Several related strands have come together in the last week of work and thinking. Today…
I have been on the search for historical turning points again today. The famous Mitterand austerity turn in 1983 is one of these points. Another, which I will consider today, was the British Labour Prime Minster James Callaghan’s speech to Labour Party Conference held at Blackpool on September 28, 1976 was laced with pro-Monetarist assertions that have been used by many on the Left as being defining points in the decline of the state to run independent domestic policy aimed at maintaining full employment. This is a further instalment of my next book on globalisation and the capacities of the nation-state, which I am working on with Italian journalist Thomas Fazi. We expect to finalise the manuscript in May 2016. Today, I am writing about the background events that turned Britain on to Monetarism. Margaret Thatcher was, in fact, a ‘johnny-come-lately’ in this respect. The British Labour Party were infested with the Monetarist virus in the late 1960s and Callaghan’s 1976 Speech just consolidated what had been happening over the decade prior. Further, it was not the oil crisis in the early 1970s that provided the open door for governments to reject Keynesian policy. In Britain, the Treasury and Bank of England were captivated by the ideas of Milton Friedman some years prior to the OPEC price push.
To understand how Callaghan’s Speech has been viewed over the decades, we only have to read a relatively recent article written by Liam Halligan in the UK Telegraph (August 18, 2012) – A message from the 1970s on state spending – which considered Callaghan’s speech to be “among the most important uttered in the history of modern British politics”.
The Telegraph article claimed that the Speech and the context (a British Labour Conference where Callaghan was being scorned by “a
a rabble of bearded Trotskyists from among his own party ranks”):
… marked a turning-point in Western economic policymaking.
Halligan claims among other untruths that:
1. In 1976, “the UK government had been rescued by the International Monetary Fund”.
2. “After years of industrial subsidies, soft-budget constraints and Keynesian hubris, Britain was insolvent – unable to service its debts.”
3. “After months of denial, the markets forced Callaghan’s government, ‘cap in hand’, to seek an IMF bail-out.”
4. “What brought Britain to that disgraceful nadir was a lot of self-serving ideas about the wisdom of near-limitless government largesse.”
5. “Callaghan’s words, however, were the high-water mark of Keynesian economics – which afterwards rapidly retreated. We had tried high state spending and it didn’t work. All it did was produce ghastly inefficiencies, inflation and, worst of all, expose supposedly sovereign governments to the wrath of their private-sector creditors.”
Heady stuff indeed.
First, we need to appreciate the context.
We start in 1968, with the Presidential Speech – The Role of Monetary Policy – by Chicago University professor Milton Friedman to the American Economic Association, which was published in the March 1968 edition of the American Economic Review.
[Reference: Friedman, M. (1968) ‘The Role of Monetary Policy’, American Economic Review, LVIII(1), 1-17].
The Speech laid out Friedman’s claims about the potency of monetary policy and the what he called the “increasing disillusionment with fiscal policy, not so much with its potential to affect aggregate demand as with the practical and political feasibility of so using it” (p.3).
Accordingly, he thought that because government spending responded “sluggishly and with long lags” to economic changes, policy makers focused on tax changes to stabilise the economy cycle. However, political factors always intervened “to prevent prompt adjustment to presumed need”.
Friedman was attacking the notion of ‘fine tuning’, whereby the national government adjusts its spending and tax policies to influence overall spending in the economy, with the aim of sustaining full employment without accelerating inflation.
This approach had dominated economic policy-making in the advanced nations in the period following the end of the Second World War. The dominant theoretical approach that justified the policy-making emphasis had been provided by John Maynard Keynes in his 1936 repudiation of the then dominant free market economic theory.
Friedman also rejected the idea that central banks could use changes in the money supply to target a politically-desirable unemployment rate. He introduced the famous notion of a “natural rate of unemployment”, which arises when there is no upward or lower pressure on real wage rates emanating from the labour market.
It is thus the unique unemployment rate that coincides with a stable inflation rate. In the context of the equally famous Phillips Curve, which is the relationship between nominal wage inflation and unemployment, Friedman said that the original contribution from Bill Phillips in 1958 presumed (p.8):
… a world in which everyone anticipated that nominal prices would be stable and in which that anticipation remained unshaken and immutable whatever happened to actual prices and wages …
The empirical Phillips Curve was essentially unstable – in the late 1960s it had seemed to move outwards – meaning that for any given unemployment rate, the inflation rate was now higher.
The Phillips curve was just one of a number of macroeconomic equations that ignored inflationary expectations. The misspecification was not significant while inflation was negligible.
But inflation started rising in the second-half of the 1960s, which manifested in the instability of the estimated Phillips Curve, that policy-makers had been using to determine the ‘optimal’ trade-off between the twin evils – inflation and unemployment.
The problem deepened with the oil price rises of the early 1970s. The rising inflation led to all these misspecified econometric relations breaking down in the big policy-making economic models that were in vogue at that time.
The problem was that the theoretical edifice that informed the technical specifications of these models was now vulnerable to attack, as as we know, soon fell into disrepute as the Monetarists, led by Friedman launched their attack.
Monetarist thought emerged from this wreckage as being eminently plausible.
It was a serendipitous period for the Neoclassical (free market) economists because they managed to reassert the issue of real wage bargaining before the empirical relations broke down.
Although in the mid-1960s, the Monetarist theoretical structure – which asserted that fiscal policy was ineffective and monetary policy easing would be inflationary – had undergone harsh criticism from economists like Robert Clower and Axel Leijonhufvud, the empirical shift in the Phillips curve in the early 1970s was interpreted as a validation of the Monetarist concept of a natural rate of unemployment and the negative connotations for aggregate demand management that this concept invoked
Friedman’s point in 1968 was that if the price level was rising then workers would form an expectation of the rate at which they expected prices to rise when bargaining for nominal wage increases. They did this to ensure the nominal wage outcome would reflect their real wage aspirations at any given labour market state (that is, at any unemployment rate).
In other words, if a central bank tried to “peg” (p.9) the actual unemployment rate below the “natural rate” by expanding the rate of growth in the money supply, this will, initially, “be expansionary” because it will lower interest rates according to Friedman’s logic (p.9).
However, the expansion will also push up wages and prices. Workers interpret the rising nomimal wages as a rise in the real wage and hence supply more labour – which is the reason unemployment falls, initially. It takes some time for the workers to find out that the real wage has actually fallen as prices rise faster than wages.
Firms, however, have more accurate knowledge of the rate at which prices and wages are rising as they set prices and pay the wages, and are willing to offer more employment because they know the real wage is has fallen.
Once the workers’ price expectations catch up they withdraw the extra labour and the unemployment rate rises back to the ‘natural rate’. The only impact the central bank expansion has had is to increase the inflation rate with no real gains.
That was Friedman’s famous story in 1968.
Friedman’s emphasis on expectations in 1968 changed the direction of policy in the 1970s but was rooted in developments a long time before this.
The idea that, in a period of sustained expansion (tight labour markets), inflation will accelerate if people build the history of inflation into their bargaining behaviour and attempt to maintain a constant real wage or real profit margin was well understood by Keynesian economists.
I discuss that point in great detail in my 2008 book with Joan Muysken – Full Employment abandoned,
However this understanding is trivial and misses the fundamental issue that Friedman and his colleagues were pursuing.
In attacking the prevailing view that there was a stable trade-off between inflation and unemployment, they were attempting to reclaim the terrain that Neoclassical monetary theory had lost after the Great Depression.
Friedman’s 1968 paper argued that monetary policy could only have real effects in the short-run, with the trade-off required increasingly worse. The starting point was Classical monetary theory, which suggests that monetary policy cannot have real effects as it simply alters prices and nominal incomes in a proportionate way.
Friedman stated “There is no long-run, stable trade-off between inflation and unemployment” (p.6), which was at odds with the Keynesian model. He wanted to deny the effectiveness of fiscal and monetary interventions by government in sustaining full employment.
To accept Friedman’s logic was to also realise there was now a policy lacuna, which required a fundamental reassessment of the way in which the government operated in the economy.
By rejecting fiscal policy as a viable tool for stabilising the economy, Friedman turned his attention to what monetary policy should do.
He said that central bankers had to “prevent money itself from being a major source of economic disturbance” (p.12) and provide a “stable background for the economy” (p.13) by providing a stable price level. In saying that, he was, of course, abstracting from the policy goals of full employment that had dominated the Post War period up until then.
The way he avoided that issue was to assert that the ‘natural rate of unemployment’, whatever level it might be, was the full employment level, because it was consistent with price stability. So by maintaining price stability, central banks would simultaneously fulfill any charter to maintain full employment. It was sleight of hand but was increasingly accepted by policy makers.
The policy advice that Friedman offered in 1968 was that the central bank should only target “magnitudes that it can control” (p.14) and he considerd the “monetary total-currency plus adjusted demand deposits” (p.15) to be the most desirable of these magnitudes.
The policy advice that emerged was the famous ‘monetary targetting’ approach, whereby the central bank would aim to achieve “a steady rate of growth” in the money supply and inform the population of the target and its resolve to maintain it.
Monetarism was born.
As we will see, the policy failed badly because it was based on an erroneous understanding of the monetary system.
But the failures would come later, The point is that Friedman’s intervention was extremely influential in policy making and business circles particularly in Britain.
On November 23, 1967, the then British Chancellor James Callaghan, who will figure large later on in this story, said in his “Letter of Intent to the IMF” that:
… the growth of the money supply will be less in 1968 than the present estimate for 1967.
The letter became public on November 30, 1967.
In October of that year, the Bank of England had raised interest rates twice in a futile attempt to defend the pound exchange rate. On November 18, 1967, the British pound was devalued from $US2.80 to $US2.40 (14.3 per cent) and the Bank of England raised the interest rate from 6.5 per cent to 8 per cent as well as freezing bank lending to all but the so-called priority borrowers.
These were desperate moves from a government and its central bank – trying to maintain the fixed exchange rate against all odds.
I considered this period in some detail in this blog – Case Study – British IMF loan 1976 – Part 6.
Kenneth Morgan wrote in his book – Britain since 1945: The People’s Peace – that (p.275):
… the affair appeared unplanned and conducted without the rapture of optimism, despite Wilson’s extraordinary chutzpah in his post-devaluation television broadcast.
[Reference: Morgan, K.O. (2001) Britain since 1945: The People’s Peace, Oxford, Oxford University Press.]
The Leter to the IMF was one of Callaghan’s last efforts as Chancellor. He was soon replaced by Roy Jenkins on November 29, 1967.
The fact is that:
For at least three years, perhaps for six, Britain had been in almost constant retreat, with repeated economic difficulties and no compensation in its foreign policy or defence postures. Labour had come to office with the credence attached to Wilson’s pre-election cries for scientific progress, planned investment, and expansive growth. These pledges were in ruins. The reality to date had been falling comparative growth despite rising domestic production per capita, repeated payments difficulties, and the entrenched power of the Treasury in curtailing growth … After three disastrous years, the nation was left with that black mood of foreboding only reinforced (Morgan, 2001: 276).
The right-wing lobby, still relatively unorganised, but increasingly centred in the media and the financial district of London (‘The City’), were creating an environment of “near frenzy” (Morgan, 2001: 276).
This was a group that was conservative by nature and, if the truth was known, had opposed the idea of State-sponsored full employment and the Welfare State from its inception.
It was also a sector that was evolving from the old days of banks who served the community desire to save and borrow for housing into what Matt Taibbi in 2010 described as being full of organisations which behave like a “great vampire squid wrapped around the face of humanity, relentlessly jamming its blood funnel into anything that smells like money”.
[Reference: Taibbi, M. (2010) ‘The Great American Bubble Machine’, Rolling Stone, April 5, 2010.].
Even in the late 1960s, with the growing global capital flows, the financial industry was growing in size and arrogance – full of pretentious, self-important operators who were intent on making as much return as they could, whatever it took, and the public could go to hell.
The message from Milton Friedman in 1968 was thus music to their ears for it gave the right-wing lobby a framework in which to not only attack existing economic policy but also to advance a new paradigm, which as it has evolved, would serve their interests handsomely.
In 1968, the British professional Magazine The Banker published four articles in the December issue (Vol 118, No. 514), which were devoted to the issue of changes in the money supply and the prominence of these changes in determining GDP and inflation.
Friedman, himself, wrote one of the articles – Taxes, Money and Stabilization – where he reiterated his rejection of fiscal policy as a reliable way of stabilising the economy and promoted his monetary targeting idea.
It was essentially a dumbed down version of his 1968 academic paper cited above and targetted at the professional policy-making community rather than the academy.
Other articles, variously, claimed that Britain was suffering from excessive liquidity and that the central bank should severely restrict the amount of ‘spending money’ that the non-government sector had access to. One article directly attributed the so-called excessive liquidity to government fiscal deficits.
Up until then, the Radcliffe Report, a 339-page study of Britain’s monetary system after 1931 – ‘Committee on the Working of the Monetary System’ – which was published in 1959, had been the major framework for conducting monetary policy in Britain.
The Radcliffe Report rejected the view that “the central task of the monetary authorities is to keep a tight control on the supply of money” (p.132).
It also rejected the view that increases in the money supply would inevitably translate into increasing inflation, a core proposition that Milton Friedman was advancing in his 1968 speech.
The Radcliffe Report said that (p.133):
… spending is not limited by the amount of money in existence; but it is related to the amount of money people think they can get hold of, whether by receipts of income (for instance from sales), by disposal of capital assets or by borrowing.
In other words, they were rehearsing the accepted understandings at the time that it was spending the created the inflation risk not the level of bank reserves or currency in existence.
It followed logically, that the Radcliffe Report would conclude that (p.134):
… the structure of interest rates rather than some notion of the ‘money supply’ … [should be] … the centre-piece of monetary action.
In the first of articles in the December 1968 edition of The Banker, this orthodoxy was attacked.
The opening article essentially rehearsed Friedman’s claim that the Bank of England had to focus on controlling the money supply if Britain was to achieve any sense of economic stability.
Aled Davies provides an excellent account of this period in his October 2012 paper – The Evolution of British Monetarism: 1968-1979 –
As Davies recounts, influential media such as the Financial Times ran stories in 1968 following Friedman’s Speech that promoted his ideas.
Davies also noted (p.6) that “the US Government and the IMF were seen to be increasingly dissatisfied with the ‘rather old-fashioned’ rejection of exogenous monetary theories embodied in the 1959 Radcliffe” Report. That was no secret.
On November 3, 1959, the Board of Governors of the Federal Reserve System in the US published a – Review of Foreign Developments – which focused on the Radcliffe Report. It was highly critical (p.2):
When the foreigner considers the wealth of analytical material in the Report and its disorganization, he is tempted to throw up his hands … These results may explain the ambiguities, numerous cross-opinions, and even inconsistencies in the report. Perhaps they will also help British residents to understand why so many foreigners have expressed disappointment in the labors of the Radcliffe Committee. They have inevitably been led to ask themselves if the Report is a contribution worthy to take the place with a long line of memorable British reports and tracts, extending over two centuries, which make up a valuable part of our common monetary and banking heritage.
The point that Davies was making is that in the chaos that followed the 1967 devaluation, “the British economy was particularly susceptible to the institutional opinions of global economic bodies” (p.6)
On June 19, 1968, Britain drew on the November 1967 stand-by arrangement with the IMF.
The domestic policy restraint imposed in 1968 saw some improvement in the external position by year’s end and domestic policy was further tightened in late 1968 and again in early 1969. Credit was restricted and taxes were raised.
To shore up the loss of reserves, the UK government secured a further stand-by arrangement with the IMF on June 20, 1969 of $US1 billion. There were two quantitative conditions imposed as part of this stand-by arrangement. First, that the Government would achieve a balance of payments surplus by early 1970. Second, that domestic credit growth would be required to stay within agreed upper limits.
By late 1969, an external surplus was achieved, mostly because external conditions were favourable to a substantial growth in exports. The devaluation also had improved Britain’s competitiveness, which enhanced the economy’s capacity to exploit the buoyant world trade situation.
The domestic restraint saw a significant slowdown in domestic spending and there was a substantial inflow of reserves as confidence in the sterling increased in 1969. The improved external position allowed Britain to repay significant amounts of its external debt liabilities.
However, inflation was still persisting at 5 per cent and this created mounting wage pressures as workers sought to defend their real standard of living.
The Government’s position was clear. It wanted the nominal devaluation in 1967 to “stick” in real terms, which meant that wages could not be compensated for the higher import prices. The trade unions opposed this and in 1968 and 1969 were able to gain nominal wage increases consistent with the underlying inflation rate.
The incomes policy guidelines imposed by Government were not capable of restricting the nominal wages growth and industrial unrest was relatively high as workers sought to improve their real living standards.
This tension would feature throughout the 1970s, which became more complicated with the collapse of the Bretton Woods system in 1971.
Adel Davies also notes that Friedman’s message was reverberating throughout the financial markets and business sector in Britain. He lists a range of leading firms who were starting to propagate the message about monetary targets.
By the end of 1968, the Bank of England was catching the virus. In its December edition of the – Quarterly Bulletin – there was a new section introduced – “Money supply: April-September 1968” which discussed movements in the broad aggregate (deposits plus notes and coins) in the previous quarter.
Davies notes that the Bank used the “‘counterparts’ approach” in this regard (p.6):
The ‘counterparts’-derived definition of the money supply explicitly linked the budget-deficit (PSBR) to monetary growth (alongside private bank lending) – a relationship which was to become central to the MTFS.
The MTFS was the Medium Term Financial Strategy introduced by Margaret Thatcher in March 1980, which was, arguably, the final act in the Monetarist’s delusion that the Bank of England could control the monetary supply.
The discussion leads to a rather stark conclusion. The British Labour Party did not meet their Waterloo, with respect to its attraction to Keynesian policy intervention in 1976, when James Callaghan stood up to deliver his Blackpool Speech.
The abandonment of its Labour Party belief system with respect to economic policy began in the late 1960s as they attempted to maintain a fixed exchange rate parity within a monetary system (Bretton Woods) that was unsustainable, and, which, would soon fall apart.
The attempt to maintain the parity contrary to reality created domestic problems, which were then wrongly construed as a failure of the Keynesian counter-stabilisation policy.
The real problem was the continued belief within the British Labour Party that somehow the value of the pound was a status symbol that ‘grand old’ Britain had to hang on to at all costs.
Further, in trying to maintain the value of the pound at levels in excess of what reality would permit, given the logic of Bretton Woods system, the British government created domestic chaos (high unemployment, wage-price spirals and the like), which was falsely attributed to some conception that the ‘Keynesian’ policy framework was no longer sustainable.
Adel Davies notes (p.8) that:
What emerged after 1968 was a widely held view that international and domestic authorities were increasingly influenced by new theoretical ideas regarding the role of the money supply. It appeared to observers that these various authorities attached considerable importance to the money supply, and were thus liable to shape their policies in accordance with a strategy to control monetary growth. The academic development of Chicago monetarism created a new intellectual climate which, whilst being conceptually stimulating for some, was more notable for its perceived influence on key economic institutions.
Britain was thus infested with Monetarism in the immediate years following Friedman’s 1968 Speech.
At the time, as part of the conditionality that Callaghan, and then Jenkins acccepted in relation to the Stand-by arrangements with the IMF, it was agreed that the Bank of England would somehow start controlling the money supply.
Forrest Capie says (p.456) that the “IMF had more or less demanded that control of DCE be implemented and taken seriously”. Domestic Credit Expansion (or DCE) was the aggregate that the IMF wanted governments to control.
[Reference: Capie, F.H. (2012) The Bank of England: 1950s to 1979, Cambridge, Cambridge University Press].
IMF official, William Day wrote in his 1979 report – Domestic Credit and Money Ceilings under Alternative Exchange Rate Regimes – that DCE (p.491):
… is a measure of the increase in the money supply caused by domestic financial institutions – that is, what is obtained after adjusting the realized increase in the money supply to take account of the change caused by the external payments surplus or deficit. Only if there is external payments balance will domestic credit expansion and realized monetary expansion be equivalent.
[Reference: Day, W.H.L. (1979) ‘Domestic Credit and Money Ceilings under Alternative Exchange Rate Regimes’, IMF Staff Papers 26, 490-512.]
The money supply aggregate, M3 is defined as the notes and coins in circulation, plus all sterling bank deposits and UK deposits in foreign currencies. DCE is the change in M3 adjusted for the nation’s balance of payments position. So when a nation is running an external deficit on the current account it is supplying more of its currency to foreigners than foreign currencies are being supplied to domestic residents.
The supply could be in the local currency, which reduces reduces British resident bank deposits and M3. If the payments are in foreign currency, the British resident must first exchange sterling in the foreign exchange market, which in a similar way, reduces British resident bank deposits.
The impact on M3 is to attenuate any increase or promote a decline in the aggregate.
The IMF believed that the DCE concept was a more appropriate measure of the influence of the growth in the monetary aggregate on the domestic price level because it was not affected by the status of the nation’s balance of payments. It solely measures the expansion of domestic credit.
In policy terms this was a big difference, because the IMF argued that a central bank could meet M3 targets merely by running external deficits, a problem avoided by targetting DCE.
Further, given the IMF’s obsession with eliminating current account deficits, it believed that controlling DCE would allow a nation to reach balance of payments equilibrium, because growth in DCE would stimulate national income and imports.
Importantly, it was another of those ‘fixed exchange rate’ concepts, because under flexible exchange rates, the link between domestic income expansion and the balance of payments position is compromised – imports no longer respond in the same way to national income.
The IMF aggressively pushed the idea that the Bank of England had to control the DCE and a conference in October 1968 where the IMF, HM Treasury, Bank of England and other British government officials marked a crucial turning point in economic policy making in Britain.
The British government formally adopted the DCE ceiling in May 1969.
In his grand history – International Monetary Cooperation Since Bretton Woods – published jointly in 1996 by the IMF and Oxford University Press, Harold James wrote (p.191) that this decision formalised the “beginnings of an intellectual conversion” within the British Treasury (see also Needham, 2012, p.7)
[Reference: Needham, D. (2012) ‘Britain’s money supply experiment, 1971-73’, CWPESH No 10, University of Cambridge.]
A series of Bank of England papers and reports followed extolling the virtues of imposing controls on the monetary aggregates, even though the capacity to maintain ‘ceilings’ on credit expansion proved to be very limited.
The next attempt came with the introduction by the Bank of England of its so-called Competition and Credit Control (CCC), which was introduced in September 1971. This formalised the growing emphasis among the banking sector and economists that the central bank had to ‘control’ the money supply.
While many people think that it was Margaret Thatcher that brought Friedman’s Monetarism to the UK – the infestation had already taken hold by the early 1970s.
1. The failure of CCC technically but its success as an ideological tool to condition British politicians.
2. The Oil Crisis.
3. The re-election of British Labour and Callaghan’s sell out speech.
The series so far
This is a further part of a series I am writing as background to my next book on globalisation and the capacities of the nation-state. More instalments will come as the research process unfolds.
The series so far:
The blogs in these series should be considered working notes rather than self-contained topics. Ultimately, they will be edited into the final manuscript of my next book due later in 2016.
That is enough for today!
(c) Copyright 2016 William Mitchell. All Rights Reserved.