In the 1960’s the advisers to government on macroeconomic policy were almost exclusively Keynesian economists. They were relatively pleased that they had more or less achieved their full employment target but were also frustrated by the fact that they felt they could do more to promote real growth in the economy.
As they saw it, their expansionary monetary and fiscal policies always hit the brick wall of a fixed exchange rate and their GO for expansion became a STOP as both fiscal and monetary policy were held back to maintain the value of the currency. However this was not always successful and sterling had to be devalued by 14% in 1967.
The Tory government formed in June 1970 was persuaded that fiscal deficits and accommodating monetary policies could be used to not only sustain full employment, but also to encourage the economy to grow faster. The Keynesian economists had diagnosed our comparatively low rate of economic growth as a result of the uncertainty created by a fixation on a fixed exchange rate.
If businesses became used to a year on year expansionary set of policies, then they would be prepared to invest and grow the economy, and if the exchange rate come under pressure, then it should be floated and side lined as an economic target. “Adopt our policies” and the Keynesian promise of 5% economic growth year on year will be achieved.
Unemployment was rising when the conservative government came to power and so yearly budget deficits were used in 1971 onwards to expand aggregate monetary demand. The immediate effect on unemployment was good (the unanticipated inflation effect as Friedman would say) reducing it from above 1m to 600,000.
In contrast the immediate effect on the balance of payments current account was not good as the expansionary policies were sucking in imports and applying pressure to further devalue the currency. In June 1972 the currency was floated (downwards) and the stage was set to continue the fiscal and monetary expansions.
By 1974 unemployment had once again risen above 1 million (in spite of the expansionary policies) and the fiscal deficits continued to grow in 73/74 to £4.2 billion. A new labour government in 1974 aimed to reduce this total but it grew to £8 billion in 74/75 and to £10.5 billion in 75/76.
The expansionary monetary and fiscal policies caused inflation to rise from 7.1% in 1972 to 24.9% in 1975 (a monetarist interpretation of the cause of inflation) and by April 1976 the U.K. had to go cap in hand to the IMF for a loan to support our dwindling foreign exchange reserves. This was offered on the condition that we reduced our borrowing requirement by half from £10.5 billion to £5.5 billion over two years and kept within the constraints imposed, by the IMF for domestic credit expansion. The UK government complied and things started to improve, but as soon as the IMF removed the shackles and election frenzy returned, things began to unravel.
So what are the significant points? –
- Keynesian demand management does not facilitate growth, in fact the very opposite, as the 5% yearly target for the U.K. turned out to be 0.6% p.a.
- Unemployment will not fall and will probably rise as soon as expansionary polices and inflation are anticipated.
- James Callaghan got it right when he said, under direction from the IMF, on the BBC in 1976 “We used to think that you could spend your way out of a recession and increase employment by cutting taxes and boosting government spending. I tell you in all candour that that option no longer exists, and in so far as it ever did exist, it only worked on each occasion since the war by injecting a bigger dose of inflation into the economy followed by a higher level of unemployment as the next step”
- The Phillips Curve and Automatic stabilisers are Keynesian myths not supported by fact.
- Reducing the budget deficit by 50% caused things to improve, at least until another frenzy of overspending occurred in 79/80 and 80/81.
- Floating the exchange rate in June 1972 exposed the weakness of the Keynesian argument.
- What happened to the UK economy from 1970-1976 showed the really damaging side of Keynesian economics.
- Unfortunately these exact same policies were introduced again in 2009. In 1976 the IMF could tell us to stop, but now all G20 members are complicit so who is left to clear up the mess?
John Hearn 11/2/2015