By Brian Cronin

This week sees the 20th anniversary of a traumatic event for the British government. Wednesday, September 16th 1992 was the day that Britain exited the Exchange Rate Mechanism in rather ignominious fashion. It would forever after be known as Black Wednesday. It is also a good lesson for today’s investors in that trying to defend something that is inherently indefensible, will see punishment meted out in severe fashion.

First, a little bit of history to explain the context and it involves another trip down memory lane. This will give you some idea of the long gestation period for the euro and the various forms monetary union took before the single currency was achieved. It also illustrates why tying yourself to a system when your economies are misaligned is a recipe for disaster. A word of warning though: this gets a little wonky!

The European Monetary System (EMS) reflected the desire of the European Economic Community member countries to join together into an eventual United Europe of States. European monetary union was to be the objective and the “snake in the tunnel,” (because it looked like that graphically), formed in the aftermath of the collapse of the fixed exchange rates in August 1971, was the first step. The snake allowed each currency to fluctuate within 2.25% on either side of its dollar par value, and it was hoped that those bands could be narrowed in the future. Unfortunately, speculation in the markets in 1973, saw the collapse of the Smithsonian agreement which had fostered the snake.

The Common Market countries, whose currencies were now allowed to float freely against each other, decided nevertheless to maintain the snake. Eventually, pressures built up in various countries for a variety of reasons making the snake unworkable. The United Kingdom and Ireland left in June 1972 and Italy left in February 1973.  Norway joined in May 1972 and Sweden in March 1973. France left in January 1973, rejoined in 1975, but opted out again in March of 1976. A complete mess.

By the end of 1978, the heads of government of the five surviving snake members decided to establish a new snake, starting in March of 1979. Norway meanwhile had opted out of the system, worried that the new EMS would exclude either Great Britain or Sweden. France had been persuaded to rejoin after haggling over concessions on agricultural prices.Aware that problems of the past should not be repeated, safeguards were built into the new EMS – the ERM – Exchange Rate Mechanism. The member countries, now consisting of Germany, France, Holland, Belgium and Luxembourg, Denmark, Ireland, and Italy were all bound to each other. No currency was allowed to fluctuate more than 2.25% (6.00% in the case of Italy) above or below its central parity point. Parity was now fixed not in terms of the dollar, but the ECU, or European Currency Unit.

The ECU, based on the old European Unit of Account (EUA) and with almost the same composition, was the new international currency. It was a “basket” currency made up of shares of the member currencies and reflected the importance of the countries’ GDP to the overall GDP of the EU. The ECU values determined the central parity points in the parity grid. The central point of one currency against a second currency was simply a mathematical expression of these two values.

In addition, the ERM also had built into it a new device designed to ring alarm bells if pressure started to build within the system. In the past, when the upper or lower limit was reached for one currency against another, both central banks concerned were obliged to intervene by buying the weak currency and selling the strong currency. Now what happened, was that when a currency moved to 75% of 2.25% (or 6.00% for Italy) away from its fixed central ECU rate, it would be at its threshold and would trigger a divergence indicator, or “rattlesnake”, often before pressure built up in the parity grid. The Central Bank of the offending currency would then bear the burden of action alone rather than as a bilateral measure between two central banks as on the parity grid.

When the divergence threshold was reached the Central Bank concerned had to act. It was not obliged to intervene, but it had to take appropriate corrective measures, which could include intervention, but might just as easily be changing interest rates or local money market intervention levels. If it did nothing, it had to explain its actions to a variety of bodies, including the EEC Council of Ministers.

Since its inception in 1979, the ERM worked reasonably well preventing massive strains from building up within the European Community. Currency traders handled the mathematics of all this pretty well. There were realignments from time to time as pressure built up and markets deemed that current values did not reflect reality.

Although Britain did not join the ERM at its inception, the pound nevertheless “shadowed” the mark for a considerable time. But on Friday October 5th, 1990, the UK Treasury took markets by surprise and announced Great Britain’s entry into the Exchange Rate Mechanism effective the following Monday with a 6.00% fluctuation either side of parity. It was announced that the central rate for the pound would be 2.9500 marks. Chancellor of the Exchequer John Major had been instrumental in convincing the Cabinet to sign on to the ERM. Prime Minister Margaret Thatcher had long resisted entry but finally gave in. Just over a month later, she was ousted in a “palace coup” and replaced by Major. However, with inflation considerably higher than in Germany and interest rates at around 15%, the conditions were not ideal. Markets began to sense that after waiting all this time to go into the ERM, when they finally did go in, it was at the wrong level.

Over the next two years, with German interest rates elevated to counteract the inflationary pressures of reunification causing stress throughout the ERM, speculators, George Soros famously among them, decided that the Bank of England was defending the indefensible. The pound gradually slid gradually and then precipitately to its lower limit against the mark (2.7778). Soros is estimated to have made $1.0 billion from his speculative assault on the pound.

After resolutely denying the obvious, raising interest rates to as high as 15% when a faltering economy required lower interest rates, and spending, it is estimated, close to £3.3 billion on Black Wednesday alone, the Old Lady gave way and Britain withdrew from the ERM. The amount that the UK Treasury had spent in trying to prop up the pound was around £27 billion. If the pound had not been bound to the mark and been allowed to devalue, the UK Treasury could actually have made a tidy profit by standing aside but devaluation was not in the government’s arsenal of weapons since it was deemed to be inflationary.

So, here we are, twenty years later, and monetary union is still causing heartache. There is nothing new under the sun. If markets determine that a currency does not reflect the fundamentals and that a country’s interest rates are not at a level sufficient to reflect its fiscal position, it will be attacked. Although few people thought so at the time, Britain’s exit was the best thing that could have happened for its economy and its finances. Denmark and Sweden discovered the same thing when they opted out of the ERM and the eurozone.

I’m not sure if you can define what happened this past Wednesday in Karlsruhe also as Black Wednesday, but for some opponents of the European Stability Mechanism, the permanent bailout fund, it might just as well have been. The German Constitutional Court (BverfG) decided that the ESM was legal and did not contravene the German Basic Law. It can now be signed into law by President Joachim Gauck. However, the ruling did come with that proviso that said that the German representative on the ESM board must agree to any breach of the upper limit of Germany’s commitment of €190 billion and that it then had to be approved by the German parliament thereby ensuring that the Bundestag is not left twiddling its thumbs when it came to budget matters. In addition, the Bundestag cannot be shut out from information vital to its decision making process whatever the confidentiality requirements are of the ESM.

Opponents are disgusted that the court has basically gone along with government wishes and point out that it has never given a contrary opinion. And that means it is losing its credibility. Those opposing the ruling fear that Germany will just be a giant money transfer machine with German taxpayers on the hook. Elsewhere though, there are grumblings too that Germany is going to get special treatment as the 800 pound gorilla in the room. Other nations have to accept what Brussels decides, but Germany has the right to have the Bundestag weigh in and pass judgment. The one hope for euroskeptics is that the BverfG ruling is preliminary. They have yet to opine on the role of the ECB and its bond purchase to see whether they contravene EU treaties.

There was more optimistic news in Holland last Wednesday when the pro-Europe parties beat back the euroskeptics and left Prime Minister Mark Rutte in power in the general election. That should give Frau Merkel some cause for optimism and take some of the pressure off. Now all eyes will be on Brussels and the attempt at a more perfect banking union, supervisory authority and deposit insurance like the FDIC in the US, presumably administered by the European Central Bank. Germany wants a banking regulator in place before anyone starts to tap the ESM and wants to slow down the pace and the enthusiasm engendered by the BverfG decision. The question being raised by nations outside the eurozone is whether the new banking regulations will apply to them, whether it will apply to all banks or merely the transnational banks. Great Britain, as the most prominent outsider, is leading the charge on that. And can an entity like the ECB which might lend directly to banks also be its regulator?

So the markets breathed a sigh of relief and the euro is “saved” – for now. But the problems remain. Greece is still Greece and Spain is still a mess. The fund, as currently constituted, may be large enough to take care of smaller emergencies, but it is doubtful that it could handle Spain and Italy combined should it come to that. That’s a whole different ballgame. When things start to go bad, the speed of the decline is much faster and widespread than anyone can imagine. You only have to look at examples like the collapse of the Soviet empire after the fall of the Berlin Wall, the so-called Arab Spring last year and the current Mideast unrest to see that things can happen at warp speed.