by Alain Naef (Banque de France)
The author is an economist at the Banque de France and cofounder of sustainable macro. He recently published a book, An Exchange Rate History of the United Kingdom, 1945-1992 (Cambridge, 2022). The views expressed in this blog do not represent the opinion of the Banque de France or the Eurosystem.
Government policies can be costly, and sometimes unsuccessful. But rarely are they as costly and unsuccessful as they were for the Bank of England on Black Wednesday. On that day, in an attempt to defend the pound, the Bank of England spent, in only a few hours, as much as the annual GDPs of Bulgaria and Croatia combined—over £600,000 per second during market hours. But it was all for nothing. Britain abandoned the European Exchange Rate Mechanism (ERM), along with the idea that the UK could one day join the Euro.
This large crisis for the pound had begun, as have other crises in Europe, with tensions in Italy. It is relevant for today, as hedge funds have started to build their largest short position against Italian debt since 2008. Figure 1, reproduced from Eichengreen and Naef (2022), visualizes a pressure index for the 1992 ERM crisis. Darker colours and higher numbers mean more pressure. It is clear that Italy was under pressure before Britain felt anything. But then Britain got hit suddenly, and, if the pressure index is to be believed, very violently. The shock to the pound on that day, Black Wednesday, was the most violent shock of the decade, if not the century.
Figure 1. Pressure index for 1992 ERM crisis
Yet, what is more surprising in this story is that the pressure on the pound did not originate from evil and bloodthirsty speculators on a whim; it was mostly the result of friendly fire. The fire came from a member of what Harold James calls a ‘brotherhood’ of central bankers. The brother in question was Helmut Schlesinger, President of the Bundesbank. Brother Schlesinger (if I may), sparked a speculative run with just a tiny remark on 15 September 1992. The remark was small, but he was an important character in the story. He said to a journalist that he thought that, after the Lira was devalued, there would have to be a more comprehensive realignment of currencies in Europe. The subtext was that the pound would have to be devalued, and the market read the message loud and clear.
Counterfactuals are dangerous, but danger is also appealing. In my recent book, I offer a counterfactual analysis of what would have happened to the pound, if Schlesinger had not made his remarks (Naef 2022). As with all counterfactuals, caveats apply. I forecast the pressure on sterling after 15 September, absent Schlesinger’s comments. In my model, I deleted existing data for pressure on the pound (but only that variable) after the remark by Schlesinger. I then forecast the data for pressure on the pound. The model makes use of observations of pressure on other currencies, the German-dollar rate (which influenced the pound), and the German interest rate, which was then the European equivalent of the Fed rate. I only use the model to forecast twelve days after Schlesinger’s remarks. The results are presented in figure 2. The counterfactual shows that, without the comments, the pound would have suffered pressure, but much less. Indeed, Britain could have stayed in the ERM. It is also apparent that pressure was lower once Britain had left the ERM.
Figure 2. Actual and counterfactual pressure on the pound, September 1992
Finally, what is interesting about this crisis is that the French experienced almost the same crisis a few days later. If you look at the pressure index in figure 1, you can see pressure on France mounting as soon as Black Wednesday had blown out. France spent similar amounts on stopping the crisis of the franc. But there is no French equivalent of a Black Wednesday. The crisis was avoided, and the Banque de France, unlike the Bank of England, was able to recuperate its reserves lost in the battle with currency traders. France’s avoidance of a crisis was partly due to the fact that France, unlike the UK, was essential to the ERM and to the European project. And on this occasion, there were no remarks from the Bundesbank, and there was even active support to keep the franc in the ERM.
The consequences of Black Wednesday were important and, in the context of Brexit, have potential ramifications for today. Right after the crisis, the Bank of England stopped foreign exchange interventions, bar a few instances for international cooperation. Black Wednesday also marked a new era of inflation targeting for the Bank of England. Moreover, the episode was one among many that showed British independence from European institutions, forecasting a future of more distance between British and European interests.
To contact the author:
Eichengreen, B. and Naef, A., ‘Imported or home grown? The 1992-3 EMS crisis’, Journal of International Economics, 138 (2022), No. 103654.
Naef, A., An Exchange Rate History of the United Kingdom, 1945-1992 (Cambridge, 2022).