It is also a means of evaluating one country’s worth in terms of another’s and, depending on
circumstances, can therefore exist as a store of value.
Between 9000 and 6000 BC cattle (cows, sheep, camels) were used as the first and
oldest form of money.
THE BARTER SYSTEM
Throughout history, people have traded for various reasons: sometimes to obtain desired raw
materials by barter; sometimes to sell finished products for money; and sometimes to buy and
sell commodities or other goods for no other reason than to try to profit from the transaction
involved. For example, a farmer might need grain to make bread while another farmer might
have a need for meat. They would, therefore, have the opportunity to agree terms, whereby
one farmer could exchange his grain for the cow on offer from the other farmer. The barter
system, in fact, provided a means for people to obtain the goods they needed as long as they
had goods or services that were required by other people.
This system worked quite well and, even today, barter, as a system of exchange, remains
in use throughout the world and sometimes in quite a sophisticated way. For example, during
the cold war when the Russian rouble was not an exchangeable currency, the only way that
Russia could obtain a much-needed commodity, such as wheat, was to arrange to obtain it
from another country in exchange for a different commodity. Due to bad harvests in Russia,
wheat was in short supply, while America had a surplus. America also had a shortage of
oil, which was in excess in Russia. Thus Russia delivered oil to America in exchange for
wheat.
Although the barter system worked quiet well, it was not perfect. For instance it lacked:
- Convertibility – What is the value of a cow? In other words, what could a cow convert into?
- Portability – How easy is it to carry a cow around?
- Divisibility – If a cow is deemed to be worth three pigs, how much of a cow would one pig be worth?
It was the introduction of paper money – which had the three characteristics lacking in the
barter system – that allowed the development of international commerce as we know it today.
THE INTRODUCTION OF COINAGE
Approximately 4000 years ago, pre-historic bartering of goods or similar objects of value
as payment eventually gave way to the use of coins struck in precious metals. An important
concept of early money was that it was fully backed by a reserve of gold and was convertible
to gold (or silver) at the holder’s request.
Even in those days, therewas international trade and payments were settled in such coinage as
was acceptable to both parties. Early Greek coins were almost universally accepted in the then
knownworld; in fact, many Athenian designs were frequently mimicked, proving the coinage’s
popularity in design as well as acceptability.
Cowries (shells) were viewed as money in 1200 BC.
The first metal money and coins appeared in China in 1000 BC. The coins were made
of base metals, often containing holes so that they could be put together like a chain.
The first paper bank notes appeared in China in 800 AD and, as a result, currency
exchange started between some countries.
THE EXPANDING BRITISH EMPIRE
Skipping through time, some banking and financial markets nearer to those we know today
began in the coffee houses of European financial centres. In the seventeenth century these
coffee houses became the meeting places of merchants wishing to trade their finished products
and of the entrepreneurs of the day. Soon after the Battle of Waterloo, during the nineteenth
century, foreign trade from the expanding British Empire – and the finance required to fuel the
industrial revolution – increased the size and frequency of international monetary transfers.
For various reasons, a substitute for the large-scale transfer of coins or bullion had to be found
(the ‘Dick Turpin’ era) and the bill of exchange for commercial purposes and its personal
account equivalent, the cheque, were both born. At this time, London was building itself a
reputation as the world’s capital for trade and finance, and the City became a natural centre for
the negotiation of all such instruments, including foreign-drawn bills of exchange.
THE GOLD STANDARD
Gold was officially made the standard value in England in the nineteenth century.
The value of paper money was tied directly to gold reserves in America.
Foreign exchange, as we know it today, has its roots in the Gold Standard, which was introduced
in 1880. The main features were a system of fixed exchange rates in relation to gold
and the absence of any exchange controls. Under the Gold Standard, a country with a balance
of payments deficit had to surrender gold, thus reducing the volume of currency in the
country, leading to deflation. The opposite occurred to a country with a balance of payments
surplus.
Thus the Gold Standard ensured the soundness of each country’s paper money and, ultimately,
controlled inflation as well. For example, when holders of paper money in America
found the value of their dollar holdings falling in terms of gold, they could exchange dollars
for gold. This had the effect of reducing the amount of dollars in circulation. Inevitably, as the
supply of dollars fell, its value stabilized and then rose. Thus, the exchange of dollars for gold
reserves was reversed. As long as the discipline of linking each currency’s value to the value
of gold was maintained, the simple laws of supply and demand would dictate both currency
valuation and the economics of the country.
The Gold Standard of exchange sounded ideal:
- inflation was low;
- currency values were linked to a universally recognized store of value;
- interest rates were low, meaning that inflation was virtually non-existent.
The Gold Standard survived until the outbreak ofWorldWar I, after which foreign exchange,
as we know it today, really began. Currencies were convertible into either gold or silver, but
the main currencies for trading purposes were the British pound and, to a lesser extent, the
American dollar. The amounts were relatively small by today’s transactions, and the trading
centres tended to exist in isolation.
The early twentieth century saw the end of the Gold Standard.
THE BRETTON WOODS SYSTEM
Convertibility ended with the Great Depression, and the major powers left the Gold Standard
and fostered protectionism. As the political climate deteriorated and the world headed for
war, the foreign exchange markets all but ceased to exist. With the end of World War II,
reconstruction for Europe and the Far East had as its base the Bretton Woods system.
In 1944 the BrettonWoods agreement devised a system of convertible currencies,
fixed rates and free trade.
In 1944, the post-war system of international monetary exchange was established at Bretton
Woods in New Hampshire, USA. The intent was to create a gold-based value of the American
dollar and the British pound and link other major currencies to the dollar. This system allowed
for small fluctuations in a 1% band.
THE INTERNATIONAL MONETARY FUND
AND THE WORLD BANK
The conference, in fact, rejected a suggestion by Keynes for a new world reserve currency
in favour of a system built on the dollar. To help to accomplish its objectives, the Bretton
Woods conference instigated the creation of the International Monetary Fund (IMF) and the
World Bank. The function of the IMF was to lend foreign currency to members who required
assistance, funded by each member according to size and resources. Gold was pegged at $35
an ounce. Other currencies were pegged to the dollar and under this system, inflation would
be precluded among the member nations.
In the years following the Bretton Woods agreement, recovery was soon evident, trade
expanded and foreign exchange dealings, while primitive by today’s standards, returned. While
the amount of gold held in the American central reserves remained constant, the supply of
dollar currency grew. In fact, the increased supply of dollars in Europe funded the post-war
reconstruction of Europe in the 1950s. It seemed that the Bretton Woods accord had achieved
its purpose. However, events in the 1960s once again bought turmoil to the currency markets
and threatened to unravel the agreement.
THE DOLLAR RULES OK
By 1960, the dollar was supreme and the American economy was thought to be immune to
adverse international developments, and the growing balance of payments deficits in America
did not appear to alarm the authorities. The first cracks started to appear in November 1967.
The British pound was devalued as a result of high inflation, low productivity and a worsening
balance of payments. Not even massive selling by the Bank of England could avert
the inevitable. President Johnson was trying to finance ‘the great society’ and fight the
Vietnam War at the same time. This caused a drain on the gold reserves and led to capital
controls.
In 1967, succumbing to the pressure of the diverging economic policies of the members of
the IMF, Britain devalued the pound from $2.80 to $2.40. This not only increased demand for
the dollar but it also increased the pressure on the dollar price of gold, which remained at $35
an ounce. Under this system free market forces were unable to find an equilibrium value.
Source: A Foreign Exchange Primer
