Concern about exchange rates is a relatively new phenomenon in the history of trade and commerce. From classical antiquity, precious metals - gold and silver - provided a common medium of exchange throughout Europe and the eastern Mediterranean. So, for example, a 14th century English merchant selling wool to Flanders would exchange the wool for a quantity of gold or silver coins. If he wanted to know how much the unfamiliar coins were worth in terms of English sovereigns, he could weigh the coins and assay the purity of the metal to determine what weight of pure gold or silver they represented. Although there were a bewildering variety of coins in circulation in various parts of Europe, money changers could quote fixed rates of exchange between them.
From the late 14th century, Italian bankers began to issue paper notes in lieu of gold or silver, so that merchants did not have to carry trunk-loads of coins around. By the 18th century, paper money had come into widespread use. But its value was still tied to precious metals - each note was theoretically redeemable by the government concerned for a set weight of gold or silver. As this amount changed only infrequently, traders rarely had to worry about foreign exchange fluctuations affecting their profits.
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.
Money, in one form or another, has been used by man for centuries. At first it was mainly Gold or Silver coins. Goods were traded against other goods or against gold. So, the price of gold became a reference point. But as the trading of goods grew between nations, moving quantities of gold around places to settle payments of trade became cumbersome, risky and time consuming. Therefore, a system was sought by which the payment of trades could be settled in the seller’s local currency. But how much of buyer’s local currency should be equal to the seller’s local currency?
The answer was simple. The strength of a country’s currency depended on the amount of gold reserves the country maintained. So, if country A’s gold reserves are double the gold reserves of country B, country A’s currency will be twice in value when exchanged with the currency of country B. This became to be known as The Gold Standard. Around 1880, The Gold Standard was accepted and used worldwide.
Up to the First World War and beyond, the value of all major currencies was fixed in terms of the amount of gold for which each could be exchanged - this was the gold standard. This meant that the value of the major currencies compared to each other were also essentially fixed. Exchange differences were not a common item in traders' accounts. For this reason, the early development of case law on the taxation of trading profits makes almost no reference to how exchange differences should be taxed.
The gold standard collapsed in the world recession following the First World War. Many countries tried to stimulate domestic demand by devaluing their currencies, leading to retaliatory action by other countries.
During the first World War, in order to fulfill the enormous financing needs, paper money was created in quantities that far exceeded the gold reserves. The currencies lost their standard parities and caused a gross distortion in the country’s standing in terms of its foreign liabilities and assets.
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. Representatives of 44 countries met at a US resort called Bretton Woods to design such a system.
What came out of the Bretton Woods meeting was a partially fixed exchange rate keyed to the US dollar. An exchange rate for each participating currency (including sterling) against the dollar was agreed, with only minimal fluctuations being allowed. Fixing the US dollar at USD35/oz and fixing the other main currencies to the dollar - and was intended to be permanent.
Stability was maintained by central banks intervening in foreign exchange markets to buy weak currencies and hence increase demand. An institution, the International Monetary Fund, was set up to lend money to governments to help them do this. Occasional devaluations and revaluations were allowed if a country's economic position changed substantially.
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 The Bretton Woods system collapsed in the early seventies because of pressures on the dollar, caused partly by the USA's huge balance of payments deficit following the Vietnam War and partly by rising oil prices. 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.
A further system of partially fixed exchange rates was introduced in Europe in 1979, in order to encourage closer economic union. This was the Exchange Rate Mechanism, or ERM. A central rate of exchange was fixed against the European Currency Unit, or ecu. The ecu was not a real currency, but was calculated from a weighted average of all currencies in the European Union.
By 1992, divergent economic performance among EU countries was putting the ERM under severe pressure. As a result, the UK and Italy left the system, while currencies remaining in the ERM were allowed to fluctuate by up to 15% either side of the central rate.
Nevertheless, progress towards closer monetary union continued to be made and at the beginning of 1999, the euro was introduced. The currencies of 12 'eurozone' countries - Austria, Belgium, Finland, France, Germany, Greece, Ireland, Italy, Luxembourg, Netherlands, Portugal and Spain - were tied to the euro, so that from 1 January 1999 onwards, they ceased to fluctuate against each other. From 1 January 2002, the euro became the national currency of the countries concerned.
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.
- The Gold Standard Creates An International Economy
- The U.S. Becomes The New Global Economic Stronghold
- The US Economy In The Great Depression
- Anointing the Dollar As The World Currency
- Free Market Capitalism Is Born
- OPEC & The International Oil Crisis Of The 1970's
- Dollar Devaluation And The Plaza Accord
- Russian Financial Crisis
- Asian Financial Crisis
- Brazilian Real Crisis
- The Birth of Euro Currency
- Islamic Foreign Exchange
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