From the archiveCase study · Sep 19925 min read
Black Wednesday: promising 15% couldn’t save the pound
On 16 September 1992 the UK raised interest rates to 12%, promised 15% and still left the ERM by nightfall: the pound fell about 15% against the Deutschmark and George Soros’s fund made about $1bn.
On 16 September 1992 the UK raised rates from 10% to 12%, promised 15% and still left the ERM that evening. The pound fell about 15% against the Deutschmark in the weeks after.
Markets doubted the UK would keep rates that high with its economy already weak, so each rise read as desperation and selling sterling at its floor became a one-way bet.
A peg is only as strong as the pain its government will bear. Within a month the UK swapped its exchange-rate anchor for an inflation target, and it still targets inflation today.
The trader’s angle
A currency peg holds only while the government is willing to pay for it. Once markets doubt that, the defence turns into a lopsided bet for anyone selling at the edge of the band.
Sterling’s ERM floor
DM2.78
central rate DM2.95Sterling joined on 8 October 1990 in the wide 6% band. At the floor the Bank had to buy pounds or raise rates.
Base rate at 11am, 16 Sep
12%
upfrom 10%The pound stayed stuck at its floor. A further rise to 15%, announced for the next day, never took effect.
Pound vs Deutschmark
about -15%
downin the following weeksOnce the floor was gone, nothing held sterling up. Base rates were cut by a point within a week.
Quantum Fund’s profit
about $1bn
short reported at about $10bnGeorge Soros’s fund bet that the Bank of England lacked the reserves to hold the line.
In the European Exchange Rate Mechanism (ERM), each currency had a central rate against the others and a band around it. Sterling joined in October 1990 at a central rate of DM2.95, free to move 6% either side. That put its floor at about DM2.78. That floor was a the UK had promised to defend.
At the floor, the Bank of England had two tools: buy pounds with its foreign-currency reserves (), or raise interest rates to make holding pounds more attractive. Both are hard to keep up. Reserves are finite, and every rate rise squeezes households and firms at home.
That made selling sterling at the floor a lopsided bet. If the peg held, the pound could only bounce a little inside its band. If it broke, it could fall a long way.
What happened
On the morning of Wednesday 16 September 1992, sterling was pinned to the bottom of its ERM band, about DM2.78, despite heavy buying by the Bank of England. At 11am the government raised the Bank’s from 10% to 12%. The pound didn’t move off its floor. In the early afternoon it announced a further rise, to 15%, to take effect the next day.
That failed too. That evening the Chancellor, Norman Lamont, announced that the UK was suspending its ERM membership, and the second rise never took effect. Italy also suspended its membership and the Spanish peseta was devalued. Freed from its floor, the pound fell about 15% against the Deutschmark over the following weeks.
Why it happened
The ERM tied its members to German monetary policy. After reunification the Bundesbank kept interest rates high, worried about the inflation risk from the big budget deficits Germany was running to support incomes and rebuild infrastructure in the former East Germany. With capital free to move, money flowed towards the Deutschmark. Other members had to keep their own rates high to hold their currencies in the band, even though they needed lower rates to pull their economies out of recession.
By September the strain was showing. The Italian lira was devalued within the system on Monday 14 September, and doubts over the Maastricht Treaty, with a French referendum days away, had markets asking who would be next.
The UK’s answer, ever higher rates for an economy that was already weak, convinced no one. Traders judged the government would not keep rates that high for long, so each rise read as a sign of desperation. The market was testing the government’s , not just the Bank’s reserves.
How it ripples through markets
How a German rate problem broke a British peg
- 1
The Bundesbank keeps rates high
upDeutschmarkAfter reunification it tightens to contain the inflation risk from Germany’s big , and higher German rates make the Deutschmark more attractive to hold.
- 2
ERM partners must follow
With capital free to move, money flows to the Deutschmark, and other members need high rates to stay in their bands despite weak economies.
- 3
Doubts spread
downSterlingThe lira is devalued on 14 September and the French Maastricht vote looms, so markets ask who will be next. Selling pushes sterling to its floor of about DM2.78.
- 4
The defence escalates
upUK base rateTo make holding pounds pay, the Bank buys pounds and rates go from 10% to 12%, with 15% promised for the next day. Traders judge the government won’t keep rates that high in a weak economy, so each rise reads as desperation.
- 5
The UK leaves the ERM
downGBP/DEMThat evening membership is suspended and the 15% rise is dropped. The pound falls about 15% against the Deutschmark in the weeks after.
- 6
Rates fall and a new anchor arrives
downUK base rateFreed from Germany’s rates, base rates are cut by a point within a week, and a 1–4% inflation target follows on 8 October.
Why it mattered for traders
For speculators the trade was lopsided. With sterling at its floor, the most it was likely to do if the defence held was bounce a little inside the band. If the floor broke, it could fall a long way. Selling borrowed pounds did mean paying sterling’s high interest rate, but a few days of interest, even at 15% a year, is small next to a devaluation.
George Soros’s Quantum Fund, with Stanley Druckenmiller running the trade, built a short position in sterling reported at about $10bn, on the view that the Bank lacked the reserves to defend the pound. It made about $1bn. The Bank’s could not absorb selling on that scale, and the rate rises only confirmed it was running out of tools. Treasury papers released in 2005 put the net cost of the defence at about £3.3bn.
What happened next
Leaving the ERM freed UK interest rates from Germany’s. The Bank cut base rates by a point on 22 September, and by late January 1993 they were around 6%, half the level set on Black Wednesday morning. On 8 October 1992 Lamont gave policy a new anchor: a target of 1–4% for underlying inflation, measured by retail prices excluding mortgage interest payments.
Inflation targeting has guided UK monetary policy ever since; today the target is 2% on the consumer prices index. Many economists now see the exit as the start of a long period of stability. The political legacy was harder: the episode deepened British scepticism about European monetary union.
Academy lessons for this story
- X9What moves currenciesExplain why a currency moved: interest rates, inflation, what a country sells, fear in markets, or the authorities stepping in.
- F9Fiscal policy, debt and bond supplyExplain deficits and debt, project debt against GDP, and say why heavy government borrowing pushes up long-term interest rates.
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Sources
- Bank of England — Operation of monetary policy (Quarterly Bulletin, 1992 Q4)
- Bank of England — The exchange rate mechanism of the European monetary system (Quarterly Bulletin, 1990 Q4)
- Bank of England — Operation of monetary policy (Quarterly Bulletin, 1993 Q1)
- Economics Observatory — The birth of inflation targeting: why did the ERM crisis happen?
- National Institute of Economic and Social Research — Six lessons from Black Wednesday for today’s central bankers
- Federal Reserve Bank of New York — Economic Policy Review, August 1997 (UK inflation targeting)
- Bloomberg — George Soros vs the Bank of England, Round II (Matthew Lynn column, 16 December 1998)
- Central Banking — Treasury papers on the cost of the 1992 ERM defence
An original summary written from the sources above. Figures are rounded; follow the links for the full record.
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