UK CPI inflation in 1975 reached 25%, a period now known as the ‘Great Inflation’. This column uses a range of empirical and narrative evidence to illustrate the importance of fiscal policy in this period. While stabilising and reducing debt has been the primary peacetime fiscal policy objective for most of modern British history, this was almost completely abandoned during the Great Inflation period. The Great Inflation ended, in part, following a series of fiscal reforms, thus highlighting the importance of the fiscal regime for inflation and the effective operation of monetary policy.
Exactly 50 years ago, the British government announced that inflation, based on the retail price index (RPI), had reached a post-war high of 27% in August 1975 – equivalent to a 25% rate on a modern consumer price index (CPI) basis (Figure 1). This was worse than in any other peer country. The economy was also in recession, making the third quarter of 1975 the nadir of ‘stagflation’ in the UK. In new research (Bordo et al. 2025), we revisit the ‘Great Inflation’ through a new lens. Using a range of empirical and narrative evidence, we show that the operation of fiscal policy was important in understanding the UK’s poor inflation performance.
Figure 1 UK consumer price inflation
Sources: Thomas and Dimsdale (2017), ONS and authors’ calculations.
Although the UK has experienced double-digit inflation several times since the start of the 20th century, the scale and persistence of the inflationary problem in the 1970s were unprecedented. Conventional explanations of the Great Inflation in the UK attribute responsibility to monetary policy (Nelson 2003, Nelson and Nikolov 2004), a badly designed incomes policy (Miller 1976), and bad luck in the form of rapidly increasing commodity prices, falling trend growth, and rising structural unemployment.
We show that the degree of inflation persistence cannot fully be explained by these factors. Instead, we find that, once high-frequency ups and downs have been accounted for, inflation was largely driven by shifts in inflation expectations (Figure 2). These expectations began rising in the late 1960s, well before the first oil shock.
Figure 2 A semi-structural model decomposition of inflation
Source: authors’ calculations.
Using a range of empirical tests, we show that expectations were less adaptive than suggested by the conventional wisdom and appear to be best modelled as a sequence of regime shifts which, from the 1970s onwards, appear associated with news about the fiscal regime (Figure 3).
Figure 3 Inflation expectations regimes based on step-indicator saturation tests
Sources: Batchelor and Orr (1988) and authors’ calculations.
We present evidence of a striking contrast between the conventional use of fiscal policy and how it was used in the years of the Great Inflation. In the regime in place for most of modern British history, the primary peacetime fiscal objective has been to stabilise or reduce debt.
By the start of the Great Inflation, the debt stabilisation objective was not merely downgraded, but completely abandoned. This was reflected in Budget speeches, the main vehicle for Chancellors to make both fiscal policy announcements and explain the strategy underlying them. Figure 4 shows how frequently they discussed debt and Figure 5 shows how often they justified specific fiscal announcements by appealing to the need to stabilise or reduce debt. They tell the same story: that debt was a far less important factor in fiscal policymaking than in most of British history before and after.
Figure 4 Importance of debt sustainability: Mentions of ‘debt’ in Budget speeches
Note: This chart shows the frequency with which Chancellors referred to debt in Budget speeches.
Source: Bush (2024).
Fiscal policy was instead used for a variety of purposes which went well beyond Keynesian demand management. It was used to ‘go for growth’ in the hope that higher demand would prove self-sustaining through an investment channel. It was used to subsidise food, rent, and mortgages to protect those who were perceived to have lost out from terms of trade shocks. And it was used as a sweetener to secure undertakings with unions to limit their wage demands. On top of this, public sector spending was allocated and monitored in volume terms, so cost increases were automatically accommodated.
Figure 5 Deficit reduction-related tax changes, 1918-1997
Note: this chart shows the fiscal impact of tax policy announcements attributed to deficit reduction.
Sources: Cloyne (2013) and Cloyne et al. (2024).
This change in the fiscal policy regime was pointed out by Chancellor Nigel Lawson in his 1988 Budget speech:
“A sound monetary policy needs to be buttressed by a prudent fiscal stance.
At one time, it was regarded as the hallmark of good government to maintain a balanced budget; to ensure that, in time of peace, Government spending was fully financed by revenues from taxation, with no need for Government borrowing. Over the years, this simple and beneficent rule was increasingly disregarded, culminating in the catastrophe of 1975–76…”
It was noticed at the time by high-profile financial commentators and analysts such as Tim Congdon (of The Times) and Gordon Pepper (at W. Greenwell & Co.), who also saw a link between public borrowing and inflation.
We too see a link between fiscal deficits and inflation in this regime. Ultimately, debt has to be stabilised one way or the other. Traditionally, it was stabilised through fiscal policy. But in the 1960s and 1970s, it was stabilised through unexpected changes in the price level. We present evidence in favour of this view. Whereas in the interwar and the post-Great Inflation eras, expansionary fiscal shocks had no impact on inflation, in the Great Inflation era, they caused a large and persistent increase in the price level.
The Great Inflation was brought to an end in part through a series of fiscal reforms, culminating in a return to a regime in which fiscal policy is used to stabilise debt. This finding is consistent with Sargent’s (1981) view that moderate inflations are brought to an end as much by changes in the fiscal policy regime as by changes in the monetary policy regime.
The policy implications of our work are that the fiscal regime matters for inflation and the effective operation of monetary policy. In regimes in which debt is stabilised by fiscal policy, fiscal policy isn’t an important driver of fluctuations in inflation and monetary policy can do its job unimpeded. But when fiscal policy isn’t used to stabilise debt – like in the 1960s and 1970s UK – inflation can be the mechanism by which fiscal imbalances are resolved.
Source : VOXeu
