UK Monetary Policy from Devaluation to Thatcher, 1967-82

Duncan Needham

• Publisher: Palgrave Macmillan
• Year: 2014
• Print ISBN: 9781137369536
• eBook ISBN: 9781137369543
• Topic: Economics
• Subtopic: Economic History
• Index: Economics

This book charts the course of monetary policy in the UK from 1967 to 1982. It shows how events such as the 1967 devaluation, the collapse of Bretton Woods, the stagflation of the 1970s, and the IMF loan of 1976 all shaped policy. It shows that the 'monetarist' experiment of the 1980s was based on a fundamental misreading of 1970s monetary policy.

1

From Devaluation to Competition and Credit Control, 1967–71

We have increasingly shifted our emphasis towards the broader monetary aggregates − to use the inelegant but apparently unavoidable term: the money supply.

Sir Leslie O’Brien, Governor of the Bank of England, May 1971.¹

Introduction

On 17 November 1967, after a three-year battle to defend the pound, the British government finally admitted defeat and informed the International Monetary Fund (IMF) that sterling would be devalued from $2.80 to $2.40 the next day.² The Fund’s Managing Director, Pierre-Paul Schweitzer, reacted ‘without surprise and with little comment’, dispatching a team to London that evening armed with a set of policy recommendations.³ This chapter shows how, in the aftermath of devaluation, the IMF provided the catalyst for the most thorough investigation into monetary policy in the UK since the Radcliffe Report. The conclusions reached by the Bank, and then the Treasury, appeared to offer an alternative to a monetary system tested almost to destruction by the post-devaluation lending controls. The result was the most radical overhaul of monetary policy since the Second World War, Competition and Credit Control (CCC), in 1971. Along the way, key Bank officials discarded some of their Keynesian principles for a system predicated on controlling the money supply. The process stalled several times. But in 1971, the Heath government’s refusal to raise interest rates in the face of rising inflation provided the final spur for the Bank to overhaul the system of monetary control.

To win the government’s approval, Bank officials had to play up the competitive aspect of the new strategy. This continues to sow confusion amongst even the keenest students of Bank history. Forrest Capie identifies three strands behind CCC: the desire for a more competitive banking industry, frustration with lending controls, and a renewed emphasis on controlling the money supply. He prioritises the first two, arguing that the UK authorities did not pay ‘serious attention’ to monetary targets for another nine years.⁴

In reality, the desire for banking reform and frustration with lending controls were long-standing concerns that had already generated a number of unsuccessful proposals for monetary reform.⁵ 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.

Monetary policy following devaluation

At 9:30 p.m. on Saturday, 18 November 1967, the Chancellor, James Callaghan, announced that the pound was now worth 14.3 per cent less against the dollar. To help the transfer of resources from domestic demand to the export sector sufficient to generate a current account surplus, Bank Rate was raised from 6.5 to 8 per cent, aggregate bank lending was frozen for all but priority borrowers (exporters and shipbuilders), and hire purchase controls were tightened. Defence spending and capital expenditure on the nationalised industries were cut, and corporation tax raised from 40 to 42.5 per cent.⁶ Since it would take time to turn the current account around, and with foreign currency reserves depleted, Callaghan also announced that he had asked the IMF for a $1.4 billion loan.⁷

The Fund mission had arrived that morning, intending to impose a £250 million limit on Exchequer borrowing from the banking system, and a £500 million ceiling on total Domestic Credit Expansion (DCE), in return for its loan.⁸ This, they estimated, would be required to generate a current account surplus over the next year. They immediately ran into trouble. Callaghan was naturally concerned about the political criticism IMF-imposed performance targets would attract, both from the Conservative opposition and from his own backbenchers. He even tried to persuade the head of the IMF mission, Richard Goode, that quantitative targets for public borrowing were incompatible with the British parliamentary system, in which taxation and spending are voted by the House of Commons.⁹

While Callaghan’s concerns were primarily political, Bank and Treasury officials’ were more technical. The Deputy Governor, Sir Maurice Parsons, told Goode that ceilings on bank lending simply did not work in the UK. British banking is traditionally reliant on overdrafts, which can be drawn at the convenience of the borrower. This makes it very difficult for the banks to predict the exact size of their future lending. Also, within the sophisticated British financial system, it is relatively easy for borrowers to find other sources of finance, thus bypassing lending controls applied to the major banks. There was also a problem with the gilt market. With over £1 billion of new gilt sales required each year simply to fund maturing debt, management of the gilt market was perceived to be a fine art.¹⁰ Officials argued that if the market knew the authorities were missing an IMF target, they could be held to ransom, forced to pay a higher rate on the new issues required to get DCE or the Public Sector Borrowing Requirement (PSBR) back on track. These political and technical concerns were enough for the Permanent Secretary to the Treasury, Sir William Armstrong, to tell the Fund that Britain would rather go without a loan than accept quantitative ceilings.¹¹

After four days of negotiations, and still flatly refusing to accept a DCE ceiling, Armstrong proposed that the two sides discuss DCE at a future date, outside the pressurised atmosphere of a loan negotiation.¹² In the meantime, both sides would agree to the sufficiently vague ‘expectation at present that bank credit expansion will be sufficiently limited to ensure that the growth of the money supply will be less in 1968 than the present estimate for 1967’.¹³ This passage was carefully drafted to avoid the impression, not only that the British had been forced to accept a money supply target, but that they were trying to control the money supply in the first place.¹⁴ It certainly fell short of the conditions imposed on developing nations, whose loans were phased according to their meeting specified DCE ceilings. By contrast, the British were allowed to draw down the full $1.4 billion immediately.¹⁵ Capie believes the lack of strict conditionality attached to the 1967 loan facility is ‘a puzzle’.¹⁶ The puzzle is easily solved. The IMF’s Managing Director was fully aware that he would run into trouble with representatives from developing nations. But with many of the world’s currencies still pegged to sterling, he explained to his Board that this was ‘a special situation of extraordinary importance’ which required immediate action to forestall any further damage to the international monetary system.¹⁷ Phasing the loan might delay the return of confidence to currency markets. Instead of performance targets there would be more intensive surveillance, involving three compulsory missions in 1968.

The IMF Board unanimously approved the £1.4 billion stand-by facility on 29 November. However, the Brazilian Director, Alexandre Kafka, queried the lack of phasing and DCE trigger clauses. He noted that other borrowers would argue that the terms applied to the UK should be applied to them and that, in the absence of a simple, standardised set of criteria, ‘the Fund’s role as the trusted and impartial advisor of member countries would be jeopardized’.¹⁸ The Board responded to these ‘serious misgivings about the equality of treatment’ by harmonising the conditions attached to loans to developing and industrial nations in September 1968.¹⁹ The UK was represented at the critical meeting by its Alternate IMF Director, Guy Huntrods, who contributed to the discussion.²⁰ The UK authorities should have been in no doubt that further loans would come with DCE performance criteria attached.²¹

Three weeks later, an IMF team led by its Research Director, Jacques Polak, arrived in London for the seminar on DCE with Bank and Treasury officials, proposed by Sir William Armstrong a year earlier.²² Harold James correctly identifies this as the ‘beginning of an intellectual conversion’ within the UK monetary authorities.²³ While the chairman, Sir Alec Cairncross, felt that ‘no great new truths’ emerged from the four days of talks, he did discover that ‘there were some closet monetarists in our midst’.²⁴ Despite general British scepticism towards the more active monetary policy proposed by the Fund, the exercise was important for two reasons. First, given the continuing current account deficit, it was highly likely that Britain would require another loan in 1969 to repay previous drawings. The seminar helped British officials understand the DCE conditions that would be applied. Second, discussion on the third day revealed a significant divergence of opinion amongst the British participants on the operation of the gilt market. Given the scale of the UK National Debt, and the fact that much of it was held in speculative hands, the Bank had long argued that it needed to intervene in the market to reduce price volatility. Unless the Government Broker ‘leant into the wind’ to smooth out price changes, then gilts would lose their marketability, and the government would struggle to fund itself. This was still the Bank’s position in October 1968. But, as the IMF noted, it was no longer the unanimous view of Treasury officials, some of whom agreed with the Fund that the Bank had diluted the impact of the post-devaluation credit squeeze by leaning into the wind.²⁵ In stabilising the market, the Bank had pumped money into the economy at precisely the wrong time. Positing a direct link between the money supply and the balance of payments, the IMF explained that this was why, in 1968, despite a tough March Budget, the government had been unable to close the current account deficit. Fund staff subscribed to the ‘economists theory’, whereby lower prices meant increased demand for gilts. This, they explained, was how government bond markets worked elsewhere.²⁶

A month later, with global market volatility increased by speculation against the Bretton Woods parities, and continuing poor balance of trade figures, the Bank agreed to modify its tactics.²⁷ The Governor wrote to the Permanent Secretary, ‘if a further upward pressure on long-term rates does develop, we should be prepared to retreat as rapidly as we judge to be safe’.²⁸ O’Brien still had some waspish remarks for those within the Treasury who believed the market should be free to find its own level. Tactics should be left to ‘those responsible for the conduct of international operations’.²⁹ A complete withdrawal of the Government Broker would be ‘a catastrophic error of policy’ that might lead to the collapse of the gilt market.³⁰ This could generate huge money supply growth as investors ‘monetised’ the National Debt, either by selling existing holdings or simply not re-investing the proceeds of maturing gilts. But, as the Bank revealed seven months later, the Government Broker was no longer leaning quite so far into the wind.³¹ As we shall see, the further withdrawal of the Government Broker from the gilt market was the first major innovation introduced by Competition and Credit Control in 1971.

The Money Supply Group

The October 1968 ‘DCE seminar’ was also the catalyst for a major monetary policy review within the Ba...

Table of contents

• Cover
• Title
• Introduction
• 1  From Devaluation to Competition and Credit Control, 196771
• 2  Competition and Credit Control, 197173
• 3  The PSBR Takes Over, 197476
• 4  Too Many Targets, 197779
• 5  The Lady Is for Turning, 197982
• Conclusion
• List of Names
• Chronology of Events
• Notes
• Bibliography of Cited Secondary Sources
• Index