Download Appendix to Chapter 4: The Economy of Great Britain (Fall 2006)

1
Chapter 5: The Economy of the United Kingdom
(Revised 2009)
1. Introduction
In contrasting the liberal market capitalist economy and the social market capitalist economy,
the economy of Great Britain is especially relevant. Great Britain was a social market capitalist
economy until 1979. Then, Margaret Thatcher changed it into a liberal market capitalist economy
in a matter of eleven years.
Great Britain has a parliamentary system of government. There have been three main political
parties, of which only two have held a majority since World War II. On the political left is the
Labour Party. As its name implies, it sides with working class interests. It has been very
closely allied with the trade unions. The current leader of the Labour Party is Gordon Brown,
also the current prime minister. The prime minister is the head of government. On the political
right is the Conservative or Tory Party. It is closely allied with business interests. The current
leader of the Conservative Party is David Cameron. In addition, there is a Liberal-Democratic
Party (a merger of what were formerly the Liberal Party and the Social Democratic Party).
This is a center-left party that now receives about 20% of the vote. The current leader of the
Liberal-Democratic Party is Nick Clegg.
In 1945, in a surprise, the British people voted out the Conservative Prime Minister and war
hero Winston Churchill and voted in a Labour government under Clement Attlee. This began the
British move to a social market capitalist economy. Over the decades of the 1950s, 1960s, and
1970s, Britain was a classic social market capitalist economy – despite several shifts from a
Labour government to a Conservative government and back again. First, Britain went farther
with nationalization (government ownership) than many of the other countries of Europe. The
Bank of England, the nation’s central bank and then a private company, was nationalized. The
public utilities (electricity, natural gas, and telephone companies) were all nationalized. The
government also came to own the coal companies (then the main heating fuel), the railroads,
British Airways (the national airline), the steel companies, shipbuilding companies, and aerospace
companies. The government even came to own automobile maker Jaguar and part of Rolls Royce.
There were other nationalized companies as well. Nationalization of the “commanding heights”
was a major aspect of the program of the Labour Party; indeed until 1994, it was built into the
Constitution of the Labour Party. Second, Britain also adopted a form of guidance planning.
Their planning was very similar to the French system as described in Chapter 4. Guidance
planning ended in the 1970s. Third, Britain had strong trade unions. Unlike much of Western
Europe, British collective bargaining was not centralized. Britain has a union confederation called
the Trade Union Congress (TUC) that is closely allied with the Labour Party. But the TUC does
not do the collective bargaining. This is handled by the individual trade unions, as is done in the
United States. As mentioned in Chapter 4, the relationship between the business owners and the
trade unions in Britain was very adversarial. Britain once had a rigid class system, with neither
social class trusting the other. As a result, Britain was often plagued with long and bitter strikes.
While Britain did not have significant employee participation, as found in other countries of
Europe, it did have strong employment security rules. Fourth, Britain had a very significant
welfare state. The British National Health Services was described in Chapter 4. Britain had most
of the other welfare state programs mentioned in Chapter 4. Some of these will be described
below. Government spending was over 40% of GDP, as in all European countries. Taxes were
high and progressive. The top income tax rate was 83%. The British welfare state served to
redistribute income from the richer people to the poorer people. As a result, Britain had greater
equality than that found in the United States.
The British economic performance during the 1960s and 1970s was below the standards
of the United States and the rest of Western Europe. The average growth rates of GDP and of
2
income were lower than that of the United States, Japan, or any of the leading countries of
Western Europe. Productivity (production per hour worked) was lower in Britain than in any of
these countries. As a result, income per person in Britain was lower than in any of these countries.
There were government budget deficits (called the public sector borrowing requirement) that
equaled a very high 8% to 10% of GDP for much of the 1970s. In 1967 and again in 1976, Britain
faced financial crises that forced the government to depreciate the British pound. Britain used to
be called “the sick man of Europe”.
In 1979, Britain made a major shift in policy. It elected the Conservative Party under the
leadership of Margaret Thatcher. As we will see, Thatcher made a very strong effort to reform
Britain along the lines of a liberal market capitalist economy. (The United States began to make
the same shift a year later when it elected Ronald Reagan as President.) Margaret Thatcher
stayed as Prime Minister until 1990. But her Conservative Party maintained the majority in
Parliament until 1997. Her successor, John Major, followed most of her policies. So the
Conservative Party dominated British politics for 18 consecutive years – a significant opportunity
to remake Britain according to the model of the liberal market capitalist economy. We discuss
and evaluate their reforms in some detail in Part 2 of this chapter.
After losing so many elections in a row, Tony Blair became the leader of the Labour Party in
1994. Along with others, he set out to remake the Labour Party. Those that supported the policies
of the 1950s, 1960s, and 1970s (described above) he labeled as “Old Labour”. He set out to create
a “New Labour” or as he called it a “Third Way”. The term “Third Way” implies that he would
accept some of the ideas of the liberal market capitalist economy and some of the ideas of the
social market capitalist economy. However, in his view, Britain would not be a full liberal market
capitalist economy such as the United States. And Britain would not be a full social market
capitalist economy such as Sweden. Blair was elected prime minister in 1997. He stepped down
in 2007 and was succeeded by Gordon Brown. The Labour Party has been the party of
government for 12 years now. No election is mandatory until 2010. We discuss and evaluate New
Labour (the “Third Way”) in Part 3 of this chapter.
The long period of control of government by one party makes Britain an interesting study of
economic systems. From a strong social market capitalist economy, the Conservative Party had
18 years to change Britain to a liberal market capitalist economy. This is a significant transition.
Then for another 12 years (and counting), the Labour Party has had the chance to change Britain
once again. What was attempted and how well it succeeded tells us much about the strengths and
weaknesses of the various approaches to capitalism.
2. The Thatcher (Conservative) Reforms: 1979 to 1997
A. Privatization
As was stated above, upon election in 1979, Margaret Thatcher set out to remake Britain
according to the ideas of the liberal market capitalist economy. The first of her reforms that we
will discuss is privatization. “Privatization” means the sale of assets owned by the government
to private interests (the reverse of nationalization). Mrs. Thatcher’s purposes, as her
government stated them, were first to reduce the involvement of the government in the economy.
Second, she saw privatization as a way to improve overall efficiency as she believed that
privately owned companies would be more efficient than government owned companies. Third,
she saw privatization as a way to reduce government spending and the budget deficits. This
would occur because many of the government-owned companies lost money and needed to be
subsidized by the government budget. Fourth, she saw privatization as a way to weaken the
3
power of the trade unions (see below). She believed that trade unions would have less power if
they had to bargain with privately-owned companies than they did in bargaining with the
government. Fifth, she saw privatization as a way to spread the ownership of shares among more
people. In 1979, only 3 million British people (5% of the population) owned any shares either
directly or through mutual funds. (By 1990, some 11 million people (about 20%) owned shares.
But that declined to 9.5 million in 1996.)
Privatization in Britain began slowly but then became quite significant from the mid-1980s to
the mid-1990s. It occurred in two stages. In the first stage, the companies that were privatized
were those that had been in competition with private sector companies when they had been
nationalized. So the first privatization was the sale of part of the government shares in British
Petroleum (BP), reducing the government’s ownership below 50%. (More of the government
shares of BP were sold later.) British Aerospace (manufacturer of airplanes) was sold in 1981. In
the second phase, the public utilities were privatized – first Britoil and British Ports, in 1983,
then British Telecom in 1984, then British Gas, and finally the electricity and water companies.
British Telecom (the government telephone monopoly) attracted 2.3 million shareholders. In
1979, when Mrs. Thatcher began, the government produced some 12% of Britain’s economic
activity. By 1997, when New Labour came to power, this share had been reduced to 2%.
The most common technique of privatization was the Initial Public Offering (IPO).
Underwriters were hired to determine the value of a government enterprise. They then offered the
shares for sale to the public. The price had to be adjusted to assure that the enterprise would be
completely sold. In order to have widespread participation, small shareholders were given
preferential prices. The prices at which the shares were offered were quite low. In some
cases, the prices rose as much as 40% on the day the stock was sold (the average price rise
was 20%). So someone who bought shares of these companies often made a substantial gain in
one day. While perhaps 10 million individuals bought shares, most of the shares were purchased
by financial institutions and foreigners. In other cases, there was a negotiated sale. A
government owned company would be sold to one buyer for a negotiated price. So, for example,
the car company British Rover was sold to British Aerospace (who later sold Rover to BMW),
Jaguar was sold to Ford, and the automobile part of Rolls Royce was sold to BMW. Finally, in a
few cases, the government owned company was sold to its management and workers. The
best known of these was the National Freight Corporation, a road transportation company. This
company, as government owned, had been making consistent losses. According to the books, the
assets of the company were worth 93 million pounds. The company was sold to the workers and
management for 53 million pounds. Of this, 46 million pounds was set aside for the pensions of
the workers. This company is best known because it did so well. In just a few years, its profits
soared. After seven years, the company was sold to the public for 890 million pounds. Each
employee who had contributed 600 pounds (approximately $300), now had a share worth 60,000
pounds (approximately $30,000).
The results of privatization are very hard to measure. First, in many cases, productivity
improved, as in the case of the National Freight Corporation. Productivity in electricity also
increased, mainly due to the shift from coal to natural gas. But in other cases, the results were not
as good. So, for example, Railtrack (the private company that owned the track on which the
railroads operated) had to declare bankruptcy in 2001. In the most exhaustive study of British
privatization yet, Italian economist Massimo Florio concluded in 2004 that “I have been unable to
find sufficient evidence that … productivity in the United Kingdom increased substantially as a
consequence of ownership change at privatization compared to the long-term trend.” Second, in
some cases, private monopolies replaced the government monopolies. Private monopolies can
be more damaging to consumers than the government monopolies because private monopolies
can increase their profits by raising prices. Unusually high returns to shareholders continued to
exist in these companies for a long period – higher than for most other British companies. Third,
in most cases after a company was privatized, employment fell. In some of these cases,
4
employment fell dramatically. But this is misleading in interpreting the effects of privatization.
Most of the jobs lost in these companies came before the privatization, while the companies were
still government owned. But this evidence does indicate that, as government-owned companies,
these companies were over-staffed. Fourth, in most cases, after privatization the wages of
workers stayed at the same relative level. This means that if a worker had a wage 10% above
the average wage before privatization, that worker maintained a wage 10% above the average
wage after privatization. Workers do not seem to have suffered in pay because of privatization.
However, there was greater job insecurity. Fifth, in most cases after a company was privatized,
the pay for the top executives rose considerably (although the pay of the top executives
remained below the average pay of top executives in private companies). This was especially true
for the companies that had been public utilities (such as electricity, gas, and British Telecom).
Finally, although there were some cases on private monopoly, as noted above, in other cases,
privatization and de-regulation did stimulate competition where none had existed before.
As one example, this competition is the reason that, in every country of Western Europe, there are
more cell phones per capita than in the United States. In conclusion, Massimo Florio’s study
found, surprisingly, that the overall welfare benefits (at least the ones that could be
measured) of British privatization were very low. Most of the benefits went to the new
shareholders and to consumers as lower prices, mostly for telecommunications. And he found that
most of the benefits from privatization went to the richest 20% of the British population while
most of the costs were paid by the poorest 20% of the British population.
While discussing privatization, we need to mention the sale of public housing. Large
numbers of lower-income British people (some 35% of the entire population) had lived in
government owned housing, called council houses, at subsidized rents. Councils, in Britain, are
local government agencies. In the 1980s, these council houses were sold to the tenants at
discounted prices. Those who had lived in the house for 2 years received a discount of 20% off
the market price. Those who had lived in the house for 20 years received a discount of 50% off
the market price (later raised to 80%). Between 1971 and 1991, the proportion of homeowners
in Britain rose from 50% to 68% (about the same percent as is found in the United States).
Over one million council houses had been sold by 1990. Yet about a fifth of the British
population still lives in subsidized rented housing.
B. Changes in the Welfare State
As one can imagine, the Conservatives, upon coming into power, set out to significantly
change the welfare state and to shrink the size of government. One major aspect of their welfare
state reform was that, for some programs, the provision of the service was contracted out to
private commercial companies rather than provided by government agencies. For example,
by 1998, some 88% of residential care for elderly people was provided by private companies, up
from 40% in 1980. And almost half of home-help care for elderly people was done by private
companies, up from practically none. The private providers were forced to compete for the
government contracts. It was hoped that this competition would improve efficiency and quality.
Similarly, there was some privatization involved with the National Health Service (described in
Chapter 4). Private health insurance was introduced, similar to the kind that would be found
in the United States. By the early 1990s, perhaps 10% of the British population chose to be
covered by private health insurance. Private acute hospitals and nursing homes, some owned by
American companies such as AMI and Humana, were introduced, although they are still
relatively small compared to the government-owned hospitals. Many doctors shifted some of their
business into private practice. By the early 1990s, about one-third of general practitioners’
income was coming from private practice. Yet the Conservatives did not change the essence of
5
the National Health Service. Health care provision in Britain is still very different from that of
the United States.
The largest Welfare State program involves social security. Compared to the other countries
of Europe, Britain is a low spender on social security. Only Spain, Portugal, Ireland, and Greece
spend less as a percent of GDP. Under Thatcher, Britain became the only large, industrial
country to shift from a public, pay-as-you-go, earning related pension system to a partially
privatized system. As of 1978, the State Earnings Related Pension System (SERPS) had gone
into effect. It set up second-tier pensions to replace about 25% of a worker’s wage earned in the
best 20 years of work. (In addition, there is a Basic State Pension that replaced about 16% of the
worker’s pre-retirement wages – bringing the total replacement up to about the same 41% as is
found in the United States.) This low replacement ratio indicates that the pension was designed
to supplement other private pension savings, not to be the sole source of income. The Social
Security Act of 1986 (implemented in 1988) offered workers significant financial incentives to
opt out of SERPS altogether and set-up personal retirement savings accounts (called
Appropriate Personal Pensions or APPs). The financial incentive was that the government
contributed 2% to one’s pension if one used the APP. A portion of the payroll tax that had gone to
SERPS could now be sent to a personal account with a provider of one’s choice. (This change
should look familiar. It is similar to the 2003 proposed reform of social security in the United
States by President George W. Bush. President Bush’s proposed reform was never enacted.) In
addition, this Act reduced the replacement ratio of SERPS from 25% to 20% and based the
pension on lifetime earnings, not just the best 20 years.
From the vantage point of 2009, a few conclusions about the pension reforms in Britain can be
derived. First, the APPs were at first very popular, especially among young people and more
affluent people. Later, the number of people who chose the APPs over the traditional system
leveled out at about 20%. (There was a scandal in the 1990s involving selling 1.5 million people
APPs that were inappropriate for them. Due to misrepresentation by people selling the APPs,
many pensioners suffered significant losses. This reduced the popularity of the APPs.) Second,
the private pensions earned a very significant rate of return – estimated at a real (adjusted for
inflation) rate of return of 8.7% from 1986 to 1995 (a period in which the stock market was
increasing rapidly). However, the APPs have a complex set of fees, reducing the return to the
worker. (They have obviously done less well since 2007 when the stock market has been
declining.) Third, the poor are much more dependent on government-provided pensions
than are the rich. In Britain, among the elderly, 15% of the income of the richest 10% of the
population is derived from public pensions in contrast to the 85% of income of the poorest 10%
of the population. (The figures for the United States are 19% and 70%.) Fourth, the
administrative costs associated with personal pensions (APPs) tend to be high. Estimates are
that administrative costs for the average worker are about 1.5% to 2.5% of the value of the
account. This is double to triple the administrative costs for SERPS. (The same has been
estimated for the United States. Social Security is much cheaper to administer than the Personal
Savings Accounts advocated by President Bush.) In 1997, the Conservative Party proposed a full
privatization of the pension system. They lost the election. The Labour Party has not proposed
full privatization. But it also has placed greater emphasis on the private sector and has not
rescinded the Thatcher reforms.
Another aspect of the Welfare State that the Conservatives tried to change was
unemployment benefits. The change here involved a shift away from simply providing
financial benefits to the unemployed to increasing work incentives. The old system had been
based on the assumption that, at certain times, jobs were simply not available. People had to be
supported until the jobs came back. The new system is based on the assumption that jobs are
available but that the unemployed are not making a concerted effort to find them. In the new
6
system, the replacement ratio for unemployment benefits was reduced (meaning that
unemployment benefits replaced a smaller percent of pre-unemployment wages). Benefits were
eliminated for 16 and 17 year olds altogether. Benefits came to have a lower value relative to
wages than they did before. This was to provide an incentive to find work. In addition, the
Restart Program (1986) required all unemployed people to be interviewed about their job
search every six months. The unemployed were required to generate evidence of their job search
into order to continue collecting benefits.
C. Changes in the Size of Government
Given these and other changes to the Welfare State, you might guess that a goal of the
Conservatives was to shrink the size of government in Britain. And indeed it was. When
Margaret Thatcher took power in 1979, government spending as a percent of GDP had been
growing in Britain – from 32% in 1970 to about 40% of GDP. In the early years of Mrs.
Thatcher’s first term, government spending as a percent of GDP kept increasing, reaching 42.5%
by 1984. But then, the government made a major attempt to reduce its spending. By 1990,
government expenditures as a percent of GDP had declined to 36% (only slightly higher than
would be found in the United States). But then, under John Major, government spending as a
percent of GDP rose once again, reaching about 40%. So taking the entire period of
Conservative rule as a whole, the Conservatives were not successful in reducing the size of
government in relation to the economy.
The British government keeps separate budgets for government investment spending (buying
of new capital goods). In the United States, government investment spending and government
consumption are lumped together. In Britain, government investment spending as a percent of
GDP fell dramatically – from 2.5% in 1980 to about 1% by 1997. A big part of this decline in
due to decreases in spending on public works programs. So public works (government
infrastructure) took the brunt of the cuts in government spending.
Consistent with what had happened to government spending, the burden of taxation changed
very little under the Conservative government. In 1980, taxes in total took 39.6% of the GDP.
By 1997, that had dropped only to 37.8%. (The personal income tax took 11% of the GDP in
1980 and 10% in 1997, again not much of a change.) But what is as important is that the
progressivity of the income tax was decreased (as was also done in the United States). There
were 11 tax brackets in 1979. By 1997, there were only three. The tax rate in the highest tax
bracket in 1979 was 83%. This was lowered first to 60% and then to 40%. The tax rate in the
lowest tax bracket was reduced from 30% to 20%. For the vast majority of taxpayers, the percent
of their income paid in income tax fell from 33% to 30%. (It fell much more, of course, for the
richest taxpayers.) This decline was offset by the rise in the Value-Added Tax (VAT), a form
of sales tax, from 8% in the 1970s to 17.5% by 1995. The other major tax is the social security
tax. In 1979, of the 20.5% of worker’s income paid as social security tax, 13.75% had been paid
by the employer and 6.75% had been paid by the worker. In 1997, the social security tax
overall was 20.2% of the worker’s income. Of this, the share paid by employers had fallen
to 10.2% and the share paid by the workers had risen to 10%. (In the United States, workers
pay 7.65% of their income for Social Security and Medicare and the employer also pays 7.65% of
their income.) Finally, the tax rate on corporate profits fell from 52% to 32%. (Other than the
rise in the VAT, these tax changes are very similar to ones that took place in the United States in
the 1980s under President Reagan.)
In the 1970s, Britain had experienced budget deficits. These had been reduced before the
Conservatives took power in 1979 and were reduced still more under the Conservatives. But in
the 1990s, this trend was reversed. In the 1990s, the budget deficits reached 7.8% of GDP for
7
two years in a row. (In contrast, the 2008 budget deficit of the United States of about $400
billion was only 3% of GDP.) The national debt had fallen to 26% of GDP by 1994 but then
rose to 44% of GDP by 1996. By the end of the period of Conservative government in 1997, the
budget deficit and national debt were about the same as at the beginning in 1979.
In all then, eighteen years of Conservative rule did not change the size of government nor the
tax burden significantly. But it did change the composition of government spending, significantly
reducing government investment spending. And it did change the nature of the tax system --what kinds of taxes were more prominent and who paid them. As mentioned above,
“Thatcher-omics” in Britain had many similarities to “Reagan-omics” in the United States.
D. Changes in Labor Relations
The Conservative Party saw labor unions as having too much power – both economically and
politically – and as a source of many of the problems the British economy was facing. The desire
to rein in the labor unions increased after they won the 1979 election, an election they won
largely because of large-scale industrial unrest. During the eighteen years of Conservative Party
government, there were five Employment Acts affecting labor unions. These Acts had several
ramifications. First, these Acts gave union members more power in relation to their union.
Unions were now required to hold secret elections for the election of union officials (as is true in
the United States). They are also required to hold votes as to whether or not to go on strike (also
true in the United States). And unions no longer were allowed to discipline union members who
refused to go on strike or who crossed a picket line. Second, these Acts narrowed the scope of
what could be considered a legitimate labor dispute. And if unions acted (for example by
striking) in a dispute not considered legitimate, the union could now be held financially liable to
the employer. Third, the closed shop was effectively eliminated. (A closed shop means that no
one besides a union member can be hired to work in that company. Closed shops were eliminated
in the United States in 1946.) Fourth, restrictions were put on picketing and on secondary
actions (striking one company in order to get them to do something to hurt another company).
For the first time, workers could be dismissed for striking. In all, the Employment Acts shifted
the legal balance in favor of employers and against labor unions. Employers are now more
likely than they were before 1979 to go to court to have certain labor union activities stopped.
The period since 1980 has seen a major decline in the significance of British labor unions
(as is also true in the United States as was noted in Chapter 2). The percentage of British workers
who belong to labor unions has declined by 25% (less than it declined in the United States). The
number of strikes and the number of workers involved in strikes fell to barely 1/6 of their
previous level. But it is hard to estimate how much of this decline has resulted from the laws
passed by the Conservative Party. Other factors have likely had a larger impact. (1) For much of
the period after 1979, Britain experienced high rates of unemployment. This made it hard for
labor unions to exert any influence in order to raise wages. (2) The importance of manufacturing
declined in Britain (as in most other countries) while the importance of services increased.
Manufacturing workers are much more likely to be unionized. Service workers, especially white
collar workers, have proven hard to unionize. (3) More women have entered the labor force in
Britain (as in all industrial countries). Women are less likely to belong to labor unions than are
men. (British women comprise about half of the labor force but only 1/3 of union workers.) (4)
The number of workers who work for the government has declined (mainly due to privatization).
Government workers are more likely to be union members than are private sector workers. (5)
There are more part-time and temporary workers in Britain (as there are in the United States).
These people are very unlikely to belong to unions. So, economic forces are major causes of the
decline of labor unions in Britain.
8
Whether caused by Conservative Party policies or by economic forces, the Conservative Party
would be pleased with the decline of labor unions. The labor unions have much less political
influence today. Industrial disputes and strikes are much rarer than they used to be. Wages are
more likely to be set by market forces than was true before 1979. But labor unions still exist and
collective bargaining still goes on. Unlike other countries in Europe, collective bargaining takes
place at the company level. The national organization (the TUC) does not engage in collective
bargaining. Nor does the government get involved with collective bargaining. The British labor
market has come more to resemble that of the United States and less that of other European
countries. Indeed, Britain has still not accepted the Social Charter of the European Union (see
Chapter 7).
E. Monetary Policy
The Conservative Party, under Mrs. Thatcher, was labeled as “monetarist”. More than in any
other country, Mrs. Thatcher seemed to follow the prescriptions of the monetarist economists,
especially those of Milton Friedman. Monetarist economics was a reaction to high rates of
inflation. Indeed, Britain had been experiencing high rates of inflation when the Conservative
Party was elected. The peak had come in 1975 when the inflation rate reached about 24%. By
1979, inflation was still running at about 17% (rising to 18% by 1980). Monetarist economists
believed that inflation is caused by the creation of too much money. So they stressed getting
control of the money supply as a means of controlling inflation. The policy of the Thatcher
government was to gradually reduce the rate of growth of the money supply. (In Britain, the
central bank, called the Bank of England, was part of the government. At that time, it was not
independent of the government as was the Federal Reserve System in the United States.)
Following the prescription of the monetarist economists, a target rate of growth was set for the
money supply. For 1980-1981, the target was that one measure of the money supply (called
M3) was to rise between 7% and 11%. This target range was to decline by 1 point each
year: 6% to 10% in 1981-1982, 5% to 9% in 1982-1983, and to 4% to 8% in 1983-1984. It
was believed that if these targets were announced in advance, people would come to believe that
inflation rates would be coming down. If people believed that inflation rates would be coming
down, they would act in ways that would indeed make this happen (such as by ceasing to rush to
buy goods before they became too expensive or by demanding very high wage increases to keep
up with expected inflation).
As also happened in the United States at that time, the inflation rates in Britain fell
dramatically. From 18% inflation in 1980, the inflation rate fell to 12% in 1981, 8% in 1982,
and 5% in 1983. But this did not result from the monetary targets. First, it proved much
harder to control the money supply than had been thought. The money supply (M3) actually
grew much faster than the target range: by 19.4% in 1980-1981, by 12.8% in 1981-1982, by
11.2% in 1982-1983, and by 9.4% in 1983-1984. If you compare with the targets, you can see
that the actual growth of the money supply missed even the upper limit of the target range by a
considerable amount. Second, the connection between the money supply (M3) and prices proved
much harder to predict than had been previously thought.
The inflation rates in Britain declined so greatly first because of a severe worldwide
recession. From a bit over 5% in 1979, the British unemployment rate rose to about 6.5% in
1980, over 10% in 1981, 11.8% in 1982, and 12.5% in 1983. For a country that had experienced
low unemployment since the end of World War II, these unemployment rates were extremely
high.
Second the inflation rates declined so greatly because of a very high exchange rate. The
high exchange rate made British exports expensive to foreigners (reducing the demand for them
and therefore reducing their domestic prices) and made British imports cheap (reducing the prices
that are counted in the measure of inflation). The very high exchange rate was the result of the
9
discovery of North Sea oil. This oil was in great demand. People wanting this oil had to buy
British pounds to pay for it. Their buying of pounds raised the price of the British pound. The
high price of the pound, as has been said, made British goods more expensive for foreigners to
buy. Many of these goods are manufactured goods. Many of the companies that produced these
manufactured goods depended heavily on exports for their business. So the discovery of oil in the
North Sea, through this process, deeply hurt many manufacturing companies and their workers.
This phenomenon is known as the “Dutch Disease” (the same result occurred with the discovery
of natural gas off the coast of the Netherlands).
In the mid-1980s, this monetarist approach was essentially abandoned. For the rest of the
decade, there was no clear framework for monetary policy. The goals of monetary policy seemed
to be to keep interest rates relatively low and to depreciate the British pound. The low interest
rates made it desirable for consumers and businesses to borrow and spend. The depreciated
pound made British goods cheaper for foreigners, inducing them to buy more of them. The
depreciated pound also made foreign goods more expensive for the British, stimulating the British
people to buy more British goods. These factors, plus the tax reductions mentioned above, all
stimulated the economy to expand – a period known as the Lawson Boom (Nigel Lawson was
the Chancellor of the Exchequer, equivalent to the American Secretary of the Treasury). During
this boom, inflation rose once again, reaching 10.4% in 1990. Then, beginning in 1990, monetary
policy became subordinated to the needs of the Exchange Rate Mechanism (ERM). This is
discussed in the next section.
F. Relations with the European Union
Britain is a member of the European Union. Generally, the Conservative Party has been more
averse to joining with Europe than have the other British political parties. This aversion was
especially great during the time that Mrs. Thatcher was prime minister. The European Union is
the topic of Chapter 7. As a member of the European Union (then called the European Economic
Community or EEC), Britain had eliminated its tariffs on products of the other European
countries, harmonized its tariffs against non-member countries’ goods with the other European
countries, allowed the free movement of labor and capital between Britain and the European
countries, ands participated in the Common Agricultural Policy (see Chapter 7 for details).
However, unlike the other European countries, Britain refused to sign the Social Charter (again
see Chapter 7 for details).
The main debate within Britain involved the Exchange Rate Mechanism (ERM) of the
European Monetary System. The idea was for all European countries to keep their exchange
rates fixed against the others (within a narrow band). So for example, the exchange rate with
Germany was to be fixed at 2.95 German Marks equaled one British pound. This was seen as a
precursor to a common currency. If the exchange rate stayed fixed for a long time, it would be
easy to substitute Euros for German Marks and for British pounds. So for example, if every
German Mark were replaced by one Euro (it wasn’t), then every British pound could be replaced
by 2.95 Euros. The Euro began to be used in Europe in 2002 and is discussed in Chapter 7.
While Margaret Thatcher was prime minister, she was adamantly opposed to joining the
Exchange Rate Mechanism. She believed that Britain should maintain its own policies and not be
bound by the need to maintain the exchange rate. When John Major took over as Conservative
Party Leader and Prime Minister in 1990, Britain did join the Exchange Rate Mechanism.
Germany was then the dominant country within the Exchange Rate Mechanism. At this time,
Britain was in the midst of a recession and needed low interest rates to get people to spend more.
Germany was worried about inflation (a result of a great increase in government spending needed
to integrate the former East Germany into the rest of the country). Germany therefore desired to
keep its interest rates high in order to reduce spending and fight inflation. This increase in
German interest rates attracted savers from the United States, Japan, and the rest of Europe. To
10
lend in Germany, these people had to buy German marks. Their buying of German marks
caused the German mark to appreciate (go up in value). The appreciation of the German mark
created problems because the countries of Europe had agreed to keep their exchange rates fixed.
In order to maintain a fixed exchange rate with the German mark, the Bank of England (and also
the central banks of France, Sweden, and Italy) also had to increase their own interest rates.
Given the economic situation in Britain at the time, the increase in interest rates decreased total
spending, plunging Britain into deeper recession.
At first, the British government pledged to do whatever was necessary to maintain the fixed
exchange rates. Although they said that they were willing to accept the risk of a recession, foreign
exchange speculators (especially one George Soros) did not believe them. A speculator is one
who tries to gain income by buying one currency and selling another, hoping that the price of
the one bought will rise and the price of the one sold will fall. The speculator is gambling. The
situation presented a great opportunity for these speculators. The great opportunity was to “bet”
that the British pound would lose value in relation to the German mark. That is, the speculators
bet that Britain would not accept a recession and therefore would not maintain the fixed exchange
rate. The speculators would “bet” by buying German marks and selling British pounds. So let’s
say a speculator takes one billion British pounds and buys 2.95 billion German marks. If the
speculators were right and the fixed exchange rates were not maintained (the pound depreciates),
they could make a great amount of money. Let’s say that the pound depreciates to 2.45 German
marks. The speculator could then take the 2.95 billion pounds and see them for 1.2 billion British
pounds (approximately). The speculator would profit by .2 billion pounds --- this is 200 million
British pounds (or about $400 million). And it all could be done in a very short time. If the
speculators were wrong and the fixed exchange rates were indeed maintained, they could sell the
2.95 billion German marks they had bought and get one billion British pounds --- they got their
money back. (There was absolutely no chance that the British pound could be worth more in
relation to the German mark.) Either they win or they break even. Not a bad deal for a gambler!
Britain did try to maintain the fixed exchange rates. They did so by having the Bank of
England buy British pounds and sell German marks in the foreign exchange market. They
were selling the German marks that the speculators were buying. The Bank of England sold the
German marks from the foreign exchange reserves that it had previously accumulated. It has been
estimated that the Bank of England lost $7 billion worth of its foreign exchange reserves in just a
few hours by this process. The Bank of England could not go on losing foreign exchange reserves
at this rate. So after awhile, it abandoned the system of fixed exchange rates. George Soros had
gained billions in a very short time.
Several things had gone wrong. First of all, the economies of Britain and Germany were
dealing with completely different economic problems. Trying to coordinate these countries
was extremely difficult, if not impossible. Indeed, the British economy is probably better
connected to the United States than it is to Germany. Second, the exchange rate of 2.95
German marks to one British pound was probably too high of a rate for Britain. To the
British public, the experience with the Exchange Rate Mechanism was very unpopular. It had
cost a large amount of British foreign exchange reserves. It had delayed by at least one year the
ability of Britain to lower its interest rates to stimulate spending. More spending would have
created more jobs and would have helped to end the recession. And the experience of the
Exchange Rate Mechanism was a blow to British national pride. It has been said that the British
see a depreciation of the pound as equivalent to losing a war! No politician in Britain would dare
propose anything like it again. Britain has not become part of the European Monetary Union and,
as of this writing, still uses the pound instead of the Euro. The debacle of the Exchange Rate
Mechanism was a major reason that the Labour Party, under Tony Blair, was able to win the 1997
general election.
11
3. The Economy under New Labour: 1997 to the Present
In 1994, Tony Blair was chosen as leader of the Labour Party. As mentioned earlier, this
marked the transition to what has been unofficially called “New Labour”. “New Labour” is a
more centrist (moderate) political party whereas “Old Labour” was considered more to the
political left. On the political scale, “New Labour” is what is called the center-left. In May of
1997, the Labour Party won the general election. Tony Blair became prime minister, a position
he held until June of 2007 (making him the longest serving Labour Prime Minister in the party’s
history). He won re-election in 2001 and again in 2005. When Tony Blair stepped down as Prime
Minister, the Labour Party simply elected a new leader. That new leader, Gordon Brown, became
British prime minister in 2007 and is currently in that position.
An important feature to note is that many of the policies of “New Labour” have been
reasonably consistent with the policies of the Conservatives. Unlike “old Labour” and unlike the
Social Democratic Parties of Europe, “New Labour” is more willing to accept a major role for
free markets, a reduced role for government in the economy, and an especially significant
reduction in the influence of the labor unions. At the beginning of its first term (from 1997 to
2000), it was considered very important for the Labour government to mollify business and
financial interests. The wished to reassure businesses that the new government was not a threat.
The unions were basically ignored.
Some have said that “New Labour” differs from the Conservatives in matters of detail, but not
in matters of substance. Others have said that New Labour has taken British politics beyond
Thatcherism, drawing on the Party’s traditions but changing them to reflect the new economic
and social conditions in the world.
Some very important economic policies of the Conservatives were maintained under “New
Labour”. One economic policy that was maintained is privatization. The privatizations of the
1980s, described above, have not been reversed. All of the companies that were privatized have
remained under private ownership. And no new companies have been nationalized except for
banks that got into deep financial trouble with mortgage lending – Northern Rock, Lloyds (43%
government owned), and the Royal Bank of Scotland (68% government owned) as well as the
savings company Bradford and Bingley. The nationalization of those banks is expected to be
temporary. Another Conservative economic policy that was not changed significantly
involved the system of labor relations. Despite being a Labour Party, and despite a close
affiliation with the Trades Union Congress (TUC), none of the laws restricting the powers of
labor unions were rescinded. The labor unions and the Trades Union Congress have not had
significant political influence under Tony Blair or Gordon Brown, as they once had with previous
Labour Party Prime Ministers. Union density continued falling to about 16% of all workers by
2006. The number of days lost to strikes has also fallen since 1997 and is among the lowest rates
in Europe. However, New Labour did introduce a minimum wage for the first time --- presently at
about $10.70 per hour. Britain was the only country in Europe to reject any use of social
partnership between business, unions, and the government. Nor has there been a large increase
in government spending under the “New Labour” government. In the early years of the
“New Labour” government, government current expenditure as a percent of Gross Domestic
Product actually declined to levels not seen since the early 1970s. In 2003 to 2005, this percent
rose slightly. But at 38% in 2004-2005, it was below the percents found in most of the years in
the 1980s and 1990s and well below the percents found in most of the countries of Europe.
Government spending grew significantly starting in 2008 in response to the major world
recession and is expected to reach over 40% of GDP (see the chart below). Taxes were not
changed much either. The value-added tax is still 17.5%. The standard income tax rate was
lowered from 23% to 20% by 2008. The highest income tax rate was maintained at 40%. The
corporate tax rate was lowered from 30% to 28% in 2007.
12
The most significant changes made by the “New Labour” government involved
macroeconomic policy. This includes both monetary policy and fiscal policy. First, consider
monetary policy. Until 1997, the Chancellor of the Exchequer (equivalent to the American
Secretary of the Treasury) was responsible for both monetary policy (changes in the money
supply in Britain and therefore changes in British interest rates) and fiscal policy (policies relating
to the spending of the government as well as its tax policies). The central bank is called the Bank
of England. Its head is entitled the Governor, presently Mervyn King. While the Governor and
the Chancellor would meet often to discuss monetary policy (especially what interest rates would
be), the responsibility ultimately fell to the Chancellor. This contrasted with the United States
where the Federal Reserve (headed by a Chair) is formally independent of the government and of
the Secretary of the Treasury. In the United States, the Chair of the Federal Reserve and the
Secretary of the Treasury meet to discuss economic matters. But monetary policy (especially
what interest rates will be) and fiscal policy (the government’s spending and tax policies) are
made by different groups of people, often with differing goals. The government (the President of
the United States and his Secretary of the Treasury) cannot change any policy made by the
Federal Reserve regarding interest rates. (The central banks of Germany, France, and Canada
were all more independent of the government than was the Bank of England.)
On May 6, 1997, only four days after winning the British election, the new Chancellor of the
Exchequer, Gordon Brown, announced that the British central bank, the Bank of England,
would become independent. This was a major change. Under the new system, the Chancellor,
not the Bank of England, set the target rate of inflation. In 1997, this was set at 2.5% inflation per
year. In 2003, the target was lowered to 2% inflation per year when Britain adopted the new
common European measure of inflation. The Governor of the Bank of England is required to
write a public letter to the Chancellor if the actual inflation rate deviates from the target by more
than one percentage point. The new policy created a new institution, the Monetary Policy
Committee, charged with the task of setting interest rates. This committee has nine members.
One is the Governor of the Bank of England. Four others are high-level employees of the Bank
of England. But the other four are outsiders, mostly economists. The Monetary Policy Committee
has fixed meeting dates; all announcements of changes in interest rates are made at noon of the
second Thursday of the month. The inflation target and the fixed meeting dates were intended to
promote stability; people in financial markets could have a good idea of what was coming and
when it was coming and so could plan accordingly.
13
Because Britain had been more economically unstable than most other European countries,
Britain had had to pay higher interest rates to borrow internationally. These higher interest rates
were to offset the risk of lending to Britain. As soon as the new monetary policy was announced
in 1997, this interest rate difference disappeared. Lenders saw the policy as reducing the risk of
lending to Britain. Since 1997, inflation rates in Britain have been stable and close to the target
rate. (They did increase to 3.2% in 2008 as a result of the depreciation of the British pound.). At
first, interest rates in Britain fell so that by August of 2003 they were at their lowest level in 50
years. After 2003, interest rates rose somewhat as they did elsewhere. Then they fell back again.
(For example, the bank rate --- known in the United States as the discount rate --- rose from the
low of 3.5% to a high of 5.5%, before falling to the current (March 2009) rate of 0.5 %.)
The other major macroeconomic change of “New Labour” involved fiscal policy. In 1997, the
new Chancellor of the Exchequer, Gordon Brown, announced new fiscal rules. Most significant
was the so-called “golden rule”. This required the government to run a balanced budget
over the business cycle. This means that government spending, excluding money for investment
in infrastructure, would equal the tax revenues from the peak of one business cycle to the peak of
the next business cycle. Government spending would not equal tax revenues each and every year.
But if government spending exceeded tax revenues in the years in which unemployment were
especially high, it would have to be less than tax revenues in the years in which unemployment
were especially low. The idea, once again, was to increase the predictability of government
policy. Another rule was that net national debt as a percent of GDP was not to exceed 40%.
While the government has maintained the goal of having a balanced budget over the business
cycle, it is under no mandate to do so. For example, in 2005, it looked as though the government
would have a budget deficit. The Chancellor was faced with the prospect of having to raise taxes
to meet the balanced budget goal. He did not want to do this. So he re-defined the business cycle
to include different years. With the re-definition of the business cycle, he could meet the goal of a
balanced budget without raising taxes. He received much criticism, including a rebuke from the
Governor of the Bank of England, for such shenanigans. Nonetheless, as you can see from the
data below, the budget deficits in Britain were held to very low levels until 2002-2003. Indeed,
there were budget surpluses from 1998 to 2001. Since then, the budget deficits increased. As you
can also see, the public sector net debt as a percent of GDP has already increased to 49% as of
2009 and is expected to increase much more. This recent increase is the result of the need to
borrow a large amount of money that will be used to stabilize the financial system and to
stimulate the economy out of the recession. Without the need to borrow money to stabilize the
financial sector, this would have been a bit over 40%.
Year
1996-97
1997-98
1998-99
1999-00
2000-01
2001-02
2002-03
2003-04
2004-05
2005-06
Public Sector Borrowing (% of GDP) Public Sector Net Debt (% of GDP)
3.5%
43.6%
0.8
41.4
-0.4
39.3
-1.7
36.3
-1.7
31.4
0
30.4
2.3
31.8
3.1
33.2
3.3
35.0
3.0
36.4
2008
February 2009
47.2%
49.0%
14
A surprise to many people was that New Labour did not act to restore the Welfare State
reductions that had occurred under the Conservatives. First, in contrast to “Old Labour”, the
New Labour government dealt with unemployment by trying to increase employability rather
than by increasing transfer payments. In contrast to the Conservative Party, the focus was on
increasing employability rather than on increasing job search among the unemployed. In 1997,
the new Labour government raised 5 billion pounds from a windfall tax on the private utilities to
spend on what it called “New Deal” programs. These programs included counseling for the
unemployed as well as employment and training programs. Those without basic education are
now able to have full time education and training for 12 months without losing their
unemployment benefits. People (especially young people) who are unemployed and refuse to go
through these programs have their unemployment benefits reduced. The Working Tax Credit
was offered to working families with low wages, similar to the Earned Income Tax Credit in the
United States (only larger in amount). Childcare support to working parents was increased. By
2000, registered unemployment had fallen to its lowest level in about 20 years. The
macroeconomic policies noted above were mainly responsible for this. But the New Deal
employment policies might also have contributed something to this result.
Second, the concern with being “fiscally responsible” meant that there was little money for
New Labour to spend on public housing. So the housing changes made by the Conservative
government have basically continued intact.
Third, the New Labour government did manage a substantial increase in spending for
education. Britain had gone from a high level of spending on education compared to other
European countries to a relatively low level of spending. Its educational performance had also
become lower compared to the rest of Europe. The New Labour government has tried to reverse
this trend. In education, the government has tried to use partnerships with private
businesses to improve services. Businesses are encouraged to finance new schools, called city
academies, particularly in run-down inner city areas. (This is part of the Private Financial
Initiative – see Page 15.)
The National Health Service was described in Chapter 4. The British people have expressed
less satisfaction with their health service than do other Europeans. The system has been underfunded. Some facilities are old and in need of repair or replacement. Waits are long for elective
procedures. Since New Labour took over the government in 1997, spending on the National
Health Service has increased rapidly. By 2008, the budget of the National Health Service was
three times what it was in 1997. When New Labour took over the government in 1997, Britain
spent 6.8% of its GDP on health care compared to about 8% of GDP for the countries of
continental Europe. By 2008, it is expected that Britain will spend some 9% of its GDP on health
care -- close to the highest levels found in continental Europe (but well below the level found in
the United States). Much of this increase in spending has gone for increased pay in an attempt to
attract more people to work in health care. Indeed, the total employment of the National
Health Service has risen by 300,000 people since 1997 (a 30% increase). Pay has risen
especially for general practitioners – from about 50,000 pounds in 1997 to 100,000 pounds in
2006 (about $200,000). British general practitioners are among the best paid in Europe (but still
earn less than American doctors).
Besides increasing spending on the National Health Service, New Labour has enacted reforms
to make it more market driven. Beginning in 2000, the system has devolved into a number of
Primary Care Trusts. These Trusts receive a budget from the National Health Service and use
the money to buy hospital and community health services. Starting in 2006, patients are given a
choice of four hospitals for non-emergency operations. They previously had no choice. The
plan is that, within a few years, patients will be able to choose any hospital in the country.
Hospitals are now paid per patient treated. In the past, hospitals were simply given a lumpsum amount of money. As was seen with education, the New Labour government is encouraging
15
more services to be provided by the private sector.** Some 80 Foundation Hospitals were
created and encouraged to use contracts with private companies to improve their services.
**A major aspect of New Labour has been the Private Finance Initiative. In this, private companies
borrow money and build construction projects for the government. For 1997 to 2007, there were 100 such
projects in education and 80 hospitals. The private companies then rent these to the government for
negotiated rental payments over 20 to 30 years.
The table below shows the very slight shift in government spending priorities during the New
Labour government:
Percent of GDP
1994/95 2002/03
Education
5.1%
5.1%
Health
5.5
6.3
Housing
0.8
0.4
Law and Order
2.2
2.4
Defense
3.3
2.4
Social Protection
12.9
11.7
That there was no large increase in government under New Labour is illustrated by the fact that
the total number of government employees declined from 5.8 million in 1991 to 5.2 million
in 2001.
One issue on which New Labour has differed from previous British governments has involved
the environment. In 2006, a major report (called the Stern Commission Report) indicated that
global warming presented major economic problems for the world. This report also argued that
the costs of policies to reduce global warming were quite small. Long before the report was
issued, the New Labour government set a goal of reducing carbon emissions in Britain by 20%
between 1990 and 2010. In 2001, the government created a climate change levy (tax) on
business use of energy. (The levy is 0.43 pence per kilowatt hour of electricity, 0.15 pence per
kilowatt hour of natural gas, and so forth.) This tax on the use of energy is matched by a decrease
in the business’ contributions to the national health insurance fund. In all, the overall business tax
burden actually decreased very slightly. But the tax on energy did provide an incentive for
businesses to become more energy-efficient. The climate change levy is estimated to have
reduced carbon emissions in Britain 16.5 million tons through 2005, with another 3.5 million
tons per year expected through 2010. According to estimates, energy demand is 2.9% lower in
Britain as a result of the climate change levy.
Another area in which New Labour is more like Old Labour has been its focus on social
exclusion. A number of programs have been aimed at improving the life chances of low income
people. These programs, especially the Working Tax Credit (see above) and the minimum wage
(about $10.70 per hour), were aimed at low-income people who work. The trend toward an
increase in inequality was stopped. In particular, the income gap between the poorest and the
middle classes has diminished. In the graph below, the Gini Index measures inequality. It is a
number between zero and one. The higher the number, the more unequal is the distribution of
income.
16
Gini Index
Most of the ten year period also showed slight declines in poverty (in contrast to the United
States).
Relative Poverty*
1996-97
2005-06
25.3%
21.6%
Absolute Poverty**
25.3%
12.6%
*Percent of people in households with less than 60% of the median income.
**Percent of people in households with less than 60% of the 1996 median income.
Overall, the British economy performed well in the years since 1997 until the global
recession hit in 2008. From 1997 to 2007, Real GDP (production) grew at an annual average
rate of 2.7% per year. This is slightly less than the American rate of 2.9% per year over the same
period. But it is higher than the growth rates of most European countries. (Total Real GDP per
person became higher than France or Germany in 2006.) It was also a long period of continuous
expansion (increases in Real GDP). Productivity (production per hour worked) grew at an annual
average rate of 2.08% per year between 1997 and 2006, below the rate of growth of the United
States but above the rates of growth of France and Germany. The skill level of the labor force
improved. 15% of workers are now considered high skilled (compared to 8% in Germany). 14%
are considered low skilled (compared to 30% in Germany). Workers now have longer tenures
with their employers. Productivity in Britain is still below that of Germany, France, and the
United States. (In the case of Germany and France, this may result because the low skilled
workers are more likely to be unemployed and therefore not counted.) Unemployment averaged
5.5% each year between 1997 and 2006, with a low of 4.7% in 2004. This is higher than the
American average of 4.9%, but much lower than Germany (9.1%), France (9.7%), or Italy
(9.2%). It was also well below the British average unemployment from 1992 to 1997 (9%). This
occurred despite the increase in immigration from central and Eastern Europe. Inflation averaged
1.7% per year over the period 1997 to 2007, a very low rate. The inflation target is 2% per year;
this was adhered to very closely but was exceeded recently in March of 2007 (due to rising oil
prices) and in 2008, as mentioned earlier. Interest rates declined. The pound sterling
appreciated (about 14%), especially in relation to the Euro and the American dollar. Private
17
consumption grew impressively. Investment spending as a percent of GDP grew by one
percentage point (but is still relatively low). Wealth increased, especially as a result of a rapid
rise in home prices (similar to the rise that occurred in the United States). The wealth of the
richest 1,000 families is estimated to have quadrupled. However, most of Britain’s income groups
experienced large increases in their living standards, in contrast to the past.
Real Income Growth by Quintile Groups
Income Quintile Group Poorest
2
3
4
Richest
1979 – 1997
Thatcher (1979 – 1990)
0.8%
0.4%
1.1%
1.2%
1.6% 1.9%
2.1% 2.7%
2.5%
3.6%
1997 – 2006
2.2%
2.4%
2.0% 1.9%
2.0%
Beginning in 2007 and 2008, Britain’s economic performance became much weaker. This
resulted mainly for the same reasons as it did in the United States. Indeed, in a global economy,
the recession involved a spread from the United States to the rest of the world. (An old saying is
that “when the United States catches cold, the rest of the world gets pneumonia”!) Like the
United States, Britain experienced a real estate boom financed in many cases by questionable
mortgages. When the boom turned to bust and these mortgages could not be repaid, many of the
financial institutions get into serious financial trouble. (These financial institutions are
collectively known as The City of London, or The City). Their lending was reduced greatly.
Unable to get loans, many companies had to reduce production and lay-off workers. With lower
incomes, these workers became unable to pay their debts further hurting the financial institutions.
This became a vicious circle! British GDP grew very little in 2008 and is expected to contract in
both 2009 and 2010. The year 2009 is expected to have the rather large contraction of more than
3%. The unemployment rate reached 6.3% in 2008 and is projected to increase to between 8%
and 10%. Housing prices have declined and are expected to decline much more. The current
recession is the worst since the end of World War II.
The British government, under Gordon Brown, acted to help the financial institutions, in
ways similar to those of the American government. As of this writing, some 400 billion British
pounds have been injected into financial institutions. As mentioned earlier, two major financial
institutions, Northern Rock and Bradford and Bingley, have been nationalized. The British
government also created a large stimulus package, as did the American government. The valueadded tax was temporarily decreased and government spending was increased. Because of the aid
to the financial institutions and the stimulus package, the British budget deficit, already at 5.3%
of GDP in 2008, is projected to increase to 11% of GDP in 2009 and 13% on 2010. The goal of
having a balanced budget over the business cycle has been abandoned. The national debt is
expected to increase from 47% of GDP in 2008 (see Page 13 above) to 70% by 2010. The goal of
keeping this below 40% has also been abandoned. Like the American Federal Reserve, the Bank
of England has decreased interest rates so that the main interest rate is now 0.5%. These are all
large steps to help overcome the recession. They illustrate that overcoming the recession is now
the main priority of the New Labour government. How well it accomplishes this will determine
how well the Labour Party will do in the election expected to be help in 2010. (At the time of this
writing, the polls are projecting the party to lose.)
4. The Third Way?
As can be seen from the above description, the New Labour government did not create a
radical departure from the policies of the Conservative government. It certainly did not
18
reintroduce the policies of Labour governments of the 1960s and 1970s. To many supporters of
the Old Labour Party, this was a major disappointment. But to others, this represents a major shift
in the policies of the political left. In 1999, Tony Blair and Gerhard Schroeder (then German
Chancellor from the Social Democratic Party) issued a paper entitled “The Third Way”. In it they
argued for a new approach midway between the policies of the Old Labour Party (or Socialists)
and the policies of the Conservatives. Let us conclude this chapter by examining some of their
ideas as presented in this paper.
First, there is a rejection of some of the tenets of the Socialist (or Old Labour)
philosophy. Most notably, they rejected the idea of imposing equality of outcomes, the need to
raise levels of government spending, the disproportionate influence of government bureaucracies
over private activity, the neglect of personal responsibility, and the idea that government can
“fine tune” the economy in order to generate economic growth and stability. They argued that
while the government must improve its performance, it should not increase its size.
Second, there is general support for a market economy. Government’s function is seen
as creating the conditions in which private businesses can prosper. They argued that
government must invest in “human capital” so that people have the skills and abilities they need
for the new global economy. They argued that in a world of increasing change and flexibility,
government policies need to help people move from one job to another. This may involve
changes in worker training and also changes in the social security system. It also may involve
changes in union rules so that companies have more freedom to change the number of workers
they hire. Government must also provide adequate infrastructure.
Third, they argued that concern for the environment is very important. However, they
believe that market-based solutions are superior to command-and-control solutions.
Fourth, they argued for what they called a “supply side agenda”. This agenda includes
policies for free and open international trade as well as policies to promote domestic competition.
This agenda also includes decreases in taxes on corporations (as was done in Britain) and lower
tax rates on individuals. The lower taxes on businesses and on individuals, they argued, should be
offset by taxing “bads”, such as environmental pollution (see the discussion of the climate levy
above). This agenda included policies to promote small and medium-sized businesses. And
finally, this agenda included policies to balance the government’s budget (the government’s
spending should equal its tax revenues – see the discussion on the “Golden Rule” above). Doing
so would reduce the need for the government to borrow, thereby lowering interest rates. Lower
interest rates would make it easier for businesses to borrow money to buy new capital goods.
Fifth, they argued that the approach to a welfare system should be “welfare-to-work” --programs that enhance the ability of those on welfare to get jobs. This is shown well by the
policies pursued by the New Labour government, as described above. “Active Labour Market
Policies” (such as the “New Deal”) should replace part of the “social safety net”. Whereas the
Conservatives had believed that unemployed people were simply not searching for jobs hard
enough, New Labour believes that unemployed people often do not qualify for the jobs that are
available. Retraining is a major aspect of their welfare program.
This description is a mere introduction to the philosophy being called “The Third Way”.
Assignment
Argue for one of the following statements. (1) This is a real “third way”. The ideas of the Third
Way are indeed between the ideas of the old Socialists and the ideas of the liberal market
capitalist economy? OR (2) The “Third Way” illustrates only that the political left has now fully
accepted the ideas of liberal market capitalism.
19
5. Conclusion
In this Chapter, we have summarized the policies of the Old Labour party – the British version
of the social market capitalist economy as it existed in the 1960s and 1970s. We have then
summarized the radical shift toward a liberal market capitalist economy that was accomplished
under the Conservative governments over the period 1979 to 1997. Finally, we discussed the
changes made by New Labour since 1997. These changes were not radical at all. On the whole,
the liberal market economy seems to have triumphed in Britain, much as it has in the United
States. This is one of the only conversions from one type of capitalism to another type ever
attempted.
Assignment
Go back to the Appendix to Chapter 2. From that, try to explain why the shift to the liberal
market capitalist economy occurred in Britain after 1979 and why it has not been reversed.