Sunday, March 20, 2022
Lessons from the 1970s on when policy goes wrong
Posted by David Smith at 09:00 AM
Category: David Smith's other articles

My regular column is available to subscribers on www.thetimes.co.uk This is an excerpt. Not to be reproduced without permission.

It is the chancellor’s spring statement on Wednesday and, according to an authoritative report by my colleague Tim Shipman in this newspaper last week, Rishi Sunak has been preparing for it, in part, by studying the oil shocks of the 1970s, and being briefed by officials on them. That is no bad thing for, while the oil price has come down in recent days – though not much so far at the petrol pumps – it is always good to be prepared.

Neither the chancellor nor I suspect the officials who briefed him had been born at the time of the first oil shock in the 1970s, the decision by member of Opec (the Organisation of Petroleum Exporting Countries) to suspend oil exports to America in October 1973 and the subsequent quadrupling of the oil price.

But, while there are parallels between the threat of an energy supply and price from Russian oil and gas, the differences between the current situation and the 1970s are greater than the similarities. The old cliché about the 1960s was that if you remember them, you weren’t there. That was always a bit of an exaggeration, though that may be because the swinging sixties never made it West Bromwich.

If you lived through the 1970s, which through the prism of history looks like a grim parade of runaway inflation, strikes, the three-day week, IRA bombs and impossibly flared trousers, you will know that it was not as bad as that, and it was a Technicolor time of cultural awakening, particularly for music. There was also, though nobody used such a crass term as levelling up, a bit of unintended regional rebalancing.

London in the 1970s was on the ropes, crime-ridden, polluted and suffering population decline. Its subsequent revival was far from guaranteed.

The important thing about the first Opec oil shock is that inflation was already high when it happened. Retail price inflation, the measure of the time, rose to more than 10 per cent in 1971 and was around 9.5 per cent during 1973, in the months before the oil price shock. That pushed inflation up into the mid and upper teens during 1974. But the full extraordinary inflation peak, 26.9 per cent in August 1975, came well after the surge in oil prices.

That it did so was because the inflation of that period was the result of a cocktail of factors, and not just the oil price. The inflation of the very early 1970s was partly a follow-though from sterling’s November 1967 devaluation. The pre-Opec inflation in 1973 was a consequence of the Barber boom, after the then chancellor Anthony Barber, the economy in that year growing at its fastest rate in the post-war period, at least until last year pipped it. 1973’s growth was not, however, preceded by a pandemic slump in activity and the biggest drop in gross domestic product for a century.

The very high inflation of 1975, after the oil price shock, was due to what economists call second round effects. Wages and salaries grew by 29.4 per cent in 1975, according to a now discontinued official series. The wage-price spiral was alive and well and living in Britain.

In economic terms, perhaps the biggest impact of the inflation of the 1970s was that it brought about a fundamental change of policy. Monetarist economists such as David Laidler and Alan Walters made their names by predicting that the rapid money supply growth of the early 1970s would bring about very high inflation.

Those predictions, together with the Labour chancellor Denis Healey’s failed attempt to expand the economy out of recession caused by the oil shock, led directly to the monetarist revolution. James Callaghan, the Labour prime minister, buried post-war Keynesianism with his famous “you can’t spend you way out of recession” speech in 1976, written by his son-in-law and former Times economics editor Peter Jay.

When Labour was forced to turn to the IMF for a bailout that same year, the Washington-based Fund insisted on the adoption of targets for the money supply. These were willingly embraced, at least for a while, by the Thatcher government elected in 1979. The economic policy landscape was never quite the same again.

There are, as noted, more differences between now and the 1970s than similarities. There will be no wage-price spiral this time. Higher petrol prices, and even more gas prices, make us wince and will make life very uncomfortable for many people, starting next month. But the economy is less sensitive to changes in energy prices, and less critically dependent on energy for economic growth, than it was, because of the decline of heavy industry – and industry in general – and improved energy efficiency.

The energy ratio, or energy coefficient, measures how much more energy is needed to produce a 1% increase in GDP. In the 1970s it was roughly one to one; every 1% GDP rise required a 1% increase in energy consumption. Now it is a quarter of that, perhaps less. Even since 1990 the energy ratio has more than halved. The old rule of thumb, that an energy price shock guaranteed recession, no longer applies.

You should not, as somebody once said, let a crisis go to waste. In the 1970s, the crisis led to a fundamental rethink of economic policy. Fiscal fine-tuning could not work in an environment of much bigger economic changes.

The current crisis is bringing change too. Germany is revisiting her energy and defence policy and all countries are aiming to reduce dependence on Russian energy.

But, after a week in which both the Bank of England and the Federal Reserve have announced modest increases in interest rates, it is time to ask whether monetary fine-tuning works either.

In a couple of months, the Bank will mark 25 years of independence. The anniversary will occur with consumer price inflation not only above the 2 per cent official target but decisively so, by several percentage points, and at 8 per cent on its own projection.

For the first of 10 years after independence, inflation was extraordinarily well behaved. When inflation is more than 1 per cent away from the official target, the Bank governor has to write an open letter to the chancellor to explain why, and what the Bank is doing about it. For 10 years there were no such letters. Since 2007, by my calculation, there have been well over 20 such letters. Given that they have only to be written every three months that inflation is off beam, that is a lot of missed targets.

The inflation overshoot in coming months will be easily the biggest in the period of independence. Questions will be asked about the Bank’s credibility and whether peashooter increases in interest rates can be effective. The Bank would argue that it was caught in a trap and that, to head off the inflation that we are now seeing, not only would it have had to raise interest rates during the worst phase of the pandemic, but that it would have seriously hampered the economy’s post-Covid recovery.

It is legitimate to ask, however, whether the framework established a quarter of a century ago is still fit for purpose. As in the 1970s, it may be time for a rethink. That should not mean abandoning Bank independence. It does mean conceding that, when the economy is faced with a global inflationary shock, and the trade-off between growth and inflation has worsened, it is fantasy to think that the Bank’s monetary fine tuning can keep everything under control.