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Black Wednesday 1992: When Sterling Left the Exchange Rate Mechanism

On September 16, 1992, the United Kingdom withdrew the pound from the European Exchange Rate Mechanism, a system that kept European currencies within set bands against one another. The day became known as Black Wednesday.

The pound had entered the mechanism at a rate many market participants thought too high for the British economy, which was in recession. Maintaining it required high interest rates, which hurt households and businesses. Speculators, including famously the fund manager George Soros, took large short positions in sterling, betting that the government could not defend the rate.

On the day itself, the Bank of England raised interest rates sharply and spent billions of pounds of reserves buying sterling, but the selling continued. By the evening, the government announced that sterling would leave the mechanism. The pound fell substantially in the following days and weeks.

The episode taught several lessons. A fixed exchange rate can be defended only while the government is willing to bear the economic cost. Markets can test commitments, especially when fundamentals point the other way. And the cost of defending a currency can exceed the cost of letting it go.

The event also showed how large speculative positions can influence policy, though the underlying cause was the mismatch between the rate and the economy.

Practical step: summarize in three lines why the peg was unsustainable, and look for the same pattern in a current managed currency.

The interest rate hikes on the day are the striking part. Raising rates during a recession to defend a currency shows how expensive a peg can get. The Bank of England raised its base rate from 10 percent to 12 percent that morning and announced a further rise to 15 percent later in the day, and still the selling didn't stop. Markets could see that the government couldn't keep rates that high for long without crushing the economy, so the defence wasn't credible. Sterling left the ERM that evening and the 15 percent rise was never actually applied. When a defence looks politically impossible to keep going, the market tends to test it.

Good reminder that the speculators didn't create the problem, they spotted it. The rate was out of line with the economy, and that's what got tested. The UK was in recession with high unemployment, while German rates were high because of reunification, and the ERM forced the UK to follow. That mismatch was visible to anyone who looked. The famous profit made by Soros's fund came from betting on an outcome that the fundamentals were already pointing to. The useful lesson for us is to look for pegs or managed rates where the policy needed to defend the currency is clearly hurting the domestic economy. Those are the ones that break.