Margaret Thatcher drew on two broad sets of economic ideas, both matching a political philosophy based on economic liberalism in which economic decisions should be made primarily by individuals or households in the context of a free market economy. The first set of ideas work at the macroeconomic level. And it’s often labelled monetarism. These ideas are closely associated with the work of the economist Milton Friedman. The second set of ideas work at the microeconomic level. And it’s concerned with enabling decision makers to make informed and coherent choices. These ideas motivated Thatcher’s argument to roll back the states through privatisation, and are often linked to the economist Friedrich Hayek.
The economic arguments surrounding Thatcher’s macroeconomic policies can be illustrated using a simple aggregate demand aggregate supply diagram. The location of the aggregate demand curve depends on consumers’ and governments’ demand for goods, firms’ investment demand, and foreigners’ demand for our exports. If prices are lower, all of these demand more, so output goes up as prices fall. The aggregate supply curve summarises the influence of technology on workers’ and firms’ decisions on how much to make and supply, being willing to supply more when prices go up in this diagram The overall outcome of output in prices is where aggregate supply and aggregate demand are equal.
Much of the debate in the ’50s and ’60s was concerned with finding the best way to influence aggregate demand to raise output– through the treasury’s fiscal policy on government spending and taxation, through the central bank’s monetary policy, or through exchange rate policy. One side of this argument, put forward by Milton Friedman, was that monetary policy was key. The emphasis on the importance of the money supply in controlling demand was widely approached, was labelled monetarism. And an attempt to control the money supply in Thatcher’s Medium Term Financial Strategy was indeed one of the more well-publicized elements of her early years in power.
But a more important element of the macroeconomic argument was a shift in focus from demand-side economics to supply-side economics. If the aggregate demand aggregate supply diagram looks more like this, then the arguments about which is the best tool to affect aggregate demand becomes important for outputs. Monetary and fiscal policy can only affect prices with output determined solely on the supply side by technology on workers’ and firms’ decisions. This idea of a vertical supply curve was also suggested by Milton Friedman, calling this the natural level of output with the associated natural level of employment and unemployment. The underlying explanation focused on the detail of how workers and firms make their decisions.
While there might be temporary deviations from the natural level defined by these decisions, if expectations were out of line with reality, ultimately output would be fixed on the supply side. This argument was behind the stridently anti-inflation rhetoric of the Medium Term Financial Strategy, with the stated aim of controlling demand to defeat inflation. The hope was that, with this stridency, inflationary expectations would be adjusted quickly and a more stable inflation rate achieved relatively painlessly with aggregate demand shifting up the diagram at a slower rate. In the event, inflation, which had been running at very high levels throughout the ’70s, was brought under control. But the macroeconomy was found to be more complicated than the straightforward natural rate story.
And the pain of adjustment, in terms of lost output and unemployment, was felt for much longer than had been hoped. Importantly, though, Friedman’s broad idea– that output level is dominated in the long run by the supply side so that demand management should be focused primarily on price stability– has become the consensus among macroeconomic policymakers. And these ideas certainly took a firm hold of policymakers’ views during Thatcher’s term of office.
The microeconomic strand of Thatcher’s economic policies are in line with the macroeconomic ones. And her emphasis on privatisation, deregulation, and freeing up markets can be interpreted as supply-side policies and to improve the context for decision making and to raise productivity. At the heart of the approach is a belief in the effectiveness of market mechanisms. A core element of every undergraduate course in economics is the formal argument of the First Welfare Theorem.
This shows, mathematically, that if there are lots of well-informed consumers, prices are free to adjust, and there’s plenty of competition between producers, the free working of the market would deliver an outcome that’s sufficient, meaning that no individual consumer can be made to feel better off without someone else feeling worse off. Friedrich Hayek’s contribution here was to breathe some realism into the theorem, celebrating the role of prices and allocating resources and framing the discussion in terms of the use of knowledge. Hayek emphasised the complexity of production, with most goods involving many different production stages, with firms of each stage making decisions on where to source their inputs, how many workers to hire, how many machines to buy, and so on.
All these decisions are directed towards the consumers of the final good. Whose preferences are difficult to judge, and who may want the good or who might prefer something else instead? A central planner would have to know how much individuals like all the various goods that can be made and all the production possibilities that are available to allocate resources efficiently, a seemingly impossible task. The price mechanism, on the other hand, automatically and concisely passes to each individual and each firm all the information that they need to have for them to make their choices and decisions optimally.
Hayek’s vision of prices and the market mechanism as a force for good informs the macroeconomic policy argument and sets the agenda for Thatcher’s microeconomic policies on privatisation. On the macro side, the defeat of inflation becomes a policy objective in its own right. If inflation distorts relative prices– if some prices rise more quickly than others, for example– then it spoils the value of price signals and undermines the purity and effectiveness of the price mechanism and the efficiency of the system Hayek described so eloquently. Seen in this light, defeating inflation actually raises the natural level of output, again just defying the fierce anti-inflation stance of Thatcher’s Medium Term Financial Strategy.
Hayek’s vision also motivates the argument to roll back the state through privatisation. By the late ’70s, almost 12% of UK GDP was produced by publicly-owned enterprises and decisions made in the public sector substantially influenced the decisions made in the private sector. It was argued that, in the absence of market discipline, public sector enterprises showed lower productivity and higher production costs than corresponding private sector enterprises.
To the extent the outcomes in the public sector differed from those that would be achieved in a perfectly competitive free market, resource allocation in these sectors was inefficient and perverted decision-making elsewhere in the economy, with each poor decision compounding the mistakes of the previous one so that resources are misdirected and productivity eroded, exactly as was the case with generalised inflation. The aim of privatisation was to improve the efficiency of public sector activity by providing appropriate incentives and information to decision makers, taking the activities in these sectors and elsewhere in the economy closer to those of the free market outcome promoted by Hayek.
Thatcher’s policies, which just transferred a substantial fraction of the UK state-led activities to the private sector throughout the ’80s, reversed the trend in the growth of government in the UK emulated around the world.