Chapter 19: International Monetary Regimes
The Foreign Exchange market ignores the demands of governments and central banks, and bases the value of currency on supply and demand. As with the stock market, the "price" of a currency indicates the last price at which it traded between two parties who agreed of their own volition to exchange for that price, and recent exchanges influence the price for which other parties will negotiate.
However, those who supply money to the foreign exchange are not the producers of currency, merely its current holder. Governments and central banks ultimately determine how much of their currency is supplied to the world market. The traders in the foreign exchange are merely bargaining over the amounts they have in their possession and cannot arbitrarily create more or less of a currency.
The author suggests that the "free float" of foreign exchange has been the primary monetary "regime" since the 1970s.
Prior to the second world war, the main regime was called "specie standard" in which the money of any country was based on the amount of specie (gold and silver) it held. Most nations were on a gold standard, or a silver standard, or a bimetallic standard, meaning its money could be exchanged for a fixed weight of precious metal (though the government could arbitrarily change that amount) and the relative value of currencies was based on the amount of specie the currency represented.
Between World War II and the 1970s, the "Bretton Woods System" was in effect. Essentially, here was a conference held (at Bretton Woods) among most of the major countries by which they ceded authority to the International Monetary Fund (IMF) for determining the value of their currencies, and participating governments would need to appeal to the committee to change the exchange rate of their currency. It was at this conference that the US Dollar became the base currency of the entire world, as the US agreed to maintain a gold standard ($35 per oz). When President Nixon took the US off the gold standard (as of August 15, 1971), this essentially ended the formal stability of the US Dollar and collapsed the BW system.
Agreements between nations are tenuous at best, and even today countries use various systems to set the value of their currency - some are still based on specie, others are pegged to the US dollar (or other currencies), and others are abandoned completely to the free floatation of the foreign exchange.
Two Systems of Fixed Exchange Rates
The author returns to the gold standard, in which the amount of money a state issued was compared to its supply of physical gold to determine the value of its money, and the exchange rate between currencies merely reflected the amount of gold it represented. Banks and clearing houses did much to reduce the actual transportation of gold (filling inbound orders with outbound ones), but the movement of actual metal did need to occur on occasion. But from a perspective of currency exchange, the gold standard did much to stabilize the system because governments would very seldom change the amount of metal their currency represented.
The Bretton Woods system was essentially little different than to gold standard because it fixed the exchange rate of every other currency to the US dollar, and the US dollar was backed by gold: 1/35 of an ounce. Soto say that the franc or pound or mark was worth two dollars was essentially declaring it to be worth 2/35 ounces of gold. They physical gold did not need to be transported from one country to another (essentially the US held it all for them), but it still left nations unable to flex their money supply because they could only issue so much money (because there could only be so many dollars backed by the gold in the US vaults). And so, it was still a fixed exchange rate.
The Managed Float
While the foreign exchange of the present day is said to be a floating exchange that is based on supply and demand, it is not completely free-floating because most nations manage their money supply, increasing or decreasing the amount of money in circulation. Generally speaking, central banks allow market forces to determine the day-to-day (and second-to-second) rates of exchange, but are prepared to intervene if their own currency grows too weak or too strong - and in general, tries to keep the exchange rate fairly stable.
To manage the float, central banks can intervene by issuing more or less of their own currency to decrease or increase its vale. They also maintain reserves of foreign currencies - so purchasing a foreign currency puts more domestic currency on the market (weakening it) and less of the foreign currency on the market (strengthening it), whereas selling a foreign currency to reclaim domestic currency has the opposite effect. This may not always be desirable to the other nation - when one country dumps the currency of another on the open market, it weakens the other country's currency, who must respond by buying up its currency, dumping other currencies on the market to obtain it, and so on in a domino effect. So far, there has not been a serious international incident because the adjustments countries have made have been too small to have a significant effect on the market.
This also provides the opportunity for countries to render assistance to a struggling economy, to strengthen its currency by purchasing it off the market. This debases their own currency, but generally it is countries with strong economies bailing out the currencies of those with weaker economies, so they can well afford to take on the debasement and the risk that the currency they are buying up may become worthless.
There is also a brief mention of inter-government lending, which is often done indirectly: a government issues bonds in the open market that are available to anyone to purchase, and a foreign nation purchases this debt. The problem with this situation is that a nation that goes deeply in debt can simply flood the market with money and repay loans at a fraction of their cost with debased currency. For this reason, loans of significant size are generally denominated in the currency of the lending nation (so debasement would only harm the debtor).
The Choice of International Policy Regime
Problems can ensue when a central bank runs out of reserves (which happened in Thailand in 1997), in which case the International Monetary Fund (IMF) can extend loans to countries to help defend the value of their currencies. Technically, it is not a "lender of last resort" because it is not a central bank and has no mechanism for creating money and is merely a broker between lending and borrowing nations. Ultimately, a default on an IMF loan short-changes the lending countries, and the damage is visited on their taxpayers.
In other instances countries may divest themselves of foreign reserves in order to gain complete control over their own currency (which happened in Germany in 1990) to combat domestic inflation. This tends to strengthen it s own reserves by weakening those of other nations whose currency it dumps. The effect of this tends to be rather weak (because it's done when their own currency is significantly weakened) and the impact is divided among several other countries.
There is also some concern about undervaluing currencies to boost domestic development. And undervalued currency makes domestic goods cheaper in foreign markets, creating great demand for domestic manufacturing, funding jobs and industrial development with foreign dollars. Many suggest that China is currently maintain an unfair exchange rate for its Yuan and expect that it is inevitable that it will snap back to its value - which will make cheap Chinese goods more expensive in markets around the world. While this means industry and jobs will be created in other countries, it will take time for them to ramp up.
There's a mention of instances in which countries simply give up maintaining their own currency and instead use the currency of another nation: the US Dollar is the official currency of a number of countries in the Caribbean, Central America, and the South Pacific and the Euro is used in a number of countries in West Africa. There is no international law preventing this and the countries whose currency is adopted generally are unaffected because the nations that adopt foreign currencies generally have small economies so there is not a significant drain on the domestic supply.
The practice of pegging a currency can be effected in two ways. Most often, a country may maintain a reserve of foreign currency against which its own national currency can be redeemed. In other instances a country may not maintain a reserve of foreign funds, but merely manage its money supply toward maintaining a stable exchange rate against a specific foreign currency. In the latter case, there is always fluctuation caused by being too proactive or not reacting quickly enough, which creates gaps that can be exploited by speculators, who make billions by recognizing inaccuracies in the management of pegged currencies.