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The long journey from Black Wednesday to Brexit

Britain’s departure from the exchange rate mechanism of the European Monetary System on September 16 1992 — a day that came to be known as “Black Wednesday” — had important consequences. One might see this as the beginning of the UK’s slow separation from the EU that culminated in the Brexit vote last year.

Many countries in the Exchange Rate Mechanism system of fixed exchange rates with relatively narrow bands underestimated its weaknesses, particularly its vulnerability to speculative attacks. A speculator acting on the expectation of a member country devaluing could expect high profits, but practically no risk if devaluation did not arise.

During her visit to Germany shortly after Black Wednesday, Queen Elizabeth asked me: “Is the speculation really so strong?” My modest answer, was: “In this system, the possibilities of profit are very high and the risks are negligible.”

Many experts believed that the pound entered the ERM in 1990 at too high a rate. Yet thorough, open discussion about this among the partner countries did not take place.

One form of defence against currency depreciation, often with only a limited impact, consists of changing interest rate differentials between the “weak” and the “strong” currency. Inevitably, there were loud calls in 1992 for the Bundesbank to cut rates. But the rapid unification in 1990 of the two parts of Germany, which had very different economic structures, had led to strong monetary tensions, in particular, accelerating inflation. The Bundesbank had to fight this with high interest rates, even though the economic situation in some EMS countries demanded lower rates.

To resolve such tensions, the rules of the monetary system provided for the possibility of exchange rate adjustment. In the days leading up to Black Wednesday, with the Bundesbank forced into obligatory intervention to support individual currencies, especially the Italian lira, the central bank asked the German government to pave the way for an ERM realignment.

According to ERM rules, this should have led to a meeting of the European Monetary Committee, but only bilateral telephone conversations took place. Later information showed that Britain did not know of the German initiative. So, initially, nothing happened apart from the devaluation of the Italian lira.

Later in September 1992, speculation escalated towards more devaluations. For the pound, the tension was defused only with the UK government’s decision to leave the ERM. I regret to this day that a general remark of mine, not focused specifically on the pound, should have played a role in aggravating sterling’s position.

George Soros, the most powerful speculator at the time, had already geared himself to the pound’s depreciation.

The ERM currency system with narrow bands failed as a result of its over-ambitious construction. This became clear when the French franc came under pressure in the summer of 1993.

A decision was taken to widen the bands, to plus or minus 15 per cent. This eliminated the incentive for risk-free speculation on parity changes. The ERM functioned without tensions until the introduction of the single currency in 1999.

Political clashes over exchange rates change are nothing new. In the case of the UK, the decision to reject devaluation and leave the EMS reversed the loss of national autonomy associated with membership of the ERM. The longstanding member countries of what was then the European Community, on the other hand, already had years of experience of co-operation, involving self-imposed constraints on their freedom of action. Since the creation of economic and monetary union in 1999, these limitations have become more pronounced.

The establishment of the single currency did not bring economic tensions to an end. After the global financial crisis, divergences flared up again. As exchange rate changes were no longer available, financial and monetary policy instruments were used to promote internal adjustment. This generated severe domestic tensions in the countries concerned, as well as turbulence in relationships between member states.

Nevertheless, these countries now appear to be in an advanced state of integration. And the practical difficulties Britain is encountering in negotiating its exit from the EU offer other member states little encouragement to follow the same path.

The writer was Bundesbank president 1991-93. This is an extract from the foreword to ‘Six Days in September: Black Wednesday, Brexit and the making of Europe’ by William Keegan, David Marsh and Richard Roberts