Thursday, January 28, 2010

George Soros

I mentioned George Soros in the last lecture, as the "man who broke the Bank of England", selling pounds in 1992 in response to speculation that the pound would be devalued.

Soros is back in the news with his support for breaking the banks up. Bank regulation is more something you covered in econ101a, but Soros is described in this article as the "legendary speculator".

I should perhaps have made it clear in the lecture that such speculation is only likely to be worthwhile if an exchange rate is fixed, such as in a fixed exchange rate system like the Exchange Rate Mechanism (ERM) of the European Monetary Union (EMU) was.

It's only if exchange rates are fixed that they can end up above or below the equilibrium value, or the rate that a freely floating currency would achieve.

In the case of the pound in 1992, the equilibrium value of the pound had dropped below what the pound was fixed at against the Deutschmark - the old German currency. Currency speculators like Soros would have begun to notice this as an excess supply of the currency would have been noted.

Hence Soros sold many pounds (millions and millions), greatly increasing the supply for the currency. In order to maintain the pound's fixed value against the German mark, the UK (via the Bank of England) had to match this supply with demand. In effect it had to buy the pounds that Soros was selling in order to keep the pound at its fixed rate.

Eventually, the Bank could no longer keep matching the increased supply, and had to let the pound devalue. The main implication of this was that the Bank lost huge amounts of money because it bought assets (pounds) at much too high a price. You saw in the lectures that the pound lost at least 15% of its value after the crisis.

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