Exchange rates

A The Bretton Woods agreement of 1944 established fixed exchange rates, defined in terms of gold and the US dollar. Between 1944 and 1971, many currencies were pegged against the US dollar, i.e. their parities with the US dollar were fixed. In this period, a US dollar was a promissory note issued by the United States Treasury. If anybody requested it, the Treasury had to exchange the note for 1/35th of an ounce of gold. Under this system, overvalued or undervalued currencies could only be adjusted with the agreement of the International Monetary Fund. Such adjustments are called devaluations and revaluations. The Bretton Woods system of gold convertibility and pegging against the dollar was abandoned in 1971, because following inflation, the Federal Reserve did not have enough gold to guarantee the American currency.

B Gold convertibility was replaced by a system of floating exchange rates. (Today, the US dollar - the unofficial world currency - is merely a piece of paper on which is written 'In God We Trust.' God, not gold!) A freely (or clean) floating exchange rate is determined purely by supply and demand. Theoretically, in the absence of speculation, exchange rates should reflect purchasing power parity - the cost of a given selection of goods and services in different countries. Proponents of floating exchange rates, such as Milton Friedman, argued that currencies would automatically establish stable exchange rates which would reflect economic realities more precisely than calculations by central bank officials. Yet they underestimated the impact of speculation, and the fact that companies and investors frequently follow short-term money market trends even if these are contrary to their own long-term interests.

C In the late 1970s and early 1980s, the American, British and other governments deregulated their financial systems, and abolished all exchange controls. Residents in these countries are now able to exchange any amount of their currency for any other convertible currency. This has led to the current situation in which 95% of the world's currency transactions are unrelated to transactions in goods but are purely speculative. Enormous amounts of money move round the world, chasing high interest rates or capital gains, as investors - including rich individuals, companies and pension funds - seek to maximize the value of their assets. In London alone, in the late 1990s, over $300 billion worth of currency was traded on an average day - the equivalent of about 30% of the value of the goods Britain produces each year. Banks, of course, make a profit from the spread between a currency's buying and selling prices.

D Few governments, however, leave exchange rates wholly at the mercy of market forces. Most of them attempt to influence the level of their currency when necessary. Managed (or dirty) floating exchange rates are more common than freely floating ones. For example, in the 1980s, most Western European governments joined the EMS (European Monetary System), which established parities between member currencies. There was also an Exchange Rate Mechanism (ERM): if the rate diverged by more than plus or minus 2 1/4 per cent from the central parity, central banks had to intervene in exchange markets, buying or selling in order to increase or decrease the value of their currency.

E Yet international speculators can be more powerful than governments. For example, on a single day in September 1992 the Bank of England lost five billion pounds in a hopeless attempt to support the pound sterling. For weeks, all the world's financial institutions and rich individuals had been selling their pounds, as everyone except the British Government believed that the pound had been seriously overvalued ever since it belatedly joined the ERM in 1990. When the British central bank ran out of reserves and could no longer buy pounds, the currency was withdrawn from the ERM and allowed to float, instantly losing about 15% of its value against the D-mark. The next year, speculators attacked five other European currencies, and the European Monetary System was suspended. It was later reintroduced in a looser form.

F Many manufacturers are in favour of fixed exchange rates, or a single currency. Although it is possible to some extent to hedge against currency fluctuations by way of futures contracts, forward planning is difficult when the price of raw materials bought from abroad, or the price of your products in export markets, can rise or fall by 50% in only a few months. (Since exchange controls were abolished, currencies including the US$ and the £ sterling have in turn appreciated by up to 100°/o and then depreciated by more than 50% against the currencies of major trading partners.)

G Pressure from industrialists and governments led to the introduction of the euro. Twelve countries fixed their exchange rates against the new currency, and beginning in 1999 the new currency was used as a means of payment between companies and in foreign trade, and bonds were denominated in it. The euro came into existence as a real currency in 2002, when the old notes and coins in the twelve member countries were withdrawn.