Economics
Currency Pegs and Speculative Attacks
Quick fact
The British pound was forced out of the European Exchange Rate Mechanism on 'Black Wednesday' (1992) after George Soros bet heavily against the peg, making over $1 billion in profit.
Why this is interesting
Imagine a country promises to exchange its currency for gold at a fixed price. What happens when everyone suddenly wants gold? The promise might break. That's the drama of currency pegs and speculative attacks.
Read the full explanation
Understanding Currency Pegs and Speculative Attacks
Think of a currency peg like a government's price ceiling for its own money. The government says, 'One dollar will always buy 10 pesos.' To keep this promise, the government must be willing to trade pesos for dollars (or vice versa) at that rate. It uses its foreign currency reserves (like dollars) to buy up excess pesos when people want dollars, and it prints more pesos when people want pesos. The peg works as long as the government has enough reserves to meet demand. But if people lose confidence and start swapping their pesos for dollars en masse, the government's reserves drain quickly. When reserves run low, the government can't keep the promise and must either abandon the peg or devalue (make the currency cheaper). This is the moment speculators are betting on.
A deeper explanation
A speculative attack happens when traders believe a peg is unsustainable. They might be right or wrong, but their actions can trigger the crisis. If traders expect a devaluation, they sell the currency (or short it), hoping to profit from the fall. This selling increases the pressure: the central bank must use more reserves to defend the peg. This drains reserves faster, making the peg even more likely to fail. This is a self-fulfilling prophecy: the expectation of a crisis can cause the crisis. Why would a peg be unsustainable in the first place? If a country has high inflation relative to its peg partner, its goods become more expensive, leading to trade deficits. This means more money is leaving the country than coming in, putting downward pressure on the currency. The central bank must sell its foreign reserves to counter this. But if inflation continues, the peg becomes increasingly overvalued, and the cost of defending it grows. Eventually, the central bank might find it too costly to maintain the peg, and speculators know this. The mechanism is a battle between a fixed price and market forces. The government controls the price but must sacrifice international reserves to do so. Market forces, if strong enough, can overwhelm those reserves. The attack is essentially a bet that the government's commitment will break, and sometimes the bet itself helps break it. This is why pegs are often seen as risky: they require huge reserves and strong discipline, and they invite speculation when economic fundamentals look weak.