Taking back control

It is convenient to link the current state of the UK’s relationship with the EU to the events of 25 years ago today, when on 16 September 1992 the UK suspended its membership of the European Exchange Rate Mechanism (ERM). This is not as ridiculous as it sounds: 1992 proved to be a liberating experience for the UK which some have argued could be achieved on an even bigger scale by leaving the EU. The event was also significant from a policy perspective in that it marked the end of British attempts to peg the exchange rate. The ERM departure marked the third devaluation of a fixed peg, following those of 1949 and 1967. It finally proved to policymakers what many economists had said all along, that it was impossible to simultaneously operate a fixed exchange rate and an independent monetary policy whilst allowing free capital movement.

To set the scene, recall that the UK had been shadowing the DM since early 1987 in a bid to hang onto the coat tails of German policy credibility. It formally joined the ERM in October 1990 at an exchange rate of 2.95 to the DM which many people, including the Bundesbank, thought was too high. It is important also to recall that in spring 1992 Danish voters rejected the Maastricht Treaty and on 20 September, the French electorate was to due vote on the issue. European tensions were thus running high and currency markets were testing European government's commitment to maintaining their currency parities. As is now well known, sterling came under speculative pressure and the British government realised that the markets could throw more capital to attack the pound than it could muster to defend it. After a day of drama, which included a 500 bps rise in interest rates, the UK decided to leave the ERM.

Many lessons were learned that day as the recriminations began to fly. The Bank of England was disappointed that the Bundesbank did not do more to provide support. This reinforced the resistance of the policy establishment to fixed exchange rates and is one reason why the BoE came out so strongly against joining the European single currency. At the time, my view was that the debacle highlighted flaws in the ERM. The Bundesbank did not have an obligation to support ERM countries in trouble and was in any case battling with problems of its own in post reunification Germany. With hindsight, the BoE was perhaps right. The Bundesbank put its own interests first and whilst it could perhaps get away with this in the ERM, which after all was a voluntary arrangement, it raised questions about its motives, which resurfaced during the euro zone crisis of 2012. If Jens Weidmann had had his way, Greece would not have received additional aid and would surely have been ejected from the euro, which might have changed the European political landscape today.

Domestically, ERM exit changed the nature of the political debate. Conservative eurosceptics were emboldened by the lack of European cooperation to start challenging the government more aggressively on its position on EU issues. Whilst many of the political class of 1992 are no longer active in front line politics, the likes of John Redwood are still around who continues to occupy a prominent position on the right of the Conservative Party. The Chancellor in office at the time was Norman Lamont, whose career was effectively terminated by the ERM affair, and he became a trenchant EU critic who in 2016 was a prominent supporter of Brexit.

However, departure from the ERM was a liberating economic experience for the UK. It literally could take back control of its monetary policy which had effectively been subordinated to maintaining the currency parity. This allowed the BoE to cut interest rates from 10% pre-crisis to 5.25% less than 18 months later which helped to propel an economic recovery that occurred without a major pickup in domestic inflation. Not for nothing did some commentators try to portray what became known as Black Wednesday as White Wednesday.

But for those who believe that leaving the EU will prove similarly liberating, I suspect they will be disappointed. The ERM was a simple fixed exchange rate mechanism with no institutional commitments. Countries could come and go as they pleased. Indeed Italy, which also left the ERM in 1992, rejoined in 1996. Leaving the EU is a whole sight more complicated, and explains why the UK is still a member 15 months after the referendum. And unlike 1992, there has been a pickup in domestic inflation in the wake of sterling's depreciation which has proven to be very damaging to household real incomes.

That there were real benefits to be had from the ERM departure is not in dispute. Although it felt painful at the time, it hardened the UK's resolve not to join the single currency which proved to be a wise decision for a country whose currency has been devalued by two-thirds over the past century. But it also arguably heightened the belief that the UK is economically better off on its own. This is a falsehood. European monetary arrangements left a lot to be desired in 1992, and perhaps still do today. But the UK has become ever more strongly intertwined with the EU over the past 25 years, thanks to the establishment of the single market, which has largely been to its economic benefit. The lesson of 1992 is that it pays to have an independent monetary policy and that taking back control can be positive. However, as the Brexit negotiations have proven, taking back control is harder than it looks.