establishing Newton’s ratio as an exchange rate between the pound and gold. The Bank of England also pioneered the role of central bank, acting as exclusive financial agent for the government and eventually acquiring the unique prerogative of issuing legal tender notes.
Individual products had a value in terms of a nation’s money, the pound sterling in Britain’s case. But economic progress resulted in an ever growing range of goods and services. A new idea – of the price level of all products in general – could be formulated. Through the 18th century, Newton’s fixed exchange rate seemed sufficient to ensure that the general price level was fairly stable. In its imperial heyday, Britain conducted its public finances and international commerce according to a mere three principles:
— maintaining the gold standard,
— balancing the budget, and
— leaving British citizens free to buy whatever they wished – with no tariff or other impediments – from the rest of the world.
To say that these three principles represented ‘economic policy’ in the British Empire is not silly, but in truth, the notion of ‘policy’ was empty when so little discretion was left to the state. The gold standard worked admirably, but the world wars and instability of the early 20th century undermined its viability. Britain’s power declined, and its share of both world output and the global gold stock went down. In 1931, the Bank of England left the gold standard and allowed the pound’s external value to find its own level in currency markets.
However, after the Second World War, the world’s new leading nation – the United States of America – wanted to restore the stability which seemed to have been once achieved by linking paper money to gold. The international financial system agreed at the Bretton Woods Conference of 1944 gave the US dollar a prominent role in world trade and finance, while the US undertook to keep the value of the dollar fixed at $35 an ounce. Further, Britain’s pound and indeed all other currencies were to be fixed in value relative to the dollar.
The Bretton Woods system may have seemed to be a new departure, but it was in fact a refurbishment of the classical gold standard. The same kind of monetary discipline was at work in the ever more integrated post-war world economy as had once applied in the British Empire. If too much paper money were created relative to the amount of gold, the value of the paper money – even the value of the supposedly ‘mighty’ dollar – would drop.
The American government might have been the most formidable on the planet, but it could not defy the laws of economics. If it engaged in an expensive war in Vietnam, ran large budget deficits and financed them by issuing too much money, the $35-an-ounce gold price would be threatened and might prove unsustainable. In 1971, President Nixon decided that the US should no longer be subject to this constraint. His announcement was that the dollar’s convertibility into gold would be suspended, but in practice gold convertibility has never subsequently been restored.
Also in the early 1970s, many governments – including the British – broke their currencies’ link to the dollar. Barriers to monetary expansionism had been built into the Bretton Woods system, but these were now being removed. Marked accelerations in the growth of the quantity of money occurred in the vast majority of nations, resulting in a worldwide boom in 1972 and 1973. The boom initially drove up asset prices and made people feel good. But it soon affected wage costs and commodity prices, and eventually provoked surges in prices at factory gates and in the shops.
These processes were particularly salient in the United Kingdom, where the growth of broadly-defined money (using the so-called ‘M3 aggregate’) exceeded 20% a year for several quarters and retail inflation peaked at over 27% in 1975. The episode is usually known as ‘the Heath-Barber boom’, after the Prime Minister and Chancellor of the Exchequer most responsible for it. But the UK was far from alone. In Japan, France and Italy, the highest inflation numbers in 1975 were well into the double digits.
An important exception to the wider pattern was West Germany. Many of the officials in late career at its central bank, the Bundesbank, had memories of the Weimar hyperinflation of 1923. They were convinced that preventing the monetisation of public debt and controlling the quantity of money were vital to avoid inflation. They clamped down on money issuance and let the German currency, the deutsche mark, rise in value against the dollar on the foreign exchanges.
In reaction to these events, policymakers around the world had to rethink economic management. The essence of the gold standard was to tie the value of paper money to the precious metal at a fixed price or ‘exchange rate’. Well into the 1980s and 1990s, many British economists believed in a return to a fixed exchange rate for the pound – now relative to the deutsche mark rather than the US dollar – as an appropriate monetary arrangement for the UK. But the debates on these issues had a long pedigree and extended far beyond Europe. An alternative to the fixed-exchange-rate approach had always been available. This was understood – for example – by Henry Thornton in a 1802 work ‘An Enquiry into the Nature and Effects of the Paper Credit of Great Britain’ and John Maynard Keynes in his 1923 ‘A Tract on Monetary Reform’.
Both Thornton and Keynes had seen that policy could be conducted with a view to stabilising the value of money not relative to the external anchor of gold, but relative to the internal price level. Indeed, Keynes mocked the gold standard as ‘a barbarous relic’, and argued that monetary policymakers were ‘compelled’ to choose between the external and internal benchmarks. In the ‘Tract on Monetary Reform’, the crux of Keynes’ answer was ‘a managed currency’, which would keep the growth of money at an appropriately low level compared with the growth of national output.
Thornton’s analysis in 1802 had been even more forward-looking, in that it anticipated the US’s problems and the international money crisis of 1971. Because of the financial pressures arising from the Napoleonic Wars, Britain had suspended the pound’s convertibility to gold in 1797. (It was to resume the gold standard in 1821.) Thornton’s advice to the Bank of England in the post-1797 situation was remarkable in its emphasis on the quantity of ‘paper credit’, and its anticipation of later events and thinking. In Thornton’s words, the aim should be to ‘limit the amount of paper issued, and to resort for this purpose, whenever the temptation to borrow is strong, to some effectual principle of restriction’. The ideal would be ‘to let [the sum in circulation] vibrate only within certain limits’ and ‘to afford a slow and cautious extension of it, as the general trade of the kingdom enlarges itself’.
Britain’s shockingly high inflation in the mid-1970s caused a number of economists to propose the same kind of response as Thornton in 1802 and Keynes in 1923. The state had to impose ‘some effectual principle of restriction’ on the quantity of money – in other words, explicit targets for money growth – if inflation were to be beaten. Such targets were introduced for a broadly-defined money measure in July 1976 and stayed in place until they were dropped in autumn 1985. The targets did what they were supposed to do. Inflation came down from the high double digits and for some years was stable at about 5%. Unfortunately, Nigel Lawson – Chancellor of the Exchequer from 1983 to 1989 – was nostalgic for a fixed-exchange-rate, externally-based solution. From 1985, the broad money target no longer operated and the settings for monetary policy went wrong. Another silly boom emerged, with inflation climbing again in the late 1980s and peaking in double digits in 1990.
Sir Tim Lankester, a civil servant who was the first private secretary for economic affairs to Margaret Thatcher, has just published a new book, ‘Inside Thatcher’s Monetarist Experiment’, which discusses these matters. The book spans a long period, beginning in the 1960s and continuing, if rather patchily, to today. But the focus – and it is a very critical focus – is on a central 1979-82 period of ‘hard monetarism’ (Lankester’s phrase) in the first three years of the Thatcher government. According to Lankester, the cost of bringing inflation down was excessive and ‘the experiment’ was a failure.
Economic policy in those three years was controversial at the time and no doubt will always be so. But Lankester proposes no serious alternative to the actual policy adopted and, at various points in his book, concedes as much. One reason that the cost of reducing inflation was so high was the noisy opposition of the overwhelming majority of British economists to the monetarist agenda. Their attacks undermined the government’s credibility and made the job that much harder. The facts remain: any complex civilised society uses money in transactions, and a relationship holds between the quantity of money and the price level of output. As Thatcher insisted, there was – and is – no alternative to maintaining an appropriately low rate of money growth if inflation is to be kept under control.
Let me say that Lankester is accurate and fair to me, in his references to my role as an advocate for monetarism in those events. But he is wrong to say (on p. 37) that I had personal contact with Thatcher before the 1979 general election. (I first met Thatcher at a dinner in late 1982. The occasion did not go well. I had no further contact with her while she was Prime Minister, but we became quite friendly afterwards. I helped her in the early 1990s with a couple of speeches.)
Lankester refers to Patrick Minford, an economist who was closer to Thatcher than me. Minford and I do not agree about monetary theory and policy, and I do not regard him as a monetarist. Anyhow, towards the end of the book Lankester notes that, in some of his writings, Minford favoured even more monetary ‘shock’ in the first two years in order to improve medium-term outcomes. Lankester remarks that – given the severe political challenges facing Thatcher – Minford was ‘talking in the realm of the fairies’.
Fair enough, but the larger problem was that in those years most British academic economists were also in a world of fantasy. Through the 1960s and 1970s, they believed that fiscal policy could manage aggregate demand and employment, that any inflation excesses could be quelled by prices and incomes policies, and that ‘planning’ from Whitehall and Westminster would boost economic growth. Astonishingly, many of them denied that the quantity of money was relevant to anything. Monetarism was needed, at that time, to remind these people of certain inescapable aspects of economic life. Later in the 1980s, when they realised that prices and incomes policies had become unacceptable, a majority of Britain’s economists harked back to an exchange rate discipline of the gold-standard sort; they supported accession to the European exchange rate mechanism as the best way to tackle inflation. In the two years to September 1992, Britain was inside the ERM, but the result was yet another vicious recession, with big losses of output and employment.
For one of his terms as a student at Cambridge, Lankester had the left-wing Keynesian, Joan Robinson, as his supervisor. She is described as ‘wildly eccentric and brilliant’. He does not recall that in an ‘Open letter from a Keynesian to a Marxist’, republished in her ‘Collected Economic Writings’, she said that she had ‘Marx in my bones’. He also does not mention that, for decades, Robinson was – in her own words – a ‘sympathetic visitor’ to Mao’s China and even North Korea. I am not suggesting that Lankester also admires Mao’s China and North Korea, but it worries me that he can cite Robinson with evident approval.
Also at Cambridge, Lankester read the 1961 edition of Paul Samuelson’s celebrated textbook, ‘Economics: an Introductory Analysis’. As Lankester notices, in that edition the quantity theory of money was described as being for the most part ‘a blind alley or possibly a red herring’. The Samuelson textbook went through 19 editions, with its views changing substantially between them. But a recurrent assertion in the editions of the 1950s and 1960s was that, because of its superior growth performance, the planned, communist economy of the Soviet Union would ultimately overtake the free market, capitalist economy of the USA in size. (The latest World Bank figures show that in 2023 the Russian Federation had a nominal gross domestic product was just above $2,000 billion, whereas that of the USA was almost $27,500bn.)
Sure enough, Thatcher and monetarism had a difficult time in the early 1980s. But the events of those years deserve a more sympathetic treatment, and should be set against a larger historical background, than in Lankester’s book.
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