The Downing Street Years (120 page)

There was nothing secret about these facts. They were available to anyone who wanted to know them. But nothing is more obstinate than a fashionable consensus. Nor is it without influence on Cabinet committees. I had no support at the seminar at the end of September. Nor did my arguments budge Nigel and Geoffrey. There was no point in continuing the discussion. I said that I was not convinced that the balance of argument had shifted in favour of joining. I said that I would hold a further meeting to which other colleagues would be invited.

Before this took place I had a long list of questions drawn up about the implications of the ERM. I hoped that these would illuminate some of the points we would need to discuss. It would be more charitable than accurate to suggest that the answers provided by the Treasury did so. Yet the paper which Nigel presented at the meeting now seems strangely prophetic. He suggested that we had to convince people that inflation would continue to come down and stay down, adding that there was still a nagging fear that sooner or later we would succumb to the temptation of going for an easy inflationary option. He also suggested that after a period of some years sticking to the same policy, this now needed a shot in the arm, a touch of imagination and freshness to help the explanation and to ensure that our policies continued to carry conviction. Entry into the ERM was, of course, the answer. Since it was Nigel’s policy of shadowing the deutschmark — an informal version of ERM entry — that was to lead to inflation and undermine confidence, there now seems a certain irony in these assertions.

It has to be said that the wider meeting which I held to discuss the ERM on the morning of Wednesday 13 November did not advance us any further than the earlier meetings. We went over the same ground and at the end I repeated that I had not been convinced by the arguments I had heard. However, I agreed that we should strictly maintain the line we had taken so far, namely that Britain would join the ERM ‘when the time was right’.

The position was unsatisfactory. Most of the arguments which
persuaded me that we should not now enter the ERM applied to the principle — not just the circumstances — of entry. I knew that I was in a very small minority within the Cabinet on this matter, though most of my colleagues were probably not overinterested in it anyway. Geoffrey and Nigel, by contrast, were fervent. For Geoffrey membership of the ERM would be a demonstration of our European credentials. For Nigel it would provide stability in the turbulent and confusing world in which decisions about interest rates and monetary policy had to be made. And there is no doubt that those decisions could on occasion be extremely difficult.

It is worth noting at this point where the difficulty lay — and where it did not. Until 1987 when Nigel made the exchange rate the overriding objective of policy, there was no fundamental difference between us, although Nigel apparently now thinks I was ‘soft’ on interest rates. Anyone who recalls our decisions from 1979 to 1981 will find that implausible. It would also surprise anyone who considers that one of the main arguments advanced for joining the ERM, which Nigel so passionately wanted, was that it would lead to
lower
interest rates. And, as I shall show subsequently, there were occasions when I thought that
he
was soft on interest rates and wanted to raise them more quickly.
^*
The two of us were equally opposed to inflation. If anything, I was more concerned than he was. It was my constant refrain that much as I might admire his fiscal reforms, he had made no further progress in getting down the underlying inflation rate.

Nevertheless, Nigel and I did have rather different starting points when it came to these matters. I was always more sensitive to the political implications of interest rate rises — particularly their timing — than was Nigel. Prime Ministers have to be. I was also acutely conscious of what interest rate changes meant for those with mortgages. Although there are several times as many savers as borrowers from building societies, it is the borrowers whose prospects — even lives — can be shattered overnight by higher interest rates. My economic policy was also intended to be a social policy. It was a way to a property-owning democracy. And so the needs of home owners must never be forgotten. Other things being equal, on every ground
a low interest rate economy is far healthier than a high interest rate economy.

High real interest rates
^*
do ensure that there is a high real reward for saving. But they discourage risk-taking and self-improvement. In the long run, they are a force for stagnation rather than enterprise. For these reasons I was cautious about putting up interest rates unless it was necessary.

Another reason for caution was the difficulty of judging precisely what the monetary and fiscal position was. The MO figures were volatile from month to month. The other aggregates were worse. We were given figures which underrated economic growth and so caused us to exaggerate the likely size of the PSBR. In these circumstances, making the right judgement about when and whether to cut or raise interest rates was indeed difficult. So at the meetings I had with Nigel, the Bank and Treasury officials to decide on what must be done I would generally cross-examine those involved, give my own reaction and then — when I was sure all the factors had been considered — go along with what Nigel wanted. There were exceptions. But they were very few.

It was only from March 1987 — though I did not know it at the time — that Nigel began to follow a new policy, different from mine, different from that to which the Cabinet had agreed, and different from that to which the Government was publicly committed. Its origins lay in the ambitious policy of international exchange rate stabilization. In February Nigel and other Finance ministers agreed on intervention to stabilize the dollar against the deutschmark and the yen by the ‘Louvre Accord’ agreed in Paris. I received reports of the massive intervention this required which made me uneasy. And it was not clear how long this would last.

In July Nigel raised again with me the question of whether sterling
should join the ERM. He felt that the first year of a new Parliament would be the right time to join. Membership would give us as much exchange rate stability as it was possible to achieve and help business confidence. I was not unprepared for this and had earlier talked the subject through with Alan Walters and Brian Griffiths, the head of my Policy Unit who in an earlier incarnation had been Director of the Centre for Banking and International Finance at the City University. I said to Nigel that the Government had built up over the last eight years a well-founded reputation for prudence. By joining the ERM we would in effect be saying that we could not discipline ourselves and needed the restraint provided by Germany and the deutschmark. ERM membership would reduce the room for manoeuvre on interest rates which would, at times of pressure, be higher than they would be if we were outside. I had heard the arguments about external discipline before. I recalled that Ted Heath had claimed in the early 1970s that European Community membership would help discipline the trade unions. But this had not happened; and the attempt to use ERM membership to influence the expectations of management and workforces would be an equal failure. Overall, when things were going smoothly membership of the ERM would add nothing to our economic policy-making, and when things were going badly membership would make things worse. Nigel completely rejected this. He said he would want to discuss it all again with me in the autumn. I said that was much too soon: I would not wish to hold a further discussion on the subject until the New Year.

By now there was some evidence that the economy might be growing at a rate too strong to be sustainable. The monetary figures were ambiguous, but the PSBR looked as if it would turn out much lower than expected at the time of the budget. In August 1987 Nigel proposed a 1 per cent rise in interest rates on the grounds that this was required to defeat inflation by the next election. I accepted the proposal. That was the position when on ‘Black Monday’ (19 October 1987) there was a sharp fall in the Stock Market, precipitated by a fall in Wall Street. These developments were, in retrospect, no more than a market correction of overvalued stocks, made worse by ‘programmed selling’. But they raised the question of whether, far from overheating, we might now be facing a recession as people spent less and saved more in order to make up for the decline in the value of their shares.

I was in the United States when I learnt about the Stock Market collapse. I had flown from the Commonwealth Conference at Vancouver to Dallas, where I was to stay with Mark and the family. As it happens I dined that evening with some of America’s leading
businessmen and they put what had happened in perspective, saying that, contrary to some of the more alarmist reports, we were not about to see a meltdown of the world economy. Still, I thought it best to make assurance doubly sure, and I agreed to Nigel’s request for two successive half percentage point cuts in interest rates in response to help restore business confidence.

What I did not know was that Nigel was setting interest rates according to the exchange rate so as to keep the pound at or below DM3. It may be asked how he could have pursued this policy since March without it becoming clear to me. But the fact that sterling tracks the deutschmark (or the dollar) over a particular period does not necessarily mean that the pursuit of a particular exchange rate is determining policy. The same effect can have several causes. There are so many factors involved in making judgements about interest rates and intervention that it is almost impossible at any particular time to know which factor has been decisive for whoever is in day-today charge.

Of course, as the months pass and people look back at what has been happening questions begin to be asked. Nigel, who is nobody’s fool, must have recognized that this would happen. Indeed, he presumably intended it. Had all gone well, it would have been taken as proof that we could enter the ERM at about DM3 with no adverse consequences. He would have been able to overturn my veto on entry under circumstances in which it was almost impossible for me to reimpose it. To some extent, indeed, this is what happened, though he did not actually force us into the ERM. Once the financial markets have become convinced that a particular policy — in this case shadowing the deutschmark at a particular parity — is the central guarantee of financial stability, the effect of moving away from this approach is profoundly destabilizing. That is why, when I discovered what was happening, I found we had already forfeited some of our freedom of action.

Extraordinarily enough, I only learnt that Nigel had been shadowing the deutschmark when I was interviewed by journalists from the
Financial Times
on Friday 20 November 1987. They asked me why we were shadowing the deutschmark at 3 to the pound. I vigorously denied it. But there was no getting away from the fact that the chart they brought with them bore out what they said. The implications of this were, of course, very serious at several levels. First, Nigel had pursued a personal economic policy without reference to the rest of the Government. How could I possibly trust him again? Second, our heavy intervention in the exchange markets might well
have inflationary consequences. Third, perhaps I had allowed interest rates to be taken too low in order that Nigel’s undisclosed policy of keeping the pound below DM3 should continue.

I did not want to raise this matter with Nigel until I was absolutely sure of my ground. So I brought together as much information as I could about what had been happening to sterling and the extent of intervention. Then I tackled him. At our meeting on Tuesday 8 December I expressed very strong concern about the size of the intervention needed to hold sterling below DM3. Nigel argued that the intervention had been ‘sterilized’ by the usual market operations and that it would not lead to inflation. I understood sterilization to mean that the Bank sold treasury bills and gilts to ensure that the intervention funds did not affect short-term interest rates. But the large inflow of capital, even if sterilized in this sense, had its own effect, on the one hand in increasing monetary growth and on the other in putting additional downward pressure on market interest rates. This was an environment where Nigel superficially could justify lower base rates than domestic pressures warranted. As a result, inflation was stoked up.

In the early months of 1988 my relations with Nigel worsened. I sought to discourage too much exchange rate intervention, but without much success. It seemed to me contradictory to raise interest rates — as we did by half a percentage point in February — while at the same time intervening to hold down sterling. But, equally, I knew that once I exerted my authority to forbid intervention on this scale it would be at the cost of my already damaged working relationship with Nigel. He had boxed himself into a situation where his own standing as Chancellor would be weakened if the pound went above DM3. It was a convincing if unwelcome demonstration of the folly of regarding a particular exchange rate parity as the criterion for political and economic success.

By the beginning of March, however, I had no option. On 2 and 3 March 1988 over £1 billion of intervention took place. The Bank of England, which is traditionally all for a managed exchange rate, was deeply anxious about the policy. So, I knew, were senior Treasury officials, though of course they could not say so openly.

I had the matter out with Nigel at two meetings on Friday 4 March. I again complained about the level of exchange rate intervention. For his part, Nigel said it would be sterilized. But he did accept that intervention at the present rate could not continue indefinitely. I asked him to consult the Bank of England and report back later that day on whether the DM3 ‘cap’ should be removed and, if so, when. When
he returned he accepted that if on Monday there was still strong demand for sterling the rate should be allowed to go above DM3. He was keen to have some further intervention to break the speed at which the exchange rate might rise. I expressed my concern about this and said that my strong preference would be to allow time for the rate to find its own level without any intervention. But I was prepared to go along with some limited intervention if necessary. The pound accordingly rose through the DM3 limit.