The history of Foreign Exchange: Part 1

The fascinating history of foreign Exchange

Forex trading (foreign trading) is the act of trading of one’s currency with another country’s. It is thought to be centuries old, dating back to the Babylonian period. To date, the forex market is one of the biggest, most liquid and accessible markets in the world, where countries flourish and prosper through trading with other foreign countries.

It’s crucial for both aspiring and seasoned forex traders to understand the history of foreign exchange and the historical events that helped shape the market. After all, history tends to repeat itself and those who do not learn history are doomed to repeat it.

In the Beginning

It all started with the humble barter system, which was introduced by the Mesopotamians (1 of the 5 early civilizations). It is known as the system where people exchanged services and goods for other goods and services. The system first began in 6000BC and is known as the oldest method of exchange.

So, what were the most traded goods among the people of the past? Was it Gold? Jewelry? Weapons?

No, people were far simpler back then. Perishable goods and livestocks were among the most traded goods and fresh produce such as vegetables, chicken and eggs was the hot commodity. While the system worked, there was one fundamental problem—they lost their value overtime as the quality couldn’t be preserved or be divided. In order to facilitate the system, gold coins were introduced and they grew to be the standard currency due to how portable, durable, divisible and acceptable they were.

The reason gold coins were so widely accepted were due to the rarity of gold veins and difficulty to smelt gold. It wasn’t impossible to forge gold coins but it was very difficult. Therefore it became the “perfect” form of currency as only the central bank could afford to manufacture it.

However, it was difficult to trade large amounts of gold and ferry it overseas as the weight of the gold coins would have limited the amount of cargo the ship could carry. Not to mention that there is a risk of theft by the dock workers or crewmates. So, in the 1870s, countries adopted the gold standard system. The gold standard in short, guaranteed that the government would redeem any amount of printed paper money for its value in their gold reserve. During World War I, European countries became so desperate that they forwent their own gold reserves to print more money to fund the war. And at the end of World War II, the gold standard system was suspended as the entire system proved to be vulnerable and flawed. Consequently, this led to a much needed change in the system.

The Bretton Woods System

The first major transformation of the foreign exchange market was the Bretton Woods System which was first formed toward the end of World War II. Gold was the basis for the US dollar and the Bretton Woods system basically pegged 43 countries’ currency to the US dollar’s value.

But why the US you may ask, why not Great Britain or other allied powers?

Well, it turns out that the United States had the largest gold reserve in the world after World War II and was the only country whose economy was largely unscathed by the war while most of the major European countries suffered major economic losses, rendering the US the only suitable candidate. In fact, World War II vaulted the US from a failed currency after the stock market crash of 1929 to benchmark currency by which most other international currencies were compared.

To ensure the revitalization of the affected countries’s economy, the International Monetary Fund (IMF) was created to enforce the Bretton Woods agreement and the World Bank was responsible to help rebuild war-ravaged countries. The goal was to create a stable environment for global economies to slowly recuperate on their own, thus fixing the exchange rate to the US dollar. This is fundamentally the reason why the world traded in US dollars.

The Bretton Woods Agreement (BWA) eventually failed as the US dollar did not have enough gold to back the amount of US Dollars in circulation. In 1971, President Richard Nixon, ended the Bretton Woods system which soon led to the beginning of the free floating system.

Free Floating system

The Smithsonian Agreement came into play in December of 1971 after the failure of the Bretton Woods Accord. The system basically devalued the value of the dollar by pegging the US dollar to gold from $35 to $38/ounce. The agreement also allowed the other countries to revalue their currencies against the US dollar.

In 1972, the European Joint Float (similar to The Smithsonian Agreement) was then established by West Germany, France, Italy, the Netherlands, Belgium, and Luxemburg to move away from its dependency on the US Dollar. However, both of the systems collapsed when the lack of federal reserves for the dollar became apparent in 1973.

In February 1973, the US unilaterally devalued their dollar by 10%, raising the price of gold to $42/ounce. These failures resulted in an official switch to the free-floating system. The free-floating system in short is a flexible exchange rate system solely determined by the market. Government intervention is non-existent and while they could introduce certain policies that could decrease or increase the value of the currency by a small margin, generally they do not directly intervene. This free floating system defined the currency exchange rate and allowed for greater flexibility.

The Plaza Accord

In the early 1980s, the dollar had appreciated greatly against the other major currencies. However, having a strong value of currency meant lower exports as other foreign countries couldn’t afford imports from such a strong valued currency.

But, what caused the dollar to appreciate so much?

Well, in the 1970’s, after the fallout of the gold standard, stagflation (high unemployment, high inflation, low economic growth) began in the early 1980s, plummeting the country’s economy. In response to the stagnation, Paul Volcker (the Chairman of the Federal Reserve) made an unprecedented move. He raised interest rates despite the objection of his colleagues, which caused a strong US Dollar at the expense of the US industry’s competitiveness in the global market. This succeeded in achieving price stability.

However, with the appreciation of the US dollar, the exports of the country started to fall and American factories started to dwindle due to the lack of international demand which then led to unemployment rates. To combat the strong currency issue, the Plaza Accord was signed in the Plaza Hotel in New York City in 1985. The goal of the Plaza Accord was to encourage the appreciation of non-dollar currencies among US closest allies. The US, Japan, West Germany, France and the UK agreed to intervene in the currency markets to drive down the value of the dollar. It worked as the dollar fell in value by 50% relative to the yen and Deutsche mark. Despite all the systems, agreements and policies, the free floating system has ultimately allowed many opportunities for traders as they realized the potential profits. With little government intervention, fluctuation in the market allowed profits despite the uncertainty and risk.

We will continue the history of foreign exchange in part 2, so stay tuned!  

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