How Britain Turned Itself into a Monetary Colony with the ERM

ByPrimary Researcher

Executive Summary

  • Britain became involved in a monetary union that connected the Pound to the Deutsche Mark.
  • George Soros took advantage of this mistake by Britain.

Introduction

Many people have heard that George Soros made a fortune from betting against the British Pound, but the story of how tends to get left out. This quote explains the story.

“Despite the economic slowdown, inflation remained persistently high. To reign it in, Prime Minister John Major decided to join the European Exchange Rate Mechanism (ERM) in October 1990. This seemed like a reasonable solution to the Prime Minister because of Germany’s ironclad post-WWII history of controlling inflation. However, it turned into a disaster for Britain. The ERM was a currency union by eight countries to help stabilize trade and currency fluctuations. Each country’s central bank maintained its currency within a tight trading band to the other currencies by buying and selling foreign currencies. And Since the ERM was weighted toward the Deutsche Mark, each country in the ERM basically pegged their currency to the Mark. In joining the ERM in 1990, Britain also pegged the Pound to the Mark. Even though Britain had its own sovereign currency, its own ability to tax, and its own bond market, Britain adopted the monetary policies of Germany. Instead of simply using its own policy tools to reduce inflation by raising taxes, Britain turned itself into a colony. The problems of pegging Britain to a foreign country’s currency became apparent almost immediately. While Britain was dealing with a slowing economy, Germany was experiencing record growth. Germany had been spending to re-integrate East Germany and needed to keep monetary policy tight to reign in inflation. But the United Kingdom was already in a recession and needed expansionary monetary and fiscal policies. This dichotomy turned out to be a huge problem for the Bank of England and gave George Soros his opportunity. A free-floating currency is the “pressure release valve” of a country’s monetary and fiscal policies. All things being equal, when a country’s economic growth slows, the currency declines as well. But in the case of the Mark and the Pound, the two currencies couldn’t unlink because the UK had joined the ERM the year before. And the ERM required the Bank of England to maintain the Pound within a 3% +/- range with the Mark. In short, once the Pound started falling and traders piled on, the Bank of England quickly started running out of foreign currency reserves. Within two weeks, the Prime Minister went from defending the ERM to leaving it. Although Britain had its own sovereign currency, the country had pegged its currency to the German Mark. That meant it needed foreign currency reserves to maintain the peg. The Bank of England literally had to spend billions of German Marks to defend its currency. All in all, it’s estimated the Bank of England spent 6 billion on its futile defense. That was real money England could have used to import goods from Germany. The most amazing part of the whole episode was the outcome. Namely, nothing. The Pound settled into a long trading range that lasted the remainder of the decade. And the devaluation of the Pound ended up being a benefit to the economy because it helped spur exports. GDP growth accelerated and unemployment continued to decline until 2001.”

Source: Contrahour

https://contrahour.com/2019/08/everything-you-know-about-economics-is-wrong-how-soros-broke-the-bank-of-england.html. This is a good example of why various monetary unions don’t work.

The EU is negative for its member countries because it has created a monetary union. However, there are questions about whether freely floating currencies allow for currency speculators to do what Soros did to the British Pound. However, it made more sense for the Pound to float in any case over the long term.