The Downing Street Years

by Margaret Thatcher

  With this moderate Cabinet reshuffle, I had hoped that we would be able to face our economic difficulties with greater unity and determination. Certainly, both qualities were needed: the criticisms of our strategy were mounting. I counter-attacked. Both in my Weekend World interview on 1 February and a few days later in my speech in the Commons economic debate I replied to the arguments of those who believed that the real problem in Britain was lack of economic demand and who argued that we should remedy it by reflation. I told the House:

  As governments tried to stimulate employment by pumping money into the economy they caused inflation. The inflation led to higher costs. The higher costs meant loss of ability to compete. The few jobs that we had gained were soon lost; and so were a lot more with them. And then, from a higher level of unemployment and inflation, the process was started all over again, and each time around both inflation and unemployment rose.

  But the other side had important allies in the media. A leading article in the Sunday Times, usually a Conservative paper, carried the headline ‘Wrong, Mrs Thatcher, Wrong, Wrong, Wrong’. Indeed, the press was full of hostile comment. And that hit the morale of my supporters. On 27 February I received a memorandum from Ian Gow:

  Prime Minister

  1. I am sorry to say that there has been a noticeable deterioration in the morale of our back-benchers.

  2. I attribute this to:-

  (a) Increasing concern about the extent of the recession and unemployment.

  (b) The perceived defeats for the Government on Coal and, to a lesser extent, in the pay settlement for the water workers.

  (c) The size of the PSBR and the slowness with which interest rates are falling.

  (d) The insatiable appetite of the Public Sector — notably BL, BSC, NCB.

  (e) The Rate Support Grant.

  Many of the critics inside and outside the Conservative Party felt that they had detected weakness, were determined to exploit it and saw their chance coming with the 1981 budget.

  THE 1981 BUDGET

  I shall never forget the weeks leading up to the 1981 budget. Hardly a day seemed to go by without the financial scene deteriorating in some way. At the end of January Geoffrey Howe was still hoping to make serious cuts in capital taxation and to provide substantial assistance for industry, but by the beginning of February the Treasury was already becoming more cautious and pessimistic about the outlook. The PSBR for the current year seemed likely to turn out between £4 and £6 billion more than the figure forecast in the 1980 budget. The current Treasury forecast, which assumed indexation of personal tax allowances and of specific duties and took account of the measures announced in November 1980, showed a PSBR for 1981–2 in the region of £11 billion (nearly 4.5 per cent of GDP), compared with a figure implied by the MTFS of around £7.5 billion (some 3 per cent of GDP). At this point the Treasury believed that we should aim for a PSBR somewhat below £10 billion. There was, therefore, a gap of £1 billion to £1.5 billion.

  Personal incomes had been increasing while company profits had been shrinking, so it was clear that any extra taxation should be borne by the personal rather than the corporate sector. The Treasury were talking of raising personal allowances by a minimum of 6.5 per cent — they hoped for 9 or 10 per cent — rather than the full 1.5 per cent required to take account of inflation. They were planning to raise the specific duties on alcohol, tobacco and petrol by one and three-quarters or perhaps twice the rate necessary to take account of inflation. Business — especially the CBI — was pressing hard for a reduction in the National Insurance Surcharge (NIS), but there were problems with this proposal: the full year cost of each percentage point reduction was very large, the relief was indiscriminate and there was the risk that some of it might go quickly into wages. Other possible ways of helping industry — each of which had its own disadvantages — included a cut in Corporation Tax or in the Heavy Fuel Oil Duty. We had in November announced extra taxation on North Sea oil and gas profits. The question now was whether to levy a windfall tax on bank profits. Naturally, the banks strongly opposed this; but the fact remained that they had made their large profits as a result of our policy of high interest rates rather than because of increased efficiency or better service to the customer.

  Yet these were essentially secondary issues — and on larger issues there were legitimate disagreements inside the ‘dry’ section of the Government. The main problem was to determine how tight the fiscal stance of the budget should be and the monetary policy which it would be supporting. On this question Alan Walters, who had now joined me at No. 10, had his own strong views. He argued for a larger cut in the PSBR than Geoffrey Howe was proposing. He also believed that the way in which the monetary policy was conducted was defective. But the Treasury were not prepared to move to the system of monetary base control which Alan favoured and to which I was attracted by his clear and persuasive analysis.

  And this was much more than a technical disagreement. Alan Walters, John Hoskyns and Alfred Sherman had suggested that Professor Jurg Niehans, a distinguished Swiss monetary economist, should prepare a study on our monetary policy for me. Professor Niehans’s report which I read in early February, though framed in highly technical language, had a clear message. It was that North Sea oil had probably not been a major factor in sterling’s appreciation; rather, tight monetary policy had caused the pound to rise so high, imposing such pressure on British industry and deepening the recession. The report argued that we should use the monetary base rather than £M3 as the main monetary measure and suggested that we should allow it to rise in the first half of 1981. In short, Professor Niehans thought monetary policy was too tight and should quickly be loosened. Alan emphatically agreed with him.

  My doubts at this time about the Treasury’s conduct of monetary policy, however, were more than matched by the concern I felt at the steady growth in its estimates of the PSBR — the target by which we steered our fiscal policy. On 10 February 1981 Geoffrey Howe and I met to discuss the budget strategy. Geoffrey now told me that the forecast for the PSBR had been updated and showed not £11 billion but £13 billion. He was now talking about raising income tax allowances by only 6 per cent rather than the 10 per cent he had earlier envisaged — though he still wanted a substantial enterprise package. I told him that our primary concern must be to boost industry and that this meant giving priority to a reduction in interest rates, which would also help get down the exchange rate. If there were to be a choice between cutting the NIS and a lower PSBR I preferred the latter.

  I was worried by the prospect of a 2 per cent addition to the RPI as a result of the indirect tax increases which were being proposed. I was sure it would be better to achieve further public expenditure cuts. But I had to agree that the chance of achieving these, given Cabinet attitudes, was very slim indeed.

  At this meeting Alan Walters continued to press the view that we should allow the monetary base to grow more quickly. We also discussed the timing of any interest rate cuts which we would be able to make.

  The starkness of the choices before us was now becoming clear. Later that day Alan sent me a note which summed up the problem with the PSBR. We were confronted with rapid and huge changes in the figures which made the strategic planning of the budget very difficult. But one thing was clear. The trend of PSBR forecasts was upwards. The likelihood was that we would budget for too low a reduction in the PSBR, as we had in 1980–81. To repeat that mistake would either force us to introduce an additional budget in late summer or autumn, or put great strains on the funding of government borrowing. In the last resort it might lead to a funding crisis, and it would certainly force us to increase interest rates, keeping sterling high and increasing the already severe squeeze on the private sector. We had to avoid such an outcome. We might still get things right in time — but only if we made painful decisions now, and presented them effectively, as the only possible response to the costs of the last wage round and nationalized industry losses. What we needed was a budget for emplo
yment.

  On Friday 13 February I had a further meeting with Geoffrey Howe. Alan Walters was also present. The latest forecast for the PSBR was between £13.5 billion and £13.75 billion. The tax increases Geoffrey was proposing would reduce it to something between £11.25 billion and £11.5 billion, but he did not believe it was politically possible to go below £11 billion, and in his view an increase in the basic tax rate had to be ruled out. But Alan argued strongly that the PSBR should be lower still. He told us that a PSBR of, say, £10 billion would be no more deflationary than one of £11 billion because the latter would actually be worse for City expectations and for interest rates. Alan concluded by arguing that we had no alternative but to raise the basic rates of income tax by 1 or 2 per cent.

  Alan was the economist. But Geoffrey and I were politicians. Geoffrey rightly observed that introducing what would be represented as a deflationary budget at the time of the deepest recession since the 1930s would be difficult enough; doing so via an increase in the basic rate would make it a political nightmare. I went along with Geoffrey’s judgement about the problems of raising income tax, but I did so without much conviction and as the days went by my unease grew.

  When Geoffrey and I had our next budget meeting on 17 February, he said that he too had been having second thoughts. He was now prepared to contemplate a basic rate increase. But his concern was whether it might not be better to raise the basic rate of income tax by 1 per cent and personal allowances by about 10 per cent, thus reducing the burden on people below average earnings. I confirmed that I in turn was prepared to contemplate this, but I also told him that I was coming to the view that it was essential to get the PSBR below £11 billion.

  My advisers — Alan Walters, John Hoskyns and David Wolfson — continued to argue for this much lower PSBR with great passion. Keith Joseph also strongly backed this view. Alan, who knew that he could always have access to me more or less when he wished — as in my view any really close adviser should if a prime minister is not to be the prisoner of his (or her) in-tray — came in to my study to have one last attempt to get me to change my mind about the budget. He ran over again the reasons why we could never have lower interest rates — which was what the economy desperately needed — unless we had lower borrowing, which now meant higher taxes. I know today that he went away still believing that I was not persuaded. But the more I wrestled with the problem in my mind, the more accurate his analysis seemed. The budget he was arguing for would be unpopular with the public, mystifying to many of my strongest supporters in the Commons and the country and incomprehensible to those economists still stuck in post-war Keynesian orthodoxy. Its consequences for my administration were unpredictable. Yet I knew in my heart of hearts that there was only one right decision, and that it now had to be made.

  Geoffrey Howe and I — without Alan who was engaged on some other business but with Douglas Wass, the Treasury’s Permanent Secretary — met for a further discussion of the budget on the afternoon of Tuesday 24 February. Geoffrey still envisaged a PSBR for 1981–2 of £11.25 billion. I said that I was dismayed by such a figure and that I doubted whether it would be possible to cut interest rates, which we badly needed to do, unless government borrowing was reduced to a figure around £10.5 billion. I said that I was even prepared to accept a penny on the standard rate. In the light of all the taxpayers’ money which had gone to coal and steel there would at least be a clear explanation for this.

  Geoffrey argued against a penny on income tax — on which I was not too difficult to persuade for I was horrified at the thought of reversing even some of the progress we had made on bringing down Labour’s tax rates. But he also argued against the need to bring down the PSBR further, and on this last point I was not persuaded at all. We had further inconclusive discussion about alternative ways to raise tax. Time was growing very short. Geoffrey was still prepared to hope for the best as regards the effect of an £11.25 billion PSBR figure on interest rates. But he knew that I just could not accept this. He went away to think further about what should be done.

  Early the following morning, Alan came in to see me when I was in the flat packing my hats into boxes for my trip to the United States that afternoon. I told him that I had insisted on the lower PSBR he wanted. But I still did not know quite how Geoffrey would react. Then shortly before I left for America Geoffrey came in to see me. Having consulted his ministerial colleagues in the Treasury that morning he had accepted that we should have a smaller PSBR, below £11 billion. Rather than increase the basic rate of income tax he proposed the less unpopular course of withholding any increase in tax thresholds — though this was still an extraordinarily bold move when inflation remained at 13 per cent. This was the turning point. I was glad that Geoffrey had accepted the argument and I was pleased that he had found a way of increasing tax revenues that did not run counter to our long-term strategy of reversing Labour’s high tax rates. Our budget strategy was now set. And it looked as if we would be able to announce a reduction of 2 per cent in MLR in the budget the following Tuesday.

  There was one other change announced in the budget, apparently technical but of great significance: the change to planning public expenditure in cash rather than what were called ‘volume’ terms. Each minister would be given a cash budget within which to keep his expenditure. Since the spring of 1980 we had been considering how this should be done and I discussed it with Geoffrey Howe and others in the Treasury over lunch there on 28 January 1981. It would have seemed distinctly odd to any company finance director, or housewife for that matter, how the government in those days used to work out its annual expenditure. The Chancellor would make his assessment of government revenue in cash, but spending decisions were made in terms of the volume of services it was desired to deliver, and denominated in what commentators used to call ‘funny money’ — neither the prices at the time of the spending decision, nor those when the money was actually spent. The result was that the Treasury never knew until far too late in the day the cash consequences of decisions on spending. Cash limits on some government spending had already been introduced, but paradoxically, this increased the confusion as spending which had been planned in volume ran up against them. From now on everything was to be planned in cash — though, of course, departments would still have to estimate the volume of services which their cash limits would enable them to afford. This imposed the sort of financial discipline on government departments with which the private sector had to deal. The ‘cash limits’ approach had the valuable consequence of bearing down on real public expenditure. It also gave departments a much stronger interest in seeking out the most efficient way of delivering the services expected of them.

  Unsurprisingly, however, it was not the adoption of cash planning which grabbed the budget headlines, but rather the severity of the tax increases. The budget was very unpopular. But some of the leader columns were more favourable than the headlines and no one could doubt that this was a coherent budget which had required a good deal of courage to introduce. In the eyes of our critics, of course, the strategy was fundamentally wrong. If you believed, as they did, that increased government borrowing was the way to get out of recession, then our approach was inexplicable. If, on the other hand, you thought, as we did, that the way to get industry moving again was above all to get down interest rates, then you had to reduce government borrowing. Far from being deflationary, our budget would have the reverse effect: by cutting government borrowing and over time easing the monetary squeeze, it would allow interest rates and the exchange rate to fall, both of which had created severe difficulties for industry. I doubt that there has ever been a clearer test of two fundamentally different approaches to economic management.

  The economists themselves realized that this was so. At the end of March 1981 no fewer than 364 leading members of the profession published a statement taking issue with our policy. Samuel Brittan of the Financial Times defended us, and so did Professor Patrick Minford from Liverpool University, who wrote to The Times
answering the 364; I in turn wrote to congratulate him on his brilliant defence of the Government’s approach. We had made our decision: the task now was to hold the political line and, where possible, to win the political argument while waiting for the strategy to work. I was confident that it would.

  The dissenters in the Cabinet, meanwhile, had been stunned by the budget when they learnt its contents at the traditional morning Cabinet on budget day. The press was soon full of leaks expressing their fury and frustration. They knew that the budget gave them a political opportunity. Because it departed so radically from post-war economic orthodoxy, even some of our supporters would not wholly believe in the strategy until it started to yield results. That might not be for some time. So it was clear that the Party in the country must be mobilized in support of what we were doing. The forthcoming Central Council of the Conservative Party in Bournemouth provided an opportunity for me to do this. I had decided some time before that I would try not to go to every Central Council because the number of party political occasions I was under pressure to address each year was enormous: there were separate conferences of the English, Scottish and Welsh parties, the Women’s Conference, Local Government Conference and Conferences of Young Conservatives, Conservative Students and Conservative Trade Unionists. However, I soon learnt that Central Council provided an opportunity which I could never afford to miss. Certainly that was true on this occasion. John Hoskyns and I worked late on Friday night and early into Saturday morning on my speech, which I delivered later that day. In it I threw down the challenge: