by rockytimber
Prior to the EU, there was the European Exchange Rate mechanism (ERM). European countries fixed their currencies (+/- about 5%) to the German Deutschemark because Germany had the strongest economy.
In order to maintain the exchange rate, the Bank of England had to intervene. It can do this by buying/selling British or foreign currency and setting interest rates. Messing with interest rates messes with the whole economy so buying/selling currencies is the better (less distorting) way to manage the exchange rate.
Due to political developments in Great Britain around 1990, Great Britain entered the ERM and pegged British pounds at around 3 Deutschemarks per British pound (3:1). From 1990-92, everything was great. But, there was a global recession in 1992. The Bank of England wanted to cut interest rates to increase investment and consumption. Unfortunately, this also impacted the currency peg mandates so it couldn’t. Through some other mechanisms, the British pound became overvalued and was traded at the lower end of the agreed upon range. As long as Great Britain maintained the range, all would be fine.
Enter German Central Bank President. He allowed off the record remarks to be printed if paraphrased and he was basically quoted as saying a currency “could come under pressure” before a referendum in France to join the EU.
Enter George Soros. He reads these comments in the Wall Street Journal and bets he is talking about British pounds. He starts increasing his short position (not short selling per se, but more complicated instruments) against the pound (which was guaranteed by the British government). He also started short selling British pounds outright.
Short selling can go very bad, very quickly because its a bet that the value of the asset will go down. You are selling today and buying tomorrow, pocketing the difference. But British pounds were already at the bottom of the range allowed, meaning they can’t appreciate any more, so the value of British pounds could only go down!
If the value of the pound stayed the same, Soros wouldn’t make any money, but he more or less couldn’t lose any either. Overnight (literally, he was in NYC) while Europe slept, he borrowed and sold pounds until he owned about $10b worth of currency. Other hedge funds caught on and by the time London woke up, British pounds were about to trade below the required level. The Bank of England tried buying them up, but it didn’t work. It couldn’t raise interest rates because of the recession. Eventually Great Britain was forced to leave the ERM and float the British currency on an open market. The value fell 15%.
www.reddit.com/r/AskEconomics/comments/altvbm/the_man_who_broke_the_bank_of_england/