Inside Story: The breaking of the pound: The long plunge into crisis is chronicled by Christopher Huhne, Donald Macintyre and John Eisenhammer
At the stroke of 11, the Bank had announced a measure the Chancellor had desperately hoped to avoid: a two-point increase in interest rates to 12 per cent. British business and industry would be appalled and people with mortgages sickened. But, his many advisers agreed, it was the only thing that could save sterling on the foreign exchange market. It had to be done.
As the seconds ticked away past the hour, Lamont stood with officials by the desk of his private secretary, Jeremy Heywood, watching a Reuters screen for signs of the market reaction to the Bank of England's announcement. The rate against the German mark, locked at 2.7780, should have been going up. One minute elapsed; then two minutes. There was no movement. Traders, it seemed, were taking their time to digest the news.
At that point, apparently unable to stand the tension, Lamont turned his back on the screen and walked into his long wood-panelled office to sit alone smoking one of the dozens of cheroots he was to get through during that extraordinary day. A moment of calm and silent consolation, it might have been a scene from a Hamlet commercial except that the punchline was to be rather different.
The Chancellor allowed himself 10 minutes, then he returned to the outer office and walked over to the Reuters screen. Sterling was still, as an official would later describe it, 'flat as a pancake'.
Although that 'extremely turbulent and difficult day', as he later called it, held many more twists and turns, Lamont almost certainly knew then that the game was up for Britain's membership of the exchange rate mechanism, the cornerstone of his policy as Chancellor.
CRISIS had been stalking sterling for weeks, some would say for many months. Britain's long and miserable recession has been far worse than anything seen on the Continent. A weak economy would normally drag down a currency automatically, but for almost two years sterling had been a member of the European Monetary System, its rate guaranteed within prescribed margins by the solidarity of the 11 EMS member governments, and held up most of all by the strength of the mighty mark.
The EMS had become central to all Britain's economic policies, and the Government was intent on exploiting its disciplines to wring inflation out of the economy. Indeed, such was John Major's enthusiasm that he told one newspaper he wanted sterling to become stronger than the mark itself. Events would mock those words.
Three developments brought the pressure on the pound to a head. First, with US interest rates at 3 per cent, their lowest for 20 years, the dollar became a less attractive buy for investors.
Second, German interest rates are unusually high at nearly 10 per cent. This was Germany's way of squeezing out the inflationary effects of the huge increase in public spending involved in rebuilding what had been East Germany.
Dealers and investors deserted the dollar, buying marks and pushing up the German currency. Britain had no choice but to hold rates high or see a flight of currency to the banks of Frankfurt and a consequent collapse of the pound. This, cruelly, depressed the British economy further as companies and houseowners struggled to service their debts.
All this might just have been endurable had it not been for the third factor: the decision of the French President, Francois Mitterrand, to hold a referendum on the Maastricht treaty. One element of Maastricht is a timetable for progress towards a single European currency. As the financial markets knew well, if this schedule was to be met, governments would have to show even greater monetary rigour than was already dictated by the EMS. Acceptance of Maastricht across the EC would underpin the member currencies.
Denmark, however, had already rejected it and its future was uncertain. If France voted 'no', the EMS, with all its internal stresses, would be shaky. Monetary discipline in the EC, instead of tightening, might weaken. As the summer passed and a 'no' vote looked steadily more likely, foreign currency dealers, multinational companies and large international investors grew increasingly concerned that European finance would crack down the middle.
The crack, they imagined, would divide a 'first tier' of strong currencies including the German mark, Dutch guilder, Belgian franc and probably the French franc from a 'second tier' of weaker currencies, mainly those of the Mediterranean countries but also including the pound.
Dealers, companies and investors saw their self-interest clearly. To guard against losses they would hold as little of the second tier and as much of the first tier currencies as possible ahead of the French referendum. Holdings of weak currencies were sold and companies brought forward the purchases of German marks or dollars they had intended to make at a later date to pay for future imports.
This was the position two weeks ago, when the finance ministers and central bankers of the EC gathered for a routine weekend meeting in Bath. The mood was one of tension and alarm; matters were perceived to be getting out of hand.
One man was the principal butt of criticism: Helmut Schlesinger, the tall, silver-haired president of the Bundesbank, Germany's central bank. High German interest rates, for which Schlesinger bears responsibility, might appear to suit immediate German needs, he was told, but they were dragging down the rest of the Community and delaying the economic upturn that Germans too wanted to see. The message was clear: German rates should be cut.
Schlesinger proposed a different solution. He made a plea, stacked with facts and figures, for a general realigment to ease the tensions in the EMS.
Realignment is the measure by which governments change the rates at which the currencies are held within the EMS: the mark would go up, others down. In principle it is a simple, technical business, but it has far-reaching economic consequences for all involved, and is usually politically unpopular. Most people regard it as a sign of failure for the EMS and defeat for governments. Schlesinger argued, however, that the exchange rates no longer reflected the relative strengths of several economies. A realignment was vital to ease the strain. His words were not just ignored, but scorned by politicians committed to monetary union. Schlesinger was so angry he rose at one point to storm out of the meeting, and was only restrained by the German Finance Minister, Theo Waigel.
The days that followed saw the warnings of strains turn into brutal reality. As the odds shortened on a French 'no' the market drift from 'second tier' currencies to the 'first tier' acquired a momentum of its own. The first to feel the sting was the lira. With the Italian economy, political system and rule of law all cracking, it was an obvious target. Selling became a stampede and the central banks of Europe, as they are required to do, stepped in to prop up demand by buying lira.
Since most of the lire were being sold in exchange for the strong mark, it was Schlesinger's Bundesbank that found itself buying most heavily. For the dealers, increasingly certain that the Italian currency would have to be devalued, this arrangement was too good to be true. You could sell lire for marks at a fixed price in the confident expectation that after the devaluation you could buy back the lire more cheaply. Better still, the more you sold the more likely it was that Italy would have to devalue. Everybody with lire, including many quite small businesses in Italy, was getting in on the act. On Friday alone, Schlesinger spent billions of marks in the biggest central bank support operation in two decades.
On Friday night, the Bundesbank president telephoned Helmut Kohl. 'Mr Chancellor, things are getting out of control,' he said. 'If we don't get a realignment, the whole system could fall apart. And the mark would go with it.'
Schlesinger, the hardest of the hard men at the Bundesbank, professorial sometimes to the point of pedantry, is not a person easily flapped. This was enough to get Kohl shouting for Waigel on another line.
The Chancellor and Waigel agreed to press for an urgent realigment but, aware of the demands from their European partners, they also pointed out that it would have to be accompanied by a German interest rate cut. Schlesinger, still smarting from the meeting in Bath, was in little mood for any such deal.
Hasty finance ministry contacts with Rome had by now formed the outlines for a lira devaluation. But the British and Spanish, whose currencies were next in line, were refusing to go along with it. Schlesinger, who was prepared to make the painful and sensational U-turn of a rate reduction only if there was a general realignment, continued to resist. On Friday evening, Kohl took the extraordinary step of flying to Frankfurt with Waigel and his top international finance expert, Horst Kohler, to confront Schlesinger in person. They pushed the deal through.
Schlesinger was in a far from happy mood as on Saturday morning he began phoning round the other 17 members of the Bundesbank's decision-making central council, to win support for the interest rate cut/realignment package. For the bank's central council alone decides interest rate movements in Germany, on the basis of a majority vote.
The members, the 11 heads of the state central banks, which are mini-Bundesbanks, and seven professionals from the Bundesbank itself, are fiercely protective of their independence. The arguments are often acrimonious, and so they were that Saturday. Schlesinger sought the nine votes he needed to get the deal passed. Eventually, he was able to inform Waigel there would be an extraordinary Bundesbank meeting the following morning at which an interest rate cut would be approved.
In Britain, this news was greeted with enormous relief. The pound's distress through the previous week had barely been masked by the extraordinary collapse of the lira. The Chancellor and his officials had been obliged to talk the pound up all week, repeating again and again their determination to stay in the EMS and keep the existing rate against the mark.
Major, in a forthright speech to the Scottish CBI on Thursday night, mocked the devaluation option as 'fool's gold' and restated his determination to keep the EMS at the heart of British economic policy. 'He's put his job on the line,' one currency dealer said.
Now the Government could look forward to the first cut in German interest rates in five years to help sterling and boost the economy. In the City as well as Whitehall, Monday dawned with an unfamiliar sense of optimism in the air.
ON THE 11th floor of the Bundesbank's concrete monolith in Frankfurt, the mood was rather different. The members of the central council were outraged. On the previous evening, on the island of Sylt, where Kohl was with the Spanish Prime Minister, a beaming Waigel had gone before the television cameras to declare that, alongside the lira devaluation, the Bundesbank central council would hold an extraordinary meeting the next morning to set a cut in German interest rates.
'Our blood ran cold when we saw him,' one central council member said. 'Mr Waigel's show was utterly unnecessary. It made it look as if the Bundesbank had crumbled under political pressure.' There was even talk of resignation by some members, but they found a different way of venting their fury.
What they announced was a grudging quarter-point interest rate cut, the smallest possible. Schlesinger made no effort to disguise the bad grace, stressing that domestic economic considerations, taken in isolation, would 'not have allowed this easing of the monetary reins'. His deputy, Hans Tietmeyer, described the cut as a 'limited signal'.
In London, there was no disguising the disappointment, although Downing Street tried. In an extraordinary departure from the usual official reticence on interest rates, an official declared: 'It probably has brought forward the time when British interest rates will move.' He meant downward. Nobody was fooled. Nevertheless, most large banks and finance houses were still convinced that the Government would hold the line on sterling.
The pound finished the day two pfennigs up at DM2.8125, comfortably above the EMS floor, the minimum permitted level, of 2,7780. The French vote was a week away, but it looked just possible that sterling might survive until then.
IT WAS lunchtime on Tuesday when things began to fall apart.
The trigger was the lira. Dealers who had bought back the devalued lira at a profit began to sell again. The mark was the easiest route, so for the most part that is what they bought. The mark began to gain strength and other currencies to weaken correspondingly. Sterling wobbled, then slipped. A rumour, soon confirmed, helped speed the decline: Major had cancelled a trip to Spain at short notice. The market construed this as a sign of weakness, or even panic.
This decision had been taken 12 hours earlier, with the pound still strong. The public reason was pressure of work, but there was another reason. The main purpose of the trip was to be a visit to the British pavilion at the Seville Expo, but it was emerging that this might prove embarrassing. A shop and a restaurant in the pavilion had gone bankrupt, and there were problems with the building itself.
The cancellation, at such a moment, was unfortunate. Dealers and the media were quick to recall the infamous occasion in 1976 when Denis Healey, then Chancellor, turned back on the road to Heathrow airport to tackle a sterling crisis, thereby making the crisis worse. The parallel may have been false, but it was employed to justify the pound's downward trend. Some of the largest British pension funds and some multinational companies began to get rid of their sterling holdings.
According to Ifty Islam, currency strategist at Barclays de Zoete Wedd, the market was unnerved at this stage because the Bank of England had made no significant attempts to intervene in the pound's favour. 'The key to intervention in this dollars 650bn-a-day market is timing - it is a game of bluff and signals. Central banks cannot alter the balance of demand and supply. If you added all their reserves together it would not equal one day's turnover in the foreign exchange market.'
The Bank had missed a chance to influence the market when it might have done so relatively cheaply. The pound, finding no ground beneath its feet, slid down to close 3.25 pfennigs lower at 2.7800 marks, its lowest level since joining the EMS 23 months before and a whisker off its floor.
At 6.45pm on Tuesday, in the Chancellor's office in the Treasury, the first of a long series of high-level meetings took place to plan strategy to save the pound. Present were the Governor of the Bank of England, Robin Leigh- Pemberton, and the Bank's executive director, Ian Plenderleith. They briefed Lamont and his Treasury team on the day in the markets. The conclusion was inescapable: the following day, the pound would face exactly the kind of furious pressure that had forced the Italians to devalue.
The outline of a defence plan was drawn. The first line would be overt intervention: standing openly in the market to buy the pound before it hit the floor of the system. The second line was interest rates, a weapon that carried the risk that it could cripple business and prolong the recession. For the first time, the serious possibility of a 2 percentage point interest rate rise was mooted.
After the meeting, the Chancellor dressed for dinner and made his way to the American ambassador's elegant residence in Regent's Park. He knew sterling's future was on a knife edge, but he still had weapons to defend it and he might yet prevail. Ray Seitz, the affable anglophile who is the US ambassador, was just the right company for the night before the battle. Unfortunately, Lamont's evening was ruined, and again the blow came from the Bundesbank.
At 4pm that day, Schlesinger had received in his office two journalists, from the Dusseldorf financial paper Handelsblatt and from the Wall Street Journal. It was an on-the-record interview, although, as usual, the Bundesbank reserved the right to approve or alter before publication any quotes attributed to Schlesinger. The two papers intended to publish the interview on the Thursday.
When the Handelsblatt correspondent, Werner Benkhoff, returned to his office he and his editors realised they had a story too good to hold. They decided to publish straight away, in the Wednesday edition. It was too late to go back to the Bundesbank and go through the quotations, so a device was employed. The story was printed without any quotations, all of Schlesinger's remarks appearing as indirect speech.
The story began: 'The president of the Bundesbank, Professor Helmut Schlesinger, does not rule out the possibility that, even after the realignment and the cut in German interest rates, one or two currencies could come under pressure before the referendum in France. He conceded in an interview that the problems are of course not solved completely by the measures taken.' Handelsblatt, as is its custom, issued advance notice of the story to news agencies on Tuesday evening.
The measured tone of these words belies their extraordinary power. Schlesinger might as well have said: 'More EMS currencies are going to have to be devalued this week.' Or, in the shorthand of the market: 'Sell sterling, lire and pesetas.'
Lamont was telephoned at the ambassador's residence and given the news. He left the dinner table and made a series of desperate calls in an effort to limit the damage. The Bundesbank was persuaded to deny the report, but it was too late. Lamont called another strategy meeting of his advisers early in the morning.
'The Chancellor was extremely upset by the Schlesinger interview,' one adviser said. 'I didn't realise the extent of the differences between them. I did not realise how upset Schlesinger had been about being pressured into the Bath finance ministers' statement about no need for higher interest rates'.
A Treasury official said: 'I don't think it was malice. I think it was incompetence. Schlesy is a courteous German of the old sort. He's just a bit nave and he was upset by the implication that he was being got at by Kohl and Waigel.'
The group that met at 8.30 at the Treasury on Wednesday morning were already tired and grim. They were led by Sir Terry Burns, the Treasury's permanent secretary, a jovial grammar school boy and union official's son who became an academic economist before moving into the Treasury as chief economic adviser.
The other senior people were the dour Nigel Wicks, the second permanent secretary in charge of international finance, Alan Budd, the chief economic adviser and long-time associate of Sir Terry, Bill Robinson, the Chancellor's special adviser, the rising star Andrew Turnbull, deputy secretary in charge of monetary policy, and the Chancellor's private secretary, Jeremy Heywood.
Representing the Bank were the Governor and his deputy, the chain-smoking Eddie George, nicknamed 'Rock Steady Eddie' for his unflappability.
They draw up detailed lists of tactics - weapons - to impress the markets. 'We were always aware that the game could end in suspension,' said one, 'but we were determined to give it our best shot.'
After the meeting, Lamont telephoned Major to brief him on plans. The scene was set for a desperate attempt to save sterling.
AS THE markets formally opened at 9am, Major was convening a Cabinet committee meeting, originally intended to discuss Maastricht. The group included Michael Heseltine, President of the Board of Trade, Douglas Hurd, Foreign Secretary, Kenneth Clarke, Home Secretary, and Richard Ryder, the Chief Whip. It is an interesting cast: not only does it comprise the most senior ministers (officials talk of the 'Big Beasts'), but in Hurd, Heseltine and Clarke it includes the three most important pro-European Tories.
They held a total of three formal meetings during the day, their numbers augmented often for a short time by officials such as Sarah Hogg, head of the Downing Street policy unit, and Sir Terry Burns.
They met, not in Number 10, where building work was in progress to reinforce windows, but in the rather luxurious surroundings of Admiralty House, which is usually used for government hospitality. The ministers had no market printer or Reuters screen, so they had to wait for periodic updates on the crisis to be brought in on slips of paper or telephoned from the Bank of England or the Treasury.
One participant recalled: 'Of course a lot of time in these meetings was spent sitting around waiting for a phone call. But it was quite a cheerful atmosphere, oddly. I suppose it was spirit of the First World War trenches.'
In the markets, the Bank of England, the Bundesbank and the French central bank were soon buying sterling heavily as the pound dropped to its floor. It was very soon apparent that the tactic was not working. It was the lira all over again.
Seeing this, Lamont deployed his second big gun. At 10.30 he telephoned Major in Admiralty House to request permission to raise interest rates by 2 percentage points. This permission was a formality; the shape of the defence had already been determined. Major said yes, and passed on the news to his increasingly depressed colleagues.
At 11am, the Bank of England announced the rate change and a couple of minutes later Lamont adjourned to his office to smoke his lonely cheroot. The gun was fired but, as he saw once the cheroot was stubbed out, the attackers simply kept coming.
The failure itself fed the frenzy: if the Government's armoury was not working, a devaluation became more certain. Sellers redoubled their efforts and the Bank of England continued to soak up sterling. The cost was almost unimaginable: the British currency reserves had stood at dollars 44bn, and one third of it was spent in the day.
'I can't stress enough the sheer scale of the selling,' an adviser said. 'This generation at the Bank had never seen anything like it. A lot of contingency plans had been laid, but every new weapon we brought out seemed to have less and less effect on the market. It was as if an avalanche was coming at us.'
At 12.45, the key meeting of the day was held in the dining room at Admiralty House. The Prime Minister assembled his 'Big Beasts' once again. The Chancellor arrived with Sir Terry Burns, followed by the Governor and the Deputy Governor. Number 10 fielded Sarah Hogg, Robin Butler, the Cabinet secretary, and some senior officials.
Leigh-Pemberton is normally a diffident country gentleman, but he and his deputy could not have stated the situation more clearly or firmly. 'The meeting at lunchtime was important because the Bank laid it on the line about how difficult, nay impossible, it was to hold the line,' one adviser said. Drastic steps were now needed.
At 2.15, interest rates were raised for the second time in a day, to 15 per cent. In homes and businesses across the country, hearts sank at the prospect of interest payments rising by half. But the truth was that it was a tactical measure, and no one expected it to last long enough to hit mortgages.
The idea was to buy time, so that an even more sensational step could be taken: the withdrawal of sterling from the EMS. And there was another reason. The Government wanted to keep open the option of going back into the EMS, and so had to be seen to have tried everything. 'If 12 per cent was all we had done, people would have said that we had held back from doing what was necessary,' one adviser said. 'My great fear was that it would work.'
The Prime Minister consulted Chancellor Kohl and the French Prime Minister, Pierre Beregovoy, on the telephone shortly after 3pm, explaining the great difficulties Britain was having in keeping to the rate and also that the Schlesinger remarks had sparked the problem. There was, though, no rancour in the Prime Minister's calls. 'It was not the shouting match some people portrayed.'
Why withdrawal? Why not devalue? The Italian example stood as a warning. The Italians had tried a 7 per cent devaluation and were already pinned to the new floor. Devaluing the pound would merely have given the markets another target to shoot at.
The final prime ministerial meeting of the day was held at 5pm. An hour earlier the market had formally closed and the requirement to buy sterling had lapsed until the next morning. Closure at 4pm is a fiction; trading goes on, and once the Bank of England pulled out the pound had gone through the floor.
The withdrawal had been agreed and a special meeting of the EC's monetary committee had been called in Brussels that night to approve the change formally and discuss what more should be done. Nigel Wicks was despatched to request that the whole EMS system should be suspended. (In a final humiliation for the Government, this option was to be contemptuously rejected. Instead only the lira and the pound were pushed out, with the Spanish peseta staying in with a 5 per cent devaluation.)
By this time, Treasury bitterness with the Bundesbank was high. One official asked another how the Treasury delegation would travel to Brussels that night. 'The RAF are taking them,' he was told. 'Let's hope they get out their World War II maps of Dusseldorf before they go,' the official retorted.
Lamont found time to watch the now famous interview on ITN with Mark Clarke, a currency dealer at Bank of America who said he had dumped pounds 500m of sterling. 'We've had an excellent day. We've made a lot of money,' he told 8.5 million viewers. Asked how much he made selling pounds that day the trader replied ' pounds 10m.' Lamont, confronted so bluntly with the previously unseen force that had defeated him, shook his head and turned to the young official next to him. 'That's capitalism,' he said.
Once he had made his statement on the steps of the Treasury, an almost tangible sense of relief swept through the Treasury. Senior staff ordered pizzas and opened a couple of bottles of wine. They watched as, in New York, sterling immediately fell to 2.687 marks, glad at least that they were no longer required to stand in the way of the whirlwind.
Late in the evening the Prime Minister rang the editor of a pro- Tory national newspaper. How was the story going to play, he asked. The editor replied with a blunt phrase making clear that Major would not like what he saw the following morning. There was a pause, and then the editor added, in case there should be any impression on the Prime Minister's part that he was joking: 'And I'm serious.'
(Photographs and graph omitted)
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