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9-709-026
REV: SEPTEMBER 9, 2009

NIALL FERGUSON
JONATHAN SCHLEFER

Who Broke the Bank of England?
Late in the summer of 1992, George Soros, the currency speculator, philanthropist, and amateur philosopher, faced the biggest decision of his career.1 The Exchange Rate Mechanism (ERM), which managed the exchange rates of twelve European currencies, including the British pound, French franc, Italian lira, and German mark, appeared to be in jeopardy. Could he profit from its breakdown?

The ERM had been established to prepare the members of the European Community (EC) for a future merger of their currencies into a single European money. Monetary union would be the final phase of a project they had already committed themselves to: the creation of a large, unified European market, comparable in scale with that of the United States, allowing the unimpeded flow of finance, goods, and workers across the EC’s internal borders. The EC member states’ trade with one another had been growing more rapidly than their trade with the rest of the world since the 1960s, a trend that had accelerated following the adoption of the Single European Act in 1986. By 1992 around 60% of member states’ trade was intra-EC (Exhibit 1a). Not only would a single currency reduce cross-border transaction-costs and increase price transparency, further boosting intra-European trade. It was also hoped by some countries that it would help reduce their inflation rates and perhaps also increase their fiscal stability. Monetary union was also supposed to strengthen the political bonds among European nations, at a time when the former Soviet Union and Eastern Bloc had recently disintegrated, and turmoil in Central and Eastern Europe seemed to threaten the continent’s stability. Some proponents of monetary union also expressed the hope that a European currency would emerge as a counterweight to the U.S. dollar.

The ERM was thus a halfway house between freely floating exchange rates and a single currency. It was up to the twelve countries’ central banks to keep their respective currencies within agreed trading ranges or bands. By August 1992, however, the predicament of several EC members, notably Britain, France, and Italy, raised doubts about whether they could maintain their currencies within these bands. If Soros could work out in advance which currencies would fall out of the ERM and which would not, he stood to make a large amount of money.

At one level, the decision was straightforward. The markets already seemed to be making it for Soros. Futures contracts to buy the franc and lira several months ahead were trading at prices below their respective bands, whereas contracts to buy the pound still remained within sterling’s band.2 That implied that other traders expected the French and Italian currencies to exit the ERM, but not the British.

________________________________________________________________________________________________________________ Professor Niall Ferguson and Research Associate Jonathan Schlefer prepared this case. This case was developed from published sources. HBS cases are developed solely as the basis for class discussion. Cases are not intended to serve as endorsements, sources of primary data, or illustrations of effective or ineffective management.

Copyright © 2009 President and Fellows of Harvard College. To order copies or request permission to reproduce materials, call 1-800-545-7685, write Harvard Business School Publishing, Boston, MA 02163, or go to www.hbsp.harvard.edu/educators. This publication may not be digitized, photocopied, or otherwise reproduced, posted, or transmitted, without the permission of Harvard Business School.

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Who Broke the Bank of England?

Such judgments had to be based on political as well as economic considerations, however. By linking their currencies’ exchange rates together, while maintaining more or less free cross-border capital movements, the ERM member states had implicitly renounced the right to pursue independent monetary policies. That meant that, in practice, interest rates were set by Germany, which, in addition to having the biggest economy in the EC, also had the central bank least susceptible to political pressure, the Bundesbank, and the currency least prone to inflation since the process of European integration had begun in the 1950s, the deutschmark (DM). If the EC members already resembled an “optimal currency area”, with relatively synchronized macroeconomic performance, this would not pose a significant problem. But if the other economies had lower growth than Germany’s, their central banks would not be free to cut interest rates, because remaining within the ERM bands trumped domestic demand management. There could therefore be a trade-off between the long-run benefits of the ERM and the short-run costs of following the Bundesbank. Born in Hungary, a refugee from Nazism and a graduate of the London School of Economics, Soros knew a thing or two about both Europe and exchange rates. He knew that a system of fixed exchange rates would come under strain if there were significant and persistent differences in the member states’ economic performance, whether in terms of inflation, labor costs, government finance or even the timing of the business cycle. But Soros also knew that if his Quantum Fund and other associated hedge funds bet heavily enough against a currency, they could actually cause it to crash, regardless of the economic “fundamentals”.3

Proudly unorthodox in his approach to economics, Soros believed that “reflexivity” played a central role in financial markets. As he put it in a talk to the Massachusetts Institute of Technology Economics Department in 1994: “Reflexivity is, in effect, a two-way feedback mechanism in which reality helps shape the participants’ thinking and the participants’ thinking helps shape reality.”4 Financial markets, according to Soros, often (though not always) behaved reflexively: The generally accepted theory is that financial markets tend towards equilibrium, and on the whole, discount the future correctly. I operate using a different theory, according to which financial markets cannot possibly discount the future correctly because they do not merely discount the future; they help to shape it. In certain circumstances, financial markets can affect the so-called fundamentals which they are supposed to reflect.5 In fact, Soros found some support for his position within the economics profession. Only a few years earlier, several well regarded economists, including Maurice Obstfeld of the University of California at Berkeley, had developed models of “self-fulfilling” currency crises, in which currency speculation could itself cause a crisis that would not otherwise occur, and in doing so could actually alter the economic fundamentals. Barry Eichengreen of the University of California at Berkeley and Charles Wyplosz of the Graduate Institute in Geneva saw the ERM as being vulnerable to just such a crisis in late 1992.6 Other economists, however, questioned the models of self-fulfilling economic crises and how far they applied to the ERM in 1992; they insisted that the real issue was the fundamentals.7

The Political Economy of European Integration
The Bretton Woods agreements, established by the allied powers at the Bretton Woods Hotel in New Hampshire in 1944, had pegged all participating currencies against the dollar, but they had allowed exceptional adjustments and explicitly permitted capital controls: outright prohibitions, taxes, and other regulations to restrict financial flows across borders. Exchange-rate stability

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Who Broke the Bank of England?

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provided a predictable framework for the growth of trade, while capital controls gave nations control over their domestic macroeconomic policies and interest rates.8 After World War II, Europeans saw economic cooperation as a way to help prevent another eruption of the internecine conflict that had plagued their continent’s history.9 After an initial effort to pool coal and steel production, in 1957 six nations—West Germany, France, Italy, Belgium, the Netherlands, and Luxembourg—had signed the Treaty of Rome, founding the European Economic Community (EEC).1 The initial focus of the EEC was on trade liberalization rather than financial integration. Nevertheless, the first serious discussion of monetary union took place as early as 1969.10 As Bretton Woods began to unravel—the United States devalued the dollar against gold in 1971 and abandoned the fixed exchange-rate system in 1973—the EC nations sought to stabilize their currencies in the so-called “Snake,” which allowed them to fluctuate no more than 2.25% above or below agreed exchange rates. (Central banks established bilateral parities between each pair of currencies within the Snake. If any two currencies diverged from their bilateral parity by 2.25%, both central banks were required to intervene to prevent further divergence.)11 The United Kingdom, Ireland, and Denmark joined the Snake when they became EC members in 1973, but high and erratic inflation in the wake of the first oil shock soon forced the UK—along with France and Italy—to leave the system. The experiment seemed to have failed.

Nevertheless, in 1979 all the EC members except the United Kingdom again tried to stabilize their currencies through the ERM, which was technically a mechanism within a wider European Monetary System (EMS). Like the Snake, it established +/-2.25% bands (Italy was allowed a looser +/-6% band). But while the Snake had been seen as just an economic device, the promoters of the ERM, notably French President Valéry Giscard d’Estaing and German Chancellor Helmut Schmidt, “explicitly tied monetary stability to broader European integration,” according to Harvard political scientist Jeffry Frieden. The founding documents of the ERM “implied that a country not in [it] would become a second-tier member of the Community.”12 Chancellor Schmidt called the ERM his “grand strategy for integrating Europe,” and in particular for “binding West Germany closer to Western Europe.”13 President Giscard had a complementary view: “What I want France to achieve is to make sure that there are in Europe at least two countries of comparative influence … Germany and France.”14

During the 1980s politicians in France and Italy came to see the ERM as a way of piggy-backing on the anti-inflationary reputation of the Bundesbank.15 Fighting inflation by domestic means alone had proved difficult because of domestic political resistance to tighter monetary policy. The need to maintain an exchange rate peg furnished an additional argument against premature interest rate cuts. But the same economic interest groups that resisted such policies also had reasons to oppose the ERM.16 When French and Italian inflation exceeded German inflation under fixed exchange rates, as often happened, their goods became more expensive abroad, so exports stalled, and foreign goods became cheaper at home, so imports rose. Some domestic firms lost market share, and workers lost jobs. The opposition of such firms and workers made the ERM “unattainable” on its own merits in both countries, according to Frieden. Moreover, the post-war tendency of most European governments to try to stimulate growth with Keynesian policies (e.g. combating unemployment by running government deficits to pay for public job-creation schemes) clashed with the requirements of the ERM. There was a clear conflict between the domestic policies of the Socialist government of

1 In 1967 the European Economic Community was merged with the European Coal and Steel Community and the European Atomic Energy Community to form the European Communities, more commonly referred to in the singular as the European Community.

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Francois Mitterrand in its first two years and French membership of the ERM, leading to a succession of embarrassing devaluations.
However, by linking the ERM to the broader goal of European integration it was possible to sugar the pill of fixed exchange rates. Two of the major political parties in France and all the major parties in Italy supported “Europe” (shorthand for the idea of an ever closer union). Mitterrand saw the March 1983 French municipal elections as furnishing fresh evidence of pro-European sentiment among French voters. And, like Giscard, Mitterrand saw sustaining the ERM as essential to maintaining French influence within Europe. Jettisoning his earlier socialist policies, he appointed the economist Jacques Delors as a “super minister” of Economics, Finance, and Budget. The MitterrandDelors austerity measures halved inflation from 12.6% in 1982 to 6% in 1985 (though at the cost of driving up unemployment above 10%). In French eyes, this price was worth paying only if it meant maintaining France’s position as one of the two leading actors in Europe, alongside Germany. By the late 1980s, the ERM was coming to be regarded as a success. Exceptional currency realignments had initially been allowed, but these had grown less frequent over time. In the first four years (1979-83) there were seven; in the next four years (1983-87) there were four; but in the next four years (1987-91), there were none (see Exhibit 3a).17 The fact that this coincided with further enlargement of the EC (Greece joining in 1981 and Spain and Portugal in 1986) suggested that “deepening” and “widening” could be pursued simultaneously. The United Kingdom, however, was unenthusiastic about the ERM. British trade unions disliked it for the same reasons French and Italian unions did: in their view, the stability of the exchange rate should come second to maintaining employment and wage levels. An old-fashioned Labor politician, Prime Minister James Callaghan took a similar view and decided not to join the ERM when it was created.18 The Conservative leader Margaret Thatcher, who replaced Callaghan as Prime Minister in 1979, was equally opposed to the ERM (though she favored the trade-liberalizing Single European Act). This was partly for the opposite reason—she wanted to retain the power to set interest rates at a sufficiently high level to reduce inflation, regardless of the effects on the exchange rate and unemployment. She also believed it was wrong in principle to try to “buck the market”.19 But alongside these economic objections there was a political one. Neither Labor nor Conservative politicians wanted to join a system requiring them to subordinate their macroeconomic policy to the German central bank.20 Although World War II had ended thirty-four years before Thatcher entered 10 Downing Street, many British voters remained stubbornly resistant to any further diminution of their national sovereignty. One Conservative minister was forced to resign in July 1990 for saying out loud what many privately thought: that the project for monetary union was “a German racket designed to take over the whole of Europe.”21

Nevertheless, by the mid-1980s, both the governor of the Bank of England and the Confederation of British Industry (CBI) were pressing Britain to join the ERM. Indeed, Nigel Lawson, the chancellor of the...

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previous price price-elast primari prime princip principl privat pro pro-european probiti problem procedur process proclaim produc product profess professor profit prohibit project promis promot prone propon propos protector protest protocol proud prove provid provis public publish pull purchas pure purpos pursu put qualifi quantiti quantum question quiet quit quot r racket rais ran rang rapid rate rates.46 rates.8 rather ratif ratifi ratio ration rawi reach read readi real realign realiti realiz realli reason rebuff rebutt recal received.112 recent recess reconstruir recov reduc refer referendum reflect.5 reflex refuge refus refused.51 regard regardless region regul reignit reject rejoin rejuven relat relationship relianc reliant relief reluct remain remaind remark remov render renounc repeat replac repo report repres reproduc repurchas reput request requir research resembl reserv reserves.94 resign resist respect respond respons rest restrict result resum resumed.116 retain retort return reunif reunifi rev revalu review revolt reward richard ridley right rigor rise risk risk-reward road robert role romania rome room rose rout routledg rudig rule run sacrif said sake sank save saw say scale scheme schlefer schlesing schmidt school scientist scrape second second-ti secretari sector secur see seem seen self self-fulfil selffulfil sell seller sentiment seoul sep septemb serious serv servic set settlement seven seven-year seventh sever shadow shall shambaugh shape share shift shiratori shock short short-run short-sel short-term shorthand show shrug side sign sign.39 signific similar simpli simultan sinc singl single-hand singular sink sinon situat six skeptic skyscrap slight slim slovakia slovenia slow slump small sme snake so-cal social socialist sold sole somehow someth somewher soon soro sort sought sound sourc sovereignti soviet spain spanish speak speci special special-interest specifi spectat specul speculate.106 speech spend split spoke spokesperson spécule stabil stabl stage stake stall stand standard stanley start start.32 state state.60 statement stateown statist statutori stay steel stefan step sterl still stimul stock stood stop straightforward strain strategi street strengthen strike stroke strong struggl stubborn studi stun subordin subsequ subsidies.62 substanti succeed success successor suffer suffici sugar suggest sum summer super suppli support suppos sure surg survey surviv suscept suspend sustain swamp sweden swedish swift synchron system tabl tacit tailor take talk target.22 taught tax taylor technic technolog telegraph temptat ten tenaci tend tendenc tension term text thatcher theater theater-go theori therefor thing think third thirti thirty-four though thought thousand thousand-fold threat threaten three threw thus tie tier tighter time today togeth told toni too.69 took toppl tori total tough tourist toward town trace trade trade-liber trade-off tradeoff trader transact transaction-cost transfer transform translat transmit transpar treati treaty.66 tremend trend tri trilemma trillion trump tuesday tunnel turbul turmoil turn turnov twelv two two-way u.s uk ultim unanim unattain unauthor uncompetit uncompetitive.41 understand understood unemploy unenthusiast unexpect unfold unforeseen unfortun unif unifi unilater unimped union union.33 union.87 unit uniti univers unless unlik unlimit unmitig unorthodox unravel unstabl up.74 upper us use usher vain valu value.2 valéri varieti various vast verbal verdi versus vice victori view vis vis-à-vi visitor vol voluntari vote voter vulner w wage wait wake wall walsh want war warrant way weak weak.118 weaken weaker websit wednesday week weekend weight well well-nigh wesley west western westview whatev wherea whether white whole wide widen wider widespread wiley will win withdraw within without wittich won wonder wood work worker world worri worth would write wrong wrote www.bis.org www.hbsp.harvard.edu www.hbsp.harvard.edu/educators. www.newyorkfed.org www.newyorkfed.org/markets/foreignex.html). wyplosz xx year year.117 yet york à