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Kennedy School of Government Case Program

C18-95-1296.0

Black Wednesday in Britain: The Politics of the ERM Crisis

In the late summer of 1992, British Prime Minister John Major and his top economic advisors faced escalating pressure to rethink the central pillar of their economic policy. The source of anxiety was the European Exchange Rate Mechanism (ERM), a voluntary arrangement which restricted fluctuations in the value of member currencies against one another. While its supporters argued that the ERM had worked well for Britain since joining in late 1990, new and unprecedented strains on the system were testing the ability of several members to operate their economies within its agreed-on parameters. The ERM appealed to those European leaders who felt that, historically, exchange rate instability had caused social upheaval and economic hardship. These countries have highly interdependent economies, with trade indispensable to their economic survival. Whenever exchange rates fluctuated, imports became more expensive for one partner while exports became less profitable for the other. Consequently, the one country typically would suffer higher inflation while the second would see unemployment go up as export-producing firms cut back. While fixed rate exchange rate systems have always had their critics (who feel controls are unsustainable), proponents believed that governmentimposed limits could cushion some of the undesirable effects of exchange rate fluctuations. Since creation of the ERM in 1979, the stable German deutschemark had emerged as the ERM linchpin currency: the one against which other currencies maintained their value. Under the watchful eye of the Deutsche Bundesbank, mandated to keep inflation under control, Germany had enjoyed low inflation rates throughout the 1980s. Low inflation and a steadily growing economy contributed to create a strong currency that replaced the dollar as the investment currency of choice for cautious international money managers. Other ERM governments found that tying their currencies to the deutschemark gave them the external discipline needed to tackle inflation in their own economies. But the ERM served a wider purpose: It was the first step on the road to European Monetary Union (EMU), required according to the 1991 Maastricht Treaty to be in place by 1999. To convinced ERM supporters, economic union—with a common currency, central bank and unified monetary policy— offered benefits to all participants. Its detractors, however, viewed EMU as an appalling economic scheme, as well as an ill-disguised stalking horse for another European crusade: political union. In Britain, This case was written by Kirsten Lundberg for Professors Ernest May and Philip Zelikow at the John F. Kennedy School of Government, Harvard University, for the Harvard Intelligence and Policy Project, with support from the Central Intelligence Agency. (1095) Copyright © 1995 by the President and Fellows of Harvard College. To order copies or request permission to reproduce materials, call 617-495-9523, fax 617-495-8878, email [email protected], or write the Case Program Sales Office, John F. Kennedy School of Government, 79 John F. Kennedy Street, Cambridge, Mass. 02138. No part of this publication may be reproduced, revised, translated, stored in a retrieval system, used in a spreadsheet, or transmitted in any form or by any means—electronic, mechanical, photocopying, recording, or otherwise—without the written permission of the Case Program Sales Office at the John F. Kennedy School of Government

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Major’s Tory party had split publicly over EMU and its first stage, the ERM. Major favored the ERM, although he had well-documented objections to EMU and had secured Britain’s right to opt out of a common European currency. But other major Tory figures were vehemently opposed to all aspects of the ERM and EMU, which they perceived as a sell-out of national sovereignty and the principles of democracy. This division took on new life when, in June of 1992, a bombshell struck the world of those committed to European monetary union. Danish voters, in a national referendum, rejected the Maastricht Treaty. When the French government reacted by setting September 20 as the date for a French referendum, the stage was set for a summer of economic uncertainty. Speculative pressure mounted against weaker ERM currencies as currency traders began to question just how committed to unity—and the ERM—Europe’s political leaders could afford to be. Thrust to center stage was an increasingly visible disparity between Germany, which needed high interest rates to keep rising inflation in check, and other ERM members who needed lower interest rates to stimulate their recession-afflicted economies. Britain, for example, had been mired in recession for over a year but its interest rates, to remain at the ERM parity, needed to be at least as high as Germany’s. British leaders knew the impending French referendum put the pound sterling at risk of speculative attack. But many experts, Major included, felt the pound could ride out the storm. Moreover, that appeared to be the least-cost option in political terms. Any steps Major might have taken to accommodate pressure on the pound would have reverberated as concessions to his “Eurosceptic” Tory opposition. Such steps would also have undermined Major’s central economic policy resolve: to prove to dubious financial markets—through resolute adherence to the ERM compact—his government’s staunch commitment to the battle against inflation and to a strong pound in coordination with his European partners. Yet the Eurosceptics were not alone in believing that Britain should act preemptively— according to varying scenarios to avert a crash of the pound or a full-fledged depression—by devaluing within the ERM, raising interest rates, lowering interest rates or pulling out of the ERM altogether. Prime Minister Major, with the credibility of his economic policy very much at stake, had to consider whether it was still possible or advisable to maintain the value of the pound within the agreedupon range of the Exchange Rate Mechanism. History of the ERM The countries of Europe, with their economies heavily dependent on trade for economic prosperity, have long sought to stabilize exchange rates among themselves. The most recent effort dates back to March 1979, when members of the European Community (EC) led by German Chancellor Helmut Schmidt and French President Valery Giscard d’Estaing created the European Monetary System (EMS)— characterized as a “zone of monetary stability in Europe.”1 Central to EMS was the Exchange Rate

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A previous system to maintain relatively stable exchange rates, known as “the snake,” had led only to currency instability and disturbingly high inflation. In 1972, the UK under Prime Minister Edward Heath was embarassingly forced out of the snake after a mere six weeks.

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Mechanism (ERM), under which parities, meaning central rates, were established for member currencies—formally against the ecu and against each other member currency. In practice, rates were maintained against the strongest and most disciplined currency, the deutschemark (DM). Exchange rates could fluctuate only within given parameters. Initial participants in the ERM, a non-binding and voluntary system, were Germany, France, Holland, Belgium, Luxembourg, Denmark, Ireland and Italy. The ERM structure. At first the ERM was flexible. Under the initial agreement, exchange rates could fluctuate 2.25 percent (6 percent for the Italian lira until January 1990) to either side of the agreedon parity, or currencies could realign altogether. If a currency came under pressure from speculators pushing its value down, that nation’s central bank, other central banks and most especially the Bundesbank would intervene in the market to buy up the beleaguered currency. Often, nations facing speculative pressures would choose instead to realign, meaning devalue the relative position of their currencies within the band.2 To apply for a realignment, a member nation turned to the EC Monetary Committee, a necessarily discreet body which ruled on how much of an adjustment would be accceptable to all.3 Within the first eight years of the ERM, currencies realigned 11 times in order to compensate for the varied inflation rates in member countries. Most of these realignments resulted in raising the value of the deutschemark and the Dutch guilder, thereby devaluing the currencies of the other European participants. In almost all cases, realignments took place over a weekend. European Union. Meanwhile, a political movement to promote European Monetary Union (EMU) gathered momentum. In December 1985, members of the European Council meeting in Luxembourg agreed to the Single European Act, which set up schedules for achieving a single market for goods, services and capital by 1992. In 1989, the unity process took a major step forward when member states adopted the recommendations of the so-called Delors Report, produced by EC Commission President and convinced Europeanist Jacques Delors, to transform the ERM into full monetary union with a single currency and a European central bank. One of the less publicized purposes behind EMU was the desire of other European nations, principally France, to reduce Germany’s de facto influence over European monetary policy by substituting a common currency for the deutschemark. Details of the EMU timetable, however, were left open. Moreover, it was clear that some participants, notably the Germans, had grave hesitations about the wisdom of a single currency.

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For example, if a pound at one point traded for DM2.90, after a devaluation it might trade for DM2.75. Devaluations happen for complex reasons, many psychological. Often, the economy has ceased to be competitive and cannot export sucessfully, so the government seeks to make exports cheaper by devaluing. For their part, currency traders make money by selling a currency expected to devalue and buying one expected to gain (such as the DM). After a devaluation, the “victim” currency can be repurchased at a discount. The difference is profit. If hundreds of traders sell at once, it becomes a very expensive proposition for central banks to keep buying their own currency (known as intervention)and devaluation becomes an attractive option. 3 Devaluations among friends are tricky, because the products of a country whose currency has just become worth less enjoy an instantaneous competitive advantage over its trading partners. At the same time, economic policymakers recognize that insufficiently large devaluations simply exacerbate the speculative pressures on a currency, making a further devaluation quite likely. Thus, the committee is the scene of considerable debate over the scale of devaluations.

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‘Franc fort’ policy. The French, however, were leaders in the campaign for a single currency, which they felt would offer the benefits of the ERM without allowing the German deutschemark such a dominant role. Under ERM, France had seen inflation fall from above 11 percent in the early 1980s to an average 3.5 percent. Avoiding devaluation, French leaders felt, had been essential to their successful battle against inflation and they formally adopted a “franc fort” policy with a renewed commitment to maintaining the franc’s value against the deutschemark.4 As other ERM members also used every means to avoid devaluation, the ERM from 1987 on evolved into a de facto locked exchange rate system. That the deutschemark could be such a reliable linchpin for the ERM was due to the credibility of the institution which governed its stability: the central Bundesbank. The Role of Germany West Germany in the 1980s was one of the leading economies of the world and its currency among the most stable. The deutschemark had replaced the dollar as the “safe” currency of choice among traders. Much of the credit for this confidence can be laid at the door of the Bundesbank. The German central bank is, even more than the US Federal Reserve, independent of the government. In post-war Germany, this independence had taken on an almost sacred significance in the nation’s vigilance against rising inflation. Germans blamed wildcat inflation for much of the social and economic dissatisfaction which fueled the rise of Hitler and Nazism in the 1930s. Therefore, under the 1957 Bundesbank Law, the central bank was charged with safeguarding the value of the nation’s currency, i.e. controlling inflation. The Bundesbank controlled the nation’s monetary policy, chiefly through interest rates. The German government, however, retained responsibility for economic policy, which included exchange rates. Headquartered in Frankfurt, the Bundesbank was led by a council of 18 governors, some with specific portfolios such as president; others drawn from banking circles in the nation’s Lander, or states. The Bundesbank president could influence, but not direct, the governors. Likewise the German president could seek to persuade the Bundesbank to follow a particular course of action, but he could not enforce it. With this independence from domestic political dictates, the Bundesbank had succeeded in keeping German inflation at a consistently low rate through the 1980s.5 Much of the appeal of the ERM lay in the hope that, if other countries tied the value of their currencies to the self-disciplined mark, their economies too could enjoy the low inflation that seemed to fuel a steady growth of the German economy. In effect, they would delegate responsibility for fiscal conservatism to the Bundesbank. In doing this, they implicitly accepted that on occasions when domestic monetary policy needs might conflict with an exchange rate target, the exchange rate would win out. It was precisely this aspect of the ERM which excited the skepticism of British Prime Minister Margaret Thatcher, who brought the UK into the ERM only reluctantly in October 1990. As she remembers thinking in 1987:

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ERM opponents point out that the French success against inflation came at the cost of high, sustained unemployment. German inflation reached one percent in the late 1980s.

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By joining the ERM we would in effect be saying that we could not discipline ourselves and needed the restraint provided by Germany and the deutschemark. … Overall, when things were going smoothly membership of the ERM would add nothing to our economic policy-making, and when things were going badly membership would make things worse.6 Britain’s Road to the ERM Britain was a latecomer to the ERM. Thatcher, Conservative prime minister from May 1979 to November 1990, believed that British participation in any political or economic European union would be dead against British interests. She assuaged her European partners with promises that Britain would join the ERM “when the time was right.” But in truth, Thatcher felt that EMU would mean “the end of a country’s economic independence and thus the increasing irrelevance of its parliamentary democracy,” and that ERM was an inexorable step on the path to EMU.7 Yet in these views she was increasingly opposed not only by the opposition Labour Party, but by members of her own Cabinet and their supporters within the Tory Party. By and large, these Euro-enthusiast Tories did not support a federal Europe. But they believed strongly that for Britain to play a role in Europe, it needed strong membership credentials in institutions like the ERM. They also thought the ERM made sense economically for an economy mired by 1990 in 10 percent inflation and 15 percent interest rates. One of the strongest supporters of UK entry into the ERM was Thatcher’s chancellor of the Exchequer, Nigel Lawson.8 He and his colleagues felt the ERM offered Britain a valuable tool in the battle against inflation. As he would later write: “… an external monetary discipline, such as the gold standard, was the best practicable monetary rule. In modern circumstances, this in practice meant adherence to the Deutschmark standard via membership of the Exchange Rate Mechanism of the EMS.”9 Lawson resigned in October 1989, partially in protest against Thatcher’s refusal to move on ERM membership. His successor was John Major. It quickly became apparent that Major, like Lawson, favored entry into the ERM. He hoped that, as the advantages of ERM membership became apparent, entry would heal the Tory divisions over Europe. Moreover, EC leaders would be meeting in December 1990 to discuss EMU and there was a presumption that Britain would have no voice at that meeting unless it were an ERM member. Some in the Bank of England (the British central bank), thought the UK would do better to wait even longer before joining the ERM. But the Bank of England is not an institution independent of government, and so these doubts were muted. As one Bank of England insider puts it:

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Margaret Thatcher, The Downing Street Years. HarperCollins Publishers Inc., New York. p. 700. Ibid. p. 691. Lawson never, however, supported EMU or a federal Europe. Nigel Lawson, The View from No. 11. Bantam Press: London, New York. 1992. p. 1022.

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The markets had that deadline [the EC meeting]. That made it difficult to argue we should not go into the ERM. If we had gone on without joining, it seemed likely the markets would put the currency into a nosedive just as we wanted to bring down interest rates. So entry offered the best prospect for sensible domestic monetary policy. In at DM2.95. On Friday, October 5, 1990, Major won his case and Britain entered the ERM at a parity against the deutschemark of 1 pound to DM2.95, with a floor of DM2.78. There was debate at the time as to whether this rate was too high because the economy, thanks to a North Sea oil bonanza, was booming at the end of the 1980s and the pound arguably overvalued. But DM2.95 was the market exchange rate on the date of entry. Other ERM countries would likely have opposed allowing Britain to enter at a lower rate as giving the UK an unfair competitive advantage. DM2.95 also happened to be roughly in the middle of the range of rates sterling had hit in the previous five years.10 Upon entry, the British emphasized the flexibility of the arrangement. Unlike other ERM members, the pound was granted a “wide band” of rate fluctuation—six percent to either side of the parity. In addition, Thatcher says she insisted that if sterling came under sustained pressure, she would neither spend down reserves to intervene nor raise interest rates simply to defend the parity. Instead, she reserved the right to realign. For me, willingness to realign within the ERM—as other countries had done—if circumstances warranted it, was the essential condition for entry. … A rate that is right today can be wrong tomorrow and vice versa. Until now, the ERM had never been a rigid system.11 18 Months of ERM For 18 months or so, the ERM seemed to do for the UK economy precisely what its supporters had promised. Between October 1990 and the summer of 1992, the UK Treasury reduced interest rates nine times (by a total 5 percent) to 10 percent, only just above German rates. Inflation was brought from 11 to 4 percent. What’s more, these achievements took place despite considerable political and economic turmoil. Political transition. Shortly after Britain’s entry into the ERM—and many believe in large part because of her implacable hostility toward plans for European political or monetary union—Prime Minister Thatcher was forced from office by opponents within her own Tory party.12 Her successor was John ...