Some years ago, experts at the Federal Reserve in Washington DC put together a model designed to predict future trends in the world’s major currencies. They had access to more information on foreign-exchange markets than economists in any other country and they were confident of success. For months they worked on the project until, at last, it was time to switch on the machine …
Days later it was clear that the experiment was a complete flop. According to the then Fed Chairman, Alan Greenspan, “The rate of return on that investment of time and effort and people was zero.” Such a result was perhaps unsurprising. The foreign-exchange markets attract trillions of dollars of speculative investment every year as people try to second-guess currency movements. But they are arguably the most volatile and unpredictable of all markets.
All of us become currency speculators of a sort, when we travel abroad. As soon as we swap dollars or pounds for pesos or euros we are investing in a foreign currency, the value of which is likely to rise or fall by the time we arrive back home.
Currency markets Currency markets, often known as Forex (short for foreign exchange), are where investors buy and sell currencies. They are among the world’s oldest financial institutions, stretching back to Roman times and before, and have existed for as long as there has been money and international trade. But the Romans would reel at the size, sophistication and international breadth of the markets that have evolved today.
The euro and currency unions
The most famous currency union, whereby different countries share a single currency, is the euro—the 15-member currency union in Europe (as of 2008). Preceded by the European Exchange Rate Mechanism (ERM), which ensured prospective members kept their economies in lock-step with each other, the euro was introduced fully in 2002, replacing each member state’s currency.
Past attempts at other currency systems had collapsed as national governments sought independence in economic policy, but the Euro’s founders tackled this by creating one central bank to set interest rates for the entire euro area, and an agreement over the limits within which governments can borrow and spend.
More recently, there have been talks between countries in, respectively, the Persian Gulf and Latin America about possible currency unions.
Every year trillions of dollars’ (or euros’, or pounds’) worth of currency is bought and sold by investors. Sometimes those investors will be companies, keen to ensure their profits are not obliterated if, for instance, the strength of the dollar leaps, making their imports from the United States much more expensive. They are seeking currency hedges in order to insure themselves against risk. At times they are governments, intervening in the currency markets to ensure their own currency remains at a certain level. At other times they are investors and hedge-fund managers with a hunch that a currency is about to take a tumble. And sometimes they are merely foreign tourists like you and me.
Rises and falls There are many reasons why a currency rises and falls, but two in particular affect its behavior. First, and most importantly, a currency tends to rise and fall in tandem with perceptions of the economic health of the country with which it’s associated (or the jurisdiction that issues that currency).
Second, currency investors tend to chase the currency with the highest yield. If a country has high interest rates it means the government bonds and other investment opportunities it issues will offer a greater return than in a country with very low interest rates. Investors from around the world buy them up, and as a result of this extra demand for the country’s investments, the value of the currency increases. In contrast, the currency falls if rates are low and people abandon their investments denominated in that currency.
“The dollar may be our currency but it’s your problem.”
John Connally, Nixon’s Secretary of the Treasury, to European central bankers
Floating or pegged? Since the 1970s almost every country in the Western world has had a floating currency, the value of which ebbs and flows against other currencies as determined by the markets. However, there are notable exceptions, with some countries fixing their currencies against either another currency or a group of them. The most renowned example is China, whose government carefully controls the value of the renminbi against the dollar by buying dollar-denominated assets as necessary.
Other nations occasionally intervene by doing the same if they believe their currency is over- or undervalued. Japan and the euro area have both done so since the turn of the millennium. There is considerable evidence that it is highly beneficial for vulnerable, emerging nations to fix their currencies in this way, since it improves stability, encourages people to invest and helps trade relations.
Floating rates were not the norm in the world until relatively recently. Throughout much of the 19th and 20th centuries, governments kept the rate of their currencies fixed. In the times of the Gold Standard, they fixed the values of their currencies against the amount of gold they had in their vaults. The idea was that gold is a universal currency, of equal value anywhere in the world.
The system improved global trade, since businesses did not have to worry about how the rise or fall of currencies in countries to which they were exporting would affect their profits. The problem was that the amount of gold being mined could not keep pace with the growth of trade and investment. The Gold Standard eventually became a major restraint on fast-growing economies, and was abandoned by many around the time of the Great Depression.
Bretton Woods After the Second World War, a group of economists and policymakers met in the smart Mount Washington Hotel in the US town of Bretton Woods, New Hampshire, to devise a new system for regulating international exchange rates. They came up with a fixed-rate system, this time aligned to the US dollar, since the US by that stage was clearly the world’s economic superpower, and the dollar happened to be stable, its value fixed against gold. Each country pledged to peg its currency—in other words, to ensure it remained equal to a certain number of dollars.
The problem with fixing a currency against another, however, is that the country in question loses some of its ability to control its economy. When one country in a currency union raises its interest rates the rest have to do so as well, or risk setting off a major inflationary spiral. The Bretton Woods arrangement started to break down in 1966, but, as we shall see, it was not the last of the major currency systems.
Currency speculation Some argue that fixed exchange-rate systems can mask the true value of a currency, and there have been many examples in recent years when speculators launched assaults on a country’s currency—selling it off in the belief that the pegs were unsustainable. This happened to various Asian countries during the financial crisis of the late 1990s and, even more notoriously, to sterling. On “Black Wednesday” in September 1992, the UK was forced to abandon its brief membership of the ERM (European Exchange Rate Mechanism) after speculators, led by hedge-fund billionaire George Soros, attacked it. Despite raising interest rates to double-digit levels, the UK Treasury was unable to prevent an exodus of investors from the pound, and eventually it surrendered, allowing the pound to depreciate (fall) against other currencies around the world. It was a traumatic day for the UK economy, and encapsulates precisely how directly a currency’s level reflects perceptions of a country’s economic policies.
the condensed idea
The barometer of a country’s standing
| timeline | |
|---|---|
| 1944 | Bretton Woods agreement |
| 1966 | Bretton Woods starts to break down |
| 1979 | Introduction of the European Exchange Rate Mechanism |
| 2002 | Full introduction of the euro |
| 2005 | China loosens its peg on its currency, the renminbi |