Black Wednesday explained

'A slightly cruel summary of it would be to say that we went into the ERM in despair and left in disgrace. Nevertheless, we are still enjoying the benefits of it,’ – Alan Budd, author of ‘A Re-Examination of Britain’s experience in the Exchange Rate Mechanism’ for the Institute of Economic Affairs, 2004.

Over a quarter of a century on and the effects of Black Wednesday are still being felt. The day brought about major change and reshaped the UK’s political and economic landscape in ways that can still be seen today.

The debate continues about whether the short-term costs of withdrawing the pound from Europe’s currency scheme was worth the economic recovery that followed. We have a look at how Black Wednesday panned out and explain why it is still relevant now.

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The background to Black Wednesday

The UK economy had been underpinned by strong growth and moderate inflation during the post-war period, but this changed dramatically in the early 1970s.

The pound traded under a fixed exchange rate until 1972, when the government decided to float the pound as part of plans to curb inflation, which was a priority. This meant rather than controlling the supply of sterling to keep the rate within a predetermined range, the value of the pound would now be determined by the private market and based on pure supply and demand.

There was another element to the decision. Floating the pound was originally part of a joint effort known as the ‘currency snake’, which saw Germany, France and Italy all follow suit to align all their respective currencies in the first tentative step toward what would eventually be the euro. However, the life of the snake was short after the pound plunged and the bloc soon realised that the markets were simply too volatile to allow them to peg their currencies to that of European allies.

High inflation and pressure on the pound was exacerbated from 1973, when Arab countries wielded their dominance in the world oil market by placing an embargo on exports to the US. This was a way of hurting the country and its western allies that were perceived to be supporting Israel during the Yom Kippur war against Egypt. Crude oil prices had quadrupled by the following year and, coupled with higher food prices caused by shortages, pushed UK inflation from 5% at the start of 1970 to over 25% by 1975. As the pound collapsed – falling below the $2 for the first time ever in International 1976 - the government had to borrow $3.9 billion from the International Monetary Fund (IMF) to stabilise the currency and in return, cut public spending and raise interest rates.

Successive governments continued to struggle to get a grip on inflation and the pound throughout the 1980s. Inflation had fallen back below 5% by 1985 but was still too high and the pound remained volatile, falling from almost $2.50 at the start of the decade to near parity in 1985. As the UK approached the end of the decade the pound had strengthened but inflation had started to creep higher yet again.

There was good reason to strive for a stable currency. Businesses couldn’t plan effectively for the future: for example, if the pound fell then it would be a boost for British exports as goods become cheaper to foreign buyers, but if the devaluation was only deemed as temporary then no one would invest in new factories or plants. All attempts to bring inflation under control and to stabilise the pound had proven futile, partly because it was also trying to integrate it as part of the closer Europe that was emerging.

In the late 1980s the government persisted and started to peg the currency to that of Germany’s, with a view that the pound would not exceed three (2.95) Deutsche Marks. This was in the hope that the UK could align itself with Germany’s considerably lower level of inflation, which was running at a rate three times lower than the UK. This was the precursor to joining the European Exchange Rate Mechanism (ERM).

Black Wednesday and the European Exchange Rate Mechanism

The ERM was introduced by Europe in 1979 to reduce volatility in exchange rates and stabilise monetary policy across the bloc. This was a revived effort to introduce a single European currency built on the lessons learnt from the failed attempts to align currencies across the EU, like the currency snake. The major difference compared to previous attempts was the fact that central rates were set independent of the dollar.

Each individual government was responsible for managing their own currency but had to ensure it stayed within a predetermined range of other European currencies, known as a semi-peg. This meant currencies could fluctuate against one another but only by a certain degree, therefore providing the stability that they had all been yearning for. To do this, the governments had to sell the strongest currencies and buy the weakest ones to keep rates in line with their targets.

The UK had held a referendum on continuing its membership of the European Economic Community (EEC) in 1975 that saw 67% vote in favour of staying in, but it did not join the ERM when it was initially launched. The Conservative party had snatched power from Labour the same year as the ERM was launched and, generally onboard with the growing integration of Europe at the time, many members of the cabinet had urged leader Margaret Thatcher to peg the pound under the European scheme. Thatcher resisted these calls for over a decade until it eventually boiled over in 1990 when John Major took over as prime minister. Major was among those who had long supported joining the ERM as the previous Labour party had tried to do before Thatcher got the Conservatives into government. There was broad support for joining the ERM across the political spectrum, but Thatcher remained staunch against it.

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Major’s tenure, therefore, paved the way for the UK to join the ERM in October 1990, only months after becoming prime minister. Although he inherited the economic boom that Thatcher had nurtured the picture wasn’t perfect. Inflation was again climbing and had hit its highest level in nearly a decade and Major put the ERM at the centre of his policy to curb it. The pound initially rallied, and inflation started to decline but things started to sour quickly.

What happened on Black Wednesday?

Black Wednesday was on 16 September 1992, when the UK had to withdraw the pound from the European ERM. When the pound joined the ERM it was among the weakest currencies alongside the Italian lira and the Spanish peseta and the government had insisted that joining the ERM would not cause a devaluation of the pound as some critics had warned.

Within two years of joining the ERM the pound started to struggle to stay within the agreed range and fell by more than the 6% limit against the stronger currencies at the time, including the leading Deutsche Mark. This required the government to take action to shore up sterling and get it back within range but ended up demonstrating why we have institutions like the Bank of England (BoE) today. The BoE has, of course, been around for centuries but was under the thumb of the government of the day. Major and his team addressed the falling pound by raising interest rates – which generally pushes inflation down and the pound up. The BoE was also instructed to spend nearly £30 billion of its reserves – up to 40% of the entire kitty - on buying the pound to help counter the heavy selling that continued to ensue.

The problem was that interest rates were already running at 10% - levels that today’s generations have never experienced – and the jump to 12% was unexpected. But there was a bigger underlying problem that meant this didn’t work. Quite simply, the rate at which the UK had tried to peg the pound was too high, the economy was not strong enough and higher interest rates ultimately failed to prop up the pound to the desired range.

Today, financial markets and consumers are being eased into higher interest rates and the impact is being priced in well in advance of the actual hikes. The Black Wednesday rate rise was sudden and the first for three years and therefore the market either panicked in confusion or lacked confidence in the government’s ability to bring the pound under control. The Confederation of British Industry (CBI) was quick to criticise the rate rise and the fact that government had been ‘blown off course by the currency markets’, warning of the impact of pricier mortgages on the housing market. Building societies and banks also held off immediately passing on higher rates to customers in a sign that industry felt the rate hike was the result of short-term disarray rather than long-term planning.

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This was vindicated after the government proposed raising interest rates further to 15% - a 5% rate rise in the same number of hours - before later reverting on the decision, and the fact that interest rates the day after Black Wednesday were back at 10%.

(Source: Bank of England. Bank rate is the interest rate charged to commercial banks that influences the interest rates those banks offer to their customers)

Black Wednesday and Germany’s central bank

Germany’s central bank, Deutsche Bundesbank, played a significant role in Black Wednesday. As stated earlier, those countries with the strongest currencies were supposed to help support the weaker ones to bring stability to all those under the ERM. But instead of selling the Deutsche Mark and buying the pound, the central bank sowed seeds of mischief and shut the vault.

As the former chief dealer of the BoE Jim Trott described, the Bundesbank was the ‘cavalry’ that never arrived. ‘We kept on looking over the hill, but there was no dust and there no hats and no sabres’, he said in the years following the crisis. In the end, not only did the cavalry fail to turn up but they aided the enemy by fuelling reports that the Bundesbank believed the pound needed to be devalued and therefore spending taxpayers’ money on purchasing the pound was pointless.

With little belief behind the UK’s ability to manage monetary policy and the confirmation that no rescue was on its way the markets began to take advantage. The pound kept falling and the BoE’s spending spree meant there was a big buyer to provide liquidity. The BoE ended up buying more sterling on Black Wednesday than it ever has before – up to £2 billion per hour - and the rate was lower with virtually every purchase.

What was George Soros’s role on Black Wednesday?

‘Markets are constantly in a state of uncertainty and flux and money is made by discounting the obvious and betting on the unexpected,’ - George Soros.

George Soros, the world-renowned billionaire investor, made his name on Black Wednesday by betting against the pound and making a staggering £1 billion. It was a brave move based on a sharp approach. Soros had actually backed the pound to the tune of £1.2 billion only one month before Black Wednesday, but quickly reversed his position as the sell-off started and the devaluation began.

Through his Quantum Fund, Soros instructed his team to borrow UK gilts and sell them before repurchasing them later on at a lower price. Much like the BoE lost more money with every transaction, Soros and his team were turning a profit with each trade. Reports suggest he eventually built up a short position worth £10 billion on Black Wednesday.

All in all, Soros made £1 billion profit by betting against the pound and the BoE, engraving his name in the history books forever.

What happened to Britain and Europe after Black Wednesday?

The UK’s withdrawal of the pound from the ERM only caused sterling to suffer further and threatened to bring down the entire European project. Europe’s monetary policy committee tried its best to keep the system intact and even sought to capitalise on the UK’s withdrawal by proposing a broader realignment with the possibility that those with weaker currencies, like Spain and Portugal, could be forced out along with the UK.

Initial estimates suggested the BoE had spent anywhere between £13 billion-£27 billion on buying the faltering pound on Black Wednesday, but it was not until 13 years later that the true sum was revealed at just £3.3 billion. This was, according to declassified Treasury papers, because the BoE committed to buying foreign exchange over the following six months so to avoid an immediate hit to country’s reserves.

The ERM eventually unraveled by the end of the decade with nothing to immediately replace it, before being revived under ERM II in 1999, which allowed currencies to trade within a much wider range of 15% within the central rate applied against the euro (for non-euro currencies like the Danish krone). The introduction of the euro, however, slowly eroded the need for a system like ERM.

After Black Wednesday, Major’s government had years to go until it had to call a general election but the event pencilled in a Labour government years beforehand as trust in the government’s ability to manage the economy diminished. A year after Tony Blair swept to success in 1997 his government introduced a crucial policy that gave the BoE the independence that it had long argued for, separating political problems from monetary policy.

Black Wednesday or Bright Wednesday?

The upfront costs of Black Wednesday are evident but the longer-term outcomes are still debated to this day. The pound’s exit from the ERM caused further devaluation as the effect rippled through financial markets around the world. After the UK markets closed on Black Wednesday the sell-off continued as traders in New York picked up the baton before passing it on to traders in Tokyo who followed their lead to provide sterling with another hammering.

However, there is strong evidence that Black Wednesday brought benefits. Interest rates were gradually cut to 7% and this, combined with the devaluation, helped lower inflation to spur an economic recovery through 1993 and 1994. According to the Institute of Economic Affairs, the Treasury estimated the output gap in 1993 (the difference between actual and potential output) was around 4% of gross domestic product (GDP) and didn’t close until 1997. Although this helped to bring down inflation, it also held the UK economy back for five years.

Norman Lamont, who took over Major’s role as chancellor when he took the top job, has long held his position that withdrawing from the ERM had achieved the government’s goal: ‘we joined to get inflation down and…succeeded in that’, he said in 2011. Lamont also claimed other members of the ERM had suffered ‘similar losses’. A year later, Major himself claimed there are ‘more myths about Black Wednesday than the Greeks ever created’.

(Source: ONS)

In fact, many dubbed the ERM the ‘Eternal Recession Machine’ and were glad to see the back of it. The underlying problem was that the pound’s withdrawal was forced, not chosen, and the reluctance to withdraw earlier and admit the mistakes that had been made simply exacerbated the volatile situation of the day. Although many point to the improvement in the UK economy after Black Wednesday it is fair to argue that the policies could have been introduced without the huge political and economic cost.

Black Wednesday and Brexit: part of the same story

The political ramifications of Black Wednesday are still evident today and part of the same story that led us down the road to Brexit. The mood toward Europe after Black Wednesday changed markedly and the more European-leaning Conservatives gave way to the sceptics that today are at the forefront of British politics: people like Boris Johnson and Michael Gove. The prime minister that got us into the Brexit debacle in the first place, David Cameron, stood alongside the Treasury’s Gus O’Donnell (as his assistant) on the evening of Black Wednesday when he announced the pound was being withdrawn from the ERM.

In 2005 – five years before Cameron would win over the electorate from Labour – the then future prime minister ominously said he and the Conservatives would never again put ‘economic stability at risk’ as they had done on Black Wednesday. A decade later when he was in office Cameron would end up doing exactly that by calling the EU referendum that happened in 2016, underpinned by the rising resentment toward Europe by Conservative ministers that are still reeling from the events of the 1990s.

It is also sagas such as this that have helped fuel the doubters in fiat currencies and the traditional financial system altogether, birthing new modern day creations like cryptocurrencies.

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The lessons learned from Black Wednesday

Black Wednesday fundamentally reshaped both the political and economic landscapes in the UK and wider Europe and some lessons are still being learnt over a quarter of a century later. The farce of the ERM and other early attempts to introduce a precursor to the euro sowed tensions over an ever-closer Europe and ultimately stopped the UK joining the single currency. Today, those holding grudges against a singular European bloc are fighting their battles with the European Union on a different battleground – Brexit – but about many issues that have been stewing for decades.

Black Wednesday also showed the importance of the BoE’s operational independence and the separation of long-term, stable economic policy and the shorter, more tumultuous terms of governments that come and go. It also demonstrated the limitations of interest rates and highlighted how a ‘one size fits all’ model doesn’t work: the ERM rates had been based on Germany and not wider Europe, setting a standard that others couldn’t meet. As the Labour leader John Smith said the day after Black Wednesday: ‘the real lesson of the ERM crisis was that “before you can have a strong currency you need a strong economy”’.

The geopolitics of Black Wednesday also showed that, amidst all the noise of bringing Europe together and the ‘all for one and one for all’ rhetoric being bandied about, relations were far from flourishing and the events of the day proved that the UK had failed to organise an orderly plan with its European partners.

But, the most extraordinary lesson of Black Wednesday is never rule anything out and seek the opportunity in the chaos. At the time, the idea that interest rates could jump 5% in a single day or that the pound could be forced to withdraw from the ERM was not even considered an option by many and the sums made by speculators on the day show there is money to be made, even if it is from huge errors of judgement by government.

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