Why we get it wrong: former UK Treasury chief on the dangerous power of economic orthodoxies

By on 18/10/2019
Nick Macpherson. (Image courtesy: Strand Group, KCL).

Reviewing a century of economic crises, former HMT permanent secretary Nick Macpherson sees a common thread: having bought into an economic model, policymakers cling to it long after the world outside has moved on. Matt Ross hears him call for civil servants to stop accepting the accepted wisdom

People rarely draw parallels between Her Majesty’s Treasury (HMT) and a local group of revolutionary Communists – but Nick Macpherson, who served as the UK Treasury’s permanent secretary from 2005 to 2016, believes these very different organisations have at least one thing in common. In considering HMT’s approach to developing its world view, he said wryly, “I always likened it to a Leninist cell: there was a huge debate about what the line was – but once the line had been agreed, you got behind it.”

And once people have bought into the new line, he argued, they follow it too far. Speaking earlier this month at an event organised by King’s College London’s Strand Group, Lord Macpherson was discussing the causes and consequences of Britain’s economic crises – and many of them, he concluded, were rooted in HMT’s failure to ditch outdated thinking before it leads the country into disaster. “Policymakers become mesmerised by a particular theory or policy which might have been right once but no longer holds good,” he said. “The old Keynes quote is still relevant: ‘Practical men, who believe themselves to be quite exempt from any intellectual influences, are usually the slaves of some defunct economist’.”

Britain’s return to the gold standard in 1925 was a classic case, he argued. The decision by then-chancellor Winston Churchill led to deflation, rising unemployment and a general strike; a run on the pound finally forced the government to retreat in 1931. Churchill was “deafened by the clamorous voices of conventional finance,” said Macpherson, and “gravely misled by the experts.”

Macpherson: “Policymakers become mesmerised by a particular theory or policy which might have been right once but no longer holds good.” (Image courtesy: Strand Group, KCL).

Similar dynamics were at play in 1990, when the UK joined the European Exchange Rate Mechanism. Acknowledging that he and his Treasury colleagues had backed the policy, Macpherson explained that Britain chose an exchange rate that over-valued the pound; a recession and high German interest rates made the currency vulnerable to speculators, and the UK crashed out in 1992. These are “interesting examples of crises which were government-created,” he said. “In each case, the government did not need to enter the regime, and in each case it had a choice as to the rate of exchange.”

In 1974, he continued, the application of a different brand of economic orthodoxy to the problems created by the oil crisis and miners’ strikes had equally disastrous outcomes – forcing new Labour PM Jim Callaghan to seek an IMF loan in 1976. “We used to think that we could spend our way out of recession and increase employment by raising taxes and boosting government spending,” Callaghan told Labour conference, reviewing a disastrous period of stagflation. “I tell you in all candour that that option no longer exists.”

The mother of all crises

In the 1980s HMT moved onto its next orthodoxy, enthusiastically adopting Margaret Thatcher’s monetarist, free-trading ethos. And in the years running up to 2008, the Treasury, Financial Services Authority and Bank of England were again blind to the flaws in their world view – failing to spot the danger of over-leveraged banks exchanging ever more complex loan packages. “The regulators misunderstood the risk building up in the system,” said Macpherson. “The fact is that there was a massive, collective, intellectual error.”

Macpherson says the slowdown in productivity growth and flat wages following the 2008 financial crisis “perhaps more than any other factor explain why Britain voted to leave” the EU. (Image courtesy: Strand Group, KCL).

Event chair Ed Balls, who was in the mid-2000s a Treasury minister and key ally of then-chancellor Gordon Brown, recalled that regulators were preoccupied with “micro prudential” issues such as the mis-selling of pensions. “The big institutions were not considered to be where the risks were,” he said. Even when Scottish bank RBS took over its Dutch rival ABN AMRO in 2007, “the idea that this was going to further stress an already stressed balance sheet was not the focus. There was an assumption, from the Bank of England governor down, that this was okay.”

The consequences of this most recent failure have proved far lengthier and more disruptive than HMT’s previous errors. The UK still hasn’t closed its public finance deficit – in part, Macpherson noted, because the financial crisis permanently destroyed “taxable capacity” in the City of London. And in the years after the crisis, an “extraordinary slowdown in productivity growth fed straight through into real wages, which have now been flat for over a decade – and, perhaps more than any other factor, explain why Britain voted to leave the European Union.” That vote in turn hit both the value of the pound, pushing up inflation, and inward investment – further weakening productivity, which has fallen by 0.7% over the last year.

Politically, the referendum created huge tensions within the government machine, with Brexiteers – armed with their direct mandate – undermining civil servants and institutions whose advice or analysis they disliked. Macpherson’s Treasury was one of the first targets, and the House of Lords, MPs and judges have since come under fire. “These institutions have been under continued attack over the last few years,” said Macpherson. “I can assure you that these attacks will impose a price.”

Collateral damage

Asked by Global Government Forum what currency that price will be paid in, Macpherson warned that the erosion of conventions undermines faith in the system. Breaking a long-standing convention, he noted, “the government has effectively attacked judges” – and when businesses see supposedly independent decision-making processes being weakened, they worry that policies and appointments will be shaped by politics rather than evidence.

“Once you start messing about with institutions, it impacts on the credibility of macro-economic policy,” said Macpherson, adding that the appointment of the next Bank of England governor “will be an interesting test. If the government does appoint someone who, it becomes clear, was not recommended by the process put in place, there will be a cost. Markets want certainty in economic policy.”

Macpherson predicts that Brexit could take a quarter to half a percent off annual growth in productivity and living standards. That’s “barely perceptible” he says, but over a 10-20 year period, it could have an effect “much bigger” than past financial crises. (Image courtesy: Strand Group, KCL).

And while Brexit’s economic impacts are proving slower and more subtle than the other events he’d examined, Macpherson warned that leaving the EU could cause greater harm to Britons’ living standards than any of those short-lived crises.

“Economic crises, by their nature, are visible: the currency collapses, or gilts become friendless in the market, or there’s a sharp fall in living standards,” he explained. “If the government handles Brexit sensibly – and that’s a big ‘if’ – the impact of Brexit is likely to be rather less visible. My guess is that it could take something like a quarter to half a percent off annual growth in productivity and living standards. That’s barely perceptible – but over a 10-20 year period, it could have an effect much bigger than any of the crises I’ve described today.”

So the failures of economic policymakers and regulators in the years leading up to 2008 ultimately fostered a chronic, drawn-out economic and political crisis likely to affect the country for years to come. To spot the flaws in the next generation of accepted wisdoms, civil servants and ministers will have to become more testing, more sceptical, and more independent-minded. “When things have gone wrong for the Treasury, it was to do with the fact that the Treasury had somehow lost touch with the outside world,” said audience member Margaret Exley, who in 1999 became HMT’s first non-executive director. “I wonder whether it’s got that weakness: that it’s just not plugged in enough to what’s going on in the wider world.” Nick Macpherson didn’t argue. “The Treasury does have a tendency, once a new orthodoxy has been created, to hang onto it too long. Debate about the line is really important – and you’ve got to ventilate the institution to have debate,” he said. “You should really worry when people tell you: ‘This time, it’s different.’ Because it very rarely is.”

About Matt Ross

Matt is a journalist and editor specialising in public services, policymaking, government and management. He was the editor of trade title Civil Service World from 2008 to 2014, serving an audience of senior UK officials; and the features editor of weekly news magazine Regeneration & Renewal between 2002 and 2008, covering urban regeneration, economic growth and community development. He has also been a motoring and travel journalist, and now combines his role as editorial director of Global Government Forum with writing for other publications including The Guardian and Planning magazine.

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