European integration may be a feat achieved despite considerable trials and tribulations. Of a financial sort, perhaps the two most notable of these are the crisis with the ‘Exchange Rate Mechanism’ in 1992-93 and the sovereign debt crisis of roughly 2009-15. The former perhaps presaged the latter. Yet, the problems with the Exchange Rate Mechanism, in which European countries fixed the values of their currencies to each other, are largely remembered because of Britain’s unceremonious exit from the system in September 1992. Perhaps this could be considered the first of two Brexits. However, the events extended well beyond Britain and so, ought the crisis to be remembered for more significant and fundamental reasons than this?
Exchange Rate Mechanism
The Exchange Rate Mechanism (or ERM) was devised by the European Council, today one of the principal European Union institutions, in December 1979 to bring about monetary stability. This was thought of as the next logical step in European integration by then E.U. Commission President, Roy Jenkins. The ERM was the response of Jenkins and others to the question of how floating currency exchange rates, subject to so much change, would possibly work in a closely integrated single market. Under the ERM, two controls were implemented. First, a parity grid was introduced, more-or-less fixing participating European currencies to each other.
Second, any currency revaluations were to be agreed upon by consensus; they were not to be unilateral decisions any longer. This did not necessarily make revaluations rare; adjustments to the parity grids were common between the 1979 introduction of the ERM and a 1987 rework of the framework (the Basle-Nyborg Agreement).
Outside of these consensus-driven revaluations, which generally saw the German deutschemark appreciate against other monies, each member state’s currency was confined to trading within a range. For most currencies, this range was set at +/- 2.25%. Central banks would endeavor to enforce the trading range by adjusting interest rates or using their foreign currency reserves as needed to defend the value of their currencies or those of other member states.
The United Kingdom, not a member initially, eventually joined the ERM, convinced it could help the country tackle inflation. It had stayed out in 1979 because then-Prime Minister James Callaghan was more focused on unemployment as the paramount policy challenge. Callaghan worried that an improperly-fixed exchange rate, namely one that overvalued the pound, would interfere with handling unemployment. Britain was for many years the only holdout among members of the European Community, as the E.U. was then known.
The U.K. also had the highest inflation of advanced economies after the oil shock of 1973 and it was stubbornly high. A focus on reducing inflation eventually overcame a large degree of Euroscepticism to encourage it to give the ERM a try in the waning days of Margret Thatcher’s leadership. In 1990, the pound was fixed at 2.95 deutschemarks, albeit with a wider +/- 6.0% trading range which Britain shared in the early 1990s with new entrants into the ERM, Spain and Portugal.
Besides Britain, other countries in the Exchange Rate Mechanism, like France and Ireland, also saw in it a means of controlling inflation. Under the ERM, countries would be tying their own monetary policy, at least loosely, to that of Germany which seemed the most successful country in taming inflation and whose currency and central bank were at the center of the ERM. The inflation rates of these and other ERM countries did eventually converge with those of Germany. All seemed to be going well. Further, while not ERM members, Sweden, Norway, and Finland also linked their currencies to those of ERM-members, effectively incorporating Scandinavia into the system, if informally.
The new paradigm changed foreign exchange markets as fixed exchange rates encouraged investors to move money to countries with higher interest rates, so long as they had faith that the exchange rates would continue to remain stable. After all, depreciation of these higher-yielding currencies could turn their gains into losses. For a while, especially prior to 1987, periodic devaluations of these higher-yielding currencies meant this was a risky gamble. Interest rates were higher in these currencies, like the Danish krone or Irish pound, for a reason.
However, when devaluations became less common starting in the late 1980s, a result of an intensification of the fixed exchange rate regime by an agreement known as Basle-Nyborg, this seemed a safer maneuver. In a sign of further entrenching of exchange rates, the Italian lira, regarded as among the continent’s weaker currencies, had transitioned in January 1990 from a +/- 6.0% trading range to the tighter +/- 2.25% range in use elsewhere.
Germany was at the center of the Exchange Rate Mechanism. In effect, other ERM members shadowed German monetary policy decisions to keep their exchange rates in line. However, Germany was increasingly shaped by unique events, having to tackle the challenges associated with German reunification.
The absorption of East Germany into the Federal Republic entailed large subsidies to the former, primarily to support otherwise unsustainably high consumption and support inefficient firms. For political reasons, this was done without tax increases. Further, East German marks were converted into West German deutschemarks at a 1:1 rate. These measures would have caused inflation and indeed Germany’s inflation rate, usually the lowest on the continent, was rising above that of several other countries.
Even more so than the monetary authorities of other countries, Germany’s central bank, the Bundesbank, was particularly concerned with inflation. So, it enacted tighter monetary policy which led to an appreciation of the mark. Also, in comparison to other central banks, the Bundesbank was particularly paranoid about maintaining its independence. So, it was especially reluctant to allow the concerns of politicians, or the bankers of other countries, to influence its own policy. While German monetary and fiscal policy was causing the deutschemark to appreciate, the survival of the ERM made such an appreciation, at least against other European currencies, impossible without the sort of consensus-driven revaluations that had occurred in the past. By now though, governments were as shy as ever about such a revaluation.
In any case, as a knock-on effect of reunification, by the summer of 1992, German inflation had risen, at least by some measures, above those of even the U.K., which was not exactly a role model on controlling inflation. So, on July 16, 1992 the Bundesbank raised its discount rate from 8.0% to 8.75%. The size of this rate hike came as a surprise and the deutschemark strengthened further. Against a more-or-less freely floating currency, like the U.S. dollar, the deutschemark could simply appreciate, as it did this time, strengthening from about 1.50 marks to the dollar in July to 1.39 in early September. Against an ERM currency, the mark could strengthen as well, but only within the designated band. Central banks committed themselves to check any further appreciation against their currencies.
Informed opinion was skeptical of the sustainability of this strict system. The Germans still envisioned periodic revaluations, which used to happen about once per year in the earlier days of the ERM. They were not too opposed to devaluations of other currencies, though this could be argued to harm German export industries. In 1986 for example, when Ireland requested a devaluation of the Irish pound, the Germans argued that the Irish should accept an even larger devaluation than the one they requested.
In any case, devaluations were not popular. Since pursuing its franc fort (‘strong franc’) policy, France wanted to maintain the system even in the face of severe challenges. If talk of revaluation began, it could threaten the French effort to keep the franc resilient. Upon reunification, the Germans had actually brought up the topic of a revaluation privately with other ERM countries given the change in circumstances this event would bring. The French, however, refused, though France was not the only country committed to a strict implementation of the system.
While there had been no revaluations of ERM currencies between January 1987 and September 1992, this was all about to change in a very big way. Setting the stage, political conditions increased uncertainty. A few countries put the new Maastricht Treaty, which would further European integration, to a vote, Denmark and Ireland for constitutional reasons and France by the choice of its government. In a surprise, Danish voters rejected the treaty, which among its provisions would have implemented a single currency for Europe. Opinion polling in France for an upcoming referendum on the treaty in that country wasn’t looking good for the ‘Oui’ side.
These votes cast doubt on the future of a single currency for Europe and with it the convergence of monetary policies. The effect was pressure on European currencies, particularly those of countries on the periphery of the continent. Selling pressure on several currencies, including the Italian lira, the Portuguese escudo, and Irish pound, was particularly strong. Initially, there was no discernable pressure on the British pound.
At this stage of the brewing crisis, Italy was in the greatest predicament. The problem here was compounded by domestic political uncertainty accompanying a change in government late in the Spring of 1992. After selling pressure increased in August, Germany intervened to support the lira on September 3-4. The Banca d’Italia did its part, increasing interest rates by 1.75%.
The European Union’s Economic and Financial Affairs Council met in Bath in the U.K. on September 4-5 and central bank governors met in Basel on September 8. The two meetings did not produce a unified message of any particular significance with regard to the growing crisis. So, further interventions were needed to support the Italian lira. Germany intervened once more, this time alongside the Netherlands and Belgium, to keep the lira within the ERM boundaries. Still the pressure remained but Germany’s Finance Ministry and the Bundesbank together agreed that this would be the last of their interventions.
The crisis would soon, and rather unexpectedly at this stage, jump to Britain. While the U.K. was not seen as among Europe’s weakest links for most of 1992, it was at risk. The country was reluctant to raise interest rates, the standard medicine to support the currency, because Britain’s central bank rate was already at 10.0%. There were perfectly justified fears that rate hikes would slow the economy. Higher mortgage rates would make housing unaffordable, violating an electoral promise made by the governing Conservative Party. The economy was already in a reasonably severe recession, arguably the most severe the country faced since the 1930s.
Britain also rejected a revaluation of currencies. At Britain’s insistence, the finance ministers of European Community countries had issued a statement that ruled out this possibility back on August 29. At least a few other countries were in favor of such a move, which the Germans had insisted was needed for some time. However, France, like Britain, was opposed, in the case of France because a devaluation would not have helped the chances of the ‘Oui’ side in the upcoming treaty referendum there. Still, there was hardly any pressure on sterling in the week ending Friday, September 11, 1992, the week before Black Wednesday.
By Monday though, things would change. That weekend, the Italian lira was devalued by 7%. Germany’s Bundesbank cut its discount rate by 0.5%, which would have helped to weaken the deutschemark. Unfortunately, these were regarded as inadequate developments. Either revaluations or interest rate cuts by the Bundesbank would need to be larger.
A larger revaluation, suggested by the German finance minister Horst Köhler, would have seen the currencies of peripheral Britain, Italy, Spain, Portugal, Ireland, and Denmark devalued against those of Germany, France, Belgium, and the Netherlands. Britain rejected being grouped in this way with the weaker currencies of the continent. Instead, it would try its luck at maintaining the existing exchange rate which, in any case, looked defensible enough up to this point in the crisis.
However, investors saw the weekend’s activity as showing inadequate commitment to the defense or reform of the ERM. The effect of these developments was to cause investors to pull money from higher interest rate countries, whose currencies’ values were now in maximum doubt, and reallocate towards lower interest rate countries with stronger currencies, most notably Germany.
In a remarkable turn, and skipping over the likes of Ireland and Portugal, Britain was now seen as the next candidate for devaluation. The pound fell 1.16% on Monday despite the Bank of England using $788 million to support the currency. The central banks of Italy, Portugal, Spain, and Sweden were also intervening to prop up their own currencies as Britain was far from alone in facing difficulties.
On Tuesday evening, the President of the Bundesbank Helmut Schlesinger, in a meeting with reporters, considered the possibility of future revaluations. In a sense, there was nothing new to this statement of Germany’s opinion on the matter, but most of the German insistence on revaluations up to now was conducted in private. The Bundesbank tried to walk back the comments. Nonetheless, by the morning of Wednesday, September 16, the pound had broken through its trading range overnight. The Bank of England responded by using over £1 billion, or around $1.8 billion, to support the pound and this just by 9:00am that day. The government, which then controlled the Bank of England, was hesitant to raise rates that morning. Rate hikes would normally be announced by 9:45am on a given day, but the first of two rate hikes by the Bank of England on Black Wednesday, lifting the policy rate to 12.0%, was not announced until 11:00am.
This intervention, maybe because of the apparent hesitation, was not successful. Thus, a second rate hike, to take effect the next day, one lifting rates to 15.0%, was announced at 2:15pm. This may have helped stem the falling pound but did not restore the currency to its trading range. In all, $22 billion in reserves were sold by the Bank of England in efforts to prop up the pound and it was all unsuccessful. By 4:00pm, the Bank of England had alerted other central banks that it would leave the ERM, at least temporarily. This was announced publicly by the Chancellor of the Exchequer Norman Lamont at 7:30pm.
The Exchange Rate Mechanism was supposed to promote stability. After Britain’s exit, it was watered down amidst chaos. Having already devalued, Italy left the ERM the day after Britain. The trading ranges of other European currencies were widened to a broad +/- 15%. The episode had caused interest rates in various countries to fluctuate wildly. The overnight central bank rate reached 500% in Sweden. In Ireland, money market rates occasionally reached 100%.
In an interesting contrast, the U.K. was not too battered by leaving the ERM. Indeed, Britain saw an economic recovery the following year. The rest of the European Union largely did not and the economies there contracted overall in 1993. Tighter monetary policy in these countries, needed to save their currencies from a fate similar to the pound, was blamed. Still, several countries, namely Ireland, Spain, and Portugal, chose to devalue in 1992-93. Further, the Scandinavian countries ‘shadowing’ the ERM altogether abandoned their pegs to ERM-currencies. Of course, despite all of this, the single currency was not ultimately derailed and the euro was launched late in the decade.
Today, the ERM Crisis of September 1992 is largely remembered with respect to its effect on Britain and its own relationship with the rest of Europe. Britain’s detached relationship with Europe ever since only reinforces this interpretation. However, the causes and the effects of the crisis were international in scope. The movements in currencies were the result of a perceived weakening in commitment and coordination within the ERM, changes in the international monetary order, and divergence in the level of suitable interest rates across countries. The effects were profound not just in Britain but in the rest of the European periphery. Its lessons ought to have been more widely respected.
But as events become history they are inevitably simplified; losing their detail, they become little more than an effigy of their former selves. The seismic but technical background to a crisis is overridden in memory by the dramatic highlights or the most politically salient results. As such, events brought on by systemic flaws are reduced to idiosyncratic developments with the passage of time. In this way, even in international discussion, the ERM Crisis became merely a British story. In a similar way, perhaps the European sovereign debt crisis of the early 2010s will in time be reduced to merely a consequence of Greek fiscal policy of the 2000s and some anti-austerity protests in Athens in May 2010.
More from the Tontine Coffee-House
Read about the creation of a monetary union in 19th century Europe and the role of the ERM crisis in contributing to a banking crisis in Sweden. Consider subscribing to this blog’s newsletter or checking out book recommendations, which include many of the sources often referenced in my posts.
1. Corsetti, Giancarlo, et al., editors. The Making of the European Monetary Union: 30 Years since the ERM Crisis. Centre for Economic Policy Research, 2023.
2. Harmon, Mark D., and Dorothee Heisenberg. “Explaining the European Currency Crisis of September 1992.” German Politics & Society, no. 29, summer 1993, pp. 19–51.
3. Naef, Alain. “Chapter 14 – Britain’s Last Currency Crisis.” An Exchange Rate History of the United Kingdom, 1945-1992, Cambridge University Press, Cambridge, 2023, pp. 204–225.
4. Truman, Edwin M. “Economic Policy and Exchange Rate Regimes: What Have We Learned in the Ten Years since Black Wednesday?” European Monetary Symposium. 16 Sept. 2002, London, U.K., London School of Economics.