UK (2013): Thatcher's Economic Legacy

George Buckley, London.

Following the death of Margaret Thatcher on April 8, Britain’s first female prime minister and the longest serving in over 150 years, we take a look at her legacy and how today’s economy has been shaped by her influence.

Intellectual Style
Thatcher’s intellectual economic style can probably best be described as ‘economic liberalism’. Her focus on self-interest harks back further than Friedrich von Hayek and Milton Friedman to Adam Smith’s ‘invisible hand’. In the Wealth of Nations (1776) Smith wrote that led by “an invisible hand” an individual pursuing their own interest “frequently promotes that of the society more effectually than when he really intends to promote it”. This is probably the underlying message Thatcher wanted to convey when she said in a 1987 interview that “there’s no such thing as society. There are individual men and women and there are families…people must look after themselves first”.

Her economic inspiration came from von Hayek and Friedman via Keith Joseph the Conservative Party’s economic guru, who had a sizable influence on her thinking in the run up to the 1979 election and thus the content of the party’s election manifesto. Socialism became enemy number one; as leader of the opposition Conservative Party she quipped in a television interview in 1976 that socialist governments, “always run out of other people’s money”. Rolling back the frontiers of the state was her aim, which she delivered by freeing up markets and encouraging self-reliance.

Since 1979 no truly left-wing party has stood much of a chance in a British general election. The Labour Party was forced to change to ‘New Labour’, migrating towards the centre-ground in a ‘median-voter’ style shift. Differences between the major parties have become far more limited than they were in the 1970s and 1980s, which in turn can be seen as partly responsible for the first coalition government since the 1930s.

Labour Market Reforms
Perhaps the most well known of the supply side reforms enacted by the Thatcher governments in the 1980s are those related to the liberalization of the labour market. In the 1970s unions were all-powerful and membership rates were high, leading to an average of over 1 million days per month lost to labour disputes and a monthly average of nearly 300 stoppages. This was epitomized by the devastating miners strikes of the early 1970s during the Heath administration and the Winter of Discontent in 1978-79 during Callaghan’s premiership.

By the first half of the 1990s those figures had fallen to just 69,000 days per month lost and 38 stoppages respectively, down by around 90% relative to the 1970s – see chart 1. Union membership is now just half what it was when Thatcher came to power. This was brought about by significant changes to union legislation throughout the 1980s, the Employment Act being rewritten four times. Key changes included restricting picketing and the closed shop (1980), limiting the definitions of a ‘legal’ strike and requiring unions to pay damages for strikes (1982), making it illegal to strike without a ballot (1984) and making it illegal for unions to discipline their members who did not participate in strike action (1988).

Of course the reforms were not without their critics, and the flash-point came in 1984/85 in the form of the miners’ strike with the government closing a series of state owned coal pits. The defeat of the National Union of Mineworkers’ strike in 1985 would prove to be a key moment in Thatcher’s premiership – and generally in changing the nature of the contract between the employer and the employee.

Thatcher’s labour market and trade union reforms continue to have an impact today. They may be able to explain some of the current productivity puzzle, whereby the flexibility of the labour market has allowed many more employees to retain their jobs in exchange for significant cuts to real wages. With it being easier to hire and fire, employing has become a more desirable prospect than investing for corporate during the current period of uncertainty in relation to the euro area crisis. This is illustrated in chart 2, where employment intentions have improved more quickly than those of investment during the current recovery.

While the productivity puzzle comes with its own problems (high unit labour cost growth and sticky inflation, for example), these supply side reforms have been highly beneficial. Changes in labour market law, particularly in relation to long-term contract rigidity, might be welcome developments in some euro area economies (such as France, Spain and Italy).

The Economy & Monetary Policy
There were important changes to the operation of monetary policy under the Thatcher administrations. While money supply targeting effectively began in 1976 following the sharp rise in inflation and the IMF’s bailout of the UK towards the end of that year, it took on an even more prominent role during Thatcher’s first two terms under the guise of the Medium Term Financial Strategy (MTFS) announced in the 1980 Budget. Controlling (or attempting to control) money supply targets continued to be the main thrust of UK monetary policy until the targets were finally abandoned in 1987.

The government’s desire to control the money supply was based on the Quantity Theory of Money, or M x V = P x T (where M is the money supply, V is velocity, P is the price level and T transactions). The idea was that if velocity was constant then for any given level of transactions changes in the money supply would have a direct impact on the level of prices and thereby the rate of inflation. While focusing on money did end up leading to a sharp fall in inflation (see chart 5), the money supply was especially difficult to control with the assumption of stable velocity proving unreasonable. The final three years of Thatcher’s tenure as Prime Minister saw money targets abandoned, replaced with a regime of fixing sterling, first shadowing against the Deutschmark and from 1990 within the ERM.

While both policies were flawed (monetary targets proving difficult to control and fixed exchange rates leading to a severe recession) what Thatcher was successful in doing was flushing inflation out of the system. The Lawson boom towards the end of the decade helped re-stoke inflation back into double digits again, but generally the lesson had been learned – no longer would high and volatile inflation be tolerated.

These policies were an important stepping stone towards the inflation targeting policies that we see in place globally today. The aversion towards high inflation that became entrenched during Thatcher’s premiership and the lessons learned from trying to achieve low and stable inflation through intermediate money supply targets were key in influencing policymakers to target inflation directly from the end of 1992, following sterling’s ejection from the ERM. Inflation was only brought under control at the expense of a deep recession in the early 1980s – austerity (Howe’s 1981 Budget) and tight monetary policy (interest rates raised from 12% to 17% within six months of Thatcher taking office in 1979) led to GDP contracting by 6% and unemployment rising from 5.3% in mid-1979 to 10-12% between the end of 1981 and 1987. UK industry was decimated in the process.

Low inflation is not a given – it has been hard won in the UK and elsewhere. This was surely on the minds of the current Chancellor and his team when considering a change in the Bank of England’s remit last month. Twenty years is the longest period that a single policy regime (inflation targeting) has survived for a generation, and the Chancellor was right in our view to make few changes to the target. In fact we have learned from the mistakes of a lack of flexibility in monetary policymaking by crafting a new remit to give the Bank of England some leeway in allowing growth to recover during a period of above-target inflation. In practice, this is nothing more than making explicit what was already assumed implicitly. This week’s Consensus Forecast publication shows that the Chancellor may be already reaping the benefits from retaining the 2% target, with long-run economist forecasts of inflation being revised down (see chart above right).

While Thatcher’s economic legacy has undoubtedly been positive for economic growth there is little evidence of particularly strong growth having been generated during her term in office. The two charts below illustrate this. During the Thatcher years economic growth ran at a rate very close to its long-run average, as chart 8 shows. When it comes to GDP per capita the evidence is mixed; chart 7 shows that the UK performed significantly better than most other G7 economies during the 1980s, but in nominal US$ terms the UK was at the bottom of the pack. After all, her term in office was topped and tailed by recessions in the early 1980s and 1990s thanks to tight monetary/fiscal policy and the fallout from the ERM exit respectively.

Fiscal Policy
Aside from introducing significant supply side labour market reforms and bringing down inflation, Thatcher’s premiership was also about rationalising the size of the state and addressing the deficit. After all, Thatcher already had a reputation as being fiscally austere after her stint as Education Secretary in the Heath administration of the early 1970s; sizable spending cuts were required in order to deliver on Heath’s manifesto pledge for lower taxes.

It is perhaps understandable why the current Conservative Chancellor has pursued significant fiscal tightening since the coalition came to power when one looks at the evidence of previous Conservative austerity programmes in both the early 1980s (under Thatcher/Howe) and in the 1990s (under Major/Clarke). This is shown in chart 10, page 6. Previous fiscal austerity programmes, including that of the early 1980s (epitomised by the 1981 Budget, met with the inner city riots and an open letter to The Times signed by 364 economists arguing that tight policy was wrong against a backdrop of weak growth) had been associated with relatively strong growth – either at the same time as, or soon after, the fiscal tightening itself.

This time, however, it would seem that the combination of a credit crisis (which may have raised the fiscal multipliers associated with spending cuts) and the large exposure of the UK to Europe have been sufficient to dampen the recovery to just a third of what might be termed a ‘normal’ pace (1% versus a typical 3% post-recessions).

Still, just as in the early 1980s, we believe the government is right in addressing the structural deficit, and that the short-term difficulties that fiscal tightening will inevitably create will be worth it for the longer-term gain associated with lower government debt and less crowding out of the private sector. It is worth noting, again from chart 10, on the following page, that after averaging -1.5% in the 1970s Thatcher’s decision to address the public finances led to the cyclically adjusted primary balance moving back into positive territory for almost the entirety of the 1980s. Politically, the first Thatcher term was only saved by the Falklands War; the weak economy and high unemployment were the immediate consequences of fiscal tightening which was clearly not popular with the electorate (recall Thatcher’s conference speech of 1980: “The Lady’s not for turning”).

While spending was being cut, so too were taxes. Top rates of income tax were slashed soon after the 1979 election, down from 83% to 60% in Howe’s first Budget then further under Chancellor Nigel Lawson to 40% in 1987. The basic rate of income tax was cut from 33% to 30% financed by a rise in VAT (which of course made the control of inflation all the more difficult), although it is interesting to note that the burden of taxation did not fall during Thatcher’s premiership. (Indeed, in 1979-80 taxes and national insurance contributions as a proportion of GDP stood at 33.7%. They rose to a peak of 37.6% in 1981-82 edging back down to 34.6% by the early 1990s.)

The same mix of policies appears to be favoured by the current coalition: cuts to welfare spending (after all, research suggests that spending cuts provide a more lasting fiscal adjustment than tax rises), lowering the top rate of income tax and reducing corporation tax. By means of comparison, from 1979-80 to 1990-91 real spending growth (total managed expenditure deflated by RPI) averaged +1.3% per year, versus the current government’s plan of -2%.

The public finances were also buoyed by a number of high profile sales of public sector assets – something that former Conservative Prime Minister Harold MacMillan described as “selling the family silver”. Subsidies of state industries were reduced and, after some hesitation (according to Thatcher’s first Chancellor Geoffrey Howe), were privatised. Big names included BAe (1981), British Gas (1986), British Telecom (1984), British Airways and BAA (1987), and the gas and water (1989) utilities – which combined quadrupled the number of shareholder households in the UK. In addition to the large scale privatisation programme, the government embarked on an ambitious programme of council house sales.

While privatisations were successful in the sense that they generated a huge amount of interest from the public (and thereby cash for the Treasury), and private enterprise is usually assumed to be associated with better outturns in terms of the efficient delivery of goods and services, not all privatisations were as successful today as might have been hoped. Taking a look at a map of high speed European rail links shows that the UK still has some of the slowest networks, particularly when compared with the euro area big-four (notably France). This is what has been behind the government’s decision to press ahead with investing in the High Speed 2 (HS2) – a planned high-speed railway.

European Union
Thatcher’s stance on Europe still exerts an influence on the British people – and particularly the Conservative Party – today. Under Edward Heath, a government in which Thatcher was Education Secretary, the UK entered the European Economic Community (EEC) in 1973 and as leader of the opposition she campaigned in favour of a yes vote in the 1975 referendum. She signed the Single European Act in 1987. But that is where the positive attitude to Europe ends. As the years went on, she became less than enthusiastic, culminating in her Brussels speech of 1988 (“We have not successfully rolled back the frontiers of the state in Britain, only to see them re-imposed at a European level”) and of course her eventual resignation following disputes with cabinet colleagues over the Exchange Rate Mechanism and the European project more generally.

The Conservative Party lost the following three general elections at which divisions on Europe played no small part. Today Europe is no less a bugbear for the Party. David Cameron’s recent speech in London offering a referendum on a reworked European Union was no less significant as Thatcher’s Brussels speech: “The European Treaty commits the Member States to ‘lay the foundations of an ever closer union among the peoples of Europe’. We understand and respect the right of others to maintain their commitment to this goal. But for Britain – and perhaps for others – it is not the objective”.

Unlike previous Conservative discontent about Europe, offering a referendum could end up being a political masterstroke. After all, at the time of the next general election in 2015 the Conservative Party may be able to claim that it is the only party which is large enough to form an independent government and offer the electorate a referendum on Europe – potentially taking support away from the UK Independence Party and also from Labour, the leadership currently unwilling to match the Conservative Party’s commitment to deliver a referendum.

Either way, some twenty five-years on from Thatcher’s Brussels speech the issue of Europe has not gone away – rather, it has become even more significant and could yet prove to be the ruin of political careers.

Financial Sector
Finally, under successive Thatcher governments dramatic changes were made to the legal framework under which the financial sector operated. The financial sector was deregulated in October 1986 when the structure of the market underwent a huge change via Big Bang. Stockbrokers and marketmakers were allowed to exist under the same roof from this point, thereby signalling the rise of the one-stop-shop investment bank in the UK.

Some would argue that these changes laid the groundwork for the current financial crisis, although this would be somewhat unfair. After all, the credit crisis was a global phenomenon and reflected moves towards looser regulatory regimes across the world – which are now being reversed. Had UK legislation not become more lenient then the economy would not have benefited to the same extent from the twenty-year boom in the run up to the crisis and would still have been at the mercy of the global crash when it came. Still, the extent of liberalisation was a step too far, and both the previous and current governments have made amends.

Conclusions
As our discussion above makes clear, our view is that Thatcher’s economic legacy is a positive one. But it is important not to gloss over some of her mistakes and failures. Income inequality increased under Thatcher as the tax system became less progressive, but as she herself argued in the House of Commons towards the end of her premiership, “all levels of income are better off than they were in 1979”. Indeed, the second half of her premiership saw real incomes rise at a rate of nearly 4.5% per year.

That brings us on to the second negative issue – the Lawson boom, which itself generated a sizable portion of these rises in income via lower tax rates and the boosting of an already inflated housing market. Third, some industries and parts of the UK were hit hard by her policies. Providing state support for failing industries can never be sustainable in the long-run, but allowing these businesses to fail has led to an over-dominant service sector; having all eggs in one basket increases the vulnerability of an economy. Manufacturing is now worth just 10% of GDP, compared to around a third at the start of the 1970s. Some regions prospered at the expense of those whose industries lost the support of the government. Still, Thatcher was simply allowing the theory of comparative advantage to take its course – the need to focus on those businesses that are self-sufficient without government support, while buying in the tradeable goods we are less efficient at producing.

More important than those faults, however, Thatcher’s governments squeezed inflation out of the system through monetary policy, rejected Keynesian fiscal demand management policies, cut back on public sector spending, reduced taxes, introduced important supply side labour market reforms, and privatised state industries – all of which helped push back the frontiers of the state and encouraged enterprise, efficiency, competition and self-reliance through the means of the free market. This was a dramatic change to what went before: high tax and spend, prices & incomes policies and exchange controls – in short a ‘big state’ and highly interventionalist government policies.