Although the global financial crisis has brought many dramatic events that once would have been thought near impossible, nothing quite matches the drama of 'Black' Wednesday, 16 September, 1992. This was the day when, in a few hours, Britain's economic policy was destroyed by the power of the markets. When, at the end of that day, Norman Lamont, the then chancellor, announced the suspension of Britain's membership of the European exchange rate mechanism (ERM), it was the economic equivalent of a surrender, every bit as humiliating as a major military defeat.
That evening, with the country's foreign exchange reserves squandered in a vain effort to prevent the pound from crashing out of the ERM, it felt as if Britain had reached a point lower even than Harold Wilson's 1967 devaluation or the 1976 bail-out by the International Monetary Fund.
Though Black Wednesday was not a uniquely British event — other countries were affected, most notably Italy — it felt like it. Certainly there was nothing like the safety in numbers of the global financial crisis of 2008-9. The British economic renaissance of the 1980s, as described by Margaret Thatcher's former economic adviser, the late Sir Alan Walters, appeared to come down to earth with a spectacular bump.
First a little background. What was the ERM, and why was Britain in it? In the mid-1980s, when I joined The Times as economics correspondent, some ministers were increasingly concerned about the economic instability caused by a volatile pound. In one month, January 1985, interest rates began the month at 9.5 per cent and ended them at 14 per cent, the cause being official efforts to stop a plunge in the pound.
So Nigel Lawson, the then chancellor, and
Sir Geoffrey Howe, foreign secretary, began pushing Thatcher to join the ERM, the European system established in 1979 in which currencies were pegged against each other. Britain had chosen not to be an early participant in this European project — and Thatcher too was having none of it. But Lawson and Howe persevered, threatening to resign if she did not at least agree to conditions under which Britain would join. Lawson even experimented with adjusting interest rates as if Britain were in the ERM, a policy that contributed to the inflationary boom of the late 1980s.
Thatcher eventually agreed to joining the ERM but only in 1990. By that time Lawson and Howe had gone from their posts and it was John Major, Lawson's successor, who persuaded her. Thatcher by 1990 was politically weakened and the business, political and media establishment was overwhelmingly in favour of joining.
Britain joined the ERM in October 1990 and membership proved problematical from the start. So focused on entry were the Treasury and Major that they failed to spot that Britain's boom had turned to bust. The economy entered recession in mid-1990. Not only that but the reunification of East and West Germany occurred. This meant not just a post-unification boom for the new Germany but also high interest rates to prevent that exuberance spilling over into inflation.
This and the fact that Britain probably joined
at too high an exchange rate meant the period of ERM membership was fraught. Germany effectively set the floor for interest rates and, at a time when Britain needed low rates to escape recession, the system prevented them from being cut below 10 per cent (albeit from a
15 per cent level on the eve of entry).
Matters came to a head in September 1992. Tension was rising in the markets because of an upcoming referendum in France on the Maastricht treaty and on the morning of Wednesday, 16 September, the waves of selling pressure began. Led by George Soros, the legendary hedge fund boss who had warned Britain's position was untenable, the markets were in full flight. The Bank of England resisted, buying pounds with Britain's foreign exchange reserves, but to little avail. Interest rates were raised to 12 per cent, with a threat to raise them even further, to 15 per cent. But the markets were winning. It was like the battle of Rorke's Drift during the Zulu wars but this time without a British victory.
Or was it? Sterling's humiliating exit from the ERM was followed by weeks of despondency, years of economic doubts and a landslide defeat for the Tories in the 1997 election. Quietly, though, Britain's economic performance was improving. Exports and investment were picking up. Unemployment, which touched three million, started to fall.
One benefit of Britain's 23 months in the ERM was that it brought down inflation. In a brilliant reconstruction of economic policy, Lamont replaced the exchange rate target of the ERM with an inflation target that survives to this day. The Bank was given an enhanced role, culminating in its independence in 1997.
The early years after the ERM exit were characterised by fears of job insecurity and worries about whether the economy could ever properly recover. Will Hutton's downbeat book, The State We're In, became a bestseller. Yet it transpired that the economy was recovering even as Britain was on the ERM rack, and that recovery was to last for an extraordinary 16 years — 63 consecutive quarters — only coming to an end in the crisis of 2008-9.
Things are different now, and the challenges are arguably much greater. But the ERM episode is a reminder that, from the depths of despair, things can and usually do get better.
David Smith is economics editor of the Sunday Times.
The revised edition of his book Free Lunch: Easily Digestible Economics is published by Profile Books, £9.99
*source: Bank of England
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