John Phelan is an economist at the Center for the American Experiment.
At 7.40pm on Wednesday 16 September 1992, Britain’s Chancellor of the Exchequer, Norman Lamont, announced the country’s withdrawal from the exchange rate regime in a televised address. Monetary policy announcements rarely get live, prime time coverage, but it came at the end of one of the most significant days in British economic history.
Entered, 1978 to 1990
Believing that exchange rate fluctuations create barriers to cross-border trade, in 1978 the European Community established the European Monetary System, the centerpiece of which was the Exchange Rate Mechanism (ERM). These limited member currencies are in a 2.25% band (6% for the Italian lira) on either side of their parity with the European currency unit, a basket representing a weighted average of member currencies.
Britain stayed out. Prime Minister James Callaghan noted that the scheme “effectively meant turning Europe into a Deutschmark region”:
“I was sympathetic to the general proposal, but I had to make it clear that, as proposed, the effect of this scheme would be detrimental to Britain, as a strong Deutschmark would have the effect of pulling sterling upwards with inflationary consequences for our economy, unless long-term credit was absolutely unlimited. “
Callaghan’s successor, Margaret Thatcher, agreed. Apart from concerns about British sovereignty, he considered the exchange rate to be a price determined by the market.
Britain finally joined the ERM in October 1990. In October 1989 Thatcher lost a chancellor, Nigel Lawson. When her successor John Major threatened to resign if Britain did not join, the increasingly embattled Thatcher agreed and Sterling joined the ERM. October 1990 at 2.95 DM. Thatcher was forced from office the following month and replaced by Major, who appointed Lamont as his chancellor.
Stay, 1990 to 1992
What attracted Lawson and Major to the ERM was the opportunity to import German monetary policy, or, as their detractors would say, to blame it for reprehensible or painful policy choices. In 1985, with sterling at 4.00 DM, looser monetary policy was needed. In 1988, with inflation rising, tighter policy was needed and ERM membership offered an attractive cover.
Lawson and Major raised the Bank of England’s base rate from 7.38% in May 1988 to 14.88% between November 1989 and September 1990. Inflation declined from an annual rate of 9.2% in October 1990 to 3.7% in August 1992. But in October 1990. , reunified Germany. Faced with inflationary pressures, the Bundesbank began raising interest rates. Even as British inflation eased, interest rates did not fall commensurately. Callaghan’s predictions and Thatcher’s fears were borne out.
Between 1991 and 1992, doubts grew about whether Britain – and others – could maintain their ERM parity. In June, Danish voters rejected the Maastricht Treaty which, among other things, set the path for the proposed single currency out of the ERM. This route now seems less navigable and the ERM less objective. The parties are under pressure.
The situation exploded on September 15, 1992, when Bundesbank President Helmut Schlesinger called for “a far-reaching realignment” of the currency. The market sensed an impending sterling devaluation. The next morning, they start ‘shorting’ sterling: borrowing it, selling it, buying it lower, paying off the debt and pocketing the profit. Sterling is devastated. To support this, the British government began spending foreign exchange reserves to buy sterling. By mid-morning the selling was so intense that Bank of England officials were buying up to 2 billion pounds sterling every hour. The Treasury later in the day’s trading estimated the loss at £3.3 billion.
But Britain’s currency reserves had limitations. At 11am, Major decided to raise interest rates to 12%, but the market did not believe he would do the economic damage necessary to maintain parity, and sterling’s rout continued. TV schedules were barred from bringing regular updates on financial talks. That afternoon, Lamont called Major to tell him the game was over, but Major disagreed. Instead, he insisted that the interest rate go to 15%. Even that didn’t work, and sterling was still out of its currency band when the market closed. Black announced Lamont’s surrender at 7:40 p.m. Wednesday.
Kept Outside, 1992 –
Thatcher once said, “You can’t take money out of the market.” Major tries and the market boos him. Politically, after a surprise election victory in April 1992, the Conservatives’ polls slipped, never recovered, and the Labor Party defeated them in a landslide in 1997. Their core voters, the homeowners who bought into Thatcher’s “property-owning democracy”. ERM has been particularly hard hit by the debacle.
Economically, the British government adopted inflation targeting for lack of any other ideas. It worked. Inflation was low in the 1990s and 2000s, and the economy grew until 2008. The prospect of British membership of the euro was effectively dead. Indeed, with hindsight, many came to remember September 16, 1992 as ‘White Wednesday’.