Initially, the
value of goods was expressed in terms of other goods, i.e. an economy based on
barter between individual market participants. The obvious limitations of such
a system encouraged establishing more generally accepted means of exchange at a
fairly early stage in history, to set a common benchmark of value. In different
economies, everything from teeth to feathers to pretty stones has served this
purpose, but soon metals, in particular gold and silver, established themselves
as an accepted means of payment as well as a reliable storage of value.
Originally, coins were simply minted
from the preferred metal, but in stable political regimes the introduction of a
paper form of governmental IOUs (I owe you) gained acceptance during the Middle
Ages. Such IOUs, often introduced more successfully through force than
persuasion were the basis of modern currencies.
Before the First World War, most
central banks supported their currencies with convertibility to gold. Although
paper money could always be exchanged for gold, in reality this did not occur
often, fostering the sometimes disastrous notion that there was not necessarily
a need for full cover in the central reserves of the government.
At times, the ballooning supply of
paper money without gold cover led to devastating inflation and resulting political
instability. To protect local national interests, foreign exchange controls
were increasingly introduced to prevent market forces from punishing monetary
irresponsibility. In the latter stages of the Second World War, the Bretton
Woods agreement was reached on the initiative of the USA in July 1944. The
Bretton Woods Conference rejected John Maynard Keynes suggestion for a new
world reserve currency in favour of a system built on the US dollar. Other
international institutions such as the IMF, the World Bank and GATT (General
Agreement on Tariffs and Trade) were created in the same period as the emerging
victors of WW2 searched for a way to avoid the destabilizing monetary crises
which led to the war. The Bretton Woods agreement resulted in a system of fixed
exchange rates that partly reinstated the gold standard, fixing the US dollar
at USD35/oz and fixing the other main currencies to the dollar - and was
intended to be permanent.
The Bretton Woods system came under
increasing pressure as national economies moved in different directions during
the sixties. A number of realignments kept the system alive for a long time,
but eventually Bretton Woods collapsed in the early seventies following
President Nixon's suspension of the gold convertibility in August 1971. The
dollar was no longer suitable as the sole international currency at a time when
it was under severe pressure from increasing US budget and trade deficits.
The following decades have seen
foreign exchange trading develop into the largest global market by far.
Restrictions on capital flows have been removed in most countries, leaving the
market forces free to adjust foreign exchange rates according to their
perceived values.
The lack of sustainability in fixed
foreign exchange rates gained new relevance with the events in South East Asia
in the latter part of 1997, where currency after currency was devalued against
the US dollar, leaving other fixed exchange rates, in particular in South
America, looking very vulnerable.
But while commercial companies have
had to face a much more volatile currency environment in recent years,
investors and financial institutions have found a new playground. The size of
foreign exchange markets now dwarfs any other investment market by a large
factor. It is estimated that more than USD1,200 billion is traded every day,
far more than the world's stock and bond markets combined.
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