Twenty-five years ago today, the British government withdrew from the European Exchange Rate Mechanism (ERM). The Conservative administration found itself unable to maintain the agreed upon semi-pegged exchange rate, set between the pound sterling and the German mark, and was forced to leave on September 16, 1992, what was later coined as “Black Wednesday.”
Readers will surely see the modern-day parallels with the recent referendum to leave the European Union. In the Conservative Party’s 2015 election manifesto, former Prime Minister David Cameron originally announced his plan to hold a referendum. (In fact, since 2013, Cameron had made a pledge to hold one). The electorate was to be asked a simple question: “Should the United Kingdom remain a member of the European Union or leave the European Union?” Among the British voting population, the Brexit vote itself became an issue that surrounded the two issues of migration and economic independence. By June 24, the results arrived: 48.1% voted Remain and 51.9% voted Leave. As promised, the government under subsequent-PM Theresa May began the process of withdrawing from the EU.
The narrative of Britain’s withdrawal from the European Exchange Rate Mechanism began two years earlier. With the fall of the Berlin Wall in 1989, Germany began the gradual process of reunification. In addition to the numerous political changes and social welfare programs that extended to fellow citizens in East Germany, several economic initiatives were also underway. On May 18, 1990, the two states signed the Treaty Establishing a Monetary, Economic and Social Union between the German Democratic Republic and the Federal Republic of Germany, which made the West German Deutsche Mark (DM) the official currency for both states.
More importantly, the reunited Germany was also treated as a successor state to West Germany, not to East Germany, and was granted the same membership status in both the European Community and the ERM. The system had been established in 1979 and sought to bring about a more unified western Europe, eliminating the need for cross-border tariffs or restrictions on labor movement. To accomplish this task, the ERM was intended to deter high inflationary patterns in various European nations by tying their currencies together. As the predecessor to the European Union, the ERM also established semi-pegged exchange rates with the DM as the de facto currency to which all others were pegged. Several mandates dating back to post-World War II had severely curbed inflation, which was likely in tragic remembrance of the economic state during the Weimar Republic.
The government of West Germany poured funding into East Germany in order to raise the standard of living and encourage social welfare programs similar to those in the West. In order to secure an equitable distribution of the DM, the German central bank, the Bundesbank, mandated the exchange of the East German currency to the DM at a rate of 1.8:1. Not only did this lead to inflationary pressures in the East, but the bank had to print DM at an unprecedented rate. Fearful of hyperinflationary pressures reverberating throughout West Germany, the Bundesbank raised interest rates by almost 3 percent in the 1991 and 1992.
From Central Europe, attention turned to the British Isles. The UK had suffered the hardest blow to German expansionary fiscal and contractionary monetary policies, which was only accentuated by the country’s worst recession in the since the 1970s. The low-growth quarter was mainly caused by falling housing prices and an undervalued exchange rate. As a result, manufacturing output was at a standstill and productivity lagged around 22 percent behind German levels in 1987. Capital also retreated from the British stock market, as investors sought the higher returns promised in Germany. Along with the UK, the other member countries of the ERM were forced to raise their own interest rates and maintain their peg, but at the cost of lower economic growth and higher unemployment.
France was much more open to depleting its foreign currency reserves, emphasizing that a short-term cost to the French central bank would be offset by the possibility of future economic deterrence. With the hopes of protecting the Franco-German Friendship, President Mitterrand and Chancellor Kohl were all too ambitious to see the single currency system survive. A French exit would have been an end to the hopes of any type of European monetary system, according to one scholar, because the “credibility of the European monetary system would be utterly destroyed.” The UK held contrarian views to their continental counterparts, and the government decided to hold off on selling too many reserves for fear of harming their own declining industrial capabilities. This pressure fueled the financial flames that led up to Black Wednesday.
To stay within the range of the permitted fixed-exchange band, interest rates in the UK had to be pushed up to meet equilibrium between domestic and foreign returns. The Bank of England was obligated to buy any amount of sterling within the exchange rate, as per the ERM’s direction. Macroeconomic theory suggests that this policy would be tautologically necessary for it was the very purpose of a semi-pegged monetary union. Investors were not tempted by British pounds even when base interest rates rose from 10 to 12 percent. That same day, even a 15 percent promised return could not successfully tempt investors. The Financial Times reported that the sterling “was sold like water running out of a tap.” George Soros, the famous investor, continued to short the pound, which netted him more than one billion pounds. After spending ₤27 billion of reserves and little impact on financial markets, the Treasury and the Bank of England were running out of options. Further interest rate hikes were incredibly unfavorable political moves as it would push Britain further into recession.
By 7:30 pm, Chancellor of the Exchequer Norman Lamont reported that “Britain’s best interests would be secured by suspending membership in the Exchange Rate Mechanism.” His statement followed unprecedented financial outflows from the British stock market. Over the next several weeks, the pound fell by 15 percent and resulted in an estimated £3 billion in Treasury losses. Mr. Lamont received a barrage of criticism from his opponents, including Liberal Democrat Paddy Ashdown. MP Ashdown cited Lamont’s “lost control of the economic situation” as a direct failure of the administration.
This incident of British exceptionalism is reflective of Britain’s distancing itself from the ERM, similar to the Brexit of 2016. Since the ERM’s founding, under the Thatcher administration, economist Alan Walters shared his doubts over the set of fixed exchange rates. He suggested the situation would soon turn into a one-currency disaster. Nonetheless, the UK joined the ERM in 1990 and maintained a semi-peg of 2.95 DM per pound. Furthermore, the prospect of leaving the ERM had not been solely in response to West German actions, but rather had been in talks since January. The housing market had maintained unsustainably high prices for several years. By February, one Bank survey estimated that one million British households had homes worth less than their mortgages. But the reunification of Germany itself was the catalyst for Britain’s withdrawal. Some economists, such as Bryon Higgins at the Federal Reserve Bank of Kansas City, argued that the whole unfortunate disaster was simply “a combination of bad luck and bad policy decisions.”
The British exit from the ERM serves as an event similar to the recent “Brexit,” in which the UK was uncertain of its own economic prospects and sought to leave a monetary union that it believed restrained economic growth. The incidents of 1992 and 2016 are not only moments of British exceptionalism (by the neutral definition) of the British desire to save their economy, but also act as a challenge to the frameworks for understanding monetary unions. Since World War II, one study claimed that 69 countries had left monetary unions. Whether it was the the CFA franc in Central Africa or the East Caribbean dollar, these events often involve colonies declaring independence and cutting both political and economic ties with their colonizer. The British incidents of 1992 and 2016 serve as a reminder of how such unions can represent a similar political statement of independent policymaking. The cases here are imperative for understanding how economic historians can interpret financial systems from a non-colonial perspective.
Eventually, the UK did recover but not without a serious blow to its economic growth and a high cost to taxpayers. Such errors were likely the reasoning behind delaying membership in the Eurozone until 1999, an admission which undoubtedly had Eurosceptics since the beginning. Fast forward to 2016 and the economy faced a similar hit immediately following the referendum. However, just a week after the Brexit, the FTSE jumped back to its pre-referendum levels and soon reached its highest level since 2011. Whether the exit decision proves to be a deathly blow or an economic stimulus to the UK remains to be seen. Investors and economists continue to debate the efficacy of a referendum and what implications exist for the UK. The two monetary independence movements are alike in creating a state of mind in which the United Kingdom deems itself distinctly separate from its continental peers in the EU, but economically still linked to its key trading partners. The country is forced once again to be more global in its commercial endeavors and seek to redefine its place within the world economy.
Image Credit: Pound Sterling Live