One day in 1992, George Soros became one of the most famous currency traders in the world. This was all thanks to his timely and brave bet against the Bank of England on what became known as "Black Wednesday."
Setting the Stage for Black Wednesday
The European Exchange Rate Mechanism (ERM) was set up in March of 1979. Its purpose was to reduce exchange rate variability and stabilize monetary policy across Europe before introducing a common currency; it would eventually be known as the euro. Simply put, the ERM set an upper and lower margin in which exchange rates could vary. This is known as a semi-peg.
Britain declined to join the ERM when it originated. Later on, it adopted a semi-official policy that shadowed the Deutsche Mark. In October 1990, the country decided to join the ERM, preventing its currency from fluctuating more than 6% in either direction by intervening in the currency markets with countertrades.
What Caused Black Wednesday?
When Britain joined the ERM, the rate was set to 2.95 Deutsche Marks per Pound Sterling with a 6% permissible move in either direction. The problem was that the country's inflation rate was high, and interest rates were over 13%. The country's economic boom was far into a period of unsustainable growth. This set the stage for a bust period.
Currency traders took note of these underlying problems and began shorting the Pound Sterling. More specifically, they bought one currency, such as the Deutsche Mark, using the Pound Sterling. This allowed them to profit as the Pound Sterling fell in value by comparison to the other currency. George Soros was one of these bearish currency traders. He amassed a short position of more than $10 billion worth of pounds.
Black Wednesday and Its Aftermath
The UK's prime minister and cabinet members approved the spending of billions in Pounds Sterling. This was an attempt to contain the short selling by speculators. Then, the British government announced that it would raise its interest rates from 10% to 15%. This was in order to try to attract currency traders looking for greater yield on their currency holdings.
But the currency speculators didn't believe the government would make good on these promises; they continued shorting the pound. After an emergency meeting among top officials, the country was ultimately forced to withdraw from the ERM to let the market revalue its currency to more appropriate, lower levels.
The country was arguably thrown into a recession afterward. Many British citizens began referring to the ERM as the "Eternal Recession Machine." While the government lost a lot of money, some politicians are glad the ERM disaster occurred, since it paved the way for more conservative policies that would ultimately be credited for reviving the economy.
What Did Black Wednesday Teach Us?
Black Wednesday teaches a number of important lessons to both currency traders and governments. Some of these lessons may come as a surprise.
For instance, statistical data suggests that the British economy was growing faster in the ERM than published figures suggest. The recession may have been due to the aftermath of the Lawson boom. This was a period of economic growth in the years leading up to 1992.
Lessons for governments might include:
- Don't dictate interest rates: The ERM interest rates were set for Germany. But they should have been set by Europe, for Europe.
- Pick your fights against speculators: Taking extreme measures to counteract decisive market action may be in vain; plus, it can be costly.
Lessons for currency traders could include:
- Nothing's impossible: Britain leaving the ERM was unthinkable to many during the crisis. But even governments make big mistakes.
- Be ready for extreme measures: Britain's decision to raise interest rates from 10% to 12% to 15% in a single day shows potential government resolve.
The Bottom Line
Black Wednesday is well known as the day that Soros broke the Bank of England and made over $1 billion. But the real lessons are found by taking a look into the underlying causes of the crisis and how they quickly led to problems.
By understanding these issues, central banks can avoid future crises sparked by regulatory constraints.