Britain's Money Supply Experiment, 1971-73

Britain’s money supply experiment, 1971-73 Duncan Needham University of Cambridge [email protected] CWPESH no. 10 Abstract: This article challenges the claim that monetary policy neglect was responsible for the unprecedented UK inflation of the 1970s. It departs from the historiography by showing the Bank of England following money supply objectives from 1971, two years earlier than is currently acknowledged and five years before Denis Healey first published a money supply target. 1 After missing its monetary objectives in 1972-73, the Bank concluded that tight control of the money supply was impracticable in the UK. Conservative policymakers drew the opposite conclusion, that only tighter control of the money supply would cure Britain of its economic ills. This failure to heed the lessons of 1970s monetary policy would have profound consequences for the British economy in the early 1980s and beyond. Acknowledgements: I am grateful to Sir Samuel Brittain, Sir Alan Budd, Sir Douglas Wass, Martin Daunton, Charles Goodhart, Anthony Hotson, William Keegan, Jim Tomlinson, two anonymous referees and the participants of the Cambridge Finance seminar, the Winton Monetary Seminar in Oxford, and the Monetary History Seminar in London for their comments on earlier drafts of this paper. One referee expressed reservations about the use of ‘monetary target’ before 1976 while acknowledging that the phrase was in use in policy circles at the time. Therefore, unless the phrase is contained within a quotation, I have used ‘monetary objective’ prior to 1976. 1 For an alternative approach, please see F.H. Capie, The Bank of England: 1950s to 1979 , (New York, 2010). 2 In September 1980 Bank of England Director John Fforde was summoned to Downing Street to explain why the money supply had overshot the government’s published target. 2 There he was subjected to a Prime Ministerial lecture on the importance of controlling of the money supply in the fight against inflation, then running at sixteen percent. 3 Following Milton Friedman’s dictum that ‘inflation is always and everywhere a monetary phenomenon’, Ministers had recently launched the Medium Term Financial Strategy (MTFS), placing a four-year series of target ranges for broad money (£M3) at the heart of economic policy. 4 While £M3 targets remained in place until 1987, Ministers had, by then, successively downgraded their importance. Inflation did eventually fall to four percent by the time of the 1983 election. However, this came at a heavy cost. The recession of 1980-1 was the worst in the UK since the 1920s. 5 With nominal interest rates at seventeen percent, the soaring pound priced exports out of global markets, making Britain a net importer of manufactured goods for the first time since the Industrial Revolution, and pushing unemployment above three million for the first time since the 1930s. 6 Fforde was an ironic choice for a lecture on the importance of controlling £M3. In 1971, he had designed a previous failed attempt to control the money supply, Competition and Credit Control (‘CCC’ or ‘the New Approach’) − ‘the biggest change in monetary policy since the Second World War’.7 Since the war, the authorities had sought to control the largest counterpart of the broad money supply (M3), bank lending to the private sector, with a raft of quantitative and qualitative controls. 8 The 2 Fforde and the future Governor, Eddie George, were summoned as both the Governor and the Deputy Governor were overseas on business. Mrs Thatcher set the tone by asking ‘who are these people?’ W.J.G. Keegan, Mrs Thatcher’s economic experiment , (Harmondsworth, 1984), p. 153. 3 Lankester to Wiggins, 9 September 1980, London, The National Archives (hereafter ‘TNA’), PREM 19/178. 4 M. Friedman, The counter-revolution in monetary theory , (London, 1970), p. 24. £M3 comprises currency in circulation with the public and the sterling deposits of UK residents. 5 In this article ‘1980-1’ means the two calendar years 1980 and 1981. ‘1980/1’ means the financial year ended 31 March 1981. 6 Real interest rates were negative in 1980-81. However, with declining inflationary expectations, capital flows were largely driven by forward rates which are calculated from nominal rather than real interest differentials. 7 Capie, 2010, p. 427. 8 M3 comprises currency in circulation with the public (excluding cash in banks’ vaults but including non UK residents’ currency holdings) and (sterling and foreign currency) deposits of UK (public and private) residents with UK banks. Following the ‘credit counterparts’ approach, M3 can also be defined as the Public Sector Borrowing Requirement, less gilt sales to the non-banks, plus bank lending to the private sector plus flows from abroad. 3 New Approach swept all of these away. Henceforth, bank lending would be controlled on the basis of cost i.e. through interest rates. Loans would be granted to those companies and individuals that could pay the highest rate, rather than to those that fulfilled the authorities’ qualitative criteria within the overall quantitative restrictions previously imposed on the banks. By allocating bank credit solely on the basis of cost, CCC replaced years of credit rationing ‘by control’. Out went the restrictions on lending to less-favoured sectors and ceilings on bank advances that had been a feature of British banking for much of the post-war era. In came the ‘interest rate weapon’ - more active use of Bank Rate to control the demand-for-money. In the recent official history of the Bank of England (the ‘Bank’), Forrest Capie identifies three strands behind CCC: dissatisfaction with lending controls; a desire for more competition within banking; and a renewed emphasis on controlling monetary growth. He prioritises the first two, arguing that: it was 1976 when something drastic needed to be done and International Monetary Fund (IMF) financing was needed and the knowledge that this time the IMF would demand determined action on containing monetary growth before serious attention to monetary targets took place 9 This article agrees that the catalyst for reform was Bank frustration with controls and its preference for a more competitive banking system. However, these were longstanding concerns that had already generated a number of unsuccessful proposals for monetary reform. 10 In 1971, the Bank believed it had identified a stable demand- for-money function in the UK and that it could control monetary growth by manipulating interest rates. This gave officials the intellectual confidence to sweep away the post-war system of controls and focus on the money supply instead. This was clearly acknowledged at the time by officials, practitioners and academics. The Governor announced in 1972 that, ‘I accept, as most central bankers would, that control of the money supply is my principal, if not my most important, concern’. 11 The influential City analyst, Gordon Pepper of W. Greenwell & Co., informed his clients at the launch of CCC that ‘the main emphasis will be placed on attempting to 9 Capie, 2010, p. 645. 10 For example: Methods of Credit Control, London, TNA, T326/1063 and Restraint on Bank and Finance House Lending, London, Bank of England Archive, (hereafter, ‘BOE’), 3A8/8. 11 Quoted in G.T. Pepper, ‘Investment Analysts Meeting on Thursday, 25 th January. Gilt- edged: the future outlook’, 1972, Cambridge, Churchill Archives Centre (hereafter ‘Churchill’), Churchill College, THCRAS 3/17. 4 control the domestic money supply’. 12 And, as Brian Griffiths, one of the leading British monetarists of the day, pointed out: ‘the intention of the new system is to move away from control of bank lending to control of one of “the broader monetary aggregates”’. 13 After outlining the transition towards M3 objectives before 1971, this article analyses the normative consequences of the New Approach for three of the four monetary policy instruments identified by Thomas Saving in 1967: the discount rate; bank reserves; and operations in the government debt markets.14 This early experiment was not a success. The unpublished M3 objective for 1972/3 was twenty percent. The outturn was thirty-one percent. By the time CCC was de facto abandoned in December 1973, M3 had grown by seventy-two percent. Two years later, inflation hit a record twenty-seven percent, apparently vindicating Friedman’s claim that excess monetary growth led inexorably to higher prices after a long and variable lag. The Thatcher government, far more committed to (by then published) targets, experienced similar difficulty in hitting its monetary objectives. The target range for £M3 in 1980/1 was 7-11 percent; the outturn was eighteen percent. Treasury Ministers invoked Goodhart’s Law, which states that ‘any monetary aggregate ceases to be reliable the moment it becomes a target for policy purposes’. 15 But Goodhart’s Law was not new in the 1980s. It was first outlined in 1975 in response to the authorities’ failure to hit their money supply objectives between 1971 and 1973. 16 Conservative policymakers, Bank officials and Treasury civil servants drew very different lessons from the failure of the 1971-73 money supply experiment. This would have profound consequences for the British economy in the early 1980s and beyond. I 12 G.T. Pepper, ‘The gilt-edged market and the Bank of England’s proposals’, June 1971, Churchill, THCRAS 3/17. 13 B. Griffiths, ‘Resource Efficiency, Monetary Policy and the Reform of the U.K. Banking System’, Journal of Money, Credit and Banking , vol. 5, no. 1, part 1 (Feb., 1973), p. 72. 14 T.R. Saving, ‘Monetary-policy targets and indicators’, Journal of Political Economy , vol. 76, (1967), pp. 446-56. Saving’s fourth instrument is the monetary base or ‘high-powered money’ comprising currency outstanding with the public, UK banks’ till money and UK banks’ deposits with the Bank of England.

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