Is high inflation in the UK dead or dormant? Kit McMahon, formerly chairman of Midland Bank, takes an historical look at rising prices and considers whether inflationary fears are now dampening growthby Kit Mcmahon / February 20, 1996 / Leave a comment
Published in February 1996 issue of Prospect Magazine
In April 1992, when the annual rate of inflation in the UK dipped below 4 per cent, it was only the second time it had done so in 24 years. During those years the pound had lost seven-eighths of its purchasing power. At its height, during the 1970s, annual inflation had been in double figures for six out of seven consecutive years. Moreover, the only previous year that inflation fell below 4 per cent (in 1986) appeared to have been a fluke: price rises soon started accelerating again, briefly reaching 10 per cent during 1990 before dropping back.
It is not therefore surprising that for everyone under, say, 45-which includes almost everyone working in financial markets and most financial and economic commentators-there has been much scepticism about sustaining low inflation. In particular there was widespread anxiety that being driven out of the Exchange Rate Mechanism (ERM) in September 1992 would swiftly lead to a resurgence of inflation. But despite a substantial devaluation of the pound, inflation in the succeeding three years averaged below 3 per cent. Will this prove too good to be true?
Three questions arise. How inflation-prone does history suggest the UK to have been? How far are the factors which have caused most inflationary trouble in the past likely to persist? And how does past experience of inflation, through expectations thereby generated, influence its future course?
The long view
Among the main industrial nations the UK is often thought of as a relatively high-inflation economy. But on the long view that is not so. If we imagine ourselves back 50 years, what would then have been our memories of inflation? Naturally prices had risen during the second world war (by about 30 per cent) but even so they were no higher in 1945 than they had been in 1918. Prices doubled during the first world war but, going back further, the price level in 1914 appears to have been considerably below that of 1815.
Comparisons over such long periods are impossible to make with any precision. Not only are the statistical sources relatively poor; it is also difficult to link price indices when what people buy and consume has changed so much. Who cares what candles cost today? Who knew what oil cost then?
But there are other ways of assessing what one might call the “inflationary climate.” Most statistical problems inherent in the construction of price indices can be side-stepped if we simply look at the direction of change from one year to the next. From this the striking fact emerges that over the whole period from 1815 to 1945, including two world wars, the number of years in which prices fell (57) was virtually the same as those in which they rose (60).
Thus, although this long period was not characterised by price stability, price expectations were probably quite stable. In this climate fixed monetary fees were appropriate, the recipients only losing on the roundabouts when prices rose what they had gained on the swings when they fell. In the 1930s my father used to refer to a somewhat humdrum solicitor of his acquaintance as “the same old six and eightpence.” He explained that the phrase derived from the regular solicitor’s fee. The Oxford Dictionary cites a reference to six and eightpence as a definition of a lawyer in 1785; and one from 1700 to what was obviously the original of the sum: “the usual Fee given to carry back the Body of the Executed Malefactor, to give it Christian burial.” The Act nationalising the Bank of England in 1946 provides a more recent example: non-executive directors continue to receive only the ?500 annual fee enshrined in the Act.
Other industrialised countries started the post-war period with a more inflationary past and, one may therefore assume, greater inflationary expectations or fears. The German experience was the most dramatic. In the 40 years before 1914 prices rose by one-quarter (when in other large industrial countries they were stable or falling). Between 1914 and 1920 they went up tenfold. Then they took off. In headline terms the story is familiar: hyper-inflation in the early 1920s wiped out the middle classes and led to Hitler. But it still comes as a jolt to read the figures for 1920 to 1923 (see box). After the crisis and monetary reconstruction, price stability was achieved and persisted up to the outbreak of war. Indeed, German inflation was relatively moderate even through the war itself, only breaking out again in the post-war turmoil, until the monetary reform of 1948, after which prices stabilised.
France had experienced no such drama but nevertheless had an enormously more inflationary past than the UK. By 1929 prices were six times what they had been in 1914. Then, after a 20 per cent price fall during the 1930s, inflation picked up with a vengeance during the war and its aftermath, so that by 1950 prices were more than 16 times the 1929 level (and therefore more than 100 times that of 1914).
The experience of the US had been much more like that of the UK-though still markedly more inflationary. Between 1914 and 1929 prices went up by 70 per cent. They fell back in the 1930s but rose again during the war and immediately afterwards, so that by 1950 they were nearly 2.5 times the 1914 level. By 1950 the UK’s inflation, both during the war and in the five years after it, was less than half of that of the US.
The post-war earthquake
Since the war it has been very different. In no single year have prices fallen in any large industrial nation. In the UK, prices have increased twentyfold over the 50 years since 1945-an experience without parallel in our history. Moreover, there has been a marked acceleration within the period. From 1948 to 1968 prices doubled; from 1968 to 1995 prices rose almost ninefold.
No wonder people are pessimistic about the chances of permanently subduing inflation, even after the encouraging performance of the past three years. An acceleration over a 50-year period must presumably indicate some fundamental forces at work which would be difficult to reverse. But the picture of what has actually happened over the past 50 years is rather more encouraging.
The record of inflation in the UK between 1948 and 1995 (see next page) first shows a “spike” in 1951 and 1952-reflecting partly the 1949 devaluation, but mainly the worldwide explosion in commodity prices caused by the Korean war. But this inflationary injection did not spark a wage/price spiral. Moreover, at least up to 1968, there is no sign of a trend. Contrary to what is often said, each cyclical inflationary peak was not higher than the one before. Until the end of the 1960s, inflation in the UK fluctuated around a stable underlying rate of between 3.5 and 4 per cent. (This was pretty much in line with the UK’s main competitors. France turns out to have been more inflationary than the UK. Germany-despite its image as an inflation-hating country with an austere and powerful central bank-performed only slightly better than the UK.)
But that quarter century looks benign compared with what followed. Towards the end of the 1960s a number of developments combined to produce the most massive inflationary injection the industrialised world has seen for at least a century.
The Bretton Woods system of fixed but adjustable exchange rates came under increasing strain as tensions grew between the US, the anchor of the system, and the creditor countries, notably Germany. The situation was exacerbated by the US’s unwillingness to raise taxes to finance the Vietnam war. Inflationary pressures and international political tensions grew until, in August 1971, President Nixon abandoned the US obligation to maintain the $35 per ounce link with gold-effectively floating the dollar. Despite various efforts to put Humpty Dumpty together again, this marked the beginning of the regime of floating exchange rates which has persisted ever since.
The breakdown of the world fixed exchange regime was doubtless inevitable. And in the international monetary turmoil that characterised most of the 1970s, floating rates provided a necessary safety valve for most countries. But the abandonment of the Bretton Woods discipline led quickly to inflationary economic policy making. In too many countries, the UK in particular, the abolition of the need to maintain a particular exchange rate was greeted as if the constraints of reality itself had been relaxed. To the effects of the Vietnam war, and its inflationary financing in Washington, were added lax budgetary and monetary policies in many other capitals. World commodity prices (excluding oil) more than doubled between 1971 and 1974 and inflation in most industrialised countries accelerated.
Then in October 1973 there occured an event without parallel in economic history this century. The main oil-exporting countries of the world formed a cartel with the explicit aim of drastically reducing the supply of their oil to the rest of the world; the effect was to quintuple its price. This action provided an inflationary shock unprecedented in size and complexity because, in relation both to supply and demand, oil turned out to be unique.
On the supply side, the Opec nations were able to maintain a rigidly effective cartel for a number of years. Underpinning this politically was a strong sense of acting out of pan-Arab motives. However, this would probably not have been strong enough to prevent the cartel’s erosion had not Saudi Arabia, with the biggest reserves and least need for income, been prepared to act as the “swing” producer, allowing the greedier or more needy members to cheat on their quotas, while the world price of oil was kept up.
Demand for oil, on the other hand, showed an almost uniquely low price elasticity. In the long run, of course, adjustments will always be made if the price of something rises. But in the short run-which involved years not months-the only way of adjusting to a fivefold increase in the price of one of the most important commodities would have been a massive reduction in economic activity-deflation on a post-1929 scale.
Confronted by these difficulties, governments and international financial institutions got some things right and some things wrong. Substantial inflation could not be avoided in any country, at least for a few years. Sensible transitional policies were devised to allow oil importing nations to finance their swollen oil bills, so as to allow time for them to adjust. Unfortunately this was often used as a way of avoiding adjustment and running up foreign debts.
So in 1978, when the oil producers gave a further kick to the oil price and inflation started to accelerate again, policy makers changed their stance. Monetary policies were drastically tightened. This produced a severe recession and a world debt crisis as the oil-importing nations found themselves unable either to borrow more or to service their existing loans. It took much of the 1980s to sort out the consequences, but inflation throughout most of the rest of the world fell to somewhere near the levels that would have been regarded as normal before 1970.
The UK’s bad patch
During this difficult period the UK’s performance was unambiguously worse than that of her main competitors. Inflation was higher in the 1970s and showed a recrudescence in the mid-1980s. Why?
The main reason was worse policy. At the beginning and end of the period we had the irresponsible Heath/Barber and Thatcher/Lawson booms-both examples of a misunderstanding of the relationship between the underlying rate of growth of the economy and short run cyclical expansion. Up to and including the Heath/Barber boom, governments of all persuasions had believed that by “revving” the economy it could be made to grow faster. By the late 1980s Thatcher and Lawson believed that their policies had already wrought an economic miracle, and that the economy could handle their boom.
In between these two experiments, admittedly confronted by the worst of the problems, the Labour administration made a poor fist of it: believing that international holders of sterling would bail us out of currency crises; mesmerised by the pot of oil at the end of the rainbow (largely wasted when it was finally reached); and behaving cravenly towards organised labour.
However, apart from the various mistakes made by all UK administrations during the 1970s and 1980s, there were two special factors which made things worse.
First, the trades unions, whose actions in the 1950s and 1960s had been merely irritating, began to exploit their power-bringing down the Heath government and, effectively, the Callaghan one. Confronted by the huge external inflationary shocks of the 1970s, they resisted the necessary reduction in real income much more effectively and for longer than was the case in other countries.
Second, there was a large scale deregulation of the financial system under the Conservatives which, although undertaken for good structural reasons, caused a largely unforeseen expansion of credit. Moreover, the Conservatives aggressively encouraged house-owning in the 1980s-through subsidiary mortgages and the purchase of council houses. In those febrile years everyone thought they were making their fortune out of the house they lived in. Together with large reductions in tax on higher incomes, all of this prompted a re-emergence of inflation-particularly in house prices-which necessitated another more brutal squeeze.
What clues does this give as to the likely inflationary climate in the future-not just for the next couple of years but for the next couple of decades? There are good reasons to believe that on average it will be well below 5 per cent-say between 1 per cent and 4 per cent (which, as it happens, is the present government’s target range).
The years in which inflation went above 5 per cent-let alone those in double figures-have been concentrated in a period heavily influenced by uniquely adverse factors in the global economy. All the main industrial countries were affected, though most of them to a lesser degree. All have come through these shocks and many have now registered relatively low inflation for nearly ten years.
It seems reasonable to believe that some of the adverse factors specific to the UK during the past 25 years will not be repeated. The trade unions will not regain the power they wielded so irresponsibly in the 1970s. Perhaps under a Labour government-and if we integrate more closely in Europe-there will be some recovery from their present state of weakness. But the Thatcher reforms were widely seen as necessary and there is growing interest in the rest of Europe in UK labour market de-regulation. In any case, the heavy constraint of high unemployment seems likely to persist for many years.
More generally, lessons have been learned which are unlikely to be forgotten in a hurry. We can probably rule out any substantial move back towards artificially stimulating the housing market. And even on macro-economic policy it seems reasonable to be a little optimistic-at least as regards control of inflation. Recent memories have led UK citizens, as they led German citizens a long time ago, to a common concern not to let inflation return; and these memories are informing policy. Of course one cannot rule out political ineptitude or folly-there are bound to be years when inflation goes over 5 per cent. But the forces to reduce it quickly are likely to be strong.
In all this, expectations will play an important role. We have seen the force of this in looking at the past. At first sight, for example, the pre-war period may seem to have little relevance. It was a long time ago and circumstances were different. Wages could be forced down, unlike today. Food and raw material prices which did-and do-fall as well as rise were much more important in the overall price level then than now.
Nevertheless, the pre-war experience shows how strongly entrenched expectations about the future course of prices can become-and how they can persist even when they have been rendered inappropriate by later experience. The fact that up to 1950 the UK’s past was strikingly less inflationary than all her main competitors (including the US) may help to explain subsequent events. British society was probably less disturbed by the dangers of inflation than other countries, more prepared to experiment with over-expansion, less prepared to stand and fight when the external inflationary threat finally became serious. And this attitude was not seriously modified by experience up to the end of the 1960s. It was radically changed by the traumas of the 1970s; and the inflationary expectations then generated made the 1980s problems worse.
Now we are in an anomalous situation. Inflation memories may be strong enough to ensure that one way or another inflation is kept down in the future, but so long as people continue to expect more inflation than is likely, the authorities have to continue to behave as if these expectations are correct-so as to demonstrate finally that they are not. It is not a trivial problem to have inflationary expectations out of line with what actually happens. It means that interest rates are higher than they should be; that borrowing, investing and spending decisions are lower than with hindsight it will be clear they should have been-which means, of course, a brake on economic growth.