The monetarist controversy and the British experiment

The Monetarist Controversy and the British Experiment

THOMAS WILSON*

From the outset, Britain's experiment with monetarist policy under the Thatcher government has attracted much interest abroad as well as at home. This is scarcely surprising for the monetarist prescriptions had not hitherto been adequately tested. It is true that there is a long history of the use of monetary policy for the control of inflation. It is even true that in Bri- tain the previous Labour Government, acting initially under pressure from the IMF, had re- sorted to monetary policy expressed through targets for increases in the money supply. But the Thatcher government was fully committed to monetarist theory in a pure form, uncontam- inated by eclecticism. Whereas its predecessor had proposed targets for wages as well as the money supply, the new government would control the latter and leave the former to the market. The shambling pragmatism of the past would be brought to an end. This was to be done, moreover, by a strong government-strong in Parliament, strong in its support throughout the country, strong in its leadership. It was therefore natural to assume that the experiment would be particularly informative.

The outcome after two years would appear to be deeply disappointing. There can be no serious doubt that in the opinion of a large proportion of the electorate the government has failed and so, by inference, has monetarism. Unemployment is more than twice what it was when the government came into power at mid- 1979 and the likelihood of any significant im- provement seems to lie far in the future. Out- put is depressed with real GDP in the second quarter of 1981 about 5 percent less than it was in the second quarter of 1979. Manufactur- ing production has been particularly hard hit and in the first quarter of 1981 was running at about 19 percent below its level in the quarter

*University of Glasgow. Invited address, Eleventh International Atlantic Economic Conference in Lon- don on August 18, 1981.

before the assumption of office by a government that was pledged to strengthen manufacturing relatively to other sectors, in particular relatively to the public sector. In the event it is the latter, that has grown.

It is true that inflation in early 1981 was at only about half the high level reached in 1980, but is still in the region of 10 percent. Thus the cost has been heavy and the achievement appears to have been small. What is particularly disturbing is that there is little evidence--at all events little public evidence-that any policy has been prepared that would prevent a resurgence of inflation when GNP begins at last to recover. On a superficial view at least, the sacrifice would seem to have been largely in vain.

This is the case for the prosecution. Is it fair? A number of points for the defense can be made at once: that inflation was rising again before the government came into office; that it had inherited from its predecessor some large post-dated cheques made payable to the unions; that the unions were totally and quite unreason- ably opposed to any restraints on wage-demands, whether imposed by monetary and fiscal policies or by an agreed labor-market plan; that the second oil crisis has given a powerful impetus to inflation. It may be further pointed out that 1978/9 was a cyclical peak in most countries and a subsequent fall was the general experience, although Britain suffered more than most. In short, the government was faced with a particularly difficult combination of circumstances and its options were narrowly restricted. In response to its critics, it can reasonably be asked what they would have been able to do in practi- cal terms in such circumstances.

These points cannot be dismissed as invalid or insignificant-provided one is prepared to adopt a pragmatic point of view and to admit that economic policy is a complicated affair. But this is where one's point of view is so ira-

13

14 ATLANTIC ECONOMIC JOURNAL

portant. For it is by no means clear that committed monetafists for their part can resort to such lines of defense without relaxing the two basic propositions of monetarist theory:

First, that the private economy is inherently stable and, when subjected to autonomous shocks, will soon be restored to equilibrium by the gyroscopic control exerted by market forces.

Secondly, that the government's role is to control the rate of growth of the money supply and, if this is done, inflation will surely be conquered and unemployment will return to its natural level.

To quote Friedman's famous dictum: "'Infla- tion is always and everywhere a monetary phe- nomenon." For the policy-maker, monetary control is thus the centerpiece. It is not only the necessary, but the sufficient, condition for a successful macroeconomic policy. There is, then, really no need to hope for favorable "ad- ventitious" circumstances such as the calming effect on inflation of favorable terms of trade, or moderation in wage demands by the unions, and no need, therefore, to deny to monetary policy the full credit for achieving stability. But consistency requires that the same dismissal of other factors be made if the outcome proves to be disappointing! It will not do, if things go wrong, to plead as an excuse that the unions were unreasonable, that the world economy was in difficulties.

Even the rise in oil prices should have had no very serious effect for, with a strict monetary policy, offsetting falls in other prices would have occurred. At worst, an increase in the money supply might have been made to accom- modate the rise in the oil price but this would have permitted, not inflation, but merely a once-for-all rise in the general price level. The honest monetarist who advances such large claims for his recommendations must be prepared to accept responsibility for the consequences, be they good or bad, within the field of policy to which they apply.

It may be objected that any verdict advanced now is bound to be highly tentative for little more than two years have elapsed since the government came into power. Would it not, then, be rash to assume that we have missed the buoy,

put down the helm and go off at once on another tack?

The particular brand of monetarism that is being adopted becomes highly relevant at this point. The Prime Minister has frequently warned the country that it will be a long slog. But a long slog to what? It will certainly be a long one before industrial efficiency can be satis- factorily raised and structural adjustments car- ried out. But, from the rational expectations viewpoint, it should not take long for inflation to be brought under control and unemployment brought back to its "natural" level. In the ear- tier monetarist literature, the lag was indeed expected to be quite long-five years or so, according to David Laidler. For it was held that inflationary expectations built up in the past could not be quickly dispelled. To suppose otherwise and to act accordingly could lead, on this view, to an unnecessarily severe recession and perhaps to the political rejection of the whole experiment. It would appear that the government has adhered on the whole to this earlier monetarist standpoint.

If, however, a long period for adjustment is required, this may have the immensely important implication that the monetarist remedy may be too slow to fit into the electoral cycle. And political economy is the name of the game. Unless the process of adjustment can somehow be reconciled with election pressures, the monetarist solution may simply be politically un- acceptable and therefore unworkable. Let me add at once that, even if this conclusion is accepted, it does not follow that there must of necessity be some other satisfactory solution ready to hand. This may or may not be so, but additional evidence is clearly required. In particular it will not do simply to accept that all would be well with a permanent incomes policy without attempting to consider whether any such policy would, in its turn, be both accept- ablea nd workable.

It would be fascinating to take up these various themes and try to trace them through the detailed events of the past two years. That, of course, would be far too large an undertaking for the present paper. It must suffice to select from some of the central features of government policies over these years.

WILSON: MONETARISTS AND THE BRITISH EXPERIMENT 15

Applying Monetarist Policy

(1) The doubling of VAT in 1979. One of the first acts of the new government was to double the rate of value-added tax and to reduce the heavy burden of direct taxation. It was a change that reflected conservative views about direct and indirect taxation-views that had nothing much to do with monetarism. Even if the Labour Party had returned to power there would have been some change along these lines. VAT would the probably have risen to 12½ percent. Something on this scale was, indeed, expected, but the actual rise to 15 percent was a largely unanticipated shock.

Fears were expressed at the time that the consequential rise in the price level would strengthen inflationary pressures to an extent that would more than offset the soothing effect of lower direct taxes (see Figure I). From a strictly monetarist point of view, however, such

FIGURE I

. . . . . Retail Price Index

_ . _ _ Tax and Price Index

\

1979 1980 1981

Soaree: Central Statistical Office

relative changes in the tax structure should have no effect on inflation which is determined by the rate of growth of the money supply. Was it not, however, the case that inflationary expectations were bound to be strengthened by the rise in VAT so that the short-run cost, in terms of lost output and lost jobs, of containing inflation at any given rate would be enhanced? Presum- ably the monetarist answer would be that a once-and-for-all rise in prices must be distin-

guished from a continuing rise reflecting an excessive rate of growth of the money supply.

Thus, although the rise in VAT was not in itself an implementation of monetarist doctrines, these doctrines may have helped to dis- pel whatever misgivings the government may have had. One can only guess whether or not this was so. There are, however, two other points to be made. The first is that even a once-and-for-all rise in prices caused by fiscal policy may set up a chain reaction-analogous to the chain reaction set up in the earlier trade-cycle theory by an autonomously induced rise in investment. Even if the series is damped, not explosive, it will be troublesome enough for quite a while. Secondly, it was not really the case that the rise in VAT was a once-and- for-all fiscal adjustment. Other changes were to follow, in particular cuts in subsidies, and the combined effect must surely have been to strengthen inflationary expectations.

It can reasonably be argued that all or most of these fiscal changes were desirable on their merits. Even so, it may be objected that the timing was unfortunate and that the government ought to have concentrated its efforts on the control of inflation. This objection will not, however, carry much force if inflationary expectations are believed to be based essentially on expectations about the rate of growth of the money supply.

(2) Monetary targets and expectations. It is quite possible to attach importance to the control of the money supply without regarding monetary policy, expressed by means of monetary targets, as the central control device, set in splendidly simple but possibly dangerous isolation. More moderate Keynesians, such as Tobin, concede the importance of monetary policy without casting it for so exclusive a role. There have also been strong advocates of monetary policy, such as Lionel Robbins and the now almost forgotten Denis Robertson, who could not be described as monetarist in any of the modern senses of the tenn.

Perhaps I should make my own position clear. About a quarter of a century ago I ad- vocated control of the money supply-at a time when any espousal of monetary policy


was widely regarded as prima facie evidence of mental derangement. I was one of the few economists to recommend such control in evidence to the Radcliffe committee on the working of the financial system in the early sixties. I have introduced this personal note because I shall be somewhat critical of monetarism in the present paper.

It is not to be inferred, however, that this criticism implies support for the extreme neo- Keynesian opposition to monetary policy. May I rather express some impatience with tile modern habit of assuming that all economists must be either Keynesian or monetarist to the ex- clusion of all other possible positions?

In monetarist theories, monetary targets are, of course, crucial, and it is assumed that people will respond to the announcement of a planned decline in the rate of growth of the money supply by moderating their demands for money income. It is an assumption that needs to be un- ravelled.

First, it is held that people will learn how to respond to these monetary signals because it will pay them to become informed, perhaps by hiring the services of professionals. This, of course, is only an assumption. It is by no means clear that, in practice, people see their true interests in this light and act accordingly. Let us however, suppose that this is how people behave-people who are now quaintly described as "economic agents" in some of the literature. (Agents of whom? For what?) Even so a assumption is required.

In reacting to the signals given, people must adopt some theory about what the effects of official action will be. Now it is taken for granted in the monetarist literature that monetarist theory will be generally accepted as being the right theory. If it is not so regarded, then expectations would lead people to respond quite differently to the signals sent out even by a monetarist government. It may be held that other "faulty" theories will be eliminated by a process of natural selection. But this process may not only require a great deal of time. The process itself will be affected by expectations about its outcome.

There is a strong suggestion of circular reasoning here. Monetarism will work because a

monetary policy will evoke the right responses, and the right responses will be evoked because it is recognized that monetarism works!

There is a similar, though even more curious, circularity in the reasoning of the New Cam- bridge School. This school is strongly protectionist. It is conceded that the protectionist case would be greatly weakened if the proposed 30 percent duty on Britain's imports of manu- factures were to lead to retaliation by other countries. It is held, however, that other countries will not retaliate because they will recog- nize that protection is needed for quite a long period in order to achieve an industrial renais- sance in Britain and in the end the net balance would be favorable to other countries as well.

In short, foreigners will be prepared to accept the diagnosis of British ills made by Kaldor, Godley, and their colleagues and to endorse the protectionist remedy. With expectations based on the acceptance of these views, they will then behave in a way which helps to vindicate these views by refraining from retaliation! It is, I fear, a line of reasoning that strains credu- lity to the breaking point.

To return to monetarism. When other theories are held, rational expectations should lead to different responses. What response should be expected, for example, from Communists in the British trade unions when government ann- nounces increasingly restrictive monetary targets? Their objective is not an individualistic pursuit of the most satisfactory combination of income, work, and leisure within a social system which they take for granted. Their aim is to overthrow that system. It would, therefore, be sensible to press strongly for higher wages in the full knowledge that these demands, if granted, would lead to more unemployment. Moderation, if ever appropriate, should be adopted only for special tactical reasons. It is perhaps understandable that those U.S. monetarists whose concern is really with their o w n country should ignore Communist reactions of this kind. It is more difficult to excuse British monetarists.

(3) Achieving a target and missing a target. Although there has been much debate about monetary-base control, successive governments


in Britain directed their policies to changes in £M3-roughly corresponding to M2 in the U.S. The Labour Government's target for 1978/79 was a rise limited to 8 -12 percent and this was achieved. The new Conservative Government set and also achieved a target within a range of 7 - 1 t percent for the ten months to April 1980.

The Medium Term Financial Strategy, an- nounced in early 1980, set targets providing for a diminishing rate of growth of £M3 in subsequent years [HMSO, 1980]. This was a clear case of adopting Friedmanite monetarism and the strategy was subsequently endorsed by him [Friedman, 1980]. These money targets would shape the expectations and thus determine the actions of labor and management. Inflation would be gradually squeezed out of the system. It was explicitly recognized, however, in the official announcement of policy that targets must in fact be achieved if credibility was to be retained. Moreover, it was important for people to believe that there was not alternative policy [Peston, 1981].

The first target in the medium term financial strategy was a rise in £M3 of 7-11 percent as the annual rate from February 1980 and April 1981, but it was missed by a wide margin (see Table 1). The rise was estimated by the Bank of England (1981) to have been 17½ percent, after correcting for a distortion caused by the remov- at Of a control previously imposed on the growth of interest-bearing bank deposits (the "corset").

Why was the target missed by so wide a margin? The demand for bank credit from the private sector was larger than expected mainly as a consequence of the recession. But this does not explain why £M3 rose so much, for rising demand need not have been met. Basically, the reason was that the government was somewhat reluctant, and the central bank probably very reluctant, to accept the full implications of abandoning totally the long-observed practice by which increases in £M3 were accommodat- ing. It had proved very difficult to reduce total public expenditure. If, then, the monetary target had somehow been achieved, public borrowing would have crowded out private expenditure through higher interest rates to an even greater extent than did in fact occur and

the recession would have been deeper that year.

Even before the full extent of the failure to meet the target had been revealed, Friedman had expressed his dismay at official persistence with the policy of determining, or trying to determine, interest rates. It was the money supply that should be firmly controlled with interest rates left to find their own market levels [Fried- man, 1980]. Here, then, is a case where official performance departed from the monetarist pre- scription and did so-whether for good or i l l - by a wide margin. This is so, at least, if attention is confined to M3.

The rise in M1 was much more modest: 8.1 percent between February 1980 and February 1981. Some slight attempt was made by ministers to draw attention to this better showing of M1-bet ter and, one might suppose, more im- mediately relevant. But the harm had been done. Even if the M3 target for 1981/82 is achieved, the anticipatory effect of its announcement has been dulled by the experience of 1980/81.

What workers and managers are influenced by-what they have always been influenced by -are the actual and anticipated growth of expenditure and the effect on jobs and prices. Would it not, indeed, be sensible to direct attention not to changes in M but changes in MV? It is interesting to record that Mr. Samuel Brit- tan, a leading financial journalist and a strong monetarist, has now come down in favor of MV [Brittan, 1981]. The reversion to monetary expenditure rather than the money supply as the chosen target constitutes, in effect, the partial abandonment of a monetarist position in favor of the inlermediate position, neither strictly monetarist nor strictly Keynesian, to which I referred at the outset.

Consider the consequences of neglecting V. Although £M3 went up by 17½ percent between February 1980 and February 1981, velocity fell by about over 6 percent-which puts a different and better complexion on the achievement of anti-inflationary policy. Or consider M1 which rose by a more modest 8.1 percent. But its velocity went up q,~ite sharply by 3¾ percent. It is true that there are lags to be taken into account and year-to-year variations in V may be largely smoothed out later. It is of interest to


note, however, that even when short-run move- ments are ignored, £9/3 velocity rose by about a fifth between the early 1960's and the late 1970's and early 1980's.

If, however, it were decided to extend the range of policy in order to embrace changes in MV, or total expenditure, rather than merely changes in 1143, we should be engaged once more in what is now perjoratively described as "fine- tuning"-though it need not, admittedly be so "fine" as in the days when a 0.1 percent var- iation in unemployment received as much attention as might have been given to a 1 percent change by Keynes himself! [Wilson, 1981 ].

(4) Public expenditure, taxation and borrowing. In Britain, as in other countries, public expenditure has risen strongly over the years relatively to GNP. Clearly, this rise could not con- tinue indefinitely-a rather obvious fact which some people, including some of the trade-union leaders, have been perversely reluctant to accept. Indeed, there has long been evidence that people are inconsistent in their attitudes: they will support increased public programs as voters but will not readily accept the implications for taxation. The burden of taxation can therefore strengthen inflationary pressure and this must give cause for concern-unless one is so very confident of the monetarist faith as to believe that inflationary pressures will be not only in- effective but harmless so long as the money supply is controlled.

The Thatcher government has tried to check the growth of public expenditure and, like its predecessor, has found it easier to cut public capital expenditure than public consumption (Table 2). Thus, the former at constant prices (including investment by the nationalized industries) was brought down by over 40 percent between 1974/75 and 1978/79 under the Labour Government while public consumption rose by 9 percent. Between 1978/79-Labour's last year-and 1981/82 capital expenditure may have fallen by roughly another 14 percent while current spending may have gone up by another 4½ percent.

The cuts in public investment have been much criticized and increases demanded on two grounds: first to provide jobs, a proposal which,

of course, raises all the basic issues of inflation and public finance; secondly, in order to im- prove important services. Although it should be noted in passing that the need for capital expenditure under some headings (.e.g., schools, trunk roads) has declined, the current level seems unduly low relatively to current public expenditure. It is, of course, more difficult to cut current expenditure on goods and services and especially pay in the public sector. Table 3 shows how plans for total public expenditure have changed and also shows what has happened.

As a consequence of these difficulties, it has not been possible to reduce the total burden of taxation. Nor has it been possible to hold down the public sector borrowing requirement which exceeded the official projection for 1980/81 by 60 percent and came to 6 percent of GNP. It is only fair to add that the percentage was sub- stantially higher at I0 percent during the recession of the mid-seventies. The projection for the PSBR in 1981/82 is 4½ percent of GNP- which, it should be noted, already implies a more relaxed fiscal stance than the earlier projection for 1981/82 of 3¼ percent of GNP, although it is also true that the 1981/82 budget was aimed at preventing a yet further rise in the PSBR (see Table 4). The outcome may be more because of the civil servants' strike. It should be noted in passing that interest payments on the outstanding debt now amount to about half the borrowing requirement. The PSBR has, of course, been increased by the-depression itself which has been responsible for two-thirds of the excess over the projection of 1980/81.

Two points can be made in summing up at this stage:

(1) It is very difficult to cut public expenditure or the borrowing requirement when output is falling. Moreover, one may ask whether an attempt to do so should be made unless it can be shown that the proper aim is to deepend the recession deliberately in order to curb inflatiori- ary wage demands.

(2) Whatever the policy with regard to the actual PSBR, it would make sense to give more emphasis to supplementary targets as percen- tages of output at some constant hypothetical use of capacity. This need not involve any dub-


ious assumption about where "full employment" is now located; "constant" is the key word.

(5) Monetarism and the labor market. There can be no doubt that the government's policies have been partly responsible for the present said state of the British economy. What is also true is that a very substantial part of the blame rests elsewhere.

Sometimes the criticism directed against the government is so partisan that no possible ground for complaint is neglected, even if this entails inconsistency. Thus the more extreme of the neo-Keynesians point to the failure to achieve stated monetary targets and even assert that the money supply simply cannot be controlled. At the same time, however, they com- plain that monetary policy has been so restrictive that it has gravely damaged the economy!

Let us set aside these inconsistent complaints. It is still necessary to ask whether government policy has really been so restrictive and, if so, in what way. After all, the rise in £Ma in 1980/ 81 would have financed an expansion of output at a high rate for, say, over three years- i f unit costs had not increased. Even the monetary target of 6 - 1 0 percent forM3 in 1981/82 (annual rate from mid-February 1981 to April 1982) would also be far more than enough for a strong non-inflationary recovery. When the government is attacked on the ground that its "'restrictive policies" have caused depression, its critics should be remorselessly pressed to say whether they regard the huge rise in £M3 in 1980/81 as inadequate or that proposed for 1981/82 as too meager!

If the recession has deepened so much, not- withstanding these very large rises in the money supply, the reason is that the increases have been dissipated in rising input prices. It has been largely a rise in the price of domestic inputs with the rise in import prices (including oil) about half as large in percentage t e rms- though even that was substantial enough. And the domestic inputs that have gone up in price have not been profits which have been severely cut, but wages and salaries, interest charges, and the price of North Sea oil. Dear money has, indeed, been burdensome; but the higher cost of labor has been far more important. It is

worth reflecting that average interest rates would have to fall by 3 percent in order to offset even a 1 percent rise in labor costs in industrial and commercial undertakings. Over 1980, earnings rose in Britain by 17½ percent!

The labor market has been the crux and, unfortunately, monetarism is particularly weak on this subject. It is customary, in monetarist literature, to discuss this market as though it con- sisted of isolated individuals, each seeking to maximize his own satisfaction by making his choice between work and leisure. Unemploy- ment is therefore voluntary-even in Liverpool in 1981 ! [Minford, 1981 ]. Trade unions are not altogether ignored-for it is recognized that they may raise the natural rate of unemployment. But there is a quite inadequate under- standing of the extent to which the cost of conquering inflation, in terms of lost output and high unemployment, can be raised by trade-union activity.

Admittedly it can still be maintained that markets clear and the private economy is self- correcting even with trade unions-but only by so interpreting "equilibrium" as to reduce the proposition to tautology-like the old Keynesian tautology that savings and investments are equal, ex post. It was as a protest against this interpretation of equilibrium that Buiter wrote his article on the economics of Dr. Pangloss [Buiter, 1980]. You will recall that Dr. Pangloss, in Voltaire's Candide, maintained that "all is for the best in the best of all possible worlds" - and was burned at the stake by the Spanish Inquisition for propounding so monstrous a heresy. Let us hope - i f only on broad humani- tarian grounds-that even the most extreme proponents of rational expectations do not meet with some analogous fate!

Professor Friedman, for his part, has always maintained that trade unions cannot cause inflation, and has done so not only in his writings but on British television-notably in early 1974 when Prime Minister Heath was fighting to prevent a wage explosion. Now it is perfectly true that a prolonged inflation cannot occur without a rise in the money supply. (The rise had been very large under the Heath Government.) Even so, an increase in the money supply need not be the initiating factor. Moreover, even if the


money supply is restricted, the unions can push up costs and prices quite steeply over a period of years and may well be prepared to accept the unemployment that will follow. And this so- called short period may be of critically impor- ,5 rant length in the electoral cycle. To quote:

"Sectoral trade unions are anxious to use their u0 monopoly power in the interests of their own employed members, without much regard for the small minority who may thereby become 105 unemployed, and with no regard for potential recruits, let alone the general public."

The quotation is not from Professor Hayek ~00 but from two Keynesian economists, Mat- thews and Reddaway [1980]. 95

Let us recall that rather more than half the British labor force is in unions, as compared with less than a fifth in the U.S., and that wages boards, operating on the basis of comparabilities, extend the unions' influence to various non- unionized industries. And over half the union members are in the public sector.

Wages and salaries have been driven up in face of rising unemployment and by more than enough to compensate for changes in prices and taxes. Thus real disposable earnings rose by 15 percent over the three years 1977 to 1980 (Table 5). With a high exchange rate and a rise in M V which, though large, was not fully ac- commodating, the outcome was inevitable. Profits have been severely cut -so much so as to be virtually zero in the manufacturing in- dustry on a true cost basis. And employment has fallen dramatically as the unions have priced more and more of their members out of jobs (Figure II). As Table 6 shows, a high rate of growth of total personal disposable income relatively to GDP has been a marked feature of this recession.

Professor Hayek saw dearly enough from the outset that union power could wreck the government's efforts to control inflation in a politically sustainable way. He therefore re- commended that the power of the unions should be greatly reduced in particular by depriving them of their legal immunity from civil suits for damages. In the event the government did nothing for a time and then did rather little. Power was taken to check abuses in picketing-a reasonable enough measure in

1975 = 100

F I G U R E 11

Real Product Wage and Employment in UK Manufacturing

I 1 t

yl

i¢ / \ \ / / / ~ / ~'~.. / ~ Employees in Manufacturing

g / \ \ / \ (plotted 2 years later than \ date shownl \

I l : : l l l t : l l ) l l l l l l l k l l l I ) 1 1 1 1 1950 55 60 65 70 75 79 Source: Midland Bank Research Department

itself but far too modest to make any serious impact on union power.

What other course might have been followed? A forum of government, unions and industrial. ists might have been held just after the new administration had assumed office as the CBI and various individuals-including myself-had proposed. It would then have been made clear that the government would not go on financing inflation. I f unemployment, already too high, was to be reduced, the unions would have to moderate their wage demands. I f they did n o t - if they persisted in rejecting pay policies, cash limits, moderation in any form as they had done under the Labour Government-they would have to bear the responsibility for the deepening of the recession that would ensue with the lengthening queues of unemployed.

Of course the unions would have rejected this approach initially. After destroying their own Labour Government, they would not have been prepared to cooperate with a new Tory


government. It is hard to believe that there was any way in which agreement could have been prevented from causing some rise in unemployment-although a freeze combined with strict financial control might have helped. The plea for a more responsible approach could, however, have been made and repeated again and yet again.

There was no need for the government to slam the door on any kind of cooperation in labor market reform, no need to keep the unions rather ostentatiously at arms length. By doing so, the government has been less successful than it might have been in driving a wedge between the moderate leaders and the Marxists. By doing so, it has damaged its public relations with the result that the anger and resentment against the unions, so strong and widespread in 1979, has now been largely shifted to the government itself.

Does this matter from an economists's point of view? The answer must be that it matters a great deal. For the success of a policy depends largely upon the extent to which it is understood and supported by the public.

No doubt the response of both unions and public would have been different in a world of rational expectations. There is, perhaps, something a little unnatural about associating ration- ality with the British trade union movement! In any case, we encounter at this point what is, I believe, a serious fault in the theory of rational expectations itself.

To the best of my admittdedly limited knoweldge, that theory has not been satisfac- torily extended to cover situations where reaction functions are interdependent, as i~ the case when the labor market is highly unionized. The leaders of some unions may indeed be fully aware of the evils of inflation and strongly inclined to present only moderatewage demands. They may, however, feel that moderation in isolation is too dangerous a game; for other unions may still press for larger increases and get them. In short, there is a prisoner's dilemma. (This interdependence in reaction functions is broadly reminiscent of oligopolistic situations in product markets.) A less organized, more atomistic labor market would be better; so might one with more centralization such as

exists, for example, in Sweden. Britain, in her mezzanine position, seems to get the worst of both worlds.

These are important considerations which should not be forgotten in assessing the argu- ments for or against some form of incomes pol icy- to be viewed, of course, as a comple- ment to financial control, never as a substi- tute for such control. Of course, expenditure must be kept under control if inflation is to be kept under control. Nothing I have said implies the contrary.

The problem remains of how to achieve this victory over inflation at the least cost in lost output and jobs-and without discreditiing the free market system in a world where the judge- ments made are by no means always fair and rational. The wider dispersion of private wage- settlements may seem to indicate a breaking of the prisoner's di lemma-but only at the cost of depression.

There was, of course, a great deal of scepticism about incomes policies or a wage-freeze, apart from any effect monetarist doctrines may have had. Unfortunately, a proper distinction was not always drawn between a situation where labor is scarce and controls must fail after a short period and the different situation where the supply of labor is far from scarce and an incomes policy-in one form or another-is designed to achieve two objectives: first, to bring down inflationary expectations more quickly and, secondly, to deal with the prisoner's dilemma discussed above which con- fronts union leaders. Unfortunately, mone. tarist theory seemed to afford analytical support for undiscriminating condemnation.

In saying this, I do not for a moment wish to imply that an incomes policy affords a ready- to-hand solution to our difficulties. I have indeed little sympathy with those who simply reiterate that an incomes policy is the answer without attempting to assess the likelihood of any such policy being acceptable and workable.

But it is a mistake to believe that inflationary pressures can be properly understood and contained unless the impact of the union is taken fully into account and the various means of dealing with this impact explored in an open- minded way. After all, quite a number of pro-

22

posals have been made, some of them ingenious- ly designed to strengthen the means of containing inflation without loss of flexibility in the labor market. Moreover, there are other possible ways of modifying the working of a unionized labor market as well as the adoption of an incomes policy-such as attempts to reduce leap-frogging by a closer synchronization of settlements. The stimulus to explore and assess these possibilities must, however, be weakened if one accepts the monetarist dogma that unions cannot cause inflation.

Recovery Without a Resurgence of Inflation?

There has been a good deal of speculation about the ending of the downturn and timing and scale of a possible recovery. This contem. porary debate will not be reviewed in the present paper. May I rather direct attention to more basic questions?

Is it the case that inflation has been reduced only by accepting another evil in the form of a severe depression? Is a resurgence of inflation to be expected when recovery begins? If no t - i f expansion could safely begin-should it not be helped by a little pump-priming which could, of course, take the form of tax-cuts rather than increased public expenditure? It is hard to determine what the government, for its part, has in mind. For the Prime Minister and some senior ministers have spoken hopefully about recovery and have given the impression of wishing to see it begin. Yet they have opposed any stimulus, fiscal or monetary. One of the reasons given is that no net benefit would occur because there would be Crowding-out. Crowding-out may, however, take more than one form.

Financial crowding-out. This false argument can be regarded as a revival of what was known in the twenties and thirties as the "Treasury View." A cut in taxation or a rise in public expenditure will increase public borrowing and private borrowers must be crowded out as a consequence with no net rise in expenditure. This contention rests on the assumption that MV cannot be expanded. But it is hard to see how any recovery could ever take place includ- hag a recovery that started in the private sector [Keynes, 1952, p. 121].

Physical crowding-out. This is a different

ATLANTIC ECONOMIC JOURNAL

matter. If an economy is working at something like full capacity, then increased expenditure in one direction may crowd out expenditure elsewhere if the net increase in demand cannot be accommodated by growth. Physical crowding- out ought then to be matched by financial crowding-out. But output could obviously be expanded in the early 1980's without en- countering this physical barrier.

Preventing further rises in union demands. It may be held that the restriction of demand con- tinues to be necessary in order to prevent wages and salaries from rising still faster. If this is indeed believed to be so, it is inconsistent to speak hopefully about an impending recovery for a recovery, whether wholly private in its initiation or stimulated by public policy, will lead to a new acceleration of inflation.

The Chief Secretary to the Treasury, Mr. Leon Brittan, in giving evidence before the Treasury and Civil Service Committee [HMSO, 1981 ], has said that the government was taking seriously the view that a limit should be set to total expenditure: "A constraint on the growth of money expenditure implies that an increase in investment, whether public or private, must be accompanied by some reduction in other expenditure." (Italics added.) The Committee concluded in its report:

"These statements imply that increases in expenditure anywhere in the economy may result in government steps to reduce expenditure by the same amount. Government would ensure that crowding-out was complete, either by tak- Lug severe action on interest rates or by direct action, say, by raising taxes and reducing ex- penditures elsewhere . . . . A policy of setting a limit on money GDP implies more severe action, in the short term at least, than a policy of maintaining monetary targets."

Indeed it does, for any rise in velocity will, if possible, be checked or offset. The Commit- tee goes on: "That such action would occur under present policy appears to follow from the Treasury belief that even with a f~xed money supply a rise in public (or indeed private) investment would still be inflationary."

If this were the official view, it would be inconsistent for ministers to offer hopeful fore- casts about recovery. It would also be inconsistent to relax the fiscal stance because of increased tax receipts from rent on North Sea


oil or because of a reduction in Britain's con- tribution to the EC budget. Nor should any fall in the personal savings ratio from the very high levels of recent years (see Table 7) be al- lowed to stimulate expenditure; its effect must rather be offset.

It will be apparent that if the government is really going to follow this course, it will of necessity be involved in short-term discretionary intervention of a kind that is viewed with scepticism and disfavor by monetarists (see above). It will also be apparent either that no strategy has been devised as yet for a recovery without a new intensification of inflation or that, in the official view, the time has not yet come to put such a strategy into operation.

Is this officially expressed fear of expansion reasonably well founded? The rate of growth of wages had declined sharply by 1981 but may not fall much below 10 percent a year-roughly twice the rate in West Germany. Significant increases in productivity have been achieved [NEDO, 1981]; but what is relevant here is the likelihood of further improvements in productivity during an expansion and these might well be insufficient to offset other inflationary pressures. The lower pound and the need to increase gross profit margins will put some pressure on real wages [OECD, 1981], and this pressure may be resisted by stepping up demands for higher money wages and salaries.

The sheer weight of unemployment should be a restraining factor. Here we return to the question whether the excess of unemployment over some minimum rate ( U - U*) is likely to outweigh the effect of changes in unemployment (0) . We have come back, in short, to the old debate about "loops," although any em- pirical conclusions from that earlier work can be of only doubtful relevance when ( U - U *) is so very much larger than it was in the 1960's and early 1970's.

In these circumstances it would be rash to ignore the danger of accelerating inflation and irresponsible to advocate, as the TUC has done, a vast rise in expenditure without at the same time recommending some effective means for preventing costs from soaring upwards. The government, for its part, is undoubtedly right

to be cautious; but the unanswered questions begin to accumulate.

If a strong recovery would be premature, as Mr. Leon Brittan appears to believe, at what stage is it likely to be appropriate? For how long are the misery of high unemployment and loss of output to be endured? Will recovery be envisaged when inflation is down to 8 percent? Or 5 percent? Or what? If the natural rate of unemployment is defined as the level at which actual inflation is equal to expected inflation, how are we to tell when we have got there? [Fellner, 1976]. And if we are there and know ourselves to be so, we may still have a level of unemployment far above what could plausibly be regarded as the structural and frictional minimum. How is this excess of job- lessness to be dealt with? [Wilson, 1980].

Unfortunately, monetarist theory is very reticent about such matters. The theory is not only inadequate in this respect but also inhibit- ing, for it fosters an excessively heavy emphasis on monetary targets to the neglect of the des- perately urgent need for labor market reform.

At the beginning of this paper it was said that the government appears to lack a satisfactory policy for a non-inflationary recovery. With the best effort in the world, the task of devising such a policy is bound to be difficult, but one cannot help feeling that the government might have put forward a better and an earlier effort if it had not been so preoccupied and more than a little bemused by the confident assertions of the monetarist school.

TABLE 1

Changes in the Money Supply

Feb. 1 9 8 0 - Feb. 1981:

Target for £343 : + 7 - 11%

Actual for £M3 : + 19¾%

Actual for £343 (adjusted) 1 : + 171A%

PSL 12 : + 15%

M1 : +8.1%

Notes: 1 £M 3 adjusted to allow for the effect of removing the control on the growth of interest-bearing deposits, i.e. the "corset." 2PSL I: private sector liquidity category I which con- sists of £M 3 plus acceptance credit. Source: Bank of England Quarterly Bulletin


TABLE 2

Public Expenditure 1979/80 = 100

1975/76 1976/77 1977[78 1978/79 1980/81 1981/82

Current 93.1 93.2 93.4 97.6 101.7 (102.1 )

Capital 155.6 126.7 93.7 99.3 96.6 (88.9)

Total 104.5 101.8 95.6 100.2 101.9 (101.9)

Notes: The figures for 1981/2 are estimates. The total is the sum of the first two rows plus borrowing by the nationalized industries, receipts from special sales of assets and minor items. Source: The Government's Expenditure Plans 1981-82 to 1983-84, Cmnd 8175.

TABLE 3

Public Expenditure: Planned and Actual - £ Billion

1979/80 1980/81 1981/82 1982/3 1983/4

As planned in January 1979 by Labour Government (Cmnd. 7439)

As planned in March 1980 by Conservative Government (Cmnd. 7841)

As planned in March 1981 (Cmnd. 8175)

Actual (Cmnd. 8175)

80.5 82.1 83.5 85 .I

77.8 79.2

77.8 76.9 75. .4 75.2

79.2 77.9 76.6


TABLE 4

Public Sector Borrowing Requirement

TABLE 5

£ billion

Projection for 1980/81 8½

Actual 13% ~

Projection made in March 1980 for 1981/82 7½

Projection for 1981/82 before the 1981/2 budget 14

Projection for 1981/82 after budget changes 10½5

Notes: Equivalent to 6% of GDP.

2 Officially estimated at 4%% of GDP. Source: Bank of England Quarterly Bulletin.

Indices of Average Earnings of All Employees and the Tax-Price Index

Gross Earnings TPI ~ Real Disposable in Current £'s Earnings

1976 100.0 100.0 100.0

1977 109.0 114.7 95.0

1978 123.2 118.2 104.2

1979 142.4 132.4 107.6

1980 t71.8 155.3 110.6 1981 (Apr.)188.2 178.2 105.6

Note: 1The tax-price index reflects both changes in retail prices and changes in direct taxation, The latter refer to a weighted average for families of different sizes. Source: Monthly Digest of Statistics (HMSO)

TABLE 6

Annual Rates of Change: Year On Year At 1975 Prices

Gross Domestic Product

1975-76

1976-77

1977-78

1978-79

1979-80

(a) (b) Per~nal Output Average Disposable Personal Ba~d E ~ a t e Income Consumption

1.9 2.7 -0.6 -0.3

2.6 1.9 -1.8 -0.6

3.4 3.1 8.4 6.0

2.2 1.5 6.3 4.0

-3.0 -2.0 2.1 0.6

Source: Economic Trends, HMSO.

1975

1976

1977

1978

1979

1980

TABLE 7

Personal Saving as Percentage of Personal Disposable Income

12.7

11.9

10.8

12.7

14.1

15.3

Source: Economic Trends, HMSO

26 A T L A N T I C ECONOMIC J O U R N A L

REFERENCES

W. H. Buiter,"The Macroeconomics of Dr. Pangloss: A Critical Survey of the New Classical Economics, Economic Journal, March 1980.

W. J. Fellner, "Criteria for Demand Management Policies in View of Past Failures" in Contemporary Economic Problems, edited by William J. FeUner, American Enterprise Institute for Public Policy Research, Washington, D.C., 1976.

M. Friedman, Memorandum to the Treasury and Civil Service Committee in Memoranda on Monetary Policy, HMSO, July 17, 1980.

J. M. Keynes, Essays in Persuasion, Rupert Hart- Davis, 1931.

R. C. O. Matthews and W. B. Reddaway, "Can Mrs. Thatcher Do It?" in Midland Bank Review, Autumn 1980.

T. Mayer, The Structure of Monetarism, W. W. Norton and company Inc., New York, 1978.

P. Minford and D. Peel, "Is the Government's Economic Strategy on Course?", Lloyds Bank Re- view, April 1981.

M. Peston, "The Integration of Monetary, Fiscal and Incomes Policy," Lloyds Bank Review, July 1981.

T. Wilson, "Policy in War and Peace: The Recom- mendations of J. M. Keynes," paper read at Keynes Seminar, University of Kent, November 1980. (To he published. Available as University of Glasgow Discussion Paper, No. 37.)

- - , "Robertson, Money and Monetarism," Jour- nal of Economic Literature, December 1980.

- - , "1929-33-Could it happen again?" Three Banks Review, December 1980.

The Government's Expenditure Plans, Cmnd. 8175, HMSO, March 1981.

Monetary Control, Cmnd. 7858, HMSO, February 1980.

Treasury and Civil Service Committee: evidence submitted by the Chief Secretary to the Treasury as reported in the Financial Times, August 15, 1981.

Bank of England Quarterly Bulletin, March, 1981. Midland Bank Review, "Economic Outlook,"

Autumn 1980.

Documents

The monetarist controversy and the British experiment