I spent Black Wednesday – the day the markets successfully bet against the power of the British government to prop up the pound sterling – on the 28th floor of Dresdner Bank’s headquarters in Frankfurt. I had just been hired as an exchange-student intern in the back office for currency options and interest rate derivatives. Though all days on the trading floor were busy, I had never seen anything like it before.
From one end of the room to the other, men in suits (there were few women) were shouting down phone lines, shouting at each other, or doing both at the same time. There were piles of feather-light trade tickets with numbers scribbled on them: 10, 50 or 100 million Deutschmarks, dollars, francs or pounds.
The excitement was over the exchange rate mechanism (ERM), the framework set up by the European Economic Community in 1979 to keep its members’ currencies in a “trading band” of similar values. If a currency threatened to breach its band, central banks had to intervene. This forerunner to the euro was designed to avoid sharp currency fluctuations and high inflation, and for years did rather well.
Eight countries initially joined: France, West Germany, Belgium, Luxembourg, Ireland, Denmark, Italy and the Netherlands. As a traditionally strong currency in a country of low and stable inflation, the West German deutschmark (DM) acted as the de facto anchor.
France even coined a new phrase for the effect of the ERM on its national currency. “Franc fort” or “strong franc” was not only a homage to the strong anchor but also a cheeky reference to Germany’s financial heartland.
Enter the British
The British famously stayed out of the ERM during the 1980s because Margaret Thatcher didn’t want monetary policy subordinated to Brussels. When she finally agreed to join in October 1990 in the dying days of her premiership, she locked in the pound at £1.00 = DM2.95 plus or minus 6%, meaning it could fluctuate between DM2.77 and DM3.13.
The nation had just entered a recession, however. With high inflation, high interest rates, high government budget deficits, a collapsing housing market and low competitiveness, traders became increasingly doubtful about the Bank of England’s ability to defend the DM2.77 floor.
To rub salt in the wounds, West German premier Helmut Kohl had generously offered a 1:1 conversion rate for East Germans converting East German marks to Deutschmarks following the German reunification in 1990. This spurred inflation in Germany, and the Bundesbank responded by raising interest rates.
The Deutschmark grew stronger as a result, making it harder for the pound and other currencies to stay in their bands. Nonetheless, Thatcher’s successor, John Major, committed to defending the pound at all costs. These were still the days when decisions on interest rates were ultimately taken by the government and not the Bank of England.
After weeks of mounting pressure, on the morning of September 16 1992, the Bank of England was forced to unexpectedly raise interest rates from 10% to 12%. Rates had been at these levels in 1988-91 to counteract a boom, but a raise was the last thing the economy needed during a recession.
Currency traders were unconvinced that raising rates would work and redoubled their bets that the band would not hold. And even when the Bank desperately announced that afternoon that it would raise interest rates to 15%, it did not revive the pound. At 7pm the game was up: Chancellor Norman Lamont announced Britain would leave the ERM.
The pound now returned to “floating”. Or more precisely, it sank like a stone, falling from above US$2 to below US$1.50 in the coming weeks. The whole event dealt a huge credibility blow to the ruling Conservatives. George Soros, a leading currency trader, reportedly made £1 billion betting against sterling.
Central bank independence
Black Wednesday can be placed alongside other watersheds in contemporary British-European political history such as opting out of the euro, not signing up to the Schengen area of free movement of people, and, of course, Brexit.
Yet from an economic perspective, its ramifications are arguably unique. The crisis, which also saw the Italian, Swedish and Finnish currencies coming under pressure, led to a consensus that central banks should become independent from their governments and focus on inflation and essentially nothing else.
The Bank of England officially became responsible for targeting inflation in October 1992, before being granted independence in 1997 under Tony Blair’s administration. The European Central Bank (ECB), modelled mainly on the Bundesbank, focused just on targeting inflation from its inception in 1999, and many others have followed suit.
But the true legacy of Black Wednesday is that it was the day the state fought the markets, and the markets won. Financial markets grasped power, and few have dared to challenge them since.
The new rulers
There are, of course, other events that symbolise the rise of market-oriented thinking: Thatcher’s “big bang” deregulation of the City of London in 1986, the fall of the Berlin Wall in 1989 and arguably even Blair’s election win in 1997. But the timing of Black Wednesday was perfect. The ideological and institutional foundations for free markets had been laid.
Capital had been allowed to flow across borders. Financial innovation had ensured the markets had grown just large enough to be reckoned with. Once they struck the heart of the establishment that September in 1992, it killed off any idea that they could be tamed by democratic means.
They went on to grow ever larger and more powerful, evolving into machines that provide immediate unsentimental verdicts on the history politicians and policymakers are trying to write. It has become hopeless to fight back because the markets are deemed “right”.
Politicians instead compete to please these new rulers. Look no further than former Chancellor Rishi Sunak warning that Liz Truss’s campaign promises would see the markets losing faith in the UK economy. He may not have persuaded voters, but Truss will undoubtedly change tack if there are signs that investors are losing faith in her policies.
It has become, to paraphrase the late philosopher Mark Fisher, easier to imagine an end to the world than an end of the rule of the markets. If I had to pick one day in history to symbolise the supremacy of markets over states and democracies, Black Wednesday would be the one.