"Black Wednesday": two paradoxes

20 years ago yesterday, sterling left the exchange rate mechanism. This episode raises two paradoxes that haven't had the attention they should.

Both exist only if you accept the hypothesis that the conduct of monetary policy since 1992 has been better than what went before. I don't think this is wholly unreasonable. Granted, it's still controversial as to how much post-1992 monetary policy contributed (pdf) or not to the "great moderation" of 1992-2007. And inflation targeting might be inferior to NGDP targeting.But nobody really now thinks inflation targeting is inferior to monetary or exchange rate targets. So in this sense, there has been some progress.

Conditional upon this assumption, my first paradox is this. The decision to join the ERM followed years of intense discussion among economists and yet proved to be a bad one, whereas the decision to adopt inflation targeting was taken hurriedly and yet proved a better idea*. This suggests that cool-headed, lesiurely and informed policy-making after lengthy debate isn't always better than quick panicky decisions.

Leaving the ERM created the conditions for a long period of strong growth and falling unemployment. How far this was due to the falling pound, to lower interest rates or to inflation targeting itself is unimportant for my purposes. Despite this, the move led to a drop in Tory support from which the Major government never recovered, and the day was long known as "Black Wednesday"; efforts to rename it "Golden Wednesday" never succeeded.

Which gives my second paradox: a government that takes a decision that's good for the economy can actually suffer from doing so. I don't think this is because voters blamed the government for taking us into the ERM in the first place. For one thing, that decision did not prevent the Major government winning the 1992 election. And for another, the decision had bipartisan support; Labour's 1992 manifesto promised to "maintain the value of the pound within the European Exchange Rate Mechanism.**" Instead, I suspect the Major government suffered from being seen as too weak to defend the pound, even though such weakness was good for the economy.

Putting these two paradoxes together suggests something curious - that informed expert opinion on economic policy can sometimes be wrong, and so can voters.

* Milton Friedman had suggested (pdf) price-level targeting in 1968, but by the early 90s there was little interest in the idea in the UK.

** An interesting exercise in counterfactual history would be: what would have happened if Labour had won the 1992 election and been forced out of the ERM? It would have suffered a reputation for bad economic management, and we'd not have had a New Labour victory in 1997.

Comments

[Keith]

There has been a strong tendency despite contrary arguments for the political ruling class and economist policy advisers to back a fixed exchange rate including the Gold standard for literally over a century and a half. The Gold fix also fixes the exchange rate of all the participating territories with respect to each other. I interpret this as the explicit and implicit power of finance capital. Fixed exchanges appeal to those who want to move capital around based on only private gain as it makes the location of investment irrelevant in theory. Money invested in Rio de Janeiro is as safe as Sunderland.

In practice fixed exchange rates restrict the freedom of monetary and fiscal policy and so have been abandoned repeatedly. People in Rio de Janeiro do not vote in British Parliamentary elections but the Geordies do. The fact people interpret the need to ditch the fix as a verdict on the Government is amusing and reflects the erroneous idea that a "strong" currency is good like a virility symbol. But it is also a reflection of the failure of the contrary arguments for a float to be taken seriously by the ruling class so the verdict is just. Accidentally adopting the right policy as the speculators crash your wrong policy is hardly a reason to reward the Government in power. Both Labour and Tory talk balls and it is reality that forces them to do the correct thing. It took the Invergordon Mutiny to scupper the Gold Standard. All the chatter at upper class dinner parties about the wonderful power of magic metal was put to silence.

[Nick Rowe]

Really good post. On your first paradox: spot on. I have spoken to the people who were in at the very beginnings of inflation targeting in Canada, and they basically confirm what you say. To oversimplify massively, the story goes like this:

New Zealand: The new PM wanted every government department to set a target, for public choice reasons. When he asked the RBNZ what their target would be, they replied: "Ummmm, dunno. Inflation?"

Canada: The Bank of Canada was trying to reduce inflation, but it didn't say how much. Businesses were trying to negotiate wages with their workers. They complained that it was hard to do this if they didn't know what inflation rate the Bank of Canada was aiming at. So the Bank of Canada thought about it, and invented inflation targeting.

Inflation targeting did NOT come out of a university seminar.

[Britmouse]

Nice post! The Treasury papers released in 2005 are a real gold mine, and lots of discussion of NGDP :)

http://www.hm-treasury.gov.uk/foi_introduction_of_inflation_targets_2005.htm

[Nina]

Sometimes informed experts view can be wrong, because most of the time experts propose economic policies based on what they know from previous experience.
Economics is a very dynamic field as new markets emerge and nations put up new political fronts to “safeguard” their nations’ interests.
A policy that might have worked previously in a particular situation is not a given that it will work in what is seemly a similar situation because of all the human dynamics that are involved. As such when economics are confronted with new challenges, they have to study every variable to see how each every responds to different situation. This is quit daunting and challenging, for this reason, when economist put up their proposals, they should do so with some sense of apprehension and caution.

[Bernie G.]

I can’t recall that at the time many voters had an opinion about the ERM outside of the fact that it caused us all a lot of pain. We had struggled to pay mortgages with the 16% price tag that was deemed necessary to meet the requirements of the ERM. Following so-called Black Wednesday, after the Germans had contrived to have us ejected, Lamont dismissed the years of pain with a good riddance, implying he’d always thought the ERM a dumb idea anyway. That hurt, it really had been a struggle, and people wanted payback for Lamont’s glib remark. Much as we would have liked to deliver a message to the Conservative Party in 1992 the thought of Kinnock leading the country was too much. I don’t believe any of us thought he was intellectually capable. That Black Wednesday proved to be good for the country didn’t figure in our calculation when voting. By 1997 everyone had become sick of the Conservatives and their internal bickering and just wanted to see the back of them. Blair was a credible cross-party option.

[John H]

I think the main reason why Black Wednesday had such an impact was that at the time it was experienced as a rather traumatic and chaotic event, and that sudden shock had a greater impact on perceptions than the longer-term economic benefits that followed. I wonder if the Tories would have done better to ditch Norman Lamont straight away - pinned as much of the blame on him as possible (however unfairly) and presented his successor as the "new broom", sorting out the mess (rather than singing in the bath...).

[Broilster]

"whereas the decision to adopt inflation targeting was taken hurriedly and yet proved a better idea*."

Really? Given where we are now, does anyone still believe this? Methinks it's another of those Zombie ideas that refuses to die despite its not even tenuous link to growth.I mean isn't inflating away some of the debt one of the options de nos jours?

"Putting these two paradoxes together suggests something curious - that informed expert opinion on economic policy can sometimes be wrong, and so can voters."

I can't work out if this has been written with tongue firmly in cheek. If not, is it a more significant conclusion than that one plus one equals two?

[Account Deleted]

The Major government suffered because it made a totem of the ERM, or more specifically the Pound shadowing the DM. The modern equivalent would be Osborne banging on about the importance of low yields on gilts.

If the (paradoxical) impact of austerity is that it balloons the projections of future debt, then we could see yields rise as a symptom of the market's lack of confidence (or expectations that inflation will be let rip in lieu of tax rises). Hoist/petard time.

The real significance of Black Wednesday was that it was the last time we worried about a run on the Pound. Consider the generally favourable reaction to the 25% devaluation since 2007.

[Matt Nolan]

Nice post.

"New Zealand: The new PM wanted every government department to set a target, for public choice reasons. When he asked the RBNZ what their target would be, they replied: "Ummmm, dunno. Inflation?""

I don't think that is a particularly fair conception of what was going on at the time Nick - the Labour party, and applied economists wandering around the country, were keen on price stability, and growth in the CPI of 0-2% given the bias in the CPI was seen as a justification for price stability.

There was a tacit belief between political parties and economics institutions at the time that price stability was the sufficient, and only achievable, goal of monetary policy - this may not be accepted now, but it was the justification.

At least, this is the story I've been told - I was a bit busy running around a field to actually observe what was going on in real time.

Yes, there was no welfare maximisation models that suggested this at the time - so the principles behind the policy were different. It doesn't mean they just made things up because they sounded good though - it was given certain assumptions between the optimal price level and the inflation-output trade-off.

[Nick Rowe]

Matt: OK. I was a little tongue-in-cheek there. But isn't it correct to say that the idea that the RBNZ would be held accountable for hitting some announced target came from the PM, for public choice reasons, wanting all government departments to do the same?