What Black Wednesday can teach us about the euro crisis
Matthew Partridge Sep 24, 2012
Last week saw the twentieth anniversary of Britain’s exit from the European Exchange Rate Mechanism (ERM).
At the time it was seen as a disaster. The Bank of England’s futile attempts to keep sterling in the ERM cost taxpayers £3bn (we’ll explain how in a moment). The pound dropped 15% in a couple of days. The Conservative government of the time, led by John Major, would never recover.
However, the cuts in interest rates that followed the exit, led to a long boom. At the same time, inflation, which many pundits thought would spiral, actually stayed low. Both these factors boosted shares, with the FTSE doubling in five years.
So what can investors learn from the ERM debacle and its aftermath?
Britain and the ERM
From 1986, the-then Conservative chancellor Nigel Lawson relaxed monetary policy. He also cut taxes while increasing spending. This created a credit-fuelled boom and boosted house prices. It also led to retail price index (RPI) inflation surging from an annual rate of 2.4% in August 1986, to 10.9% within four years.
As a result, the government decided to join the ERM. This fixed the value of the pound to various European currencies within a trading band of 6%. The idea was that the Bank of England (and the other central banks) would follow the lead of the Bundesbank (the German central bank). Since West Germany had a reputation for monetary stability, it was felt that this would help get inflation under control.
The problem was that when the UK joined in 1990, the British economy was already slowing as a result of the housing bubble bursting. Meanwhile, in Germany, the Bundesbank was raising interest rates in order to prevent the economic boom that followed reunification from leading to inflation.
This forced the Bank of England, along with the other central banks of member countries, to keep interest rates high at a time when the economy was too fragile to bear it. Without monetary easing, and locked into too high an exchange rate, the British economy went into recession. House prices collapsed.
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The attack on the pound
By 1992 it was clear that things had gone badly wrong. Inflation had fallen to below 3%. But with interest rates remaining high, this put firms and households under a huge amount of pressure. Unemployment went up to just under 10% while house prices fell 20% from their peak.
The government insisted that quitting the ERM was not an option. Indeed, as late as 11 September 1992, John Major stated that leaving would be “a betrayal of Britain's future”. Interest rates were hiked to 10% - giving a real (after inflation) interest rate of 7%. (The kind of return investors would kill for these days.)
Despite all these efforts, the markets were convinced an exit was just a matter of time: the British economy couldn’t take the pain of staying in. The pound plunged to the lowest level permitted under the ERM. In order to prop it up, the Bank of England started using Britain’s foreign currency reserves to buy sterling. But the market just kept on selling. (This is where the £3bn cost to taxpayers was incurred – the losses the Bank of England made on these currency transactions.)
On 16 September, interest rates were increased to 12%, and then later in the day to 15%. When it became clear that this had failed to stop the markets dumping sterling, the government finally quit the ERM.
Without the need to protect the value of the pound, the government was able to take steps to boost the economy. Indeed, just a few months later, interest rates were back down to 6%. This cut the cost of borrowing for firms and households. Property prices began to recover and unemployment began to fall the next year.
Italy would also quit the ERM shortly afterwards. While the ERM survived the British exit (and would form the basis for the euro), the currency band had to be increased from 6% to 15%. This turned it into a much looser system.
What can we learn from the ERM mess?
So what does this tell us about the future of the euro? There are three lessons. It suggests that a 'one size fits all' policy is doomed to failure – especially if there is disagreement between the members.
As we’ve pointed out, while northern European countries like Germany are worried about inflation, higher prices would help the peripheral countries to bring down their labour costs and debt.
It also shows that there is a limit to the power of governments to 'buck the market'. The main reason ERM collapsed was that the currency markets simply didn’t believe that the British government would keep rates at 15%. If the bond markets get the idea that the European Central Bank isn’t willing to do enough to keep Spain and Italy in the euro, then interest rates will again spiral out of control. Despite Draghi’s promise of “unlimited” support, Capital Economics thinks that, even with European Stability Mechanism (ESM) money (the big bail-out fund) and the bond buying, the ECB only has enough resources to buy Spain and Italy another two extra years.
Finally, it shows that a partial, or even full, breakup of the euro might not be the end of the world. Indeed, we’ve long argued that there are only two ways the debt crisis can be solved: either the ECB prints a huge amount of money or the peripheral nations devalue and default. While we prefer the second solution, the first solution will also be good for European shares.
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