A brief history of... Black Wednesday

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Black Wednesday is remembered as a dark day in British economic history. But the clouds were lined with gold. Martin Upton, head of the Centre for Financial Management at The Open University Business School tells Ione Mako about the upside.

By: Ione Mako (Guest) , Martin Upton (Department for Accounting and Finance)

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Ione Mako: You’re listening to the Open Finance series on Lessons From History from The Open University Business School. My name is Ione Mako and today we’re looking at Black Wednesday with Martin Upton, Head of the Centre for Financial Management at the Open University Business School. Hello, Martin.

Martin Upton: Hello.

Ione Mako: Black Wednesday, September 16th 1992, that’s almost two decades ago now, so could you just briefly remind us what happened on that day?

Martin Upton: Well you must remember the TV pictures; 7pm outside the Treasury in London and the Chancellor of the Exchequer, Norman Lamont, walks outside and in front of the TV cameras, after a day that the pound had taken a battering, he was forced to announce that the UK was suspending its membership of the European Exchange Rate Mechanism - the ERM. It was a stunning day on the markets, one which will live in history, and one which dented the morale of the UK in such a way that the Tories now still blame it for the failure of them to win the next election in 1997.

Ione Mako: And what was the ERM, why was it important, why was the UK in it in the first place?

Martin Upton: Well the ERM, the Exchange Rate Mechanism, was effectively the precursor to the European single currency, the euro. It was a mechanism which required member countries to keep their national currencies, like the pound, like the deutschmark, within defined and fairly narrow levels against each other. And it was the responsibility of the member countries to ensure that, if movements in national currencies threatened to take their national currency in terms of its value outside those narrow ranges, then intervention had to take place to ensure that the currency was maintained within its permitted range against other currencies. The dominant currency was the deutschmark, and member countries’ currencies were effectively priced at a range around the deutschmark.

You may ask yourself the question, okay, well why did the European member countries need to have the ERM, what was the benefit? Aside from the fact that, in my view, this was a preparatory move ahead of the launch of the single currency, the euro, in 1999, the key perceived advantage was that it avoided wide fluctuations in currencies in value against each other. If you’ve got wide movements in exchange rates it is difficult for people engaged in international trade. Keeping exchange rates more closely aligned was a way of getting round that difficulty.

Ione Mako: And what were the events which then led up to the UK’s decision to suspend its membership of the ERM? Presumably it was costing us money?

Martin Upton: In effect you’ve really got to go back to the point at which the UK entered the ERM and, like with so many things European, the UK entered the ERM late. From quite early on it became clear that the Bank of England was going to have to intervene quite regularly to keep the pound within its permitted range against the deutschmark within the ERM, and at times obviously, in terms of the foreign currency intervention which was required, this was costly. In addition, at the time, interest rates in Europe and even in Germany, which was dealing with reunification, were high and that meant that UK interest rates had to be high because otherwise a differential between the interest rates in Germany and the rest of Europe and in the UK would have led to more pressure in terms of the value of the pound. There would have been downward pressure on the pound if the UK had cut interest rates at the time when European interest rates were high.

And this caused a particular problem for the UK economy because, at the start of the 1990s, there was a recession in the UK. They were very bad times in the housing market and the economy was crying out for low interest rates. There was a clear and manifest conflict between the requirements for continued membership of the ERM and the requirements for the economy as a whole. The economy as a whole was saying we must have lower interest rates but the Government and the Bank of England couldn’t deliver them because, basically, interest rates had to be kept high to maintain the value of the pound against the deutschmark.

Ione Mako: So they’d been struggling for some time; was there a straw that broke the camel’s back?

Martin Upton: Well, I think during the summer of 1992 pressure was building up in the foreign exchange markets and a lot of speculators were starting to take the view, “Well, hang on a second, the UK cannot really carry on as a member of the ERM, can it?” And they were taking the view that the pressure would mount to such a point that maybe membership would have to be suspended and, if that happened, the pound would fall in value. So, as a consequence, in anticipation of that, there was a mass selling of the pound on the foreign exchange markets, and the only way then that the Bank of England could keep the pound within its permitted range within the ERM was to go into the foreign exchange markets and buy pounds and shore up the value of the pound as best it could. But, by the end of the day on Black Wednesday, the Government and the Bank of England concluded that they just couldn’t carry on supporting the pound and that, therefore, the only thing left to do was to suspend membership of the ERM, and that’s what happened at 7pm that evening.

Ione Mako: Naming it "Black Wednesday" implies it was catastrophic for the UK, was it? In what way was it catastrophic?

Martin Upton: It was bad news for the Government; they got appalling headlines out of this; their opinion poll ratings went down and never recovered before the 1997 general election which, as we know, saw the Labour Party sweep to power. It was also bad news for the Bank of England, and effectively, therefore, for us because the defence of the pound had cost about £3.4 billion, so that was bad news. And I think it was also bad news in terms of morale. The other European countries who carried on with their membership of the ERM were in a sense turning round to the UK and saying “Look, you know, you can’t even sustain membership of the ERM for more than - what? - two years.” It was viewed as a pretty humiliating performance.

Ione Mako: Were there winners as well as losers?

Martin Upton: Yeah, sure, there were winners. Many of the speculators made huge amounts of money out of this and we’ve heard the stories about how much George Soros allegedly made out of the plight of the pound because, after the pound was suspended from its membership of ERM, its value fell significantly and, as a consequence, people who’d been selling the pound at its higher rate when it was still a member of the ERM benefited by being able to cover what are called their short positions at a profit. They bought back the pound at a cheaper price. They made huge amounts of money. Again, that didn’t help when it came to the newspaper headlines because people felt okay, you know, “Greedy speculators making money out of the general public.”

Ione Mako: Yet again.

Martin Upton: Yet again. But actually there was another side to Black Wednesday, one which was actually very good for the economy as a whole. By no longer being a member of ERM, the government could now cut interest rates. And they did; they came down from 12% on Black Wednesday to 6% the following year. A substantial reduction and one which started to trigger slowly a recovery in the UK housing market and the economy as a whole. In fact you could argue that the boom in the economy which we had from the mid 1990s until recently when the latest recession started can be attributed to the fact that during membership of the ERM inflation was effectively eliminated within the UK. It was pushed down to historically low levels, certainly in terms of the history of the previous two decades, which enabled interest rates to come down which enabled the economy to expand and enabled employment to expand.

So, if you take a longer term view, you can actually say that there was a golden aspect to Black Wednesday. Perhaps we should call it Golden Wednesday because it laid the foundations for the economic boom which followed for the next fifteen years or so.

Ione Mako: That’s interesting, actually you saying, "Golden Wednesday", because the papers rushed to name these dates headline grabbing "Black Wednesday", but then from a stance of a few years on we can look at it in a more balanced way.

Martin Upton: Well yes, it’s a bit of a cliché isn’t it. I mean we’ve had a Black Monday, and that was in 1987 when the stock market fell, we’ve had a Black Wednesday too. Back in 1929 the stock market crash then, that was on a Friday, so we’ve had a Black Monday, Wednesday and Friday. If you’re working in the financial markets I suggest you keep your eyes on Tuesday and Thursdays in the future.

Ione Mako: Fine, we’ll do that. But just to wind up, have we learnt anything from so-called Black Wednesday 1992? Has anything changed? What have we learnt from that one?

Martin Upton: One key thing which we have learnt is that, if you do enter any exchange rate mechanism, or indeed if you enter, become part of a single currency, you have to go in at the right time and at the right exchange rate. And if you don’t then you store up economic problems. In addition, if you are part of any exchange rate mechanism, the Government loses the ability to use exchange rate management to help the economy. It loses that flexibility, and that’s clearly what was lost during 1990-1992.

Ione Mako: But, supposing we got the timing right and managed to stay within the limits, wouldn’t there also be a benefit from being part of single currency?

Martin Upton: Well certainly you would have the benefit of stability in exchange rates. By definition, if you’re part of the single currency, there are no exchange rates with the other member countries of that single currency. And also you would lose the costs of foreign exchange transactions, you know, when you go and buy your currency to go on holiday and you can buy the euro at one rate and sell it at another and there’s quite a big difference between the two. So you would lose that cost, therefore that would be a benefit to people who are not just people going on holiday, but people engaged in international trade within the single currency zone. But one thing you certainly give up is, again, the flexibility on monetary policy in terms of your ability to move interest rates. With the euro currency zone the rate is determined by the European Central Bank, so national governments lose the ability to manipulate interest rates, move interest rates to benefit their local countries.

Ione Mako: So what you gain in international trade you might lose in local autonomy.

Martin Upton: Yeah, particularly in terms of flexibility to manage the economy.

Ione Mako: Great, thank you very much, Martin.

Martin Upton: Okay.

Ione Mako: You’ve been listening to Open Finance on Lessons From History from The Open University’s Business School.

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