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The Turning Point: 1975-76
In the crisis year of 1976, Harold Wilson's third Labour Government had been in office for two years. Its parliamentary majority of three disappeared in that year as a result of defections and by-election defeats, but it might plausibly have been able to 'muddle through' towards a general election expected in 1978 or 1979. By that time, the economy was expected to be out of the deep recession associated with the OPEC oil price shocks, the government's efforts to get the inflation rate down below 10 per cent by 'social contract' deals with labour unions (which had replaced the earlier Conservative Government's statutory price and wage controls) might have been expected to have borne some fruit, and revenues from the developing North Sea oil and gas fields would be rising sharply, giving room for tax cuts or spending increases that would help to improve Labour's re-election prospects.
In the event, the Labour Government found itself in a dramatic crisis. It began to shift from the initial revenue squeeze to raise public spending to a squeeze on spending in the autumn of 1975, when (following months of talks between the Treasury and the IMF) the Labour cabinet agreed to apply to the IMF for a stand-by loan to support the currency, which had fallen sharply since 1971. Since the IMF, probably under US influence, had become more sceptical of Keynesian-type expansionary fiscal policy than it had been a few years earlier and was likely to demand spending cuts as a condition of a major loan, the Chancellor presented the cabinet with a spending plan that involved no cuts in planned public expenditure for the next financial year (1976/77), but reductions in planned increases in public spending of the order of 1bn in 1977/78 and ?2.4bn in 1978/79. These proposals were opposed on the left by Labour heavyweights Tony Benn and Anthony Crosland, even though the latter had argued in a much-quoted 'party's over' speech earlier that year that local government spending needed to be cut. But the cabinet as a whole approved Healey's spending plan and in return the IMF approved a stand-by loan of some US $2bn from the start of 1976 (Hickson (2005: 58-9)).
Those cuts in planned future spending were announced early in February 1976 in a White Paper on Public Expenditure to 1979/80. Written for several audiences (Labour's left-wing Tribune Group as well as the IMF), the White Paper was carefully packaged as a plan to hold public spending broadly constant in real terms over four years, in contrast to what had happened over the previous few years. It began by stating that voters' expectations of better public services and welfare programmes had not been matched by economic growth or willingness to pay more taxes, such that in the previous three years, national output had risen by less than 2 per cent while public expenditure had grown by nearly 20 per cent and the ratio of public expenditure to GDP had gone up from 50 per cent to 60 per cent. The White Paper partially blamed the world recession for that outcome and declared there were signs that the recession was bottoming out, meaning that its plan to stabilize public spending at its 1976/77 level for some years would cause the public expenditure to GDP ratio to fall again when economic growth returned (and implying that there might be some fiscal relaxation as the next general election approached, as did indeed happen).
But that White Paper, comprising the fiscal package agreed by the cabinet to accompany the January IMF loan, came to grief on the floor of the House of Commons as a result of a left-wing Labour backbench revolt after a debate on 9 and 10 March. The voting outcome was messy and complicated, with an Opposition motion to reject the White Paper defeated but the Chancellor's motion to approve the White Paper also defeated, by twenty-eight votes. That vote left fiscal policy in confusion and indeed raised constitutional questions as to whether the Labour Government should resign at that point, but the government succeeded in winning a confidence vote the next day.
Less than a week afterwards (on 16 March), the prime minister, Harold Wilson, suddenly announced his retirement at the age of sixty, a bombshell announcement that came out of the blue and is still the subject of numerous conspiracy theories (see, for instance, Wright 1987; Leigh 1988), though the mainstream explanation is that it reflected Wilson's developing health problems. There then followed three weeks of policy paralysis in government as Labour's left-wing heavyweights (Michael Foot and Tony Benn) battled in party leadership elections against figures from the centre-right (James Callaghan, Denis Healey, Roy Jenkins, and Tony Crosland) in three successive ballots. Healey's chances were damaged by the conflict over his public expenditure plans, and Callaghan, who had been the first Chancellor in the Labour
Government of the 1960s (as discussed in Chapter Six), was eventually elected at the third ballot. Callaghan defeated Michael Foot (who had led in the first ballot) by some thirty-nine votes, but his victory was hardly a walkover, and his cabinet consequently included some key figures from the left of the Party (such as Tony Benn and Peter Shore) in major ministerial positions.
Just two days after Callaghan became prime minister following his election as Labour leader, the Party lost its fragile majority in Parliament with the resignation of one of its MPs to join the English National Party. One seat short of an overall majority, Callaghan struck a deal with the Scottish National Party and Plaid Cymru, promising legislation to introduce devolved assemblies in Scotland and Wales in exchange for parliamentary support from those parties. And the day after Callaghan's election, the Chancellor introduced what he described as an 'almost neutral budget', reiterating the policy proposed in the February Expenditure White Paper of holding public spending at current levels for several years but also declaring that 'we have set ourselves against short-term cuts in spending in the current year' (a stance which led to attacks from the Opposition Conservatives under their new leader Margaret Thatcher as avoiding tough decisions in reducing the deficit: 'a big borrower's budget from a soft-options Chancellor'19).
But in the summer of 1976 the fiscal squeeze moved from reining in future planned increases in public spending to plans for deeper spending cuts in FY 1977/78 along with a further revenue squeeze. As already mentioned, the currency had fallen precipitously on the international money markets since early March. It continued to slide after Callaghan's election, despite the government's reiteration of its policy to stabilize public expenditure as the recession ended. In June it hit what was then a record low against the US dollar, dropping from $2.40 in early 1975 to under $1.60 at one point, and it went on falling until October. Accordingly, in mid-1976 the government faced the options of letting the pound going into free fall, imposing severe import restrictions despite the UK's entry to the EEC, or going for a bailout deal with economic allies to prop up the currency while a further fiscal squeeze was applied to meet the conditions for a bigger IMF bailout loan later in the year.
The battle between right and left in the Labour Party turned on the choice between the second and third option, with Callaghan and Healey opting firmly for the third, while the Labour left (led by Tony Benn and Peter Shore) and the Trades Union Congress argued for the second. Despite the ideological differences between the UK Labour Government and Gerald Ford's Republican Administration then in office in the United States, the US Treasury Secretary agreed in June to part-fund a short-term stand-by loan of $5.3bn to support the pound. But this bailout was only a temporary stopgap: the money had to be repaid by December and by September the UK government had drawn so heavily on this loan that it could only repay it by borrowing from another source, namely the IMF.
Going for a major IMF loan led to repeated battles within the Labour cabinet and later in the Party's annual conference during two phases of decision to tighten the fiscal squeeze in July and December 1976. In July the government went beyond the cuts in planned increases in future spending that had been proposed by the February Expenditure White Paper to announce a further ?1bn of cuts in planned expenditure in 1977/78 accompanied by a surcharge on employers' National Insurance contributions that was expected to bring in another ?1bn in revenue in 1977/78. And in December, as part of a bailout package agreed with the IMF, the government announced a further ?1bn reduction in planned spending for 1977/78 and a ?1.5bn reduction in planned spending in 1978/79.
Treasury files from the period show how officials and ministers worked over the hot summer of 1976 to arrive at that July fiscal squeeze package. The Treasury extended cash limitation of budget allocations (a powerful way of reining in spending at a time of high inflation) from a measure used mainly for capital projects to a much larger swathe of public expenditure (Hickson 2005: 58), a move Healey later described as highly successful. And an extra ?1bn of proposed spending cuts for 1977/78 was presented by the Chancellor to the House of Commons on 22 July 1976, which was reported in the press to have been the subject of some seventeen hours of cabinet discussion, indicating the level of friction and political stress involved in the process.
Before that July statement, the prime minister, James Callaghan, was reported to have met with seventy junior ministers to explain the proposed cuts and call for government unity—an approach that evidently had the desired political effect, since there were no resignations either from the cabinet or from lower ministerial ranks at this point. The parliamentary vote on the public spending package was tight because the Conservatives under Margaret Thatcher chose to welcome the 'belated' plan to cut public sector borrowing but to attack the specific means chosen, and the Scottish National Party's then ten MPs voted against the government with the Conservatives.
But the July fiscal squeeze package was not the end of the process. In September the government formally applied to the IMF for a loan of nearly $4bn (at least $30bn today) on top of the $2bn the IMF had provided in January. That was then the largest amount ever requested from the IMF, which had to obtain extra funds from the US and Germany to raise the sum required, and the last time any Western country went to the IMF for a loan until Iceland, Hungary, and Belarus did so in 2008. The bailout plan was opposed by the left in cabinet, because in return for the IMF loan a cap had to be agreed on public sector borrowing, requiring further spending cuts on top of those already planned—a far cry from the absence of any serious conditions attached to the IMF loan at the time of the sterling devaluation in 1967. The bid for a further IMF loan also led to strife in the Labour Party's annual conference in September, when Callaghan made a speech containing a famous passage written by his son-in-law Peter Jay: 'We used to think that you could spend your way out of a recession by cutting taxes and boosting government spending. I tell you in all candour that that option no longer exists.'
That third stage of fiscal squeeze in 1976 culminated in a formal application for the further IMF loan in mid-December, after a battle in cabinet early that month, when proposals from ministers on the left (Tony Benn and Peter Shore) for import quotas were finally rejected in favour of the IMF bailout option. That bailout involved a ceiling on borrowing that required a further reduction of ?1bn in 1977/78 spending plans and ?1.5bn in spending plans for the following year—plus further increases in alcohol and tobacco taxes, as announced by Denis Healey just before the Christmas holiday. A key feature of the package—almost a fifth of the total—was the announcement of an intention to sell government stock in the state-owned oil company BP while retaining a majority shareholding.
In this squeeze episode, sharply contrasting with those of the 1920s and 1930s, as well as most of the other post-World War II episodes, social security spending was not cut. The Labour cabinet decided at the outset against spending cuts in this domain, in part reflecting the Party's inherited political baggage over that issue from 1931. It also gave priority to overseas aid and to some industrial spending, increasing funding for public venture capital in industry and to the nationalized British National Oil Corporation while cutting back on capital spending by other state-owned enterprises. And as already mentioned, another distinctive feature of this squeeze is that there was no major cut in defence spending, unlike in the 1920s squeeze and all the other post-World War II spending squeezes.
The Treasury's approach, as in the case of the Geddes Axe in the 1920s, was to start by looking at what could feasibly be cut without legislative change (and that was arguably an even more important consideration in this episode, given that the Labour Government had lost its overall majority in Parliament). As a result, many of the cutbacks comprised delays or deferrals of existing capital projects, imposing moratoria on new spending and limiting new commitments in areas such as road building. Consequently, capital spending fell sharply, with deep cuts in public sector net investment from 1976 onwards.
Cuts in housing expenditure (which, as noted earlier, Labour's February 1974 manifesto had promised to increase) figured large in those reductions, and central government housing expenditure relative to GDP fell from around 6.7 per cent in 1974 to 2 per cent by 1979. Indeed, in a memo written ahead of the July squeeze package, considering cuts that could feasibly be made in 1977/78, the Chief Secretary (Joel Barnett) saw housing as offering the greatest scope for spending reductions without legislation, since there were some large items that could be cut back quickly. The following month, a Treasury official (Nicholas Monck) described housing, along with regional and industrial policy, as the spending domain presenting the greatest political difficulties for the Labour cabinet. Monck was referring to a reduction in planned local authority council house building from 10,000 to 6-7000 starts per month in England (with similar reductions in Scotland and Wales) which was part of the spending reduction package and was described by Monck as 'politically the most explosive component', indicating the political costs involved to Labour ministers.
In the same vein, the July 1976 spending cuts package for 1977/78 included an accelerated phase-out of the food subsidies promised by Labour in its February 1974 election manifesto. And whereas social security was 'ring- fenced' in this episode, education spending was cut sharply, as with all of the other spending squeeze cases examined in this book except for the 1940s and 1990s. Education spending was cut by nearly 1 per cent of GDP, falling mainly on spending on schools and the further education colleges that were then funded by local authorities. Cuts were also applied to spending on police, fire services, and local authority garbage collection and sewerage services. Civil service employment started to fall from a high point through staffing reductions, mainly achieved by a hiring freeze.
The overall result in reported financial outcomes, as discussed in Chapter Two, was a very hard expenditure squeeze in 1977/78, with a fall in public spending of 3.7 per cent in constant prices and some three percentage points relative to GDP. But by no means all of those dramatic reductions came from the cuts mentioned above, and some of them seem to have come from convenient if not creative accounting. Douglas Wass (2008: 331), the then Permanent Secretary of the Treasury, notes that part of that large fall in reported public expenditure in 1977/78 came from an increase in foreign currency borrowing by state-owned industries and from a fall in refinancing of export credits (as a result of private banks being persuaded to refinance such credits). Joel Barnett (1982: 124-6), Chief Secretary of the Treasury at that time, also comments extensively on the effort and ingenuity (in that case said to have come from Harold Lever, the Chancellor of the Duchy of Lancaster) that went into the export refinancing switch and other related changes to produce reductions in reported public spending and the estimated Public Sector Borrowing Requirement.