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EC-111 British EconomyRecent UK

Macroeconomic TrendsDr Catherine Robinson

F35, Richard Price BuildingOffice Hours: Mondays 10:30-11:30 and Thursdays 9.30-10.30

Appointments: c.robinson@swansea.ac.uk

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Recapitulating yesterday...Thatcher came in…

Adopted Medium Term Financial Strategies

Followed a monetarist policy for the first of theseThe cost was unemployment and particularly hard

hit was the manufacturing sector

Reverted to a fixed exchange rate system within EuropeERMPegged to the Deutschmark

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The exchange rate became the target

Monetarism had pretty much failed

Fiscal policy was seen as a short run instrument to balance the budget No long term function of Keynesian times

But what happened in the ERM? It was the ONLY external policy target and the interest rate was the only instrument Sterling was pegged too high

By late 1992, sterling had been forced out of the ERM Sterling fell by 14% against the DM and 20% against the $ This all led to fear of inflation driven by higher import prices The resurgence of fiscal policy!

Pro-ERM case If UK inflation increased within a fixed

exchange rate system, UK goods would become uncompetitive leading to a current account deficit, which would tend to lead to an overall balance of payments deficit.

Then, either central bank intervention to buy £’s or rise in interest rates (to attract mobile capital)

automatic tightening of monetary policy, and reduction of inflationary pressure.

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Anti-ERM case If UK inflation increased within a fixed

exchange rate system, investors would anticipate a rise in UK interest rates, and move mobile capital into sterling, leading to capital account surplus and thus either central bank intervention to sell £’sor cut in interest rates (to deter mobile capital)

In both cases leading to a loosening of monetary policy, and acceleration of inflationary pressure.

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MAIN SHORT RUN ECONOMIC ISSUE

Would ERM membership be helpful or harmful in the fight against inflation?

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The debate was really about whether the current account or capital account (especially short run capital movements) adjustment tended to dominate.

Current account dominance → ERM membership would be stabilizing.

Capital account dominance → ERM membership would be destabilizing.

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In 1985, the anti-ERM faction (led by PM Thatcher) won the debate about membership, and the UK stayed out.

But the pro-ERM faction (led by Chancellor Lawson and Foreign Secretary Howe) continued to argue the case.

By 1987, Lawson was running an unofficial strategy of ‘shadowing the DM’ (intervening on the currency markets to keep the exchange rate within the range £1=DM2.80 to £1=DM3.00).

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The evolution of PolicyMeanwhile the economy was booming

unsustainably due to:Substantial income tax cuts (basic rate was cut

from 30% to 25% 1986-8),More financial deregulation,A housing market boom which increased

consumer spending.

Against this inflationary background, ‘shadowing the DM’ provided a test case for pro and anti-ERM arguments.

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WHAT HAPPENED? Speculative pressure in favour of sterling (1987-

8)

Relaxation of monetary policy (cut interest rates) to prevent £ exceeding its upper limit leading to

Sharply increased inflation.

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WHAT HAPPENED?

In Spring 1988:

interest rates were increased sharply,

‘shadowing the DM’ was abandoned and £ rose sharply.

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VALIDATION OF THE ANTI-ERM CASE?

Perhaps, but pro-ERM faction argued shadowing failed because it had been attempted without convergence between UK and European economies.

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The aftermathThe collapse of the experiment in shadowing the

DM did not bring the boom conditions to an end at once.

But the continued monetary squeeze eventually led to a fall in household spending.

In 1990 the economy fell into another deep recession, one led, most unusually, by a fall in consumption.

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The aftermathSo independent discretionary monetary policy

did not seem to be particularly happy either.

Thoughts turned once again to attempts to choose an outside anchor for UK monetary policy.

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Trying AgainJohn Major (new Chancellor) announced entry in

Oct 1990, still before convergence had been achieved.

PM Thatcher was replaced by Major in Nov 1990.

Entry at a central parity of £1=DM2.95 (with a 6% margin on either side permitted).

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BACKGROUND TO ERM MEMBERSHIP

By 1990, economy was in deep recession, due to policy responses to the ‘Lawson Boom’.

Underlying theme of the 2-year period of membership – conflict between:Need to cut interest rates (to combat recession),Need to maintain interest rates to prevent £ from

falling.

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THE EXPERIENCE OF ERM

£ was below its ERM central parity (1991). Then a brief improvement, due to:Maastricht Treaty (Dec 1991) which gave a

timetable for European Monetary Union (UK & Denmark could opt out),

4th Conservative election victory (April 1992).

Then, a ‘No’ vote in Danish Maastricht referendum (June 1992) unsettled the currency markets.

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THE EXPERIENCE OF ERM

Speculation against £ (& the lire) increased (summer 1992).

UK raised interest rates from 10% to 12%, then 15%. But £ still fell below its lower ERM bound on ‘Black Wednesday’ (Sept 16 1992).

£3bn of foreign currency reserves were lost in the attempt to stay in the ERM.

Summer 1993: further currency market turbulence forced a widening of all ERM bands to 15% (much looser arrangement).

So European monetary union was put on hold.

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WHAT WENT WRONG? Weakness of the German economy in the early

1990s, following monetary unification of West/East Germany (July 1990).

Guaranteed parity between DM and Ostmarks (public subsidy from west to east) meant that high interest rates were required to curb inflationary pressure.

High German interest rates attracted mobile capital into DM, away from currencies such as £.

Downward pressure on £ implied that the UK had to keep interest rates high, despite recession.

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WHAT WENT WRONG?In effect this is a textbook’ argument against

fixed exchange rates:

a ‘shock’ affecting one country strains the entire system, forcing exchange rates apart.

ERM crisis brought out a contradiction between the Bundesbank’s duty to keep German inflation low, and its responsibility for stability of ERM.

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WHAT WENT WRONG?Other factors included:

The UK's parity was too high. At the time, £1= DM2.95 did not reflect true purchasing parities.

Difficulties in establishing the credibility of commitment to ERM, due to the UK’s poor track record, & anti-European rhetoric.

No realignments within the ERM had taken place since 1987, so pressures were building up anyway.

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Effective Exchange RateSterling effective exchange rate 1975-2005, monthly average

0

20

40

60

80

100

120

140

160

Jan-7

5

Jan-7

7

Jan-7

9

Jan-8

1

Jan-8

3

Jan-8

5

Jan-8

7

Jan-8

9

Jan-9

1

Jan-9

3

Jan-9

5

Jan-9

7

Jan-9

9

Jan-0

1

Jan-0

3

Jan-0

5

month

exch

ang

e ra

te in

dex

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Base Ratesbase rates 1975-2005

0

2

4

6

8

10

12

14

16

18

02/0

1/19

75

02/0

1/19

77

02/0

1/19

79

02/0

1/19

81

02/0

1/19

83

02/0

1/19

85

02/0

1/19

87

02/0

1/19

89

02/0

1/19

91

02/0

1/19

93

02/0

1/19

95

02/0

1/19

97

02/0

1/19

99

02/0

1/20

01

02/0

1/20

03

02/0

1/20

05

date

rate

per

cen

t

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DM/£ exchange RateDM/£ exchange rate 1975-2001

0

1

2

3

4

5

6

Mar

-75

Mar

-77

Mar

-79

Mar

-81

Mar

-83

Mar

-85

Mar

-87

Mar

-89

Mar

-91

Mar

-93

Mar

-95

Mar

-97

Mar

-99

Mar

-01

date

Pri

ce o

f £

in D

Ms

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MTFS 5: 1993-1996POST ERMShift in focus – to the domestic side of thingsPolicy of debt sustainability

Focus on the ratio of debt to GDP Should not be allowed to accelerate rapidly

Loose fiscal policy This led to a need for tight monetary policy

Long term aim of fiscal balance by 2000 Inflation targeting, but broad limits (1-4%)The ERM experience led the chancellor to focus on a wider

range of intermediate objectives and instrumentsA shift to more of a Theil-type approach to target settingMacroeconomic modelling became important again

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So now you know...A bit more about the Thatcher years and macro

policies....

The rise and fall of monetarism

The role of exchange rates in controlling inflation

The fundamental problems with exchange rate systems

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Next Week....The Blair years...

Bank of England independence

The emergence of ‘spin’

But what changed in terms of macro policy?

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ReferencesGriffiths and Wall 9th edition, chapter 24

Managing the economy

Also chapter on European Union and exchange rates and trade performance(chapter 27 in 12th edition)