The Downing Street Years, 1979-1990

A correct economic policy depends crucially upon a correct judgement of what activities properly fall to the state and what to people. The state has to set a framework of laws, regulation and taxes in which businesses and individuals are then free to operate. But there also has to be a financial framework for policy. After a long struggle during my first term, from 1979 to 1983, like-minded ministers and I had largely converted the Cabinet, the Conservative Party and opinion in the worlds of finance, business and even the media to a more restrictive view of what the state’s role in the economy should be. Moreover, as regards the regulatory framework within which business could run its affairs, there was a general understanding that lower taxes, fewer controls and less interference should be the goal. But as regards setting the overall financial framework, within which the real economy generates wealth, there was less common ground. Whereas Nigel Lawson and I agreed strongly about the role of the state in general, we came sharply to differ about monetary and exchange rate policy.

Our success in bringing down inflation in our first term from a rate of 10 per cent (and rising) to under 4 per cent (and falling) had been achieved by controlling the money supply. ‘Monetarism’ — or the belief that inflation is a monetary phenomenon, i.e., ‘too much money chasing too few goods’ — had been buttressed by a fiscal policy which reduced government borrowing, freeing resources for private investment and getting the interest rate down. This combined approach had been expressed through the Medium Term Financial Strategy (MTFS) — in large measure Nigel Lawson’s brainchild.[94] Its implementation depended heavily on monitoring the monetary indicators. These, as I have noted, were often distorted, confusing and volatile. We needed other indicators as well. So, before the end of Geoffrey Howe’s Chancellorship the value of the pound against other currencies — the exchange rate — was also being taken into account.

It is important to understand what the relationship between the exchange rate and the money supply is — and what it is not. First consider the effect of an increase in the exchange rate; that is, one pound sterling is worth more in foreign currency. Because most import and export prices are fixed in foreign currencies, the sterling prices of these tradeable goods will fall. But this only applies to goods and services which are readily imported and exported, like oil, grain or textiles. Many of the goods and services that comprise our national income are not of this sort: for example, we cannot export our houses or the services provided in our restaurants. The prices of these things are not directly affected by the exchange rate, and the indirect effect — passed on via wages — will be limited. What does more or less determine the prices of houses and other ‘non-tradeables’, however, is the money supply.

If the money supply rises too fast, the prices of non-tradeable domestic goods will rise accordingly, and a strong pound will not prevent that. But the interaction of a strong pound and a loose money supply causes the export sector to be depressed, resources to flow to houses, restaurants and the like. The balance of trade will then go into larger and larger deficits, which have to be financed by borrowing from foreigners. This kind of distortion just cannot last. Either the exchange rate has to come down, or monetary growth has to be curtailed, or both.

This result is of the utmost importance. Either one chooses to hold an exchange rate to a particular level, whatever monetary policy is needed to maintain that rate. Or one sets a monetary target, allowing the exchange rate to be determined by market forces. It is, therefore, quite impossible to control both the exchange rate and monetary policy.

A free exchange rate, however, is fundamentally influenced by monetary policy. The reason is simple. If a lot more pounds are put into circulation, then the value of the pound will tend to fall — just as a glut of strawberries will cause their value to go down. So a falling pound may indicate that monetary policy has been too loose.

But it may not. There are many factors other than the money supply which have a great influence on a free exchange rate. The most important of these are international capital flows. If a country reforms its tax, regulatory and trade union arrangements so that its after-tax rate of return on capital rises well above that of other countries, then there will be a net inflow of capital and its currency will be in considerable demand. Under a free exchange rate, it would appreciate. But this would not be a sign of monetary stringency: indeed, as in Britain in 1987 to mid-1988, a high exchange rate may well be associated with a considerable monetary expansion.

It follows from this that if the exchange rate becomes an objective in itself, as opposed to one indicator among others for monetary policy, ‘monetarism’ itself has been abandoned. It is worth repeating the point because it is of such importance to understanding the arguments which took place: you can either target the money supply or the exchange rate, but not both. It is an entirely practical issue. The only effective way to control inflation is by using interest rates to control the money supply. If, on the contrary, you set interest rates in order to stick at a particular exchange rate you are steering by a different and potentially more wayward star. As we have now seen twice — once when, during my time, Nigel shadowed the deutschmark outside the ERM and interest rates stayed too low; once when, under John Major, we tried to hold to an unrealistic parity inside the ERM and interest rates stayed too high — the result of plotting a course by this particular star is that you steer straight on to the reefs.

ECONOMIC AND MONETARY UNION (EMU)

These questions were not ones for the technicians alone: they went to the very heart of economic policy, which itself lies at the heart of democratic politics. But there was an even more important issue which was raised first by argument about whether sterling should join the ERM and then, in a more acute form, about whether we should accept European Community proposals for Economic and Monetary Union (EMU). This was the issue of sovereignty. Sterling’s participation in the ERM was seen partly as proof that we were ‘good Europeans’ (a phrase which in fact increasingly meant bad Europeans, as the Community adopted a selfish, protectionist stance to liberated eastern Europe). But it was also seen as a way of abdicating control over our own monetary policy, in order to have it determined by the German Bundesbank. This was what was meant when people said we would gain credibility for our policies if we were — to adopt another Euro-metaphor — ‘anchored’ to the deutschmark. Actually, the metaphor is strangely appropriate: for if the tide changes and you are anchored, the only option to letting out more chain as your ship rises is to sink by the bows; and in an ERM where revaluations were ever more frowned upon there was no more chain to let out. Which leads on to EMU.

The ERM was seen by the European Commission and others as a path to EMU — and this subtly changed the former’s purpose. But EMU itself — which involves the loss of the power to issue your own currency and acceptance of one European currency, one central bank and one set of interest rates — means the end of a country’s economic independence and thus the increasing irrelevance of its parliamentary democracy. Control of its economy is transferred from the elected government, answerable to Parliament and the electorate, to unaccountable supra-national institutions. In our opposition to EMU, Nigel Lawson and I were at one. Indeed, perhaps the most powerful critique of the whole concept was that contained in Nigel’s lecture at Chatham House in January 1989 when he said:

Alas, by his pursuit of a policy that allowed British inflation to rise, which itself almost certainly flowed from his passionate wish to take sterling into the ERM, Nigel so undermined confidence in my government that EMU was brought that much nearer.

EARLY DISCUSSION OF THE EXCHANGE RATE MECHANISM (ERM)

To trace the course of our arguments in government about the Exchange Rate Mechanism of the European Monetary System (EMS) it is necessary to go right back to our first year in office. The Foreign Office and the Treasury both had an interest; the former regarded it as a question of European relations, the latter — rightly — as an economic question. I decided early on to be closely involved in the issue and held an initial meeting to discuss the question in October 1979. In retrospect, the balance of opinion in the Cabinet is of some significance. Geoffrey Howe as Chancellor was against membership at present, partly because of uncertainty about the effects of abolishing exchange controls. The then Governor of the Bank of England, though he agreed, was more enthusiastically in favour. Keith Joseph and John Nott were against. So was I. But since we had devised the formula that we would join when the ‘time was right’ (or ‘ripe’ as it was sometimes expressed) there seemed no need to change our basic position. The time was not ‘right’ and no one seriously thought it was. Geoffrey Howe gave no hint of his future position. Indeed, in December he came to see me to complain that in a speech he had made about the subject in Brussels Peter Carrington had been too positive about the EMS.

Even at this stage, the basic arguments for and against the ERM were known, though none of us had, of course, given as much thought to the subject as we would do later. Britain had already had an unhappy experience of trying to peg sterling in a European currency system. In 1972 Ted Heath’s Government had ignominiously been forced to leave the European ‘snake’ — the forerunner of the ERM — after a mere six weeks. So any British Government would need to be cautious.

There were two other matters which bore on the decision. First, there was no disguising, for reasons I have explained, that there was always going to be potential for conflict between our domestic monetary policy and an exchange rate target — this was brought out clearly in Treasury papers prepared for us now. Second, we were conscious — perhaps over-conscious as Alan Walters would argue — of sterling’s position as a ‘petro-currency’. The pound’s value was affected by the discovery and exploitation of huge quantities of North Sea oil. This had the apparently perverse result that whereas higher oil prices increased the value of the pound, they would generally reduce the value of other western European currencies. But the greatest destabilizing factor was the appalling condition of the British economy in 1979. Until inflation had been brought under control and the public finances restored, it was not, in my view, realistic to consider participation in the ERM.

But in early 1980 Helmut Schmidt was urging me to enter the ERM and I was anxious to be as co-operative as possible to the Germans because I needed their support on the question of our Community budget contributions. So I reopened the question. The more I looked at the papers and the facts they revealed, the more sceptical I became. The Treasury were firmly against our joining. They noted that if we had joined in September 1979 there would have had to be very heavy intervention in the exchange markets — selling pounds — to hold sterling down. I chaired a meeting on the subject in March 1980 at which I opened by saying that domestic monetary policy must remain paramount. After we had argued all the points through, we concluded that we should not join in the immediate future but stick to the line that we intended to join when conditions permitted.

There was further discussion in the autumn of 1981. It will be remembered that this was a difficult time when some of the gains of lower interest rates obtained through our tough 1981 budget looked as if they might be dissipated as a result of international pressures. United States interest rates rose as the Federal Reserve Bank attempted to restrain the inflationary pressure generated during the previous Carter presidency: throughout the world interest rates followed. I asked Geoffrey Howe to bring forward a paper looking once again at the question of whether we should join the ERM. Opinion among Treasury ministers was divided. But both Geoffrey Howe and Leon Brittan (then Chief Secretary) were against our joining. The position of Nigel Lawson, then Financial Secretary, was less clear.

I said that I would need to be convinced that there were positive arguments for joining, not just an insufficiency of arguments against. My caution was reinforced by powerful advice from Alan Walters. His view was that it was wrong to think of the ERM as a force for stability. It did not even have the — arguable — merits of a system of fixed exchange rates. The parities moved within a band. Then, after bumping along against the ceiling or the floor, they would go through a process of periodic realignments in which the rates moved in discrete jumps. These movements, moreover, were the subject of political horse-trading rather than the workings of the market — and the market does a better job.

After several postponements as a result of other pressures on my diary, I eventually chaired another meeting on the subject in January 1982. Geoffrey Howe’s view was still that this was not the right time to join. I agreed. I said that I was not convinced that there would be solid advantage in joining the ERM. I did not believe that in practice it would provide an effective discipline on our economic management. Rather, it removed our freedom of manoeuvre. I accepted, however, that when our inflation and interest rates moved much closer to those of West Germany the case for joining would be more powerful. For the time being, we would maintain our existing position on the issue.

ARGUMENTS ABOUT THE ERM: 1985

There could be no question of our entering the ERM on the eve of a general election, so this was the situation which Nigel Lawson inherited when I made him Chancellor in 1983. At this time the exchange rate was just one factor being taken into account in order to assess monetary conditions. It was the monetary aggregates which were crucial. The wider measure of money — £M3 — which we had originally chosen in the MTFS had become heavily distorted. A large proportion of it was in reality a form of savings, invested for the interest it earned. In Nigel’s first budget (1984) he set out different target ranges for narrow as well as broad money. The former — M0 — had been moving upward a good deal more slowly and this was taken into account in plotting the future course. But at this stage M3 and M0 were formally given equal importance in the conduct of policy. Other monetary indicators, including the exchange rate, were also taken into account. Our critics, who had until now denounced our policy as a rigid adherence to a statistical formula, began to denounce our rootless and arbitary pragmatism. And indeed, sensible as this change was, it was to mark the beginning of a process by which the clarity of the MTFS became muddied. This in turn, I suspect, caused Nigel, as the years went by, to search with increasing desperation for an alternative standard — reliable in itself, convincing to the markets — which he finally thought he had found in the exchange rate.

Events in January 1985 brought the ERM back into discussion. The dollar was soaring and there was intense pressure on sterling, in spite of the soundness of Britain’s finances. I agreed with Nigel that our interest rates should be raised sharply. I also agreed with Nigel’s view that there should be co-ordinated international intervention in the exchange rates to achieve greater stability, and I sent a message to this effect to President Reagan. This policy was formalized by Nigel and other Finance ministers under the so-called ‘Plaza Agreement’ in September. In retrospect, I believe that this was a mistake. As Alan Walters would always argue, if intervention is ‘sterilized’, that is to say not allowed to affect the money supply and short-term interest rates, it will have only a fleeting effect; on the other hand, if it does promote monetary growth then it will be inflationary. The Plaza Agreement gave Finance ministers — Nigel above all perhaps — the mistaken idea that they had it in their power to defy the markets indefinitely. This was to have serious consequences for all of us.

Sterling’s problems also prompted Nigel to raise with me in February the issue of the ERM. He said that in his view controlling inflation required acceptance of a financial discipline which could be provided either by monetary targets or by a fixed exchange rate. It was essentially a secondary matter which of these was chosen. But new factors, argued Nigel, favoured the ERM. First, it was proving difficult to get financial markets to understand what the Government’s policy towards the exchange rate really was: the ERM would provide much clearer rules of the game. There was also a political consideration. Many Conservative MPs were in favour of joining. In arguments about additional spending and borrowing it would, he thought, be helpful to be faced with a discipline which MPs themselves accepted. Entry into the ERM would also move the focus of attention away from the value of the pound against the dollar — where, of course, the problem at this particular moment lay. Finally, £M3 was becoming increasingly suspect as a monetary indicator because its control depended increasingly on ‘overfunding’, with the resulting rise in the so-called ‘bill mountain’.[95] I was not convinced on any of these counts, with the possible exception of the last. But I agreed that there should be a seminar involving the Treasury, the Bank of England and the Foreign Office to discuss it all.

Alan Walters could not attend the seminar and so he let me have his views separately. He put his finger on the key issue. Would membership of the ERM reduce the speculative pressure on sterling? In fact, it would probably make it worse. That was the lesson to be drawn from what had happened to other ERM currencies, like the franc. Moreover, in view of Britain’s open capital and exchange markets and the international role of sterling, we would be subject to greater pressures than France.

At my seminar Nigel did not argue that it would be right to enter the ERM under current circumstances. But he repeated the general argument in favour of joining which he had put to me earlier. Perhaps the most significant intervention, however, was that of Geoffrey Howe who had now been converted to the Foreign Office’s departmental enthusiasm for the ERM and thought that we should be looking for an appropriate opportunity to join — though he too did not think the circumstances at the moment were right. In the course of the discussion it became clear that we would need to build up foreign exchange reserves if we wanted to be in a position to enter. I agreed that the Treasury and the Bank of England should consider how this should be done. But since no one was arguing for immediate entry, there was no other decision to take. The meeting ended amicably enough.

During the summer of 1985 I started to become concerned about the inflation prospect. I was uneasy for a number of reasons. £M3 was rising rather fast. Property prices were increasing, always a dangerous sign. The ‘bill mountain’ was worrying too — not because it suggested anything about inflation (indeed the overfunding which led to it was in part the result of the Bank’s attempt to control £M3). Rather, since we had decided against a policy of overfunding as far back as 1981, the fact that it had been resumed on such a scale without authorization did not increase my confidence in the way policy in general was being implemented.

Even now it is unclear whether my misgivings were justified. Some analysts — notably the perceptive Tim Congdon — would argue that the rise in £M3 now and later did cause inflationary problems. By contrast, Alan Walters, who believed that MO was the best indicator, reckoned that monetary policy was sufficiently tight, as did the rest of my advisers. Essentially, these tricky questions are always a matter of judgement. The important thing is that when clear evidence appears that things are slipping you take action fast. Certainly, I do not believe that monetary policy in 1985 — or 1986 — was the main cause of the problems we were later to face.

Nigel now returned to the charge on the ERM. I agreed to hold a further seminar at the end of September. The subject seemed to be becoming something of an idée fixe. Nigel even sent me a paper envisaging what would happen if we were in the ERM in the run-up to a general election which the financial markets thought that we might lose. In such circumstances, he argued, we would need to announce our temporary cessation from operating the system coupled with an undertaking that on our return to office after the election we would immediately resume at the same parity as before. In itself, of course, this was an example of the perils of committing oneself to fixed parities irrespective of outside events.

By now I was more convinced than ever of the disadvantages of the ERM. I could see no particular reason to allow British monetary policy to be determined largely by the Bundesbank rather than by the British Treasury, unless we had no confidence in our own ability to control inflation. I was extremely sceptical about whether the industrial lobby which was pressing us so hard to join the ERM would maintain its enthusiasm once they came to see that it was making their goods uncompetitive. I doubted whether the public would welcome what might turn out to be the huge cost of defending sterling within the ERM — which, indeed, might well prove to be impossible in the run-up to a general election and so be compounded by a forced devaluation. Looking back over the last few years it was clear that sterling had not tracked other European currencies in a stable way. In 1980, sterling rose 20 per cent against the European Currency Unit (ecu). In 1981 it fell by 15 per cent from peak to trough. In 1982 it did the same. In 1983 it rose by as much as 10 per cent. In 1984 it was somewhat more stable. But in 1985 it had risen by more than 10 per cent. To control such movements, we would have needed recourse to huge quantities of international reserves and to a very tough interest rate policy.

There was nothing secret about these facts. They were available to anyone who wanted to know them. But nothing is more obstinate than a fashionable consensus. Nor is it without influence on Cabinet committees. I had no support at the seminar at the end of September. Nor did my arguments budge Nigel and Geoffrey. There was no point in continuing the discussion. I said that I was not convinced that the balance of argument had shifted in favour of joining. I said that I would hold a further meeting to which other colleagues would be invited.

Before this took place I had a long list of questions drawn up about the implications of the ERM. I hoped that these would illuminate some of the points we would need to discuss. It would be more charitable than accurate to suggest that the answers provided by the Treasury did so. Yet the paper which Nigel presented at the meeting now seems strangely prophetic. He suggested that we had to convince people that inflation would continue to come down and stay down, adding that there was still a nagging fear that sooner or later we would succumb to the temptation of going for an easy inflationary option. He also suggested that after a period of some years sticking to the same policy, this now needed a shot in the arm, a touch of imagination and freshness to help the explanation and to ensure that our policies continued to carry conviction. Entry into the ERM was, of course, the answer. Since it was Nigel’s policy of shadowing the deutschmark — an informal version of ERM entry — that was to lead to inflation and undermine confidence, there now seems a certain irony in these assertions.

It has to be said that the wider meeting which I held to discuss the ERM on the morning of Wednesday 13 November did not advance us any further than the earlier meetings. We went over the same ground and at the end I repeated that I had not been convinced by the arguments I had heard. However, I agreed that we should strictly maintain the line we had taken so far, namely that Britain would join the ERM ‘when the time was right’.

The position was unsatisfactory. Most of the arguments which persuaded me that we should not now enter the ERM applied to the principle — not just the circumstances — of entry. I knew that I was in a very small minority within the Cabinet on this matter, though most of my colleagues were probably not overinterested in it anyway. Geoffrey and Nigel, by contrast, were fervent. For Geoffrey membership of the ERM would be a demonstration of our European credentials. For Nigel it would provide stability in the turbulent and confusing world in which decisions about interest rates and monetary policy had to be made. And there is no doubt that those decisions could on occasion be extremely difficult.

INTEREST RATES AND INFLATION: 1986

It is worth noting at this point where the difficulty lay — and where it did not. Until 1987 when Nigel made the exchange rate the overriding objective of policy, there was no fundamental difference between us, although Nigel apparently now thinks I was ‘soft’ on interest rates. Anyone who recalls our decisions from 1979 to 1981 will find that implausible. It would also surprise anyone who considers that one of the main arguments advanced for joining the ERM, which Nigel so passionately wanted, was that it would lead to lower interest rates. And, as I shall show subsequently, there were occasions when I thought that he was soft on interest rates and wanted to raise them more quickly.[96] The two of us were equally opposed to inflation. If anything, I was more concerned than he was. It was my constant refrain that much as I might admire his fiscal reforms, he had made no further progress in getting down the underlying inflation rate.

Nevertheless, Nigel and I did have rather different starting points when it came to these matters. I was always more sensitive to the political implications of interest rate rises — particularly their timing — than was Nigel. Prime Ministers have to be. I was also acutely conscious of what interest rate changes meant for those with mortgages. Although there are several times as many savers as borrowers from building societies, it is the borrowers whose prospects — even lives — can be shattered overnight by higher interest rates. My economic policy was also intended to be a social policy. It was a way to a property-owning democracy. And so the needs of home owners must never be forgotten. Other things being equal, on every ground a low interest rate economy is far healthier than a high interest rate economy.

High real interest rates[97] do ensure that there is a high real reward for saving. But they discourage risk-taking and self-improvement. In the long run, they are a force for stagnation rather than enterprise. For these reasons I was cautious about putting up interest rates unless it was necessary.

Another reason for caution was the difficulty of judging precisely what the monetary and fiscal position was. The MO figures were volatile from month to month. The other aggregates were worse. We were given figures which underrated economic growth and so caused us to exaggerate the likely size of the PSBR. In these circumstances, making the right judgement about when and whether to cut or raise interest rates was indeed difficult. So at the meetings I had with Nigel, the Bank and Treasury officials to decide on what must be done I would generally cross-examine those involved, give my own reaction and then — when I was sure all the factors had been considered — go along with what Nigel wanted. There were exceptions. But they were very few.

SHADOWING THE DEUTSCHMARK: 1987–1988

It was only from March 1987 — though I did not know it at the time — that Nigel began to follow a new policy, different from mine, different from that to which the Cabinet had agreed, and different from that to which the Government was publicly committed. Its origins lay in the ambitious policy of international exchange rate stabilization. In February Nigel and other Finance ministers agreed on intervention to stabilize the dollar against the deutschmark and the yen by the ‘Louvre Accord’ agreed in Paris. I received reports of the massive intervention this required which made me uneasy. And it was not clear how long this would last.

In July Nigel raised again with me the question of whether sterling should join the ERM. He felt that the first year of a new Parliament would be the right time to join. Membership would give us as much exchange rate stability as it was possible to achieve and help business confidence. I was not unprepared for this and had earlier talked the subject through with Alan Walters and Brian Griffiths, the head of my Policy Unit who in an earlier incarnation had been Director of the Centre for Banking and International Finance at the City University. I said to Nigel that the Government had built up over the last eight years a well-founded reputation for prudence. By joining the ERM we would in effect be saying that we could not discipline ourselves and needed the restraint provided by Germany and the deutschmark. ERM membership would reduce the room for manoeuvre on interest rates which would, at times of pressure, be higher than they would be if we were outside. I had heard the arguments about external discipline before. I recalled that Ted Heath had claimed in the early 1970s that European Community membership would help discipline the trade unions. But this had not happened; and the attempt to use ERM membership to influence the expectations of management and workforces would be an equal failure. Overall, when things were going smoothly membership of the ERM would add nothing to our economic policy-making, and when things were going badly membership would make things worse. Nigel completely rejected this. He said he would want to discuss it all again with me in the autumn. I said that was much too soon: I would not wish to hold a further discussion on the subject until the New Year.

By now there was some evidence that the economy might be growing at a rate too strong to be sustainable. The monetary figures were ambiguous, but the PSBR looked as if it would turn out much lower than expected at the time of the budget. In August 1987 Nigel proposed a 1 per cent rise in interest rates on the grounds that this was required to defeat inflation by the next election. I accepted the proposal. That was the position when on ‘Black Monday’ (19 October 1987) there was a sharp fall in the Stock Market, precipitated by a fall in Wall Street. These developments were, in retrospect, no more than a market correction of overvalued stocks, made worse by ‘programmed selling’. But they raised the question of whether, far from overheating, we might now be facing a recession as people spent less and saved more in order to make up for the decline in the value of their shares.

I was in the United States when I learnt about the Stock Market collapse. I had flown from the Commonwealth Conference at Vancouver to Dallas, where I was to stay with Mark and the family. As it happens I dined that evening with some of America’s leading businessmen and they put what had happened in perspective, saying that, contrary to some of the more alarmist reports, we were not about to see a meltdown of the world economy. Still, I thought it best to make assurance doubly sure, and I agreed to Nigel’s request for two successive half percentage point cuts in interest rates in response to help restore business confidence.

What I did not know was that Nigel was setting interest rates according to the exchange rate so as to keep the pound at or below DM3. It may be asked how he could have pursued this policy since March without it becoming clear to me. But the fact that sterling tracks the deutschmark (or the dollar) over a particular period does not necessarily mean that the pursuit of a particular exchange rate is determining policy. The same effect can have several causes. There are so many factors involved in making judgements about interest rates and intervention that it is almost impossible at any particular time to know which factor has been decisive for whoever is in day-today charge.

Of course, as the months pass and people look back at what has been happening questions begin to be asked. Nigel, who is nobody’s fool, must have recognized that this would happen. Indeed, he presumably intended it. Had all gone well, it would have been taken as proof that we could enter the ERM at about DM3 with no adverse consequences. He would have been able to overturn my veto on entry under circumstances in which it was almost impossible for me to reimpose it. To some extent, indeed, this is what happened, though he did not actually force us into the ERM. Once the financial markets have become convinced that a particular policy — in this case shadowing the deutschmark at a particular parity — is the central guarantee of financial stability, the effect of moving away from this approach is profoundly destabilizing. That is why, when I discovered what was happening, I found we had already forfeited some of our freedom of action.

Extraordinarily enough, I only learnt that Nigel had been shadowing the deutschmark when I was interviewed by journalists from the Financial Times on Friday 20 November 1987. They asked me why we were shadowing the deutschmark at 3 to the pound. I vigorously denied it. But there was no getting away from the fact that the chart they brought with them bore out what they said. The implications of this were, of course, very serious at several levels. First, Nigel had pursued a personal economic policy without reference to the rest of the Government. How could I possibly trust him again? Second, our heavy intervention in the exchange markets might well have inflationary consequences. Third, perhaps I had allowed interest rates to be taken too low in order that Nigel’s undisclosed policy of keeping the pound below DM3 should continue.

I did not want to raise this matter with Nigel until I was absolutely sure of my ground. So I brought together as much information as I could about what had been happening to sterling and the extent of intervention. Then I tackled him. At our meeting on Tuesday 8 December I expressed very strong concern about the size of the intervention needed to hold sterling below DM3. Nigel argued that the intervention had been ‘sterilized’ by the usual market operations and that it would not lead to inflation. I understood sterilization to mean that the Bank sold treasury bills and gilts to ensure that the intervention funds did not affect short-term interest rates. But the large inflow of capital, even if sterilized in this sense, had its own effect, on the one hand in increasing monetary growth and on the other in putting additional downward pressure on market interest rates. This was an environment where Nigel superficially could justify lower base rates than domestic pressures warranted. As a result, inflation was stoked up.

In the early months of 1988 my relations with Nigel worsened. I sought to discourage too much exchange rate intervention, but without much success. It seemed to me contradictory to raise interest rates — as we did by half a percentage point in February — while at the same time intervening to hold down sterling. But, equally, I knew that once I exerted my authority to forbid intervention on this scale it would be at the cost of my already damaged working relationship with Nigel. He had boxed himself into a situation where his own standing as Chancellor would be weakened if the pound went above DM3. It was a convincing if unwelcome demonstration of the folly of regarding a particular exchange rate parity as the criterion for political and economic success.

By the beginning of March, however, I had no option. On 2 and 3 March 1988 over £1 billion of intervention took place. The Bank of England, which is traditionally all for a managed exchange rate, was deeply anxious about the policy. So, I knew, were senior Treasury officials, though of course they could not say so openly.

I had the matter out with Nigel at two meetings on Friday 4 March. I again complained about the level of exchange rate intervention. For his part, Nigel said it would be sterilized. But he did accept that intervention at the present rate could not continue indefinitely. I asked him to consult the Bank of England and report back later that day on whether the DM3 ‘cap’ should be removed and, if so, when. When he returned he accepted that if on Monday there was still strong demand for sterling the rate should be allowed to go above DM3. He was keen to have some further intervention to break the speed at which the exchange rate might rise. I expressed my concern about this and said that my strong preference would be to allow time for the rate to find its own level without any intervention. But I was prepared to go along with some limited intervention if necessary. The pound accordingly rose through the DM3 limit.

Immediately, the Opposition and the media sought to make capital out of divisions between Nigel and me. I set out the policy accurately and the thinking behind it in the House of Commons on Thursday 10 March at Prime Minister’s Questions:

My Rt. Hon. Friend the Chancellor and I are absolutely agreed that the paramount objective is to keep inflation down. The Chancellor never said that aiming for greater exchange rate stability meant total immobility. Adjustments are needed, as we learnt when we had a Bretton Woods system, as those in the EMS have learnt that they must have revaluation and devaluation from time to time. There is no way in which one can buck the market.

This last remark however provoked a flurry of press comment to which truth was no defence. The trouble was that it appeared to contrast with Nigel’s continuing public statements that he did not want to see the exchange rate appreciate further. From now on it would be increasingly difficult to convince the markets that my Chancellor and I were at one. And, of course, the perception they had was basically an accurate one.

The question arises whether at some point now or later I should have sacked Nigel. I would have been fully justified in doing so. He had pursued a policy without my knowledge or consent and he continued to adopt a different approach from that which he knew I wanted. On the other hand, he was widely — and rightly — credited with helping us win the 1987 election. He had complete intellectual mastery of his brief. He had the strong support of Conservative back-benchers and much of the Conservative press who had convinced themselves that I was in the wrong and that only pettiness or pig-headedness could explain the different line I took. Whatever had happened, I felt that if Nigel and I — supported by the rest of the Cabinet — pulled together we could avert or at least overcome the consequences of past mistakes and get the economy back on course for the next general election.

But this was not to be. Whatever I said in the House in answer to questions about interest rates and the exchange rate was given a construction to suggest that either I was not endorsing Nigel’s views or that I was protesting too much — and so unconvincingly — my adherence to them. In these situations you just cannot win. Nigel was extremely upset over my remarks at Prime Minister’s Questions on Thursday 12 May. Though I warmly supported him and his public statements I had not repeated Nigel’s view that further exchange rate appreciation would be ‘unsustainable’.

Geoffrey Howe was now also making mischief. From this time on it became clear to me that Nigel and he — by no means on friendly terms in earlier years when there was a good deal of jealousy between them — were in cahoots, and that of the two Geoffrey was the more ill-disposed to me personally. Earlier — in March — Geoffrey had made a speech in Zurich which was widely taken as siding with Nigel against me on the question of the exchange rate. Then on Friday 13 May he quite gratuitously slipped into his speech to the Scottish Party Conference in Perth the remark, apropos of our commitment to join the ERM ‘when the time is right’, that: ‘We cannot forever go on adding that qualification to the underlying commitment.’ This led the press to widen the perceived rift between me and Nigel over the ERM once more. I was not best pleased. When Geoffrey imprudently telephoned me the morning after his speech to ask for a meeting at which he and the Chancellor should come to see me later in the day to ‘settle the semi-public dispute’, I told him that I would be seeing Nigel later in the day to discuss the markets — which Geoffrey’s own remarks had unsettled. But I was not seeing them together. I told him three times — since he did not seem to take it in and persisted in his attempt to contrive a meeting at which he and Nigel could get their way — that the best thing he could do now was to keep quiet. We were not going into the ERM at present and that was that.

I spent Sunday at Chequers working on a speech I was to deliver to the General Assembly of the Church of Scotland: there was some mirth when my speech writers and I were discovered down on our knees in an appropriate posture, though drawing on the resources of sellotape rather than the Holy Spirit. But, following the news reports during the day, I was also aware of just how damaging the constant media reports of splits and disagreements on the exchange rate were becoming.

Nigel arranged to see me on the Monday. He wanted to agree a detailed formulation for use by me in the House to describe our policy. I had been told by the Treasury in advance of the meeting that Nigel wanted a further interest rate cut. For my part, I had become appalled at the size of our intervention in the money markets which was clearly still failing to hold sterling at the level Nigel wanted and which, in spite of assurances from Nigel, I feared might prove inflationary. But I had got part of what I wanted — which would ideally have been a pound which found its own level in the markets — in that sterling had been allowed to rise to DM3.18. So I was not unhappy to have the suggested interest rate cut I knew he wanted. I was also aware that the speculators were beginning to consider sterling a one-way bet and that allowing them to burn their fingers a little would do no end of good.

Above all, however, this reduction of the interest rate on Tuesday 17 May by half a point to 7.5 per cent was the price of tolerable relations with my Chancellor, who believed that his whole standing was at stake if the pound appreciated outside any ‘band’ to which he might have semi-publicly consigned it. If I had refused both intervention and an interest rate cut and sterling had drifted up to find its proper level there was little doubt in my mind that Nigel would have resigned — and done so at a time when both the majority of the Parliamentary Party and the press supported his line rather than mine. Yet the economic price of accepting this political constraint now seems to me to have been too high. For the whole of this period the interest rate was too low. It should have been a good deal higher, whatever the effect on the level of sterling — or the level of the Chancellor’s blood pressure.

I also agreed to use in the House a detailed endorsement of the line which Nigel and I had agreed at our Monday meeting on the place of the exchange rate as an element in economic policy. I had to go further than I would have liked, saying:

ECONOMIC PROBLEMS MOUNT

In fact from June 1988 onwards interest rates rose steadily. Nigel insisted on raising them only half a per cent at a time. I would have preferred something sharper to convince the markets how seriously we took the latest indicator that the economy was growing too fast and that monetary policy had been too lax — namely the balance of payments figures. Nigel took a more laid-back view of these than I did. He thought that the current account balance of payments deficit, which was growing ever larger, was more important as an indicator that other things were going wrong than in its own right. But the deficit worried me because it confirmed that as a nation we were living beyond our means — as well as suggesting that higher inflation was on the way.

House prices were rising sharply. MO was still growing too fast — outside its target range. The forecasts of inflation were constantly being revised upwards, though they still turned out to be too low. For example, in the September 1988 monthly Treasury Monetary Assessment inflation in March 1989 was forecast at 5.4 per cent. In October’s note the forecast was 7 per cent. (In fact it turned out to be 7.9 per cent.) So as 1988 drew to a close — and although unemployment was down and growth and incomes were well up — there was trouble ahead.

It is on the face of it extraordinary that at such a time — November 1988 — Nigel should have sent me a paper proposing an independent Bank of England. My reaction was dismissive. Here we were wrestling with the consequences of his diversion from our tried and tested strategy which had worked so well in the first Parliament; and now we were expected to turn our policy upside down again. I did not believe, as Nigel argued, that it would boost the credibility of the fight against inflation. In fact, as I minuted, ‘it would be seen as an abdication by the Chancellor when he is at his most vulnerable.’ I added that ‘it would be an admission of a failure of resolve on our part.’ I also doubted whether we had people of the right calibre to run such an institution. As I told Nigel when he came in to discuss his paper, I had thought in the late 1970s about having an independent central bank but had come down against it. I considered it more appropriate for federal states. But in any case there could be no question of setting up such a bank now. Inflation would have had to be well down — to say 2 per cent — for two or three years before it could be contemplated.

In fact, I do not believe that changing well-tried institutional arrangements generally provides solutions to underlying political problems — and the control of inflation is ultimately a political problem. It can be kept down if you have the will to do so, as the Germans do because of their bitter experience of hyperinflation. We too could have kept it down if we had pursued a sufficiently tight monetary policy — without an independent central bank. What perhaps I should have taken more notice of, however, was that this proposal of Nigel’s showed his attitude to the economic difficulties now clearly visible on the horizon. He wanted to pass the responsibility for them to something — or someone — else.

The year 1989 — Nigel’s last as Chancellor — was a time of increasing political difficulty for me. It was the tenth anniversary of my becoming Prime Minister — an anniversary which I insisted should be kept as low-key as possible but which was inevitably the occasion for unflattering reviews in the press designed to leave the reader with the strong feeling that ten years of me was quite enough. It was also a time of very high interest rates — 13 per cent in January, 14 per cent from May and 15 per cent from October — and with inflation still rising and the forecast figures apparently inexorably rising too. The trade figures continued to be bad, especially July’s, which undermined confidence and weakened the pound. Alan Walters’s view was that there was now too tight a monetary squeeze which would push the economy into a serious recession. In particular, he strongly advised against raising interest rates to 15 per cent, as Nigel wanted in response to a rise in interest rates in Germany. Alan was right. But I went along with Nigel’s judgement and up went interest rates again. It is perhaps sufficient comment on the later allegation that I was undermining the Chancellor’s position by not dismissing Alan Walters, that I backed Nigel against Alan’s advice and against my own instincts just days before Nigel walked out.

THE DELORS REPORT ON EMU

Apart from the conduct of monetary policy, there were two economic issues of substance which concerned us during this period. On the first — the ERM — Nigel and I were sharply at odds. On the second — European Economic and Monetary Union (EMU) — we were in complete agreement.

As a result of the Hanover European Council in June 1988 a Committee of European Community central bank heads — serving in a personal capacity — had been set up under the chairmanship of Jacques Delors to report on EMU.[98] Nigel and I hoped that together Robin Leigh-Pemberton, Governor of the Bank of England, and Karl Otto Pöhl, President of the Bundesbank, would prevent the emergence of a report which would give momentum to EMU. Herr Pöhl we considered strongly hostile to any serious loss of monetary autonomy for the Bundesbank and Robin Leigh-Pemberton was in no doubt about the strength of our views — and indeed those (at this stage) of the great majority of the Parliamentary Conservative Party and of the House of Commons. Our line was that the report should be limited to a descriptive not a prescriptive document. But we hoped that paragraphs would be inserted which would make it clear that EMU was in no way necessary to the completion of the Single Market and which would enlarge upon the full implications of EMU for the transfer of power and authority from national institutions to a central bureaucracy.

Nigel and I had met the Governor on the evening of Wednesday 14 December 1988 and urged him to make all these points in the discussions on the text which ensued. We saw the Governor again on the afternoon of Wednesday 15 February. What we had seen of the draft report seemed thoroughly unsatisfactory, along lines known to be favoured by M. Delors who was clearly making the running. Nigel and I wanted the Governor to circulate his own document; but when this appeared it was something of a mouse. Most damaging of all was that Herr Pöhl’s known opposition to the Delors approach simply was not expressed.

Whatever the Governor may have done proved ineffective. When the Delors Report finally appeared in April 1989 it confirmed our worst fears. From the beginning there had been discussion of a ‘three-stage’ approach, which might at least have allowed us to slow the pace and refuse to ‘advance’ further than the first or second stage. But the report now insisted that by embarking on the first stage the Community committed itself irrevocably to the eventual achievement of full economic and monetary union. There was a requirement for a new treaty and for work on it to start immediately. There was also plenty of material in the treaty about regional and social policy — costly, Delorsian socialism on a continental scale. None of these was acceptable to me.

THE AMBUSH BEFORE MADRID

Whatever problems the Delors Report raised, it won few friends at home. However, Nigel and then Geoffrey used it to reopen the argument about the ERM. Nigel argued at our meeting on the afternoon of Wednesday 3 May that we should now enter the ERM. I replied that the overriding priority must be to get down the rate of inflation and it would be quite wrong to adopt the objective of exchange rate stability. This is what we had done when we had been trying to shadow the deutschmark, and it had compromised our battle against inflation. I did not believe that the Delors Report on EMU altered the balance of argument on the ERM. On the contrary, we should certainly not be drawn further into a European system that would almost certainly change following the Delors Report. I did not accept the premise that it was necessary to join the ERM in order to prevent developments in the Community which we did not like. I thought that the idea of setting a target date for joining some time in the future would be particularly damaging. Nigel disagreed. But I said that I did not want the issue of UK membership of the ERM to be raised at this stage.

This did not mean that I was giving no thought to it. Indeed, a few days later Alan Walters sent me a paper entitled ‘When the time will be ripe’, spelling out the conditions which must be met before we would join. He suggested that all the constituent countries must have abolished all foreign exchange controls and the legal machinery through which they were imposed. All domestic banking systems and financial and capital markets must be deregulated and open to competitive entry from EC countries. Any institution, corporation, partnership or individual must be free to enter any banking or financial business, subject only to minimum prudential conditions.

These were bold suggestions. On the one hand, they would certainly give our position a much more positive aspect. The moves against corporatism in France, Germany and Italy would be valuable in their own right. Whether the ERM could for long stand the removal of all these controls, which helped give it a false stability, was to be seen. The difficulty of Alan’s approach, of course, was that it did not remove the fundamental objections which both he and I had to the system of semi-fixed exchange rates which the ERM constituted. But in the end I knew that Alan’s ingenious suggestion might be the only way in which I could resist the pressure from Nigel, Geoffrey and the European Community for early entry.

Leon Brittan — now Vice-President of the European Commission — came to see me soon afterwards to try to persuade me of the benefits of ERM membership. He argued that it would give us an important say in the next steps of economic and monetary co-operation. Indeed, he said that it would enable Britain to dictate the pace and course of further progress in this area. He had apparently been reinforced in this view by a remark made to him by M. Delors over dinner to the effect that ‘if she joins, she wins.’ I was not, however, overimpressed by the European Commission President’s table-talk. I said that I did not believe that those who wanted to advance along the route mapped out by the Delors Committee on EMU would be deterred from pressing ahead by British membership of the ERM. And so, of course, it proved.

My relations with Nigel went through another difficult patch in May when an interview I gave to the World Service came indiscreetly close to admitting that the reason why our inflation rate had increased was because we had been shadowing the deutschmark. This, of course, was true, but it was a departure from the convenient answer that it was because we cut interest rates in the wake of the ‘Black Monday’ Stock Market crash and held them down too long that inflation had begun to rise. Nigel was at a European Finance ministers’ meeting in Spain and became very upset. So I authorized a line for the press which reverted to the less accurate but more mutually acceptable explanation. But I did at this time ask the Treasury to provide me with a paper giving their explanation as to why inflation had risen. I was subsequently interested to learn that Nigel had asked that the first draft of this paper, which had focused almost exclusively on the shadowing of the ERM, should be revised to extend the analysis to cover the earlier 1985–6 period as well.[99] Not surprisingly under these circumstances, I found the finished product less sharp and persuasive than some other Treasury papers.

There was worse to come. On Wednesday 14 June 1989, just twelve days before the European Council in Madrid, Geoffrey Howe and Nigel Lawson mounted an ambush. Geoffrey, I soon learnt, was the moving force. They sent me a joint minute arguing that in order to strike an acceptable compromise on the Delors EMU proposals — agreeing to Stage 1 but with no commitment to Stages 2 and 3 or an Inter-Governmental Conference (IGC) — I should say that I would accept a ‘non-legally binding reference’ to sterling joining the ERM by the end of 1992, provided that certain conditions were fulfilled by then. The alternative was — as usual — ‘isolation’. It was a typical Foreign Office paper which Nigel Lawson in his better days would have scornfully eviscerated.

I had myself, since reading Alan’s earlier paper on the conditions for entry into the ERM, been giving a great deal of thought to this subject. It was not clear to me whether spelling out these conditions at this stage would help deflect the other Community countries and the Commission from the course towards EMU on which they seemed set. I was not convinced about the alleged political advantages. I was deeply concerned about the consequences of setting a specified date for the currency markets. However, I saw Nigel and Geoffrey on the evening of Tuesday 20 June to discuss their minute and its contents. At the end I said that I would reflect further on the way in which this issue should be handled at Madrid. I remained sceptical whether a concession on membership of the ERM would really achieve our agreed aim of blocking an IGC and Stages 2 and 3 of Delors. But this could only be judged on the spot at Madrid. In any event I remained very wary of setting a date for sterling’s membership.

I had not liked this way of proceeding — by joint minutes, pressure and cabals. But I was more than angry about what happened next. I received a further joint minute. In this Nigel and Geoffrey said that just spelling out in greater detail the conditions which would have to be fulfilled before we joined — widening these to include for example Single Market measures — would be ‘counterproductive’. There must be a date. And they wanted another meeting before Madrid.

I read their minute on Saturday morning at Chequers and almost immediately received a telephone call from my office to ask about the time for a meeting. This was extremely inconvenient. On Sunday afternoon I was due in Madrid. But they could not be deterred. I could have seen them late on Saturday night or early on Sunday morning at No. 10. They chose the latter.

I knew that Geoffrey had put Nigel up to this. He had been in a great state about the European election campaign which had not gone well for us. I knew that he had always thought that he might one day become Leader of the Conservative Party and Prime Minister — an ambition which became more passionate as it was slipping away from him. He considered himself — with some justice — as an important contributor to our past successes. This quiet, gentle, but deeply ambitious man — with whom my relations had become progressively worse as my exasperation at his insatiable appetite for compromise led me sometimes to lash out at him in front of others — was now out to make trouble for me if he possibly could. Above all, I suspect, he thought that he had become indispensable — a dangerous illusion for a politician. There is no other explanation for what he now did and put Nigel up to doing.

Geoffrey and Nigel came to see me at 8.15 on Sunday morning, as arranged. They were shown into my study and sat down facing me on the other side of the fireplace. They had clearly worked out precisely what they were to say. Geoffrey began. He urged that I should speak first at the Madrid Council setting out the conditions on which I would have sterling join and announcing a date for entry into the ERM. He and Nigel even insisted on the precise formula, which I took down: ‘It is our firm intention to join not later than — ’ (a date to be specified). They said that if I did this I would stop the whole Delors process from going to Stages 2 and 3. And if I did not agree to their terms and their formulation they would both resign.

Whether I could have withstood the loss of both my Foreign Secretary and my Chancellor at the same time in this way I am not sure. But three things jostled together in my mind. First, I was not prepared to be blackmailed into a policy which I felt was wrong. Second, I must keep them on board if I could, at least for the moment. Third, I would never, never allow this to happen again. But this third reflection I pushed for the moment to the back of my mind. I told them that I already had a paragraph spelling out in more detail the conditions under which sterling could enter the ERM and I would be using this in my opening speech. But I refused to give them any undertaking that I would set a date. Indeed, I told them that I could not believe that a Chancellor and a former Chancellor could seriously argue that I should set a date in advance: it would be a field day for the speculators, as they should have known. I said that I would reflect further on what to say at Madrid. They left, Geoffrey looking insufferably smug. And so the nasty little meeting ended.

I shall explain shortly the rest of what happened at the Madrid Council. Suffice it to say here that on the basis of what Alan had already suggested and with some modification I spelt out what became known as the ‘Madrid conditions’ for sterling’s entry into the ERM. I reaffirmed our intention to join once inflation was down and there was satisfactory implementation of the first phase of the Delors Report, including free movement of capital and abolition of foreign exchange controls. But I did not set a date for entry, nor was I put under any pressure at Madrid to do so.

I do not believe that spelling out the Madrid conditions significantly modified the pace, let alone the direction, of discussions on the Delors report on EMU. Only someone with a peculiarly naïve view of the world — the sort cultivated by British Euro-enthusiasts but without any equivalent among hard-headed continental Euro-opportunists — could have imagined that it would. In fact, though, the Madrid conditions did allow me to rally the Conservative Party around our negotiating position and got us away from the tired and faintly ridiculous formula of ‘when the time was right’. The outcome of Madrid was widely praised back at home. Unfortunately, in a sense the time would never be ‘right’ — because the ERM, particularly now that the Delors objective of EMU had come out into the open, would never be ‘right’. But that was something I could do little about.

Back home, Cabinet began as usual at 10.30 on Thursday 29 June. Normally, I would sit at my place with my back to the door as Cabinet ministers trooped in. This time, however, I stood in the doorway — waiting. But there were no resignations. The condition that there must be a date for our joining the ERM might never have been mentioned. Nigel Lawson even managed the remark that Madrid had gone rather well, hadn’t it. He certainly had a nerve, I thought: but then Nigel always did. That was one of his engaging characteristics.

MORE TENSION WITH NIGEL LAWSON

It was from this time that tension between myself and Nigel Lawson arose over the independent economic advice that I was receiving from Alan Walters. Alan had returned to No. 10 in May 1989. I have already described his contribution to the ‘Madrid conditions’ for ERM entry. While the Treasury, thoroughly alarmed by the inflationary effects of Nigel’s policy of shadowing the ERM, kept urging ever higher interest rates, Alan now drew my attention to the danger that excessively high interest rates might drive the economy into recession.[100] He was, in short, doing precisely what a prime minister’s adviser should. He also had the merit of being right.

However, during his five-year absence from No. 10, he had been asked to give his views in all sorts of different fora; and Alan’s views were always trenchant. Various reports, articles and lectures containing his thoughts about economic policy issues in general and the ERM in particular kept on surfacing. Partly because these were exploited by the press to point up divisions between Nigel and me and partly because Nigel himself, knowing that he was being blamed for the return of inflation, was becoming hypersensitive, they became a major problem.

The important point, however, was that all this press speculation reflected an underlying reality. This was that Nigel and I no longer had that broad identity of views or mutual trust which a Chancellor and prime minister should. Nor was there any way — short of a full and totally uncharacteristic mea culpa on his part — that commentators were not going to hold Nigel to blame for the worsening economic outlook.

All of this was evident at the 1989 Party Conference — for which with greater optimism than caution the new Party Chairman, Ken Baker, had chosen the theme ‘the Right Team’. A German rise in interest rates had led us to follow suit and we took the unpalatable decision to raise them to 15 per cent on the eve of the conference. The Daily Mail duly savaged Nigel as ‘this bankrupt Chancellor’ and demanded that he go. Nigel, who never lacked courage, gave a robust and successful speech. But even now the two of us had to negotiate the wording of his and my references to the exchange rate. There was a clear difference of emphasis — if no open contradiction — between his formulation:

— a statement which implied that it was in our hands what the ultimate value of the pound in the exchange markets would be, and my own:

— a rather different point, based on a quite different economic analysis.

We survived the conference without mishap. But there was a general feeling in the press that with more unpleasant economic news to come it would be difficult for Nigel to continue. If he sought to do so, he would have my backing and indeed protection, as he always had. However convenient it might have been, I was not going to throw him to the wolves. Perhaps slightly less charitably, I felt that since he had got us into this inflation he should face up to the unpopular requirements for getting us out of it. It would, after all, be a highly unpalatable prospect for a new, incoming Chancellor. In any case — for reasons and in circumstances I shall describe shortly — I had made what I intended to be the last major reshuffle of this Parliament, moving Geoffrey Howe from the Foreign Office to be Leader of the House. I had decided — rightly or wrongly — that Nigel should stay. But what had Nigel himself decided?

NIGEL LAWSON’S RESIGNATION

I have already mentioned the stir which Alan Walters’s comments, dragged out of the past and often torn out of context, created. Moreover, since the timing was quite unpredictable — it depended on how quickly journalists tracked down and republished past comments — there was very little my staff or Alan could do about it. The Financial Times published on 18 October an article in which Alan was quoted, among other things, as describing the ERM as ‘half-baked’. This article was based on an essay to be published in the American Economist. But what the FT did not say was that the latter was written by Alan in 1988, long before he returned as my economic adviser. I felt that he had nothing to apologize for and minuted:

At 4.30 in the morning on Wednesday 25 October the VC10 which brought me back from the Commonwealth Conference at Kuala Lumpur arrived at Heathrow. Back at No. 10 I sorted out my personal belongings, discussed my diary with Amanda Ponsonby (my indispensable diary secretary), had lunch in the flat and then saw Nigel Lawson for one of our regular bilaterals. He was exercised about Alan Walters, having been repeatedly questioned in interviews about whether Alan should be sacked. But there were many other things we had to think about. In particular, we had to agree the line which Nigel would take at the forthcoming meeting of European Community Finance ministers on EMU. Nigel had devised an ingenious alternative approach, based on Friedrich Hayek’s idea of competing currencies, in which the market rather than governments would provide the momentum for monetary union. (Unfortunately, this proposal did not in fact get very far, not least because it was not at all in the statist, centralist model which our European Community partners preferred.) After seeing Nigel, I held a wider discussion of EMU which also included John Major (Foreign Secretary) and Nick Ridley (Trade and Industry Secretary) at which we endorsed Nigel’s proposed approach in his paper, while accepting that its purpose was mainly tactical in order to slow down discussion of EMU within the Community.

The next day, Thursday, was bound to hold its difficulties. But I did not know at this stage how many. Not only were there Prime Minister’s Questions: I also had to make a statement and answer questions on the outcome of the Kuala Lumpur CHOGM and, inevitably, on South Africa. I was under the hairdryer shortly after 8 o’clock in the morning when I received a message from my Private Office via Crawfie that Nigel Lawson wanted to see me at 8.50, that is just before I began my regular briefing session for Parliamentary Questions. Crawfie said something to me about it all being quite serious and that Nigel might be going to resign. But I said: ‘Oh no dear, you’ve got it all wrong. He’s going to Germany this afternoon for a meeting and I expect he wants to see me about that.’ So when I came downstairs to see Nigel in my study I was quite unprepared for what he had to say. He told me that either Alan Walters must go or he — Nigel — would resign. He wanted me to agree there and then to his demand.

At first I could hardly take him seriously. I told him not to be ridiculous. He was holder of a great office of state. He was demeaning himself even by talking in such terms. As for Alan, he was a devoted and loyal member of my staff who had given me frank and good advice but had always acted within the proprieties. If others, including the media, had attempted to exploit and exaggerate legitimate differences of opinion, that was no responsibility of his. There was no question of my sacking him. The meeting ended inconclusively. I asked Nigel to think again. I thought he accepted this advice. But there was little time to talk since I had to discuss the briefing for Parliamentary Questions and my statement at a meeting due to begin at 9.00 a.m.

An hour later Nigel came into a meeting with other ministers on the future of the Atomic Weapons Establishment at Aldermaston. He seemed on good form and made several acute interventions in the discussion. I hoped and believed that the storm had blown over. Then we met again — this time at Cabinet. I opened Cabinet by saying that we must be business-like and get through the agenda promptly because two ministers had to leave for meetings in Europe. Nigel was one of them.

I was, therefore doubly surprised when I was told over the light lunch — soup and fruit — I used to have on Parliamentary Questions days that Nigel again wanted to see me. I had thought he was not even in the country. We again met in my study where he repeated his demand and said that he wanted to resign. There was nothing much new I could say and not much time to say it since I had soon to be in the House of Commons. But I made it clear that Alan Walters was not going and hoped that Nigel would reflect further. I said that I would see him after I had finished with Questions and my statement.

Over in my room in the House of Commons I was having a last look through my briefing when at 3.05 p.m. — a bare ten minutes before I was due to answer Questions in the House — Andrew Turnbull, my private secretary, came in to tell me that Nigel Lawson had decided to resign and that he wanted an announcement out by 3.30 p.m. This was out of the question. We had not told the Queen. We had no successor arranged. The London financial markets would still be open. I myself was about to face an hour on my feet answering questions and making a statement on the Commonwealth Conference. I repeated that I would see Nigel some time between 5.00 p.m. and 5.30 p.m. back in No. 10.

I only got through Questions and the Statement by relegating the crisis of Nigel’s departure to the back of my mind. About an hour later, on my way out of the Chamber, I asked John Major, who as Foreign Secretary had been sitting beside me for my Statement, to follow me to my room: ‘I have a problem.’

Ideally, I would have liked to make Nick Ridley Chancellor. But, particularly under these difficult circumstances, Nick’s scorn for presentational niceties might well have compounded the problem. John Major, who knew the Treasury from his days as Chief Secretary, looked the obvious choice. I had already thought that John might succeed me. But I would have liked him to gain more experience. He had only been at the Foreign Office for a few weeks and had not yet fully mastered this department, so very different from the Treasury where he had been an effective and competent Chief Secretary. He would have liked to stay as Foreign Secretary rather than return to pick up the pieces after Nigel. When he expressed some reluctance to go from the Foreign Office to the Treasury, I told him that we all have to accept second best occasionally. That applied to me just as much as to him. So he agreed with good grace.

I dashed back to No. 10 to see Nigel, who was still insisting that his resignation should be announced immediately. On reflection there seems to me just one explanation for Nigel’s indecent haste. I think that he feared that I might telephone Alan Walters, who was in America and quite oblivious to what was happening, and that Alan would resign. This would have deprived him of the excuse he wanted. I now told Nigel that John Major was succeeding him. There was nothing left to discuss and it was a short meeting. I was sorry that our long and generally fruitful association should end in that way. I then telephoned Alan to tell him what happened. He told me that Nigel’s resignation had put him in an impossible situation and so he insisted, against all my attempts to persuade him, on resigning too.

JOHN MAJOR AS CHANCELLOR

Nigel’s departure was a blow to me — and one which Geoffrey Howe used to stir up more trouble when, the following weekend, in a speech of calculated malice, he praised Nigel as a Chancellor of great courage and insisted on entry into the ERM on the terms outlined at Madrid. But Nigel’s going was also a boon in one respect. At least in John Major I had a Chancellor who, though he lacked Nigel’s grasp of economics, had not got personal capital sunk in past policy errors. He was psychologically more able to deal with their consequences.

The three main tasks we faced were: first, to bring inflation under control, though it was important to moderate the pressure in time to avoid recession; second, to deal with the thorny issue of the ERM, which had done so much damage to the Government’s unity and standing; and third, to avoid being sucked into European Economic and Monetary Union. On the first of these — inflation — it was mainly a matter of applying the continuing and unpalatable medicine of high interest rates. It may be that interest rates were kept rather too high for too long: they had already been 13 per cent or above for a year and had risen to 15 per cent the previous month. Yet as each month the forecast inflation figures kept on being revised upwards there was a general air of uncertainty about what precisely the underlying position was. We therefore thought it right to err on the side of financial prudence. John and I had no serious disagreements on this policy. By October 1990, when I insisted on a 1 per cent cut on entering the ERM, this was justified on the grounds that the money supply had turned sharply downwards: the RPI figure too was just on the turn, after reaching almost 11 per cent — a figure I had never believed would be reached again while I was Prime Minister.

On the questions of the ERM and EMU, I was increasingly conscious of dealing with a very different sort of Chancellor than Nigel. John Major — perhaps because he had made his name as a whip, or perhaps because he is unexcited by the sort of concepts which people like Nigel and I saw as central to politics — had one great objective: this was to keep the Party together. To him that meant that we must enter the ERM as soon as possible to relieve the political strains. This primacy of politics over economics — an odd attribute in a Treasury minister — also meant that John was attracted by a fudge on EMU which would assuage the anxieties of the timorous Europhiles in the Party that we would otherwise be ‘isolated’. On ERM, much as I continued to dislike the system and distrust its purpose, I had agreed the principle at Madrid subject to the conditions expressed. Eventually, I was to go along with what John wanted. On EMU, which for me went to the very heart not just of the debate about Europe’s future but about Britain’s future as a democratic, sovereign state, I was not prepared to compromise.

DISCUSSIONS ABOUT ERM AND EMU: 1990

From the spring of 1990 I discussed the ERM with John Major on a fairly regular basis. When I saw him on the morning of Thursday 29 March I said that I did not believe that the conditions for our membership had yet been met. Although the issue of the timing of membership would need to be considered in the run-up to the next election it would in any event be out of the question to publish a precise date by which the UK would join. I was glad to find that John agreed with me. Unlike Geoffrey and Nigel, he realized that to set an advance date for joining would leave us at the mercy of the markets. But it was increasingly clear that he still wanted us to join soon. He said that bearing in mind the likely favourable impact of entry into the ERM on political sentiment and in turn on sentiment in the markets, it would be easier to bring interest rates down and maintain a firm exchange rate if we were inside rather than outside the ERM. That sounded all too like Nigel’s cracked record to the effect that you should steer by the exchange rate rather than by the money supply. Alas, that policy had steered us into inflation. John’s approach was that if the Party and the Government united around the policy and we looked like winning the next election, the economic prospect would improve as well. But I knew full well that whenever you take economic decisions for political purposes, you run considerable risks.

A few days later I discussed EMU and the Delors Report with John. He said that he would be minuting me with his conclusions on the best way forward. He said that the strategy must be to slow down the advance towards Stages 2 and 3 of Delors and the erosion of national sovereignty they entailed, but to ensure all the while that the UK was not excluded from the negotiating process. This had an indiarubber feel to it. So I said that there were serious dangers if we adopted a posture which implied that moves beyond ERM membership towards further economic and monetary integration could be contemplated. If other member states wanted to take such steps that was up to them. But the UK would not participate in that process. If we made that absolutely clear, I thought it was likely that, under pressure from the Bundesbank, Germany would also decline to move to the next stages of EMU. I sought to get John to view all this in a wider context and talked to him about the need to develop free trade relations with the USA and other countries, pointing out that centrally controlled blocs of countries — such as a federal Europe looked like being — must not be allowed to stand in the way of this.

John Major became increasingly worked up about both ERM membership and EMU. On 9 April 1990 he minuted me that he had been startled by the determination of other European Community Finance ministers to agree a treaty for full EMU. He had found little support for our new alternative approach — a ‘hard ecu’ circulating alongside existing currencies, managed by a European Monetary Fund — which we had advanced as an ‘evolutionary approach’ to EMU.[101] He therefore set out a number of options as to how we might proceed. Of these the option which he recommended — and which was ultimately to be developed further at Maastricht — was to work for a treaty which gave a full definition of EMU and the institutions necessary for its final stage (together with any transitional stage, if agreed) but then allowed an ‘opting-in’ mechanism for member states. This would allow them to join in the new Stage 3 arrangements — that is the single currency — at their own pace. He believed that this should be the goal we should work for as the outcome to the IGC. At a meeting with me on Wednesday 18 April, John rehearsed the arguments of his paper, emphasizing that the goal of full EMU as described by Delors was shared by all except the United Kingdom.

I agreed neither with John’s analysis nor his conclusion. I said that the Government could not subscribe to a treaty amendment containing the full Delors definition of EMU. Further work should be done to develop our proposal for a European Monetary Fund which we could put forward as the most that it was necessary for the Community to agree upon for now. I was extremely disturbed to find that the Chancellor had swallowed so quickly the slogans of the European lobby. At this point, however, I felt that I should hold my fire. John was new to the job. He was right to be searching for a way forward which would attract allies in Europe as well as convince Conservative MPs of our reasonableness. But it was already clear that he was thinking in terms of compromises which would not be acceptable to me and that intellectually he was drifting with the tide.

ENTRY OF STERLING INTO THE ERM

In tandem with consideration of tactics for EMU went consideration of timing for the ERM. The Treasury drew up a note for me about the best time for sterling to join, bearing in mind economic circumstances and political events. Although the other countries and central banks were pressing for our membership there would still be an established procedure to go through. So it was assumed that we would announce our intentions on a Friday so as to leave the weekend for the details to be settled before markets opened on Monday. There would have to be an initial discussion of the details between Finance Ministry and Central Bank representatives in the EC Monetary Committee: the possibility of a full meeting of EC Finance ministers and governors in person had also to be allowed for, though in practice this proved unnecessary. After timing, the two most important questions were with what width of ‘band’ (that is how much leeway would there be above and below the central parity chosen) and at what rate sterling should join. Of course, both these points received very close attention from me and the Treasury. Earlier hypothetical discussions had taken place on the basis of a narrow (+ or — 2.25 per cent) band; but John and I now believed that the wider (+ or — 6 per cent) band would be better, giving greater room for manoeuvre.

As for the central rate of sterling against the deutschmark, this was influenced by several factors. First, the rate chosen had to be credible in the light of recent exchange rate movements. Second, it should not be so low that it weakened the fight against inflation, by requiring imprudently low interest rates to keep sterling down. Third, and by contrast, it must not be so high that it imposed unnecessary pressure on industry, both through high interest rates which made borrowing expensive and a high exchange rate which made our goods uncompetitive.

It would, of course, test the wisdom of Solomon to settle on the ‘right’ rate: indeed, I doubt if Solomon in his wisdom would ever have set himself such a task. This is because ultimately there can be no ‘right’ level of sterling apart from what the market says it is. To search for such a thing is in a sense to fall into the trap of believing in the old precapitalist concept of a ‘just price’. Had Nigel Lawson managed to persuade me to have sterling enter the ERM in November 1985 the sterling/deutschmark rate would have been about DM3.75. A year later the pound was down to DM2.88. In November 1987 it was up to DM2.98. In November 1988 it was right up to DM3.16. In November 1989 it was back down to DM2.87. When we entered it was at a central parity of DM2.95, which was the rate at which the London market closed that day. What this shows on even a cursory glance is that revaluations and/or heavy intervention and very large shifts in interest rates would have been necessary to keep sterling in the mechanism throughout this period. It is, in fact, a demonstration that Alan Walters had been right all along in his view that the ERM ensured not stability, but rather the kind of instability which comes from movement in large leaps rather than by the more gradual accommodation of the market.

Only at my meeting with John Major on Wednesday 13 June did I eventually say that I would not resist sterling joining the ERM. But the timing was for debate. Although the terms I had laid down had not been fully met, I had too few allies to continue to resist and win the day. There are limits to the ability of even the most determined democratic leader to stand out against what the Cabinet, the Parliamentary Party, the industrial lobby and the press demand — particularly when you have lived for so long, as I had, with a thoroughly unsatisfactory form of words (‘joining when the time is right’), since qualified further by the Madrid conditions. By this stage all my advisers were telling me — though on political rather than economic grounds — that I should have sterling enter. Almost my only ally in the Cabinet was Nick Ridley — who was shortly to resign: together we were not a strong enough combination to have done what we would have had to do — that is to state that on grounds of principle we would not have sterling enter the ERM now or in the future.

But my willingness to join the ERM was qualified by a crucial condition. I was not prepared to keep to any particular parity at the expense of domestic monetary conditions. I insisted that we enter the wide band — 6 per cent on either side. Even then I made it very clear to John Major that if sterling came under pressure, I was not going to use massive intervention, either pouring in pounds and cutting interest rates to keep sterling down or raising interest rates to damaging levels and using precious reserves to keep sterling up. For me, willingness to realign within the ERM — as other countries had done — if circumstances warranted it, was the essential condition for entry. This makes nonsense of the claim, sometimes heard from ERM proponents justifying the subsequent collapse, that we were right to go in, but wrong to do so at that rate. In fact, a rate that is right today can be wrong tomorrow and vice versa. Until now, the ERM had never been a rigid system. I did not need to spell this out to our European partners because, whatever the fine points of detail, a country which wished to realign had always been able to do so in practice. Now that the UK was inside the ERM, other countries would have been so anxious to keep us in that they would have made little or no difficulty about realignment.

With the publication of the Delors Report, however, the Europeans began to regard the ERM as part of the move towards locking currencies, leading to a single currency. Accordingly, devaluations were more frowned upon than they had been. But they still occurred and would have to occur as long as we insisted on them. It was only when my successor went along with the objective of EMU as spelt out in the Maastricht Treaty and made it clear that sterling would enter the narrow band of the ERM that the pressure never to revalue ‘growed and growed’ until it became an overriding dogma. I had not the slightest doubt that if the ERM ever developed in the rigid way in which I knew many other European governments and the Commission would have liked, it would prove unworkable and would break up. I never envisaged that a Conservative government would talk itself into the trap of regarding a particular parity for sterling as the touchstone of its economic policy and indeed its political credibility.

I resisted John Major’s wish to go into the ERM in July. The monetary signals, indicating that inflation was starting to turn down so that we could enter the ERM with some confidence that the parity could be sustained, were not yet in place.

By the autumn, however, the high interest rates were clearly doing their work. The money supply fell sharply. It was clear that interest rates should now be reduced, quite apart from the question of the ERM. As regards ERM entry, the Madrid conditions had not been fully met. But the most important consideration was inflation. It was not till the end of the year that inflation as measured by the RPI (heavily distorted by mortgage interest rates and the way the community charge figured in it) began to fall. Other indicators, however, — CBI surveys, car sales, retail sales and above all the money supply — showed that we were getting on top of inflation. I insisted against the Treasury and the Bank on a simultaneous announcement of a 1 per cent cut in interest rates. They had not disputed that the monetary and other figures warranted this; but they had wanted to delay. But I for my part was determined to demonstrate that we would be looking more to monetary conditions than to the exchange rate in setting interest rates. So on Friday 5 October we announced that we were seeking entry into the ERM, and I placed heavy emphasis on the interest rate cut and the reasons for it in presenting that day’s decision.

NO COMPROMISE WITH EMU

As I have explained, the attitude taken by Britain and the rest of the Community to EMU had a bearing on the operation and development of the ERM. But, of course, EMU was a far greater question. The sense that I had had at my meeting with John Major in April that he was going wobbly on this increased when I received a further paper from him a little later, at the end of May. John’s paper contained all the now familiar phrases about the prospect of a ‘two-tier Europe’ — on which I noted ‘What’s wrong with that if the other tier is going in the wrong direction?’ — and the awful possibility of the other eleven negotiating a separate treaty for EMU — on which I wrote, ‘So be it. Germany and France would have to pay all the regional subventions — OR there would be NONE in which case the poorer nations could NOT agree.’ Quite apart from this tendency to be defeated by platitudes, which I found disturbing, it did not seem to me that John, who prided himself on his tactical political sense, had thought through the implications for the rest of the Community countries if they had to go ahead without us.

So at our meeting on the evening of Thursday 31 May I tried to stiffen John’s resolve and widen his vision. He reiterated his concern that we would find ourselves ‘isolated’ in the run up to a general election. He argued that to avoid this we should agree to a treaty amendment establishing the aim of full EMU, but insist on an ‘opting-in’ provision which left it to individual member states whether and when to join. I rejected this. I said that it was psychologically wrong to put ourselves in a frame of mind in which we accepted the inevitability of moves towards EMU rather than attacking the whole concept. We had arguments which might persuade both the Germans — who would be worried about the weakening of anti-inflation policies — and the poorer countries — who must be told that they would not be bailed out of the consequences of a single currency, which would therefore devastate their inefficient economies. I said that I did not regard John’s proposed ‘opting-in’ mechanism as an adequate defence against being drawn into full EMU. The same reasoning which led him now to argue that we had no alternative but to accept the treaty objective of full EMU would be employed later to concede that we could not afford to be left out of the move to a single currency either. So accepting the opting-in mechanism now would be tantamount to joining eventually and I was not prepared to make that commitment.

We had to use the time between now and the IGC in December to try to undermine the will of the other states to move to Stage 3 of the Delors Report and to develop a wider vision of the way ahead. I rehearsed once again my objection to the establishment of tight blocs of countries which stood in the way of a wider internationalism. I said that we must build on the American proposals for strengthening the political aspects of NATO, by suggesting a trade dimension to the alliance which would join Europe to a North American (US and Canada) Free Trade Area. I saw this as a way of averting the dangerous prospect of a world divided into three protectionist trading blocs, based on the European Community, Japan and the United States, which over time could become seriously unstable. I also suggested that we look at an idea on which Alan Walters had been working — a system of linking currencies to an objective reference standard, such as a commodity index, which would work automatically, without the bureaucratic paraphernalia and the intrusive federalism of the Delors proposals. Such a system might include both the dollar and the yen. I said that we had to set out our ideas boldly at international summits, emphasizing that we were going beyond the narrow European goals and were much more in tune with wider political developments. I was aware that this was visionary stuff: but if there was ever a time for vision this was it. So I had the Treasury and the Foreign Office work up these ideas, which without noticeable enthusiasm they did.

I felt that, much as I liked John Major and valued his loyalty, we had to bring others who were more at ease with large ideas and strategies into the discussion. So — as well as Douglas Hurd, who as Foreign Secretary was necessarily involved, for EMU was by now at the centre of debate in the European Council — I brought in Nick Ridley. I asked Nick to prepare a paper on EMU and the alternatives and he attended my meeting with John and Douglas on the morning of Tuesday 19 June before the forthcoming Dublin European Council. Nick made two contributions of great importance to the concept of an alternative Europe, going in a direction different from that of the inward-looking, statist and protectionist Europe with which we were faced. The first was to stress that the Delors-style Europe with a single currency would obstruct the enlargement of the Community. Our own vision of a wider, freer, more flexible Europe would be much more accommodating to the countries of the post-communist world. The second observation Nick made was to point out that we should not be alarmed by some countries going ahead with EMU and leaving us out: indeed, this was a model we should encourage — a wider Community in which different countries came together for different purposes on different occasions.

At this point it makes sense to consider how matters had been developing within the European Community itself and the stance we took in the face of the drive for federalism which was underway. But if there is one lesson which is to be learnt from the economic developments of the period of 1987 to 1990 — confirmed since by the circumstances preceding Britain’s undignified departure from the ERM in 1992 — it is that contained in the phrase I used in the House of Commons, which so infuriated Nigel and summed up the difference between us: ‘there is no way in which one can buck the market.’ I might add that if you try to do so, the market will buck you. The belief that the laws of economics and the judgements of the markets can be suspended by clever people — and Nigel Lawson was one of the cleverest people in British politics — is a perpetual temptation to folly. That folly cost us dear. But then the idea that other clever people — and Jacques Delors was one of the cleverest people I met in European politics — can build their Tower of Babel on the uneven foundation of ancient nations, different languages and diverse economies is still more dangerous. Work on that shaky construction is still proceeding.