In the 10 years before Margaret Thatcher’s election victory in 1979, inflation averaged close to 12%. Various explanations were put forward. The most popular was the ‘oil shocks’ of 1973 and 1979 when disruptions in Middle Eastern oil production sent prices skyrocketing. Another was the pay demands of trade unions which brought the country to a shuddering halt in the winter of 1978.
Indeed, both of these arguments have echoes today. The rise in oil prices since 2003 has been presented by the government as a major factor in current inflation and the trade unions are squaring up to Gordon Brown and demanding higher pay to match inflation.
In 1979 the incoming Conservative government largely ignored both of these arguments armed as it was with the theory of monetarism. Popularised by Milton Friedman monetarism held that “Inflation is always and everywhere a monetary phenomenon”. The key, indeed probably the only, determining factor in inflation was the increase of the money supply.
The money supply is the total amount of money available in an economy at a particular point in time. It includes cash, deposits, checking accounts, liquid assets and much else besides. The exact make up depends on which measure of the money supply you happen to be using. In essence, monetarism held that if the growth in the money supply matched the growth of the economy then prices would remain stable. If it exceeded economic growth however, the resulting gap would be inflation.
In the case of rising oil prices being a cause of inflation, monetarism held that they were not, that in the 1970’s as now, they were merely price rises reflecting relative demand and supply. Inflation is not the rise in price of a particular good or service but “the increase in the general level of prices over a specified period”
Likewise, the wage demands of trade unions need not be inflationary. If the government raises wages by £X but raises taxes by £X to cover this, the money supply has not increased, rather a portion of it has simply been shifted from one large and disparate group (taxpayers) to a smaller and more concentrated group (the public sector). If the government funds wage increases by taxation, it will not be inflationary, if it funds them through an increase in the money supply, it will not only be inflationary but will prompt another bout of demands in the future.
This is what happened through the 1970’s. Government expenditure eventually reached the limits that taxation could support with marginal rates of 90% but even this was insufficient to fund it all. So the government took to expanding the money supply, “printing money” in the popular phrase of the time, which fuelled inflation. And as wage settlements caused further inflation unions came back with further wage demands. This became known as the ‘wage-price spiral’. But according to the monetarist doctrine of the Thatcher government and its Chancellor Geoffrey Howe, the inflationary factor was not rising wages but the governments’ expansion of the money supply to pay for them.
How relevant is this today? We have inflation albeit not of the double digit variety the Conservatives inherited in 1979. As we have seen, we also have people eager to blame oil prices and public sector wage demands. But what’s been happening to the money supply? Simon Heffer explained back in June.
“There is not inflation because of rising prices, or rising wages…Growth is at present about 2 per cent, and predicted to fall to about 1.4 per cent over the next year.
Inflation, on the bogus measure of Consumer Price Index, is more than 3.3 per cent. Even if we believe these two figures, their sum is about 5 per cent. How fast is the supply of money increasing in the M4 measure? More than 12 per cent.”
This is the real cause of inflation now at its highest rate since 1992. Since Gordon Brown ditched the Conservative spending plans he adhered to in the first Blair administration, public spending as a share of GDP has risen by nearly 5% of GDP to 42% for 2007-2008. This has been paid for by government borrowing which has produced a deficit of 2.8%. This avalanche of cash has flowed straight into the money supply.
It is likely that an incoming Conservative government in 2010 will have to deal with circumstances similar in their fundamentals to the situation of 1979. Sadly, the remedy is likely to be similarly painful with unemployment and higher interest rates. One note of comfort comes from the new monetarist consensus as demonstrated by Mervyn King, it is hard to imagine 300 economists taking up their pens in anger now.
Ultimately it proves the truth of Kenneth Clarke’s observation that Labour governments are elected for as long as it takes them to wreck the economy and Conservative governments are then elected to sort it out.
(Printed in The Caerulean, Issue 11, September 2008)