What Was Black Wednesday?

What Was Black Wednesday?

Black Wednesday refers to September 16, 1992, when a collapse in the pound sterling forced Britain to withdraw from the European Exchange Rate Mechanism (ERM). The U.K. was forced out of the ERM because it could not prevent the value of the pound from falling below the lower limit specified by the ERM. The European ERM was introduced in the late 1970s to stabilize European currencies in preparation for the Economic and Monetary Union (EMU) and the introduction of the euro. Countries seeking to replace their currency with the euro were required to keep the value of their currency within a specific range for several years.

Understanding Black Wednesday

Before Black Wednesday, the U.K. had been in the European ERM for two years. However, the pound was depreciating and falling close to the lower limits set by the ERM. The British government took steps to bolster the pound, including raising interest rates and authorizing the use of foreign currency reserves to purchase pounds.

However, George Soros thought that the U.K. would ultimately fail in its attempts to prop up the pound. Soros quietly accumulated a large short position against the British currency. He then began speaking publicly about his belief that the pound could not be defended. Other speculators also started betting against the pound, while investors sought hedges against a collapse in the exchange rate.

The Soros-inspired pile on against the pound had many of the characteristics of a self-fulfilling prophecy. As more people came to believe that the British pound would crash out of the European ERM, a crisis became more likely. As it became more likely, businesses and investors had to prepare for it. Their preparations then put further pressure on the pound.

Expectations play a significant role in determining exchange rates.

The day before Black Wednesday, Soros' Quantum Fund began selling large amounts of pounds on the market, causing the price to plummet further. Although the Bank of England took steps to stem the sell-off, it was unsuccessful. On Black Wednesday, the Bank of England declared that the U.K. would leave the European ERM. Because of Black Wednesday, George Soros is known for "breaking the Bank of England." It has been reported that he made a $1 billion profit that day, which cemented his reputation as a great forex trader.

Criticism of Black Wednesday

Black Wednesday was widely condemned as a massive waste of money at the time. It also damaged the reputation of British Prime Minister John Major and the Conservative Party for effective economic management. The U.K. government expended billions of pounds worth of foreign exchange reserves in an ultimately futile attempt to prevent Black Wednesday. The public seemed to receive no benefit at all, while Soros and other wealthy speculators made billions.

The political damage from Black Wednesday was much worse because the Conservative Party had recently won reelection on a pro-euro platform. The center of John Major's economic policy was Britain's participation in the European ERM and eventual adoption of the euro. This policy was a complete failure. The subsequent prosperity of the U.K. during the mid-1990s was seen as happening in spite of government policy. The Conservative Party lost the 1997 U.K. general election in a landslide, in large part because of Black Wednesday.

Benefits of Black Wednesday

Although Black Wednesday is described as a disaster by many, others think that it helped prepare the way for an economic revival. They believe that economic policies enacted in the U.K. in the aftermath of that day contributed to an improvement in economic growth, lower unemployment, and less inflation.

Black Wednesday kept the U.K. out of the eurozone and saved it from more serious economic problems later on. In particular, the British economy performed much better during the European sovereign debt crisis. Britain was able to use monetary policy more effectively because it retained the pound. Black Wednesday was ultimately far less expensive than the bailouts required to keep several countries in the eurozone.