Throughout most of recent history currency was based on a material of value.  This was typically either silver or gold, though in more recent times copper has also been used.  In more modern times gold has been used to support paper currency.  At this point all major nations have now stopped backing their currencies with gold and in turn rely on the market to give its currency value.

            A large benefit of having a gold backed currency is the intrinsic value associated with the currency.  Jacques Ruff of the French Academy was an ardent supporter of the gold standard because it forced “discipline” (Ball, McCulloch, Frantz, Geringer, Minor, 2006, p. 147).  This was because under the gold standard a country is not free to print currency that is not backed by gold, and thus it is an effective means of controlling inflation (Ball, et al., 2006, p. 147).  Another significant advantage of the gold standard is that it can buttress business confidence when participating in international trade, thereby removing a key concern to international business (Gold standard, n.d., Theory section, para. 1).

            Unfortunately, there are significant negative aspects to a gold standard.  An early example of this was the Great Britain silver backed currency in the 1790’s when there became a severe shortage of silver due to the one-way trading with China (Gold standard, n.d., The crisis of silver currency and bank notes section, para. 2).  Probably the largest concern is that with a fixed value gold standard there can become a significant differential between the gold standard price and the value of the gold.  Ultimately the differential would result in a run on the bank resulting is huge losses to the country (Gold standard, n.d., Effects of gold-backed currency, para. 1). Ultimately, this part of the reason that the United States backed out of the gold standard before there was a rush to on their currency; which was exacerbated by a lack of gold within the reserve to fully back the currency and within the London Gold Pool (Bretton Woods system, n.d., The U.S. balance of payments crisis, para. 4).

            The precursor to the modern foreign exchange markets was the International Monetary Fund established after World War II at the Bretton Woods conference where it was decided:

There was a consensus that (1) stable exchange rates were desirable but experience might dictate adjustments, (2) floating or fluctuating exchange rates had proved unsatisfactory, thought the reasons for this opinion were little discussed, and (3) the government controls of trade, exchange, production, and so forth, that had developed from 1931 through World War II were wasteful, discriminatory, and detrimental to expansion of world trade and investment. (Ball, et al., 2006, p. 148)

The IMF operated primarily with fixed exchange rates until the 1970’s, though it had already made some modification in the late 1960’s, when the United States abolished its gold standard and the IMF ultimately abolished this unreasonable goal (Ball, et al., 2006, p. 150).  In the aftermath of the fixed exchange rate system there has been to a greater or lesser degree a free currency float where free market conditions dictate the value of the currency.  The exception to this is when currency tends to become over, or under, valued or there are inflation problems.  The later are addressed through a managed currency float to correct for these errors (Ball, et al., 2004, p. 161).  The IMF also plays a role in the managed currency float with its new role as “firm surveillance” (Ball, et al., 2006, p. 150).  The IMF accomplishes this role through (1) monitoring member countries economic policy, (2) holding discussions on world economic outlook, and (3) contributing to policy coordinating with industrialized nations based on the first two facets (Ball, et al., 2006, p. 150).

            Further complicating the foreign exchange market is that most countries have the United States dollar used as their central reserve.  This asset is typically held as a United States Treasury Bond.  This creates a conflict of interest internationally because they want the United States dollar to increase in value.  This then complicates their policy of the value of their currency as well as other major currencies in the world.  Even more significantly this complicates United States domestic policy because it can have a dramatic impact on world trade and economies.  Finally, this is a significant consideration is trading in the foreign exchanges because the value of most other currencies is heavily influenced by the dollar and policies set within the United States. (Ball, et al., 2004, p. 168)

            Another important aspect of foreign exchange is the Bank for International Settlements.  Residing is Basel, Switzerland it provides a forum where member countries can exchange currency and gold with virtual anonymity.  Probably most significant to investors, and those participating in foreign exchange, is their published papers on economic research.  This is a means of assessing risk both in the bond markets as well as currency.  (Ball, et al., 2004, p. 155)

            In conclusion, with the demise of fixed exchange rates and the transition to free float it has added a significant amount of uncertainty to the foreign exchange market.  This has become even more complex with the consolidation of European currencies into the Euro and the establishment of the European Central Bank (Ball, et al., 2004, p. 172).  This is further exacerbated by the European Central Bank setting monetary policy for all of the European Union (Ball, et al., 2004, p. 172).  With the strong force of the Euro is can strongly influence the dollar and the rest of the world-wide currencies.  Furthermore, with the opening of the currency system to a free float market this has significantly minimized the power of the International Monetary Fund to regulate exchange rates, inflation, and world economic policy.  There has also been a significant effort made to forecast currency value changes with greater or lesser degree of success.  Due to the nature of inherent differences within countries and with trade it is difficult to come up with a base metric to evaluate currency valuation, much like the purchasing power parity.  Special Drawing Rights currency may be a move that can remove much of the volatility from the currency market with its value based on the performance of a number of currencies (Ball, et al., 2004, p. 168).  Some think that this is a good first step towards a world currency and is probably the most stable currency (Ball, et al., 2004, p. 147). 

References

Ball, D., McCulloch, W. H., Frantz, P., Geringer, J. M., & Minor, M. (2006) International business: The challenge of global competition. New York: McGraw-Hill Irwin.

Bretton Woods system (n.d.). Retried July 10, 2005 from http://en.wikipedia.org/wiki/Bretton_Woods_system

Gold standard (n.d.). Retried July 10, 2005 from http://en.wikipedia.org/wiki/Gold_standard