Foreign Exchange History
Before there was currency, nations traded goods directly, paying for one good by exchanging it for another. It was barter on a national scale. However, barter had major disadvantages: it could not be divided into units of equal amounts, the value of the barter frequently depended on the quality of the goods, and the value of those goods would generally decrease over time. Animals, for instance, were frequently traded, but they age and eventually die, so their value would decline over time, eventually to nothing. Because of its many advantages, money was eventually created to facilitate trading. Money could be divided into equal units that each has the same value, and because its value did not depend on its condition, its nominal value did not change. Thus, money, unlike barter, can serve as a unit of account and as a store of value, the 2 main functions of money. Additionally, it was also a better means of exchange: easier to carry, easier to store, and eliminating the need that one trader had exactly what the other trader wanted, and vice versa. In the beginning, trading partners would use a common form of money to conduct their business, which was usually gold or silver. Then eventually the benefits of paper currency became evident, but since each country issued its own currency, it wasn't very useful for international trading, since the purchasing power of each currency differed considerably and could differ over time depending on how much currency the countries issued.
Hence, foreign exchange history can be viewed as a series of solutions that allowed countries to issue their own currency and to conduct their own monetary policy while also allowing international trade to be conducted by providing a means of exchanging one currency for another according to the exchange rate between them, which was either agreed-upon or set by the market.
Money, Currency, and Foreign Trade
One of the qualities that money requires is that it be scarce. If it were not, it would have no value as money. For instance, if ordinary stones were money, then anyone could just pick some up off the ground and pay a merchant for his goods. But why would a merchant accept stones when he could just stoop down to pick up stones, too. He wouldn't need to sell merchandise, or do anything at all, if he could just pick up some stones and use it for money. Everyone else would think similarly. Hence, there would be no economy, and nothing to buy with the stones.
Although many different items were used for money in the past, people eventually discovered that gold was the ideal material for money. It could not be manufactured or printed, it was not easily mined, and it was difficult to find new sources of gold. That it was also the most ductile and malleable of metals made it easy to fashion into coins. But gold was heavy, and how much a person could carry is severely limited, since a 10 dollar gold piece would be 10 times heavier than a 1 dollar gold piece.
So governments decided that printed currency, usually called bills or notes, was the solution. A 10 dollar bill, for instance, weighs just as much as 1 dollar bill or a 100 dollar bill. This was a good solution, but still had some problems. What would prevent anybody from just printing money? Governments solved that problem by using secret methods of printing and passing harsh laws to punish anyone who would try.
But what would prevent the government from just printing more money to pay itself and others? Many governments have done that — Germany, after World War I, for instance. Consequently, their currency become worthless. It took a wheelbarrow of cash to buy a loaf of bread. Germans were literally burning money to keep warm in the winter. Oftentimes, people in such economies turn to hard currency, which is a trusted currency of a stable country, because nobody wants to buy or sell using currency that is continually devaluing. So obviously, there must be some way to prevent governments from just printing money, and the way that was done was to make it equal, by law, to something else that couldn't be easily made, printed, or found — gold.
The advantages of using money backed by gold:
- Since every country had gold, a natural material, and most people were familiar with it, it provided a common measure of value.
- It helped keep inflation in check by keeping the money supply based on the gold standard limited, thus stabilizing economies. Inflation is the result of increasing supplies of money for a given economic state. More money causes the price of everything to go up because it increases the demand for goods and services before the economy has time enough to expand its supply — so prices go up. By tying the amount of currency to the amount of gold that a country possesses, it limits the amount of currency that can be printed.
- Low inflation allows long-term planning. There are many large projects that must be paid for over time. It would be impossible to project future costs without knowing what future prices would be.
Fixed Exchange Rates
Before there was significant trade between countries, there was little need for foreign exchange, and when there was a need, it was served by gold, since gold was used by most of the major countries. However, as trade expanded, there was a need to exchange currency rather than gold because gold was heavy and difficult to transport. But how could different countries equalize their currency in terms of another currency. This was achieved by equalizing all currencies in terms of the amount of gold that it represented — the gold-exchange standard.
Under this system, which prevailed from 1879 to 1934, the value of the major currencies was fixed in terms of how much gold for which they could be exchanged, and thus, they were fixed in terms of every other currency.
Example: Calculating Exchange Rates Based on the Gold Standard
When the United States adopted the gold standard in 1879, it fixed the United States dollar to an ounce of gold at the rate of $20.67. Also at this time, the British sterling pound was pegged at £4.2474 per ounce. To calculate the exchange rate between United States dollars and British pounds, divide the value of one currency by the other. So to calculate the number of United States dollars per British pound:
$20.67/4.2474 = $4.8665
To calculate the value of British pounds in terms of dollars:
£4.2474/20.67 = £0.2055
Note that this is the same method as calculating currency cross rates, where the rate between 2 currencies is determined by calculating their exchange rate with a 3rd currency where both exchange rates with the 3rd currency are known.
One of the requirements that the countries adhering to the gold standard needed to follow was to maintain their money supply to a fixed quantity of gold, so the government could only issue more money if it had obtained more gold. This requirement, of course, was to prevent countries from just printing money to pay foreigners, which had to be prevented because, otherwise, there could be no foreign trade. Why would a trader accept currency for his goods if the country could just print more of it, thereby reducing the value of the currency that was already available, and thereby reducing the value of the currency held by the trader?
A corollary of this requirement is that gold had to flow freely between different countries; otherwise no country could export more than they import, and vice versa, and still maintain its supply of currency to the gold it held in stock. So if there was a net transfer of currency from one country to another, gold would have to follow. (Or, at least the ownership of it. The New York Federal Reserve, for instance, held the gold of many countries, so countries could settle in gold by updating their accounts at the New York Fed.)
The Collapse of the Gold Standard
The main problem with the gold standard was that if a country was not competitive in the world marketplace, it would lose more and more gold as more goods were imported and less exported. With less gold in stock, the country would have to contract the money supply, which would hurt the country's economy. Less money in circulation reduces employment, income, and output; more money increases employment, income, and output. This is the basis of modern monetary policy, which is implemented by central banks to stimulate a sluggish economy by increasing the money supply or to reign in an overheating one by contracting the money supply.
During the 1930's, the world was in the throes of the Great Depression. Countries started abandoning the gold standard by reducing the amount of gold backing their currency so that they could increase the money supply to stimulate their economies. This deliberate reduction of value is called a devaluation of currency. When some of the countries abandoned the gold standard, then it just collapsed, for it was a system that could not work unless all the trading countries agreed to it.
Of course, at some point, something else would have to take its place; otherwise, there could be no world trade — at least not in the quantities that were then occurring. As World War II was coming to a close, it was obvious that another system would be needed.
Bretton Woods and the Adjustable-Peg System
The leaders of the allied nations met at Bretton Woods, New Hampshire in 1944, to set up a better system of fixed exchange rates. The U.S. dollar was fixed at $35 per ounce of gold and all other currencies were expressed in terms of dollars. This official fixed rate of exchange was known as the par value of currency (aka par of exchange, par exchange rate).
However, to avoid making deleterious macroeconomic adjustments to maintain the exchange rate, the new system provided for an adjustable peg, that allowed the exchange rate to be altered under specific circumstances. Thus, this Bretton Woods system was also known as the adjustable-peg system. To actuate this new system, the International Monetary Fund (IMF) was created.
Each country had to maintain an account at the IMF that was proportional to the country's population, volume of trade, and national income. One of the services provided by the IMF was to provide accounts for each of the participating countries that held Special Drawing Rights (SDR), which were units of account that could be used to settle IMF transactions through the transference of the SDRs. Although initially the SDR was pegged to gold, it is currently equalized to the weighted average of the currencies of the 5 largest IMF exporters.
The new system required that each country value its currency in terms of gold or the United States dollar, which, of course, fixed the exchange rate among all currencies. The countries were required to maintain the exchange rate to within 1% of the peg, but, if special circumstances required, they could allow the exchange rate to fluctuate by up to 10%. However, if this was not adequate, then the country would have to seek approval from the IMF board to change the exchange rate by more than 10%. This prevented countries from devaluing their currency for their own benefit.
To maintain the limits, a country could:
- use official reserves, which is the foreign currency held by a country from a previous surplus.
- borrow from the IMF by borrowing the foreign currency, and using its own currency as collateral.
- sell gold to a country for its currency.
The Bretton Woods system began to weaken in the 1960s, when foreigners accumulated large amounts of U.S. dollars from post World War II aid and sales of their exports in the United States. There were concerns as to whether the U.S. had enough gold to redeem all the dollars.
With reserves of gold falling steadily, the situation could not be sustained and the U.S. decided to abandon this system. In 1971, President Nixon announced that U.S. dollars would no longer be convertible into gold, so the exchange rate was allowed to float. Because of the central role played by the United States, the Bretton Woods system could not be sustained. By 1973, this action led to the system of managed floating exchange rates that exists today.
The Managed Floating Exchange Rate
Managed floating exchange rates are rates that float, but are sometimes changed by countries, by having their central banks intervene directly in the forex market, usually by buying or selling the currency that the country wants to influence, so that the exchange rate is changed by the new supply or demand. However, direct intervention by the major countries has been rare. For instance, the Federal Reserve has only intervened 8 days in 1995, and only 2 days in the 10-year period 1996-2006. Many smaller countries, however, either peg their currency to the United States dollar, or, like Singapore, peg it to a basket of currencies.
The major benefit of the flexible floating exchange rate is that it corrects imbalances automatically. If a country imports more than it exports, then its currency will decline in relation to the importing country's currency, which will make imports more expensive and exports less expensive, thus reversing the imbalance, or at least mitigating it. It also helps to adjust the system when events happen with a significant impact on the balance of trade, such as the spike in oil prices in 1973-1974 and 1981-1983, or when countries experience significant recessions.
Another major benefit of the floating exchange rate is that it allows countries to manage their own economies through monetary policy, expanding the money supply to stimulate the economy, or contracting it to rein in inflation. Indeed, the publication of significant changes in monetary policy, such as the raising or lowering of interest rates, by the major countries increases volatility in their currencies, both before and after the news is published. Many traders stay out of the market during these times because of its unpredictability. Most major forex trading websites have a calendar of these events for the currency pairs that they offer for trading.
Before pegged systems were abandoned, it was feared that flexible exchange rates would diminish trade because of unknown changes in the rate that could affect sales or projects that take time. However, this problem has been solved with FX forward contracts that eliminate any uncertainty about future exchange rates.
The International Monetary Fund and the World Bank
The IMF has survived the demise of the Bretton Woods system. Today it loans money to developing countries or to those in crisis, or to Communist countries changing over to capitalism. It can impose strict rules, if necessary, over the economies of the loan recipients to help them repay their debt.
Another organization created by the Bretton Woods Agreement — the International Bank for Reconstruction and Development (IBRD), or World Bank, has also survived. The World Bank's original purpose was to finance the reconstruction of Europe and Asia after World War II. Today, the World Bank loans money, mostly to developing countries, for commercial and infrastructure projects, and the loans must be backed by the country receiving the loans. It does not, however, compete with commercial banks.