Forex Investment and Currency Trading

Up until 1973, currencies were fixed in value against the US Dollar, according to the system introduced on July 22, 1944 by the United Nations Monetary and Financial Conference in the resort of Bretton Woods in New Hampshire. This agreement became known as the “Bretton Woods” system. The Bretton Woods conference was at the same time the founding venue for the International Monetary Fund, a supranational entity. The IMF was a multilateral decision-making body with limited authority. There was a surprisingly large consensus among the 44 allied nations (plus neutral Argentina) participating in the conference. Everybody wanted to devise a system that would avoid a repetition of the inter-war monetary chaos. Almost everyone agreed that the flexible exchange rates of the 1920s and 30s had fostered speculation and discouraged international trade. The US and Britain dominated the conference. The two principal proposals were by Harry Dexter White of the US Treasury and by John Maynard Keynes of the UK. The compromise that was finally accepted was closer to White’s plan, though in retrospect, the differences between Keynes and White were not all that significant. While floating rates were clearly seen as bad, a totally fixed system like the Gold Standard of the 19th century was viewed equally undesirable. Governments wanted to retain the freedom of redefining the value of their currency to adapt to changing conditions. The final plan implemented a system of pegged currency rates, whereby each country had to define the “par” value of its currency vs. the USD while the USD would be fixed against gold. A currency would be allowed to float in a +/-1% band around its “parity”.

To give the desired flexibility, the system allowed for adjustments in the pegged “par” rates, if conditions warranted. This allowed a country to devalue or revalue its currency when there was a “fundamental disequilibrium” in its balance of payments. The fact that it was never spelled out what specifically constituted a “fundamental disequilibrium” proved a serious omission in later years. Gold was to continue to be the major reserve asset for all central banks and gold convertibility among central banks was to continue. In order to create additional liquidity, a system of quotas was created within the IMF. Each member country would pay a subscription according to its quota into the fund. ¼ of the subscription had to be in gold or a gold-backed currency, while ¾ could be in the country’s domestic currency. Whenever a member country ran short of foreign currency reserves, it could borrow against its quota.

Finally, while the articles forbade discriminatory exchange rate policy practices and monetary controls that would impede payment for goods and services, controls for capital account transactions were not only allowed but encouraged, in order to prevent “hot money” flows that were viewed as destabilizing.

It became apparent very quickly that the additional liquidity by the fund was not sufficient by a wide margin to tide over the payment imbalances of the postwar period, and the US took over the role of liquidity provider. This eventually created a Dollar overhang in the world, which moved from a scarcity of Dollars in the 50s to a glut in the 60s.

Much of the reconstruction of Europe was financed by the US. The G.I. bill helped kickstart the US economy, after a long and costly war. The strength of the Dollar in the late fifties early sixties made imports into the US artificially cheap and US exports relatively expensive. All of this created fiscal deficits and currency account shortfalls. The 60s were marked by acrimonious debates between the US, Europe and Japan, as to who needed to do what to ease the strains on system. Japan and Europe maintained that the US had to cut its external deficit, while the US insisted that Europe and Japan needed to cut their surpluses, in addition to revaluing their currencies. While US deficits actually shrank up to 1965, increased social spending at home and the escalating cost of the Vietnam War marked the subsequent years. In addition, the US adopted a policy of “benign neglect” and let deficits and inflation run their course. Governments elsewhere were still bound to defend their currencies’ pegs against the Dollar and were thus obliged to absorb a growing overhang of Dollars. This added a crisis of confidence to the already existing monetary strains. In 1967, the “Sterling Crisis” was among the first prominent signs of the end of the Bretton Woods system of exchange rates. More episodes followed. The German Mark was revalued by +9.3% in 1969, but persistent exchange market pressures caused Germany to float its currency in 1971. Japan followed suit in August.

On August 15, 1971, Richard Nixon announced to the nation a stimulus package that included a 10% import tax on all goods and suspended the convertibility of Dollars into gold. (“I am taking one further step to protect the dollar, to improve our balance of payments, and to increase jobs for Americans. As a temporary measure, I am today imposing an additional tax of 10 percent on goods imported into the United States. This is a better solution for international trade than direct controls on the amount of imports”).

In February of 1973, after waves of speculative attacks against the new set of par values against the Dollar, the major nations finally agreed to abolish the system of fixed exchange rates. A system of freely floating currencies was adopted, instead. This is known as the “Smithsonian Agreement”. A new era of variable exchange rates had begun.

Companies with international businesses had to start coping with a new, unknown variable. Currencies that had been fixed for nearly 30 years save for periodic adjustments now changed their value continuously. This was a totally new situation.