INSIDE THATCHER'S MONETARIST REVOLUTION Also by Gordon Pepper MONEY, CREDIT AND ASSET PRICES MONEY, CREDIT AND INFLATION TOO MUCH MONEY? (with G. E. Wood) Inside Thatcher's Monetarist Revolution Gordon Pepper Professor Department of Banking and Finance City University Business School London in association with • PALGRAVE MACMILLAN lea First published in Great Britain 1998 by MACMILLAN PRESS LTD Houndmills, Basingstoke, Hampshire RG21 6XS and London Companies and representatives throughout the world A catalogue record for this book is available from the British Library. ISBN 978-0-333-72012-7 ISBN 978-1-349-26139-0 (eBook) DOI 10.1007/978-1-349-26139-0 First published in the United States of America 1998 by ST. MARTIN'S PRESS, INC., Scholarly and Reference Division, 175 Fifth Avenue, New York, N.Y. 10010 ISBN 978-0-312-21040-3 Library of Congress Cataloging-in-Publication Data Pepper, Gordon T., 1934- Inside Thatcher's monetarist revolution / Gordon Pepper. p. cm. Includes bibliographical references and index. ISBN 978-0-312-21040-3(cloth) I. Monetary policy-Great Britain-History-2Oth century. 2. Great Britain-Economic policy-I 945- 3. Economic forecasting- -Great Britain. I. Title. HG939.5.P346 1998 332.4'941-dc21 97-28271 CIP © Gordon Pepper 1998 All rights reserved. No reproduction, copy or transmission of this publication may be made without written permission. No paragraph of this publication may be reproduced, copied or transmitted save with written permission or in accordance with the provisions of the Copyright, Designs and Patents Act 1988, or under the terms of any licence permitting limited copying issued by the Copyright Licensing Agency, 90 Tottenham Court Road, London WIP 9HE. Any person who does any unauthorised act in relation to this publication may be liable to criminal prosecution and civil claims for damages. The author has asserted his right to be identified as the author of this work in accordance with the Copyright, Designs and Patents Act 1988. This book is printed on paper suitable for recycling and made from fully managed and sustained forest sources. 10 9 8 7 6 5 4 3 2 1 07 06 05 04 03 02 01 00 99 98 To my children: Alasdair, Ninna, Harry and Mark Contents List of Tables xiii List of Charts xv Foreward by Colin Robinson xix Introduction and Summary xxi Acknowledgements xxvii PART I HOW THE MONETARISTS CAME TO POWER 1 Early Monetarism in the UK 3 1.1 The Money Study Group 3 1.2 The Manchester Inflation Workshop 3 1.3 Alan Walters 4 1.4 Brian Griffiths 4 1.5 Charles Goodhart 4 1.6 Peter Jay 5 1.7 Regular Publications and Forecasts 5 2 Greenwell's Monetary Bulletin 6 2.1 The Radcliffe Report 6 2.2 The Research Project 6 2.3 Introduction to Monetarism 7 2.4 Competition and Credit Control 8 2.5 The Timing of the Release of Banking Statistics 8 2.6 A Network of Financial Economists 8 2.7 First-Hand Knowledge 9 2.8 The Team 9 2.9 The Early Bulletins 11 2.10 Keynesian and Monetarist Forecasts 11 2.11 The Transmission Mechanism 12 2.12 Speed of Production 14 2.13 Guru Status 14 2.14 Pressure from Clients 15 2.15 Pressure from the Bank 17 vii viii Contents 3 Fly on the Wall during the Thatcher Revolution 20 3.1 A Bow Group Meeting 20 3.2 The Labour Government 21 3.3 Mrs Thatcher 22 3.4 Monetary Base Control 23 3.5 Geoffrey Howe 24 3.6 Nigel Lawson 25 3.7 The Advent of Thatcherism 27 3.8 The Sight of an Abyss 27 3.9 The Search for Change 28 3.10 Financial Disruption 28 3.11 Gradualism 29 3.12 Two-Term Policy 29 3.13 Mrs Thatcher and Monetarism 30 Appendix 3.1 Extract from Monetary Bulletin, no. 199, August 1988 32 Appendix 3.2 Extract from Monetary Bulletin, no. 139, January 1983 34 4 Monetarism in the 1980s 37 4.1 The Politics of Money Supply Targets 37 4.1.1 Managing Expectations 38 4.1.2 Curtailing Public Expenditure 38 4.1.3 Overcoming Political Resistance 39 4.1.4 Degree of Precision 40 4.1.5 Perverse Effect on Expectations 41 4.2 Vested Interests 41 4.2.1 Captured Regulators 42 4.2.2 Personal Integrity 42 4.3 Distortions to Data 43 4.3.1 Summary 44 4.4 Disagreement Among Monetarists 44 4.5 A Crucial Test of Monetarism 44 PART II THE VALIDITY OF MONETARISM: ECONOMIC FORECASTS IN THE 1970s AND 1980s 5 A Brief History of Macroeconomic Models 47 5.1 Forecasts Before the Advent of Models 47 5.2 Early Models 48 5.3 Finance 48 Contents ix 5.4 Incorporating New Ideas 49 5.5 The Three Main Models 49 6 The Accuracy of Routine Forecasts 50 6.1 Macroeconomic Models 50 6.2 Monetarist Forecasts 51 6.3 Other Forecasts 51 6.4 Market Failure 52 6.5 Conclusion 52 7 Major Events 53 7.1 Recessions 53 7.2 Inflations 54 7.3 Financial Crises 55 7.4 Conclusion 55 8 The Record of the Large Models 56 8.1 Sequences of Forecasts 56 8.1.1 Summary - Inflations 57 8.1.2 Summary - Recessions 57 8.1.3 Summary - Timing of Earliest Warnings 58 8.2 Predictions Made a Fixed Period Ahead 58 8.2.1 Summary of Forecasts Made a Fixed Period Ahead 59 (i) Forecasts Made After the Start of the Year Being Forecast 59 (ii) Forecasts Made Between Three Months in Advance and the Start of the Year Being Forecast 59 (iii) Forecasts Made Between Six and Three Months in Advance of the Year Being Forecast 62 (iv) Forecasts Made More Than Six Months in Advance of the Year Being Forecast 62 8.3 Conclusions 62 Appendix 8.1 Sequences of Forecasts - Detail 63 A.8.1.1 Forecasts of Inflation - Data 63 A.8.1.2 Forecasts of Inflation - Predictions 63 (i) The National Institute of Economic and Social Research 63 (ii) The London Business School 67 (iii) The Treasury 69 x Contents A.8.1.3 Forecasts of Recession - Data 71 A.8.1.4 Forecasts of Recession - Predictions 73 (i) The National Institute of Economic and Social Research 73 (ii) The London Business School 77 (iii) The Treasury 78 Appendix 8.2 Predictions Made a Fixed Period Ahead - Detail 82 A.8.2.1 Treasury Predictions of Growth of GDP 83 A.8.2.2 Treasury Predictions of Inflation 85 A.8.2.3 LBS Predictions of Growth of GDP 87 A.8.2.4 LBS Predictions of Inflation 92 A.8.2.5 NIESR Predictions of Growth of GDP 97 A.8.2.6 NIESR Predictions of Inflation 102 Appendix 8.3 Reference Tables 106 9 A Monetarist Forecast 134 9.1 Summary - Forecasts That Were Basically Correct 134 9.1.1 The Record - Inflations 135 9.1.2 The Record - Recessions 135 9.1.3 The Record - Financial Crises 136 9.2 Summary - Forecasts That Were Incorrect and 'Wobbles' 136 9.2.1 Incorrect Prediction in 1977 of Recession After the IMF Measures 136 9.2.2 Unfounded Worries in the Early 1980s About Inflation 137 9.2.3 'Wobble' After the Stock Market Crash in October 1987 137 9.3 Assessment 137 9.4 Conclusion 138 Appendix 9.1 The Record in Detail 139 A.9.1.1 Predictions of the 1970--1 Recession 139 A.9.1.2 Predictions ofthe 1973-5 Inflation 139 A.9.1.3 Predictions ofthe 1974-5 Recession 141 A.9.1.4 Predictions ofthe Sterling Crisis in October 1976 142 A.9.1.5 Incorrect Prediction in 1977 of Recession After the IMF Measures 144 A.9.1.6 Predictions of the 1979-80 Inflation 145 A.9.1.7 Predictions of the 1979-81 Recession 147 Contents Xl A.9.1.8 Unfounded Worries About Inflation in the Early 1980s 148 A.9.1.9 Predictions of the 1989-90 Inflation 151 A.9.LlO Predictions of the 1987 Stock Market crash 152 A.9.LlI 'Wobble' After the Stock Market Crash in October 1987 152 A.9.Ll2 Predictions of the 1990-2 Recession 154 PART III REFINEMENTS, FURTHER EVIDENCE AND POLICY IMPLICATIONS 10 The 'Liverpool Six' 159 10.1 The Shadow Monetary Policy Group 159 10.2 The Liverpool Six 160 11 The Current State of Knowledge 161 ILl The Use of MO and Ml as Indicators 161 I1.Ll Non-interest-bearing Ml 163 11.1.2 Conclusions About Narrow Money 163 11.2 The Use of Broad Money for Forecasting 164 11.2.1 The Supply of Broad Money 164 11.2.2 The Demand for Broad Money 165 11.2.3 Disequilibrium 166 11.2.4 Conclusion About Broad Money 167 11.3 Turning Points 167 11.3.1 Conclusions About Turning Points 168 11.4 Practical Points 168 1l.4.1 Assessing the Adequacy of Monetary Growth 168 11.4.2 Time Lags 169 11.4.3 Momentum 170 11.4.4 Levels Versus Flows 170 11.4.5 The Influence of the Exchange Rate 170 11.4.6 Corporate Versus Personal Sectors 171 11.4.7 Financial Versus Spending Counterparts 171 11.4.8 Reasons for Borrowing from a Bank 171 Appendix 11.1 Two Types of Monetary Disequilibrium 172 12 The Forecasts of Other Monetarists 174 12.1 Patrick Minford 175 12.Ll Recessions 175 xii Contents 12.1.2 Inflations 177 12.1.3 Summary 177 12.2 Alan Walters 178 12.3 Tim Congdon 179 12.3.1 1989-90 Inflation - Warnings Prior to October 1986 179 12.3.2 Forecasts After October 1986 181 12.3.3 Warning of the 1990--2 Recession 181 12.4 Overall Conclusion 183 Appendix 12.1 Reference Tables 184 13 Conclusions and Policy Implications 192 13.1 Fine-Tuning the Economy 192 13.2 Major Economic Events 192 13.3 Money Supply Policy 193 13.4 Control of the Money Supply 193 13.5 How Quickly Should the Authorities React to Undesirable Monetary Growth? 193 13.6 The Optimum Solution 194 Notes 195 References 203 Glossary 206 Names Index 210 Subject Index 212 List of Tables 8.1 Forecasts of growth of GDP bearing a resemblance to outturns - summary 60 8.2 Forecasts of inflation bearing a resemblance to outturns - summary 61 8.3 Treasury forecasts of inflation as a period of rising inflation approaches 70 8.4 Treasury forecasts of growth of GDP as a recession approaches 80 8.5 Treasury forecasts of growth of GDP - resemblances between cyclical patterns 85 8.6 Treasury forecasts of growth of GDP - leads and lags at turning points 85 8.7 Treasury forecasts of inflation - resemblances between cyclical patterns 87 8.8 Treasury