Recent comparisons between the economic programs of Prime Minister Thatcher and President Reagan tend to ignore the significant differences between the programs themselves and between the economic environments of the two countries.
Mrs. Thatcher’s first budget represented a basically conservative, monetarist economic program, which aimed primarily to reduce inflation through lower government spending and strict control of the money supply and to redistribute (rather than reduce) the tax burden by shifting taxes from income to consumption. But Mrs. Thatcher’s government inherited a declining economy beset by domestic and external inflation shocks. Previous governments, unsuccessful in curbing the heavily unionized labor force’s unrealistic wage demands, had alternated between allowing inflation and currency depreciation to reduce the real value of pay increases and allowing unemployment to reduce inflation.
The Thatcher government initially succumbed to the unions in allowing a large public sector pay increase, but subsequently attempted to control the inflationary pay spiral by raising interest rates. The higher interest rates combined with North Sea oil to produce a sharp appreciation in the value of the pound. British manufacturers could not compete on the world market and, facing a major profit squeeze, laid off workers. Although the decision to increase interest rates may have exacerbated the recession, just as the increase in public sector pay exacerbated inflation, the inflationary and recessionary pressures were already present in the economy.
The Reagan economic program combines the monetarist goal of creating a stable, disinflationary environment through strict adherence to money growth targets with the supply-side goal of encouraging economic prosperity through reduced taxation and regulation. There is no automatic reason why such a program cannot succeed, especially since it was introduced in a relatively sanguine environment of modest economic recovery and reduced inflation. The danger, however, is that the tax cuts the administration proposes are so large in the face of uncertain social spending cuts and seemingly certain military expenditures that they threaten to overwhelm the monetarist goals.
If the Fed opts for curbing inflation, refusing to monetize a large government deficit, then the burden of adjustment will be shifted onto the private sector—creating a recession, new revenue shortfalls and even bigger government deficits. If the performance of the economy starts to become a political liability, the Reagan administration may have only two alternatives—to discard its monetarist philosophy and make a flagrantly inflationary U-turn or to discard its fiscal policy and increase taxes.