On Sept. 16, 1992, Britain's experiment with the euro ended.

The country was forced to withdraw the pound sterling from the European Exchange Rate Mechanism (ERM) after the currency strayed too far from the exchange rate bands designed to stabilize European currencies leading up to the introduction of the euro. (To learn more about the pound, check out The British Pound: What Every Forex Trader Needs To Know.)

TUTORIAL: Forex Currencies

The day of the withdrawal, dubbed "Black Wednesday," became a referendum for the leadership of the British Conservative government, led by John Major. The party seemed unable to protect the pound from currency speculators such as George Soros, and it struggled to protect households from the substantial recession that drove up unemployment. Despite the recession coming to an end the following spring, the political damage was enough to cede the opposition Labour Party control of the government in 1997.

Crisis
Fast forward to 2011. The eurozone is in crisis, and the euro is on the brink of collapse. European leaders have struggled to come up with a consistent and unified strategy to rescue illiquid governments, austerity measures have sapped economic growth and European banks face the possibility of collapse due to their exposure to sovereign debt. Did Britain dodge a bullet when it was forced out of the ERM nearly two decades ago? The answers are not so simple.

While not being a member of the eurozone has given Britain more macroeconomic and monetary flexibility, it would be wrong to believe that it is immune to problems on the mainland. The sovereign debt crisis reaches beyond Greece, Italy, Spain and Portugal, and solutions are going to have to be proposed by politicians other than Angela Merkel and Nicolas Sarkozy. If Europe is to survive, it has to use the full breadth of its financial resources to shore up the institutions that are still solvent. (For more check out EU Economics? It's All Greek To Me!)

A collapse, let alone a disruption, to European financial institutions could lead to problems in England. Solutions to such a financial contagion will require political and financial institutions to set aside some of their skepticism as to whether the euro is worth saving, how much a breakup of the eurozone would cost politically and economically, and what would happen if a run on European banks were to occur.

British Banks
At the heart of the matter is Britain's central bank, the Bank of England, and how it will handle several issues:

First, a euro collapse could have catastrophic effects on world economies. The exact impact depends on how many - and which - eurozone countries withdraw from the euro, but the breakup costs could far outweigh the cost of injecting faltering European economies with funds. While Britain has not been tapped to provide liquidity, standing on the sidelines as Europe burns could result in London's banks being caught in the inferno as well.

Second, the collapse of the euro would lead to an end to the euromarket. This would increase the cost of doing business as individual countries set their own trade policies, and political haggling over treaty details leaves markets fraught with uncertainty. A stronger pound relative to other currencies could draw in investors, pushing up rates and potentially wrecking Britain's economy. Investors may go after British banks exposed to eurozone debt, seizing the credit market, increasing unemployment and making it more difficult for austerity measures to whittle down public debt. Without substantial foreign exchange reserves available, the Bank of England might not be able to keep the pound from appreciating.

Third, as long as investors are uncertain about the euro's future they will keep deposits in big banks, but these banks will be unable to invest deposits in long-term deals because investors want liquidity first and foremost. This will keep the pound volatile as long as investors move their deposits around.

Euro Collapse
Fourth, a collapse of the euro could lead to a rampant string of protectionist measures by European central banks. Exporters would benefit from lower currency values, and will put pressure on governments to enact policies to ensure that this will happen. The Swiss National Bank, though not part of the euro, recently enacted policies designed to weaken the Swiss franc after euro investors snapped up the currency, and the willingness for this type of protectionist measure distorts markets. The desire to increase exports by depressing one's currency is great, especially in a down market, but investors know that when one currency falls another must rise.

While Switzerland may be able to enact this type of decision due to its size, a similar move by the Bank of England would cause pandemonium. Fundamentally, it is impossible for all currencies to depreciate simultaneously, and policies that ignore this premise overlook the zero-sum game that is the currency market. Recent comments by Jean-Claude Trichet, president of the European Central Bank (ECB), suggesting that curbing inflation in the medium term is no longer a top priority, have not helped keep central bankers at ease. By focusing on providing liquidity to European banks before checking euro values, investors will sell off euros.

Fifth, failing to involve itself on any level - whether through political or financial leadership - could result in Britain being kept out of future European discussions. This could be especially harmful if the 17 eurozone countries create a new set of treaties to fix the euro outside of a broader European Union treaty, essentially excluding Britain and other non-euro countries from the table.

What if Britain had remained in the eurozone and had adopted the euro as its currency? The Bank of England would have ceded much of its monetary policy, being unable to print more money or enter into quantitative easing (QE). Britain's government would have lost some of its macroeconomic muscle, and may have found itself in the unenviable position of Germany in having to bail out southern European states. High borrowing costs could still have sapped growth if investors pushed up inflation.

The Bottom Line
Much of the global financial crisis stemmed from government debt and unsustainable domestic policies. While Britain being at the table may have helped create better policies, there is little reason to believe that things would have turned out drastically different considering that both eurozone and Britain's governments independently pursued policies that met the same result. Britain may very well have dodged a bullet in 1992, but it certainly was not an innocent bystander and still managed to become collateral damage. (For more on what could happen, check out Disbanding The Euro - A Worst-Case Scenario.)

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