Interest rates of 15% slowly reduced inflation, but were critical in causing a collapse in house prices and lower consumer spending. This contributed to the recession of 1991.
The Housing Boom
By the end of the 1980s inflation was getting out of control (9.5% in 1990),(for more details see: The Lawson Boom 1986 -1990) and so the chancellor eventually persuaded Mrs Thatcher to join the ERM. In the ERM the value of the £ was kept within certain boundaries against the D Mark. However, with inflation increasing the £ became weak on the exchange markets. Therefore, the government were forced to increase interest rates to protect the value of the £ from falling.
Higher interest rates were helpful for reducing inflation. But, the problem was that because the government was targeting the exchange rate they increased interest rates by much more than was necessary to slowdown the economy. These increases in interest rates caused a big increase in the cost of mortgage payments, this led to home repossession and falling house prices. Falling house prices and lower spending caused the economy to slow down and enter into a recession. However, despite the economy entering into a recession, the government didn't cut interest rates. This is because they placed greater value on the exchange rate target than economic growth.
The markets believed the £s value against the D Mark was unsustainable given the recession. The market believed that interest rates of 15% were simply unsustainable therefore, foreign exchange dealers kept selling £s. The government responded by using foreign currency reserves to buy £ and keep interest rates high. The government were committed to maintaining the £ in the ERM, whatever the consequence. However, the problem is that the government couldn't buck the market. The market correctly predicted there was nothing the government could do to prevent a devaluation.
Eventually the government were forced to give up their misplaced efforts to maintain a high exchange rate. The UK left the ERM and interest rates were able to fall. The government felt it was a humiliation, but, it was just what the economy needed (if several months too late). The lower interest rates prevented the economy getting worse and helped prevent more home repossessions.
Unemployment rose from 7% in 1990 to 10.6% in 1993.
Graph showing quarterly economic growth. Quarterly growth of 1% equates to an annual growth rate of 4%. Since 1945, the long run trend rate of the UK has been approx. 2.5%. There is no evidence this changed during the 1980s.
The Housing Boom and Bust
The UK housing market played a key role in the recession of 1991.
Rising house prices in the late 1980s caused a rise in consumer wealth and consumer spending. High interest rates of the late 1980s / early 1990s caused a fall in house prices and a rise in home repossessions. Falling house prices led to negative wealth effect, leaving many homeowners with negative equity. Also bank losses increased too.
Mistakes of Economic Policy in the 1980s and 1990s
- Allowing the economy to expand too rapidly causing inflation.
- Targeting the exchange rate, when this was detrimental to other more important objectives like preventing a recession.
- Inflation should never have been allowed to increase so much, but when they tried to slow down the economy, they overacted making the recession deeper than it need to be.