It is a mystery to many people why currencies fluctuate against each other. To the average tourist, there seems to be no obvious reason why their dollars or yen or whatever should be worth less or more when they return to the same destination a year later.
Even at a theoretical level, it does not seem that currencies should fluctuate. They are after all the same thing: bits of paper. And under the law of one price, these bits of paper should all tend toward the same price. But a quick glance at the foreign exchange markets shows that they do not. They fluctuate all the time, usually in small movements in the numbers after the decimal point, which the dealers refer to as the “pips.” But over time these pips add up to very wide fluctuations.
It is worthwhile to look at what happened when these bits of paper actually represented something. At present, they represent nothing but themselves, whereas they used to represent a specific weight of gold. And just as one is free now to exchange any currency for another one, it used to be possible for people to export or import gold as they wished.
All this changed in 1914. The restrictive and protectionist policies enforced during much of the last century were always accompanied by restrictions on the movement of gold; sometimes, export of it was completely forbidden. The freedom to exchange currencies was gradually restored, at least for Europeans, from 1979 onward, when the British government abolished exchange controls entirely1 .
Before the first restrictions were imposed, however, there were constant movements of gold from one center of commerce or finance to another. These were reported in the newspapers in the same way that movements in the foreign exchange markets are today. But these movements of gold, which corresponded to the settling of accounts between the various trading nations, represented only about 2 percent of the total amount of traded goods2 .
The situation now is entirely reversed, since foreign trade represents only about the same small 2 percent (or perhaps even less) of the total amount of transactions on the foreign exchange markets, which apparently run to the rather staggering figure of $1 trillion per day3 .
So why this ceaseless activity in the markets, where dealers take time off only on the weekend and not always then? Some of the activity is caused by money going abroad to be invested, but the foreign investment figures come nowhere near to accounting for what goes on in the countless dealing rooms all over the world.
So what does? The answer, of course, is that a great deal of the activity is speculative. But what are the fellows in front of the screens (not to forget bored housewives in Pennsylvania or elsewhere with access to the Internet) speculating on?
As currencies are now “managed” by central banks, they are betting on the different ways the central banks manage different currencies. The U.S. central bank, the Federal Reserve, is generally thought to manage the dollar with a view to keeping the American economy “growing.” In this it has been largely successful over the last decade, although a more sober view regards what it does as more akin to blowing into a balloon and creating a pretty monstrous bubble. And in any case, the American population continues to increase thus providing natural “growth.”
In contrast, the European central bank has a remit to maintain price stability, which in effect means trying to keep inflation at around 2 percent or less. At the same time, the Europeans have shown less inclination to breed, presumably only going through the motions of this activity.
Leaving the broad policy framework aside, however, whether an economy grows is determined to some extent at least by how much economic agents, whether private citizens or companies, are taxed. On the whole, U.S. citizens and companies are less burdened by taxes than their equivalents on this side of the Atlantic. As a result, over the last two years4 , those speculating on a rising dollar have generally had the upper hand5 .
The introduction of the euro consists simply of introducing another “managed” paper currency. Whether it will go up or down against other currencies will continue to depend on how it and the other ones are managed. Given that neither the way in which both currencies are “managed” nor the respective tax regimes are likely to change in the near future, there is little reason why the current situation should not prevail for some time to come.
- 1The Maastricht Treaty nevertheless allows for exchange controls to be reimposed on a “temporary” basis, whereas the British government no longer has any legal authority to do so.
- 2See Le lancinant Problème des Balances des Paiements. Jaques Rueff 1965.
- 3The current figure of $1 trillion per day is to a certain extent an illusion, as the actual amount of money involved is much smaller. The foreign exchange market is a futures market where dealing takes place “on margin.” It is the margin — in some cases as low as 1 percent — which gives a clearer idea of the actual amounts involved.
- 4Or five, if the DM is regarded as a pseudo-euro.
- 5The sudden rise of the euro in October 2000 can be attributed to the intervention of all the central banks in support of it. Whether they, or in particular the U.S. Treasury, would repeat the exercise since the change of administration remains to be seen.
