George Soros Shorting the Pound: What the Christ?

Never one to pass up the chance to write a long-winded post on semi-relevant economic affairs, I thought I'd leave my response not sullied and obscured in the dark alleyways of the comment section unbeknownst to the vast majority of this blog's readership, but out in the clear, clean open as its very own post.
If you're too lazy to scroll down a tad, Dave made the following request:

Could someone (Ben? Lion?) explain, though, what specifically [George Soros] did to the British sterling to make him so much money?

If you're wondering who George Soros is, I'd direct you to the previous post no matter how lazy you are. I assume you know who Dave is.

Anyway, since I'm statistically unemployed and Lion is only unemployed in spirit, I thought I'd allow myself the liberty of taking the first crack at Dave's question. I will undoubtedly leave something insufficiently clear or entirely unexplained and if Lion feels this way, he can add on. In the comment section.

Since I don't actually remember all the nitty-gritty details, unless otherwise cited, I will just be posting excerpts of the Wikipedia page on "Black Wednesday" and then translating as best I can. Perhaps you think that's fairly unprofessional of me. On the other hand, I did mention that I was statistically unemployed, so I don't see how you could really expect otherwise.

First, some background:

European Exchange Rate mechanism

Definition

ERM. A system created in 1979 as a way to reduce the volatility of the various Eurpoean currencies and to create a stable monetary system. The ERM created fixed margins in which a country's currency could operate. It was the predecessor of the European Economic and Monetary Union. (Source: InvestorWords)

Ensuring the relatively stability of an exchange rate helps to ensure the relative stability of foreign trade and investment into and out of a particular country. Likewise, ensuring the relative stability of an exchange rate between a number of countries ensures the relative stability of foreign trade and investment between those specific countries. If you're a German banker who wants to invest in France (think pre-Euro), you want to make sure that between the time that you make the investment and the time that that investment matures, the Franc doesn't tank against the value of the Deutch Mark, and with it the value of your invested money. In this respect, stability ensures confidence and confidence ensures increased interconnectedness, economic or otherwise.

How is the stability of a currency ensured? Ultimately, exchange rate manipulation falls under the purview of monetary policy. Monetary policy is essentially anything the Central Bank of a country does. When the Fed of the United States lowers the interest rate (incidentally, something it won't be doing again for the next long while), it is conducting monetary policy by making money easier (cheaper) to borrow and theoretically stimulating the economy.

But as China will tell you, interest rates also play an important role in how much money is invested into a country from abroad. If high interest rates in America impose high borrowing costs throughout the domestic economy (and therefore slow economic growth), it also means that foreign investors will receive a higher return on investments made in America relative to any other country. When the foreign money comes rolling in, attracted by higher interest rates, foreign investors are essentially selling their own currency to buy up American dollars (and with those dollars, American bonds--public and private). When this happens over and over with billions of dollars, the value of the American dollar goes up. Likewise, if the Chairman of the Fed lowers the interest rate this leads many foreign investors to seek higher rates in other countries, leading to a depreciation of the dollar. While recent news might lead you to conclude otherwise, under relatively normal market conditions, monetary policy has a significant and positive impact on exchange rates: high interest rates mean a stronger currency, low interest rates mean a weaker currency. In the United States, the exchange rate value is generally the tertiary consideration of monetary policy-making, behind domestic price control (higher rates mean lower inflation, vise-versa) and counter-cyclical economic stimulus (lower rates increase economic activity, higher rates cool things down).

Not so in Europe under the EERM which was therefore not so much a central mechanism as it was a coordinated policy between a number of European Central Bankers. One such Central Bank was the Bank of England:

...John Major, who, with Douglas Hurd, the then Foreign Secretary, pressured Margaret Thatcher to sign Britain up to the ERM in October 1990, effectively guaranteeing that the British Government would follow an economic^[4] and monetary policy that would prevent the exchange rate between the pound and other member currencies from fluctuating by more than 6%. The pound entered the mechanism at DM 2.95 to the pound. Hence, if the exchange rate ever neared the bottom of its permitted range, DM 2.778, the government would be obliged to intervene.

Again, just to keep this fresh in everyone's mind, if the value of the pound stated to slide (why this might happen in a second), the Bank of England would raise interest rates, attract more foreign investment and appreciate the currency back to the prefered level. Unfortunately, as the Wikipedia article has it in the sentence immediately following, British inflation was 3 times that of the German economy. High inflation bodes poorly for the value of any currency, though according to Wikipedia, the EERM policy was intended as a way to curtail that inflation by keeping the currency stable and the interest rates in steady proportion with the German's who have traditionally maintained a relatively high and stable rate of interest in an earnestly and predictably reasonable Teutonic way.

Unfortunately, to some foreign investors, the whole plan lacked credibility. Did the Bank of England, which had been holding down interest rates for years, have the stomach for higher rates? If inflation persisted and the trade balance worsened, would they be willing to continue to increase interest rates at the expense of the rest of the economy's well-being?

From the beginning of the 1990s, high German interest rates, set by the Bundesbank to counteract inflationary effects related to excess expenditure on German reunification, caused significant stress across the whole of the ERM. The UK and Italy had additional difficulties with their double deficits, while the UK was also hurt by the rapid depreciation of the US Dollar - a currency in which many British exports were priced - that summer. Issues of national prestige and the commitment to a doctrine that the fixing of exchange rates within the ERM was a pathway to a single European currency inhibited the adjustment of exchange rates.

To summarize, the higher German rates appreciated the German DM, inducing the Bank of England to raise rates more than they otherwise might have needed to in order to stay within the "band" of accepted values. On top of that, Britain had both a fiscal deficit (which implies inflation which implies devaluation) and a current account deficit (which means they were importing more than they were exporting which also implies devaluation). Likewise, with the depreciation of the U.S. dollar and so much of the British export market (apparently) denominated in U.S. dollars, this meant British exporters were receiving even less for the same goods, putting more downward pressure on the pound.* And lastly, according to Wikipedia, Brits just weren't having the whole idea of the domestic interest rate and economy being influenced by a bunch of dirty foreigners.

And then there was the news. And everyone, especially rattled investors scouring headlines for a source of what might in the future possibly given certain contigencies lead to a trend in the market which would by the way be completely justified by market fundamentals, reads the news.

In the wake of the rejection of the Maastricht Treaty by the Danish electorate in a referendum in the spring of 1992, and announcement that there would be a referendum in France as well, those ERM currencies that were trading close to the bottom of their ERM bands came under pressure from foreign exchange traders.

Lucky George Soros. He, along with a number of other currency traders, saw that the British Pound "should" devalue, that it would be potentially very costly for the Bank of England to keep it from doing so, and therefore bet that the Pound eventually would.

How does one "bet" against the value of a currency? These financial acts of wizardry are, I think, at the heart of Dave's question. I know he listens to Planet Money, so he knows what "short-selling" is, but does everyone else?

Counter to the way that most people think of the stock market should and does work (people pick stocks of companies that look like they might do well and buy shares in those stocks), short-selling is a way to profit from a stock decreasing in value. If it sounds criminal, it's only because it perhaps should be. Here's how it works:

On Monday, Ben the Baller wishes to short-sell the stock of Grandma Philanthropy's House of Cheer and Puppies. Ben goes to Lion the Lowrider on Monday, who happens to own some prime GPHCP stock, and borrows 1000 shares while signing off on the agreement that he will return the stock plus interest on Thursday. Perhaps Ben pays Lion some additional fees as well. Regardless, once Ben has borrowed the shares, he sells all 1000 immediately at the going price. In a few days, Ben buys back the shares at the price then and pays Lion back plus interest. If between Monday and Thursday the price of GPHCP stock has fallen, say from $100 a share to $80 a share, Ben truly is a Baller worthy of the title. On Monday, Ben borrowed the 1000 shares for free, sold it all for $100,000. On Thursday, he buys back the 1000 shares for $80,000 and gives them back to Lion plus the interest he owes. A little less than $20,000 for Ben in less than a week. Lion the Lowrider wins too, since he gets the interest payment for doing absolutely nothing. Of course, if the value of the stock had gone up and not down, Ben would have been in trouble since he would have had to pay more to get the stock back. But that's a different story and I don't want to talk about it.

To explain "Black Wednesday" then, George Soros and many of other international currency traders essentially did the same thing to the Pound that Ben the Baller did to GPHCP stock. Except thousands and thousands of times and with billions and billions of dollars.

If George expects to value of the British pound to go down between Monday at noon and Monday at 2pm, he borrows £10,000,000 British pounds, exchanges them for DM 29,000,000 at a rate of 2.9DM to the pound, waits two hours and, if he is correct, exchanges back the deutchmarks for £10,740,740 British pounds at the new lower rate of 2.7DM to the pound. He pays the lender back with interest and then, finally, takes his £740,740 minus interest and quickly exchanges it back into a currency that he has any confidence in. And that is how George makes over £700,000 between lunch and tea. Except now the tea is more expensive if you're in England because it's imported from India.

It isn't perfectly accurate to call this maneuver a "bet" though. The term implies taking a position against something either happening or not happening and that this act of betting itself has no impact on the outcome. This is not strictly true of currency speculation on the Sorosian-scale just as it might not true (and totally illegal) of short-selling a stock. When a lot of people (or a few people with a lot of money) get together and to short stock, they borrow a lot of that stock, and sell it at once. This has the immediate effect of decreasing the value of the stock. How fortuitous then that in a few days when the contract is due, these investors are then able to buy back the stock at a lower price. Of course this is unlikely to happen in such a straightforward way since, believe it or not, there is regulation to prevent this sort of coordinated cheating.

I don't know if such regulation exists in foreign exchange markets and, if it does, I don't know who enforces it. Regardless, even in 1992 George Soros had more money to throw around than God and, given the fact that so many investors were just waiting for the first signs of a dip in the British pound to send all their money Eastward to the continent, he didn't have to start short-selling much to get a tidal wave of investors, flighty and speculative, to conform around him and validate all of his bets.

On the receiving end of that tidal wave was the Bank of England, thrashing away with about as much success as you might expect from the metaphor:

On 16 September the British government announced a rise in the base interest rate from an already high 10 to 12 percent in order to tempt speculators to buy pounds. Despite this and a promise later the same day to raise base rates again to 15 percent, dealers kept selling pounds, convinced that the government would not stick with its promise. By 19:00 that evening, Norman Lamont, then Chancellor, announced Britain would leave the ERM and rates would remain at the new level of 12 percent.

Soros clearly wasn't alone in this operation, but he is notable both for the scope of his participation ($10 billion continually recycled in pounds) and the obscene monetary scale of his success:

Finally, the Bank of England was forced to withdraw the currency from the European Exchange Rate Mechanism and to devalue the pound sterling, and Soros earned an estimated US$ 1.1 billion in the process. He was dubbed "the man who broke the Bank of England."(Source: Wikipedia, Soros' site)

It's difficult to say just how bad the effect of Black Wednesday was. On the one hand, the value of the British currency was in the tank for some time (which may have been good for exports, but being an island and all, not great for a host of other reasons), but the Pound appreciated fairly rapidly (oddly enough) throughout the rest of the 1990s.

The high interest rates were the real kicker. Coming out of a big financial and housing boom, the U.K. went through a relatively nasty recession as a result. On the other hand, the speculative attack on the pound--and the high interest rates used to defend against it--can just as much been seen a symptom of bad monetary and fiscal policy in this respect. Nobody trusted the Pound because inflation was high, the government was in debt and the trade balance...wasn't. The Bank of England and the government could have allowed the economy to come off the EERM, at least temporarily before assigning it a new or broader band, but instead chose to fight by increasing rates.

I'm not really prepared to go all counter-factual on the Bank of England. What I will say, however, and unequivocally, is the following: the concept that a single person could so dramatically tinker with the economic future of an entire country is totally fucked. And that is my conclusion.

*If on Monday £1 = $2, a radio sold to Norway for $50 = £25. If the U.S. dollar depreciates so that on Tuesday, £1 = $3, all of a sudden that radio sold to Norway for $50 only equals £16.66. This is I think what the Wikipedia article is getting at, but I might be misinterpreting.