A bet against the pound paid off when Britain abandoned its exchange-rate target.

Why Britain Could Not Hold the Pound at Its Set Rate

The European Exchange Rate Mechanism (ERM) was designed to keep participating currencies within agreed limits against one another, a step toward greater European monetary stability. Britain had joined in 1990 and committed to keeping the pound within a specified range. That promise became costly when investors judged that the pound was too expensive relative to the economy’s condition.

To defend the rate, the Bank of England could buy pounds with foreign currency, supporting demand, or raise interest rates to make holding pounds more attractive. But buying pounds used up reserves, while higher rates made borrowing more expensive for households and businesses. The government was trying to defend an exchange-rate commitment at the same time that recession made tight monetary policy painful.

How a Short Bet Pressured the Defense

A short sale turns a fall in price into a potential gain. Soros’s fund borrowed pounds and sold them for other currencies, expecting that Britain would eventually let the pound fall. If the pound did fall, the fund could buy back the borrowed pounds for less and return them, keeping the difference after costs.

The trade mattered not just because of its size, but because it added to the selling pressure the Bank had to counter. Other investors were making similar bets. Each sale made the official rate harder to defend; defending it, in turn, required Britain to spend reserves or accept the economic damage of still higher interest rates. A government’s stated commitment could not by itself make investors believe the rate was sustainable.

The Cost of Staying—and the Cost of Leaving

On September 16, 1992, a day later known as Black Wednesday, the government raised interest rates and intervened in currency markets, but it ultimately suspended the pound’s participation in the ERM. Once the exchange-rate floor no longer applied, the pound could fall, allowing short sellers to cover their positions more cheaply. Soros’s fund made a celebrated profit from the move, though the episode was not the work of one investor alone.

Leaving was politically humiliating because it exposed the limits of the government’s promise. Yet the weaker pound also gave Britain more room to set interest rates for domestic conditions rather than for the exchange-rate target. The crisis showed how a fixed-rate pledge can become a contest between a government’s resources and the market’s belief that the pledge is worth defending.