The Geopolitical Consequence of a Monetray Policy Decision

Between Friday, 11th September and Wednesday, 16th September, 1992 the formerly so proud and enormous British Empire suffered an embarrassing and painful defeat in the monetary market, which it used to dominate, against the speculative capital appearing in the international financial world, and was forced to exit the European Exchange Rate Mechanism (ERM). The speculation against the British pound, cementing the international reputation of George Soros’s name, was an important milestone both in the history of finance and European politics, leading to far-reaching consequences beyond its immediate economic and political impact.

In their book ‘Six Days is September – Black Wednesday, Brexit and the making of Europe’, William Keegan, the doyen of British financial journalism, David Marsh, Managing Director of OMFIF, the international think tank for central banking, and Richard Roberts, a professor at King’s College even claim that the fall of the pound was the event that led to the Brexit referendum in 2016 and the exit of the United Kingdom from the European Union. The book – which focusses on those six days, as it is promised in its title – reconstructs that almost one week, and places it into context based on telephone conversations, recollections, interviews and articles of the time, presenting the events to the reader in a thriller-like manner.

But exactly what happened during those six days and how do this six-day drama and the British Euro-sceptical traditions fit together? Who made a mistake, who is responsible for the shameful fall? What role did speculators and the Bundesbank have? Can the media be blamed? Maybe exit from ERM was not a disaster, but a prerequisite for the British economic prosperity lasting until the global financial crisis?

British Isles Versus Continental Europe

The relationship between the United Kingdom and Continental Europe had never been free from problems. Without forgetting the wars fought by the British against other European powers, the rapport was influenced substantially by the fact that in the last 1,000 years, great European wars, the construction and the demolition of the Iron Curtain, the rise and fall of dictators shaping European history, the often drastic redrawing of borderlines all had taken place on the European side of the Channel, and islanders could watch events from a fair distance. The British-Continental opposition is almost a cliché; the question is when this break-up dates back to: some think it happened when the Roman legions left Britannia (around 400), others would date it in the 1530s, when Henry VIII broke away from the Catholic Church. ‘We are with Europe, but not of it’, the authors quote Winston Churchill to present the British mindset; ‘if Britain must choose between Europe and the open sea, she must always choose the open sea’, he argued.

Moving onto the recent past and its economic aspects, after World War II, Europe lay, both figuratively and literally, in ruins, and economic activities between nations practically ceased to exist. A major reason for this was the absence of an international payment and credit system, required for trade, and there were no convertible currencies. The situation was eased by the Marshall aid, as significant dollar liquidity appeared in Europe through the programme being in operation between 1948 and 1952, which enabled real economic cooperation. It resulted in the establishment of the Organisation for European Economic Co-operation in 1948, and that of the European Union in 1950, which allowed net settlement in 18 countries. In the Bretton Woods financial system dollar was the central currency, but the pound remained the second most important international currency until the 1960s.

The authors believe that the idea of joining the EEC occurred to British Prime Minister Harold Macmillan due to Britain’s diminishing weight in world politics after the Suez Crisis in 1956, which was vetoed by French President De Gaulle – again, out of geopolitical considerations, but citing economic reasons. In the 1960s, the explosion-like development of Germany’s economy and the appreciation of the German mark raised concerns, especially in Paris: De Gaulle wanted the United Kingdom, which he considered unreliable, to be outside the European cooperation, and control the ancient rival,  Germany all at once – including such elements as the veto against the British and the radical increase of the French gold reserves by 400 tons per year between 1958 and 1966 – but the French plan eventually failed. By the end of the decade the hegemony of the German economy became clear, as coalitions seeking balance of power came into fashion again among the three major powers of Western Europe. London was seen more and more as a counterweight of Bonn by Paris, arguing for exchange rate stability, and the German party, proposing a much stronger coordination of economic policies than the French were, wanted to prove with the British alliance that its Western orientation also remained strong beside the Eastern opening. The significance of the United Kingdom gained value, as a result of which there were no obstacles in her way to become an EEC member in 1973.

Monetary integration also accelerated.  Led by Edward Heath, a strong supporter of the European Communities, London joined the European currency snake in 1972, but the British “adventure” did not last long: at the end of June London announced to withdraw from the currency snake after burning reserves of $2.5 billion as an intervention. The Bank of England was not independent then, and its political weight was not significant, either, which is also demonstrated by the fact that the Governor of the Bank was notified only after the decision had been made that the pound would be permitted to float. By 1978, Italy and France had also left the currency snake, which led to the establishment of the European Monetary System in 1979. For the sake of  “burden sharing”, the Germans, happily willing to extend the appreciation of the mark and its impact on competitiveness also over other countries, were strong supporters of the EMS project; the British, however, opposed it from the very beginning amid worried about the pound and their sovereignty.

The European Monetary System

EMS was a fixed but adjustable exchange rate system, in which specific countries had the opportunity to depreciate their currency from time to time. Cross exchange rates were relatively quickly adjusted, in the first four years of the system – strongly determined by the oil crisis, the revolution in Iran and Volcker’s restrictions in the USA – in every eight months on average, and less frequently as the turbulence decreased. The United Kingdom formally joined the EMS in 1979, but not the Exchange Rate Mechanism (ERM), representing the core of the system.

In the late 1980s the voices supporting ERM became louder in London, too, not least because the dollar was getting stronger and the exchange rate was approximating the humiliating 1-dollar level. Eventually, it was ended by the Plaza agreement in 1985, but the British government resisted then – entry had only one major opponent, but her name was Margaret Thatcher, who even threatened to resign if the pound were to join the exchange rate mechanism.

In the late 1980s, the British economy underwent a significant transformation. Thanks to deregulation, credit was growing, but in the meantime interest rates were kept high in order to reduce inflation, which curbed growth. With a freely floating exchange rate, a possible reduction of exchange rates would have caused a weakening of the pound and inflation through the rise of import prices.  In this situation, ERM became an attractive opportunity: by importing the credibility of the Bundesbank, inflation could be reduced while maintaining a stable exchange rate and continuing the credit boom. At least, theoretically.  At the end of the decade, the reference interest rate was as high as 15 per cent, and the external equilibrium was dramatically deteriorating, which led to the resignation of the strongly Euro-sceptical Chancellor of the Exchequer, Nigel Lawson – the father of renowned celebrity chef, Nigella Lawson.  His successor was John Major, a supporter of Europe, who later became Prime Minister. As Chancellor of the Exchequer, one of Major’s chief political achievements was to convince Thatcher to join ERM – or perhaps such a situation evolved, partly due to the shifts in the broader political climate and partly due to the evolving British recession that this was the only possible step they could take.

Joining In Total Secrecy, Mounting Tensions

The United Kingdom joined ERM in October, 1990. High inflation was an important problem of Britain then (it was almost 10 per cent in 1990, while it was less than 3 per cent in Germany), which was accompanied by a recession. On 5th October, Major notified the leaders of Europe by phone that the United Kingdom would join the system, at a mid-market rate of DM2.95. Even then, the cross rate was considered too high by many (the leaders of Bundesbank in particular), while the fact that the British had decided on the exchange rate unilaterally while it should have been a collective decision arouse stiff opposition in others (Banque de France). In retrospect, it can be regarded symbolically that the British joined ERM five days after Germany was re-united – that is, the British tried to board Europe’s ship when the tide was changing, and it was not known which directions the others would take.

The authors think that British politics expected the pound to be strengthened by joining the system, allowing a reduction in interest rates. According to Hans Tietmeyer, International Director and later President of Bundesbank, it is incomprehensible how London could think that they would be able to reduce interest rates continuously after joining ERM, as it was obvious that German interest rates would rise due to the German re-unification. ‘If London really wanted lower interest rates, then it should have joined at a much weaker exchange rate, or should have stayed away from ERM for quite a while’, the German central banker summarized his opinion. Eventually, subsequent events justified the pessimistic scenario, although initially there were no signs suggesting any problems. The British economy arrived at the elections in April, 1992 in good strength: rise had started, inflation had decreased, the external equilibrium had improved, and interest rates could decrease. Conservatives, led by Major by then, won the election.  Deep down, however, tension started to build up. German re-unification brought about a significant transformation in the European geopolitical space, and in terms of finance, especially the decision of a strong domestic nature to convert the East German mark to West German mark at a rate of one-to-one proved to be determining.  Unification in this form undoubtedly led to the rise of inflation pressure in Germany, which was consistent with higher German interest rates. It is important to underline that Bundesbank – as opposed to other leading central banks – had already been independent from the government, and sought to keep away from political aspects. German inflation started to rise in 1991, while other Western European countries witnessed a decrease, which led to German restrictions. German interest rates were below American ones by 3 percentage points in 1989, and they exceeded them by 6 percentage points in 1992. This marked a highly significant monetary turnaround in the Trans-Atlantic region and especially in Europe.

Average annual pace, percentages

Economic growth Unemployment
1992-1999 1999-2009 2009-2016 1992-1999 1999-2009 2009-2016
United Kingdom 2.7 2.5 1.2 8.2 5.2 7.0
Germany 1.4 1.6 1.0 8.4 9.0 5.6
France 2.0 1.9 0.6 10.5 8.5 9.8

This meant that the United Kingdom was trapped: (1) the gap between British and German interest rates was narrowing rapidly, which increased the vulnerability of the pound; (2) real interest rates started to rise due to inflation; (3) the pound had risen against the dollar, which made the situation of British exporters very difficult. The Maastricht Summit took place in this already difficult situation in 1991, which laid down the fundamentals of the economic and monetary union, and set a target date for the introduction of a common European currency. Bundesbank did not support that, and after Maastricht interest rates were raised again, on the grounds of a mounting inflation pressure. The Maastricht Treaty was rejected by Denmark in June, 1992, and then French President Mitterrand announced that a referendum would be held in France in autumn. Subsequently, Bundesbank raised interest rates again, provoking considerable indignation in other Western European states, as they were supposed to raise interest rates or depreciate their currency every time the Germans raised interest rates – which was dismissed by all for domestic policy and economic reasons. Major tried to make Kohl reduce interest rates, which was rejected by the Chancellor on the grounds of the independence of Bundesbank. And Bundesbank was adamant – quoting the words of Wim Duisenberg, President of the Central Bank of the Netherlands at that time, later the President of the European Central Bank, the German central bank was ‘like whipped cream: the harder you beat it, the stiffer it gets’.

At the end of August and the beginning of September the Swedish krone got into trouble first, then the Finnish mark left the system altogether, and several tens of billions of dollars had to be spent on protecting the Italian lira. Market tension was mounting, and the British government took out an international loan of ECU10 billion as a pre-caution to defend the pound – roughly at the same time when George Soros deployed a resource of a similar amount to weaken and break the pound.

Those Particular Six Days

On Friday, 11th September, 1992 the pound started to fall; first, John Major tried to manage it verbally (verbal intervention) – without success. Friday began with the free fall of the lira, and the Italian central bank immediately asked for help from Bundesbank, which, theoretically, was as supposed to defend the exchange rate range as Banca d’Italia. Accordingly, Giuliano Amato, Italy’s Prime Minister and Carlo Azeglio Ciampi, the President of the central bank called Helmut Schlesinger, President of the Bundesbank, who surprised everyone saying that when EMS had been created, the Bundesbank had concluded a secret agreement with the German Chancellor of that time, that in case the stability of the German mark required so, the Bundesbank could not be obliged to intervene. On Saturday, a German delegation arrived in Rome, and the Italians agreed to depreciate their currency, but no decision was made on the other currencies, which remained overvalued against the mark. London learned the news of the Italian depreciation on Saturday evening, but Major would not hear of the depreciation of the pound. The French thought the same; they were preparing for the decisive Maastricht referendum, and monetary market pressure and especially a depreciation would have improved the chances of winning of “no” votes. On Sunday, one could read about a critical period and monetary frenzy in British newspapers. Having perceived the seriousness of the situation, Schlesinger called the other central banks notifying them that the Bundesbank was going to reduce interest rates – the only question was whether it was too late for the German central bank to intervene and whether this would be sufficient to sooth markets.

At 9:30 a.m. on Monday, the leadership of the Bundesbank held a meeting in Frankfurt, and reduced interest rates for the first time in 5 years. The interest rate cut, however, proved to be too modest (25 basis points), and to many, Bundesbank seemed to have made the decision under political pressure, which immediately put the pound in a difficult situation. At the press conference held after the interest rate cut, Schlesinger explained that the decision had been hard to make due to high German inflation, which did not sooth the markets, either. The crisis of the pound was increasingly becoming the question of “when”.

On Tuesday, the Financial Times wrote that after the lira, the next target of speculation would be the pound. But it was not the sensation of the day, but Schlesinger’s interview given to Handelsblatt and Wall Street Journal. The upheaval was caused by Handelsblatt, which sent Schlesinger’s answers to news agencies without authorization by Frankfurt, saying ‘before the French referendum, some currencies could still come under pressure’. If interpreted by market analyses, it meant ‘Sell sterling’. And that was exactly what traders did, that is, the fall of the pound was directly triggered by a German newspaper, which, throwing off the basic rules of journalism ethics, spread the ill-formulated words of the President of the German central bank all over the media. An official correction was issued as early as the same evening, but with no impact: the pound started to plunge, Schlesinger’s words just added fuel to the fire (the German central banker apologised for this in a section of the book written by him). In this context, Wednesday, not surprisingly, saw a complete collapse of the pound, speculators defeated the world of central banks in a couple of hours – the authors think this battle was not “fair” as the official side was divided, there were significant conflicts of interest, and all market powers re-aligned and sold the pound. The outcome could not be any more certain.

On Wednesday, the dealers of the Bank of England appeared on the market at 7.30 a.m., and sales were so intensive that by 10.00 a.m. the BoE had burnt $10 billion of its reserves, but the exchange rate did not move. This was when Major agreed to the first interest rate rise, which was immediately of 200 basis points. The British government announced that they would do anything to defend the pound, but neither this nor the interest rate rise had any effect.

The attack became fiercer, but Major was out of telephone contact as he was at a meeting with the politicians of the Conservative party. With regard to the seriousness of the situation, executives of the central bank went to see the Prime Minister in person, but he did not cut off the meeting, thus in the middle of the attack against the pound, financial leadership had to sit on a sofa in the corridor and wait for Major until 12.45 p.m. The leadership of the Central Bank proposed to suspend ERM membership, attributing responsibility to the Bundesbank and the French referendum. In this period, every single minute cost £18 million to BoE, but the markets did not calm down, therefore the central bank announced another interest rate rise of 300 basis points – the second one within one day, which was perceived by the market as a sign of weakness.  Before capitulation, the Germans rejected the British Prime Minister, and eventually the pound officially departed from ERM at 4.00 p.m., with the reserves of the Bank of England completely depleted. The pound immediately dropped by 3 per cent against the mark, earning huge profit to speculators. Italy followed the British, and Spanish peseta was devaluated.

Black or White?

In October, 1990 the United Kingdom joined ERM in full secrecy and without compulsory consultations – and two years later masses witnessed as it fell out of it tragically quickly. One month after Black Wednesday, Elisabeth II, the Queen of England, travelled to Germany and asked Schlesinger ‘whether speculators can really be so strong?’ And the German central banker just said that ‘in a system of fixed exchange rates with high differentials in the rate of inflation, they can. They have a high chance, unfortunately.’

On 20th September, the French electorate voted for the Maastricht Treaty by a very small margin, which immediately resulted in significant sales of francs in the market. Two days later, President Mitterrand received Chancellor Kohl in Paris, and the French president – unlike his British colleague – managed to convince the Germany party to reduce interest rates. ‘Germany makes a big mistake if it treats France the same way it treated Britain – the two countries cannot be compared economically, politically or strategically’, Jean Claude Trichet, the newly elected President of the Central Bank of France (and later the President of ECB) allegedly said. French arguments must have been convincing because the two central banks issued a joint statement and spent together more than $30 billion on intervention, raised the French interest rates and reduced the German ones, and managed to curb speculation, even if just temporarily.

Not surprisingly, London did not like the exceptional treatment of the French; the Kohl-Mitterrand meeting was therefore classified. Nevertheless, Paris’s resistance did not last long: a speculative attack restarted, and in the summer of 1993 the EMS era practically ended by widening the exchange rate bands by +/- 15 per cent. ‘Problems were caused by the fact that Germany could not manage reunification, and wanted the other countries to pay for the costs’, Mitterrand summed up France’s opinion, according to the book.

The sterling crisis gave way to fundamental changes, but there is no single opinion about the long-term consequences – some say that this Wednesday was not a Black Wednesday but a White one, as the British central bank became independent subsequently, and the United Kingdom saw a 15-year-long economic revival.  The pace of growth was typically higher and unemployment tended to be lower than the French or German ones, and although the pound was depreciated, it did not result in inflationary pressure – which was potentially contributable to the acceleration of globalisation, the reforms on the supply side and the relatively subdued wage dynamics. The book draws a parallel – perhaps rather a strange one at first sight – between the exit from ERM and the retreat from Dunkirk in 1940, which was not by any means a British victory, but allowed to summon up strength and of the final victory later.

British Conservatives, and Major in particular, having won an election victory couple of month earlier, could not recover from this humiliating blow for many years, which was amplified by the fact that the winners of the battle against the pound were very visible and identifiable, especially George Soros, earning international reputation during these couple of days. According to the book, which dedicates an entire chapter to introducing speculative and hedge funds, Soros could have won much more in these days than the often-mentioned £1 billion, and it also tells a lot that later Robin Leigh-Pemberton, the then Governor of the Bank of England, said rather sadly in an interview to The Guardian that he was likely to be remembered as the President of the central bank who was in office when Soros won.

Closing Remarks: First and Second Brexit?

The documents, descriptions, stories presented in the book obviously underpin that London tended to take part in European projects half-heartedly – there was maybe only one moment when this could have been turned around, the period of the ERM membership in question, which, however, ended in failure. The devaluation of the exchange rate was not unprecedented – before World War II a pound cost 4.86 dollar, in 1985 the exchange rate almost achieved parity, but the pound fiasco in 1992 could be regarded as an exceptional case because of the circumstances and the consequences. A couple of decades earlier, the country, considered to be a global empire, burnt all its reserves, depreciated its currency and was forced to shamefully face the fact that in a great political project Germany, supported in its reunification, would not help Britain out. ‘The United Kingdom supported the reunification of Germany, but many Brits feel that they have to pay a high price for this support’, the British Prime Minister summarised his frustration in a letter written to the German Chancellor, but, as we could see, in vain.

Beyond doubt, ERM membership and its disgraceful end fundamentally determined the British’ attitude towards the European integration and the European Union. One of the interesting findings of the book is that the exit from ERM in 1992 was the “first Brexit”, followed by a “second Brexit” in 2016. In October, 1990, it seemed that the traditional British-Continental controversy had been overcome at last and the opposition ended.

The pink fog, however, quickly dispersed with the debate on Maastricht and the forced exit from ERM, and this disappointment culminated in the referendum in 2016, which represents a return to the separatism of the 1950s and 1960s. The authors believe that the ERM crisis is obviously an inflexion point in the UK’s relations to Europe; this is where the estrangement, consummating in the British exit in the not so distant future, started. The authors of the book think that British politics had to pay for three big mistakes, as

– they had failed to recognise what an advanced stage the project of the common European currency was in, especially on the French side, which influenced the operation of ERM in its essentials;

– they failed to appreciate the economic and monetary policy significance of the German reunification, and the fact that due to the accompanying increase of interest rates by Bundesbank the British monetary easing would not be sustainable;

– John Major had overestimated his own capability of and opportunities for influencing German monetary policies, as practically no result was achieved whatsoever by the British Prime Minister in this critical period.

The British withdrawal from ERM in 1992 obviously brought the other European countries together. The authors point out that the sterling crisis accelerated the introduction of the common European currency, even its great opponents, Schlesinger and Issing adopted a milder tone after the crisis. Issing later admitted that the currency crisis of 1993-1993 had obviously been a turning point, subsequently the status quo could not be maintained. ‘The lira weakened by 30 per cent, South German companies manufacturing for the Italian market went bankrupt, and we concluded that the Common Market could not survive another crisis like this’, presented the real motivations the German central banker with surprising frankness. Subsequently, Frankfurt was less rigorous, and Hans Tietmeyer, heading the Bundesbank between 1993 and 1999, was the first President of the central bank who did not ever raise interest rates during his presidency of six years.

The common European currency has been introduced since then, and the central banks of the Eurozone have been replaced by the European Central Bank, but all these did not prevent European countries from being some of the greatest losers of the global financial crisis that broke out in 2007 (some even think it just made things even worse). The authors argue that the reasons for this included an inadequate monetary policy system, and “collective mistakes” (Jacques Delors) and “complacent amnesia” (Mario Draghi) characterising decision-makers in the pre-crisis period. The only question that remains is whether the second Brexit of 2016 would bring along the strengthening of the German-French axis, just like the first Brexit did, and whether the decisions made consequently would prove to be better decisions than the ones made after the sterling crisis.

Author: Pál Péter Kolozsi

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