Over the last 50 years, fiscal policy has played a limited role in controlling inflation in Britain, with Harold Wilson’s government being the last to use the policy to manage inflation on a large scale. Unfortunately for Wilson, it was the sensational failure of these policies that greatly contributed to the death of fiscal policy as an inflation management tool. In this essay, I will present the reasons for the failures of Wilson’s contractionary fiscal policy and how these failures affected the future of fiscal policy as an inflation management tool, leading to the rise of monetary policy.
When Harold Wilson entered Downing Street in 1964, he faced two major economic difficulties; increased inflationary pressure and a large current account deficit, which stood at £800 million 1 and was widening due to the lack of price competitiveness of British exports. Wilson responded through contractionary fiscal policy, hoping that the reduction in government spending paired with increased taxes would cause a reduction in Aggregate Demand (shown below)2 . This would lead to firms’ stock levels increasing due to decreased demand, causing a fall in production (Y1 -> Y2), while subsequent efforts by firms to ration demand would create demand-pull deflation (PL1 -> PL2), softening inflationary pressure. Moreover, Wilson hoped that this would narrow the trade deficit, as the decreasing price level would increase the price competitiveness of exports, increasing exports, while falling discretionary incomes caused by increased taxes would reduce imports.
Unfortunately for Wilson, his failure to recognise the demands of the public led to the failure of his policies. This is because his decision to increase taxes and reduce government spending reduced consumer incomes, while the subsequent fall in output and employment led to reduced consumer confidence regarding future employment and wages. This caused major unrest, leading to strikes such as the seamen strike in May 1966, in which workers demanded, and were awarded, a pay increase that exceeded the government’s guidelines. Consequently, unrest and strikes leading to pay rises and falling productivity caused an increase in costs of production for firms, creating cost-push inflation (shown below), which in turn damaged the price competitiveness of British exports. Therefore, the public response to Wilson’s contractionary fiscal policy led to the undoing of its initial intended impacts, confirming the failure of the policy.
The failures of Harold Wilson’s inflation management through fiscal policy reduced the appetite for the policy to be to control inflation used not only in Britain, but also elsewhere. For example, with US inflation exceeding 6% in 1968, President Johnson resisted suggestions to increase taxes, fearing resistance from the American public3 . Additionally, subsequent British efforts to use fiscal policy to manage inflation fared similarly to Wilson in the 60s, convincing many of the policy’s ineffectiveness in managing inflation. For example, during Wilson 2nd term as PM, his decision to increase taxes and reduce government spending in 1975 failed to combat inflation, which remained above 15% for the next two years4 (and Britain fell into recession for just the 3rd time since the Great Depression), while in 1981, Margaret Thatcher’s Chancellor, Geoffrey Howe, described his 1981 budget, which cut government expenditure and increased taxes, as ‘the most unpopular in history.’
Consequently, by the mid-1980s, Britain sought a new inflation management tool, and Thatcher’s pursuit of monetarism was successful in limiting inflation, as a reduction in the money supply through increasing interest rates (which rose from 12% to 17% within just 6 months of her election) led to inflation falling from 18% in 1980 to 4.6% in 1983.
Thus, originating from the failures of Wilson’s contractionary fiscal policy, monetary policy has since displaced fiscal policy as the primary tool for managing inflation in Britain, occurring due to several relative advantages that monetary policy holds over fiscal policy with regards to controlling inflation. Perhaps one of the most significant is that in most developed nations, such as Britain, monetary policy is dictated by the Central Bank, which acts independently from the government. Therefore, while controlling inflation through fiscal policy is subjected to political involvement, monetary policy avoids this issue, meaning that achieving the set inflation target is the sole priority. One further advantage is that monetary policy is far simpler to implement, as it often solely involves altering interest rates, meaning that the subsequent effects of monetary policy can be easier to predict. By contrast, as shown by Wilson and Thatcher’s attempts, fiscal policy often leads to more unpredictable results as it affects many aspects of the economy.
There are, however, several objections to the effectiveness of monetary policy in controlling inflation. For example, some argue that as interest rates tend towards the zero lower bound, monetary policy becomes ineffective, as the central bank cannot further reduce interest rates, its primary tool to control inflation. However, the severity of this issue was softened in the wake of the GFC in 2008, as despite the UK base rate falling to just 0.5% in 20088 , monetary policy remained effective through the use of Quantitative Easing, which successfully limited the risk of deflation caused by the recession, as between 2009-2014, 2011 was the sole year where inflation fell outside of the target range of 1-3%9 . Therefore, even when the zero lower bound is approached, monetary policy can still play an effective role in managing inflation.
In conclusion, it is clear that the failures of fiscal policy in regards to controlling inflation in the 60s-70s inhibited the use of the policy in tackling future inflationary issues, as the weaknesses of such an approach had become evident, as contractionary fiscal policy reduces disposable incomes, disincentivising workers and reducing productivity, thus increasing the price level and undoing the intended impact. As such, the rise of monetary policy came out of necessity, and its effectiveness in independently managing inflation through channels such as interest rates, and eventually QE, allowed it to supersede fiscal policy as Britain’s, and most of the world’s, primary method for managing inflation, causing the death of fiscal policy as an inflation management tool.