Black Wednesday: A Turning Point in British Economic History

A bit of economic history for you here from William Keegan, who looks back to Black Wednesday, which occurred 32 years ago today. It covers the decision to join and subsequently leave the Exchange Rate Mechanism, and its implications for the wider macroeconomy, and the government's reputation for economic competence.

Introduction

On 16 September 1992, a day now known as Black Wednesday, the Conservative government of the United Kingdom suffered a dramatic loss of its reputation for economic competence.

This event marked a critical turning point in British economic history and has continued to shape economic policy and political strategy to this day.

For many students of economics, understanding the events and repercussions of Black Wednesday provides a valuable lesson in the complex interplay of politics, international finance, and economic decision-making.

The Background: From Thatcher to Major

The roots of Black Wednesday stretch back to the economic policies of the 1980s and early 1990s under the Conservative governments of Margaret Thatcher and John Major.

Thatcher's tenure, from 1979 to 1990, was marked by a series of radical economic reforms, often characterised by a commitment to free-market policies, deregulation, and a focus on controlling inflation.

When John Major succeeded Thatcher in 1990, he and his Chancellor, Norman Lamont, faced the challenge of managing the aftermath of the Lawson Boom—a period of rapid economic growth fuelled by expansionary policies under Major’s predecessor, Nigel Lawson.

To curb inflation and stabilize the British economy, the Major government decided to join the European Exchange Rate Mechanism (ERM) in 1990.

The ERM was designed to reduce exchange rate variability and achieve monetary stability in Europe by tying European currencies to the Deutschmark, which was seen as a strong and stable currency due to Germany's robust control over inflation.

However, the UK's entry into the ERM was poorly timed, coinciding with significant economic pressures arising from Germany's reunification.

The Build-Up to Black Wednesday

Germany's reunification in 1990 led to significant economic strain as the country absorbed the weaker East German economy. The costs of reunification caused inflation to rise in Germany, prompting the Bundesbank, Germany's central bank, to hike interest rates. These high monetary policy interest rates were intended to control German inflation but had the unintended consequence of increasing pressure on other ERM member states, including the UK, which were forced to maintain high interest rates to keep their currencies pegged to the Deutschmark.

For the UK, the high interest rates exacerbated an already challenging economic environment. The country was grappling with the fallout from the Lawson Boom, which had led to a deep recession—the second worst since World War II. By 1992, it was clear that the UK economy was struggling under the weight of an overvalued pound, high interest rates, and rising unemployment.

Despite these challenges, the government remained committed to maintaining the pound's position within the ERM, hoping that it would eventually lead to economic stability and a return to growth.

The Crisis of Confidence

On Black Wednesday, market confidence in the pound collapsed. Speculators, betting against the UK’s ability to sustain an overvalued currency, began selling off the pound in massive volumes. The Bank of England intervened, buying billions of pounds in a desperate attempt to prop up its value and keep it within the ERM’s agreed limits. Simultaneously, interest rates were raised dramatically to attract investors, briefly reaching an unprecedented 15%.

However, these efforts were in vain. The selling pressure was too intense, and by the end of the day, the UK government conceded defeat. The pound was forced out of the ERM, and it was allowed to float freely on the currency markets, immediately devaluing significantly.

Aftermath and Recovery

The exit from the ERM was a major embarrassment for the Major government and was seen as a devastating blow to its economic credibility. Yet, in a twist of fate, the devaluation of the pound and the subsequent lowering of interest rates helped to stimulate the UK economy. The country’s competitive position improved, exports became cheaper, and economic recovery followed.

Chancellor Norman Lamont famously remarked that he was “singing in the bath” after the crisis, as the economic conditions began to ease. However, the damage to the Conservative Party’s reputation had already been done. John Major eventually replaced Lamont with Kenneth Clarke, who helped steer the economy towards stability before the Labour government took over in 1997.

Lessons for Future Generations

The legacy of Black Wednesday extends beyond the immediate economic consequences. It serves as a cautionary tale about the risks of maintaining fixed exchange rates in the face of divergent macro-economic conditions and highlights the importance of timing and judgment in economic policymaking. It also underscores how political decisions, such as the commitment to the ERM, can have far-reaching consequences that transcend economic logic.

In more recent times, the lesson from Black Wednesday about the importance of economic credibility has resurfaced in debates about Brexit and the UK's economic strategy post-EU membership.

The current Labour leadership faces its own challenges in trying to reclaim a reputation for economic competence, with decisions on trade and investment policy that will shape the future of the British economy.

Glossary of Key Economic Terms

• Bank of England: The central bank of the United Kingdom, responsible for issuing currency, managing monetary policy, and maintaining financial stability.
• Bundesbank: The central bank of Germany, known for its strong anti-inflationary policies, particularly during the post-war period.
• Devaluation: The reduction in the value of a country's currency relative to other currencies. It can make exports cheaper and imports more expensive.
• Exchange Rate Mechanism (ERM): A system introduced by the European Economic Community in 1979 to reduce exchange rate variability and achieve monetary stability in Europe by linking European currencies.
• Interest Rates: The cost of borrowing money, usually expressed as a percentage. Central banks, like the Bank of England, use interest rates to control inflation and influence economic activity.
• Lawson Boom: A period of rapid economic growth in the UK during the late 1980s, fueled by expansionary fiscal and monetary policies under Chancellor Nigel Lawson.
• Recession: A period of economic decline characterised by falling GDP, reduced consumer spending, and increasing unemployment.
• Speculation: The act of trading in financial instruments, such as currencies or stocks, with the aim of making a profit from short-term price movements.

Key Date Timeline

• 1973-74: Oil crisis and the subsequent economic challenges for the Heath government.
• 1979-90: Margaret Thatcher's tenure as Prime Minister, marked by significant economic reforms.
• 1990: UK joins the European Exchange Rate Mechanism (ERM).
• 16 September 1992: Black Wednesday – UK exits the ERM after failing to maintain the pound's value.
• 1997: Labour Party wins the general election, ending 18 years of Conservative government.

Retrieval Questions for A-Level Students

1. What were the main factors that led to the UK’s exit from the ERM on Black Wednesday?
2. How did the economic policies of the Thatcher and Major governments contribute to the events of Black Wednesday?
3. Explain the role of the Bundesbank in the lead-up to Black Wednesday.
4. What were the immediate economic impacts of the UK’s devaluation of the pound after exiting the ERM?
5. How did Black Wednesday affect the Conservative Party’s reputation for economic competence?