History of Foreign Exchange

Foreign exchange has been around as long as transactions have involved crossing country borders. No doubt, trade took place even before national boundaries and modern currencies existed. But once a country or region established a money of their own, then currency transactions became necessary. (Strictly speaking, this need not always have been the case if the two currencies were convertible. In other words, if two countries both used gold coins and the values of those coins were based entirely on the weights of the metal they contained, then there should have been a single exchange rate between those currencies).1 Although there are many interesting accounts of the early forms of money2 (dealing primarily with the use of precious metal in the form of coins), the fundamental economic principle on this topic typically goes by the name of Gresham’s Law. Thomas Gresham, in 1558, stated that bad money always drives out good money. What this means is that currency which has been debased (such as clipped or “sweated” coins or coins made of an inferior or lower precious metal content) tends to drive “better money” (whole coins or coins with a higher metal content) out of circulation (i.e., induce hoarding). When was the last time you saw a “real silver” U.S. dime, quarter, or half-dollar? John Kenneth Galbraith wrote, “It is perhaps the only economic law that has never been challenged.”3 Prior to 1900, most national currencies were backed by gold and/or silver (and were, therefore, in a sense, immediately and directly comparable). Britain adopted a gold standard around 1820. Germany and France also moved to a gold standard for their currencies in 1871 and 1876, respectively. In China, they resisted a gold-backed currency because of the dominance of silver in that part of the world. On paper, the official gold 63 standard in the United States set the value of one ounce of gold at USD 20.67—from 1834 through 1933. The United States, during the recovery after the Civil War, guaranteed that the Dollar could actually be converted into gold (but not silver) via the Coinage Act of 1873 (despite many political objections in the ensuing years); the most eloquent dissent was William Jennings Bryan’s famous “Cross of Gold” speech (advocating “easy money,” meaning currency not backed by the presence of ever scarce gold) delivered during his unsuccessful bid for the presidency in the Election of 1896). Bimetallism (the backing of fiat currency by silver and gold) was instituted soon thereafter in the United States, but the U.S. currency reverted to convertibility into gold alone in 1900. It is important to note that prior to 1900, with some high profile exceptions (such as England, Spain, and Portugal), international trade was not a significant part of many countries’ economic activity. Wheat was grown in a country, it was turned into flour in that country, it was baked into bread in that country, and that bread was consumed in that country. As transportation technology advanced (as well as the state of the art of preserving previously perishable products for extended conveyance), local specialization and the trade associated with it became increasingly important, and, consequently, more extensive economic interaction between geographies. Following World War I, Germany was burdened with large reparation payments, so large in fact that some economists (including John Maynard Keynes of Keynesian Economics fame) thought them unrealistic and potentially debilitating. As Germany (whose currency was no longer backed by gold) expanded their money supply, in part in an effort to help meet their payment responsibilities, the economy spiraled out of control. One U.S. Dollar exchanged for around 8 Marks at the end of the World War I (1918–1919); by November 1923, at the peak of the hyperinflation, one Dollar was worth 4.2 trillion Marks. Workers were paid every day before noon and then raced to the stores to buy anything they could, aware that prices changed hourly. Eventually, political intervention (the Dawes Plan) and the introduction of a new currency (the Rentenmark, so named because of its backing by land and industrial plants) together helped somewhat to stabilize the German economy. Clearly the excessive growth of money in an economy can have negative effects. Up until the global depression of the late 1920s and 1930s, most major currencies, with the exception of the German Mark, were freely traded and, as mentioned, via the gold standard, convertible into precious metal. The Great Depression changed all that. On April 5, 1933, with approximately 25% of the U.S. work force unemployed and with the world in the throes of a global depression, U.S. President Franklin Delano Roosevelt 64 FOREIGN EXCHANGE abandoned the gold standard, suspending the convertibility of Dollars into gold, and ordered all U.S. citizens to surrender their gold holdings. Milton Friedman and Anna Schwartz, in their classic A Monetary History of the United States, 1867–1960, assert that one of the primary causes of the Great Depression, and a significant factor in both the length and severity of that economic crisis, was the reduction in the supply of money in the economy; they estimate that the money supply fell by about a third between 1929 and 1933. In their words, the Great Depression was a “testimonial to the importance of monetary forces.” If money serves to facilitate trade, obviously the scarcity of money can grind an economy to a halt. It appears as if, for an economy, too much money can be a bad thing and not enough money can be a bad thing as well. Although the United States did abandon the gold standard, gold, nevertheless, did continue to be used as a settlement vehicle for international trade at the national/central bank level. In 1933, the United States officially reset the price of gold to USD 35 per ounce. This peg was maintained until 1971. As Europe entered World War II, many large economic powers were forced off the gold standard. In the case of England, their gold reserves were depleted in an effort to arm themselves for the impending military conflict. As the war approached its conclusion (July 1944), a landmark event took place: the Bretton Woods Conference. This is recognized as the first attempt ever to institute an international monetary system. As a student of economics, I always envisioned this event as taking place on a smoky battlefield in France; Bretton Woods is actually a beautiful resort community in New Hampshire, U.S.A. and the sessions were held at the Mount Washington Hotel. At these meetings, attended by representatives from the Allied countries, there was a strong resolve to avoid the previous mistakes of past postwar settlements. John Maynard Keynes, the same prominent British economist who had misgivings over the World War I German reparations, was an active and vocal participant at this conference, and an important contributor to the ultimate results of this meeting. Among other things, the Bretton Woods Agreement set up both the International Monetary Fund (IMF) and the International Bank for Reconstruction and Development, which later morphed into the World Bank, and resurrected the importance of the Bank for International Settlements (or BIS). More relevant for this book was the establishment of a fixed exchange rate system in which most of the major European currencies were pegged to the U.S. Dollar and, in an effort to provide even more stability to the new world economic order, the Dollar was pegged to gold (at the aforementioned rate of USD 35 per ounce).