Black Wednesday
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In British politics and economics, Black Wednesday refers to September 16 1992 when the government was forced to withdraw the Pound from the European Exchange Rate Mechanism (ERM) by currency speculators—most notably George Soros who earned over USD$1 billion in doing so. In 1997 the UK Treasury estimated the cost at £3.3 billion. "The trading losses in August and September were estimated at £800m, but the main loss to taxpayers arose because the devaluation could have made them a profit. The papers show that if the government had maintained $24bn foreign currency reserves and the pound had fallen by the same amount, the UK would have made a £2.4bn profit on sterling's devaluation." - (Financial Times February 10, 2005).
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The prelude
When the ERM had been set up in 1979, Britain declined to join. This was controversial, as the Chancellor of the Exchequer Geoffrey Howe, despite his economically 'dry' credentials, was a convinced pro-European. Another chancellor, Nigel Lawson, was also a believer in a fixed exchange rate, and although he was a mild Eurosceptic he admired the low inflationary record of Germany, attributing it to the strength of the Deutsche Mark and the management of the Bundesbank. The Treasury followed a semi-official policy of shadowing the Deutsche Mark. The exchange rate was largely kept in place by the use of interest rates, set without matching action to control the domestic economy. This led to a couple of years of lower interest rates than would have otherwise been in place, and hence1 rising inflation.
The pressure came to a head in a clash between Margaret Thatcher's economic advisor, Alan Walters, and Lawson, when Walters claimed that the Exchange Rate Mechanism was "half baked". This led to Lawson resigning as chancellor to be replaced by his old protégé John Major.
John Major and Douglas Hurd, the then Foreign Secretary, pressured Margaret Thatcher to sign Britain up to the ERM in October 1990, effectively guaranteeing that the British Government would follow an economic2 and monetary policy that would prevent the exchange rate between the pound and other member currencies from fluctuating by more than 6%. The pound entered the mechanism at 2.95 Deutschmarks to the pound. Hence, if the exchange rate ever neared the bottom of its permitted range, 2.778 marks, the government would be obliged to intervene. With UK inflation at three times the rate of Germany's, interest rates at 15% and the "Lawson Boom" about to bust, the conditions were not favourable. At least two of Gordon Brown's "five economic tests" were being failed spectacularly.
From the beginning of the 1990s, high German interest rates, set by the Bundesbank to counteract inflationary effects related to excess expenditure on German reunification, caused significant stress across the whole of the ERM. The UK and Italy had additional difficulties with their double deficit. Issues of national prestige and the commitment to a doctrine that the fixing of exchange rates within the ERM was a pathway to a single European currency inhibited the adjustment of exchange rates. In the wake of the rejection of the Maastricht Treaty by the Danish electorate in a referendum in the spring of 1992, those ERM currencies that were trading close to the bottom of their ERM bands came under speculative attack in the foreign exchange markets by currency speculators.
The currency speculators' attack
When the French referendum on the Maastricht Treaty yielded a yes vote, the attack, which had gathered force over the first fortnight of September, concentrated on the Italian lira and the pound sterling. Speculators borrowed pounds and lire and sold them for DM, in the expectation of being able to repay the loan in devalued currency and to pocket the difference. On September 16 the British government announced a rise in the base interest rate from 10% to 12% in order to tempt speculators to buy pounds. Despite this and a promise later the same day to raise rates again to 15%, dealers kept selling pounds. Major currency traders like Goldman Sachs knew what the British Government was trying to do and knew that the international money markets would eventually prevail against the efforts to prop up the pound. This amounted to a major transfer of wealth from the government to the speculators, both individuals and investment banks. By 7pm that evening, Norman Lamont, then Chancellor, announced Britain would leave the ERM and rates would remain at 12%.
The aftermath
Other ERM countries such as Italy, whose currencies had breached their bands during the day, returned to the system with broadened bands or with adjusted central parities. Even in this relaxed form, ERM-I proved vulnerable, and ten months later the rules were relaxed further to the point of imposing very little constraint on the domestic monetary policies of member states.
The effect of the high German interest rates, and so the high British interest rates, had been arguably to put Britain into recession as large numbers of businesses failed and the housing market crashed.
In the months and years following Black Wednesday, the pound traded substantially below its ERM lower band. It dipped below 2.20 Deutschmarks in spring 1995. From this point onwards however, it began a sustained recovery and, at one point, touched the value of 3.20 DM. Some commentators believe that 'Black' Wednesday has proved to be good for the British economy in the long-term, as interest rates were allowed to find their natural level. However, the reputation of the Conservatives for competent handling of the economy was shattered. Many commentators believe that the event is a key reason for the party's continued relative unpopularity. Many in the Party have yet to recognise that Black Wednesday was the result of poor economic management, not the cause of it.
Subsequent analysis of this event recognised that stable exchange rates are the result, not the cause, of a common approach to economic management. This resulted in the Stability and Growth Pact that underpins ERM II and subsequently the Euro single currency.
The future?
Technically any country wishing to join the single European currency would have to join an ERM-like system tagging their current currency to the euro. However given the notoriety of the system within the British public at large, many believe this will not be a prerequisite should Britain ever wish to join.
Footnotes
1 This is a matter of some debate. Former Prime Minister Edward Heath referred to this a "one club golf" policy. Interest rates are a blunt instrument that affects all aspects of the economy equally. They should be supplemented by selective fiscal policies. However, to do so was contrary to the prevailing monetarist views at the time.
2 Contemporary comment accused Prime Minister Major and Chancellor Lamont of repeated delay in taking the fiscal and monetary steps that were needed until after the latest of the many by-elections, thus accelerating the decline. At the time, the Bank of England was not independent and interest rates were set by the Chancellor of the Exchequer.
See also
- Monetary policy of Sweden (see topic "1992")