13 September 2022

Project Syndicate's Eichengreen: The Long Shadow of Black Wednesday

When the United Kingdom was forced to abandon the European Monetary System's exchange rate mechanism 30 years ago, British officials took it as a happy consequence that the UK would not qualify for the euro.

But this meant that Britain would continue to have one foot in Europe and one foot out – until it finally put both out.

This September 16 will mark 30 years since “Black Wednesday,” when the British pound was ignominiously ejected from the exchange rate mechanism (ERM) of the European Monetary System. Not all anniversaries are occasions for celebration. This one certainly is not.

Black Wednesday was “a day of disaster,” from which Prime Minister John Major’s government never recovered. It had been Major, as Chancellor of the Exchequer in Margaret Thatcher’s government, who led Britain into the ERM in 1990, overriding the objections of his balky prime minister. Major saw pegging the pound to Germany’s Deutsche Mark as a way to solve Britain’s economic problems at a stroke. Pegging to the Deutsche Mark would supposedly import German monetary-policy credibility and subdue Britain’s chronic inflation. Emulating the model of Europe’s most successful economy promised to invigorate economic growth. This, of course, was wishful thinking.

Importing German monetary policy did not automatically give Britain Germany’s investment rates, skilled machinists, or export prowess. Moreover, no sooner was the pound pegged to the Deutsche Mark than Germany experienced economic difficulties of its own, as the Federal Republic struggled to digest the former East Germany. Those difficulties included inflation, which the Bundesbank moved to suppress, as was its wont, by raising interest rates. The Bank of England had no choice but to move in lockstep. European countries had eliminated their remaining capital controls as part of the Single Market program. With finance now free to flow to higher-interest-rate jurisdictions, rates had to move together. If a country hesitated to match foreign rates, it would experience capital outflows and a deluge of currency sales. And the Major government had reason to hesitate. The British economy had entered recession in 1991, and higher interest rates aggravated its downturn. The weak economy made for a weak housing market, and home prices were already falling. In a country with variable-rate mortgages, higher BOE rates meant higher mortgage payments and a still weaker housing market. This hit the Conservative government’s core constituency, homeowners in England’s leafy suburbs, squarely in the pocketbook.

Thus, it didn’t take a political sage to understand that there were limits on how far the Major government might go to maintain the peg...

 morte at Project Syndicate

© Project Syndicate