"Markets are constantly in a state of uncertainty and flux and money is made by discounting the obvious and betting on the unexpected." - George Soros
George Soros is perhaps the most famous currency trader in the world, thanks to his timely and brave bet against the Bank of England, on what became known as Black Wednesday. With costs of around £3.3 billion, Britain's central bank was unable to defend itself from an attack in the currency markets, and Mr. Soros made an estimated $1 billion in profit as a result.
Setting the Stage for Black Wednesday
The European Exchange Rate Mechanism (ERM) was setup in March of 1979 in order to reduce exchange rate variability and stabilize monetary policy across Europe before introducing a common currency that would eventually be known as the euro. Simple put, the ERM set an upper and lower margin in which exchange rates could vary - known as a semi-peg.
Britain initially declined to join the ERM when it originated, but later adopted a semi-official policy that shadowed the Deutsche Mark. In October of 1990, the country decided to join the ERM after a shake-up in leadership, preventing its currency from fluctuating more than 6% in either direction by intervening in the currency markets with countertrades.
Black Wednesday's Underlying Causes
When Britain joined the ERM, the rate was set to 2.95 Deutsche Marks per Pound Sterling with a 6% permissible move in either direction. The problem was that the country's inflation rate was three times that of Germany's, interest rates were at 15%, and the country's economic boom was far into a period of unsustainable growth - setting the stage for a bust period.
Currency traders took note of these underlying problems and began short selling the Pound Sterling - that is, borrowing and immediately converting them into a foreign currency with the agreement to re-convert them in the future. George Soros was one of these bearish currency traders, amassing a short position of more than $10 billion worth of Pound Sterling.
Black Wednesday & Its Aftermath
The UK's prime minister and cabinet members authorized spending billions of Pounds Sterling in an attempt to contain the short selling by speculators. Moreover, the British government announced that it would raise its interest rates from 10% to 15% to try and attract currency traders looking for greater yield on their currency holdings.
Unfortunately, currency speculators didn't believe the government would make good on these promises and continued shorting the Pound Sterling. After an emergency meeting among top officials, the country was ultimately forced to withdraw from the ERM and let the market revalue its currency to more appropriate (lower) levels.
The country was arguably thrown into a recession afterwards, with many British citizens referring to the ERM as the "Eternal Recession Machine". While the government lost a lot of money, some politicians are glad the ERM disaster occurred, since it paved the way for a more conservative government to enter the fold and revive the economy.
Lessons from Black Wednesday
Black Wednesday teaches a number of important lessons to both currency traders and governments, including some lessons that may surprise readers. For instance, statistical data suggests that the British economy was growing faster in the ERM than published figures suggest, and the resulting recession may have instead been due to the aftermath of the Lawson boom.
Lessons for governments include:
- Don't Dictate Interest Rates - The ERM interest rates were set for Germany for Germany when they should have been set by Europe for Europe.
- Pick Your Fights Against Speculators - Taking extreme measures to counteract decisive market action is often a futile (and expensive) endeavor.
Lessons for currency traders include:
- Nothing's Impossible - The departure of Britain from the ERM was unthinkable to many during the crisis, but even governments make big mistakes.
- Be Ready for Extreme Measures - Britain's decision to raise interest rates some 2% to 5% in a single day demonstrates potential government resolve.
Black Wednesday is widely known as the day that billionaire currency trader George Soros broke the Bank of England and made over $1 billion. But, the real lessons are found by analyzing the underlying causes of the crisis and how they quickly led to problems.