Exchange Rate Mechanism Crisis 1992

Since the economic situation is all doom and gloom, let us take a break from the current economic crisis and remember a previous economic crisis.

The exchange rate mechanism was designed as a precursor to joining the Euro. The aim was to keep exchange rates stable; it was hoped this would
  • Keep inflation low
  • Provide stability for exporters encouraging trade
  • Enable countries to make the leap to joining the Euro.
In the late 1980s, the chancellor, Nigel Lawson was keen to join the ERM. But, Mrs Thatcher with her eurosceptic views wanted to stay out. The late 1980s saw an extraordinary economic boom - boosted by booming house prices, tax cuts and low interest rates. Growth reached record levels of 5-6% a year. Enthusiastic government ministers talked of an economic miracle - hoping Government policies had enabled, at long last, to catch up with other countries like Germany.

However, this miracle was an illusion. High growth was unsustainable and led to inflation. With inflation of 10%, Nigel Lawson was able to convince Mrs Thatcher that the UK would benefit from joining the ERM to help reduce inflation.

Therefore, the UK joined in October 1990. at a rate of DM 2.95 to the Pound

However, the problem was that the economic situation was declining quickly. The UK was sliding into recession. High inflation and deteriorating economic activity was making the Pound less attractive. Therefore, the Pound kept falling to its lower limit in the ERM. Therefore, the government was bound to protect this value of the Pound by:
  • Increasing interest rates - this attracts hot money flows - it is more attractive to save in UK with high interest rates.
  • Buying pounds with foreign exchange reserves.
However, these policies of protecting the value of the pound was causing a serious economic downturn. High interest rates particularly hit the housing market. With rising house prices, many had taken out large mortgages to get on the property ladder (sound familiar?) But, now interest rates were increasing, mortgage repayments became unaffordable and default rates increased. Combined with rising unemployment from the recession, the housing market saw a dramatic fall in prices that was to last 4 years.

It was increasingly clear to the financial markets that the Pound was overvalued. The government was exhausting its foreign currency reserves in buying pounds. But, more problematically, the high interest rates was causing a serious recession and misery for homeowners.

Financial speculators like George Soros predicted the Pound was doomed, so they were keen to sell their pounds to the British government.(It is said George Soros made £1 billion out of the UK government)

It became a question of pride for Ministers, with Norman Lamont and John Major pledging to keep the UK in the ERM, seemingly at all costs.

For a long time, the British government fought a losing battle. But, the foreign currency reserves of the British government were no match for the trillions of Pound Sterling traded on the foreign currency and the pound kept sliding. It is estimated that the Treasury used £27billion of foreign currency reserves trying to prop up the Pound. The Treasury estimated the final cost to the taxpayer was estimated at £3.4billion

On one desperate day - Wednesday 16th September, the UK government increased interest rates from 12% to 15%. In theory, these high interest rates should attract hot money flows. But, the market saw it for what it was - a measure of desperation. The market knew these were fantasy interest rates which couldn't be maintained, the sell off continued and eventually, the government caved into the inevitable and left the ERM. The Pound fell 15%, interest rates were cut, and the economy was able to recover.

It is a classic example, of failed government policy. If the UK had joined the ERM at a high level at the start of the boom, the anti inflationary impact would have helped moderate the boom, keep inflation low and prevent a painful readjustment. But, they joined at the wrong rate at the wrong time. Trying to keep the Pound artificially high caused a recession, deeper than any of our competitors. The artificially high exchange rate just attracted financial speculators who saw the British government as a source of easy profit.

On leaving the ERM, the UK economy soon recovered, but, it left painful scars and played a key role in keeping the UK out of the Euro. It also shows the mistake of targeting inflation through an intermediary such as the exchange rate. As a consequence of this episode, the government gave the Bank a direct inflation target of 2.5%. They also paved the way to given the Bank independence in 1997. The hope was that an independent bank would avoid the excesses of the Lawson boom and bust of the 1980s.

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Perma Link | By: T Pettinger | Wednesday, December 17, 2008
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