Until then, the government of Margaret Thatcher had believed it had cracked Britain's long-term economic problems, with several years of strong growth and low inflation in the mids. The then chancellor, Nigel Lawson, decided that the best way to keep the cost of living in check was for the pound to shadow the German mark, believing that this would import Teutonic anti-inflationary zeal into the UK.
It was a policy disaster. Interest rates were cut to prevent sterling from rising and this led to an orgy of mortgage borrowing. By that point Lawson had gone, but his successor — Major — decided that the way for Britain to kick its inflation habit for good was to join the ERM, a device by which European currencies had to trade within fixed bands against the mark.
The central point of the UK's band was DM2. The Treasury was convinced that ERM membership would provide a solid anchor for monetary policy, and the decision to join in October was welcomed by all three main political parties, the CBI and the TUC. Unfortunately, two things conspired to wreck the ERM experiment.
Firstly, at that very moment the economy was plunging into a deep recession triggered by a doubling of interest rates from 7. Unemployment rose sharply and many of those who had bought homes during the boom found themselves out of work, unable to pay their mortgages and sitting in homes worth a lot less than they had paid for them. Repossessions rose to record levels, as did bankruptcies. The second factor was the reunification of Germany at the end of the cold war, which led to rapid growth and upward pressure on inflation in and Germany's central bank, the Bundesbank, raised interest rates and this made the mark more attractive to investors, leading to an increase in its value.
This meant currencies could fluctuate against one another but only by a certain degree, therefore providing the stability that they had all been yearning for. To do this, the governments had to sell the strongest currencies and buy the weakest ones to keep rates in line with their targets.
The Conservative party had snatched power from Labour the same year as the ERM was launched and, generally onboard with the growing integration of Europe at the time, many members of the cabinet had urged leader Margaret Thatcher to peg the pound under the European scheme. Thatcher resisted these calls for over a decade until it eventually boiled over in when John Major took over as prime minister.
Major was among those who had long supported joining the ERM as the previous Labour party had tried to do before Thatcher got the Conservatives into government. There was broad support for joining the ERM across the political spectrum, but Thatcher remained staunch against it. Learn more about what moves forex markets. Inflation was again climbing and had hit its highest level in nearly a decade and Major put the ERM at the centre of his policy to curb it.
The pound initially rallied, and inflation started to decline but things started to sour quickly. When the pound joined the ERM it was among the weakest currencies alongside the Italian lira and the Spanish peseta and the government had insisted that joining the ERM would not cause a devaluation of the pound as some critics had warned.
This required the government to take action to shore up sterling and get it back within range but ended up demonstrating why we have institutions like the Bank of England BoE today. The BoE has, of course, been around for centuries but was under the thumb of the government of the day. Major and his team addressed the falling pound by raising interest rates — which generally pushes inflation down and the pound up. Quite simply, the rate at which the UK had tried to peg the pound was too high, the economy was not strong enough and higher interest rates ultimately failed to prop up the pound to the desired range.
Today, financial markets and consumers are being eased into higher interest rates and the impact is being priced in well in advance of the actual hikes. Building societies and banks also held off immediately passing on higher rates to customers in a sign that industry felt the rate hike was the result of short-term disarray rather than long-term planning. Source: Bank of England. Bank rate is the interest rate charged to commercial banks that influences the interest rates those banks offer to their customers.
As stated earlier, those countries with the strongest currencies were supposed to help support the weaker ones to bring stability to all those under the ERM. But instead of selling the Deutsche Mark and buying the pound, the central bank sowed seeds of mischief and shut the vault.
It was a brave move based on a sharp approach. Through his Quantum Fund, Soros instructed his team to borrow UK gilts and sell them before repurchasing them later on at a lower price. Much like the BoE lost more money with every transaction, Soros and his team were turning a profit with each trade.
The introduction of the euro, however, slowly eroded the need for a system like ERM. A year after Tony Blair swept to success in his government introduced a crucial policy that gave the BoE the independence that it had long argued for, separating political problems from monetary policy. The upfront costs of Black Wednesday are evident but the longer-term outcomes are still debated to this day. After the UK markets closed on Black Wednesday the sell-off continued as traders in New York picked up the baton before passing it on to traders in Tokyo who followed their lead to provide sterling with another hammering.
They repeated the trick every few minutes, making a profit each time. The prime minister, John Major, was staying in Admiralty house in Whitehall. He was told about the frenzy of selling and convened a meeting of key ministers.
Jim Trott, former chief dealer for the Bank of England, described the day as "stunningly expensive". He said that behind the scenes he bought more sterling in four hours that day than anybody had before or since. All of his purchases lost value during the day — and went down even more when the government pulled out.
The ERM demanded that currencies stayed within a band set in relation to other currencies in the club. To maintain the currency values relative to each other, countries with the most valuable currencies had to sell their own and buy the weakest.
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