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The economics of budgets since the war

    Clement Attlee's three Chancellors: Hugh Dalton, Stafford Cripps and Hugh Gaitskell, all had to deal with the fact that Britain had been bankrupted by six years of war and the fact that Attlee had committed them to financing an ambitious programme of nationalisation and the creation of the NHS along with the other aspects of the welfare state.

    When the USA scrapped President Roosevelt's policy of Lend Lease immediately after the end of the war, Britain badly needed an alternative source of finance from the United States. Attlee dispatched John Maynard Keynes to negotiate the provision of grant aid from the US. In fact the US only agreed to a $3.75 billion loan provided at interest in the autumn of 1945 to be repaid over 50 years. However, Britain subsequently received nearly a quarter of the $13 billion of Marshall Aid from the US. Much of this finance was used to fund the policing of the Empire and so retain Britain's pre-eminence as a super power.

    Britain entered the Bretton Woods adjustable peg exchange rate system in 1947 at a dollar-sterling parity of £1 = $4.03. This was an error of judgment as the competitiveness of British industry had eroded significantly and so sterling was overvalued at this rate. Full convertibility caused a run on the pound and had to be suspended. Sterling was devalued massively to $2.80 in 1949 in consequence.

    The realities of the economic difficulties became apparent in Hugh Gaitskell's 1951 budget when he increased taxes and introduced prescription charges for the first time. Aneurin Bevan, the creator of the NHS resigned from the Cabinet as a result, as did Harold Wilson. Labour lost the general election that year leaving the incoming Churchill government with a massive government debt.

    In 1962 the Macmillan government set up the National Economic Development Council (NEDC). This body employed the corporatist approach in an attempt to raise national economic growth from 2.7% to 4%. In 1963 Reginald Maudling's budget was to create a 'dash for growth' and was to achieve the promised 4% target without inflationary consequences. A year later, in his final budget, the reality of the economic situation was apparent, he increased taxes and acknowledged that the balance-of-payments and sterling's exchange rate in the Bretton Woods system were both under severe pressure.

    Harold Wilson's Chancellor, James Callaghan, repeatedly said that sterling would not be devalued. When it was clear to all that it would, Harold Wilson swapped him with Roy Jenkins – Callaghan becoming Home Secretary and Jenkins Chancellor. The devaluation from $2.80 to $2.40 took place in 1967 and bought some time for the economy. In his 1970 budget, Jenkins did alter tax allowances to remove two million people from tax when income tax was equivalent to 47.5p in the £, but otherwise he did not adopt any significant expansionary measures. This went down in history as an object lesson that if you don't expand the economy before a general election you lose it.

    In 1971-2 Edward Heath's Chancellor, Anthony Barber expanded the fiscal stance and the money supply to deal with growing unemployment: the 'Barber' boom. This caused a growth in inflation and the policy was consequently reversed: the notorious U-turn. Between 1971 and '73 Bank lending rose from £71 million to £1,332 million. Heath's government also introduced wage and pay freezes to help deal with the inflationary problem, which was significantly worsened by the first of two OPEC oil price rises.

    With Wilson in power again in 1974, Denis Healey's first budget increased income tax and introduced a wealth tax. With Wilson calling a general election later the same year, there was a second budget that summer where Healey announced a reduction in VAT as a pre-election bribe. Labour won the election and yet another budget followed that year with Healey clawing back the gains the public had enjoyed.

    In 1976, with 24% inflation, sterling collapsed. There was a balance of payments crisis and the government turned to the International Monetary Fund for a loan to pay external debt and to stabilise sterling. The price the government was obliged to pay was the reduction of government expenditure and a contractionary monetary policy. Healey had to some extent anticipated this with cuts to public expenditure.

    Thatcher and her first Chancellor Geoffrey Howe, altered the composition of the fiscal system: the top marginal rate of income tax was reduced from 83% as it had been under Labour, to a top rate of 60% (later 40%), and there was a reduced marginal rate for basic rate tax payers. Thatcher's belief in balanced budgets prevented her from increasing borrowing, so the reduction in direct taxation was accompanied by increasing indirect taxes.

    This change in the composition of the fiscal system was done partly for ideological reasons as it represented a shift from collectivism to individualism. When there is a high rate of income tax it is government which disposes national wealth through its expenditure programmes. When direct taxes are low, and disposable income is commensurately higher, it is the individual who disposes wealth. This was consistent with her policy of decentralising the resource allocation process. High indirect taxes were not inconsistent with this, as individuals could decide which tax they paid by their expenditure choices, also people could avoid expenditure taxes by saving, and so increasing funds available for investment.

    When in 1987 stock markets crashed around the world there was a real fear of a global recession. The Chancellor, Nigel Lawson, cut taxation, increased public expenditure, and said he would also reduce government debt. He also employed expansionary monetary policy. But the major economies recovered more quickly than expected and so the expansion proved excessive; leading to the 'Lawson boom'.

    While Chancellor, John Major was persuaded of the correctness of the fixed exchange rate policy. In 1990 he and the Cabinet persuaded Thatcher that Britain should join the Exchange Rate Mechanism of the European Monetary System, and sterling entered at 2.95 Deutschmarks, a comparatively high exchange rate at the time. This high rate was chosen because the government was convinced that it could address both the domestic inflation generated by the Lawson boom and use monetary policy to maintain the fixed exchange rate. The comparatively high exchange rate required a contractionary monetary policy to maintain it, this was disinflationary as it constrained domestic private interest sensitive expenditure. It was also disinflationary as it meant cheap import prices. Consequently there was a recession.

    The collapse of the exchange rate policy in 1992 when sterling was ejected from the Exchange Rate Mechanism, ushered in an unprecedented period of strong economic growth which would only end with the recent credit crisis. Norman Lamont was Chancellor when this occurred, but earlier that year in his budget he inaugurated a 20p marginal rate of income tax on the first £2,000 of taxable income, helping the Conservative's win the general election shortly afterwards.

    Kenneth Clarke's 1996 budget reduced the basic rate of income tax and reduced public expenditure. With the incoming Labour government the following year having committed to adhere to Conservative spending plans for the first two years, this constrained their options. By the time of Gordon Brown's 2001 budget he would hold constant excise duties on alcohol and reduce duties on petrol. The redistribution of income and wealth through tax credits and the plan to raise spending on the NHS by half in five years in nominal terms and by one third in real terms would be financed by increasing indirect taxes substantially. This initiated the so called 'stealth' taxes. If the marginal rate of income tax is raised, we all blame the government; if expenditure taxes are raised, we blame the shops!

    Brown introduced his 'golden rule' that government spending – excluding capital expenditures – must be in balance or in surplus across the economic cycle. This was his notion of fiscal prudence. However, the extent to which the golden rule is met is determined by the ambiguity between the definitions of current expenditure and investment or capital spending, whether the balance is measured in absolute terms or as a proportion of GDP in a fiscal year, and the length of the economic cycle. In July 2005 the economic cycle was extended by the Chancellor from 7 to 9 years, enabling the surpluses of 1997 and 1998 to facilitate additional current borrowing without violating the golden rule.

    The overall result of these policies was to ensure sustained low inflation; but unemployment, contrary to popular belief, remained high at around 1.5 million. This figure is as measured by the International Labour Organisation, the preferred Labour government measure. The Thatcher government had altered the way unemployment was measured, principally by measuring only those claiming unemployment benefits. This official measure was retained by the Blair government, and when measured this way unemployment was about 1 million, still historically high. The composition of the work force changed under Blair, with some loss of jobs in the private sector, but growth in employment in the public sector.

    In 2007 the mis-management of mortgage lending to sub-prime customers in the USA led to the international banking crisis. The Labour government, with its high expenditure over the previous decade, was in a disastrous position to deal with this contractionary macroeconomic phase. The government breached Gordon Brown's own rules on borrowing as it sought to maintain high expenditures in the face of falling tax receipts. Thus government borrowing has been at an unprecedented level for peace time.


    Nigel Knight is a Fellow and Director of Studies in Economics at Churchill College, University of Cambridge, and lectures in the Faculty of Economics and Politics. He has worked in national politics advising and writing policy for the Liberal Democrats and the Conservative Party.

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