BLACK WEDNESDAY was a day of national humiliation. September 16, 1992 saw interest rates soar to 15 per cent and the Bank of England spend £3.3 billion in a failed attempt to shore up the pound, before its embarrassing exit from the Exchange Rate Mechanism.
It was a pivotal moment in economic history, robbing the Tories of a record for economic competence they have yet to win back and paving the way for Labour’s landslide electoral victory five years later.
The full story of a debacle that still resonates across Whitehall was yesterday revealed in 11 previously secret Treasury documents, written by officials who witnessed events at first hand.
They show that high politics and “spectacularly wrong” economic forecasting conspired to send sterling into the ERM at the wrong rate, at the wrong time. Margaret Thatcher’s increasing political weakness over the poll tax, and impatience for an interest rate cut forced her to surrender her staunch opposition to the ERM at almost the worst time for the economy.
But in a criticism of their own Civil Service colleagues, they say officials were too timid to press Norman Lamont, the Chancellor, to withdraw from the ERM when it became clear that sterling could not survive. Aware it was a politically unpalatable course of action, they quietly dropped the idea.
In a devastating 80-page analysis, Stephen Davies, a senior policy analyst at the Treasury at the time, charts the twists and turns of the costly episode.
Nigel Lawson, the Chancellor from 1983, eventually convinced a sceptical Treasury of the benefits of ERM membership, but failed to drag a reluctant Mrs Thatcher to accepting it was in the economy’s best interests.
“Open warfare” between the Chancellor and the Prime Minister over the issue finally led to Mr Lawson’s departure in October 1989, after a period of turmoil on markets as traders struggled to work out whether the pounds would be in or out. It “made it especially difficult for the markets to decide what the effective objectives of the Government were,” the Treasury papers said.
Mr Lawson quit, frustrated that Mrs Thatcher was under the thumb of her Eurosceptic economic adviser, Sir Alan Walters, and would never yield.
John Major, the new Chancellor, eventually pressurised a vulnerable Mrs Thatcher into changing her mind.
Paragraphs removed from the two papers, but accidently leaked to the BBC, show how politics drove crucial economic decisions.
“Mrs Thatcher’s removal of her veto on ERM membership was determined by her own increasing political weakness,” the papers said. “October 1990 was clearly not an optimal time for the UK to join the ERM.” Mr Major told Mrs Thatcher ERM membership was the price she would have to pay for a cut in interest rates.
Thousands of council house tenants who took out mortgages to buy their homes under Mrs Thatcher’s policy were suffering under sky high interest rates. Knowing she was desperate for a cut, Mr Major said that there was only way to lower rates without risking higher inflation — join the ERM.
“To maintain the downward pressure on inflation it will be vital that there is no fall in the exchange rate. At the same time, given the increasing signs that the real economy is slowing down, we must find the occasion to bring about a reduction in interest rates. Entry into the ERM provides, in my view, the only circumstance in which we are likely to be able to achieveboth these objectives.” he said.
In another paper, Sir Nigel Wicks, former No 2 at the Treasury, said that persuading Mrs Thatcher of the case for entry had sapped the resources of civil servants and ministers alike.
“Pre-entry preprations focused heavily on the domestic political handling of the entry decision, notably the persuasion of the Prime Minister Margaret Thatcher. That ministerial and senior official energies were focused on that aspect provided an unhelpful and distracting backcloth for our preparations.”
Writing in Janaury 1994, he said that the political consensus in favour of the ERM was “fairly superficial” He added: “To some extent it was regarded as a useful instrument for reducing interest rates. “Indeed from personal recollection the Prime Minsiter seems to have accepted entry as a quid pro quo for a 1 per cent cut in interest rates, a cut which many of us in the Treasury were unhappy to see implemented before entry.”
The papers say the prize of an interest rate cut eventually won over Mrs Thatcher, who was worried about the risk of a weaker economic outturn than shown in the Treasury forecasts.
Her fears were well founded. The paper continued that in fact the forecasts were “spectacularly wrong”.
A separate paper by another senior official, Paul Gray, now deputy chairman of Revenue and Customs, said that the Treasury seriously misread the likely state of the economy in the early 1990s. In his reflections on membership, two years after the event, he wrote: “We were still heavily focused on fighting the battles of the 1980s, convinced that following earlier failures we needed a credible external discipline to get inflation down.
“We underestimated both the scale and duration of the process of adjustment to the excesses of the 1980s, and did not realise just how tight policy was.” As a result the main worry before membership, and for a significant period afterwards, was abour rates falling too fast, not that they would not fall by enough. That was part of the reason why they had not reflected more deeply on the possible implications of German reunification.Blinded by the political imperative of getting sterling into the ERM, economists at the Treasury paid too little attention to the rate.
“It probably is fair to say we were so dead set on getting into the mechanism — after the frustrations of the previous five years — that we were more blinkered than we should have been about some of the risks,” Mr Gray says.
Inevitably, it was not long before sterling came under pressure on the currency markets.
The economy failed to recover in line with Treasury forecasts, which boldly predicted a swift recovery. The pound was under siege. In May 1992 the Treasury started to examine whether sterling should leave the ERM. But again politics dominated.
An exit was considered “not politically feasible within the foreseeable future”, according to Mr Davies’s papers. Second guessing their political masters, Treasury officials said Britain would lose “all the credibility associated with ERM membership” and people would assume they had given up on their battle against inflation. Leaving the ERM was rejected.
And again the forecasts were at fault. “To the extent that they influenced policy decisions ... the forecasters clearly encouraged ministers and top officials to believe that the policy of sticking in the ERM at an unchanged parity should be maintained: at any time, they apparently had only to hang on for a few months and recovery would be well under way,” the paper said.
Although sterling survived the election of April 1992 with it was soon under pressure. Damaged by a “German whispering campaign” suggesting it should be re-valued within the ERM, the pound was further undermined by Helmut Schlesinger, President of the Bundesbank, who on September 15 called for a realignment of the ERM.
Sterling went into free fall. Having been sent a signal that sterling would be shored up at any cost, currency speculators, led US hedge fund supremo George Soros, made millions as the Bank of England raided its reserves to buy pounds. Interest rates reached 15 per cent before Mr Lamont pulled the plug.
In a paragraph deleted from his paper but leaked to the BBC Mr Davies sums up the experience. “There is a general problem with fixed exchange rate regimes that ministers get into positions where regime changes can take place only at enormous political cost. It becomes very difficult for civil servants to recommend (or even think of) measures that they know may well cost their political masters their careers.”
