Recalling ‘Black Wednesday’

by Martin Odoni

One tradition I do find fascinating at the close of every year is the publication of National Archives’ documents after their 30-Year-Rule protection expires. It is always a bug-bear of mine that this country does not feel its people are entitled to know much about what it does until three decades after the fact, but three decades later is better than a full lifetime later, I suppose. And it can be engrossing to learn more about the struggles that happened behind-the-scenes a generation ago.

One revelation in this year’s releases that got the BBC in its thrall is one that has been published a few years early – a row between Margaret Thatcher and her successor John Major, just weeks after he had taken over as Prime Minister in 1990.

By all accounts, when Thatcher had accepted the inevitable and resigned as Prime Minister in November that year, she had hoped Major would succeed and carry on her policy program. But in later times after he won the leadership, Thatcher increasingly undermined him as he moved in a (somewhat) more social-democratic direction. The row highlighted in the papers released this week – a row that took place on 3rd January 1991 – appears to have been the point that the divisions between them began.

The argument hinged on the issue of the Conservative Government of the time setting a very high minimum interest rate. Major had been Chancellor of the Exchequer before Thatcher had resigned, and had largely maintained the high interest rates around the 15% mark set by his predecessor, Nigel Lawson. Because of the never-ending difficulties with high inflation, which had tormented the British economy since the late-1960’s, both Lawson and Major had become obsessed with getting it under control. A frequent cause of inflation is excessive demand for goods; the more people buy goods and the scarcer they become, the more suppliers can charge for them, meaning prices go up, and so money in effect becomes less valuable. So one way of attempting to combat inflation – one whose effectiveness varies quite widely – is to encourage saving and to discourage manic spending by raising interest rates: A higher interest rate means people are likely to get extra money when saving up, while anyone borrowing money in order to purchase unnecessary goods would find themselves paying more interest on their loans. A Chancellor raising interest rates also encourages currency speculators to buy more sterling, as they will know that if they hold large numbers of pounds in UK accounts, they will again get more interest on them, which therefore can increase demand for the pound, and in turn make it more valuable.

But to discourage purchasing of goods is only a sensible move when there is too much economic activity, and when that is the main reason inflation is high. Inflation can happen for other reasons though, which means that a slow-moving economy is no guarantee that the currency will not lose value. As it happens, in late-1990, despite annual inflation being up around 7.5%, the UK economy had been in a slowdown for over a year as the (massively over-rated) ‘Lawson Boom‘ of the late-1980s rapidly ran out of steam, and the country was now moving into a recession. In any recession, more growth in Gross Domestic Product is required, which means more spending activity must be encouraged. Thatcher was therefore right to criticise the high interest rates; they were too high for a country that was in a recession. They needed to be set lower so that people would be discouraged from saving up as much, and even encouraged to borrow-and-spend more.

However, it must also be noted that Thatcher was being a hypocrite about the matter, because it was substantially her own fault that the interest rate had to remain so high. It was not for reasons of high inflation or low GDP as such.

The obstacle that Thatcher and Major had put in their own way was that the UK had joined the European Economic Community’s Exchange Rate Mechanism in October 1990 – just weeks before Thatcher was deposed. She had always opposed joining the ERM, but had finally given in to the inevitable when Major spoke out in favour, and having accepted it, she just decided that the UK would join the very next day – no planning, no calculations, no negotiations with the rest of the countries in the Mechanism. On 8th October, sterling entered the ERM.

Unfortunately, Thatcher’s timing was pretty awful. Joining the ERM was not necessarily a bad idea in itself, and might have worked pretty well if it had happened, say, in 1987, when the UK economy was near the height of the ‘Lawson Boom’. But by late-1990, the economy was back in its second annual recession in less than ten years. The Treasury therefore needed to cut interest rates to boost economic activity, but under ERM rules, the conditions of the time – the inflation-rate of the pound was fluctuating quite wildly and was at some stages roughly three times higher than the inflation-rate of the German Deutschmark – required higher interest rates to stabilise sterling’s relative value.

Joining the ERM in 1990 was therefore bound to pull the economy in two diametrically-opposed directions. The need to stimulate growth was at odds with the primary aim of the ERM, which was to fix the relative values of the currencies within it at roughly the same levels – the pound was meant to peg itself to the value of the Deutschmark.

With far higher inflation rates in the UK (almost 11% early in 1992) than in Germany (2.7%), but also with a high exchange-rate of 2.95DM to the pound, the British Treasury was giving itself a very difficult target exchange-rate to maintain right from the outset. The far higher rate of UK inflation meant that, right from the moment of joining the ERM, the pound’s value was already drifting away from the required valuation.

It was possible for the UK to join the ERM in 1990 and make it work, but only by artificially devaluing the pound first, say to a more manageable rate of 2.75DM. An artificial devaluation might well have slowed depreciation of sterling; any holders of large amounts of sterling who might have been planning to sell it off would suddenly find there was nothing to gain by doing so, and hence retain them, while any speculators would find a cheaper pound more appealing to invest in, increasing demand for the pound. More pertinently, a devaluation would also set a more realistic target exchange-rate to try and maintain. But at the time, devaluation of the currency was still seen in rather jingoistic “don’t-insult-our-beloved-pound!” terms by a wider British public who had little-or-no understanding of how currency exchanges work, and therefore would have seen such a move as somehow ‘sullying’ the country.

Thatcher never even paused to consider such matters in any event. Having lost Lawson as Chancellor of the Exchequer largely over the matter of joining the ERM less than a year earlier – he was heavily in favour while she was dead-set against – she could hardly risk losing Major from the role as well when he swiftly announced that he was in favour of the idea too. Clearly wanting the argument just to go away, Thatcher decided simply to leap in feet-first, without making sure conditions were right.

So Thatcher has to take a big chunk of the blame for the very problem she was complaining about. But Major also should not be let off the hook for the calamity that would eventually follow, as he too did not appear to consider the implications of joining the ERM during a recession with a much higher inflation level than the ‘target’ currency. Once that decision was made, Major’s hands were rather tied by ERM rules by the time that he took over at 10 Downing Street. Of course, he could have un-tied his hands at any time by suspending the UK’s membership of the ERM, but to compound the intial mistake he had shared with Thatcher, he stubbornly refused to suspend due to his narrow fixation on getting inflation down at any cost – something Kenneth Clarke and Gordon Brown were able to do more consistently in later years from outside the ERM.

To add to the UK’s ERM woes, international conditions became even less favourable. German state spending had increased markedly since 1990 due to the inevitable strains of reunification between East and West Germany, and this extra spending had led to a (relative) upswing in inflation of the Deutschmark. This caused the Bundesbank to increase interest rates to combat the effects, and under ERM rules, that made it impossible for the UK Government to lower its own interest rates. Britain’s finances were in a long-term double-deficit (exports lower than imports alongside public spending above tax income), made worse through early-1991 by a startling depreciation in the value of the US dollar, in which many British export goods were valued.

With the recession showing no signs of abating, speculators became convinced by September 1992 that suspension from the ERM would be unavoidable, probably followed by a devaluation of the pound to make sterling more attractive to purchasers and imports of British goods cheaper in other countries. The rise in German interest rates had lured currency speculators to start buying Deutschmarks in order to cash in on the higher dividends, often in exchange for pounds. This drop in demand for sterling and increased demand for the Deutschmark meant the pound was under growing pressure. Worried that their holdings would soon become less valuable, on the 16th, speculators brought about a familiar self-fulfilling prophecy; they dumped sterling in a frenzied rush of selling – a run-on-the-pound so notorious that it was given the nickname ‘Black Wednesday‘. As demand for the pound went through the floor, its value tumbled out-of-control.

The Bank of England spent billions in gold and foreign currency reserves to buy up pounds at the high ERM rate, in a frantic struggle to prop up sterling’s value. It did little to slow down its nosedive. Major ordered two large increases in interest rates during the course of the day, up to 15%, to tempt holders of sterling to resist selling with the reward of higher interest dividends on their pounds. Again, the rises failed, while also increasing the pain of the ongoing recession.

The pound lost 15% of its value in a single day, and it was clear that more was to come if drastic action was not taken immediately. Therefore, that very evening, the UK officially withdrew from the ERM, and the pound was artificially devalued, deterring holders of sterling from selling any further. Interest rates were eventually cut, giving the economy the breathing space to start growing again.

Ejection from the ERM was a complete reversal of the central pillar of Major’s entire economic policy, which had been built around the pound staying in the Mechanism, and on which he had staked his whole reputation. Black Wednesday was therefore a political disaster for the Conservative Party as much as the ERM fiasco had been an economic disaster for the country. Thousands of people lost their homes during membership, and the Major Government’s reputation for economic ‘soundness’ was irredeemably destroyed. Even though economic growth did finally recover healthily under Ken Clarke’s Chancellorship, Labour would win the 1997 General Election with the biggest landslide for any party since before the Second World War.

The story of who officially got the blame for the chaos instead of either Prime Minister is quite unjust. Norman Lamont, Major’s immediate successor as Chancellor, had lost his job within a year of Black Wednesday, scapegoated for an economic policy that he had faithfully tried to implement but with which he had never altogether agreed, and for a disaster that he was powerless to prevent. It is therefore perhaps ironic that one of his special advisors at the Treasury at the time would become a Prime Minister seventeen years later; –

Norman Lamont was Chancellor of the Exchequer during the notorious ‘Black Wednesday’ financial crash of 1992. Look who was one of his special Treasury advisers…

It should be noted that joining the ERM had not been a complete failure; inflation of the pound was brought down very substantially over the two years Britain was a member, and it paved the way for a new economic framework over the next ten years that helped keep a lid on sterling’s depreciation.

But the real drawback was that the pound had joined the Mechanism at least two years too late to get the most out of being part of it – by joining at the end of an economic boom rather than near its beginning – and then stayed in it at least three months longer than the time that it was able to provide the economy with any benefits while in the midst of a recession. Britain only joined when it did because of Thatcher’s bludgeoning impatience, and only stayed in as long as it did because of Major’s stubbornness. Both of which are examples of economic policy formulated by letting the heart rule the head. Cold, hard numbers seldom co-operate with that.

Britain’s dabbles in the ERM were not all that far from working well, but the mistakes of timing turned the whole exercise into a humiliating fiasco. Black Wednesday is therefore just one more example of how nonsensical is the notion that the Conservatives are ‘better’ at running the economy than Labour.