The monetary and fiscal policies put in place in any given country directly influence the performance of its economy. Monetary policies greatly influence the rate of growth of aggregate demand, changes in money supply and the associated price inflation. This therefore influences the value of any country’s currency and hence an important tool in determining the exchange rates. Fiscal policies are mainly determined after an analysis of the scale of public deficit which is the difference between the national incomes and expenditure. If public borrowing from both internal and external is high, there is stimulation of aggregate demand while lower borrowing levels lead to low demand and consequently, a depression in economic activity. An analysis of both monetary and fiscal policies since the post-war era in and the importance attached to each as seen by any post-war era government has been evaluated here-in.
Monetary and Fiscal Policy in Britain in the post-war era can be evaluated via a number of distinct phases:
1945-1947: The ‘Cheap Money’ Period
Under the then Chancellor of the Exchequer, Hugh Dalton, the government was keen on pursuing a cheap money policy in which bank rates were kept at 2% and long rates were kept at a low via the use of unlimited support operations. This was essentially implemented so as to ensure the National Debt was cheaply financed and a repeat of the recession after the First World War did not happen. In those times, the relationship between monetary policy and aggregate demand was unknown. There was heavy reliance on a tight fiscal policy so as to bring into control the then balance of trade deficit. However, in 1947, the sterling convertibility crisis, dollar crisis and the fuel crisis made this system impracticable.
1948-1951: Neutral Policy
After the cheap money policy was no longer practicable, the government resulted to the neutral policy. In this period, the bank rate remained at 2%. This was aimed at the growth of the economy in the long-run via a gradual expansion in the supply of money. This was practiced with the quantity theory in which prices are determined by the forces of demand and supply.
1951-1960: Change in the Monetary Policy
Britain, having had a new Conservative government, was keen on the removal of any direct controls which had been put in place over the economy. It was of the view that market forces should be left to solely act on pricing and supply. Due to inflationary pressures fueled by the Korean War, the Bank Rate was increased to 2.5% in November 1951; one month after the new government took office. This period was characterized with fiscal activism and an emphasis on macro-economic fine-tuning via implementation of fiscal policies. The deficit fluctuations were averagely between 2-3% of the annual GDP since 1953 (Woodward 1991, 6).
The Bank rate was crucial in managing the external factors and the increase in the rates enabled an inflow in the balance of payments capital account. Long-rates were disregarded in favor of higher interest rates which were thought of resulting in higher availability of funds for investment. Government securities had low returns and were seen as leading to a fund lock-in. Due to the large National Debt, the government had to keep an orderly bond market. The government had to therefore buy bonds when they were weak and sell when they were strong. This led to attenuated fluctuations in the long-rates. After 1951, there was a change from the old orthodox method which had primarily focused on the bank’s cash ratio. In the post war era, treasury bills were in large quantities implying high levels of liquidity. The new orthodox method provided for a requirement in which banks had to hold 30% in liquid assets ratio in addition to the required cash to deposits ratio. This enabled the Bank of England to control bank activities via Treasury Bills (regulation of the supply of liquid assets) in lieu of controlling the cash supply. Several instruments were used by the government in controlling banks: First, the bank rate was changed 17 times between 1951 and 1960. Secondly, there were variations in the Hire purchase regulations which chiefly aimed at durable consumer consumption. Finally, on the onset of 1957, there was a direct quantitative control on bank advances.
The 60’s: Use of Special Deposits (SDs)
In 1958, the government created the special deposits instrument, which was ready for use in April 1960. When needed, special deposits were maintained by the Bank of England where they earned an almost equivalent interest rate to that earned on Treasury Bills. This were levied as a percentage of total deposits held by clearing banks so as to reduce their liquidity which would force such banks to reduce their advances and hence a resultant leveraged effect. To re-establish a higher liquid asset position, banks could sell bonds and invest in treasury bills. Apart from SDs, the 1960s policies were similar to the 50s in which the government favored direct controls, quantitative controls, changes in the bank rate and changes in hire purchase terms. However, direct controls led to distortions as banks were keen in evading such which resulted in losses in new lending business to new lenders. Lending restrictions resulted in reduced inter-bank competition as banks colluded in a collective agreement on customer charges and deposit rates. The monetary policy was very tight in 1964, 1966 and 1969. The sterling crisis of November 1967 led to an increase in the bank rate from 6.5% to 8%. Further, hire purchase terms were tightened and the sterling devalues from 2.80 to 2.40. So as to increase flexibility in interest rates, the government set a target for consequent increase of DCE in 1969.
Since 1953 up to 1967, the deficit had fluctuated at an average varying between 2-3%. However, this deficit rose to 4% in 1967 though this was immediately followed by a tightening in the fiscal policy in 1968 which consequently led to surpluses in 1969 and 1970(Dilnot & Clark 2004, 3).
1971-73: Competition and Credit Control
The competition and credit control arrangements were introduced by the new government so as to stimulate higher levels of competition among institutions that offered credit while shifting government reliance on credit controls to reliance on interest rates and special deposits. Under this system: A minimum reserve ratio of 12.5% of sterling deposits in specified reserve rates such as treasury bills. In addition, they were to hold a 1.5% cash reserve requirement at all times. Secondly, a percentage of all deposit liabilities was to be kept at a uniform rate across the industry. Thirdly, the collective agreement on interest rates was to be discontinued by all London and Scottish banks. This was a relaxation due to the then high levels of unemployment and stagnant output. This was followed by a significant increase in M3 from 4.3% to 7.7%. In June 1972, there was a sterling crisis. Previously, the sterling had floated against the dollar but fell significantly against the DM after this period (Woodward 1991, 98).
The Bank rate was replaced by the minimum lending rate in October 1972. This was set as the averaged Treasury Bill Rate and an additional 0.5% which was rounded to the nearest 0.25%.Hence, this rate was adjusted under the market rate. However banks could still use an independent rate. By 1973, the M3 had risen by 60% (the Barber Boom). This was attributed to the CCC changes which had led to clearing banks gaining business that they had lost to non-clearing banks due to direct controls. However, the government was unwilling to increase interest rates, which resulted in failure of the CCC in July 1973. The banks previously believed that equilibrium would be created by the rapid credit expansion which would otherwise force Market Lending Rate upwards. This however did not rapidly occur, leading to government intervention. High levels of industrial unrest in 1970-74, the December 1973 oil shock and the miner’s strikes were crucial crises that aided in the failure of the CCC. Inflation rates were at 9% and nominal rates were at 13% implying a low return of only 4% in real interest rates (Lewis 1981, 36).
1973-1979: The Corset (Supplementary Special Deposits), the Implementation of Monetary Targets and the PSNB (Public Sector Net Borrowing)
Supplementary Special Deposits was a quantitative control introduced by the government aimed at bank liabilities (interest bearing eligible liabilities) rather than assets. A maximum rate at which IBELS could grow was set and any excess was places with the bank with the Bank as additional non-interest earning SSDs. The SSDs led to disintermediation into commercial bills and in the growth of other parallel markets. Banks also cut back on charges on non-interest bearing accounts which greatly reduced IBELS stock but had no consequential effects on M3 or the level of liquidity.
The Bank of England began using internal monetary targets or the M3. In 1976, the sterling targets were made public as stated in the Healey’s IMF budget. Rolling targets were published for M3 by the government. Changes were made in the MLR to meet such targets though this was in practice missed. In May 1978, the direct link between MLR and the Treasury bill rates was abolished hence eradicating control of the Bank on the Treasury bill rates. The National Debt during the Barber Boom and the first oil shock, constrained the monetary policy. So as to re-finance debt and sell its debt in larger amounts, there was a need to use short-rates so as to influence the long gilt rates. This was attained by debt sales via tenders and issue of index-linked debt. The floating exchange rate also constrained the monetary policy. The sterling was appreciating due to capital inflows. The government intervened via the FX market so as to keep the sterling low but later withdrew since this negated the set monetary target.
In 1971, fluctuations in the deficit rose. There was increased Public Sector Net Borrowing which increased deficit levels to those experienced in 1967 despite the then economic boom. This rose to even higher levels as recession struck in 1974 and reached an all time high in 1975. The government then implemented fiscal measures in reducing deficits.
1979-1987: The MTFS
In 1979, all control on the foreign exchange rate was abandoned. In June 1980, the Corset was also abolished. In November 1980, the reserve asset ratio was abolished and was replaced by requirements that were to be prudently determined. This was eventually replaced by Medium Term Financial Strategy (MTFS), which entailed a five year period. Targets were to be set annually for the public deficit and the M3. The MLR was suspended in 1983, implying all quantitative restrictions in lending had been suspended, leaving interest rates and base control as the only vital control instruments. However, the monetary targets were never met and by 1986, these targets were clearly not of any use.
1987-1990: Shadowing the Deutschmark
This period was characterized by a burst of inflation. The pound was already pushing past the established 3 DM level and the Chancellor initiated exchange-rate targeting. This necessitated multiple interest rate cuts, from 10% in 1987 to 7.5% in 1988. Inflation was further influenced by lax fiscal policy, high money supply in the United States, the eminent abolition of double mortgage interest relief, liberalization in the financial markets and the existing high demand (Posen 1999, 38).
In a period of less than 30 days, there was a sudden change in interest rates which were initially cut by 0.5% and the experienced 3 consecutive rises of 0.5 percent. A high of 15% interest rate was experienced in 1989. Consequently, the housing market crashed and consumer spending hit an all time low. The economy went into recession with the GDP significantly reduced in the third quarter of 1990
1990-1992: ERM Membership
The recession posed a challenge to the conservative Party and Ms. Thatcher. Politicians who were in support of ERM forced the government into ERM at a 2.95 central rate. This in effect reduced interest rates to9.875% by 1992. However, this was not sufficient since the Bundesbank ran a tight monetary policy and as such, Britain left the ERM after a final sterling crisis.
1992-1997: Early Inflation Targeting
The inflation Targeting policy took effect on 0ctober 1992. It placed emphasis on transparency and insisted on intermediate targets. Interest rates were determined by the Chancellor (Ken Clarke). However, he held a monthly meeting with the Bank’s Governor, which was popularly referred to as the Ken and Eddie Show. From a target of between 1to 4%, this was narrowed down to 2.5% plus or minus 1%. Oil prices remained low as inflation targeting was practiced in the post-Bretton Woods era. In this period, the culmination of the fiscal policies previously implemented in 1975 resulted in surpluses in 1988 and 1989. However, the onset of recession prompted rapid rise in borrowing pushing the previous surplus experience into a deficit (Select Committee on Economic Affairs 2004, 3).
1997 to date: Bank of England becomes independent
Gordon Brown granted the Bank of England independence on 6th May 1997. This ensured that the monetary policy would be now transparent, credible and independent. This policy has by-passed such crisis as the 1997 Asian Crisis, the 2000 oil Price shock and the 2001 recession. However, prudence was needed in the CPI target and inflationary tendencies which have been set by the government at 2%. The Bank of England is charged with maintaining price stability and encouraging growth and employment.
In March 2009, at the height of the global recession, interest rates had fallen to a low of 0.5%. The MPC (Monetary Policy Committee) consequently reduced the official interest rate by 50 base points to 4.5% (Thomson 2011, 3-6).This greatly eased inflation on food and energy prices. An Independent Bank seems to have bypassed this financial crisis albeit not so successfully. By 1993, the Public Sector Net Borrowing was at 7.8% of GDP. The fiscal stance was equally and rapidly tightened. There was a consistent drop in net borrowing culminating in a surplus in 1998. By 2000, the surplus was 2% of GDP under the Gordon Brown leadership. This suggests that an expansionary fiscal stance has been adopted across governments after the Second World War (Economic Outlook, 2008, 5-10).