Gerard Lyons: Black Wednesday, 30 years later. What is similar, what is different – and what Kwarteng should say on Friday.

dr Gerard Lyons is a Senior Fellow at Policy Exchange. During his second term as Mayor of London, he was Boris Johnson’s Chief Economic Adviser.

Last Friday marked the 30th anniversary of the day the pound tumbled out of the Exchange Rate Mechanism (ERM) – Black Wednesday as it became known.

Many aspects of that time are worth reflecting on as they may be relevant to today.

Perhaps most important is the need for credible economic policies, otherwise you will be penalized by the financial markets.

At the time, the policy of pegging the pound to the Deutsche Mark in the ERM made no sense, although economists and markets initially thought it would work. In contrast, Liz Truss’ new pro-growth economic strategy now makes sense, although it appears that the economic consensus and markets need convincing.

Black Wednesday should remind us never to underestimate the power of the markets. The markets are currently in a feverish mood.

But a welcome difference is that in 1992 it was a rigid currency peg that proved unsustainable. In contrast, we now enjoy the flexibility to adapt economic policies to our current needs.

The focus for the new Truss government is that monetary policy from an independent Bank of England should contain inflation and that while fiscal discipline is essential to curbing public spending and reducing debt, fiscal policy also helps must stabilize the economy. For example, the risk of exorbitantly high energy prices is shifted from citizens and companies to national debt.

Another lesson learned from Black Wednesday is how badly the consensus proved wrong despite being convinced it was right. At the time, I thought a devaluation of sterling was inevitable for whoever won the April 1992 elections. Devaluation was not the consensus view. Furthermore, in my view, it was clear that a devaluation would benefit the economy, as not only would the pound fall to more competitive levels, but interest rates would fall and boost the economy. In contrast, the economic consensus at the time was that a devaluation would raise interest rates and a recession would follow.

The UK has not been able to escape global trends in recent weeks. The dollar is now at its strongest against sterling since 1985. This is not a unique British situation. In fact, the dollar is strong across the board. It is seen as a safe haven and is also recovering as the US Federal Reserve raises rates aggressively and is bold in its anti-inflation messages.

Meanwhile, fears of inflation and higher interest rates have impacted bond markets across western economies, pushing up loan yields. This has also hit the UK, although lending rates are still low in real terms, i.e. measured against inflation.

The markets have some concerns. They are concerned about inflation, although it is expected to peak at around 11 percent in October and slow next year. Limiting energy prices has helped.

They also fear the economy will be hit hard by policy tightening. Also, the combination of rising interest rates and increased borrowing means borrowing costs could continue to rise and trigger a firmer sell-off in financial markets.

Monetary policy is a particular concern. Financial markets fear that whatever exit path the bank takes on interest rates, there will be problems, either because sterling is vulnerable if interest rates don’t rise enough, or that the economy and debt servicing will suffer if interest rates rise rise sharply.

Two wrongs don’t equal one right. Last year the bank made a big mistake by not raising rates at a time when it was clear that inflation was going to rise and the economy was recovering and would have been able to cope. The concern is that the bank is now tightening monetary policy too aggressively to close its credibility gap – when the economy and markets are less able to deal with it.

The prime rate is 1.75 percent. Markets expect rates to hit 4.5 percent and remain elevated. Past experience shows that bond markets often do not settle down until they are certain that the rate hike is nearing completion, and we are still a long way from that.

Therefore, one area that deserves attention is the way the bank is reversing its quantitative easing (QE).

The UK’s total debt is £2,712 billion. Because of QE, a whopping 31 percent or £838 billion is now held by the Bank of England. These cannot simply be written off, but to reduce their holdings the bank would need to sell gilts. Unfortunately, the bank doesn’t seem to have fully considered its exit strategy as it expanded QE in recent years.

The market’s ability to digest both normal gilt issuance by the Debt Management Office and additional selling by the bank through quantitative tightening (QT) is a concern. Further fiscal easing could amplify such market concerns. In my view, it would be better to pause QT for now – ideally waiting for the fiscal deficit to be lower or economic growth to be higher instead. Courses and QT are topics for the bank.

There were also some misplaced concerns about institutions – notably the Bank of England’s independence – but one might assume that such concerns would be dispelled over time as they have little basis.

Fortunately, the Chancellor can make a mark at his upcoming financial event. There he can also address market concerns while outlining the policy framework.

For example, the freezing of energy bills and the reversal of planned tax increases are positive developments and should prevent the deep recession that seemed unavoidable just a few months ago. Indeed, the greatest threat to public finances would have been such a deep recession.

However, a slowdown is already underway, here and around the world. While a recession is still possible, if it does happen it would be shallower and short-lived. In fact, the labor market is still healthy.

When it comes to fiscal policy, while markets should understand that easing is necessary to stabilize the economy, they worry – probably unnecessarily – that it may be inflationary or unaffordable.

I have already argued here that fiscal policy and the supply-side agenda can transform the economy – with a particular focus on encouraging investment and creating the right incentives.

But the chancellor needs to get his fiscal principles straight so the market understands the obligation to exercise fiscal discipline by reducing the debt-to-GDP ratio. Markers may need to be set to guide market thinking.

It is also non-inflationary because the inflationary shock is triggered by supply-side factors and the economy does not overheat as domestic demand slows. Therefore, targeted fiscal easing should not force interest rates higher than they otherwise would be.

However, the question of affordability can influence the timing of fiscal measures – such as whether plans to cut income taxes, increase tax credits, lower high marginal tax rates and create investment zones will take place in this fiscal event or in an upcoming budget. But such measures make sense.

Finally, a lesson of Black Wednesday was how events, even early in the life of a new government, can have a major impact on the subsequent election. Then Black Wednesday happened shortly after the April 1992 election, but its shadow was cast over the May 1997 election result. Now that elections are due to be called by the end of 2024, politicians must achieve quick successes.

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