The long shadow of Black Wednesday

BERKELEY  — September 16 marked 30 years since “Black Wednesday”, when the British pound was ignominiously ejected from the exchange rate mechanism (ERM) of the European Monetary System. Not all anniversaries are occasions for celebration. This one certainly is not.

Black Wednesday was “a day of disaster”, from which Prime Minister John Major’s government never recovered. It had been Major, as Chancellor of the Exchequer in Margaret Thatcher’s government, who led Britain into the ERM in 1990, overriding the objections of his balky prime minister.

Major saw pegging the pound to Germany’s Deutsche Mark as a way to solve Britain’s economic problems at a stroke. Pegging to the Deutsche Mark would supposedly import German monetary-policy credibility and subdue Britain’s chronic inflation. Emulating the model of Europe’s most successful economy promised to invigorate economic growth.

This, of course, was wishful thinking. Importing German monetary policy did not automatically give Britain Germany’s investment rates, skilled machinists, or export prowess. Moreover, no sooner was the pound pegged to the Deutsche Mark than Germany experienced economic difficulties of its own, as the Federal Republic struggled to digest the former East Germany.

Those difficulties included inflation, which the Bundesbank moved to suppress, as was its wont, by raising interest rates. The Bank of England (BoE) had no choice but to move in lockstep. European countries had eliminated their remaining capital controls as part of the Single Market programme. With finance now free to flow to higher-interest-rate jurisdictions, rates had to move together. If a country hesitated to match foreign rates, it would experience capital outflows and a deluge of currency sales.

And the Major government had reason to hesitate. The British economy had entered recession in 1991, and higher interest rates aggravated its downturn. The weak economy made for a weak housing market, and home prices were already falling. In a country with variable-rate mortgages, higher BoE rates meant higher mortgage payments and a still weaker housing market. This hit the Conservative government’s core constituency, homeowners in England’s leafy suburbs, squarely in the pocketbook.

Thus, it didn’t take a political sage to understand that there were limits on how far the Major government might go to maintain the peg.

Sentiment turned against the pound in September, when Major’s chancellor, Norman Lamont, got into a slanging match with Bundesbank President Helmut Schlesinger. Then, on September 15, Schlesinger made some remarks to the press  —  can you say “payback?”  —  about the possibility of currency devaluations, including of the pound, unleashing a tidal wave of sterling sales the next morning.

Massive currency purchases by the BOE could not stem the tide. The Major government raised interest rates twice but was unwilling to go further. That evening, the government rescinded the second rate increase, and Lamont announced that it was suspending sterling’s participation in the ERM. The BoE’s failed defense of sterling cost it upwards of £3 billion ($3.5 billion), and removed the cornerstone of Major’s economic-policy agenda.  

The consequences were far-reaching. For Britain, this represented the final abandonment of the pegged-exchange-rate regime to which it had committed and recommitted since 1717. The BoE was forced to develop an alternative monetary-policy strategy. In October, adopting an approach pioneered by the Reserve Bank of New Zealand, it turned to inflation targeting, the regime it has operated, for better or worse, ever since.

Abandoning the ERM meant that the United Kingdom would not qualify for the euro. British officials took this as a happy consequence, given their painful recent experience with imported monetary policy. But this meant that Britain would continue to have one foot in Europe and one foot out. It reinforced the country’s ambivalence toward the European project, an ambivalence that would tip into rejection with the Brexit referendum in 2016.

For other European countries, the experience highlighted the urgency of completing the euro. It showed that pegged exchange rates between national currencies were fragile, and that the Bundesbank, left to its own devices, would not tailor its policies to wider European needs.

In fact, Black Wednesday also reflected the influence of France’s imminent referendum on the Maastricht Treaty. Polls indicated that the treaty, the euro’s founding document, was headed for defeat  —  taking the euro down with it. But four days later, French voters, having just seen a demonstration of the alternative, pushed the treaty through.

In a sense, then, had Major not made his ill-fated decision to bring sterling into the ERM, Europe would not have the euro. As for the UK itself, Prime Minister Liz Truss can only hope that the 30th anniversary of Black Wednesday won’t be “celebrated” with a replay.

Barry Eichengreen, professor of Economics at the University of California, Berkeley, is the author, most recently, of In Defense of Public Debt (Oxford University Press, 2021). Copyright: Project Syndicate, 2022. www.project-syndicate/org1