Economic policy - Great Britain ; Great Britain

Kenneth Bernauer

English

Research Papers in Economics

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May 29,1981 
Thatcherism 
The current debate in the U.S. on the Reagan 
economic program has led many com-
mentators to draw parallels with the U.K.'s 
economic performance under Margaret 
Thatcher. Throughouttheir political careers, 
both Prime Minister Thatcher and President 
Reagan have consistently favored a less in-
trusive role for government. This is best 
exemplified in their espousal of lower public 
spending, reduced government regulations, 
and a hands-off approach to wage and price 
setting. On the basis of  these shared prin-
ciples, we might expect some similarity in 
other facets of  their economic programs-
and might expect that Britain's performance 
under Thatcher would provide a preview of 
the success or failure of Reagan's economic 
program. 
From this perspective, economic develop-
ments in the United Kingdom since Thatch-
er's assumption of power in May 1979 may 
prove alarming. British consumer prices rose 
18 percent during 1980-more  than 7 per-
centage points above the rate prevailing in 
the final months of  James Callaghan's Labor 
government. Despite this acceleration in in-
flation, the unemployment rate has climbed 
precipitously, from 5.3 percent in May 1979 
to 10.1  percent currently-and the actual 
number of unemployed has passed the 2.5-
million mark for the firsttime since the 1930s. 
Quoting this chain of  statistics, one might 
conclude that it wou  Id be wise for the U.S. to 
abandon similar policy initiatives. But this 
view is too narrow. In many respects, the 
differences between the Thatcher and 
Reagan programs are greater than the similar-
ities. A closer look at the British experience 
may therefore prove enlightening for U.S. 
policymakers in the current discussion. 
Shift towards conservatism 
The Tories' victory in the Spring 1979 elec-
tion reflected a myriad of factors. However, 
industrial disruptions, coupled with wage set-
tlements well exceeding the government's 
guidelines, contributed to severe economic 
problems in the winter of 1978-79. Pent-up 
frustrations with this situation led the voting 
public to demand a change. 
The victorious Conservatives' economic-
policy program called for cuts in public 
spending and persondl-income tax reduc-
tions to be financed by hikes in sales (value-
added) taxes. Overall, the program was de-
signed to lower the public-sector borrowing 
requirement (PSBR) to £8.3 billion in fiscal 
1979/80 (4.5% of  GNP) from £9.3 billion in 
fiscal 1978/79. The government hoped to 
achieve this goal despite a predicted fall in 
real economic activity and an acceleration in 
inflation brought about by the hikes in value-
added taxes. The budgetwas designed to 
restore private incentives by shifting the bur-
den of  taxation from incometo consumption, 
and reduce the government's role in the 
economy through reduced public spending. 
Concurrent with this May 1979 budget 
proposal, the government announced that 
"sterling M-3" would be kept within an an-
nual target range of 7-11  percent, down from 
the previous year's actual growth of 11112-
percent. (That money-supply measure in-
cludes, among other factors, the PSBR less 
sales of public-sector debt to the non-bank 
private sector.) The planned cut in the PSBR 
was consistent with meeting this monetary-
policy objective without putting undue 
pressure on interest rates. Reduced public 
spending and borrowing would help achieve 
a gradual deceleration in monetary growth, 
and hence in the inflation rate. 
Economic strategy 
The Thatcher and the Callaghan prescriptions 
for curbing inflation differed considerably. 
The Labor government had viewed efforts to 
curb inflation through a deflationary mone-
tary policy as too costly and inefficient, lead-
ing to large-scale unemployment. For the ffiOo.~ '~\ f{\\  1~  (l\)  $l~l;  lJJ.;  (~!,.:, L1.  )j, l(\:,  ,~, L 
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March 1973=100 
90 
80 
70 
60 
Chart 1 
Effective Exchange Rate 
(April 
()pinions e1.;prcssed in this  nevv~;\etter do not 
necessarily reflect the vie\!vs  of the rnanagement 
of ihe Federal Reserve Bank of San rrancisco, 
or of tllP rsnard  of C;overnors of the Federal 
Reserve  SVStPI'Yl. 
oT~~~  __  ~~I  __  ~~~~I~  __  ~~~I~ 
1978  1979  1980  1981 
Laborites, cost-push factors-such as leap- . 
frogging wage demands-provided a major 
impetus to inflation. Thus, the imposition of 
wage-price guideposts, in conjunction with a 
responsible monetary and fiscal policy, pro-
vided an appropriate response to inflation. 
This position on economic policy got its 
support from two large-scale econometric 
models formulated by the National Institute 
of Economic and Social Research (NIESR) 
and the Cambridge Economic Policy Group 
(CEPG). By comparison, the Tories relied 
upon the empirical work of the London 
Business School (LBS) to support their policy 
prescription of reducing money-supply 
growth. According to the LBS, a tighter mone-
tary policy would raise the exchange rate of 
the pound in terms offoreign currency, which 
in tUrn would help check domestic price and 
wage increases through increased interna-
tional competition. While agreeing that a 
higher exchange rate would lead to lower 
import prices and hence to reduced pressure 
on domestic prices, both the NIESR and the 
CEPG argued that a high exchange rate 
would not act quickly to moderate wage be-
havior, and thus would lead to greatly dimin-
ished growth of output and employment. 
Whatever their differences, all three models 
concurred with the government's conclusion 
. that the British economy was headed for a 
contraction in 1980. 
What results? 
The Thatcher government failed to achieve its 
twin objectives of cutting public spending 
and reducing money-supply growth during· 
the 1979-80 period. The main monetary ag-
gregate, sterling M-3, increased at a 16.4-
percent annual rate between the first half of 
1979 and the second half of 1980, consider-
ably above the 7-11  percent target range. The 
reason may have been a massive £S-billion 
overshoot of the public-sector borrowing re-
quirement, to £13.5 billion in fiscal 1980/81. 
Many would argue that the linchpin of  the 
Thatcher program-reducing money-supply 
2 
growth-was neverfully impiemented, so no 
lessons couldbe drawn from the experience. 
But M-1  growth was reduced by more than 
half over this period. 
Whatever the public may have thought of 
monetary policy, the foreign-exchange mar-
kets perceived it as quite tight. The pound 
sterling rose sharply in value reflecting the 
combined influence of a stringent monetary 
policy (more properly measured by high in-
terest rates and M-1 growth than sterling M-3) 
and oil-price developments (see chart 1). 
In the face of  the pound's appreciation, U.K. 
manufacturers tried without success to main-
tain their price competitiveness through re-
duced profit margins. Butthe slackening of 
export markets came at a timeof  weakness in 
domestic markets as well. This led to a record 
overhang of inventories which had to be fi-
nanced at the much higher interest rates 
created by inflation and government borrow-
ings. The inability of firms to pass on these 
costs, including increased energy costs, into 
higher prices led to a sharp deterioration in 
manufacturers' financial position. 
Under these circumstances, one would ex-
pect a strong deceleration in wage demands. 
On the contrary, wage demands actually ac-
celerated (see chart 2), partly reflecting sub-
stantial  wage  settlements  awarded  to civil-
service employees and hikes in sales taxes 
contained in the June i 980 budget. The 25-
percent annual increases in civil-service pay 
set a standard for private-sector wage earners, 
whereas the sales-tax increases raised the re-
tail-price index on which wage demands 
were partly based. As a result, average earn-
ings increased 26.1 percent between Septem-
ber 1979 and September 1980. 
The fall-off in domestic and foreign demand, 
coupled with cost increases, meanwhile led 
many firms to declare bankruptcy and to lay 
off workers. In the resultant recession, manu-
factu ri ng output dropped about 1  7 percent 
(see chart 3). However, the run-up in unem-
ployment has finally moderated wage in-1975=100 
220 
Chart 2 
Prices and Costs, Manufacturing 
~.--.-. 
200  Materials and Fuels  purChas.~ 
180 
160 
140 
120 
100 
T 
01978  1979  1980  1981 
creases in the last six months, leading to some 
abatement of cost pressures. 
Increased unemployment, and hence great-
er-than-expected outlays on unemployment 
compensation, helped push the projected 
PSBR to £14 billion -almost double the tar-
geted amount-for the current fiscal year. 
The Thatcher government thus abandoned 
scheduled income-tax reductions and raised 
an assortment of other levies to reduce the 
deficit from £14.0 billion to £10.5 billion. 
The tax hikes will be imposed on an economy 
facing an expected 2.0-percent drop in real 
output this year after a 3.0-percent decline in 
1980. 
lessons for the U.s.? 
The contentious -debate among the various 
U.K. research institutes parallels a similar 
controversy in the U.S. But whereas the U.K. 
controversy is between monetarist and non-
monetarist, the debate in this country adds an 
extra dimension in the form of "supply side" 
(tax incentive) economics. 
Administration officials predict that their 
budget and tax-cut plans will bring about 
. dramatically lower inflation and robust 
growth over the next five years. This can be 
achieved by across-the-board tax cuts which 
will promote labor productivity through in-
creased work incentives. Moreover, the Ad-
ministration figures that gradual reductions in 
.  money-supply growth will moderate infla-
tionary expectations. This in turn will lead 
workers to reduce their wage demands, and 
thus lead firms to moderate their price be-
havior. Whereas the U. K. government relies 
more on international competition to keep 
wages in check, the U.s. government counts 
on the salutary effects of reduced price ex-
pectations to accompl  ish the same effects. 
Regardless of  the means of policy response, 
both the Thatcher and Reagan governments 
can be characterized as highly optimistic re-
garding the speed of worker and producer 
response to changed circumstances. Their 
sanguine scenarios thus iustifieda hands-off 
1975=100 
110 
Chart 3 
Production,  Manufacturing 
100 
3 
90 
80 
01  I 
1978 
I 
1979 
I 
1980 
I 
1981 
approach to wage and price setting, and al-
lowed the dismantling of  the incomes 
policies imposed by their predecessors. 
The Thatcher government's miscalculation 
on wage behavior led to higher-than-
projected unemployment, and thus led to 
higher-than-expected public borrowing. To 
curb the fiscal shortfall, the Tories then raised 
taxes in the mjdst of a cyclical downturn, 
partly in order to reduce money-supply 
growth while alleviating upward pressure on 
interest rates. By contrast, the centerpiece of 
the Reagan fiscal program are spending and 
tax cuts during a cyclical upswing. From the 
Administration's perspective, the tax cut will 
not stimulate consumer demand but rather 
will spur supply through increased savings 
and investment incentives. The higher deficit 
stemming from the tax cuts will be financed 
in the short run by greater private savings and 
in the long run by higher production and 
output. Consequently, the tax cut need not 
prompt greater monetary expansion and 
higher interest rates. On the contrary, a re-
duction in money-supply growth would help 
lower expected (and actual) inflation. 
The lessons that can be drawn from U.K.'s 
experience, therefore, rest mainly in the re-
sults of its monetary-policy actions. In this 
regard, the failure of British market partici-
pants to respond rapidly to a restrictive mon-
etary policy affected output more than prices  . 
This could be a warning sign to U.S. officials 
as well. If wage behavior remains sticky, a 
tight monetary policy and high inflationary 
expectations could lead to higher-than-
projected inflation, a squeeze on corporate 
financial positions, and to lower output 
growth, which in turn will enlarge the fiscal 
deficit. Thus, such portents as the United 
Mine Workers' rejection of a 36-percent 
wage increase (overthree years) provide 
rather unsettling prospects for future stability. 
Kenneth Bernauer 'lUe::>  'o:>spueJ:I ues 
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BANKING DATA-TWELFTH fEDERAL RESERVE DISTRICT 
(Dollar amounts in millions) 
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Change from 
year ago 
Selected Assets and liabilities 
large Commercial Banks 
Amount 
Outstanding 
5/13/81 
Change 
from 
5/6/81  Dollar  Percent 
Loans (gross, adjusted) and investments* 
Loans (gross, adjusted) - total# 
Commercial and industrial 
Real estate 
Loans to individuals 
Securities loans 
U.s. Treasury securities* 
Other securities* 
Demand deposits - total# 
Demand deposits - adjusted 
Savings deposits - total 
Time deposits - total# 
Individuals, part. & corp. 
(Large negotiable CD's) 
Weekly Averages 
of Daily Figures 
Member Bank Reserve Position 
Excess ReserVes (  + )/Deficiency (  - ) 
Borrowings 
Net free reserves (+ )/Net borrowed( -) 
* Excludes trading account securities. 
#  Includes items not shown separately. 
148,888 
126,806  -
37,508  -
52,149 
22,890 
1,428  -
6,466 
15,616  -
40,480  -
28,606  -
30,226  -
79,343 
70,018 
31,784 
Weekended 
5/13/81 
n.a. 
275 
n.a. 
94  10,746  7.8 
73  •  10,371  8.9 
301  3,397  10.0 
151  5,500  11.8 
35  - 1,287  - 5.3 
234  520  57.3 
1  99  1.6 
22  280  1.8 
832  2,037  - 4.8 
246  - 2,103  - 6.8 
277  3,867  14.7 
1,118  14,502  22.4 
901  14,125  25.3 
725  8,758  38.0 
Weekended  Comparable 
5/6/81  year-ago period 
n.a.  126 
162  4 
n.a.  -123 
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Thatcherism

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Thatcherism

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