From the Gold Standard to Floating Exchange Rates

The currency or foreign exchange market has evolved gradually to become the largest capital market in the world where major currencies are actively traded in a system of floating exchange rates. The following sections cover some of the history of the currency market. This includes the transition from commercial transactions involving currency of intrinsic value like gold  – the gold standard – to the more modern prevalence of paper fiat currency that is simply backed by the credit of the country printing it.

The Forex Market’s Ancient Roots

As commerce between different countries increased in early human civilized history, a standardized medium of exchange was needed to facilitate commercial transactions. The first generally-accepted medium of exchange consisted of the precious metals gold and silver. This practice gave rise to the minting of coins during the Roman era, which in turn evolved into the issuing of paper currency in the Middle Ages.

Paper money was originally introduced as a way to represent the value of gold for security purposes. Gold would first be deposited into a trusted bank, and a receipt would then be issued for the amount of gold on deposit that could be used as a medium of exchange in place of gold.

These receipts eventually evolved into becoming the principal instruments of exchange, and so governments began to issue currency backed by the country’s gold reserves. This was later to become the first international monetary standard, known as the Gold Standard.

The modern history of the forex market begins to take shape in the late 1800s as described in the following sections.

The Gold Standard

The origins of the Gold Standard in international commerce begin in 19th century Britain after the English Monarchy adopted the Gold Standard in 1816 with the passage of the Coinage Act.

The Coinage Act was the first instance of defining the value of the British Pound Sterling in relation to gold. The value of one pound of 22-Karat gold at the time was set to be equivalent to £46 14 s 6 d or 46 Pounds, 14 Shillings and 6 Pence.

Silver was also used as a standard means of exchange. Nevertheless, the price of silver was pegged in relation to gold, and at the time of the Coinage Act, it was set to a ratio of 15 ½ units of silver to one unit of gold.

Before the advent of the Gold Standard in, most countries would use physical gold or silver for the payment of goods and debts. Nevertheless, by linking their currencies to the value of gold as a standard, nations found they could use printed paper currency backed by gold in reserve for the payment of debts.

Since the printed currency of different nations related to the price of gold, the currencies also related to each other. Furthermore, as different amounts of each currency were needed for the purchase of one ounce of gold, this created a rate of exchange among the currencies.

By the beginning of the 20th century, all of the major industrial powers had converted to the gold standard with a set amount of gold backing a specified amount of currency.

The gold standard gave stability to the world economy, enabled the industrial revolution and began a new era of international trade among nations.

Disruptions in the Gold Standard

The breakout of the First World War brought an end, at least temporarily, to the gold standard.

The enormous amount of capital needed to fund military defense projects against the German aggressors was far beyond the amount of gold available to back all of the currency.

As nations began ignoring the gold standard and no longer defined the values of their currencies in terms of gold, mass speculation in the currency markets soon followed.

By the end of the 1930s, Germany had revived its arms industry and was ready to embroil the world in a Second World War. The British Pound Sterling also lost considerable value when the Germans hatched a counterfeiting campaign which adversely affected the once powerful U.K. currency.

How the U.S. Dollar Became so Prominent

The only nation involved in World War II that did not suffer significant physical damage with respect to its infrastructure and mainland was the United States.

All other involved nations had to rebuild and this left their economies in considerable disarray. Some countries also paid for the assistance of the United States in the conflict.

The Bretton Woods Accord

Before the end of World War II, the United Nations’ Monetary and Financial Conference was held in Bretton Woods, New Hampshire in 1944. The meeting brought together delegates from all of the Allied nations who then worked out and signed the Bretton Woods Accord. Due to pressure from the United States, the U.S. Dollar eventually became the currency selected. The Accord effectively pegged the price of gold to $35 U.S. Dollars per ounce and all other currencies to the U.S. Dollar with a maximum deviation of 1%.

The Bretton Woods Accord also established the International Monetary Fund and the Bank for Reconstruction and Development that are currently part of the World Bank.

Nixon Takes the U.S. Dollar off the Gold Standard

As the United States accumulated massive budget and trade deficits during the 1950s and 1960s, the U.S. Dollar began losing its status as the world’s only reserve currency. Also, Richard Nixon, then the U.S. President, decided to end the Dollar’s convertibility into gold in August of 1971, essentially taking the U.S. Dollar off of the Gold Standard.

An agreement known as the Smithsonian Agreement, was signed by the members of the G10 Nations in December of 1971 which provided international currencies with temporary stability. In addition, another agreement was signed among European Nations in Basle, Switzerland in 1972 which established a “snake in the tunnel” system for minimizing exchange rate movements.

As currency pressures came to a head, most major nations decided to allow their currencies to float freely by March of 1973. This was the beginning of the modern-day fluctuating exchange rate system.

European Currency Union and the Modern Era

Nevertheless, controlled exchange-rate systems continued to be attempted periodically even after 1973. The European Exchange Rate Mechanism of the 1990’s was one such attempt. This mechanism, combined with the increasing political integration of Europe, eventually led to the consolidation of the major European currencies that created the Euro.

The consolidation process began with the signing of the Maastricht Treaty in 1991 by the European nations which created the European Union. The European nations then attempted to fix exchange rates among the 12 member nations which in turn led to the creation of the Euro from the 12 currencies of the European Union.

The European Monetary Union had a major setback in late 1992 when the Pound Sterling was forced to leave the system and devalue. Nevertheless, the national currencies of the other twelve European nations were replaced by the Euro in 2002.

Today exchange rates float freely for most major currencies depending on supply and demand pressures, and no major paper currencies have their values fixed to the price of gold or other hard assets.

In the process, the shift to floating exchange rates spawned today’s massive foreign exchange market that now provides ample trading opportunities for forex speculators with its active exchange rate fluctuations and notable trends seen in many currency pairs. The recent availability of online forex brokers taking accounts in amounts of under $100 has made the forex market truly available to just about anyone to participate in.

Further reading:

Fundamental forex analysis.

How gold affects the forex market today.

Floating exchange rates increase currency speculation.

Find a forex broker where you can start trading with either a demo account or for less than $100.

Risk Statement: Trading Foreign Exchange on margin carries a high level of risk and may not be suitable for all investors. The possibility exists that you could lose more than your initial deposit. The high degree of leverage can work against you as well as for you.