Thinking Makes It So: The IMF Bailout of the UK in 1976 and the Rise of Monetarism

by Philip Pilkington

Monetarism began it’s rise to world prominence in the ever-conservative Bundesbank in 1974. But it would be the government of Margaret Thatcher in the UK, elected in 1979, that would truly launch monetarism in central banking. After Thatcher’s monetarist experiment undertaken between 1979 and 1984, every economics student would be taught to recite the various monetary aggregates by heart for at least a decade or two.

This is what accounts for the monetarist bent we see in the economists of the last generation. Basically any economist trained between roughly 1980 and 1995 would be heavily exposed to monetarist dogma. And only those that read alternative accounts of money creation — namely, the theory of endogenous money — would be fully immunised. This explains, for example, why certain economists that champion Keynesian policies — like Paul Krugman — actually speak in monetarist tones.

But it was the Labour government of James Callaghan that paved the way for the monetarist dogma. The short version of the story runs something like this: in 1976 Callaghan needed a $3.9bn loan from the IMF because he was concerned that the value of the sterling was about to crash. The IMF insisted that Callaghan undertake austerity policies and that he establish a monetary target for the central bank. This is how monetarism entered the UK.

As shorthand this is pretty much accurate. But to understand the history in more depth we must consider the role of the financial markets and the financial press — two institutions that had been ‘converted’ to monetarist dogma pretty much the moment the sustained inflation of the 1970s broke out. In order to explore this I will draw on an excellent paper by Aled Davies entitled The Evolution of British Monetarism 1968-1979.

The debate surrounding monetarism began in 1968 when journalists in Britain and the US began to pay attention to Milton Friedman. This was partly because of Friedman’s communicative abilities but it was also partly because of the inflationary pressures that were beginning to build in the world economy at that time — mostly due to trade union entrenchment, upward movements in commodity prices and large deficits in the US to finance the Vietnam War. Even at this stage institutions like the OECD and the IMF were paying attention.

The financial sector already had began to take note; not so much because of monetarism’s supposed predictive capacity but rather because key institutions were investigating the aggregates. One could not hope for a better illustration of Keynes’ ‘beauty contest’ theory of financial markets. The market in which this imitative behavior most important was the market for British government debt. Davies gives us an idea of how this imitative behavior spread,

[M]onetarist interpretations began to proliferate more generally within the financial markets, providing clues to future economic growth and inflationary pressures likely to emerge. This was led by circulars and bulletins such as those published by W. Greenwell & Co., Pember & Boyle (written by Brian Griffiths), and Joseph Sebag & Co. (Alan Walters). The writers of these circulars demonstrate the significant personal and conceptual overlap between academic-, City-, and political-monetarism. Brian Griffiths was a lecturer in Economics at the LSE (1968-76) and Professor of ‘Banking and International Finance’ at City University (1977-85). Alan Walters was a Professor of Economics at the LSE (1968-76). Both of these, alongside Gordon Pepper, were senior advisors to the Conservative Party in opposition and in Government. (p10)

By the time the inflation in the UK had taken off due to the first oil price hike in 1973-1974 some of these commentators were writing letters to Prime Minister Harold Wilson saying that if he didn’t balance the government budget the UK would fall into the abyss of a hyperinflation. This was complete nonsense, of course, because the inflation wasn’t due to an unbalanced government budget at all. Rather it was due to the rising price of oil and the wage-price spiral that accompanied it. But the City of London, unfortunately, was on the side of the hyperinflationists even though the Treasury Department remained unconvinced.

The Chancellor of the Exchequer Denis Healey, however, took the monetarist critique and turned it into his own: he alleged that the monetarists were correct in their diagnosis and that the imbalanced budget had been the result of the previous Conservative government’s misguided fiscal stimulus programs. Talk about giving them the rope that they would eventually hang you with!

By 1975 the financial markets — most notably the foreign financial markets upon whom the strength of the sterling depended — had become convinced that the best manner to understand the viability of the UK’s economy was to focus on the monetary aggregates. In order for the government to appease the foreign exchange markets and foreign holders of UK government debt they had to appear to be trying to keep the money supply under control. Since these two markets had an enormous impact on the value of the sterling the government already found itself needing to drum up the monetarist rhetoric. As Davies writes,

Civil servants and Bank officials consciously expressed the view that the influence of ‘monetarist’ ideas amongst investors were a significant limitation on the Government’s policies. In a note from the Downing Street Policy Unit in January 1976 the Prime Minister was informed that ‘some people in the City…(whether correctly or incorrectly does not matter) believe that a rising money supply leads to inflation.’ (p17)

Because the Bretton Woods system had broken down only a few years before the financial markets needed a metric by which to judge whether government policies were ‘sustainable’. That metric became the money supply. This was a classic example of a rather unimportant variable becoming important merely because people began to think it important. In 1977 Treasury Minister Denzil Davies summed the situation up perfectly when he said,

[W]e should do all we can do to keep M3 within the announced target during this financial year. It matters not, it seems to me, that the definition of M3 is arbitrary; that the commitment to the IMF is in terms of Domestic Credit Expansion (although everyone knows that DCE is irrelevant when a country is in a balance of payments surplus); and that an increase in the money supply caused by “printing money” may be of a different nature to an increase caused by inflows. All this, no doubt, is good stuff for a seminar. Unfortunately, those people who have the power to move large sums of money across the international exchanges believe, on the whole, that “money counts”. The fact that it may not count as much as they think it does, seems to me to be somewhat irrelevant. (p25)

By 1976, with inflation raging and monetarism important because of the very fact that it was believed, the government felt the sterling to be faltering. They were concerned about a massive speculative attack that would crash the currency and send inflation skyward. It was at this point that the Callaghan government approached the IMF for a loan.

The Treasury hated the idea, but the Callaghan government felt compelled to accept it. And with that the government had trapped itself. By positing the need for a target without the intention of seriously pursuing it they had sealed their fate. They could now be chastised for not meeting a target which was, as those working in the Treasury at the time knew well, impossible to meet because the money supply was impossible to control (i.e. it was endogenous and determined by other variables).

In 1979 Thatcher would rise to power with full intentions to meet the targets she set, no matter what the cost. The fact that she failed spectacularly and monetarism was thrown in the dustbin after 1984 was of secondary importance; the dogma had done it’s job — it had justified the demolition of British manufacturing and the gutting of trade unions — and anyone exposed to economic ideas in this era was forever infected.

So, what can we learn from all this today? Well, certainly that the finance sector has a remarkable ability to spread ideas which become important simply for the fact that they are believed. Unfortunately, however, financiers have a very immediate and obvious interest in seeing the government tackle inflation — as it eats into their earnings — but they have no very immediate and clear incentive to have the government reflate the economy.

Nevertheless, it is clear that most of the financial community are coming around to Keynesian-ish ideas today and for those of us who want to see those sorts of policies enacted that cannot be a bad thing at all. Apart from that I think that there is much of aesthetic interest in the monetarist saga; if nothing else it shows us just what a hall of mirrors we live in, with ideas taking on a life of their own through the simple act of people pretending to take them seriously.

The New Monetarism

About a year and a half ago I wrote a three-part series on monetarism which I published on Naked Capitalism. It might be of interest to readers so I include links below.

The New Monetarism Part I — The British Experience

The New Monetarism Part II — Holes in the Theory

The New Monetarism Part III — Critique of Economic Reason