1. EC-111 British Economy
Recent UK
Macroeconomic Trends
Dr Catherine Robinson
F35, Richard Price Building
Office Hours: Mondays 10:30-11:30 and Thursdays 9.30-10.30
Appointments: c.robinson@swansea.ac.uk
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2. Recapitulating yesterday...
Thatcher came in…
Adopted Medium Term Financial Strategies
Followed a monetarist policy for the first of these
The cost was unemployment and particularly hard hit was
the manufacturing sector
Reverted to a fixed exchange rate system within
Europe
ERM
Pegged to the Deutschmark
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3. The exchange rate became the
target
Monetarism had pretty much failed
Fiscal policy was seen as a short run instrument to balance
the budget
No long term function of Keynesian times
But what happened in the ERM?
It was the ONLY external policy target
and the interest rate was the only instrument
Sterling was pegged too high
By late 1992, sterling had been forced out of the ERM
Sterling fell by 14% against the DM and 20% against the $
This all led to fear of inflation driven by higher import prices
The resurgence of fiscal policy!
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4. Pro-ERM case
If UK inflation increased within a fixed
exchange rate system, UK goods would
become uncompetitive leading to a current
account deficit, which would tend to lead to an
overall balance of payments deficit.
Then,
either central bank intervention to buy £’s
or rise in interest rates (to attract mobile capital)
automatic tightening of monetary policy, and
reduction of inflationary pressure.
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5. Anti-ERM case
If UK inflation increased within a fixed
exchange rate system, investors would
anticipate a rise in UK interest rates, and
move mobile capital into sterling, leading to
capital account surplus and thus
either central bank intervention to sell £’s
or cut in interest rates (to deter mobile capital)
In both cases leading to a loosening of
monetary policy, and acceleration of inflationary
pressure.
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6. MAIN SHORT RUN ECONOMIC
ISSUE
Would ERM membership be helpful or harmful in
the fight against inflation?
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7. The debate was really about whether the current
account or capital account (especially short run capital
movements) adjustment tended to dominate.
Current account dominance → ERM membership
would be stabilizing.
Capital account dominance → ERM membership
would be destabilizing.
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8. In 1985, the anti-ERM faction (led by PM Thatcher)
won the debate about membership, and the UK
stayed out.
But the pro-ERM faction (led by Chancellor
Lawson and Foreign Secretary Howe) continued to
argue the case.
By 1987, Lawson was running an unofficial
strategy of ‘shadowing the DM’ (intervening on the
currency markets to keep the exchange rate within
the range £1=DM2.80 to £1=DM3.00).
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9. The evolution of Policy
Meanwhile the economy was booming
unsustainably due to:
Substantial income tax cuts (basic rate was cut from
30% to 25% 1986-8),
More financial deregulation,
A housing market boom which increased consumer
spending.
Against this inflationary
background, ‘shadowing the DM’ provided a
test case for pro and anti-ERM arguments.
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10. WHAT HAPPENED?
Speculative pressure in favour of sterling (1987-8)
Relaxation of monetary policy (cut interest rates) to
prevent £ exceeding its upper limit leading to
Sharply increased inflation.
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11. WHAT HAPPENED?
In Spring 1988:
interest rates were increased sharply,
‘shadowing the DM’ was abandoned and £ rose
sharply.
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12. VALIDATION OF THE ANTI-ERM
CASE?
Perhaps, but pro-ERM faction argued shadowing failed
because it had been attempted without convergence
between UK and European economies.
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13. The aftermath
The collapse of the experiment in shadowing the DM
did not bring the boom conditions to an end at once.
But the continued monetary squeeze eventually led to
a fall in household spending.
In 1990 the economy fell into another deep
recession, one led, most unusually, by a fall in
consumption.
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14. The aftermath
So independent discretionary monetary policy did not
seem to be particularly happy either.
Thoughts turned once again to attempts to choose an
outside anchor for UK monetary policy.
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15. Trying Again
John Major (new Chancellor) announced entry in Oct
1990, still before convergence had been achieved.
PM Thatcher was replaced by Major in Nov 1990.
Entry at a central parity of £1=DM2.95 (with a 6%
margin on either side permitted).
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16. BACKGROUND TO ERM
MEMBERSHIP
By 1990, economy was in deep recession, due to
policy responses to the ‘Lawson Boom’.
Underlying theme of the 2-year period of membership –
conflict between:
Need to cut interest rates (to combat recession),
Need to maintain interest rates to prevent £ from falling.
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17. THE EXPERIENCE OF ERM
£ was below its ERM central parity (1991).
Then a brief improvement, due to:
Maastricht Treaty (Dec 1991) which gave a
timetable for European Monetary Union (UK &
Denmark could opt out),
4th Conservative election victory (April 1992).
Then, a ‘No’ vote in Danish Maastricht
referendum (June 1992) unsettled the currency
markets.
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18. THE EXPERIENCE OF ERM
Speculation against £ (& the lire) increased
(summer 1992).
UK raised interest rates from 10% to 12%, then
15%. But £ still fell below its lower ERM bound on
‘Black Wednesday’ (Sept 16 1992).
£3bn of foreign currency reserves were lost in the
attempt to stay in the ERM.
Summer 1993: further currency market turbulence
forced a widening of all ERM bands to 15% (much
looser arrangement).
So European monetary union was put on hold.
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19. WHAT WENT WRONG?
Weakness of the German economy in the early
1990s, following monetary unification of West/East
Germany (July 1990).
Guaranteed parity between DM and Ostmarks
(public subsidy from west to east) meant that high
interest rates were required to curb inflationary
pressure.
High German interest rates attracted mobile capital
into DM, away from currencies such as £.
Downward pressure on £ implied that the UK had
to keep interest rates high, despite recession.
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20. WHAT WENT WRONG?
In effect this is a textbook’ argument against fixed
exchange rates:
a ‘shock’ affecting one country strains the entire
system, forcing exchange rates apart.
ERM crisis brought out a contradiction between the
Bundesbank’s duty to keep German inflation low, and
its responsibility for stability of ERM.
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21. WHAT WENT WRONG?
Other factors included:
The UK's parity was too high. At the time, £1=
DM2.95 did not reflect true purchasing parities.
Difficulties in establishing the credibility of
commitment to ERM, due to the UK’s poor track
record, & anti-European rhetoric.
No realignments within the ERM had taken place
since 1987, so pressures were building up anyway.
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25. MTFS 5: 1993-1996
POST ERM
Shift in focus – to the domestic side of things
Policy of debt sustainability
Focus on the ratio of debt to GDP
Should not be allowed to accelerate rapidly
Loose fiscal policy
This led to a need for tight monetary policy
Long term aim of fiscal balance by 2000
Inflation targeting, but broad limits (1-4%)
The ERM experience led the chancellor to focus on a wider
range of intermediate objectives and instruments
A shift to more of a Theil-type approach to target setting
Macroeconomic modelling became important again
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26. So now you know...
A bit more about the Thatcher years and macro
policies....
The rise and fall of monetarism
The role of exchange rates in controlling inflation
The fundamental problems with exchange rate systems
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27. Next Week....
The Blair years...
Bank of England independence
The emergence of ‘spin’
But what changed in terms of macro policy?
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28. References
Griffiths and Wall 9th edition, chapter 24 Managing the
economy
Also chapter on European Union and exchange rates
and trade performance(chapter 27 in 12th edition)
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