Two decades ago, the world was quite different. The U.S. dollar was the uncontested standard of value. The euro did not exist. If small traders wanted exposure to currencies, they traded currency futures. Only big banks and million-dollar accounts did business in cash forex. Now, the cash currency markets, where as little as $25 can open an account, have the lowest barriers to entry. Among the changes that have followed are new relationships between different currencies and between currencies and gold.
Currencies are quoted as cross rates, the value of one currency in terms of another. For example, JPY/USD tells us how many yen it takes to buy one dollar. Generally, currency traders make money by forecasting these cross rates and buying or selling accordingly.
It wasn’t always like this. World currency history is rich with change. One of the biggest of the modern era happened in 1971 when the gold standard, which valued currencies in terms of gold, was dropped. This history includes the U.S. dollar becoming the world currency of measure, and its ripple effects continue to be felt today as we transition into a new financial world order. To understand this trading landscape, and the benefits it offers, it’s necessary to understand what got us to where we are today.
THE GOLDEN AGE
The years 1880-1914 are considered the classical gold standard period. High economic growth and fairly free trade marked this era. National currencies and other forms of money were converted to gold per a fixed price. In England, the unofficial tie to gold dated to 1717, after the overvaluation of the guinea in silver terms by Sir Isaac Newton, the master of the mint. Gold became the legal standard there in 1819. The United States went to a gold-only standard in 1834 and in 1900, Congress approved the Gold Standard Act.
The system broke down during the Great Depression. Currencies were devalued to make exports more competitive amid mass unemployment, shrinking demand and declining national incomes. World trade became restricted to groups of nations handling similar currency (currency blocs). Despite short-term gains, over the long term this restricted foreign investment opportunities and the international flow of capital.
To improve the international economy, the Bretton Woods planners decided upon a regulated system, an organized market with tight controls on currency values. From 1946-1971 the Bretton Woods system attempted to use the advantages of the gold standard but not its disadvantages. This meant compromise. There were permanently fixed and free floating rates with the right to revise currency values when necessary.
This system set the stage for fixed exchange rates and established the International Monetary Fund (IMF) and the International Bank for Reconstruction and Development (IBRD), now known as the World Bank (WB). It also encouraged an open system for free trade and conversion of members’ national currencies into other currencies. The IMF and IBRD are still the prominent world economic forces.
Thus, the “pegged rate” currency system came to be. Members needed to create the equivalence (parity) for their currencies in terms of gold. This was known as a peg, but they also had to maintain the exchange rates within plus or minus 1% of the parity value, known as a band. They did this by selling or buying foreign currency in the foreign exchange markets. If the IMF determined that the balance of payments of a country was disturbed, only then it approved the change of the country’s par value.
After John Maynard Keynes’ suggestion that a new currency, the bancor, which would be fixed in terms of 30 commodities, was objected by the United States, the dollar became the world’s reserve currency. This meant that other currencies were pegged against the dollar. The United States, in turn, agreed to link the dollar to gold at $35 per ounce. Hence, the Bretton Woods system established a payment system wherein all currencies were defined in dollars, which were by international agreement as good as gold.
This marked the replacement of the gold standard in the international economic market and made the U.S. currency the world currency and the standard against which other currencies were pegged. The dollar had the maximum purchasing power and was the only currency supported by gold. This position was only strengthened following World War II. European nations, deep in debt, transferred gold in large quantities to the United States. All this appreciated the dollar value rapidly, making the dollar supreme.
There was a glitch in this system, however. While the dollar was the hinge on which all international commerce turned, it was still tied to gold, and London had roughly 80% of the gold market. London issued the price of gold in the open market (the gold fix) every morning. Thus, to ensure that the Bretton system worked, there were two options. One was to change the peg of dollar to gold, while the other was to keep the open market gold price around the official (central bank) price of $35 per ounce.
The economist Robert Triffin, in 1960, put forth what came to be known as Triffin’s Dilemma, which stated that if the United States did not maintain running deficits, it would not be able to cope with worldwide economic growth. Consequently, system liquidity would be lost. The other side of the coin was that if these deficit payments continued, it would depict an unstable reserve currency and faith in the dollar would be lost.
The response to this conundrum, on Nov. 1, 1961, was to create the London Gold Pool among eight countries. If the morning’s gold fix set off spikes in the open market gold price, the gold pool sold gold on the open market. This later would be recovered when the gold price fell. The gold price increased sharply, even to values as high as $40 per ounce during significant shocks, such as during the Cuban Missile Crisis. The Kennedy administration made a radical change in the tax system hoping to increase exports by encouraging more production and, in turn, maintain the $35 peg that ended in the 1963 tax program.
In 1967, the Sterling Era witnessed a scramble for gold and the pound was attacked. This led to the forced devaluation of the pound by the British government on Nov. 17, 1967. President Lyndon Johnson was left with two tough options: enforce protectionist measures such as export subsidies, which would reduce the budget and travel taxes; or allow the risk of a gold run, which would hurt the dollar. Johnson felt that the world gold supply was not sufficient, especially to support the role of the dollar as a world currency. He also felt that to turn away from the open market would cost the United States both economically and politically.
When West Germany decided not to hold dollars or purchase gold from the United States, the pressure on the pound sterling and dollar mounted. Johnson tried many measures to stop the gold outflow and increase U.S. exports in January 1968 but all in vain, as the run on gold continued. Thus, the London gold pool was dismantled on March 17, 1968. Efforts to help the existing system continued, but as long the United States kept its commitment to the foreign operations, especially Western Europe, maintaining the gold peg remained tough. When this effort finally collapsed in November 1968, the Bretton Woods system was altered.
STRUCTURAL CHANGES
When President Richard Nixon declared in August 1971 that the United States no longer would trade currency for gold, the Bretton Woods system ended. Formal links between the major world currencies and real commodities no longer existed. Since then, the gold standard has not been used in any major economy.
The faith in the dollar began to decline as the Vietnam War worsened and inflation and the trade deficit mounted and Washington was forced to print dollars.
When the so-called “Nixon Shock” came on Aug. 15, 1971, without consult of the IMF or State Department, it brought with it many drastic measures, such as price and wage controls for a 90-day period and an import surcharge of 10%. The most important was the “closing of the gold window,” as the dollar could not be converted to gold except in open markets. By December 1971, the surcharge fell and all major currencies were allowed to devalue from the exchange rate by 2.25%. Gradually, by March 1976, all major currencies had floating values, which meant the fall of the main pillar for monetary control: exchange rates.
Although the dollar remained the world currency, it was no longer backed by anything except the good faith of the United States. Almost all countries, including the United States, are on a fiat money system, which means that the currency is only for exchange purposes. The supply and demand for a currency, as well as for other goods and services, determines the value of the money.
To help define the now wildly fluctuating values of currencies vs. the dollar, the dollar index was born in 1973, priced at 100.00. Today, the U.S. dollar index is the weighted geometric mean of the dollar as compared to the euro, the Canadian dollar, the Swedish krona, the Swiss franc, the Japanese yen and the pound sterling. It is updated 24 hours a day.
Dollar weakness has caused many issues including the recent crude oil shock. There are some benefits, however. A weak dollar helps exporters as it reduces the cost of goods sold overseas. On the other hand, imported goods become more expensive. These interrelationships have fueled a battle between countries to bring about a balance in currency relationships to serve their self-interests.
The United States has always maintained a strong dollar policy; however, this declaration has often been no more than posturing. For example, the Bush administration spoke of a strong dollar policy, but it oversaw a major decline in dollar value. In some ways, weakening your currency is a way of protecting trade without violating trade agreements.
CURRENCY WARS
A critical point in this discussion is that the value of a country’s currency is a tool to control trade. For example, if the U.S. started devaluing the dollar, at some point, Japan would start selling yen. Since the 1990s, these currency wars have become the norm until recently when the global recession took hold.
This is not insignificant. It can be argued that the current crisis has created a new paradigm. In fact, a new gold standard, the reverse of the earlier, has surfaced. The United States and other countries need to spend money to fuel the economy and help the financial system survive. Both borrowing and printing money can do this. In fact, during the Bush administration, the government stopped reporting M3, the broadest measure of the supply of money, as a way to hide the amount of money being created.
Now consider a new concept, the Inverse Gold Standard. If a country starts printing money, the value of the currency would fall compared to other currencies, which would lead to inflation. This is the standard way of looking at things.
Now assume that all major currencies have increased supplies the same way. If all countries added the same ratio of money, both the dollar index and currency cross rates would not change. Using this type of system, the major currencies could create money without leading to devaluation of their currency compared to other currencies. We would only see this devaluation relative to gold.
This new concept, the Inverse Gold Standard, which increases the world money supply without apparent inflation, gets to the heart of this. This concept explains the recent increase in the dollar amid a rally in gold and a drop in the euro. In reality, the dollar did not rally; the other currencies fell below the dollar when compared to gold.
As traders, our job is to recognize this new dynamic and determine how to take advantage of it. It begins by looking at the cross rate between gold and a currency instead of cross rates among currencies. In the second part of this two-part series, we will look at the trading implications of this concept and develop a trading system that can take advantage of it.
Murray A. Ruggiero Jr. is a consultant. His firm, Ruggiero Associates, develops market timing systems. He is the author of “Cybernetic Trading Strategies” (Wiley). E-mail him at ruggieroassoc@aol.com
