WHY DID MONETARISM GAIN GROUND FROM KEYNESIANISM IN THE 1970S?
Between 1945 and the early 1970’s
Keynes launched The General Theory Of Employment, Interest And Money in 1936 as a criticism to classical economics’ inability to deal with slow growth and high unemployment in the 1920s and 1930s. He argued that the only way to increase unemployment and rescue economies from deep recession, such as the one faced in the inter-war periods would be to increase aggregate demand, the sum of demand in the economy. This would be done either through the government lowering the rate of interest or the government spending more, or taxing less in order to encourage households and firms to consume more. This, it was argued would result in a return to economic growth and subsequently reduce unemployment. Classical economics had appeared to have failed. Previously it was argued that the only way to increase economic growth would be for workers to reduce their wages so that it would become profitable for firms to rehire them and sell goods again profitably and any other way would result in inflationary pressures. However, Keynes felt that as an economy would only be growing as a result from spare capacity any inflation would be negligible, especially given the social costs of unemployment on a mass scale.
British post-war government was highly different to the one which had existed previously. In 1944 a White Paper on Employment Policy pledged itself to maintain full employment through maintaining effective demand, something that Michael Stewart argued graphically would not have happened without the Second World War, which “acted on the nation’s values and attitudes like a microwave oven on a piece of steak”.[1] This was as a result of people having become used to employment in wartime feeling that jobs should be guaranteed to all those who demanded it. Stewart also asserts that it was almost inevitable that there would be a change in economic viewpoint given that 1939 was the nineteenth consecutive year that unemployment had averaged ten percent or more. Later, in 1959 The Radcliffe Committee concluded following extensive research that the monetarist ideas on the money supply was wrong and that it would be more effective to use interest rates to control the economy. David Smith felt that it was highly important for future policy, setting “the tone for monetary policy in the 1960s”.[2]
However, the policy was taken further by politicians so much that David Smith who claimed that “Keynes would have been unlikely to do it himself”.[3] In the 1960s and 1970s chancellors became confident about their abilities to control the economy, using forecasts to estimate how the economy will perform and use policy instruments to anticipate them. However, as Stewart noticed, “it was the forecasting of effective demand that was difficult…with such items as exports and private investment being tricky”.[4] However, the overconfidence of these chancellors resulted in what became known as the ‘Stop-Go Cycle’, where the government would constantly make very minor alterations to the economy in order to create the desired results.
However, there were problems in the data. It was very difficult to get accurate data on aspects of the economy quickly. Some data, such as unemployment could be collected relatively quickly. However, the problem was that it could easily be revised over time so that it would actually go against what was previously expected and acted upon. On the other hand, other data such as inflation could take ages to be collected. As a result of this dilemma chancellors would be constantly toying with the economy with possibly inaccurate data. Michael Stewart highlights this by commenting that, “as government forecasters put it, it is almost as difficult to forecast the past as to forecast the future”.[5]
Not only were there uncertainties in forecasting but the strength of policies and the time that it would take for it to happen were unknown and it quite possibly could have varied. Part of this is due to peoples expectations of how the economic policies would affect them. For example, a household is likely to raise its expenditure in reaction to a tax cut if it was felt that the tax cut was a one off. However, a tax cut in order to deal with an oncoming recession could signal to a household to reduce its expenditure.
The Barber Boom of the early 1970s highlights the aforementioned difficulties. In order to deal with the slowing economy and rising unemployment the Conservative Chancellor Mr Barber employed a mildly expansionary fiscal policy in 1971, which was followed in 1972 by both a looser monetary and fiscal policy in order to stimulate aggregate demand even further. The problem was that the 1971 measures had not taken effect by the 1972 Budget. By early 1973 imports had increased rapidly and industry was overheating, with expenditure on industry increasing by twelve percent in real terms, with only an eight percent increase in output, creating heavy inflation.
Despite the concerns of the Stop Go Cycle there was not too much criticism of Keynesian demand management policies, after all Britain had experiencing some of the highest periods of economic stability ever, with strong growth, low unemployment and relatively low inflation. There was always a perceived inverse relationship that there was a trade-off between unemployment and inflation, with Keynesians pointing to the Philips Curve in order to show this. It was seen that inflation experienced between the forties and sixties was adequate, as it was considered to be considerably lower than the much higher growth experienced. However, in the early seventies this appeared to be breaking down. Inflation appeared to be increasing constantly and there were fears that it would end up spiralling out of control. This was leading to stagflation, where both unemployment and inflation would increase at the same time. By the 1970s demand management policies were seen not only as being ineffective, but also dangerous. Part of this could be due to an expansion in the money supply, as a result of attempts to modernise the banking system, with an increase in the money supply of more than sixty percent in two years.
This situation was worsened in 1973 by the OPEC oil crisis where the cost of a barrel of oil increased from $1.80 to £11.60 in a year, raising the cost of world oil by $70 billion a year. Unlike other countries which had operated restrictive policies in order to pull down inflation
The success of Keynesianism in the 1950s and 1960s resulted in economists who argued for Classical and Monetarist policies being shouted down for being out of date and ineffective. Neo-Classicalism was a rebirth of Classical economics, which slowly emerged from the 1950s onwards and eventually came to prominence in the 1970s. Friedman led this assault, coming up with the Quantity Theory Of Money in 1956 to help describe the relationship with the money supply and inflation and The Natural Rate Of Unemployment in 1967 which turned the Phillip’s curve on its head. It was asserted that at any point there is only one rate of employment and to be below it would be to create increasingly higher inflation because wage demands would spiral out of control out of uncertainty in the labour market.
This was quite a break with convention. Like Keynes work in the 1930s Friedman’s predictions were increasingly seen as a way to deal with something that had not occurred previously. Monetarism gained support among academics such as Harry Johnson who ran the LSE and helped to mould a generation of economists’ thinking.
In the 1970s there was nervousness by politicians. Governments toyed and abandoned income policies in attempts to deal with spiralling wages. David Smith described Callahan’s speech to the Labour Party Conference in 1976 as sounding “the death knell for post-war Keynesian policies and ushered in the new era of monetarism”.[6] The Monetarist IMF also became more involved in British economic policy as a result of a $3.9 billion loan in order to help stabilise the pound.
In the Conservative Party failure of the Barber Boom resulted in weaker support for more central policies, such as the ones exercised in the Heath Government. The result was an increase in right wing support, headed by the then leader Margaret Thatcher who set about putting across the case for Monetarism. The election on 1979 was excellent timing for the Conservatives. Callaghan had to convince the electorate to be re-elected in the middle of the Winter Of Discontent, a strike of public service workers, which resulted in press reports of rubbish filled streets and children unable to receive medical attention. Thatcher was able to compare on one hand how Callaghan’s government attempted monetary reforms but backed down, whilst the Conservatives were going to go all the way and deal effectively with the high levels of inflation, something which their manifesto claimed “has come near to destroying our political stability”. Thatcher was elected with the largest political swing since Clement Atlee’s Labour party in 1945 and encouraged the government to go ahead with their policies, with the inherited inflation of ten percent giving them the perfect excuse to experiment with Monetary ideas and give the death knell to Keynesianism.
Monetarism gained support in the 1970s as a result of new theories by people such as Friedman who gave a possible solution to high inflation. Whilst this was happening confidence in Keynesianism was rocked by hyperinflation brought on by politicians intervening too much in the economy and not exercising enough control over wages, coupled by the oil crisis. This dissatisfaction with current policies allowed for the emergence of a political shift to the right, with a fresh looking Thatcher led Conservative Party which introduced far reaching Monetary ideas.
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