Black Wednesday

In British politics and economics, Black Wednesday refers to the events of 16 September 1992 when the Conservative government was forced to withdraw the pound from currency fix, the European Exchange Rate Mechanism (ERM) after they were unable to keep Sterling above its agreed lower limit when currency markets believed the policy was unsustainable. The most high profile of the currency market investors, George Soros, made over US$1 billion profit. In 1997 the UK Treasury estimated the cost of Black Wednesday at £3.4 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. Newspapers also revealed that the Treasury spent £27bn of reserves in propping up the pound; the Treasury calculates the ultimate loss was only £3.4bn.

Prelude

When the ERM was set up in 1979, Britain declined to join. This was a controversial decision as the Chancellor of the Exchequer Geoffrey Howe, despite his economically dry credentials, was a convinced pro-European. His successor 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 West Germany, attributing it to the strength of the Deutsche Mark and the management of the Bundesbank. Thus although Britain had not joined the ERM, from early 1987 to March 1988 the Treasury followed a semi-official policy of 'shadowing' the Deutsche Mark.

UK fiscal policy at the time was lax . Yet interest rates were set at relatively low rates and the risk of future inflation only appeared to be a secondary consideration in retrospect.

Matters came to a head in a clash between Margaret Thatcher's economic advisor Alan Walters and Nigel 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, who, with 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 economic 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 DM 2.95 to the pound. Hence, if the exchange rate ever neared the bottom of its permitted range, DM 2.778, 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 for joining the ERM were not favourable at that time.

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 deficits, while the UK was also hurt by the rapid depreciation of the US Dollar - a currency in which many British exports were priced - that summer. 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, and announcement that there would be a referendum in France as well, those ERM currencies that were trading close to the bottom of their ERM bands came under pressure from foreign exchange traders.

Currency Traders Act

The UK's prime minister and cabinet members tried all day to prop up a sinking pound and withdrawal from the monetary system the country had joined two years prior was the last resort. Prime Minister Major raised interest rates from 10 to 12 percent, then to 15, and he authorised the spending of billions of pounds to buy up the sterling being frantically sold on the currency markets.

But the measures failed to prevent the pound falling lower than its minimum level in the ERM.

The Treasury took the decision to defend Sterling's position, believing that to devalue would be to promote inflation. On 16 September the British government announced a rise in the base interest rate from an already high 10 to 12 percent in order to tempt speculators to buy pounds. Despite this and a promise later the same day to raise base rates again to 15 percent, dealers kept selling pounds, convinced that the government would not stick with its promise. By 19:00 that evening, Norman Lamont, then Chancellor, announced Britain would leave the ERM and rates would remain at the new level of 12 percent. It was later revealed that the decision to withdraw had been agreed at an emergency meeting during the day between Norman Lamont, Prime Minister John Major, Foreign Secretary Douglas Hurd, President of the Board of Trade Michael Heseltine and Home Secretary Kenneth Clarke (the latter three all being strong pro-Europeans as well as senior Cabinet Ministers), and that the interest rate hike to 15 percent had only been a temporary measure to prevent a rout in the pound that afternoon.

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 his memoirs, John Major claimed that ERM membership had had the beneficial effect of wringing inflation out of Britain's system.

The shadow chancellor, Gordon Brown, said colossal errors of judgement by the prime minister and chancellor had betrayed the British people. Liberal Democrat leader Paddy Ashdown said the government's policy had failed.

Indeed the performance of the UK economy subsequent to the events of Black Wednesday has been significantly stronger than that of the Eurozone and, despite the damage caused to the economy in the short term, many economists now use the term 'White Wednesday' to describe the day (a term originally coined by Euro-sceptics happy at the stalling of further European integration). Ironically, sterling subsequently rallied strongly during the autumn of 1996 and early 1997 back to the levels which had prevailed before Black Wednesday, and sterling's trade-weighted index remained stable at these levels until late 2006.

However, the reputation of the Conservatives for competent handling of the economy was shattered. The Conservatives had recently won the 1992 General Election, and the Gallup poll for September showed a 2.5% Conservative lead. By the October poll, following Black Wednesday, they had plunged from 43% voting intention to 29%, while Labour jumped into a lead which they held more-or-less unbroken (except for several brief periods such as during the 2000 Fuel Protests) until David Cameron became leader of the Conservative Party. It took 15 years for the Conservatives to regain the 42%+ popularity that is considered the minimum necessary for a Conservative general election victory. David Cameron, then just short of 26 years old and unknown to the public, was political advisor to Norman Lamont, the Chancellor of the Exchequer, during the problems of Black Wednesday, and can be spotted at Lamont's side in news film of Lamont's announcement of British withdrawal from the ERM that evening.

EU economists' analysis of this event concluded that stable exchange rates are the result, not the cause, of a common approach to economic management, resulting in the Stability and Growth Pact that underpins ERM II and subsequently the euro single currency.