In 1976, the minority Labour UK government of James Callaghan was ‘forced’ to borrow $3.9 billion from the IMF to stabilise the value of Pound. The loan was also accompanied with conditions to cut public spending and raise interest rates. It marked a symbolic break with the post-war economic consensus and was a reflection of persistent problems in the post-war UK economy. After the bailout, economic conditions turned around with an improvement in the current account, budget deficit and appreciation in Sterling. But, fundamental weaknesses remained with high inflation and a winter of discontent (1978/79) causing further instability.
Backdrop to the crisis of 1976
The crisis occurred against a backdrop of high inflation, the 1974 recession, oil crisis, high levels of government borrowing and a current account deficit. The weak UK economic picture had been putting downward pressure on the value of Sterling.
In 1974 the National Institute for Economic & Social Research made a report about the UK economy. Its conclusions made grim reading:
“It is not often that a government finds itself confronted with a possibility of a simultaneous failure to achieve all four main policy objectives: adequate economic growth, full employment, a satisfactory balance of payments, and reasonable, stable prices.” (Gresham Lecture)
The report could have added two further macroeconomic objectives in peril – a manageable budget deficit and stable Pound.
Given a growing budget deficit, in early 1976, James Callaghan proposed a white paper to cut the budget deficit, but it split the Labour cabinet with left-wing ministers like Michael Foot opposing the spending cuts.
The problem for the government in the 1970s was that high inflation was making government bonds less attractive. Despite high nominal bond yields, the high inflationary rate meant real returns were close to zero. With high inflation making future inflation more volatile, investors were reluctant to buy government bonds and risk losing out to inflation eroding the value of their bonds. Combined with uncertainty over the exchange rate, there was a growing reluctance to buy UK government debt.
In the post-war Bretton Woods era, governments did not fully believe in floating exchange rates but targeted a ‘managed exchange rate’ – fearing a depreciation from their target would cause economic instability and problems such as more inflation. If the government had followed a floating exchange rate and not tried to intervene in the Sterling markets, the need for the loan would have been significantly less and probably not needed.
High inflation, a current account deficit, a weak export sector and economic uncertainty were all putting downward pressure on the value of Sterling. Between 1972 and 1976, Sterling depreciated 20%. The depreciation in the value of Sterling was welcomed by some in the Treasury who saw the depreciation as a way to restore competitiveness and reduce the current account deficit. But, the government retained an unofficial policy of trying to stabilise the currency – fearing among other things – continued depreciation would worsen the double-digit inflation.
It was the fall in Sterling which caused the government to approach the IMF for a bailout (with lesser concerns about government debt)
The IMF bailout was given under conditions of higher interest rates and cutting government spending to reduce the PSBR (budget deficit as it was called then)
After the bailout, the UK economy recovered with stronger growth, growing oil revenues, an improved current account and appreciation in the value of the Pound. Even the budget deficit turned out lower than expected. The full loan was not taken out and loan was soon repaid.
“[an economist was] a man who, when you ask him for a telephone number, gives you an estimate”. Gresham Lecture
However, the crisis crystalised a new direction in UK economic policy; it was seen as the fading away of the old “Keynesian” post-war consensus and signalled a greater priority for targeting inflation, and deflating the economy if necessary.
Also, although the economy recovered, it still struggled with high inflation, poor industrial relations and (by post-war standards) high unemployment.
The recession of 1974 caused a rise in the UK budget deficit to a record post-war level; the recession caused unemployment and a fall in tax revenues.
Interesting points about IMF Crisis 1976 – compared to current situation
Government borrowing was relatively low by 2011 standards. At 7% of GDP, in 1976, the budget deficit was large, but less than the 11% seen in 2011/12. In the mid-1970s, the National debt had been steadily falling since 1945. In 1976 was less than 50% of GDP – half that of 15 years previous.
However, the presence of high and variable inflation meant investors were more reluctant to buy government debt. In 2010-16, growing debt corresponded with falling bond yields because we were in a low inflationary environment.
Managed exchange rates
A key contrast of the 1970s was the focus attached on managing the exchange rate. Ironically, after fears over devaluation in 1976, the Pound appreciated to a high of £1 to $2.5 by 1981 causing a recession – especially in export industries.
Devaluation of 1992. The 1976 crisis has some parallels with 1992 when the UK was trying (and failing) to maintain the exchange rate in the ERM. The government used foreign exchange reserves to try and keep value Pound within its target. Unlike 1976, they were also deflating the economy with very high-interest rates.