Winner of the New Statesman SPERI Prize in Political Economy 2016

Friday 27 January 2017

The UK’s 1976 IMF crisis in the light of modern theory

During the arguments over austerity, its supporters would often point to 1976 as evidence that it was possible for a country with its own currency to have a debt funding crisis. At the time this was frustrating for me, because I had been a very junior economist in the Treasury at the time, and my dim recollection was of an exchange rate crisis rather than a debt funding crisis. But I could not trust my memory and did not have time to do much research myself.

So with the publication of a new book by Richard Roberts on this exact subject (many thanks to Diane Coyle, whose FT review of the book is here), I thought it was time to revisit that episode combining Robert's comprehensive account with our current understanding of macroeconomic theory. I think any macroeconomist would find what happened in 1976 puzzling until they realised that senior policymakers did not have two key pieces of modern knowledge: the centrality of the Phillips curve, and an understanding of how the foreign exchange market works.

In terms of where the economy was, there is one crucial difference between 1976 and 2010. In the previous year of 1975 CPI inflation had reached a postwar peak of 24.2%. Although that peak owed a lot to a disastrous agreement with the unions, it probably also had a lot to do with the ‘Barber boom’ which had led to output being 6.5% above the level at which inflation would be stable in 1973 (using the OBR’s measure of the output gap). Although this output gap had disappeared by 1975 and 1976, inflation was still 16.5%. Given the lack of any kind of credible inflation target a period of negative output gaps would almost certainly be required to reduce inflation to reasonable levels.

The lack of understanding by senior policymakers of how the foreign exchange market worked was due to floating exchange rates being a novelty, Bretton Woods having broken down only 5 years earlier. We had a policy of ‘managed floating’, where policymakers thought the Bank of England could intervene in the FOREX markets to ‘smooth’ the trajectory of the exchange rate. My job at the time - forecasting the world economy - was a long way from where the action was, but my main recollection of the time comes from one of the periodic meetings of all the Treasury’s economists. It seemed as if the Treasury’s senior economists believed in the ‘cliff model’ of the exchange rate. The cliff theory suggests that if the rate moves significantly away from the target that the Bank was aiming at, it would collapse with no lower bound in sight. At the meeting I remember some more junior economists (but more senior than I) trying to explain ideas about fundamentals and Uncovered Interest Parity, but their seniors seemed unconvinced.

It is much easier to understand the 1976 crisis if you see it as a classic attempt to peg the currency when the markets wanted to depreciate it, and this is the main story Roberts tells.. The immediate need of the IMF money was to be able to repay a credit from the G10 central banks that had been used to support sterling. It is also true that sales of government debt had been weak, but Roberts describes this as stemming from a (correct) belief that rates on new debt were about to rise - a classic buyers strike. Although nominal interest rates at the time were at a record high, they were still at a similar level to inflation, implying real rates of around zero.

Here we get to the heart of the difference between 2010 and 1976. If there had been a strike of gilt buyers in 2010, the Bank of England would have simply increased its purchases of government debt through the QE programme, the whole aim of which was to keep long rates low. They could do this because inflation was low and showed no sign of rising. Contrast this with 1976, with inflation in double figures but real rates were near zero.

I think what would strike a macroeconomist even more about this period was the absence of the Phillips curve from the way policymakers thought. Take this extract from the famous Callaghan speech to the party conference that Peter Jay helped draft.
“We used to think that you could spend your way out of a recession and increase employment by cutting taxes and boosting government spending. I tell you with all candour that that option no longer exists, and so far as it ever did exist, it only worked on each occasion since the war by injecting a bigger dose of inflation into the economy, followed by a higher level of unemployment as the next step”

As a piece of text it only makes sense to modern ears if there is a missing sentence: that we failed to raise taxes and cut spending in a boom. Far from a denunciation of Keynesian countercyclical fiscal policy, it was an admission that politicians could not be trusted with operating such a policy, essentially because they imagined they could beat the Phillips curve using direct controls on prices and incomes. The fact that fiscal rather than (government controlled) interest rate policy was being used as the countercyclical instrument here was incidental.

Reading this book also confirmed to me how misleading the Friedman (1977) story of the Great Inflation was, at least applied to the UK. These were not policymakers trying the exploit a permanent inflation output trade-off, but policymakers trying to escape the discipline of any kind of Phillips curve. They were also policymakers who had not fully adjusted to a floating rate world, and the IMF crisis was superficially a failed attempt to manage the exchange rate. More fundamentally It was also a reaction by the markets to a government that was not doing enough to bring down an inflation rate that was way too high. The IMF loan was useful both as a means of paying back existing foreign currency loans, but also a means of getting fiscal policy and therefore demand to the level required to reduce inflation.

Although inflation fell steadily until 1979, another boom in 1978 together with rising oil prices reversed this, and through the winterof discontent helped elect Margaret Thatcher. Unfortunately the IMF crisis and the 1970s more generally is another example of the consequences of politicians, in this case particularly those on the left, not accepting basic lessons from economics.            


  1. To be fair to Friedman and other economists during that period, macroeconomic policy almost everywhere was very opaque during the 1970s, both in terms of strategy and tactics. I think that many economists assumed (and assumed) that policymakers were following some sort of textbook model.

    Edward Nelson's historical work is very good on that period: policymakers had a cost-push view of inflation, which combined with badly estimated output gaps to produce the Great Inflation. Popular journalism about greedy unions and wicked Arabs was much closer to policymakers' views than any Phillips Curve.

    Also, to be fair to the Labour party, the cost-push view was hardly a fallacy that was unique to the left in Britain. A lot of what Edward Heath did at both a macro and a micro level can only be understood if you realise that he thought that stagflation was produced by micro inefficiencies.

    There was a big missed opportunity in 1974-1979, because Labour could have used their connections with the unions to have an incomes policy and combined this with a slow but steady reduction of inflation to a low level. Unfortunately, as Friedman commented, Labour (like Nixon and Burns) used incomes policy as a substitute for the cure, rather than a palliative accompaniment to the cure.

    1. Surely Callaghan's government did make a concerted effort to: 'use(d) their connections with the unions to have an incomes policy and (to combine)this with a slow but steady reduction of inflation to a low level, and succeeded up to a point, until the Winter of Discontent.

      Prices controls are clearly distortionary and unsustainable. Whether that conclusion applies also to incomes policy, is less certain: compression of differentials and the deployment of potential bargaining power will tend to manifest itself sooner or later, but in the short term I would suggest that the Callaghan government's income polices helped to reduce both unemployment and inflation. The issue hinges on whether an event like the Winter of Discontent was inevitable or could have been avoided with better polictical management, particularly by the then TUC General Council and its individual members.

      Incomes Policy is still being applied in a partial form: check the multi-year 1% cap on public sector pay that has been sustained for over half-a-decade now.

  2. "in this case particularly those on the left, not accepting basic lessons from economics."

    What would that basic lesson be?
    Ah, yes, moderate inflation is much more important problem then unemployment.

    So is that way of looking at economics a basic lesson that you yourself have learned?

    Or, did you mean that those who's voice and vote is more important and as such makes them more valuable persons are rich ones and those with savings. Those with savings are sure to find moderate inflation a big problem, while those with debt find it very beneficial.
    So, 'left should learn that they should pander to wealthy instead of poor in order to stay in power no matter economic consequences'.

    Isn't it exactly such thinking that made Blair and Brown PMs but also caused Corbyn and Trump as a reaction to such betrayal?

    1. "What would that basic lesson be?
      Ah, yes, moderate inflation is much more important problem then unemployment."
      Moderate inflation is important precisely because it allows a monetary sovereign country like the UK to buy its own debt if ever the market does not trust the government anymore. In my opinion, what Simon Wren Lewis means is that governments back then did not reduce enough public spending in times of high inflationary pressures. High inflation means also that public polcies back then were not effective enough in boosting the productive capacity of the economy.

      Today you could probably say that the policy makers attache more importance to price stability than unemployment, because we have very low rates of inflation and we could afford more. But back then it was not the case, inflation was excessive and prevents you from using your power to issue money when get into troubles... The uncertainty about future inflation rates which comes with excessive inflation is good for nobody.

  3. I think your analysis of the political dimension overlooks another key point. In the 1970s the $:£ exchange rate was a number of national prestige. It was the lead story on the evening news, as were the trade balance and the BoE foreign currency reserves. No government wanted to be seen to be devaluing. The previous Labour government arguably lost the 1970 election because of the 1967 devaluation so didn't want a repeat. So it wasn't just about cliff-edge prevention, or a failure to understand floating exchange rates and macroeconomics; it was about real-politik. But in the end even real-politik cannot buck the market. It is perhaps not coincidental that James Callaghan was a central figure in both crises, and that his experience of the first influenced his attitude to the second.

    For this reason the IMF crisis of 1976 has more similarities with Black Wednesday in 1992. Both involved a government trying to peg the exchange rate and using foreign currency to do it. The difference was in 1976 we ran out of foreign currency.

  4. The UK had to buy back fortunes of strling that had been used for international liquidity, and Luxembourg did not have that problem. All economies in Western Europe had a 1930s trauma till 1939+40=1979. Thatcher&Volcker-policy would simply not stand a chance. One only can blame politicians for recognising society; even a dictator would have to do so. In a hypocracy we remain polite, so historians do not get a salary for a sinecure; that is the outrage. You are most kind to them to clear out a puzzle, but there stiil is a job for them.

  5. Simon: "These were not policymakers trying the exploit a permanent inflation output trade-off, but policymakers trying to escape the discipline of any kind of Phillips curve."

    I think this needs expanding a bit. IIRC (I was a mostly philosophy undergrad in 1976) cost-push or conflicting claims theories of inflation ("inflation before 'full-employment' has nothing to do with Aggregate Demand") had been very influential earlier in the 1970's, and more so in the UK than in the US. But by 1976 the Phelps volume and Friedman's paper were already 7 years old, so you would have thought that an expectations-augmented Phillips Curve would have at least been understood by the Bank of England. Laidler and Parkin's Inflation Survey paper was published in 1975 (I think the same year they left the UK for Canada) so the BoE can't have been ignorant of Phillips Curve ideas, could it? Or maybe I'm just forgetting how long it took for those terribly unorthodox "monetarist" ideas to take root in the UK.

    1. It took a much long time for policymakers in the UK to understand the difference between nominal and real interest rates. And insofar as there was discussion of monetarism in the BoE, it was more along the lines of using £M3 (or maybe M1) as as indicator, as well as a lodestar for... Fiscal policy!

  6. The 1976 IMF debacle in the UK was a defining moment when the promotion of full employment ended. Fundamentally though it was a political mistake by people who didn't understand that floating the UK pound fundamentally changed how it behaved.

    What happened was the government was terrified about a 'run on the pound' and wanted to keep an exchange rate of $2 to the £. The panic set in with it got to $1.80. Of course since then the £ has been down to near parity with the dollar at one point and the world didn't end.

    It's important to remember that throughout the Bretton Woods era the UK had made frequent use of the IMF facilities to keep the pound in it range. And that is what the UK government wanted to do in 1975 and 1976 using the same old fashioned techniques. But to do that you have to have sufficient foreign exchange reserves. Providing those is what the IMF did throughout Bretton Woods, and did again in 1976.

    The difference was the size of the loan - the biggest ever at that point - and the fact that previous drawings had been cleared by that time. Politically it was a huge win for the opponents of the Labour approach to government.

    What is amusing is that using fixed exchange rate thinking with floating rate currency areas is still the problem today.


    The government of the United Kingdom hereby requests of the International Monetary Fund a stand-by arrangement under which for a period of two years the Government of the United Kingdom will have the right to purchase from the Fund currencies of other members in exchange for sterling up to an amount equivalent to SDR 3,360 million. Before making purchases under the stand-by arrangement, the Government will consult with the Managing Director on the particular currencies to be purchased from the Fund.
    2. The purpose of this request is to support the policies that have been adopted by the Government of the United Kingdom to strengthen the balance of payments and create the conditions in which it will be possible to get both unemployment and domestic inflation down from the present unacceptable levels and keep them down. The standy-by arrangement will also help to repay external debt now falling due and assist in maintaining orderly conditions in the exchange market for sterling. ...

  7. Are you really sure macro-economists understand how the foreign exchange market works? I wouldn't boast too loudly about that to people who actually work in the currency markets and understand something about how it actually works.

    I am also not convinced about the 'centrality of the Philips curve', if such a thing even exists. Such devices are artificial constructs that exist purely for mathematical tractability. They distract us from understanding an economy, not help us.

    Again it is another matter of putting Model away and looking at actually what happened/s. We have some fantastic documentary evidence. This gives all sorts of insights into agent's behaviour, including the formation of expectations. You also need the big picture: often turmoil like this happens because of animal spirits, but underlying it were trends that were structural and long term: the effects of the end of the post WWII recovery and a rebalancing of economic power relations in the context of Britain's relative and absolute deindustrialisation and diminished relative status in the world economy. Eventually this would be felt as fragility in the currency markets.


    1. No empirical theory fits the available data. Check out John Harvey's work. We need to ban bank lending for currency settlement.

    2. Basically, the problem has always been treating speculation and settling trade invoices as the same - because of the neoliberal belief that trade flows prevail. When in actual fact speculative flows prevail unless you regulate them out of existence.

    3. Anonymous:
      "the neoliberal belief that trade flows prevail. When in actual fact speculative flows prevail unless you regulate them out of existence."

      Correct. Some speculation is extremely harmful, such as speculation in land, which is fixed and elastic. Eliminate land speculation (which caused the 2008 crash) and we fix a firm base. This is where Land Valuation Tax come in, as an economic stabiliser.

  8. Bill Mitchell has covered this in great depth in his books

    The British Cabinet divides over the IMF negotiations in 1976

  9. Simon's last sentence concludes that: 'Unfortunately the IMF crisis and the 1970s more generally is another example of the consequences of politicians, in this case particularly those on the left, not accepting basic lessons from economics'

    As usual truth is relative, but does the evidence and facts support this assertion? It made me to scurry to consult the books I have on the macro-economic management of the period (no doubt, selective), as well as the handbook of economic and housing statistics I produced in 1991 covering that decade (based largely on official statistics).

    Certainly the decision taken by the new Labour government in March 1974 to honour the previous Heath Government's agreements to automatically link pay increases to the cost of living, institutionalised accelerating inflation and so contributed to the 1975 inflation peak of c.27%. But given an impending election later in 1974, it was politically very difficult to do otherwise; but fair enough, more political courage and imagination needed to be shown.

    But subsequent Stage 1 and 2 Incomes Policies contributed to the combination of steady annual growth achieved in the 2.5% to 3% range combined with inflation falling to 8% in 1978 (albeit claimant unemployment remained stable above one million). Not a mean achievement, surely, particularly as macro-economic policy was also linked to social policy and redistributional objectives? True, the IMF loan that stabilised sterling along with an improved global economic environment were as if not more important drivers, but the overall policy mix was hardly economically illiterate. I would respectively suggest to Simon that he gives Denis Healey his due; I for one can't spot anyone approaching his calibre at both an economic and political level anywhere in the current forlorn political scene, or was, Simon, thinking of Tony Benn and the left wing internal opposition to the Callaghan/Healey social democratic government of the time?

  10. Perhaps the solution is direct management of the price level path
    As suggested back then by Lerner and Weintraub among many others


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