Pound Foolish

In Politics and the Pound, Philip Stephens has produced a book which should be required reading for anyone aspiring to be either Chancellor or Prime Minister. Let’s hope Gordon Brown and Tony Blair are studying it carefully. They can legitimately enjoy the more egregious mistakes made by the Tories since 1979, but they should be sparing with their scorn. They should remember the errors of previous administrations; and be thankful they did not win the last election and inherit an ERM membership which they had supported when in opposition.

Stephens’s judicious narrative of the turbulent economic events of the period provides a necessary sceptical gloss on the one Nigel Lawson gives in the thousand pages of his View from No 11. It draws on the testimony of many senior officials and other participants, who persuasively dispute Lawson’s view at many points and have not hitherto had an opportunity to state their case. But Stephens’s purpose is not so much to write a history of the recent past as to explore the twists and turns of policy towards the exchange rate and the effects these had both on the economy and on the politicians themselves. Managing the exchange rate is tricky for governments at the best of times. It is clearly a price (the price at which one currency buys another), playing a large, though much disputed, role in reflecting, transmitting and instigating economic trends. Equally clearly, it is symbolic of the doctrines and actions of a government and of how it is viewed by foreigners. Finally, because it measures the value of the nation’s currency against some other currency or asset, it can never be more than partially under a government’s control.

Given the relatively inferior economic performance of the UK compared to her main competitors for over a hundred years, and the painful decline for nearly as long from an international pre-eminence embodied in the widespread use of sterling, it is not surprising that virtually all modern British administrations have failed for a good deal of the time to manage the exchange rate successfully – even before it became entangled with the equally intractable problem of how to handle Europe.

At bottom, the policy a government adopts towards the exchange rate is an aspect of a deeper policy decision: whether to commit itself to a set of rules or to rely on pragmatic discretion. Those in favour of rules can point to the operation of the Gold Standard before the First World War and the Bretton Woods fixed exchange rate system after the Second, as both providing, through their constraints on national policy, a benign environment in which international trade and economic growth thrived. As examples of the dangers of unfettered discretion, they can point to the destructive chaos of the interwar period and the disastrous worldwide inflationary boom of the early Seventies, by when the Bretton Woods system had collapsed and governments no longer felt constrained by exchange rates or any other discipline.

Lawson, the prime exponent of the policies embraced by the Tories when they came to power, has never made any secret of his belief in the necessity for a clearly defined framework of rules. But by 1979 it was clearly impossible to reconstruct a global fixed exchange rate system. One alternative possibility, chosen in 1978 by all the members of the EEC except the UK, was a mini-system, the ERM. Callaghan said at the time that the UK would join, but only ‘when the time was right’. As repeated endlessly by Thatcher, this phrase became an embarrassing euphemism for never. But in 1978 the time was genuinely not right and was recognised not to be so by our partners – a point not made by Stephens. As a petro-currency, sterling was likely to be destabilising because any movement in world oil prices would push it and the other EEC currencies in opposite directions.

In these circumstances, the Thatcher Administration chose a set of domestic rules: establish and publish medium-term targets for the growth in the money supply and the evolution of the public sector borrowing requirement; abjure any discretionary (i.e. ‘Keynesian’ counter-cyclical) use of fiscal policy; and have no policy at all towards the exchange rate.

The theoretical underpinning for this framework was thought to have been provided by Milton Friedman and the then fashionable theory of Rational Expectations. Friedman’s views were put forward to the public in the form of simple-minded graphs purporting to show that movements in the money supply were always followed some time later by similar movements in inflation. The idea behind ‘Rational Expectations’ was that, provided the Government showed it was going to follow a virtuous fiscal and monetary path, the rest of us – businessmen, bankers, consumers – would see that, unlike in the horrific recent past, a stable non-inflationary environment lay ahead, so that we could all make fruitful and mutually reinforcing decisions.

To convince the markets that this was going to happen, the Government made great play of fettering itself with forecasts, targets and promises, which would be kept because it would be too humiliating to break them. One corollary of this was that the exchange rate must be left to itself: trying to influence it one way or the other would cut across the policies designed to achieve the fundamental domestic objectives. In any case it was believed that, perhaps after some initial wobbles, domestic stability would lead to external stability and the exchange rate would then settle down at an appropriate level. In the same way, ministers appeared to believe (Thatcher certainly believed) that domestically it would be relatively easy to control the money supply and that the desired outcome of stable non-inflationary growth would follow quite smoothly and without the intervening pain of high unemployment.

As we all know, things didn’t work out as planned. Targets were missed, redefined and missed again. The path to lower inflation proved anything but smooth as interest rates, the exchange rate and unemployment all soared and manufacturing industry was devastated. It soon became clear to all – as it had been clear to some from the start – that none of the fiscal and money supply targets would bear the weight policy had put on them. And the exchange rate began to creep back into the picture.

When in 1980 sterling went over $2.40, as a result of the mindless application of the monetarist rules to an economy with a petro-currency, Alan Walters, her personal economic adviser (and a monetarist himself, though a relatively sophisticated one) was finally able to convince the Prime Minister, as no non-monetarist could, that interest rates must be lowered – even though the money supply was roaring ahead – to ease the vice in which sterling was crushing the economy. Then, when Howe’s deflationary Budget in 1981 was followed by an extremely beneficial depreciation of the pound by some 20 per cent, interest rates were finally raised to stop it falling further. Howe commented later: ‘our benign neglect of the exchange rate could continue no longer.’ When, in January 1985, after a further switchback in the first years of Lawson’s chancellorship, the pound was heading towards £1 = $1, Thatcher pre-empted Lawson’s Budget plans by forcing a rise in interest rates to avoid that symbolically awful parity.

By that point policy was in a complete muddle. The monetary rules had proved unreliable and the exchange rate was being managed wholly pragmatically. The true doctrine of rules was still being promulgated in public but the agile mind of the Chancellor was already moving back to the exchange rate constraint he had so long derided. Later, in his memoirs, with a frankness disarming or shocking according to taste, he said that the line he took in his Mansion House speech in autumn 1984 ‘was a fiction even when I uttered it, as the exchange rate played a much larger part in policy than I was prepared to admit in public’.

During 1985 Lawson joined forces with the Bank of England and the Foreign Office to press on Thatcher the case for immediate entry to the ERM. The campaign culminated in a meeting in November in Number Ten attended by the Governor of the Bank of England, the Foreign Secretary (Howe), the Home Secretary (Whitelaw), the Trade and Industry Secretary (Leon Brittan), the Party Chairman (Tebbit), the Chief Whip (Wakeham) and the Leader of the House of Commons (Biffen). All except Biffen supported Lawson, but Thatcher refused to give way. Stephens says this was the only occasion in her prime ministership when she stood alone against the expressed view of her most senior ministers on an issue of such importance. He could surely have gone further. Can there be a precedent in the history of Parliamentary government in the UK when a prime minister has seen off such massive cabinet opposition on such a fundamental issue? Lawson and Howe claim that if we had gone in at this time much of the succeeding agony would have been avoided. They may well be right. Sterling had emerged from its petro-currency status, inflation had been brought down, the UK was roughly at the same point in the trade cycle as its partners and the ERM had not yet effectively frozen its exchange rates.

In practice, Lawson refused to take Thatcher’s ‘no’ for an answer. After presiding over a sharp fall in the exchange rate throughout 1986 (for which he later ungallantly and most implausibly blamed his officials), he started a private policy of shadowing the deutschmark. This time, not merely the public but the Bank of England, many of his senior officials and Number Ten itself were kept in the dark. They gathered in due course what he was up to but, amazingly, it appears that no memo outlining the policy was ever circulated. This was all the more surprising since he had a few months earlier said there was no role for an exchange rate target outside a formal system. The informal deutschmark target lasted a year, during which the rows were becoming more and more bitter, and more public. Finally, in March 1988, and on the advice of the Bank of England, Thatcher forced Lawson to stop the Bank intervening in the markets and the pound was allowed to float upwards.

From then until October 1990 there was effectively no policy framework at all. The results could be said to justify the worst fears of those who oppose allowing policy-makers unfettered discretion. A massive credit boom was given an extra boost by an irresponsible, tax-cutting budget. As a result, inflation, having been with so much pain and difficulty at last brought down below 5 per cent, took off and eventually went over 10 per cent again. When measures were finally taken to arrest the boom, the last of the original rules came back to afflict us. The belief that fiscal policy should not be used counter-cyclically, and that taxes (or at any rate direct taxes) should never be raised, meant that all the deflationary weight had to go onto interest rates. To cool down a boom caused primarily by over-borrowing by means of prolonged high interest rates is to maximise the damage. The effects of interest payments rapidly turning into compound interest payments, and of widespread negative equity are with us still.

This was the background to the fateful decision to enter the ERM on 5 October 1990. It had been delayed for far too long, argued for by one faction, resisted by another. The UK’s negotiating position had been frittered away by a vacillating and confused policy towards all things European, because of fundamental differences within the Government. The Bank of England and many in the Treasury had been so appalled by the mishandling of the economy since 1986 that they, perhaps against their instinctive judgment, supported the move as a strong anti-inflationary lever. With a few honourable exceptions, the great mass of industry and banking, and the majority of the press, supported it wholeheartedly. So did the Labour and Liberal Democratic Parties. So did the OECD.

The momentum was such that there was no real discussion. After 11 years of repeating that we would join only when the time was right, the question whether that time had arrived was not debated with any seriousness. A very little consideration would have shown that it had not. By October 1990 the UK was clearly heading into recession. (A complicating factor was that over this whole period the official Treasury forecasts were inexplicably optimistic; but by this point the evidence for recession was everywhere.) On the other hand Germany, whose interest rate policy would determine the rates in the rest of the system, was wrestling with the consequences of reunification, which had been brought about on very lax fiscal terms. So it was crystal clear that the UK was likely to need lower rates over the next couple of years while the Germans would probably want to raise them.

The rate at which sterling entered the ERM was DM2.95 to the £1, with a 6 per cent margin either side, yielding a floor of DM2.7780. Stephens has investigated who said what to whom in the days before entry and reaches the persuasive conclusion that by this point we had very little negotiating room – maybe 5 pfennigs at most. The Germans were very doubtful about a rate as high as 2.95 but the French made clear they would oppose any rate significantly below where sterling was currently trading (2.93). Any chance of shaving a bit off was probably thrown away by the ham-handed way we entered – not going through the normal consultative process but simply presenting the decision to our partners as a fait accompli. (This contrasts poignantly with the decision made on our last day in the system, when we went through all the niceties of raising interest rates and buying sterling, at huge cost to the taxpayer.)

But even if on 5 October we could not have entered at a significantly lower rate that does not dispose of the question. Stephens reports that the decision to enter was taken in the Treasury in early June. One of the Chancellor’s aides leaked it to the Financial Times, saying that Major wanted to enter at a relatively high rate to protect his anti-inflationary policy. The markets promptly took the hint and the pound rose strongly. There can be little doubt that if the authorities had wanted to enter at a lower rate they could have engineered this over the preceding months.

The third bad aspect of the decision was that the ERM had changed from the earlier version that we nearly joined in 1985. Originally it had been, like Bretton Woods, a fixed-but-adjustable system, allowing devaluations and revaluations from time to time. According to Stephens, Thatcher, Major and Sir Peter Middleton (Treasury Permanent Secretary) all believed they could readjust the sterling rate if necessary. But by 1990 there had been no general realignments in the system for almost four years. The participants were increasingly focused on moving to a single currency and had already, to a large extent, frozen their exchange rates.

The account of our two years in the ERM makes melancholy reading – especially to anyone like myself who has been involved in the defence of an indefensible exchange rate. There has been a predictable degree of recrimination since: allegations that the Bank’s tactical operations could have been better; that the Treasury consistently mishandled the German Government and the Bundesbank, and the relations between them; that realignment might have been possible even as late as 4 September 1992 at a regular meeting of EC Finance Ministers at Bath had Lamont not been grotesquely rude as Chairman; that all might have been well if the Bundesbank President had not made some damaging remarks about sterling; that if we could have held out to the following weekend, when the French were holding a referendum on Maastricht, new options might have emerged. But all this is superficial. The enterprise was doomed very nearly from the start because with the UK in deepening recession, it could not afford (and rightly not) to raise interest rates. The Treasury finally ‘ran up the white flag’, as one official put it, in July 1992, when the threat by a building society to raise its mortgage rate in response to the generous rate of interest offered on a new National Savings Bond caused the Treasury to cut the rate on the bond.

Whatever may be said in principle for rules as against discretion, it is clear that, as operated by Thatcher and Lawson, they were disastrous. Thatcher spoke like a rules person – indeed for most of the time and on most subjects she laid down moral or economic laws in abstract terms. But it is clear that she never felt that they need, or would, bind her; nor did they. Lawson, on the other hand, expounded the case against discretion with great intellectual rigour and clarity. The trouble was that he reserved to himself the discretion not only to decide on what the rules should be but on when and to what different rules they should be changed. Major appears to be temperamentally a pragmatist, but once gripped by the ERM he became as dogmatic as any of the earlier monetarists had been. Lamont’s contribution was further to undermine public confidence in what the Government tells us it is doing by, like Lawson earlier, admitting – or rather boasting – that he had never believed in the policy he was carrying out.

Since 16 September 1992 we have had our best three and a half years of economic management not merely since 1979, but probably since the Fifties. It has been based on an extremely well-handled devaluation, combined with increases in taxes which, however painful, were necessary to redress the extreme fiscal irresponsibility of the late Eighties. Since both these policies represent broken electoral promises, we look to be in a period of seriously unfettered discretion – though the explicit inflation objectives constitute some degree of constraint.

So does discretion finally rule? It is too soon to say. Pre-electoral considerations can easily give pragmatism a bad name. So can the excitements of inheriting power after 18 years without it. In any case, the biggest potential constraint of all is looming: the single currency. The last part of Politics and the Pound, though well done, is the least interesting, partly because all the agonising debates over Maastricht, the opt-out clauses, the war between Europhiles and Eurosceptics, are so familiar. But mainly because we don’t yet know how the story ends.

One can’t help worrying, however, about the similarities to the long run-up to ERM entry. Then, political considerations prevented what would probably have been a sensible decision in 1985 and brought about an appalling one in 1990. Looking forward, economic developments, if left to themselves, will probably, over the next five or ten years, produce conditions in which the locking of exchange rates could be beneficial. If, however, the dominant considerations are to be those of momentum, political will, seizing the moment etc, regardless of the degree of true economic harmonisation, the results could be disastrous. The trouble is that with so much dogma flying about, a decision either way is likely to be messy. If Messrs Blair and Brown are by then in charge, they will do well to remember the troubles the pound has always caused politicians, of any party.