The Downing Street Years

by Margaret Thatcher

  High real interest rates* do ensure that there is a high real reward for saving. But they discourage risk-taking and self-improvement. In the long run, they are a force for stagnation rather than enterprise. For these reasons I was cautious about putting up interest rates unless it was necessary.

  Another reason for caution was the difficulty of judging precisely what the monetary and fiscal position was. The MO figures were volatile from month to month. The other aggregates were worse. We were given figures which underrated economic growth and so caused us to exaggerate the likely size of the PSBR. In these circumstances, making the right judgement about when and whether to cut or raise interest rates was indeed difficult. So at the meetings I had with Nigel, the Bank and Treasury officials to decide on what must be done I would generally cross-examine those involved, give my own reaction and then — when I was sure all the factors had been considered — go along with what Nigel wanted. There were exceptions. But they were very few.

  SHADOWING THE DEUTSCHMARK: 1987–1988

  It was only from March 1987 — though I did not know it at the time — that Nigel began to follow a new policy, different from mine, different from that to which the Cabinet had agreed, and different from that to which the Government was publicly committed. Its origins lay in the ambitious policy of international exchange rate stabilization. In February Nigel and other Finance ministers agreed on intervention to stabilize the dollar against the deutschmark and the yen by the ‘Louvre Accord’ agreed in Paris. I received reports of the massive intervention this required which made me uneasy. And it was not clear how long this would last.

  In July Nigel raised again with me the question of whether sterling should join the ERM. He felt that the first year of a new Parliament would be the right time to join. Membership would give us as much exchange rate stability as it was possible to achieve and help business confidence. I was not unprepared for this and had earlier talked the subject through with Alan Walters and Brian Griffiths, the head of my Policy Unit who in an earlier incarnation had been Director of the Centre for Banking and International Finance at the City University. I said to Nigel that the Government had built up over the last eight years a well-founded reputation for prudence. By joining the ERM we would in effect be saying that we could not discipline ourselves and needed the restraint provided by Germany and the deutschmark. ERM membership would reduce the room for manoeuvre on interest rates which would, at times of pressure, be higher than they would be if we were outside. I had heard the arguments about external discipline before. I recalled that Ted Heath had claimed in the early 1970s that European Community membership would help discipline the trade unions. But this had not happened; and the attempt to use ERM membership to influence the expectations of management and workforces would be an equal failure. Overall, when things were going smoothly membership of the ERM would add nothing to our economic policy-making, and when things were going badly membership would make things worse. Nigel completely rejected this. He said he would want to discuss it all again with me in the autumn. I said that was much too soon: I would not wish to hold a further discussion on the subject until the New Year.

  By now there was some evidence that the economy might be growing at a rate too strong to be sustainable. The monetary figures were ambiguous, but the PSBR looked as if it would turn out much lower than expected at the time of the budget. In August 1987 Nigel proposed a 1 per cent rise in interest rates on the grounds that this was required to defeat inflation by the next election. I accepted the proposal. That was the position when on ‘Black Monday’ (19 October 1987) there was a sharp fall in the Stock Market, precipitated by a fall in Wall Street. These developments were, in retrospect, no more than a market correction of overvalued stocks, made worse by ‘programmed selling’. But they raised the question of whether, far from overheating, we might now be facing a recession as people spent less and saved more in order to make up for the decline in the value of their shares.

  I was in the United States when I learnt about the Stock Market collapse. I had flown from the Commonwealth Conference at Vancouver to Dallas, where I was to stay with Mark and the family. As it happens I dined that evening with some of America’s leading businessmen and they put what had happened in perspective, saying that, contrary to some of the more alarmist reports, we were not about to see a meltdown of the world economy. Still, I thought it best to make assurance doubly sure, and I agreed to Nigel’s request for two successive half percentage point cuts in interest rates in response to help restore business confidence.

  What I did not know was that Nigel was setting interest rates according to the exchange rate so as to keep the pound at or below DM3. It may be asked how he could have pursued this policy since March without it becoming clear to me. But the fact that sterling tracks the deutschmark (or the dollar) over a particular period does not necessarily mean that the pursuit of a particular exchange rate is determining policy. The same effect can have several causes. There are so many factors involved in making judgements about interest rates and intervention that it is almost impossible at any particular time to know which factor has been decisive for whoever is in day-today charge.

  Of course, as the months pass and people look back at what has been happening questions begin to be asked. Nigel, who is nobody’s fool, must have recognized that this would happen. Indeed, he presumably intended it. Had all gone well, it would have been taken as proof that we could enter the ERM at about DM3 with no adverse consequences. He would have been able to overturn my veto on entry under circumstances in which it was almost impossible for me to reimpose it. To some extent, indeed, this is what happened, though he did not actually force us into the ERM. Once the financial markets have become convinced that a particular policy — in this case shadowing the deutschmark at a particular parity — is the central guarantee of financial stability, the effect of moving away from this approach is profoundly destabilizing. That is why, when I discovered what was happening, I found we had already forfeited some of our freedom of action.

  Extraordinarily enough, I only learnt that Nigel had been shadowing the deutschmark when I was interviewed by journalists from the Financial Times on Friday 20 November 1987. They asked me why we were shadowing the deutschmark at 3 to the pound. I vigorously denied it. But there was no getting away from the fact that the chart they brought with them bore out what they said. The implications of this were, of course, very serious at several levels. First, Nigel had pursued a personal economic policy without reference to the rest of the Government. How could I possibly trust him again? Second, our heavy intervention in the exchange markets might well have inflationary consequences. Third, perhaps I had allowed interest rates to be taken too low in order that Nigel’s undisclosed policy of keeping the pound below DM3 should continue.

  I did not want to raise this matter with Nigel until I was absolutely sure of my ground. So I brought together as much information as I could about what had been happening to sterling and the extent of intervention. Then I tackled him. At our meeting on Tuesday 8 December I expressed very strong concern about the size of the intervention needed to hold sterling below DM3. Nigel argued that the intervention had been ‘sterilized’ by the usual market operations and that it would not lead to inflation. I understood sterilization to mean that the Bank sold treasury bills and gilts to ensure that the intervention funds did not affect short-term interest rates. But the large inflow of capital, even if sterilized in this sense, had its own effect, on the one hand in increasing monetary growth and on the other in putting additional downward pressure on market interest rates. This was an environment where Nigel superficially could justify lower base rates than domestic pressures warranted. As a result, inflation was stoked up.

  In the early months of 1988 my relations with Nigel worsened. I sought to discourage too much exchange rate intervention, but without much success. It seemed to me contradictory to raise interest rates — as we did by half a percentage point in February — while at the same tim
e intervening to hold down sterling. But, equally, I knew that once I exerted my authority to forbid intervention on this scale it would be at the cost of my already damaged working relationship with Nigel. He had boxed himself into a situation where his own standing as Chancellor would be weakened if the pound went above DM3. It was a convincing if unwelcome demonstration of the folly of regarding a particular exchange rate parity as the criterion for political and economic success.

  By the beginning of March, however, I had no option. On 2 and 3 March 1988 over £1 billion of intervention took place. The Bank of England, which is traditionally all for a managed exchange rate, was deeply anxious about the policy. So, I knew, were senior Treasury officials, though of course they could not say so openly.

  I had the matter out with Nigel at two meetings on Friday 4 March. I again complained about the level of exchange rate intervention. For his part, Nigel said it would be sterilized. But he did accept that intervention at the present rate could not continue indefinitely. I asked him to consult the Bank of England and report back later that day on whether the DM3 ‘cap’ should be removed and, if so, when. When he returned he accepted that if on Monday there was still strong demand for sterling the rate should be allowed to go above DM3. He was keen to have some further intervention to break the speed at which the exchange rate might rise. I expressed my concern about this and said that my strong preference would be to allow time for the rate to find its own level without any intervention. But I was prepared to go along with some limited intervention if necessary. The pound accordingly rose through the DM3 limit.

  Immediately, the Opposition and the media sought to make capital out of divisions between Nigel and me. I set out the policy accurately and the thinking behind it in the House of Commons on Thursday 10 March at Prime Minister’s Questions:

  My Rt. Hon. Friend the Chancellor and I are absolutely agreed that the paramount objective is to keep inflation down. The Chancellor never said that aiming for greater exchange rate stability meant total immobility. Adjustments are needed, as we learnt when we had a Bretton Woods system, as those in the EMS have learnt that they must have revaluation and devaluation from time to time. There is no way in which one can buck the market.

  This last remark however provoked a flurry of press comment to which truth was no defence. The trouble was that it appeared to contrast with Nigel’s continuing public statements that he did not want to see the exchange rate appreciate further. From now on it would be increasingly difficult to convince the markets that my Chancellor and I were at one. And, of course, the perception they had was basically an accurate one.

  The question arises whether at some point now or later I should have sacked Nigel. I would have been fully justified in doing so. He had pursued a policy without my knowledge or consent and he continued to adopt a different approach from that which he knew I wanted. On the other hand, he was widely — and rightly — credited with helping us win the 1987 election. He had complete intellectual mastery of his brief. He had the strong support of Conservative back-benchers and much of the Conservative press who had convinced themselves that I was in the wrong and that only pettiness or pig-headedness could explain the different line I took. Whatever had happened, I felt that if Nigel and I — supported by the rest of the Cabinet — pulled together we could avert or at least overcome the consequences of past mistakes and get the economy back on course for the next general election.

  But this was not to be. Whatever I said in the House in answer to questions about interest rates and the exchange rate was given a construction to suggest that either I was not endorsing Nigel’s views or that I was protesting too much — and so unconvincingly — my adherence to them. In these situations you just cannot win. Nigel was extremely upset over my remarks at Prime Minister’s Questions on Thursday 12 May. Though I warmly supported him and his public statements I had not repeated Nigel’s view that further exchange rate appreciation would be ‘unsustainable’.

  Geoffrey Howe was now also making mischief. From this time on it became clear to me that Nigel and he — by no means on friendly terms in earlier years when there was a good deal of jealousy between them — were in cahoots, and that of the two Geoffrey was the more ill-disposed to me personally. Earlier — in March — Geoffrey had made a speech in Zurich which was widely taken as siding with Nigel against me on the question of the exchange rate. Then on Friday 13 May he quite gratuitously slipped into his speech to the Scottish Party Conference in Perth the remark, apropos of our commitment to join the ERM ‘when the time is right’, that: ‘We cannot forever go on adding that qualification to the underlying commitment.’ This led the press to widen the perceived rift between me and Nigel over the ERM once more. I was not best pleased. When Geoffrey imprudently telephoned me the morning after his speech to ask for a meeting at which he and the Chancellor should come to see me later in the day to ‘settle the semi-public dispute’, I told him that I would be seeing Nigel later in the day to discuss the markets — which Geoffrey’s own remarks had unsettled. But I was not seeing them together. I told him three times — since he did not seem to take it in and persisted in his attempt to contrive a meeting at which he and Nigel could get their way — that the best thing he could do now was to keep quiet. We were not going into the ERM at present and that was that.

  I spent Sunday at Chequers working on a speech I was to deliver to the General Assembly of the Church of Scotland: there was some mirth when my speech writers and I were discovered down on our knees in an appropriate posture, though drawing on the resources of sellotape rather than the Holy Spirit. But, following the news reports during the day, I was also aware of just how damaging the constant media reports of splits and disagreements on the exchange rate were becoming.

  Nigel arranged to see me on the Monday. He wanted to agree a detailed formulation for use by me in the House to describe our policy. I had been told by the Treasury in advance of the meeting that Nigel wanted a further interest rate cut. For my part, I had become appalled at the size of our intervention in the money markets which was clearly still failing to hold sterling at the level Nigel wanted and which, in spite of assurances from Nigel, I feared might prove inflationary. But I had got part of what I wanted — which would ideally have been a pound which found its own level in the markets — in that sterling had been allowed to rise to DM3.18. So I was not unhappy to have the suggested interest rate cut I knew he wanted. I was also aware that the speculators were beginning to consider sterling a one-way bet and that allowing them to burn their fingers a little would do no end of good.

  Above all, however, this reduction of the interest rate on Tuesday 17 May by half a point to 7.5 per cent was the price of tolerable relations with my Chancellor, who believed that his whole standing was at stake if the pound appreciated outside any ‘band’ to which he might have semi-publicly consigned it. If I had refused both intervention and an interest rate cut and sterling had drifted up to find its proper level there was little doubt in my mind that Nigel would have resigned — and done so at a time when both the majority of the Parliamentary Party and the press supported his line rather than mine. Yet the economic price of accepting this political constraint now seems to me to have been too high. For the whole of this period the interest rate was too low. It should have been a good deal higher, whatever the effect on the level of sterling — or the level of the Chancellor’s blood pressure.

  I also agreed to use in the House a detailed endorsement of the line which Nigel and I had agreed at our Monday meeting on the place of the exchange rate as an element in economic policy. I had to go further than I would have liked, saying:

  We have taken interest rates down three times in the last two months. That was clearly intended to affect the exchange rate. We use the available levers, both interest rates and intervention as seems right in the circumstances and… it would be a great mistake for any speculator to think at any time that sterling was a one-way bet.

  ECONOMIC PROBLEMS MOUNT

&
nbsp; In fact from June 1988 onwards interest rates rose steadily. Nigel insisted on raising them only half a per cent at a time. I would have preferred something sharper to convince the markets how seriously we took the latest indicator that the economy was growing too fast and that monetary policy had been too lax — namely the balance of payments figures. Nigel took a more laid-back view of these than I did. He thought that the current account balance of payments deficit, which was growing ever larger, was more important as an indicator that other things were going wrong than in its own right. But the deficit worried me because it confirmed that as a nation we were living beyond our means — as well as suggesting that higher inflation was on the way.

  House prices were rising sharply. MO was still growing too fast — outside its target range. The forecasts of inflation were constantly being revised upwards, though they still turned out to be too low. For example, in the September 1988 monthly Treasury Monetary Assessment inflation in March 1989 was forecast at 5.4 per cent. In October’s note the forecast was 7 per cent. (In fact it turned out to be 7.9 per cent.) So as 1988 drew to a close — and although unemployment was down and growth and incomes were well up — there was trouble ahead.

  It is on the face of it extraordinary that at such a time — November 1988 — Nigel should have sent me a paper proposing an independent Bank of England. My reaction was dismissive. Here we were wrestling with the consequences of his diversion from our tried and tested strategy which had worked so well in the first Parliament; and now we were expected to turn our policy upside down again. I did not believe, as Nigel argued, that it would boost the credibility of the fight against inflation. In fact, as I minuted, ‘it would be seen as an abdication by the Chancellor when he is at his most vulnerable.’ I added that ‘it would be an admission of a failure of resolve on our part.’ I also doubted whether we had people of the right calibre to run such an institution. As I told Nigel when he came in to discuss his paper, I had thought in the late 1970s about having an independent central bank but had come down against it. I considered it more appropriate for federal states. But in any case there could be no question of setting up such a bank now. Inflation would have had to be well down — to say 2 per cent — for two or three years before it could be contemplated.