The Downing Street Years

by Margaret Thatcher

  It would, of course, test the wisdom of Solomon to settle on the ‘right’ rate: indeed, I doubt if Solomon in his wisdom would ever have set himself such a task. This is because ultimately there can be no ‘right’ level of sterling apart from what the market says it is. To search for such a thing is in a sense to fall into the trap of believing in the old precapitalist concept of a ‘just price’. Had Nigel Lawson managed to persuade me to have sterling enter the ERM in November 1985 the sterling/deutschmark rate would have been about DM3.75. A year later the pound was down to DM2.88. In November 1987 it was up to DM2.98. In November 1988 it was right up to DM3.16. In November 1989 it was back down to DM2.87. When we entered it was at a central parity of DM2.95, which was the rate at which the London market closed that day. What this shows on even a cursory glance is that revaluations and/or heavy intervention and very large shifts in interest rates would have been necessary to keep sterling in the mechanism throughout this period. It is, in fact, a demonstration that Alan Walters had been right all along in his view that the ERM ensured not stability, but rather the kind of instability which comes from movement in large leaps rather than by the more gradual accommodation of the market.

  Only at my meeting with John Major on Wednesday 13 June did I eventually say that I would not resist sterling joining the ERM. But the timing was for debate. Although the terms I had laid down had not been fully met, I had too few allies to continue to resist and win the day. There are limits to the ability of even the most determined democratic leader to stand out against what the Cabinet, the Parliamentary Party, the industrial lobby and the press demand — particularly when you have lived for so long, as I had, with a thoroughly unsatisfactory form of words (‘joining when the time is right’), since qualified further by the Madrid conditions. By this stage all my advisers were telling me — though on political rather than economic grounds — that I should have sterling enter. Almost my only ally in the Cabinet was Nick Ridley — who was shortly to resign: together we were not a strong enough combination to have done what we would have had to do — that is to state that on grounds of principle we would not have sterling enter the ERM now or in the future.

  But my willingness to join the ERM was qualified by a crucial condition. I was not prepared to keep to any particular parity at the expense of domestic monetary conditions. I insisted that we enter the wide band — 6 per cent on either side. Even then I made it very clear to John Major that if sterling came under pressure, I was not going to use massive intervention, either pouring in pounds and cutting interest rates to keep sterling down or raising interest rates to damaging levels and using precious reserves to keep sterling up. For me, willingness to realign within the ERM — as other countries had done — if circumstances warranted it, was the essential condition for entry. This makes nonsense of the claim, sometimes heard from ERM proponents justifying the subsequent collapse, that we were right to go in, but wrong to do so at that rate. In fact, a rate that is right today can be wrong tomorrow and vice versa. Until now, the ERM had never been a rigid system. I did not need to spell this out to our European partners because, whatever the fine points of detail, a country which wished to realign had always been able to do so in practice. Now that the UK was inside the ERM, other countries would have been so anxious to keep us in that they would have made little or no difficulty about realignment.

  With the publication of the Delors Report, however, the Europeans began to regard the ERM as part of the move towards locking currencies, leading to a single currency. Accordingly, devaluations were more frowned upon than they had been. But they still occurred and would have to occur as long as we insisted on them. It was only when my successor went along with the objective of EMU as spelt out in the Maastricht Treaty and made it clear that sterling would enter the narrow band of the ERM that the pressure never to revalue ‘growed and growed’ until it became an overriding dogma. I had not the slightest doubt that if the ERM ever developed in the rigid way in which I knew many other European governments and the Commission would have liked, it would prove unworkable and would break up. I never envisaged that a Conservative government would talk itself into the trap of regarding a particular parity for sterling as the touchstone of its economic policy and indeed its political credibility.

  I resisted John Major’s wish to go into the ERM in July. The monetary signals, indicating that inflation was starting to turn down so that we could enter the ERM with some confidence that the parity could be sustained, were not yet in place.

  By the autumn, however, the high interest rates were clearly doing their work. The money supply fell sharply. It was clear that interest rates should now be reduced, quite apart from the question of the ERM. As regards ERM entry, the Madrid conditions had not been fully met. But the most important consideration was inflation. It was not till the end of the year that inflation as measured by the RPI (heavily distorted by mortgage interest rates and the way the community charge figured in it) began to fall. Other indicators, however, — CBI surveys, car sales, retail sales and above all the money supply — showed that we were getting on top of inflation. I insisted against the Treasury and the Bank on a simultaneous announcement of a 1 per cent cut in interest rates. They had not disputed that the monetary and other figures warranted this; but they had wanted to delay. But I for my part was determined to demonstrate that we would be looking more to monetary conditions than to the exchange rate in setting interest rates. So on Friday 5 October we announced that we were seeking entry into the ERM, and I placed heavy emphasis on the interest rate cut and the reasons for it in presenting that day’s decision.

  NO COMPROMISE WITH EMU

  As I have explained, the attitude taken by Britain and the rest of the Community to EMU had a bearing on the operation and development of the ERM. But, of course, EMU was a far greater question. The sense that I had had at my meeting with John Major in April that he was going wobbly on this increased when I received a further paper from him a little later, at the end of May. John’s paper contained all the now familiar phrases about the prospect of a ‘two-tier Europe’ — on which I noted ‘What’s wrong with that if the other tier is going in the wrong direction?’ — and the awful possibility of the other eleven negotiating a separate treaty for EMU — on which I wrote, ‘So be it. Germany and France would have to pay all the regional subventions — OR there would be NONE in which case the poorer nations could NOT agree.’ Quite apart from this tendency to be defeated by platitudes, which I found disturbing, it did not seem to me that John, who prided himself on his tactical political sense, had thought through the implications for the rest of the Community countries if they had to go ahead without us.

  So at our meeting on the evening of Thursday 31 May I tried to stiffen John’s resolve and widen his vision. He reiterated his concern that we would find ourselves ‘isolated’ in the run up to a general election. He argued that to avoid this we should agree to a treaty amendment establishing the aim of full EMU, but insist on an ‘opting-in’ provision which left it to individual member states whether and when to join. I rejected this. I said that it was psychologically wrong to put ourselves in a frame of mind in which we accepted the inevitability of moves towards EMU rather than attacking the whole concept. We had arguments which might persuade both the Germans — who would be worried about the weakening of anti-inflation policies — and the poorer countries — who must be told that they would not be bailed out of the consequences of a single currency, which would therefore devastate their inefficient economies. I said that I did not regard John’s proposed ‘opting-in’ mechanism as an adequate defence against being drawn into full EMU. The same reasoning which led him now to argue that we had no alternative but to accept the treaty objective of full EMU would be employed later to concede that we could not afford to be left out of the move to a single currency either. So accepting the opting-in mechanism now would be tantamount to joining eventually and I was not prepared to make that commitment.

  We had to use the
time between now and the IGC in December to try to undermine the will of the other states to move to Stage 3 of the Delors Report and to develop a wider vision of the way ahead. I rehearsed once again my objection to the establishment of tight blocs of countries which stood in the way of a wider internationalism. I said that we must build on the American proposals for strengthening the political aspects of NATO, by suggesting a trade dimension to the alliance which would join Europe to a North American (US and Canada) Free Trade Area. I saw this as a way of averting the dangerous prospect of a world divided into three protectionist trading blocs, based on the European Community, Japan and the United States, which over time could become seriously unstable. I also suggested that we look at an idea on which Alan Walters had been working — a system of linking currencies to an objective reference standard, such as a commodity index, which would work automatically, without the bureaucratic paraphernalia and the intrusive federalism of the Delors proposals. Such a system might include both the dollar and the yen. I said that we had to set out our ideas boldly at international summits, emphasizing that we were going beyond the narrow European goals and were much more in tune with wider political developments. I was aware that this was visionary stuff: but if there was ever a time for vision this was it. So I had the Treasury and the Foreign Office work up these ideas, which without noticeable enthusiasm they did.

  I felt that, much as I liked John Major and valued his loyalty, we had to bring others who were more at ease with large ideas and strategies into the discussion. So — as well as Douglas Hurd, who as Foreign Secretary was necessarily involved, for EMU was by now at the centre of debate in the European Council — I brought in Nick Ridley. I asked Nick to prepare a paper on EMU and the alternatives and he attended my meeting with John and Douglas on the morning of Tuesday 19 June before the forthcoming Dublin European Council. Nick made two contributions of great importance to the concept of an alternative Europe, going in a direction different from that of the inward-looking, statist and protectionist Europe with which we were faced. The first was to stress that the Delors-style Europe with a single currency would obstruct the enlargement of the Community. Our own vision of a wider, freer, more flexible Europe would be much more accommodating to the countries of the post-communist world. The second observation Nick made was to point out that we should not be alarmed by some countries going ahead with EMU and leaving us out: indeed, this was a model we should encourage — a wider Community in which different countries came together for different purposes on different occasions.

  At this point it makes sense to consider how matters had been developing within the European Community itself and the stance we took in the face of the drive for federalism which was underway. But if there is one lesson which is to be learnt from the economic developments of the period of 1987 to 1990 — confirmed since by the circumstances preceding Britain’s undignified departure from the ERM in 1992 — it is that contained in the phrase I used in the House of Commons, which so infuriated Nigel and summed up the difference between us: ‘there is no way in which one can buck the market.’ I might add that if you try to do so, the market will buck you. The belief that the laws of economics and the judgements of the markets can be suspended by clever people — and Nigel Lawson was one of the cleverest people in British politics — is a perpetual temptation to folly. That folly cost us dear. But then the idea that other clever people — and Jacques Delors was one of the cleverest people I met in European politics — can build their Tower of Babel on the uneven foundation of ancient nations, different languages and diverse economies is still more dangerous. Work on that shaky construction is still proceeding.

  * See pp. 96–7.

  * Overfunding was the practice by which the Government sought to reduce private bank deposits — and hence £M3 — by selling greater amounts of public debt than were required merely to finance its own deficit. The ‘bill mountain’ arose from the use of the proceeds to buy back treasury bills from the market.

  * See p. 706.

  * In all this, it is always necessary to distinguish between nominal and real interest rates. High money interest rates are predominantly a consequence of the market’s expectations of high inflation. If inflation is expected to be high, say at 10 per cent, then, even if one ignores taxes, interest rates of 10 per cent are required just to offset the inflationary erosion of a family’s savings. In fact it is real interest rates — the excess of the percentage interest rate above the expected inflation — which affects the thrift and investment of families and businesses.

  * For this and for the Madrid European Council see pp. 740–2, 750–2.

  * The suggestion that the inflation which began at the end of 1988 and lasted until mid-1991 could be explained by decisions on interest rates and monetary policy in 1985 assumed almost a four-year lag in the effect of monetary expansion on inflation. We know that lags, in Milton Friedman’s words, are ‘long and variable’ with an average of about eighteen months. So three to four years is possible, but hardly plausible.

  * Interest rates had gone up to 13 per cent in November 1988 and to 14 per cent in May 1989.

  * Following the negative reception accorded to our original proposal for competing currencies, we began to develop this new hard ecu approach based on the suggestions made by Sir Michael Butler, Britain’s former Ambassador to the Community, now working in the City.

  CHAPTER XXV

  The Babel Express

  Relations with the European Community — 1987–1990

  I have already described how during my second term of office as Prime Minister certain harmful features and tendencies in the European Community started to become evident. Against the notable gains constituted by the securing of Britain’s budget rebate and progress towards a real Common — or ‘Single’ — Market had to be set a more powerful Commission ambitious for power, an inclination towards bureaucratic rather than market solutions to economic problems and the re-emergence of a Franco-German axis with its own covert federalist and protectionist agenda. As yet, however, the full implications of all this were unclear — even to me, distrustful as I always was of that un-British combination of high-flown rhetoric and pork-barrel politics which passed for European statesmanship.

  Indeed, the first three European Councils of my second term were very much of the traditional mould, dominated by finance and agriculture: and their outcome was equally traditional — a British victory on points. But from then on the Community environment in which I had to operate became increasingly alien and frequently poisonous. The disputes were no longer about tactical or temporary issues but about the whole future direction of the Community and its relations with the wider world changing so fast outside it. The Franco-German axis became more evident; and with the unification of Germany that relationship became still more lop-sided, with German dominance increasingly pronounced.

  The Franco-German federalist project was wholeheartedly supported by a variety of different elements within the Community — by poorer southern countries who expected a substantial pay-off in exchange for its accomplishment; by northern businesses which hoped to foist their own high costs on to their competitors; by socialists because of the scope it offered for state intervention; by Christian Democrats whose political tradition was firmly corporatist; and, of course, by the Commission which saw itself as the nucleus of a supranational government. In the face of these powerful forces I sought for allies within the Community and sometimes found them; and so my strategic retreat in the face of majorities I could not block was also punctuated by tactical victories.

  Ultimately, however, there was no option but to stake out a radically different position from the direction in which most of the Community seemed intent on going, to raise the flag of national sovereignty, free trade and free enterprise — and fight. Isolated I might be in the European Community — but taking the wider perspective, the federalists were the real isolationists, clinging grimly to a half-Europe when Europe as a whole was being liberated; toyin
g with protectionism when truly global markets were emerging; obsessed with schemes of centralization when the greatest attempt at centralization — the Soviet Union — was on the point of collapse. If there was ever an idea whose time had come and gone it was surely that of the artificial mega-state. I was, therefore, convinced not just that I was right about the way forward for Europe, but confident that if the Government and Party I led kept their nerve we would be vindicated by intellectual developments and international events.

  FINANCE AND FARMING

  After the 1987 general election I was in just the mood to force the Community to live up to its previous protestations of virtue. For all the talk of financial rectitude at and since the Fontainebleau Council of 1984, there had still been no effective budget discipline and no binding limits on spending under the CAP. The rebate I had won had limited our net contribution from rising to a totally unacceptable level; but several of our Community partners now wanted to cut or eliminate it. There was a large Community budget deficit which was starting to concentrate minds. But from the Commission it had provoked the traditional answer to any financial problem — an increase in the Community’s ‘own resources’. They wanted to increase that sum not just to the 1.6 per cent of VAT which we had agreed at Fontainebleau might happen in 1988, but to 1.4 per cent of Community countries’ GNP (equivalent to 2.2 per cent of VAT receipts). There was also on the table a pretty blatantly protectionist proposal, strongly supported by the French, for an Oils and Fats tax. This was, it is true, to be matched by measures to control spending on agriculture where huge sums were going on storing and disposing of surpluses, and to improve budget discipline. But these were not tough enough. Moreover, the Commission was still trying to whittle away at what I had secured at Fontainebleau by proposing to change our rebate mechanism. And M. Delors also wanted to double the structural funds (that is, spending on Community regional and social policy). This last proposal was, naturally, more than welcome to the southern member states and Ireland which expected to gain most from it.