It has been widely suggested and supposed that the abolition of exchange controls – one of the great episodes of financial deregulation in the United Kingdom since the 1970s – was the result of lobbying by the City of London. In this post for Fools’ Gold, Jack Copley of Warwick University explores the history, and finds a rather different story, focusing particularly on the issue of ‘competitiveness’ as it applies to the exchange rate.
What role did the ‘competitiveness agenda’ play in the Thatcher government’s deregulation of finance?
The case of exchange controls
By Jack Copley, Warwick University
Fools’ Gold has continued to expose the nefarious power of the City of London in British policymaking. As the biggest sector of the British economy, it is able to exercise undue influence over the government in order to secure preferential treatment. The notion that the City must remain globally competitive, and that ordinary people should be concerned about ensuring this, is a key part of the ‘competitiveness agenda’ in the UK.
Margaret Thatcher is the British politician most commonly associated with the City. Under her administration, a number of key financial deregulations took place, including exchange control abolition (1979), the Big Bang (1986), and the Building Societies Act (1986). Experts generally points to two explanations for the Thatcher government’s deregulatory agenda: 1) the City’s lobbying power; and 2) Thatcher’s ideological desire to promote the interests of the City over those of industry. This was particularly the case with exchange control abolition, which is widely perceived to have been a case of Thatcher giving a direct subsidy to financial elites and justifying it with rhetoric about national competitiveness.
In this post, I want to challenge this argument. The competitiveness agenda certainly played an important role in exchange control abolition, but in a more complicated way than is usually assumed. The Thatcher government did justify this deregulation with reference to the competitiveness of the City, but this was not in order to veil a policy of privileging financial services over industry. Instead, one of the key goals of this deregulation was to facilitate a relative depreciation of Sterling, by allowing some investment to flow out of Britain, so as to make British exports more competitive on global markets. This appeared crucial at a time when British companies were facing a crisis of low profitability and declining market share. Instead of admitting that they were really trying to bring about a competitive currency devaluation (a ‘bad’ kind of competitiveness!), the government claimed that exchange control abolition would boost the City’s global competitiveness and thus help the whole British economy, as well as simply being the ‘right thing to do’.
This case suggests that we draw a clear line between governments’ rhetoric about competitiveness and their real competitiveness agendas. The former, with its emphasis on an idealised notion of competition, is generally questionable; while the latter, which often entails quick-fix solutions to long-term problems and a beggar-thy-neighbour attitude to the global community, is often even less justifiable.
Why was exchange control abolition important?
Exchange controls were a type of capital controls that were imposed in Britain during World War Two. They limited the use of UK funds for overseas investment and set out rules for the repatriation of profits earned overseas. These controls did not directly restrict overseas investment, but rather affected the currency with which these investments were financed. The overarching goal of this system was to assist Britain’s balance of payments by giving the state a degree of influence over inward and outward flows of investment.
The abolition of exchange controls, which culminated in October 1979, had a huge impact on the British economy. It triggered a massive outflow of investment and exposed the City to increased global competition, which in turn helped to accelerate the processes that resulted in the Big Bang deregulation of 1986. In addition, abolition of exchange controls represented the scrapping of an important instrument for implementing Keynesian demand management. This policy decision, then, was a crucial step towards creating the kind of lopsided and finance-dependent economy that now exists in Britain.
Complicating the narrative
It may surprise some people that the first administration to significantly deregulate exchange controls was James Callaghan’s Labour government. In October 1977 and January 1978, Callaghan approved the relaxation of controls on inward investment and outward investment to the European Economic Community (EEC), as well as on things like travel and emigration. While this deregulation had a number of motivations – including the EEC’s drive to harmonise capital controls across Europe – the key driving factor was the value of Sterling.
Two things – the IMF’s seal of approval of British economic policy after the 1976 loan, and the flow of North Sea oil – had caused the pound to appreciate from late 1976. While this helped the government to fight inflation, by making imports cheaper, it was devastating for British manufacturers, who saw their products become less competitive on global markets. British industry, which had already been experiencing declining profits and worsening productivity since at least the late 1960s, now faced a very immediate crisis.
The idea was that exchange control relaxations would allow investment to flow out of Britain more easily, and thus dampen Sterling’s appreciation. In late 1977, the Chancellor, Denis Healey, outlined a plan for deregulation, which gained almost universal approval from different branches of government. The Bank of England had traditionally been hostile to these controls anyway, and could thus be counted on to endorse the move. But the Department of Trade also endorsed the plan, explaining, ‘the UK’s long-run trade and hence industrial performance will be threatened by a worsening of competitiveness … [This] is where the exchange control relaxations should help’. The Department of Industry agreed, arguing that there was ‘scope for certain selective relaxations of controls on outward investment that could benefit UK industry directly in the medium term’. The Secretary of State for Industry, Eric Varley, spoke directly to the Prime Minister, Chancellor and Bank of England Governor about the dire effects of Sterling appreciation: ‘Some of our industry was barely competitive at the present exchange rate. The textile and clothing sectors, for example, employing 850,000 people, would be severely hit, with serious political consequences’.
There was a remarkable consensus within the government, then, in favour of deregulating exchange controls. Notably, there is very little evidence of lobbying by the City. Instead, the biggest pro-deregulation lobbyist was the Confederation of British Industry, which launched a campaign in 1976 to convince the government to loosen controls.
Yet two important factors stood in the way of total abolition: Labour’s tense relationship with the trade unions and the possibility of a run on the pound. After effectively abandoning the ‘social contract’ with the unions that they had promised in their 1974 election campaign, Labour was already on thin ice with its support base. Chancellor Healey feared that announcing that the government had abandoned all limits on companies investing outside of Britain would cause too much ‘political difficulty, especially with the TUC [Trade Union Congress]’. Furthermore, since the advent of floating exchange rates in 1972, governments were very nervous about devaluing their currency in case it accidentally spooked the markets and led to a run on the currency. For these reasons, the Callaghan government’s deregulation of exchange controls was relatively cautious.
Thatcher – finishing the job
Thatcher’s Cabinet arrived in office in May 1979 with a strong desire to expose the British economy to competition and wreck the system of Keynesian demand management – exchange controls, in many ways, were the jewel in the crown of this system. However, they encountered a surprising lack of resistance from Treasury officials and the various government departments. In fact, the consensus throughout the government was the same as under Callaghan, namely that exchange controls had to be further relaxed – not to expose British industry to competition, but to boost British industry’s export competitiveness artificially.
As the pound continued to climb higher, British industry’s profits tumbled – falling by more than 13% in just the first three months of 1979. The Bank of England Governor wrote to the new Chancellor, Geoffrey Howe, in his first month in office and advised him to respond to Sterling’s overvaluation with ‘significant relaxation of exchange control’. Similarly, Treasury officials encouraged Financial Secretary Nigel Lawson’s deregulatory instincts. One such official argued that North Sea oil was ‘inorganically’ strengthening the pound, and that while this may appear to help the government defeat inflation, ‘too fast a rise in the rate will cause immediate damage to the viability of these industries before the counter-inflation benefits have had time to come through’. Officials in the Department of Trade, Department of Industry and the Foreign Office also encouraged their respective Secretaries of State to dismantle the controls in an attempt to rescue industry.
Once again, the CBI was a much more prominent lobbyist than the City, using meetings with the Treasury and Bank of England to push for exchange control relaxation. And while some officials did mention the positive effect of deregulation on the City’s affairs, this argument was greatly overshadowed by exchange rate concerns.
In contrast to the Callaghan government, Thatcher didn’t have to worry about the unions getting in the way. The Conservatives had expertly manipulated the Winter of Discontent (a series of crippling public sector strikes in the winter of 1978/79) against the unions, so as to ruin their public image and make an oppositional policy stance towards them popular. Yet there still remained the concern about currency instability in a floating rate system. As the Overseas Trade Board warned the Treasury, the government’s attempts to bring about a depreciation of Sterling ‘could easily get out of hand because of speculative action, and it might be very difficult to halt’.
To combat this risk, the Thatcher government devised a clever rhetorical strategy. Lawson’s key exchange controls advisor explained to him that it was ‘risky for Government spokesmen to say that it [exchange control relaxation] was intended to secure a depreciation in the exchange rate. Once that feeling got abroad, the short term consequences for the exchange rate could be very destabilising’. For this reason, the government should avoid ‘the argument that exchange control relaxation is intended as a means of increasing competitiveness’. In contrast, as Lawson himself explained, the best public justification for this deregulation was that it was simply ‘good house keeping’.
The government put this strategy into practice after their relaxation of controls in July 1979 and their final abolition of all remaining controls in October. On both occasions, senior government people emphasised that exchange controls had been dismantled in order to reaffirm ‘the City of London as the world’s financial centre’ (Howe) and simply because it was the right thing to do (Lawson and Secretary of State for Trade John Nott). They expected that this rhetoric would mask the fact that the government was trying to devalue the pound, and therefore avoid suggesting to the markets that they should aggressively sell Sterling. A supposedly virtuous kind of competitiveness was used to justify what was really a beggar-thy-neighbour kind of competitiveness.
Good and bad competitiveness
What can this episode tell us about the difference between the rhetoric and reality of governments’ competitiveness agendas? It suggests, among other things, that we should be very cynical about official government proclamations. Exchange controls were not primarily abolished in order to put the City on a level competitive playing field with Wall Street, and in turn promote British economic interests. Instead, this deregulation was a sneaky way to instantly boost British industrial competitiveness abroad, without any of the hard work that long-term investment, workforce training or technological innovation entails.
This case also suggests that we shouldn’t exaggerate the shadowy power of the City. While it undoubtedly currently wields an inordinate influence within the government, the deregulations that led to this situation were often pursued as a way to (mis)manage broader problems in the economy. If we understand what led states to deregulate finance, we should be in a better position to fight for re-regulation.
Quotations are from the National Archives, Margaret Thatcher Foundation, Modern Records Centre and Financial Times archives.