A fair exchange
Every time that you queue up at the airport to change your pounds into euros, you are engaging in an activity which is almost as old as money itself, says Edward Russell-Walling
Foreign exchange was the world's first fully fledged financial market and, although it is now rivalled by the derivatives market, it remains one of the biggest. The foundations were laid for foreign exchange dealing with the arrival of official coinage in Greece and the Middle East during the 7th century BC. Merchants initially sold goods in a foreign country for local currency, which they spent on local goods to take home. They soon realised it would be less cumbersome if they swapped the foreign coins for their own. Foreign exchange is the child - and, in a post-barter world, the enabler - of foreign trade.
Exchanges of the earliest coins (generally gold, silver or copper) were mere bullion transactions by weight, rather than by the number and quality of units. True foreign exchange emerged when the value of one unit began to be expressed in terms of another - thought to be some time during the 6th century BC. Soon, professional money changers, equipped with scales - the first 'bankers' - became a familiar sight at markets and temples, quoting rates in different coinages. In Jerusalem, they wore coins as earrings, badges of their trade.
The Persian Achaemenid Empire (550- 330BC) fixed the value of gold relative to silver at 1:13.5 and it remained at that level during the 4th and 5th centuries - even when ratios changed outside Persia. The ratio in Greece tightened to 1:11 as there was a persistent outflow of silver and, by the time that Alexander conquered Persia, in 330BC, silver coins were scarce. Foreign exchange arbitrage had been born.
The content and weight of Athenian silver coins was dependable, and they were widely accepted in most of ancient Greece. The city-state's perpetually adverse balance of trade - always importing more than it had exported - was settled by exporting these coins. In the 4th century BC, an Athenian merchant about to visit the Bosphorus paid a sum to an associate on the understanding that his father, who lived there, would repay the merchant in local money - this was an early 'international currency transfer'.
Rome gave the world its first 'reserve' currency in the form of the gold aureus and the silver denarius, accepted as far away as China. Starting with Nero, Rome also famously debased its currency, by mixing in inferior metals with the gold and silver, both a cause and an effect of the empire's decline. As the denarius was alloyed and became less pure, good coins issued before the debasement began to disappear, being hoarded or exported. As Gresham's Law puts it, 'bad money drives out good'.
During the Middle Ages, trade in foreign coinage was largely supplanted by bills of exchange, bought in one country and paid in another, in a different currency at a later date. Exchange rates made allowance for, among other things, the risk of devaluation in the foreign currency and were decided at quarterly fairs by bankers' votes.
Debasement of the coinage resulted from coin clipping (shaving tiny bits of metal from the coins), counterfeiting or wear and tear. More often, devaluation was a deliberate cutting of the metal content, to compensate for gold or silver outflows from the country. Official debasements were rare in England before King Henry VIII, because Parliament controlled finances, and Louis IX of France was known as Saint Louis mainly because he maintained a sound currency.
It was the German states and Spanish kingdoms, on the other hand, that had frequent debasements - often caused by a ruler's need for funds, either for war or court extravagance. These debasements provoked exchange rate volatility - then, as now, dangerous for trade but good for shrewd speculators - well into the 17 th century. Economic conditions and exchange rates were starting to become more and more intertwined. A change in the English gold-silver ratio in 1601 had the effect of strengthening sterling, the result of which was a depression in the country's exports, particularly the cloth trade, a principal export for England at that time.
Though the 'discovery' of the Americas boosted the world's supplies of gold, metal shortages eventually prompted the issue of token coins and paper money. In Britain, Bank of England banknotes became legal tender in 1844, fully backed by gold - the 'gold standard'. Since the Bank promised to redeem the notes in gold on demand, it had to hold enough gold to cover the issued notes, and could not devalue the currency (and cause inflation) simply by printing new ones. By 1900, most of the developed world had followed Britain's lead. By managing interest rates according to the gold flows, central banks stabilised currencies relative to others on the gold standard.
War and depression forced most nations off the gold standard by the early 1930s, although it resurfaced in a different form after the Second World War. At the 1944 Bretton Woods conference, 44 Allied nations agreed to fix their exchange rates relative to the gold price. Quoted in US dollars, at $35 an ounce, this pegged the world's currencies to the dollar. As the dollar was convertible into gold, it was 'as good as gold'.
Bretton Woods advocated free trade and freely convertible currencies, in contrast to the foreign exchange controls and the deliberate devaluations (to improve exports and cut deficits) of the 1930s. However, the International Monetary Fund's management of the exchange rate system finally collapsed in 1973, when the long-running US trade surplus turned into a deficit and eroded people's faith in the American dollar.
Fixed rates encourage trade stability, but can cause damaging distortions. In 1979, the European Union pegged the rates of participating currencies within the Exchange Rate Mechanism (ERM). Britain eventually joined the ERM in 1990, with the pound fixed at a rate which would prove too high against the core Deutschemark. By 1992, sterling was unable to remain within the permitted bands, particularly as a wave of speculative selling had pushed the pound down lower and, on 'Black Wednesday', 16 September 1992, Britain was forced to leave the Exchange Rate Mechanism.
The Black Wednesday debacle shattered the reputation of the Conservative Party for competent financial management and almost certainly helped contribute to their defeat at the next election. The fiasco also paved the way to the Bank of England's independence in setting interest rates. Nevertheless, to this day, the incident continues to remind people that the power of the foreign exchange markets extends far beyond the bureau de change.
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