So a friend of mine mentioned his admiration for George Soros last night, and that got me interested in looking into Black Wednesday with more detail. I understand that his scheme involved short selling (which I understand in a vague theoretical sense) and taking advantage of a flawed exchange rate. However, I wasn’t an economics major, and while I find this stuff interesting, a lot of it goes over my head. Anyone feel like explaining what happened to me in a manner that a layman might grasp?
I only vaguely understand it, but here’s part of how Wikipedia describes the incident:
I think it was very simple. The British Government offered to pay $1.85 for pieces of paper that Soros (and others) thought were worth only $1.60 or so. Naturally Soros sold the paper at the higher price! Since his credit was good, Britain even let him borrow more of the pieces of paper to sell back to them at the high price! When Soros eventually repayed, it was with paper that, as he had predicted, was worth only $1.60.
It really is as simple as that. Just like driving your truckload of oranges to the next town because you hear people there are paying $1.85 for oranges worth $1.60.
The only real confusion might be why did the British government permit this. One thing they tried was to raise interest rates to 15% per annum, but of course that wasn’t remotely enough to make Soros’ activity unprofitable for him.
Something very similar happened in 1997 Thailand. (And again Soros was one betting against the baht.) After sacrificing all but about one gigadollar of its foreign reserves, Thailand raised its relevant interest rate to a confiscatory level and the remaining speculators were forced out at a loss. (The Bank of Thailand’s “dollars for sale” window was opened briefly, the day before the devaluation, and one man – I won’t mention any names, but his sister is presently Thailand’s P.M. – scarfed up the remaining dollars.)
Amazing! The fact is, governments mostly lose when defending their currencies (against a well-heeled cash rich “investor” like Soros).
The reason why currencies fluctuate so much (and provide opportunities for sharks)is that there is so much liquid cash around-this is ultimately because governments print a lot of fiat money. Take China-they have trillions of US dollars-which they have no way of investing. So they let it out at low rates-which attracts the Soros of the world.
I did read the wikipedia article on the subject before I started this thread. I was wondering if anyone would be able to explain it in more detail.
Basic explanation of short selling:
On December 10th, I see that a gallon of milk costs 2$. I agree to deliver a gallon of milk to you for 1.80$ on December 20th. At some point inbetween December 10th and December 20th, the price of a gallon of milk dips to 1.70$. I buy it at that price and deliver the gallon of milk by December 20th for a 0.10$ profit.
Currency, inflation, interest rates:
You might want to look it up. I don’t think I can do a non-confusing job of explaining the relationship between the three that won’t be simplistic to the point of being inaccurate.
Soros and the Bank of England:
I think it’s largely inaccurate to say that Soros (or speculators) broke the Bank of England. The UK adopted an unwise policy, persevered in its error and eventually changed its policy.
The UK entered the ERM as you know which means that it got itself in a situation where it had to keep its currency within a narrow band. The UK also wanted low inflation. In order to do both of those, it had to raise interest rates to prevent its currency from getting lower and inflation from rising. However, raising its interest rates further was deleterious to many economic actors in the UK because it made it more expensive for them to borrow money and consume/invest/pay off debts.
The UK tried to prop up its currency with interest rate hikes and purchases of its currency so as to keep its value within the allowed band. Soros could sell pounds to the UK gov’t (which was willing to buy them above a sensible price to stay within the narrow band) but eventually, the UK gov’t gave up and accepted a lower currency, higher inflation and lower interest rates even if it meant exiting the ERM.
If the UK gov’t had decided that it was going to keep raising interest rates and buying back its currency to stay within the ERM no matter what, then Soros would have lost money. And the UK would have been worse off for continuing with a policy that hurt it overall.
If there’s any way that Soros broke the Bank of England, it was by calling bullshit on the UK’s policy of artificially high currency and betting his own money that the UK would eventually stop propping it up to the required levels to stay within the ERM.
While Soros ran a hedge fund and it was in his best interest to get publicity, Soros was by far not the largest player. I worked at Swiss Bank Corp at the time and Swiss Bank made much larger bets than Soros did. So did most of the investment banks. Banks don’t want the attention and do everything they can to avoid it.
The deal is, when the market lines up against you, no matter if you are the Bank of England, you don’t have enough firepower. The banks line up, leverage very large with derivatives and borrowed funds, and simply crush you. It’s a case of dog pile. This is especially true if the Bank of England or the London Whale is out of synch. As MichaelEmouse points out eloquently above, the Bank of England was also trying to force the market to accept an unnatural position with the artificially high currency.
Now, I would certainly not want to try crush the Bank of England if, for example, their currency was undervalued and I was trying to push it lower. And I’d think twice about taking on the Fed.
(hijack: kudos to the bank of England for stepping up first into the breech when Lehman’s collapsed. The Fed came in IIRC a day later.)