The Crisis Scenario around the British Pound in 1992
By the time the United Kingdom joined the European Exchange Rate Mechanism (ERM) in October 1990, it was already living a severe economic recession. A drop in industrial productivity and high levels of unemployment struck the nation after the economic growth of the 1980’s (Table 1 and 2).
Table 1 – Unemployment Rate in UK in % Source: Office for National Statistics (UK)

Table 2 – Industrial Production in UK: Percentage change year-over-year
Source: www.tradingeconomics.com

During the prosper economic period of the 1980’s there was strong private investment on household, meaning that the mortgage credit rose significantly. In the beginning of the 1990’s the level of private debt was unbearable (Graph 1).
Graph 1 - Debt to income ratio Source: Bank of England

High rates of unemployment, high private debt and lack of macroeconomic surveillance tools have been pointed out as the main reasons for the economic recession of the early 1990’s.
A sharper control over macroeconomic policies as well as an effective control of inflation and the defense of competitiveness of the sterling within Europe was some of the goals the British government aimed at by joining the ERM.
A central exchange rate for each participating currency was established against the ECU, the artificial unit of account that set the pillars for the Euro currency. In practice, the participating currencies where actually pegged to the German mark, which was the most stable currency of the group.
Still, there was no existing European central bank. So each national central bank was responsible for the control and maintenance of economic stability. Among other aspects of the arrangement, a lending mechanism was established, in which strong currency banks would help the weakest countries. Because of its credibility and success in controlling inflation, and because the German Mark was the strongest currency in the group, the Bundesbank ended up assuming a dominant role within the ERM.
After nearly two years of ERM membership and with a weakening economy, the British government and the Bank of England faced an inevitable depreciation of the sterling. Determined not to leave the ERM, the following options were considered:
• Raise of interest rates – by raising its interest rates, the Bank of England would ensure an appreciation of the sterling. However, in May 1992 the interest rates had reached a new low level and it would be economically unsustainable to raise them (Graph 2). The Bank of England did nonetheless announce two interest rate raises on the 16th September. Instead of stabilizing the pound, this step rather encouraged the speculators, which interpreted it as “an act of desperation” (Soros,1995: p82).
Graph 2 – Benchmark Interest Rate in the UK

Source: www.tradingeconomics.com

• Realignment of the currency – the participating countries were allowed to realign its fixed exchange rate within a coordinated policy. The Bank of England refused that option in the assumption that that step would catch the attention of speculators and oblige the Bank to subsequent realignments.
• Force the Bundesbank to lower its interest rates – the British government considered this measure as the only one possible. Being a central player within the ERM, if the Bundesbank decided to lower its interest rates, the German Mark would suffer a (controlled) depreciation and so would all other pegged currencies within the system. This meant that the sterling would not loose competitiveness within the European Markets. By defending this view, the British government was asking Germany to sacrifice its own currency for the common benefit of the participant countries.

Currency Crisis Model
The currency crisis of 1992 fits into the second generation models. Whereas in the first generation model two key elements build up a currency crisis, a third element is considered in the second generation models. Roughly speaking, a first generation currency crisis builds upon a conflict between domestic and monetary policies. A second generation model considers a third key element at play: the international market.
These three elements were present in the sterling crisis of 1992. When it became public that the British government was sitting on a conflict between its own domestic policies and the commitment to a fixed exchange rate, the foreign exchange market (and more precisely, speculators) intervened.
Additionally, it can be argued that an element of self-fulfilling crisis was present in the events of 1992, although opinions diverge in this matter. A self-fulfilling crisis is defined by an established lack of confidence in a currency. The lack of confidence drives the markets to sell short of the weak currency, believing that it will depreciate. The action of the markets will in itself drive the weak currency into the expected depreciation. In other words, the pressure of the markets can provoke the crisis, that otherwise, could have been avoided.
While it is clear that the sterling needed to be realigned, it is believed that the pressure of the speculators might have anticipated the events of September 16th. In the course of events during the summer of 1992, the Bank of England lost its credibility, in great part due to public statements that “rang hollow” (Slater, 2008: p.162). The speculators bet in mass against the sterling, possibly anticipating the development of the crisis as well as the gravity of the losses.

The classical one-way-bet scenario
In the vocabulary of speculative attacks, one-way bets are directly related to fixed exchange rate systems. In fact, one-way bets are pointed out by the critics of fixed exchange rates as one of its greatest risks (Hornby, 2001: p.63).
In general terms, when an exchange rate comes in disequilibrium, adjustments have to be made. Within a fixed exchange rate system such as the ERM, possible adjustments depend on the cooperation between participant countries. When the adjustment does not take place in due time, in a more controlled manner, the adjustment will be made by the markets, in a possibly abrupt intervention.
In the case of the 1992 currency crisis, it was clear that the British sterling was overvalued against the German mark. It was clear that a readjustment had to take place and this had to translate into a devaluation of the British currency. If the readjustment was to take place within a cooperative arrangement, the devaluation would have been less significant for the United Kingdom alone, because the loss would be shared by the ERM participants. The Bank of England refused at all costs to realign its exchange rate and, instead, insisted on pressuring the Bundesbank to lower interest rates.
As political tensions between Germany and the United Kingdom went public, it became clear to speculators that the readjustment would not happen within a cooperative environment. The perfect scenario for a one-way bet was set. The only way out for the Bank of England was to depreciate the sterling. The question was when and to what extent.

Germany and the Bundesbank in 1992
The German Reunification in 1990 marked a turning point in German economy. Two countries with completely disparate economies came together under the protection of the strongest tie. Western Germany absorbed the Eastern currency in a kind of solidarity act, where economic considerations where questionable. The then still existent Eastern economy collapsed, since the producers couldn’t sell their products or pay wages at the new currency value. Unemployment rates skyrocketed (Graph 3) in the Eastern states creating migration waves to the West that are still noticeable to this date. Graph 3 – Unemployment Rate Germany

Source: OECD and IMF from (Buiter, 1998: p.10)
As the new Germany channeled its financial resources in the reconstruction of the Eastern states, its public debt rose to new levels, and the economic landscape of the country changed. Most of the industrial production was invested in the reunification instead of exports. The balance between exports and imports inverted (Table 3).
Table 3 – Current Account Germany

Source: www.tradingeconomics.com
The Bundesbank faced new challenges; in fact, it faced contradictory interests. With the reunification, the Bundesbank was no longer capable of defending both the German economy and the common interest of the ERM countries. The Bundesbank had two incompatible tasks, and it decided to protect its national interests in detriment of the European pact.
With a high government budget deficit, the Bundesbank decided to gradually raise interest rates in order to control inflation. The German interest rates reached new peaks in 1992 (Graph 4). While this measure kept the German inflation under control, it suffocated other ERM participant countries, which, by that time, were already struggling with their weakening national economies. The United Kingdom was one of them.
The president of the Bundesbank at the time, Helmut Schlesinger, kept his position of defending the German economic interests and did not give in to the pressures from the Bank of England.

Graph 4 – Interest Rates Germany

Source: Bundesbank from (Buiter, 1998: p.8)

Soros’ investment strategy
George Soros was conscious that the role of the Bundesbank was delicate, since it was divided between defending the national monetary policies and simultaneously defending the common interests of the ERM. When the German reunification took place in 1990, Soros guessed that the event would turn out to be much more expensive than the German government had expected. Soros observed the arising conflicts between the Bundesbank double role, as well as the friction between the German government decisions and the Bundesbank policies.
Soros points out two decisive moments that influenced his steps. As the president of the Bundesbank insinuated that he had no intention of bailing out the sterling, Soros understood that it was time to bet against the British currency.
Soros predicted a kind of domino effect, which would develop as follows (Slater, 2008: p.165):
1. Major realignment of the currencies – meaning a depreciation of the weak currencies and an appreciation of the German mark;
2. Decrease in interest rates in Germany;
3. Rise in German bonds value but weakening of German equity;
4. Rise of stock market value in the United Kingdom.

His strategy followed the logic of the predicted course of events. Soros sold short of sterling (and other weak currencies) and went long on German marks. He bought German bonds and shorted German equity. Additionally, he bought British stocks.
The second decisive moment happened on the 16th September, as the Bank of England raised its interest rates. Soros interpreted the movement as
“an act of desperation that encouraged us to continue selling sterling even more aggressively than we did before. That was the end: Interest rates were raised by noon. By the evening, sterling had to quit the ERM.” (Soros,1995: p.82)

The downside risk of Soros’ strategy
The lack of collaboration between the ERM members determined the sizable damage of this currency crisis; thus, cooperation was a key word in the ERM agreement. Although cooperation among the ERM countries failed, some attempts towards a solution did take place during summer of 1992.
The United Kingdom was one of many countries under pressure. In the ERM context, other weak currencies were suffering the consequences of high interest rates in Germany. There were negotiations taking place, in which all but the strong currencies (in this case the German mark and the Dutch guilder) would be realigned in exchange for a reduction of the German interest rate. In this case, it is said that France boycotted the agreement. Although this negotiation failed, it showed that the Bundesbank was open to some flexibility. Given more time, the crisis might have been avoided due to cooperation among the ERM members.
This was the downside risk of Soros’ strategy. Had there been a general realignment of the exchange rates and a lowering of German interest rates, Soros would have lost his investment. Soros’ “strong German marks” (Slater, 2008: p.165) would have depreciated.

Conclusion
More than the crash of the sterling, the crisis of 1992 showed the failure of the ERM. Germany ended up suffering severe damages in the outcome of September 16th; other European countries were affected; speculative attacks to European currencies carried on during 1993. The only direct winner of the crisis was, in fact, the speculative market. In the long run, the crash of the sterling allowed a much needed economic rebirth for the United Kingdom which, to this day, refused to join the Euro area.

References

Buiter Willem H., Corsetti Giancarlo M., Pesenti Paolo A, “Interpreting the ERM Crisis: Country Specific and Systemic Issues” Princeton Studies in International Finance No.84, March 1998 http://www.princeton.edu/~ies/IES_Studies/S84.pdf

Davidson Larry, Hauskrecht Andreas, von Hagen Jürgen, “MacroNotes“, IU Kelley School of Business, Bloomington, 2012

Hornby Win, Gammie Robert, Wall Stuart, “Business Economics”, Pearson Education, 2001 http://books.google.de/books?id=pnT4LAfUuzUC&printsec=frontcover&source=gbs_ge_summary_r&cad=0#v=onepage&q&f=false Kennedy Robert E., Irwin Brian P., ”Currency Crises” Harvard Business School, 1999

Kennedy Robert E., Irwin Brian P.,” Note on Currency Crises” Harvard Business School, 1999

Krugmann, Paul “Currency Crises” http://web.mit.edu/krugman/www/crises.html

Mulhearn Chris, Vane Howard R. “The Euro, its Origins, Development and Prospects”, E.E. Publishing, 2008 http://books.google.de/books?id=qSChwhYF92kC&printsec=frontcover&dq=Vane&source=bl&ots=Mt7t2V6r5x&sig=1oH4Lt1m4gKrHkN0Z7LYLw_BOrc&hl=en&sa=X&ei=GTFfULesJsjxsgaB4IDACg&ved=0CDAQ6wEwAA#v=onepage&q=Vane&f=false Slater Robert, “Soros: The Life, Ideas, and Impact of the World's Most Influential Investor”, Chap. 18 "Taming the Snake", 2008

Soros George, “Soros on Soros: Staying Ahead of the Curve”, 1995 http://books.google.de/books?id=h2GuJ0xnhFUC&printsec=frontcover&source=gbs_ge_summary_r&cad=0#v=onepage&q&f=false Weerapana, Akila “Lecture 15: The ERM Crisis of 1992” http://www.wellesley.edu/Economics/weerapana/econ213/econ213pdf/lect213-15.pdf

------, “OECD Economic Surveys United Kingdom 1990-1991”, OECD, 1991
http://books.google.de/books/about/OECD_Economic_Surveys_United_Kingdom_199.html?id=RkHfGkT9v4wC&redir_esc=y