Options for Europe – Part 50

The title is my current working title for a book I am finalising over the next few months on the Eurozone. If all goes well (and it should) it will be published in both Italian and English by very well-known publishers. The publication date for the Italian edition is tentatively late April to early May 2014.

You can access the entire sequence of blogs in this series through the – Euro book Category.

I cannot guarantee the sequence of daily additions will make sense overall because at times I will go back and fill in bits (that I needed library access or whatever for). But you should be able to pick up the thread over time although the full edited version will only be available in the final book (obviously).


The Summer of ’92 and Black Wednesday 1992

The politicians pushing for the EMU saw the dark clouds emerging in the international currency markets as a sign that they had to move more quickly to introduce the single currency and impose harsher fiscal rules on Member States. They drew on the Delors Report (1989: 11) which urged “(g)reater convergence of economic performance” and concluded that:

With full freedom of capital movements and integrated financial markets incompatible national policies would quickly translate into exchange rate tensions and put an increasing and undue burden on monetary policy.

The Bundesbank didn’t help matters when it pushed up interest rates on July 16, 1992 because of its concern for rising inflation associated with the reunification. This had the effect of further reinforcing the view that the Mark was undervalued. This was especially the case given that US interest rates had been cut on July 2, 1992 as America battled to avoid recession. The obvious happened. International currency speculators sold the US dollar, the Italian Lira and the British Pound and shifted massive volumes of funds into the Mark.

By pushing interest rates up in Germany, the Bundesbank demonstrated that its position was fundamentally conflicted. Mallaby (2010: 152) noted that “it exposed the central bank’s conflicted role as the anchor of the deutsche mark and simultaneously of Europe’s exchange rate mechanism”. It could not serve both roles. The same type of conflict exists in the present day Eurozone. With the prospect of a total collapse in the monetary system, the European Central Bank has been forced to compromise its charter of no bail-outs. We will consider that position in later chapters.

The Bundesbank decisions were particularly problematic for Germany’s neighbours because they were facing the prospect of recession and unemployment was already high. The increased German interest rates forced them increase their own interest rates beyond the levels deemed prudent given their domestic circumstances. Monetary policy was locked into ensuring the exchange rates were stable and higher unemployment was the casualty. The increasing political backlash to the high unemployment raised further doubts in the financial markets as to the commitment by policy makers to maintaining the ‘no realignment’ policy.

The EMS was now on very shaky ground. The first cab off the rank was the Italian Lira, which came under increased speculative scrutiny in mid-1992. The depreciating US dollar has seriously reduced the competitiveness of European nations, with Italy the most impacted, given its significantly higher inflation rate. Within the logic of the EMS, the correct response would have been for the Italian government to devalue their currency by up to 10 per cent. But the Government was deeply divided over how it would go about meeting the convergence criteria and didn’t have the political will to act. The Banca d’Italia also resisted devaluation. The Italians instead attempted to maintain the exchange rate parity and raised interest rates sharply on September 4, 1992. At that point, short-term interest rates in Italy were already a growth-choking 15 per cent.

But that wasn’t enough and the Lira plunged below the allowable lower limits as investors continued to move funds out of Italy and into Marks. This, in turn, placed further pressure on the Bundesbank who had also been defending Lira by selling the Mark and buying the Italian currency. The Germans, as expected, felt that the growth in the supply of Marks would worsen the inflation in Germany and they were reluctant to hold the fort for too long.

Tensions were high as the French would soon vote on the Maastricht Treaty (September 20). Britain, in particular wanted to reduce interest rates without having to devalue the Pound as its unemployment was skyrocketing. The European Finance Ministers and central bankers met in Bath (as UK Chancellor Norman Lamont was chair of the Ecofin committee at this stage) over the weekend, September 4-5, 1992. Norman Lamont demanded that Germany cut its interest rates. According to the reports from one German central bank official, Norman Lamont, at one stage pounded his fist on the table and shouted at the Bundesbank President, Dr Helmut Schlesinger “Twelve finance ministers are all sitting here demanding that you lower your interest rates. Why don’t you do it?” (Whitney, 1992; Mallaby, 2010). In the following week, Schlesinger, twice made public statements which suggested both the Lira and Pound were overvalued, which further fuelled expectations among the currency traders that there would be realignments (Elliot et al., 1992).

Over the weekend of September 12-13, 1992, the Italians, at the instigation of the German officials, requested that they be allowed devalue (Szász (1999: 173). On September 13, 1992, the Lira was duly devalued by 3.5 per cent but this was actually a 7 per cent shift because the other currencies were revalued by 3.5 per cent. Szász (1999: 173) recounts “telephone conversations” where “it was decided to devalue the lira … by 7 per cent, disguised for reasons of prestige as a devaluation of … 3.5 per cent and a revaluation of the other currencies by 3.5 per cent”.

The Summer of ’92 was also unkind the Brits. The British Pound was also under sustained attack from speculators who, based on the declining competitiveness of the British economy and its relatively high inflation, were convinced it would have to be devalued. They were selling US dollars, Italian Lira and sterling and shifting massive volumes of funds into the Deutsche Mark. Matters came to a head a few days after the Italians devalued. In his memoirs (Lamont, 1999), he recounts that as the Italians were negotiating the terms of the devaluation with the Germans, he attended the Last Night of the Proms in London singing ‘Rule Brittania’ with “great gusto” (see Mallaby, 2010: 159). Denial.

The British government had initially refused to join the exchange rate mechanism within the EMS but had during some periods ‘shadowed’ the movements in the Deutsche Mark, the benchmark currency of the EMS, and kept the pound at around 3 DMs (BBC, 2002). The British government was clearly divided between the Pro-European camp and the Thatcher camp, which, correctly saw a move into the EMU as compromising the policy sovereignty of Britain. It was a pity her government used that sovereignty in the way it did but the point was valid. She understood the problems that would emerge if Britain decided to join the EMU and was then forced to use the ‘foreign’ single currency. There were also undertones of extreme anti-German sentiment left over from World War II driving the stance against the EMU in Britain.

However, with Thatcher’s star on the wane and the elevation of the Pro-European John Major to the role of Chancellor to replace Nigel Lawson, the Tories turned towards joining the ERM. The decision confronted British jingoism (Thatcher’s anti-German sentiment) with the ahistorical ideology of Monetarism, which were both in play during the Thatcher years. Drawing on the Monetarist influence, Major and Foreign Secretary Douglas Hurd argued that Britain could expunge the high inflation left over from the oil price shocks if it tied the Pound to the German Mark, which was equivalent to saying that the Bank of England passively follows the Bundesbank interest rate policy, which was pushing interest rates up beyond those which would be considered appropriate for a recessed British economy.

Major and Hurd won over Thatcher and Britain joined the ERM on October 8, 1990 – while mired in a deep recession and at an overvalued parity (2.95 Deutsche Marks per pound). Once John Major took over as Prime Minister in November 1990, following Thatcher’s demise in the same month, the British Government touted Britain’s membership of the ERM and the so-called ‘inflation anchor’ that it offered as the “centrepiece of the Government’s anti-inflation strategy” (Elliot et al., 1992). But as Szász (1999: 174) pointed out “Black Wednesday was pre-programmed … [and] … more than anything else, caused by the UK Government’s decision to enter into ERM without accepting its implications.”

While the Pound was allowed a 6 per cent fluctuation band as a starting point, informed observers believed that the Bank of England would never be able to sustain the currency within that band. The obvious happened – and while tying the Pound to the Mark lowered inflation, it was at the expense of a deepening recession and worsening unemployment. Italy all over again! Britain was also particularly affected by the falling US dollar, which undermined the international competitiveness of its export products. By the Summer of ’92, the pressure on the Pound was unbearable. As in the case of Italy, the Bundesbank was prepared to provide only limited support, given that they were trying to purge inflation from the German economy and to defend the Pound would require it to sell more Marks and thus increase the money supply by more than they cared.

The foreign currency markets worked out that the Pound would have to be devalued despite the on-going political resistance to the idea. The Government’s response was to push up interest rates to 10 per cent and instruct the Bank of England to intervene heavily in the currency markets to maintain strong demand for the pound. This just worsened the recession. It was also a finite strategy because eventually the Bank’s international reserves would be depleted if the speculation against the Pound continued. By September 1992, the only buyer of the Pound in the currency markets was the Bank of England such was the speculative sentiment against it.

And then Wednesday, September 16, 1992 dawned – but the ‘skies became darker’ as the day progressed. British Treasury and Bank of England officials has agreed to keep buying the Pound and had purchased £600 million in two interventions before 8.30 am (Mallaby, 2010: 163). But they were up against George Soros’s Quantum Fund, who had started an elaborate set of transactions based on their certainty that the Pound would have to be devalued. Mallaby (2010: 163) compared the ‘millions’ the Bank was buying with the ‘billions’ that Soros was selling, which then drove “legions of imitators to sell also”. Ten minutes later, the Bank bought a further £400 million but the Pound continued to hover around the lower allowable bound.

This went on throughout the morning until 11.00 at which time, the Bank of England pushed interest rates up to 12 per cent in an effort to reverse the on-going capital outflow. While pondering whether they could withdraw from the ERM, the Bank announced that rates would rise to 15 per cent the next day. But the huge sale of pounds continued in the foreign exchange markets. Macroeconomic policy was, by now, out of control – the obsession with fighting inflation by tying the Pound to the Mark was leading to frenzied and totally inappropriate changes to domestic policy settings. It was the anathema of responsible government and was driven by the fervent belief in fixed exchange rates. A similar abandonment of responsible policy in defence of an indefensible single currency is ruining prosperity in Europe in the current period.

A Bank of England official recalled later that “he bought more sterling in four hours that day than anybody had before or since” (Inman, 2012) and all the trades lost money as the Pound pushed lower. He also said that the Bundesbank was refusing to play its part, under ERM rules, to defend the Pound from its end. He said that at a conference call later in the day to the Bundesbank officials “they suddenly didn’t speak English, which was extraordinary” (Inman, 2012). Presumably, the German intransigence reflected Schlesinger’s view that a devaluation was necessary.

At 19:40 that evening, the Chancellor Norman Lamont stood outside the Treasury Building in London and announced that Britain has ‘suspended’ its membership of the ERM. The Pound has floated ever since. Overnight, the Pound plunged to 2.69 per Deutsche Mark, which was nine pfennigs below its allowable fluctuation band in the ERM (Elliot et al., 1992). During the next day, it continued to fall and devalued around 13 per cent against the Deutsche Mark and 18 per cent against the US dollar between August and October 1992, which freed the Bank of England from following the Bundesbank interest rate policy and spurred growth. Inflation didn’t break out as many mainstream economists had predicted.

For many ‘Black Wednesday’ became ‘White Wednesday’ – the day Britain regained its policy independence and distanced itself from the madness that was going on in Europe, and, which would become even more insane by the turn of the century.

Szász (1999: 175) considers the question of why the Germans and others were pressuring Britain to join the ERM, given the hostility of the British under Thatcher to the proposed EMU. He recalls a 1987 conversation with the then Bundesbank President Karl Otto Pöhl, who said that “he would not be arguing in favour of British entry if he thought they would listen”! (Szász, 1999: 175). For his part, as Britain was entering the ERM, John Major had apparently dreamed “aloud” that the sterling would replace “the German mark as the anchor currency” (Szász (1999: 177). Such was the denial that the political classes evidently had a very limited understanding of the consequences of their decisions. Not a lot has changed in Europe it seems.


The proposed rise from 12 to 15 per cent was revoked within a few hours, further reinforcing the view that the policy makers had lost their mojo. The fact is that they never had it and by blindly following the Monetarist pegged currency strategy they had destroyed millions of jobs and handed over more than a billion US dollars in profit to George Soros’s Quantum Fund (Kaletsky, 1992). At the time, it was estimated that the Bank of England had lost more than £10 billion of its foreign reserves trying to defend the currency. In 2005, the UK Financial Times newspaper sought information under the British Freedom of Information act from the British Treasury about the extent of the losses made by the Bank of England on Black Wednesday 1992. The losses were estimated to have been £3.3 billion (Tempest, 2005).


Next day, the Italian government announced it was withdrawing the Lira from the ERM and Spain announced that the peseta would be devalued by 5 per cent. The rot had set in and the speculators relentlessly attacked most of the European currencies such that by the Summer of 1993, the crisis had resurfaced and Ireland, Portugal and Spain (for the second time within a few months) were forced to devalue.


Additional references

This list will be progressively compiled.

Elliot, L., Hutton, W. and Wolf, J. (1992) ‘September 17 1992: Pound drops out of ERM’, UK Guardian, September 17, 1992. http://www.theguardian.com/business/1992/sep/17/emu.theeuro

Inman, P. (2012) ‘Black Wednesday 20 years on: how the day unfolded’, UK Guardian, September 13, 2013. http://www.theguardian.com/business/2012/sep/13/black-wednesday-20-years-pound-erm

Kaletsky, A. (1992) ‘How Mr. Soros Made a Billion’, The Times, October 26, 1992.

Lamont, N. (1999) In Office, London, Little Brown.

Mallaby, S. (2010) More Money Than God, Hedge Funds and the Making of a New Elite, New York, The Penguin Press.

Tempest, M. (2005) ‘Treasury papers reveal cost of Black Wednesday’, UK Guardian, February 9, 2005. http://www.theguardian.com/politics/2005/feb/09/freedomofinformation.uk1

Whitney, C.R. (1992) ‘Bundesbank Chief Is at Eye of Currency Storm’, New York Times, October 8, 1992. http://www.nytimes.com/1992/10/08/business/bundesbank-chief-is-at-eye-of-currency-storm.html

(c) Copyright 2014 Bill Mitchell. All Rights Reserved.

This Post Has One Comment

  1. Sadly enough, what your blog predicted years ago has now come true in France: the far-right National Front has come out particularly high in the municipal polls taking place today. This is not to be underestimated as the National Front does not normally fare well in municipal elections, where the two-round system favours traditional parties like the Parti Socialiste or the conservatives. But worse is yet to come, according to every opinion poll, when the European elections take place at the end of May, the proportional system will help push the Front National to 25% of the ballot (if not beyond), thereby BECOMING THE FIRST PARTY OF FRENCH POLITICS.

    Reading your narrative of the events which took place more than twenty years ago, I cannot help but think that things have not changed at all: mainstream politicians are ready to sacrifice their own people in the name of crazy beliefs or objectives: currency pegs, single market, European integration etc.

    Twenty years since, and I cannot even say that we are stuck in the same quagmire: no growth, no perspective of growth, this is actually much worse!

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