A very Good Morning to you, I do hope that you enjoyed your weekend. As part of the continued austerity measures I´m introducing at home, I spent yesterday evening cutting the kids´ hair with a pair of clippers borrowed from a neighbour. Looking out the window at them now, the three of them silhouetted in the back seat of the car waiting to be taxied down to the school bus stop, they resemble a row of toilet brushes about to embark on a day out – I´m going to have to work on my hair styling skills, perhaps there is a YouTube video aimed at the hopelessly inept home barber.
"Cheerio small people! Work hard!"
At 9am, today’s blog entry had the working title “Central Banks and their role in the global economy” – it was going to be hard-hitting stuff, just the sort of thing to kick off the week in our quest for financial enlightenment. But an hour and half and 800 words later, I still hadn´t even broached the subject of central banks. So now, having employed some cunning editing skills, rearranged paragraphs here and there, ruthlessly deleted some portions and spent another hour biting my lip and writing new bits, I´ve produced today´s post, which whilst it doesn´t deal with the role of central banks in the global economy, is still quite interesting, I hope. Let me begin…
2012 marks the 20th anniversary of one of the darkest days in UK economic history. Aside from making George Soros an awful lot of money, it also made him a household name as “the man that broke the Bank of England”, when the UK Treasury spent 27 billion pounds attempting to prop up sterling. I am of course, talking about Black Wednesday.
Up until 16th September 1992 I´d always assumed that governments, whilst perhaps not pursuing the exact same policies I would have favoured as a bright-eyed 21 year old (beer available on prescription, a 3 day working week, a free terrestrial channel dedicated to 24 hour topless darts) at least had some idea of the difference between their arse and their elbow when it came to running an economy. Black Wednesday made me realise that quite often that´s just not the case.
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Major´s government actively implemented a policy of promoting fully-clothed male darts.
With your permission I´ll try and set the scene: In 1990 new chancellor John Major signed the UK up to the European Exchange Rate Mechanism (The ERM), a sort of stepping stone to the euro. The golden rule for members of the ERM was that the respective governments had to maintain their currency within 6% of the other member currencies, thus ensuring monetary stability amongst the group. In principle it was a capital idea.
Except the UK really didn´t pick the best time to get into the game. The pound entered the ERM at a rate of 1GBP – 2.95Dm which when you consider that the UK was trying to deal with inflation three times that of Germany´s, a huge property bubble, and a current account and fiscal deficit – the writing was really on the wall from the word go.
It wasn´t long before foreign exchange (ForEx, FX) speculators picked up on the anomaly and concluded that the pound was significantly overvalued. The markets began to bet on a sterling devaluation and they did this by shorting the pound.
Shorting (short selling) is the practice of selling something you don´t own, then purchasing it more cheaply than you sold it for once the price has dropped in order to cover the trade.
As an example, let´s say you´re in the market for a 10Kg sack of potatoes, and you´re prepared to pay 50 cents a kilo. I´ve heard the market is about to be flooded with cheap tubers from Eastern Europe so I agree to sell you 10Kg of spuds for 5 euros. With the deal agreed I pop next door to my neighbour and borrow 10kg of spuds from her and promise her I´ll replace them next week. Then I drop them off round at yours and collect payment. Sure enough by Wednesday truckloads of potatoes are turning up in Spain and of course, due to the market forces of supply and demand, I can purchase potatoes to replace the ones I borrowed from my neighbour at 25 cents a kilo, thereby making myself a tidy little profit. That is the essence of short selling, and it goes on all the time across all the markets.
Potatoes - As cheap as chips.
This is what was happening on the currency markets in the run-up to Black Wednesday. Speculators were short selling sterling, effectively selling currency they didn´t own, then as the pound tanked, they´d purchase the currency cheaper than the sale price, and bank the difference. “But which fools were buying this overvalued currency?” you cry - The British government were, in an effort to keep sterling in the ERM.
A few years after Black Wednesday I watched an interview with Ken Clarke (the Conservative, brown-suede-shoe-wearing Lord Chief Justice – but Home Secretary back in 1992) and I was just left agog. It was a while back, so I paraphrase, but this is how he summed it up:
“Michael Heseltine (Pres. Board of Trade), Douglas Hurd (Foreign Secretary), John Major (PM) and I were in Admiralty House and we knew things weren’t going particularly well. John suggested raising interest rates from 10 to 12% which we did but it really didn´t make a jot of difference. Norman (Lamont – Chancellor) arrived, visibly flustered and said it was his opinion that the rise from 10% – 12% had done absolutely nothing to reassure markets and that the game was up, we really had to exit the ERM. John disagreed, and raised the interest rate a further 3% from 12% to 15%. But you know, we didn´t have a television, or direct access to live information. It occurred to me how absurd it was that we were the people charged with making the most important decisions regarding the economy of our country and yet we were probably the least well-informed people to be making those decisions. Michael rummaged around in a desk drawer and found an old wireless and Douglas procured some batteries from somewhere and we tuned into the BBC to see what was going on… yes, it was all a bit surreal”
Even now, 20 years later, I´m still gob-smacked at the level of incompetence. What makes it worse is that instead of losing billions, had the government maintained its dollar currency reserves it could have actually turned a profit. Of course with the benefit of 20/20 hindsight, we can see that ejection from the ERM was exactly what the UK needed. The 15% devaluation in sterling kick-started exports, cut inflation, but most importantly I think, it ultimately led to the UK seriously questioning the wisdom of a single currency that lacked complete fiscal union. It´s easy to criticize Gordon Brown, and great fun too, (although selling the UK´s gold reserves at car boot sale prices remains unforgiveable), but he did ensure that the UK remained in control of its base rate and that the Bank of England maintained control over monetary policy, and in that respect, Britain is still master of its own destiny.
Gordon Brown - texture like sun.
PS. I tried in vain to locate footage of the Ken Clarke interview, however I did find this four and half minute Andrew Marr clip which pretty much tells the same story.
www.youtube.com/watch