The Gold Standard
Sterling unofficially moved to the gold standard from silver thanks to an overvaluation of gold in England that drew gold from abroad and occasioned a steady export of silver coin, in spite of a re-evaluation of gold in 1717 by Sir Isaac Newton, Master of the Royal Mint. The de facto gold standard continued until its official adoption following the end of the Napoleonic Wars, in 1816 (Braudel, p. 361). This lasted until the United Kingdom, in common with many other countries, abandoned the standard after World War I in 1919. During this period, one pound could be exchanged for US$4.87.
Discussions took place following the 1865 International Monetary Conference in Paris concerning the possibility of the UK joining the Latin Monetary Union, and a Royal Commission on International Coinage examined the issues. Although the UK decided against joining, some of the arguments make interesting reading in the context of the current debate on the adoption of the euro.
Prior to World War I, the United Kingdom had one of the world's strongest economies, holding 40% of the world's overseas investments. However, by the end of the war the country owed £850 million, mostly to the United States, with interest costing the country some 40% of all government spending.
In an attempt to resume stability, a variation on the gold standard was reintroduced in 1925, under which the currency was pegged to the gold price at pre-war levels, although people were only able to exchange their currency for gold bullion, rather than for coins. This was abandoned on 21 September 1931, during the Great Depression, and sterling devalued 20%.
In common with all other world currencies, there is no longer any link to precious metals. The U.S. dollar was the last to leave gold, in 1971. The pound was made fully convertible in 1946 as a condition for receiving a U.S. loan of US$3.75 billion in the aftermath of World War II.
Pound sterling was used as the currency of many parts of the British Empire. As this became the Commonwealth of Nations, commonwealth countries introduced their own currencies such as the Australian pound and Irish pound. This evolved into the Sterling Area where those currencies were pegged to sterling.
Following the U.S. dollar
Since leaving gold, there have been several attempts to peg the value of the pound to other currencies, initially the U.S. dollar.
Under continuing economic pressure, and despite months of denials that it would do so, on 19 September 1949, the government devalued the pound by 30%, from US$4.03 to US$2.80. The move prompted several other governments to devalue against the dollar too, including Australia, Denmark, Ireland, Egypt, India, Israel, New Zealand, Norway and South Africa.
In the mid-1960s the pound came under renewed pressure since the exchange rate against the dollar was considered too high. In the summer of 1966, with the value of the pound falling in the currency markets, exchange controls were tightened by the Wilson government. Among the measures, tourists were banned from taking more than £50 out of the country, until the restriction was lifted in 1970. The pound was eventually devalued by 14.3% to US$2.41 on 18 November 1967.
With the break down of the Bretton Woods system - not least because mainly British currency dealers had created a substantial Eurodollar market which made the U.S. dollar's gold standard harder for its government to maintain - the pound was floated in the early 1970s and so subject to a market appreciation. The Sterling Area effectively ended at this time when the majority of its members also chose to float freely against the pound and the dollar.
A further crisis followed in 1976, when it was apparently leaked that the International Monetary Fund (IMF) thought that the pound should be set at US$1.50, and as a result the pound fell to $1.57, and the government decided it had to borrow £2.3 billion from the IMF. In the early 1980s the pound moved above the $2 level as interest rates rose in response to the monetarist policy of targeting money supply and a high exchange rate was widely blamed for the deep recession of 1981. At its lowest, the pound stood at just US$1.05 in February 1985, before returning to US$1.77 during the 1990s.
There are often long periods where the pound and the euro move in sync, although since the middle of 2006 this correlation has weakened. Inflation concerns in the U.K. led the Bank of England (BoE) to hike interest rates twice unexpectedly in late 2006 and early 2007, causing sterling to rise to its highest rate against the euro since January 2003. This had a knock on effect versus other major currencies, and the pound hit a 15 year high against the US dollar on January 23, 2007, peaking at US$1.9916 per pound.
Following the German mark
In 1988, Margaret Thatcher's Chancellor of the Exchequer Nigel Lawson decided that the pound should "shadow" the West German Deutsche Mark, with the unintended result of a rapid rise in inflation as the economy boomed due to inappropriately low interest rates. (For ideological reasons, the Conservative Government declined to use alternative mechanisms to control the explosion of credit. Former Prime Minister Ted Heath referred to Lawson as a "one club golfer").
Following the European currency unit
In another change of tack, on 8 October 1990 the Thatcher government decided to join the European Exchange Rate Mechanism (ERM), with the pound set at DM2.95. However, the country was forced to withdraw from the system on Black Wednesday (September 16, 1992) as Britain's economic performance made the exchange rate unsustainable. Speculator George Soros famously made approximately US$1 billion from shorting the pound.
Black Wednesday saw interest rates jump from 10%, to 12%, and then finally to 15% in a futile attempt to stop the pound from falling below the ERM limits. The exchange rate fell to DM2.20. Proponents of a lower GBP/DM exchange rate were vindicated as the cheaper pound encouraged exports and contributed to the economic prosperity of the 1990s. Since early 2005, the £/€ rate has returned to an average of about £1.00:€1.46, which is equivalent to DM2.85.
Bank Negara Malaysia is reported to have suffered losses of more than US$4 billion from the pound devaluation.
Following inflation targets
In 1997, the newly-elected Labour government made a surprising move when Gordon Brown handed over day-to-day control of interest rates to the Bank of England (a policy that had initially been proposed by the Liberal Democrats). The Bank is now responsible for setting its base rate of interest so as to keep inflation very close to 2%. Should inflation be more than 1% above or below the target, the governor of the Bank of England is required to write a letter to the Chancellor of the Exchequer explaining the reasons for this and the measures which will be taken to bring inflation back in line with the 2% target.
As a member of the European Union, the United Kingdom has the option of adopting the euro as its currency. However, the subject remains politically controversial, not least since the United Kingdom was forced to withdraw from its precursor, the European Exchange Rate Mechanism. The pound did not join the Second European Exchange Rate Mechanism (ERM II) after the euro was created.
Denmark and the UK have a unique opt-out from entry to the euro. Technically, every other EU nation must eventually sign up; however, this can be delayed indefinitely (as in the case of Sweden) by refusing to join ERM II.
The idea of replacing the pound with the euro has been controversial with some sectors of the British public because of its identity as a symbol of British nationalism.
In Scotland there is additional concern that the adoption of the euro would mean the end of regionally distinctive banknotes, as the European Central Bank do not permit national or sub-national designs of the banknotes.