Letter: Monetary policy while waiting to rejoin the ERM

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Sir: The withdrawal of the UK from the exchange rate mechanism has raised some most important and widely debated political issues. But there are also some very important, but unfortunately complicated, economic and financial relationships that are relevant, but which are not widely understood or very much discussed. In this letter, I try as an economist to explain as simply as possible what I conceive to be the nature of the basic underlying issues.

For the present, while we are outside the ERM, we should by stages reduce significantly the rate of interest, and leave the pound free to find its own level in the foreign-exchange markets. These measures should help

(i) to ease the overhang of mortgage and other debt, both by reducing the interest payments on such debt and by raising the value of houses and other real assets;

(ii) to promote investment in the capital equipment of our run-

down industries;

(iii) to encourage exports and discourage imports through the greater competitiveness due to a no longer over-valued currency, thus reducing our huge balance of payments deficit;

(iv) to encourage a revival in output and employment through the increase in the demand for our products, not so much for consumption purposes as for the restoration of our domestic productive capacity and the reduction of our excessive reliance on imports;

(v) to achieve such recovery by means which do not add to government expenditure, but by means which would decrease our excessive budget deficit by the reduction in the cost of support for the unemployed.

The obvious danger in such a combination of policies is the possible adverse effect on the rate of inflation of money wage rates and prices. This sets a limit to the measures described in the previous paragraph. We should accordingly be prepared:

(i) to take as our anti-inflation criterion the restriction of the growth of the money value of the UK GDP (that is, of the total amount of money expenditures on our domestically produced goods and services) to a moderate target rate of growth;

(ii) to help to curtail any annual rate of growth of the national income above the target level by using fiscal measures (for example, by a rise in the rate of income tax, in addition to the avoidance of unnecessary governmental expenditure) that would further help to reduce our excessive budget


(iii) to take radical measures to limit the rate of rise in money wage rates and prices so as to ensure that increased money expenditures on goods and services lead to increased output and employment, rather than to an increase in the money costs and prices of the existing output.

I believe that this last requirement - to deal with inflation on the supply side by control of money costs, as well as on the demand side by control of money expenditures - is far and away the most important and difficult of our economic problems and, in order to avoid intolerable adverse effects on the distribution of income, requires much more radical and unfamiliar changes in our institutions than is generally recognised. But this is much too large a question to raise in a letter, and the discussion of which I must leave to a forthcoming book.

The adoption of the measures outlined above is in no way incompatible with our rejoining a suitable ERM-type of European monetary institution. But some period of independence would be needed for the working out of the effect of these measures to indicate at what sort of foreign-exchange rate we should intitially rejoin the system.

Yours faithfully,


Little Shelford, Cambridge

26 September

The writer was awarded the Nobel Prize for Economics, 1977.