Britain Survives Black Wednesday

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First, Hello, nice to meet you, multiple apologies if this has been discussed before/is boring to you.

I've been thinking recently about Black Wednesday. Why did Britain end up failing to stay in the ERM? Could it have been avoided? And if so, at what cost?

It seems that for Britain to stay in the ERM the borrowing rate would have to remain high, and we would rely on borrowing from other countries. It would be bad short term for Britain, certainly.

Would Britain staying in impact Germany's willingness to compromise on inflation rates?

I don't seen how Denmark voting yes in the referendum on Maastricht could butterfly away currency speculation based on macro-economic factors that were already well established, but would it have an impact on response to the crisis?

Would keeping Britain stay in the ERM help Major's reputation on economics? My instinct is that it would, ironically even though the country would be in the medium term worse off.

 

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First, Hello, nice to meet you, multiple apologies if this has been discussed before/is boring to you.

It's not boring, don't worry. And nice to meet you too.

I've been thinking recently about Black Wednesday. Why did Britain end up failing to stay in the ERM? Could it have been avoided? And if so, at what cost?

An exchange rate reflects the ratio between demand for currency X and demand for currency Y. Demand for a currency is a reflection of money supply (how much is there?), inflation (how fast is it rotting?), trade (how much do we need today?), growth (how much do we need tomorrow?), and other stuff.

The root cause of pound's ERM exit was a mismatch between the demand for pounds (GBP) and the demand for deutschmarks (DM). This was in turn a reflection of the monetary and economic policies of the Kohl and Major administrations. To keep it at the pegged rate, UK would have to tighten its policy or Germany loosen its policy. Major asked Kohl (see Major's autobiography) to do the former, but faced with the problems of German reunification and the objections of the Bundesbank, Kohl did not. Faced with the loss of Major's anti-inflation policy, Major did not leave ERM voluntarily while he still could. Despite tightening monetary policy spectacularly and in a chaotic manner (10% to 12% interest rate rise, then briefly to 15% if memory serves), it was not sufficient to reconcile the mismatched demand. Unable to buy sufficent number of pounds to reconcile the mismatched demand, the Treasury had to accept a lower value and GBP fell out of the ERM involuntarily.

Could it have been avoided? And if so, at what cost?

GBP's involuntary ERM exit could have been avoided by an earlier voluntary exchange rate cut or Germany changing its economic policy or a big rapid change in world trade.

Would Britain staying in impact Germany's willingness to compromise on inflation rates?

More the other way around. If Germany had compromised, then yes, Britain may have stayed in.

I don't seen how Denmark voting yes in the referendum on Maastricht could butterfly away currency speculation based on macro-economic factors that were already well established, but would it have an impact on response to the crisis?

It may have delayed it. It would not have prevented it. Since Major did not intend to enter the Euro (UK's membership of ERM was intended to ratchet inflation downwards, not as a precursor to Euro entry), Euro conversion would not have happened in time to render the problem moot. (You would then have a whole new set of problems around a single currency, see Greece, Ireland et al, but that's not an answer to the question you asked)

Would keeping Britain stay in the ERM help Major's reputation on economics? My instinct is that it would, ironically even though the country would be in the medium term worse off.

It would certainly have helped. However, given his failure to anticipate an exchange rate crisis and his failure to deal with it rationally when it arrived, arguably he did not deserve a good economic reputation. See the Impossible Trinity