Brief History of Forex

Back in the days when kings thought they had the divine right to rule, they often wanted more money than their parliaments would grant them. But most parliamentary bodies did not consist of fools; they certainly knew better than to leave the powerful tool of taxation solely in the king’s hands.

Not being able to tax as they please, kings sometimes resorted to another financial weapon, which was to devalue their country’s currency. They would recall all gold and silver coinage, melt it down, then reissue it in lighter weight or with mixed in base metals, thus pumping up the royal treasury. Since the currency was backed more by the citizens’ confidence in the stability of their country than by anything else, most people never even noticed these changes, and kings got their way.

But sometimes people did notice changes in coins, and sometimes they were not all that confident in the stability of their country, say, if there was a threat of invasion from a powerful enemy. When that happened, often merchants refused to accept the devalued coinage in trade, demanding real gold or silver instead and rendering the king’s currency valueless. Such undermining of the currency could lead to a rapid collapse of the king’s government.

In the eighteenth and nineteenth centuries, the increasingly republican governments of the Western world began basing their currencies, not on confidence but on gold. This prevented their rulers from devaluing the currency but created other problems.

The gold standard had an inherent problem of boom and bust cycles. The imports of goods lead to outflow of capital from the country and shrinkage of money supply. The shrinkage of money supply lead to higher interest rates and lower prices because there was not enough money to buy goods. The lower prices would entice merchants from other countries to export goods from the country thus increasing the supply of money, pushing down interest rates and raising the standards of living again.

This boom-bust pattern continued in many western countries until World War I interfered with trade and stopped the flow of money across borders. The pattern resumed after the war and throughout the Roaring Twenties, until the 1929 stock market crash devalued the U.S. dollar and caused a worldwide depression. The Great Depression was relieved by the World War II, when the demand of war supplies and the drafting of men into military forces cured problems of unemployment and high prices.

Although the Second World War eased economic problems in the U.S., it caused them in other countries, which had to purchase different goods and materials that they were not able to manufacture themselves. This led to an agreement known as the Bretton Woods Accord, signed in New Hampshire in 1944 and designed to create a stable post-war economy where the Nations of the world could recover financially.

The Bretton Woods Accord pegged the value of all world major currencies to the U.S. dollar, making it the benchmark to measure all other currencies. It also pegged the U.S. dollar to the price of gold at $35 per ounce, and it created the International Monetary Fund (IMF), a confederation of 185 nations around the world, dedicated to fostering economic stability and high employment.

For decades, the Bretton Woods Accord worked well. But in the early 1970s, international trade grew to such an extent that currency rates could no longer be contained. Finally, in 1973, President Richard Nixon allowed the U.S. dollar to be taken off the gold standard, and the complex arrangement of currency values was abandoned.

The major currencies of the world have come full circle: just like in the old days of kings, the currencies are controlled by the market forces of supply and demand, without being pegged to any other currency or to any precious metal. (Some of the smaller nations of the world prefer to peg their currency to that of their major trading partner, like some Caribbean nations with the United States.) This created the Forex market, where one currency can be traded against another currency with the expectation of earning profit from changes in their relative values.

At first, only major commercial and central banks traded the Forex. But with time hedge funds, mutual funds, large international corporations, and some super-wealthy individuals discovered it. By the 1980s, about U.S. $70 billion per day was changing hands in Forex transactions.

The explosion of the Internet and sophistication of computer security systems enabled exchanging currencies online independently of any bank across the globe and different time zones.

In 2000, the U.S. Congress passed the Commodity Futures Modernization Act, which opened the Forex to the average investor. Retail brokerages sprang up across the Internet. Today about US $1.5 trillion is traded per day. Just 5% of this amount is currency conversions by travelers, banks, and international corporations. The rest of transactions represent trading for profit.

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