The Downing Street Years

by Margaret Thatcher

  It is clear that economic and monetary union implies nothing less than European government — albeit a federal one — and political union: the United States of Europe. That is simply not on the agenda now, nor will it be for the foreseeable future.

  Alas, by his pursuit of a policy that allowed British inflation to rise, which itself almost certainly flowed from his passionate wish to take sterling into the ERM, Nigel so undermined confidence in my government that EMU was brought that much nearer.

  EARLY DISCUSSION OF THE EXCHANGE RATE MECHANISM (ERM)

  To trace the course of our arguments in government about the Exchange Rate Mechanism of the European Monetary System (EMS) it is necessary to go right back to our first year in office. The Foreign Office and the Treasury both had an interest; the former regarded it as a question of European relations, the latter — rightly — as an economic question. I decided early on to be closely involved in the issue and held an initial meeting to discuss the question in October 1979. In retrospect, the balance of opinion in the Cabinet is of some significance. Geoffrey Howe as Chancellor was against membership at present, partly because of uncertainty about the effects of abolishing exchange controls. The then Governor of the Bank of England, though he agreed, was more enthusiastically in favour. Keith Joseph and John Nott were against. So was I. But since we had devised the formula that we would join when the ‘time was right’ (or ‘ripe’ as it was sometimes expressed) there seemed no need to change our basic position. The time was not ‘right’ and no one seriously thought it was. Geoffrey Howe gave no hint of his future position. Indeed, in December he came to see me to complain that in a speech he had made about the subject in Brussels Peter Carrington had been too positive about the EMS.

  Even at this stage, the basic arguments for and against the ERM were known, though none of us had, of course, given as much thought to the subject as we would do later. Britain had already had an unhappy experience of trying to peg sterling in a European currency system. In 1972 Ted Heath’s Government had ignominiously been forced to leave the European ‘snake’ — the forerunner of the ERM — after a mere six weeks. So any British Government would need to be cautious.

  There were two other matters which bore on the decision. First, there was no disguising, for reasons I have explained, that there was always going to be potential for conflict between our domestic monetary policy and an exchange rate target — this was brought out clearly in Treasury papers prepared for us now. Second, we were conscious — perhaps over-conscious as Alan Walters would argue — of sterling’s position as a ‘petro-currency’. The pound’s value was affected by the discovery and exploitation of huge quantities of North Sea oil. This had the apparently perverse result that whereas higher oil prices increased the value of the pound, they would generally reduce the value of other western European currencies. But the greatest destabilizing factor was the appalling condition of the British economy in 1979. Until inflation had been brought under control and the public finances restored, it was not, in my view, realistic to consider participation in the ERM.

  But in early 1980 Helmut Schmidt was urging me to enter the ERM and I was anxious to be as co-operative as possible to the Germans because I needed their support on the question of our Community budget contributions. So I reopened the question. The more I looked at the papers and the facts they revealed, the more sceptical I became. The Treasury were firmly against our joining. They noted that if we had joined in September 1979 there would have had to be very heavy intervention in the exchange markets — selling pounds — to hold sterling down. I chaired a meeting on the subject in March 1980 at which I opened by saying that domestic monetary policy must remain paramount. After we had argued all the points through, we concluded that we should not join in the immediate future but stick to the line that we intended to join when conditions permitted.

  There was further discussion in the autumn of 1981. It will be remembered that this was a difficult time when some of the gains of lower interest rates obtained through our tough 1981 budget looked as if they might be dissipated as a result of international pressures. United States interest rates rose as the Federal Reserve Bank attempted to restrain the inflationary pressure generated during the previous Carter presidency: throughout the world interest rates followed. I asked Geoffrey Howe to bring forward a paper looking once again at the question of whether we should join the ERM. Opinion among Treasury ministers was divided. But both Geoffrey Howe and Leon Brittan (then Chief Secretary) were against our joining. The position of Nigel Lawson, then Financial Secretary, was less clear.

  I said that I would need to be convinced that there were positive arguments for joining, not just an insufficiency of arguments against. My caution was reinforced by powerful advice from Alan Walters. His view was that it was wrong to think of the ERM as a force for stability. It did not even have the — arguable — merits of a system of fixed exchange rates. The parities moved within a band. Then, after bumping along against the ceiling or the floor, they would go through a process of periodic realignments in which the rates moved in discrete jumps. These movements, moreover, were the subject of political horse-trading rather than the workings of the market — and the market does a better job.

  After several postponements as a result of other pressures on my diary, I eventually chaired another meeting on the subject in January 1982. Geoffrey Howe’s view was still that this was not the right time to join. I agreed. I said that I was not convinced that there would be solid advantage in joining the ERM. I did not believe that in practice it would provide an effective discipline on our economic management. Rather, it removed our freedom of manoeuvre. I accepted, however, that when our inflation and interest rates moved much closer to those of West Germany the case for joining would be more powerful. For the time being, we would maintain our existing position on the issue.

  ARGUMENTS ABOUT THE ERM: 1985

  There could be no question of our entering the ERM on the eve of a general election, so this was the situation which Nigel Lawson inherited when I made him Chancellor in 1983. At this time the exchange rate was just one factor being taken into account in order to assess monetary conditions. It was the monetary aggregates which were crucial. The wider measure of money — £M3 — which we had originally chosen in the MTFS had become heavily distorted. A large proportion of it was in reality a form of savings, invested for the interest it earned. In Nigel’s first budget (1984) he set out different target ranges for narrow as well as broad money. The former — M0 — had been moving upward a good deal more slowly and this was taken into account in plotting the future course. But at this stage M3 and M0 were formally given equal importance in the conduct of policy. Other monetary indicators, including the exchange rate, were also taken into account. Our critics, who had until now denounced our policy as a rigid adherence to a statistical formula, began to denounce our rootless and arbitary pragmatism. And indeed, sensible as this change was, it was to mark the beginning of a process by which the clarity of the MTFS became muddied. This in turn, I suspect, caused Nigel, as the years went by, to search with increasing desperation for an alternative standard — reliable in itself, convincing to the markets — which he finally thought he had found in the exchange rate.

  Events in January 1985 brought the ERM back into discussion. The dollar was soaring and there was intense pressure on sterling, in spite of the soundness of Britain’s finances. I agreed with Nigel that our interest rates should be raised sharply. I also agreed with Nigel’s view that there should be co-ordinated international intervention in the exchange rates to achieve greater stability, and I sent a message to this effect to President Reagan. This policy was formalized by Nigel and other Finance ministers under the so-called ‘Plaza Agreement’ in September. In retrospect, I believe that this was a mistake. As Alan Walters would always argue, if intervention is ‘sterilized’, that is to say not allowed to affect the money supply and short-term interest rates, it will have only a fleeting effect; on the other hand,
if it does promote monetary growth then it will be inflationary. The Plaza Agreement gave Finance ministers — Nigel above all perhaps — the mistaken idea that they had it in their power to defy the markets indefinitely. This was to have serious consequences for all of us.

  Sterling’s problems also prompted Nigel to raise with me in February the issue of the ERM. He said that in his view controlling inflation required acceptance of a financial discipline which could be provided either by monetary targets or by a fixed exchange rate. It was essentially a secondary matter which of these was chosen. But new factors, argued Nigel, favoured the ERM. First, it was proving difficult to get financial markets to understand what the Government’s policy towards the exchange rate really was: the ERM would provide much clearer rules of the game. There was also a political consideration. Many Conservative MPs were in favour of joining. In arguments about additional spending and borrowing it would, he thought, be helpful to be faced with a discipline which MPs themselves accepted. Entry into the ERM would also move the focus of attention away from the value of the pound against the dollar — where, of course, the problem at this particular moment lay. Finally, £M3 was becoming increasingly suspect as a monetary indicator because its control depended increasingly on ‘overfunding’, with the resulting rise in the so-called ‘bill mountain’.* I was not convinced on any of these counts, with the possible exception of the last. But I agreed that there should be a seminar involving the Treasury, the Bank of England and the Foreign Office to discuss it all.

  Alan Walters could not attend the seminar and so he let me have his views separately. He put his finger on the key issue. Would membership of the ERM reduce the speculative pressure on sterling? In fact, it would probably make it worse. That was the lesson to be drawn from what had happened to other ERM currencies, like the franc. Moreover, in view of Britain’s open capital and exchange markets and the international role of sterling, we would be subject to greater pressures than France.

  At my seminar Nigel did not argue that it would be right to enter the ERM under current circumstances. But he repeated the general argument in favour of joining which he had put to me earlier. Perhaps the most significant intervention, however, was that of Geoffrey Howe who had now been converted to the Foreign Office’s departmental enthusiasm for the ERM and thought that we should be looking for an appropriate opportunity to join — though he too did not think the circumstances at the moment were right. In the course of the discussion it became clear that we would need to build up foreign exchange reserves if we wanted to be in a position to enter. I agreed that the Treasury and the Bank of England should consider how this should be done. But since no one was arguing for immediate entry, there was no other decision to take. The meeting ended amicably enough.

  During the summer of 1985 I started to become concerned about the inflation prospect. I was uneasy for a number of reasons. £M3 was rising rather fast. Property prices were increasing, always a dangerous sign. The ‘bill mountain’ was worrying too — not because it suggested anything about inflation (indeed the overfunding which led to it was in part the result of the Bank’s attempt to control £M3). Rather, since we had decided against a policy of overfunding as far back as 1981, the fact that it had been resumed on such a scale without authorization did not increase my confidence in the way policy in general was being implemented.

  Even now it is unclear whether my misgivings were justified. Some analysts — notably the perceptive Tim Congdon — would argue that the rise in £M3 now and later did cause inflationary problems. By contrast, Alan Walters, who believed that MO was the best indicator, reckoned that monetary policy was sufficiently tight, as did the rest of my advisers. Essentially, these tricky questions are always a matter of judgement. The important thing is that when clear evidence appears that things are slipping you take action fast. Certainly, I do not believe that monetary policy in 1985 — or 1986 — was the main cause of the problems we were later to face.

  Nigel now returned to the charge on the ERM. I agreed to hold a further seminar at the end of September. The subject seemed to be becoming something of an idée fixe. Nigel even sent me a paper envisaging what would happen if we were in the ERM in the run-up to a general election which the financial markets thought that we might lose. In such circumstances, he argued, we would need to announce our temporary cessation from operating the system coupled with an undertaking that on our return to office after the election we would immediately resume at the same parity as before. In itself, of course, this was an example of the perils of committing oneself to fixed parities irrespective of outside events.

  By now I was more convinced than ever of the disadvantages of the ERM. I could see no particular reason to allow British monetary policy to be determined largely by the Bundesbank rather than by the British Treasury, unless we had no confidence in our own ability to control inflation. I was extremely sceptical about whether the industrial lobby which was pressing us so hard to join the ERM would maintain its enthusiasm once they came to see that it was making their goods uncompetitive. I doubted whether the public would welcome what might turn out to be the huge cost of defending sterling within the ERM — which, indeed, might well prove to be impossible in the run-up to a general election and so be compounded by a forced devaluation. Looking back over the last few years it was clear that sterling had not tracked other European currencies in a stable way. In 1980, sterling rose 20 per cent against the European Currency Unit (ecu). In 1981 it fell by 15 per cent from peak to trough. In 1982 it did the same. In 1983 it rose by as much as 10 per cent. In 1984 it was somewhat more stable. But in 1985 it had risen by more than 10 per cent. To control such movements, we would have needed recourse to huge quantities of international reserves and to a very tough interest rate policy.

  There was nothing secret about these facts. They were available to anyone who wanted to know them. But nothing is more obstinate than a fashionable consensus. Nor is it without influence on Cabinet committees. I had no support at the seminar at the end of September. Nor did my arguments budge Nigel and Geoffrey. There was no point in continuing the discussion. I said that I was not convinced that the balance of argument had shifted in favour of joining. I said that I would hold a further meeting to which other colleagues would be invited.

  Before this took place I had a long list of questions drawn up about the implications of the ERM. I hoped that these would illuminate some of the points we would need to discuss. It would be more charitable than accurate to suggest that the answers provided by the Treasury did so. Yet the paper which Nigel presented at the meeting now seems strangely prophetic. He suggested that we had to convince people that inflation would continue to come down and stay down, adding that there was still a nagging fear that sooner or later we would succumb to the temptation of going for an easy inflationary option. He also suggested that after a period of some years sticking to the same policy, this now needed a shot in the arm, a touch of imagination and freshness to help the explanation and to ensure that our policies continued to carry conviction. Entry into the ERM was, of course, the answer. Since it was Nigel’s policy of shadowing the deutschmark — an informal version of ERM entry — that was to lead to inflation and undermine confidence, there now seems a certain irony in these assertions.

  It has to be said that the wider meeting which I held to discuss the ERM on the morning of Wednesday 13 November did not advance us any further than the earlier meetings. We went over the same ground and at the end I repeated that I had not been convinced by the arguments I had heard. However, I agreed that we should strictly maintain the line we had taken so far, namely that Britain would join the ERM ‘when the time was right’.

  The position was unsatisfactory. Most of the arguments which persuaded me that we should not now enter the ERM applied to the principle — not just the circumstances — of entry. I knew that I was in a very small minority within the Cabinet on this matter, though most of my colleagues were probably not overinterested in it anyway. Geoffrey
and Nigel, by contrast, were fervent. For Geoffrey membership of the ERM would be a demonstration of our European credentials. For Nigel it would provide stability in the turbulent and confusing world in which decisions about interest rates and monetary policy had to be made. And there is no doubt that those decisions could on occasion be extremely difficult.

  INTEREST RATES AND INFLATION: 1986

  It is worth noting at this point where the difficulty lay — and where it did not. Until 1987 when Nigel made the exchange rate the overriding objective of policy, there was no fundamental difference between us, although Nigel apparently now thinks I was ‘soft’ on interest rates. Anyone who recalls our decisions from 1979 to 1981 will find that implausible. It would also surprise anyone who considers that one of the main arguments advanced for joining the ERM, which Nigel so passionately wanted, was that it would lead to lower interest rates. And, as I shall show subsequently, there were occasions when I thought that he was soft on interest rates and wanted to raise them more quickly.* The two of us were equally opposed to inflation. If anything, I was more concerned than he was. It was my constant refrain that much as I might admire his fiscal reforms, he had made no further progress in getting down the underlying inflation rate.

  Nevertheless, Nigel and I did have rather different starting points when it came to these matters. I was always more sensitive to the political implications of interest rate rises — particularly their timing — than was Nigel. Prime Ministers have to be. I was also acutely conscious of what interest rate changes meant for those with mortgages. Although there are several times as many savers as borrowers from building societies, it is the borrowers whose prospects — even lives — can be shattered overnight by higher interest rates. My economic policy was also intended to be a social policy. It was a way to a property-owning democracy. And so the needs of home owners must never be forgotten. Other things being equal, on every ground a low interest rate economy is far healthier than a high interest rate economy.