Reference no: EM131737628

Case Scenario: UNITED KINGDOM: REBIRTH AFTER THATCHER

From 1950 through 1981, real growth in the UK averaged only 2.4%, compared to 3.4% in the US and 5.1% in Germany. Admittedly, Germany was more devastated by World War II than Britain, but one would have expected that the decline in British productivity during the wartime years would be quickly recovered. However, that did not happen. Democratically elected governments tend to change after major wars. While Harry Truman won reelection in 1948, the Republicans captured control of Congress in 1946 and the Presidency in 1952, and the liberal Democratic agenda of the Roosevelt years did not reemerge until 1964. In Britain, the change occurred in the opposite direction: the electorate booted out Churchill and voted in the Labour Party, which promptly proceeded to impose a welfare state in Britain, including nationalized healthcare. Between 1945, when Clement Attlee defeated Winston Churchill, and 1951, when Churchill returned to power, the Labour Party managed to squeeze all the increase in value added out of the private sector. Punitive tax rates as high as 98% on socalled ‘‘unearned'' income (interest, dividends, and rents) strangled initiative and entrepreneurship, causing an exodus of the best and the brightest. The extra money collected by the government was used to fund the welfare state. Labour also made no attempt to adjust to the realities of the post-WWII economy, instead supporting bloated payrolls in the steel, coal, and railroad industries.

Unlike Latin American nations, the British government paid for its largesse through higher taxes, so the deficit averaged only 1% of GDP in the 1950s and 1960s. Yet the cost of taxation needed to pay for these benefits was so high that private sector activity stagnated. The Tories returned to power in 1951 for 14 years but were unable or unwilling to undo the damage done by the Labour Party. Fiscal policy, then, depressed the British economy. Monetary policy did not play much of a role; the inflation rate of 3.4% was somewhat higher than the 2.2% annual increase in Germany and the 1.8% rise in the US, but not enough to make a major difference. But what about trade policy? Britain attempted to go back on the gold standard after World War II at a value of the £ equal to $4.03, the same as the interwar rate, but that was clearly too high, so it was devalued to $2.80 in 1949. At that time, the DM was set at 4.2/$, so the crossrate was DM11.76/£. Wages in Germany were about 22% lower than in Britain (in dollar terms), but some rough estimates suggest that productivity was at least 35% lower, so labor costs in the UK were probably slightly below those in Germany after the pound devalued in 1949. Compared with the US, both wages and productivity were about three times those in Britain, so the £ seemed properly valued in the 1950s and 1960s. Hence the British economy did not stagnate in those two decades because of an overvalued currency. Inflation was somewhat higher in the UK, but the £ was devalued again to $2.40 in late 1967. As a result, the currency remained near its equilibrium level during those two decades, and Britain has favored a free trade policy since the 1840s.

The economy stagnated in the 1950s and 1960s because of high marginal tax rates and burgeoning public sector spending. The 1970s were a different story. While this was an unfavorable decade for inflation around the world because of the two oil shocks, it was particularly unfortunate for the UK. During that decade, the inflation rate rose an average of 14.8% per year in Britain, compared to 8.4% in the US and 5.5% in Germany. Yet the £ returned to $2.40 in 1980 after having dipped lower in the late 1970s. By then, the British economy was being strangled by the overvalued pound. The Thatcher Administration tried to reverse this stagnation by cutting high tax rates, privatization, deregulation, and encouraging entrepreneurship. How successful was this attempt? It is a matter of perception. When Margaret Thatcher was elected Prime Minister, government spending had risen to 43% of GDP. When stepping down 11 years later amidst cries she had gutted the social welfare state and treated poor people cruelly, the ratio had declined - to 42%. Apparently the rhetoric overpowered the facts. Just as there was virtually no change in the ratio of government spending to GDP under Reagan, Thatcher was unable to make significant inroads into the relative size of the public sector. UK growth averaged only 1.9% from 1982 through 1992 - even worse than the 2.4% growth rate during the 1950-81 period. Over the same period, the average growth rate in the US declined by 1 2%, in Germany by 1%, and in France and Italy by 2%, so some of the slowdown reflected worldwide conditions. Even so, these figures do not suggest a very impressive performance.

Much of the problem remained the overvalued £ during the Thatcher years. However, that is not the end of the story because, as we have already seen, Britain was forced to let the £ float in September 1992. The turnaround was almost immediate. From 1993 through 2001, growth in the UK bounced back to 2.9% and the unemployment rate fell from 10.5% to 5.1% in 2001, even as growth in Continental Europe was stagnating. Many budding entrepreneurs from France - including but not limited to restaurateurs - departed Paris for London. Is it possible that Thatcher laid the groundwork for rapid growth but it blossomed only after her departure? One can never answer such questions with certainty. However, it does appear that the Thatcher government kept the value of the £ too high, because the economy improved soon after Britain was forced to let the £ float freely in September 1992. In the view of many economists, it was no coincidence that the UK economy recovered the following year and has remained relatively strong. Even for the US, above-average growth also requires that, in addition to correct monetary and fiscal policies, the currency be kept near its purchasing power parity. As of 2002, the outlook for the UK is favorable. Labor costs are about 15% below Continental Europe, the £ is fairly valued, and Tony Blair, while a member of the Labour Party, has joined with conservative leaders in Italy and Spain in favor of greater labor flexibility. Average and marginal tax rates are lower than in most other countries in Europe, and the current decision not to join the European Monetary System has apparently not dampened the growth rate.