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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22. Effective Exchange Rate
Sterling effective exchange rate 1975-2005, monthly average
0
20
40
60
80
100
120
140
160
Jan-75
Jan-77
Jan-79
Jan-81
Jan-83
Jan-85
Jan-87
Jan-89
Jan-91
Jan-93
Jan-95
Jan-97
Jan-99
Jan-01
Jan-03
Jan-05
month
exchangerateindex
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23. Base Rates
base rates 1975-2005
0
2
4
6
8
10
12
14
16
18
02/01/1975
02/01/1977
02/01/1979
02/01/1981
02/01/1983
02/01/1985
02/01/1987
02/01/1989
02/01/1991
02/01/1993
02/01/1995
02/01/1997
02/01/1999
02/01/2001
02/01/2003
02/01/2005
date
ratepercent
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24. DM/£ exchange Rate
DM/£ exchange rate 1975-2001
0
1
2
3
4
5
6
Mar-75
Mar-77
Mar-79
Mar-81
Mar-83
Mar-85
Mar-87
Mar-89
Mar-91
Mar-93
Mar-95
Mar-97
Mar-99
Mar-01
date
Priceof£inDMs
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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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