How 364 economists got it totally wrong
By Philip Booth
(Filed: 15/03/2006)
In 1981, Britain was at an economic crossroads. Policies that the Conservative government, elected in 1979, had been implementing to deal with accelerating inflation and a spiralling national debt were not working. Borrowing was rising. Interest rates were moving ever higher. If things had gone on as they were, credibility in the British economy would have collapsed. Investors, firms and trade unions would not have believed that any future government could have restored fiscal and monetary discipline. Britain could have become like so many South and Central American countries in the 1970s and 1980s.
Instead, Margaret Thatcher and her Chancellor, Sir Geoffrey Howe, changed tack. The 1981 Budget increased taxes by £4 billion - an enormous sum in 1981 prices. This was extremely difficult for a government elected to cut taxes. But by showing a determination to cut borrowing, the government made it easier to control monetary policy, too, as interest rates could be reduced. This helped convince the markets, which were also worried that high borrowing would lead to high inflation, because in the 1970s governments had financed their deficits by printing money.
Mrs Thatcher and Howe faced stiff opposition to this Budget, not just from the Labour and Liberal parties, but also from their own back benches. Their determination was really put to the test, however, when 364 economists signed a letter to The Times stating that there was "no basis in economic theory or supporting evidence" for the policy that the Budget was seeking to implement, that it threatened Britain's "social and political stability", and that an alternative course must be pursued.
The whole of the academic establishment - including some luminaries of today - stood against the government. The 364 included Third-Way guru Anthony Giddens; the current Governor of the Bank of England; Monetary Policy Committee member Stephen Nickell; and former and future Nobel Prize winners. Only a brave few stood out against them. Indeed, it is said that Mrs Thatcher was asked in heated debate in the Commons whether she could even name two economists who agreed with her. She replied that she could: Patrick Minford and Alan Walters. As the story goes on, her civil servant said when she returned to Downing Street: "It is a good job he did not ask you to name three." In fact, there were one or two others who deserve mention, such as Terry Burns and Tim Congdon, as well as some journalists and politicians who stayed firm and argued the case for what would today be described as orthodox fiscal and monetary policies.
In many walks of life, we listen to experts with respect. Three hundred and sixty-four experts would normally command a lot of respect. But were the 364 wrong and, if so, why were they so wrong? It should be mentioned that some of the 364 would not have agreed with all the content of the letter. Nickell has said that he signed the letter because it was "the only game in town". He agreed with aspects of it, but did not agree with it in its totality. That is fair enough. The letter was wide-ranging. But the majority of its signatories probably did accept the letter in its entirety. Furthermore, Labour peer and signatory Maurice Peston has said that there would have been hundreds more queueing up to sign it if it had not been sent over Easter.
On the face of it, they were wrong. The economic recovery that the 364 said would not happen began more or less as soon as the letter appeared. Unemployment continued to rise, but this was in the face of a highly regulated and unionised labour market and wholesale industrial restructuring. A long-term fall in the rate of unemployment had to wait until labour market and trade union reforms became embedded some years later.
The 364 were wrong because they believed the Keynesian consensus of the time. Indeed, they taught it to nearly every undergraduate in the country. The textbooks used by nearly all British undergraduates did not pay any attention whatsoever to alternatives. It was as if economic theory began and ended with the naïve Keynesianism of Keynes's immediate followers.
Howe chose not to respond to the problems of the widening Budget deficit as his predecessors had, by managing it through distortionary controls or by ignoring it. He faced it head on and increased taxes. To the naïve Keynesians, the increased taxes would lead to further contraction in the economy and no hope of economic recovery. But they ignored the wider consequences. With government borrowing back on course, Howe could reduce interest rates at a time when they had been rising and when a high exchange rate had been crippling British industry. Thus lower government borrowing meant lower interest rates. This alleviated some of the pressure on industry.
These benefits were reinforced in the medium term because, instead of credibility collapsing, as it could have done had the U-turn the 364 demanded occurred, the government's policy became more credible. Gradually investors came to believe that necessary policies would be followed through and that they would work. They could plan on the basis of lower inflation, lower interest rates and a government that would repay its debt.
At the time, Minford described the 364's letter as a "dangerous and dishonest game". This is a strong charge against fellow academics, but is it justified? The charge of dangerous probably is. The government could well have caved in under the pressure generated by so many experts. If it had done so, the long-term consequences would have been catastrophic. Unemployment of three million would probably not have been avoided in the short term and, in the long term, steady decline would have been the best possible result.
The 364's letter also affected trade union "expectations". If unions expected the government to U-turn, they would expect higher inflation and ask for higher pay increases. This could have contributed to the growth in unemployment. But were the 364 dishonest? Here Minford suggests that the evidence that the Thatcher/Howe policies were both necessary and could work was before their eyes. The alternatives of incomes policy and reflation had been tested to destruction and had failed. The supporting theory and evidence for the Thatcher/Howe approach had been circulating for some time, especially in North America.
Due to the determination of a small number of politicians, backed up by a handful of academics, the government prevailed. Even the 1997 Labour Government decided to institutionalise the pursuit of sound money and fiscal policy by its fiscal rules and by making the Bank of England independent.
There are still many problems with the over-regulated British economy, which is stifled by high government spending. More than ever, Britain needs politicians who will stand up against the experts when there is a need to implement difficult policies. Thankfully we had such people 25 years ago, when the temptations to take the easy way out must have been so great: the consequences had alternative policies been pursued do not bear thinking about.
Professor Philip Booth is editorial and programme director of the Institute of Economic Affairs.
Were 364 Economists All Wrong? is published by the IEA this week.