Treasury documents reveal warnings on UK exchange rate mishaps

How ‘Lawson’s doubters’ signalled problems that eventually brought down sterling

Documents from the UK Treasury shed new light on the background to Britain’s departure from Europe’s exchange rate mechanism in 1992 – a setback which reverberates still through UK politics today.

Along with Prime Minister Margaret Thatcher, a central figure laying the foundations for Conservative economic policies in the 1980s was Nigel Lawson, her second chancellor of the exchequer from 1983-89. Lawson, who died on 3 April aged 91, had a formidable understanding of economics and finance, wide knowledge of financial institutions and the ability to master complex issues. But he could be headstrong, which sometimes led to errors of judgement.

Lawson’s interactions with the prime minister and other leading UK figures were important staging posts leading to sterling’s entry into the ERM in October 1990, and its painful withdrawal on ‘Black Wednesday’ on 16 September 1992. The setback was one factor eroding confidence in the Conservative government, leading to its 1997 election defeat. It remains to be seen whether present-day voters’ reaction to the Conservatives’ botched fiscal package last autumn will have a similar effect at the next general election scheduled for 2024.


Nigel Lawson

Two episodes in which I was involved – as head of the Treasury’s finance economic unit in 1984-86 and its economic forecasting team in 1986-90 – illustrated Lawson’s way of working.

First, he tried and failed in 1985 to persuade Thatcher that the UK should join the ERM, the central part of the European Monetary System set up in 1979. Preparations for this step signalled the need for precautions that were fatally ignored when the UK eventually joined the ERM five years later – and left in ignominy in 1992.

Second, in 1988, he was belatedly forced to accept the need to bring under control the economic overheating dubbed the ‘Lawson boom’.

Fixed sterling exchange rate ‘sole credible macroeconomic policy discipline’

Lawson had decided that the UK should join the ERM four years before the first formal approach to Thatcher in November 1985. He saw a fixed exchange rate as the sole credible macroeconomic policy discipline following the discrediting of monetary targets. He believed such an ‘intermediate target’ was vital for controlling inflation. This view now appears odd after many years of direct inflation targeting. He saw the ERM as an essentially technical issue. He had no desire to participate in monetary union – ignoring that most other members of the European Union saw the exchange rate system as the seminal stepping stone to a single currency.

Frank Cassell

Some in the Treasury – led by Frank Cassell, a Treasury monetary policy veteran – were wary of the UK returning to a fixed exchange rate after the difficulties in maintaining sterling’s fixed rate against both the dollar and the D-Mark in the post-war era. We sent a submission to Lawson on 1 November, ‘Coping with pressures on sterling in the ERM’ (Figure 1). This was shortly before a decisive seminar on 13 November at which Thatcher vetoed membership, against the advice of the chancellor, foreign secretary, deputy prime minister and governor of the Bank of England.

In language which foreshadowed the crisis in which sterling had to withdraw on 16 September 1992, the paper stated, ‘If sterling did come under pressure intervention would be of very limited use… Flows out of sterling that the UK authorities would be required to offset would be potentially vast.’ Reimposition of exchange controls would be neither desirable nor feasible but might have to be considered – on a wider basis to those that existed pre-1979 – to stem the damage. Interest rates might have to be raised ‘very vigorously indeed’ to satisfy finance markets. The currency would be particularly vulnerable to flows out of non-residents’ sterling holdings in London. These had increased to $42.4bn by the first quarter of 1985 from $6.2bn in 1973 when the Bretton Woods system of fixed exchange rates finally broke down – 10.7% of gross national product compared with 3.6% in 1973.

Figure 1. A letter to Nigel Lawson warning of pressures on sterling














Source: Peter Sedgwick

Lawson described our analysis as ‘flawed’. He doubted downward pressure on sterling would be any stronger inside the ERM than outside. He did not accept that membership of a fixed-rate system increased the chance of ‘one-way bets’ against sterling. On the contrary, he believed ERM membership would boost confidence.

Vigorous intellectual ambience in Lawson’s Treasury – and warning from Bundesbank’s Karl Otto Pöhl

This intellectual sparring with ‘Lawson’s doubters’ underlines the vigorous ambience in Lawson’s Treasury. Such exchanges were not possible with every chancellor during my 30 years in the Treasury. However, there was some common ground. In ‘The European Monetary System’, a paper that Lawson sent to Thatcher on 11 November just before the crucial seminar, much of Lawson’s argument was consistent with his officials’ warnings.

While stressing the potential benefits of ERM membership, he emphasised that the markets could test the UK’s resolve to stick to the ERM parity, necessitating probable increases in short-term interest rates. The paper stated the need to coordinate before entry with the Bundesbank. And it postulated circumstances might warrant an exchange rate realignment or even membership suspension during an election campaign.

This list of warnings signals what went wrong in the UK’s 1990-92 experience. The UK joined the ERM without a prior agreement with the Bundesbank. It cut short-term interest rates at the time of entry. Until the final hours it did not raise them as downward pressure on the exchange rate built up in 1992. Throughout the experience the Treasury and Bank of England were determined not to seek a devaluation. They believed the UK could ride out a storm from the financial markets intensified by near-constant pressure from the Bundesbank and German finance ministry (some of it in highly undiplomatic form) for a wholesale realignment of ERM exchange rates.

Lawson ended his paper to Thatcher with a dubious claim. He wrote: ‘My judgement that the advantages of joining now outweigh the risk is shared not only by the governor of the Bank of England, but also by senior officials in both the Treasury and Bank. They all believe that it makes operational sense to join.’ This was stretching the truth. Following numerous post-war exchange rate crises, it would have been surprising if everyone concerned in the Treasury had been comfortable with ERM membership.


Karl Otto Pöhl

A prescient postscript to the 1985 warnings came from a visit to the Treasury a year later by Karl Otto Pöhl, president of the Bundesbank. Although generally in favour of ERM membership, Pöhl told Lawson on 20 October 1986 not to expect ‘any changes in the rules’ if the UK joined. He saw ‘the risk that… the pound would later come under severe speculative pressure and the UK might then be forced to leave. But on the other hand, if the UK succeeded in holding the rate – and he thought there was a good chance of this – then it would be a stable rate for exporters.’

The end of the Lawson boom

The struggle to get the UK into the ERM and the resultant disagreements with Thatcher became overriding obsessions in Lawson’s final four years as chancellor, affecting his judgement on other issues. The unannounced and unofficial policy of a DM3 target range for sterling contributed to monetary policy becoming too loose as the UK continued strong recovery from the early 1980s recession. Lawson was reluctant to raise interest rates since this would have pushed sterling above DM3. And he was eager to take his earlier tax reforms a stage further by substantial cuts in income tax rates. The reluctance to raise interest rates and the substantial income tax cuts combined in early 1988 to cause a crisis and eventually a partial change in policy.

Lawson adopted a truculent attitude towards forecasts and occasionally towards forecasters, though always remaining polite and never indulging in the insults to forecasters used by Denis Healey, chancellor under Thatcher’s predecessor James Callaghan. Lawson regretted that the Treasury was legally obliged to publish forecasts twice a year, though he had voted for this in opposition. Nevertheless, the forecasts for the main macroeconomic aggregates published by the Treasury while I was head of the forecasting team were our proposals. He never changed them for publication.

Lawson claimed that decisions, particularly on monetary policy, were not based on forecasts. Since he also believed that there was insufficient predictive power in the monetary aggregates it was difficult to understand how he made policy decisions, particularly on interest rates and tax cuts. After all, the effects of changes took time to materialise. In practice decisions seemed to be made in the light of the most recent recorded data, with the risk that decisions would be too late.

Late but decisive reaction to economic overheating

In early 1988 some in the Treasury were concerned that the economy was overheating, although the evidence was not conclusive. Notwithstanding these concerns the budget included large cuts in direct taxes, with increased effects in succeeding years. In the medium term these would be further increased by the cost of the move to independent taxation of husbands and wives (a long overdue but expensive reform for which Lawson deserves credit). These were unfunded tax cuts that could have been, but were not, offset by reductions in tax allowances such as mortgage interest relief, a move that Thatcher vigorously opposed. The 1988 budget gave a boost to demand when it was least needed.

In the months after the 1988 budget there was at first a further lowering of interest rates followed by small increases. Matters came to a head in August 1988. Information on a large monthly current account trade deficit – evidence of an overheating economy – arrived with substantial upward revisions by the central statistical office which confirmed the economy had been growing much more rapidly than previously believed.

Lawson’s reaction was swift and decisive. He returned to a sparsely populated Whitehall and engineered an immediate 1 percentage point rise in interest rates. This was followed by two further 1-point rises in November 1988 and October 1989. It still took an uncomfortably long time to end the Lawson boom, which was followed by a recession and housing market slump as high interest rates slowed the economy. The necessary correction of an over-loose fiscal policy was left to Norman Lamont and Kenneth Clarke, chancellors under John Major’s premiership.

The inflationary upsurge following the Lawson boom was lower than the three other spikes since 1970, including that in 2022-23. But the other inflation spikes – including the present one – were started or exacerbated by large rises in world fuel prices. Inflation under Lawson was primarily home-grown. He deserves credit for the speed and firmness of the monetary policy response from August 1988. He was not to blame for the statistical underestimation of economic strength in 1987-88. But a more cautious approach to fiscal and monetary policy would have been justified.

The episodes surrounding Frank Cassell’s warnings show Lawson’s boldness and imagination. But, like any strong chancellor, he was not immune to mistakes.

Peter Sedgwick was a senior Treasury official, a Vice President of the European Investment Bank 2000-06, Chair of 3i Infrastructure PLC 2007-15 and Chair of the Guernsey Financial Stability Committee 2016-19.

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