Foreign Exchange: The Complete Deal. James McDowell. Sharpe
operated in the 19th and early 20th centuries.
The gold standard
In 1914 a holder of a £1 note could go to the Bank of England and exchange the note for 0.257 ounces of gold. Similar practices existed in other European countries and the USA, which meant that there was a fixed exchange rate between the major trading currencies.
The key element in the adjustment mechanism was that domestic money supply in a country was directly related to the amount of gold held by the country’s central bank. If the UK was running a deficit there was a net outflow of pounds from the country. When these pounds in turn were exchanged for gold at the Bank of England there would be a net outflow of gold from the UK. With the reduction in gold, the Bank of England would have to make a corresponding reduction of notes in circulation. This led to a reduction in money supply as cash was withdrawn, a rise in interest rates, a reduction in loans, a weakening of prices, and cutbacks in output and employment. Meanwhile, the gold arriving in Paris or Berlin (for example) would prompt an opposite pattern: the expansion of loans activity and an associated rise in prices.
In this example, the fall in demand in the UK would reduce imports, and exports would become more competitive as prices fell. Employment would be restored, the current account would be returned to equilibrium and another cycle would begin. A deficit on the current account could not be corrected by a devaluation of the currency (as it might be in 2011) because under the gold standard mechanism the currency was fixed in value. Imbalances were corrected through deflation and reflation via interest rates and fiscal policy.
In effect the First World War marked the beginning of the end of the standard as the belligerent powers were forced to reduce their gold holdings to pay for US weaponry and wheat. US gold stocks at the end of 1914 stood at $1.5bn but by the end of 1917 they were valued at $2.9bn. In practice there was no longer a workable distribution of gold stocks because there was abundance in the US and paucity almost everywhere else.
Efforts to revive the gold standard were made in the 1920s but with little success. After the First World War no major country allowed the free export of gold. This meant that domestic policy was no longer constrained by the fear that gold would go offshore. The prospect of reduced note circulation, bank loans, and the depressing impact on prices, employment and production had been removed. As such, countries were now free to pursue their own policies with no immediate regard for what other countries were doing. The coordinating discipline imposed by the gold standard (reinforced by a balanced budget mantra) had gone.
This is similar to the dilemmas facing international exchange management in the early part of the 21st century as the demise of the gold standard coincided with growing nationalism and a growing tendency to hold governments accountable for economic performance. Under this new freedom the greatest inflations of modern history in Germany and Austria occurred, as well as the rise of fascism and communism, protectionism, and the Great Depression.
The arguments in favour of a fixed rate revolve around certainty and economic discipline. Extreme volatility under a floating exchange rate system is regularly cited as its principal weakness. This is simply because in international business there is usually an element of futurity: deals are struck now against future payment. When a currency changes in price from day to day this introduces instability or uncertainty into trade, which affects prices and in turn sales. In a similar way, importers are unsure how much it is going to cost them to import a given amount of foreign goods. Related arguments are also applied to foreign investment flows, which involve the purchase or sale of equities, bonds, commercial interests and fixed assets, e.g., land and property.
This uncertainty can be reduced by hedging foreign exchange risk, and banks have created a panoply of products to resolve this problem, many of which are discussed later. These products have certainly reduced the negative impact of volatility on trade and investment. As we have seen, trade flows and current account balances have historically been the drivers of foreign exchange markets. Of growing importance is real money portfolio flows (bonds and equities) and any hedging that may be applied to these investments. Fund managers may hedge all, part or none of their exposure.
Bretton Woods and adjustable pegs
Before long – in fact prior to the end of the Second World War – it was recognised that a new international monetary framework was required in order to determine how exchange rates would be valued and how deficits would be financed. With the aim of resolving this dilemma, at Bretton Woods in 1944 the International Monetary Fund (IMF) was established and the member countries of the fund assented to have their currencies expressed either in terms of a given amount of gold or an amount of US dollars. Each member country agreed to see that these values were maintained within a given range. At the same time the US agreed with the IMF that its currency would always be convertible into gold and that it in turn would always buy and sell gold at a fixed price of $35 per ounce. This became the basis of the US dollar reserve function. The dollar had become the predominant medium for the settlement of international transactions.
For instance, from 1949 to 1967 the pound was valued at $2.80. This was known as par value for the currency. The Bank of England agreed to maintain prices within a 1% range so the pound could fluctuate from $2.78 to $2.82. If the price drifted below or above these levels the Bank of England would intervene in the market, buying or selling pounds as appropriate.
The Bretton Woods System is the best example of an adjustable peg system. In the short term, currencies are fixed in value against one another. In the longer term, currencies could be devalued or revalued if dictated by economic fundamentals. Exchange rate stability was maintained by buying and selling currencies and was therefore crucially dependent on gold and currency reserves held by the central banks.
Up to the late 1950s the US gold reserves exceeded the total dollar reserves of all foreign central banks by a ratio of 3:1. At this time the most typical response to heavy selling pressure on a currency was to raise interest rates. This attracted speculative flows from overseas, raising the demand for, and hence the price of, the currency. This could also be allied to exchange controls. The last resort, when reserves were depleted, was to borrow from the IMF. In practice governments tended to deflate their economies, reducing imports and hence restoring a current account balance.
The 1950s can viewed as a period of relative calm. With exchange rates set by Bretton Woods and tight exchange control regulations, trading opportunities were limited and dealers did little more than execute customer orders. Therefore, the dealing function of a bank attracted little interest. In the 1950s and through the late 1960s the US was the cornerstone around which international economic policy was based. The dollar played a role as a safe haven currency within a stable price environment. If a country faced an outflow of dollars it signalled the need to take corrective measures. This could be via tighter monetary and fiscal policies, incomes policies or even devaluation. At this time it was adjustment to the US that coordinated policies amongst the industrialised nations, which in turn provided the basis of international currency stability. The key point is that if stable exchange rates were desired, price levels had to be relatively stable, or at least moving in line with one another.
The pre-eminent position of the US, crafted from the two World Wars, was becoming strained in the 1960s as cost differences and levels of productivity started to widen between industrial countries. This was most visible in Germany and Japan. Post-war both countries channelled their savings into rebuilding new, efficient industrial plants, and arms expenditures were restricted by the victorious powers. This was coupled with significantly lower labour costs.
The US, in contrast, was channelling savings into military expenditures, which later increased further as a product of the Vietnam War. The result was that the dollar was fixed at an overvalued level and sales of goods from Germany and Japan flourished. The first cracks started to appear in the US economy by late 1958. From 1958 to 1960 the US ran up deficits of $11.2bn. This led to an accumulation of dollars held by foreign corporations, which in turn spawned the Euro-dollar market. A portion of these dollars were converted into gold and so began the reversal of the reserves the US had built up as a result of the First World War.
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