The 70s New World Order

The premise behind allowing currencies to float was that it would lead to self-correcting trade balances. In a fixed-rate regime such as Bretton Woods, countries in a deficit position (such as the U.S. in the late 60s) see an outflow of gold and foreign exchange reserves. These outflows lead to a reduced capacity to consume, which is detrimental both to the deficit country and to all those exporting to it. In fact, the IMF was created in the Bretton Woods agreement to address the inevitable “balance of payments crises” associated with growing economies importing too much.

Theoretically, floating exchange rates would address payment imbalances by depreciating deficit countries’ currencies on the global market, thus reducing their purchasing power. If, for example, the U.S. ran a trade deficit, it would be pumping out additional dollars to exporters. Each new dollar on the world market would have a smaller claim on exporters’ resources and reduce the U.S.’s ability to import more. Also, U.S. exports would become cheaper on global markets and expand American exports.

The end result of a weaker currency was supposed to be a move away from a deficit condition. The opposite was supposed to occur with a stronger currency.

In practice, nothing of the sort happened. First, the notion that governments would allow currencies to float freely was politically naïve in the extreme. The U.S. engaged in policies designed to drive the dollar lower between 1985 and 1988 and again from 2002 to 2005. Other countries, particularly the mercantilist exporters of East Asia such as Japan, Taiwan, Korea, and China, have done much the same.

Second, many goods in international trade, including crude oil and industrial metals, are priced in U.S. dollars by all parties. These goods have exhibited little currency sensitivity over time. Third, other international trade goods, such as high-technology gear, military equipment, and food tend to be fairly price-inelastic.

Floating exchange rates were ineffective at adjusting trade imbalances because actual physical trade was no longer necessary for currency trading to occur. Prior to the early 70s, currency trading was a facilitation business conducted by banks to clear bills of lading, or shipping receipts, bankers’ acceptances, letters of credit and other payment mechanisms for international trade. Once currencies began to float, traders discovered quickly they were simply an interest-rate arbitrage between two countries. The principal trade — covered-interest arbitrage involves the following steps, using the Canadian dollar

(CAD) as an example against the U.S. dollar (USD):

Borrow USD

Sell USD and buy CAD at prevailing spot rate

Lend CAD

Unwind the trade in the forward market

As long as the interest-rate differentials between the USD and the CAD permit, a trader can execute the trade profitably until either U.S. rates rise, Canadian rates fall, or the spot rate for selling the USD and buying the CAD falls.

This trade involves three unknown variables — the two interest rates and the spot exchange rate — but has only one equation and therefore lacks a single and exact solution.

Because interest rates in both countries swing around for reasons totally unrelated to trade balances, the exchange rate can reach any level, irrespective of trade, as long as the interest-rate differentials make the trade profitable. It is no wonder why each of the world’s major currencies have endured at least one episode of violent movement over the past three decades.