The economy of the United Kingdom is facing a major challenge as its currency sterling pound has depreciated sharply to touch an all-time low to almost parity levels with the US dollar. The interest rates on government bonds have also risen sharply, forcing the UK’s central bank to buy the government bonds to calm markets. As we reflect on the current crisis, the mind races to a similar crisis the UK faced 30 years ago. We need a bit of history to understand the 1992 crisis and then compare it to the current crisis.
Post World War II, most economies had agreed to be part of the Bretton Woods system, where currencies were pegged against the US dollar (USD), and the USD was, in turn, pegged against the gold. The onus of running a stable monetary policy was on the US, and other central banks just copied its actions. If inflation was higher in the US, the central bank would tighten monetary policy leading to higher interest rates. The higher interest rates would lead to more capital flowing to the US, leading to the depreciation of the other currencies. The other central banks would also increase the policy rates to prevent the depreciation of their currencies.
In 1971, the US exited the Bretton Woods agreement as it was not able to align the twin goals of domestic and international economic policies. The breakdown of the system led countries to search for the next anchor for their currencies. The 1970s also saw a rise in inflation across the world due to twin oil shocks, adding to instability.
In 1979, European countries decided to establish an exchange rate mechanism (ERM) in which the member currency was pegged against all the currencies and allowed to fluctuate in a band. The ERM was similar to the Bretton Woods system and replaced the USD with European currencies. Over time, the system came to be dominated by West Germany as its monetary policy was more effective in dealing with inflation compared to other members. By keeping the exchange rate pegged to the West German currency Deutsche Mark, the countries aimed to import the low inflation of Germany to other countries.
The UK did not join the ERM in 1979 as the government thought it could set its economic house in order by itself. However, inflation in the UK remains stubbornly high than West German inflation in the 1980s. Finally, in 1990, the UK decided to join the ERM but this turned out to be very bad timing because of two reasons.
First, the member countries, including the UK, had poor macroeconomic fundamentals in the 1990s. They had higher inflation and deficits than Germany. Joining ERM and importing West Germany’s monetary policy could, at the best, be a band-aid and not a proper medical treatment.
Second, Germany’s own economy was facing problems. After the fall of the Berlin Wall in 1989, West Germany and East Germany were going to be reunified. The West German central bank was worried that the reunification will lead to higher inflation and tightened monetary policy.
These twin factors put the UK and other member policymakers in a dilemma. In order to keep the ERM functional, the members had to also tighten their monetary policies. However, a tighter monetary policy would lead to further weakening of the economy. The other option was to leave the ERM and allow the pound to depreciate. But this was not an option because they had entered the ERM recently and second it was a matter of prestige for the government. The UK government tried to remain in the ERM by using its limited foreign exchange reserves.
The financial investors, particularly George Soros, understood that the UK government’s policy was not sustainable. They had built expectations that eventually the government will have no choice but to leave the ERM and allow the pound to depreciate. They started taking financial positions to sell the pound against the government's decision to buy pounds. It was a matter of time before the mayhem.
On September 16, 1992, a Wednesday, the day of reckoning arrived. The government realised that protecting the currency was turning out to be very costly. Eventually, the government left the ERM and allowed the pound to depreciate, letting the investors make a killing on the markets. The government later estimated the cost of this Black Wednesday to be around 3.5 billion pounds.
Fast forward to 2022 and we see there are some similarities and differences. The similarity is that once again, UK’s macroeconomic performance has weakened. The economy has faced multiple shocks in the last 15 years: the 2008 global financial crisis, the 2016 Brexit, the 2020 pandemic and the 2022 war. The economy is facing low growth, high inflation and deficits as was the case in the 1990s.
The major difference is that unlike in 1992, the currency has been allowed to depreciate without any government intervention. Following the major setback in 1992, the government reformed its monetary policy by adopting an inflation targeting framework in 1998. Under ITF, the central bank was given an inflation target and autonomy to achieve the inflation target. The central bank would use interest rates to target inflation and improve macroeconomic fundamentals. The level of exchange rates was left to the markets.
The 1992 crisis was not limited to the UK but extended to other member countries such as Italy and France. These countries decided to adopt the euro as a common currency but the UK opted out of the common currency. The UK remained a member of the European Union but also opted out of this system in 2016. The pandemic and now the Ukraine war have again pushed the UK and Europe into a corner. The German economy is also reeling this time and cannot be the saviour.The US economy is reeling under high inflation but its aggressive monetary policy and better economic prospects mean investors prefer the USD to other currencies. The euro has also depreciated sharply against the USD and broken parity levels. The current exchange rate crisis has put the UK and Europe in the spotlight once again, as it did 30 years ago. It was not easy to come out of the crisis back then and it will not be easy to come out now too. The UK and Europe need deep-seated reforms to set their economic house in order.