We stand at the dawn of a new era. Before us is the most important decade in the history of civilization, a period of stunning technological innovation, unprecedented economic opportunity, surprising political reform, and great cultural rebirth. It will be a decade like none that has come before because it will culminate in the millennium, the year 2000.

- Megatrends 2000

What John Naisbitt and Patricia Aburdene said about the 1990s in their bestseller is probably as true and perhaps even more true about the 20th century. The world’s leading social forecasters identified and described the new megatrends viz. the global economic boom, free-market socialism, golden age for the arts, global lifestyles, privatization of the welfare state, the age of biology, religious revival, etc as the gateways to the 21^st century. Most of these forecasts have come true. However, what may not be immediately apparent is that the foundation for the rapid changes and reforms in the nineties was laid in the preceding nine decades. So standing on the threshold of the new millennium, let us try to see the quantum leap that mankind has taken during the 20th century in different walks of life.

If you know any centenarian, ask her or him how the world was at the beginning of the 20th century. Whatever the answer, you will realize that life was simple – simple and tough as many might think but simple and blissful as a handful few might believe. There were no airplanes, antibiotics, atom bombs….cameras, cinemas, computer... internet… .mobile phones….radios, refrigerators, rockets, ..televisions….. washing machines, etc. Surely, the list is only illustrative.

Obviously, the 20th century has seen incredible strides in all fields of science and technology leading to lower mortality, higher life expectancy, faster travel, advanced telecommunications, computing, etc. International trade, travel and tourism have brought people from different countries and continents closer, helped them to understand and appreciate each other’s culture, tradition and heritage and relate to each other as fellow human beings transcending distinctions and discriminations based on color, caste, creed, race and religion. The discoveries and inventions of the 20th century have led to the birth and rapid growth of several new industries - pharmaceuticals, petrochemicals, entertainment, hospitality, travel and tourism, software and so on and so forth. The world has become, if you will, a much smaller and a far more cosmopolitan planet. In this century, man has learnt to overcome and harness the three great energies of the universe - gravitational, electro-magnetic and atomic. Yet, this century has seen two world wars and many other wars being fought so much so that nuclear devices have become nervous and uncomfortable guardians of peace indicating that such peace rests on a shaky foundation of fear and terror rather than faith, trust and love. While man has overcome innumerable diseases caused by bacteria and viruses, he has unfortunately succumbed to psychosomatic disorders like hypertension, palpitations, ulcers and mental disorders such as insomnia, manic-depression and schizophrenia.

To sum up, as the total Intelligence Quotient of the human race on this God’s good earth has witnessed such exponential growth probably never seen before in the history of mankind, man has increasingly lost touch with his true, inner Self – call it the soul, atman or whatever. Fortunately, many in the West and many of those in the East who had begun to ape the West have begun to turn to religion and spirituality. Probably, it is high time too. An article in The Economic Times says that for many decades, IQ results were considered the best measurement of a person’s smartness and potential for success. About a decade ago, emphasis began to be placed on emotional intelligence – the thinking that gives us empathy, compassion and the ability to respond appropriately to pain or pleasure. Now at the end of the 20^th century, authors Danah Zohar and Dr. Ian Mitchell are reported to be claiming that there is another important Q to consider – the SQ, otherwise known as Spiritual Intelligence Quotient. These authors believe the SQ to be our ultimate intelligence and the necessary foundation for both the IQ and the EQ. Having had a quick bird’s eye view of the 20th century – a detailed chronological list of important events, inventions and discoveries is annexed – we now turn to the world of money, foreign exchange and banking.

A Century of Money, Foreign Exchange & Banking

THE PRE-BRETTON WOODS ERA: (1900-1945)

The Early Years of European Banking

t the beginning of the 20^th century, one United States Dollar was equal to 1 Canadian Dollar, 2 Japanese yen, 3 Indian rupees, 4.2 German marks (Reichsmarks) and 5.7 Italian lira. The British Pound and the French franc were much stronger fetching $4.87 and $19.2 respectively. Those were the days of Pax Britannica i.e. British hegemony. Almost literally, the sun never set on the British Empire and the British Pound was the world’s premier reserve currency.

After the Napoleonic wars in 1815, London had become the world’s financial center, enriched by growing private fortunes and international trade which increased with each stage of the industrial revolution. The expansion of trade also transformed the nature of banking. London was not only the richest city but it also made the most effective use of its money. Its banks were able to attract the savings of the whole country, lending them for the maximum profit, first within Britain and then across the world. The supremacy of London had attracted merchants from all over Europe, like the Barings, Rothschilds or Hambros who first used their connections with their home country to finance trade and lend money across frontiers, and later became part of the City’s financial system. However, new joint stock banks like the Westminster, the National, Lloyds and Barclays had also begun taking deposits from a growing number of small savers and lending the same cautiously but profitably. The enterprise of British banks was underpinned by the maintenance of Pax Britannica by the British Army and Navy.

Other European bankers had also begun to move more boldly abroad as prosperity and savings increased. French banks had begun looking towards Eastern Europe, Russia in particular & North Africa, which offered better opportunities than metropolitan France. German banks had also ventured abroad in America, South Africa, China, Morocco, Turkey, Iraq and the Middle East.

The bankers’ confidence in lending money was almost always fortified by their knowledge of a powerful imperial government behind them. However, World War I that broke out in 1914 and Russia’s Communist revolution in 1917 dashed the hopes of a world united by capital. The confidence of German bankers was shattered as Germany was burdened with unpayable debts and racked with inflation. French banks found that the Russian bonds they held were valueless when Russia refused to honor its debts. The British were forced to sell much of their foreign investments to pay for the cost of the war. Suddenly, American banks found themselves lending to Europe and other parts of the world.

The Early American Scene

ince independence, the subject of bankers in the Unites States was explosive. Most farmers did not trust bankers and paper money. Thomas Jefferson regarded the expansion of credit as an evil. The extreme opposition to bankers, however, waned as American commerce and prosperity increased. By the beginning of the 20^th century, Bank of America, Citibank, Chase Manhattan Bank and J.P.Morgan were well established. All these powerful banks had grown from their very different roots to become major financial operators during the boom of 1929.

After the stock market crash in October 1929, the Governor of the Federal Reserve Bank of New York saved the day by undertaking to buy huge amounts of Government bonds from the banks and provide ample liquidity to the market. The real banking crisis however began a year later when the Bank of United States closed its doors following a run on its deposits and refusal of other fellow bankers to rescue it due to allegations of anti-Semitism. Between 1929 and 1933 the number of American banks had shrunk from 25000 to 18000!

American bankers lost much political support. The Glass-Steagall Act of 1933 forced deposit banks to separate themselves from banks selling securities. Morgan, Citi and Chase divested themselves of their securities affiliates.

The World Depression

he Great Crash and the Great Depression that followed in America had long repercussions on the rest of the world. The falling production and investment from America disrupted the whole pattern of international trade. As America put up tariffs on imports, many Latin American countries, which had borrowed from the big New York banks, defaulted as their exports were severely hit. The extension of the depression to Europe eventually led to global catastrophe.

The economic ruin of Germany, the post-revolutionary chaos in Russia and the impoverishment of France and Britain had already undermined the structure of European trade and banking. In this dangerous condition, Europe was hit by the Great Depression, which dried up American orders and cut down employment. The first European bank to fall was the Rothschilds’ Kreditanstalt bank in Vienna. As the German banks tried to rescue it, they themselves faced a panic and one of the biggest German banks, the Darmstadter, collapsed. The German banks then had to be granted a moratorium on their debts. This led to a crisis in Britain as other European countries sold sterling to buy gold from London. Consequently, Britain was forced to go off the gold standard. Other countries followed suit.

The German banks were however able to integrate themselves into the war economy after Hitler came to power in 1933. Germany became increasingly self-sufficient and independent of the rest of Europe. However, the cosmopolitan world of the old German-Jewish banks was shattered when Hitler invaded Austria in March 1938.

World War II

Hitler invaded Poland on September 1, 1939. Almost immediately, Britain and France declared war against Germany and thus began World War II. Germany swept through continental Europe, occupying France in just 6 weeks. However, as we know, Britain held out till the end. In the summer of 1941, Russia was drawn into the war as Germany attacked it breaking the Russo-German peace treaty. Finally, in December 1941, America was forced to join the war after the Japanese who had attacked the British Empire in East Asia, bombed Pearl Harbor. American-led Allied troops liberated France in 1944. The war ended in the first week of May 1945 after Hitler committed suicide and after America had dropped atom bombs on Hiroshima and Nagasaki.

When the British and French economies and later the American economy were revived with full employment, the revival was ironically based on the preparation for war!

International Monetary System

At the commencement of the 20^th century, a large number of countries were on the gold specie standard. This standard called for fixed exchange rates, with parities set for participating currencies in terms of gold, and provided that any paper currency could on demand be exchanged for gold specie at the central bank of issue. The system was designed to bring about automatic adjustment in case of external deficits or surpluses in transactions between countries. The underlying concept was that any deficit country would have to surrender gold to cover its deficit - this would force it to reduce its money supply leading to lower prices and improved export competitiveness. A trade surplus on the other hand would lead to an influx of gold, commensurate increase in money supply and higher prices.

Under this gold standard, exchange rates could in principle fluctuate only within narrow limits determined by the costs of shipping and insuring gold. From 1880 till the outbreak of World War I in 1914, the "mint parity" between the US Dollar and British Pound was approximately $4.87 based on the official gold prices of USD20.67 per troy ounce in the US and GBP4.24 per troy ounce in the UK.

After the start of World War I, one combatant country after another suspended gold convertibility and floating exchange rates prevailed. The United States, which entered the war late, maintained gold convertibility, but the Dollar effectively floated against the other currencies, which were no longer convertible in to gold. Many currencies suffered substantial depreciation against the Dollar after WW-I, which ended in 1918.

The burden of war reparations and the French invasion of the Ruhr valley in 1923 led to hyperinflation in Germany. The Reichsmark had collapsed completely to 4.2 trillion per Dollar and was abandoned. It was replaced by the Rentenmark. Germany returned to the gold standard in 1924 in an attempt to stop hyperinflation. Britain followed suit in 1925 and France in 1926. Britain reestablished gold convertibility but at the pre-war parity with the Dollar in a bid to save face and maintain worldwide confidence in the Pound and in British financial institutions.

The return to the gold standard with unrealistic parities led to sudden and sharp monetary contraction. This led to the deflation of the 1930s and eventually the Depression. Britain went off gold in 1931; America followed in 1933 but only to return to the gold standard in 1934 after devaluing the Dollar from USD20.67 to USD 35 per troy ounce. France left in 1936. This was also the year of the Tripartite Monetary Agreement, which established a Dollar standard where the Dollar was the only currency, anchored to gold. All other countries in this system kept their currencies pegged to the Dollar. This system lasted till 1971. As we will see later, the Bretton Woods conference in 1944 did not establish any new international monetary system. Rather, it created two new international institutions, the IMF and the World Bank to manage international interdependence in the international financial system and provide a supranational veneer for the anchored Dollar standard.

In summing up, all the concerned currencies were stable during the first decade of the 20^th century. However, the French franc lost nearly 65% of its value during the second decade as Tsarist Russia accounted for a quarter of all French foreign investments and these were left with practically no value after the communist revolution in Russia. The French franc continued to suffer devaluation/depreciation from time to time and by the start of World War II, it had lost nearly 90% of its value against the Dollar. During the Nazi regime in Germany, the Allied Military Mark replaced the Rentenmark. It was only on June 20, 1948 i.e. after WW-II and the establishment of the Federal Republic of Germany that the Deutsche Mark came into existence. The Japanese Yen was relatively stable against the Dollar till 1939 but became practically worthless by the end of the 40's due to the devastation caused by the war.

The Bretton woods Era: (1945 TO 1973)

New International Economic System

he intellectual foundations for a new international economic system were laid at the height of World War II. Surrounded by the chaos and destruction of the war, politicians and economists were able to start again from scratch. The original concepts were put forward not by bankers, bureaucrats or politicians but by two brilliant academics – John Maynard Keynes, the renowned British economist and Harry Dexter White, adviser to the United States Treasury Secretary. Keynes wanted to avoid the chaos of exchange rates, which he had seen after the First World War and after 1941, and he constructed a bold plan for "International Clearing Union" or a "World Central Bank". White on the other hand was convinced of the need for a new international organization after the war to safeguard the monetary system, to restore foreign trade and to revive the nations’ economies. Accordingly, he drafted a plan for a "Stabilization Fund" and a "Bank for Reconstruction and Development". White proposed an international currency called the "Unitas" but the Fund would only be an agency for distributing money contributing by member nations rather than a machinery for creating credit as Keynes had proposed. The Bank for Reconstruction and Development was to be a far-reaching international lending agency, which could provide long-term loans for reconstruction, for financing trade or stabilizing commodity prices and buy/sell gold and securities like a world central bank.

Keynes’ and White’s proposals were published in April 1942. After a lot of deliberations and discussions, delegates from 44 nations met in July 1944 at the New Hampshire resort of Bretton Woods and thrashed out the post-war economic system over a period of 4 weeks. The International Monetary Fund (IMF) and the International Bank for Reconstruction and Development (World Bank) were thus born. The IMF’s role was eventually restricted to providing loans for offsetting short term exchange rate fluctuations and balance of payments crises while the World Bank was restricted to lending for specific projects.

The Soviet Union had already hardened its attitude after being refused an American loan and it did not join the Bretton Woods agreements. In the middle of 1947, the Soviets were preparing to establish their own economic bloc, COMECON.

World War II marked the end of Pax Britannica and the start of Pax Americana. The United States was assumed to remain the dominant partner in the new international economic system. The Dollar was expected to be the world’s reserve currency, interchangeable into gold, with sterling in a secondary role. It was also expected that Americans would head both the IMF and the World Bank but a last minute hitch saw a Belgian getting appointed as the Managing Director of the IMF. Thus started the tradition that the head of the IMF would always be a European while the head of the World Bank would be an American.

Under the new exchange rate regime, all other member nations agreed to peg their respective currencies to the US Dollar. Members were expected to maintain their exchange rates to the Dollar within 1% on either side of the peg or the par value. However, they were permitted to adjust the peg or par value in response to any fundamental disequilibrium, but with the approval of the IMF. On its part, the US assured full Dollar convertibility into gold at a fixed price of USD 35 per troy ounce.

The World Bank

After the first few conservative years, the World Bank underwent a decisive change from 1949 under the presidency of Eugene Black. Although still officially called the IBRD, Marshall Aid had taken over most of the reconstruction business and Black saw that the critical need was to finance development in the third world. The World Bank embarked on lending not only to safe countries like Australia and Canada but also to more doubtful developing countries like Colombia and Peru. Of course, all loans had to be for specific projects such as ports, dams or roads and had to be guaranteed by the respective foreign governments.

The World Bank was strictly businesslike demanding commercial interest rates and prompt repayment. However, most of the new developing countries needed loans on softer terms i.e. concessional interest rates and long repayment periods. The US Congress was pressing for more lenient loans to save the third world from communism. Consequently, in 1960 the World Bank established a new agency called the International Development Agency (IDA) for granting soft loans upto 50 years @ 0.75% p.a.

The Money Mandarins

The other pillar of Bretton Woods, the International Monetary Fund, had only gradually become involved with the problems of the third world. Its charter included the development of the productive resources of all its members but it was at first preoccupied with France and Britain. The IMF was constructed as a rich man’s club and it was mainly concerned with upholding financial discipline, coordinating national monetary policies and preventing economic warfare.

Commercial banks were inclined to see the IMF as an extension of the discipline and safeguards of the central banks inside each nation. It was to be a ‘lender of last resort’ which could bail out a country in extreme difficulties but only on tough terms. The Fund has often been seen to be unrelentingly strict towards developing countries prescribing bitter, unpalatable medicine. On the other hand it is also believed that many of the developing countries in trouble have, for political reasons, wanted to implement austerity measures under the aegis of the IMF!

By the late sixties, the Dollar’s role as a reserve currency began to weaken following America’s persistent trade deficits and other countries began to insist that the Fund break away from its dependence on both the Dollar and the gold. At its annual meeting in 1967, the Fund finally approved a new kind of currency called the Special Drawing Right (SDR). Two years later, the Fund agreed to make its first issue of SDRs totaling 9.5 billion Dollars, in proportion to each country’s quota. They fixed the value of SDR against gold at the same rate as the Dollar. Today, the SDR is assigned a value based on the average worth of the world’s five major currencies and is worth about USD 1.37.

London and the Eurodollars

After World War II, New York was the financial capital of the world. The big New York banks competed to attract deposits from customers and to lend the money with an aggressiveness and visibility that distressed the staid banks of Europe. In the 1950s there was little indication that London could again become a world financial center. London bankers were much more defensive and somnolent than the Americans surveying their past more lovingly than their future. However, London’s fortunes changed with the birth and growth of the Eurodollar market.

According to one version, Eurodollars came into existence in 1949 when the new communist government in China, wanting to protect its Dollar earnings from the Americans, placed them with a Soviet-owned bank in Paris called the Banque Commerciale pour l’Europe du Nord. The word Eurodollar is supposed to have originated from the cable address of this bank, which happened to be ‘Eurobank’.

After the commencement of the Cold War, the Russians also began to worry that their Dollars could be frozen in the US. Hence, they also began to keep their Dollars outside America – both in the said Paris bank and in the Moscow Narodny Bank in London.

At start the Eurodollars crept into London stealthily but soon they became an expatriate currency providing world credit on an unprecedented scale. In 1958, most Western European countries – though not Britain – made their currencies convertible into Dollars for the first time since World War II. This gave new freedom for cross-border dealings. In the same year, the United States moved into a trade deficit. Dollars were flowing freely into Europe, both companies and banks preferring to hold them in the form of Eurodollars – Dollars held in bank accounts outside the US – to earn higher interest at a time when American interest rates were strictly controlled.

The Eurodollar market multiplied rapidly. It roughly tripled in 1959 and then doubled in 1960 boosted by the European boom and the expansion of American multinational corporations. Worried by the increasing Dollar outflows, President Kennedy announced the Interest Equalization Tax in 1963 designed to strengthen the Dollar by making foreign borrowing in America more expensive. Not only did this measure fail to bolster the Dollar but it also encouraged international borrowers to turn to Europe and Eurodollars for their loans. A further boost came with the escalating Vietnam War, which pushed up the American deficit and the supply of Dollars abroad.

Collapse of Bretton Woods Fixed Exchange Rate System

The leadership of American banks had already begun to wane by the end of the Sixties, as the balance of financial power had begun to shift. Over time, the Dollar faced increasingly greater pressures, reflecting chronic US budget deficits – in part associated with the fiscal consequences of the Vietnam War and new domestic social programs in the US. The Dollar’s decline also related to the stronger competitive position of a restored Europe and Japan. Faced with rapidly mounting demands from other nations to convert their Dollars into gold, President Nixon suspended gold convertibility of the Dollar on August 15, 1971.

In December 1971, the G-10 countries – Belgium, Canada, France, Germany, Italy, Japan, the Netherlands, Sweden, the United Kingdom and the United States – negotiated the Smithsonian Agreement to devalue the Dollar’s par value against the gold from $35 per troy ounce to $38, a devaluation of 7.9%. The US agreed to the rate adjustments but did not restore gold convertibility of the Dollar. After a few months, exchange markets again became volatile. The Dollar was devalued a second time in less than 15 months by another 10% to $42.22 per troy ounce of gold. However, foreign exchange markets continued to be unstable and finally on March 11, 1973, the G-10 nations announced that they would allow their currencies to float.

Foreign Exchange Fluctuations during the Bretton Woods Era

he table shows how the relevant exchange rates moved from the end of World War II till the collapse of the Bretton Woods system of fixed exchange rates. It is evident that the Deutsche Mark and the Yen were the major beneficiaries during this period.

THE POST-BRETTON WOODS ERA:(1973-1999)

Round-the-clock Rollercoaster

With the free floating of the major currencies, the international foreign exchange market became and is till today, a round-the-clock rollercoaster from Monday morning in Wellington till Friday afternoon in San Francisco. This was and is a constant temptation for speculators. Currency futures began to be traded in Chicago in May 1972. Today, they are traded practically in all major financial centers of the world.

Rise of OPEC and Sovereign Lending

he quadrupling of the price of oil towards the end of 1973 was a big shock to the whole world. The change was so sudden that it took some time to comprehend. It was estimated that the OPEC countries would earn an extra 80 billion Dollars a year from their oil exports. The US administration saw this as a kind of treason and discouraged any plans to ‘recycle’ or lend the surplus funds to needy countries through the World Bank or the IMF. The OPEC leaders were equally bewildered by the sudden shift in wealth and dazed by their sudden success. The Kuwaitis, Iranians and Saudis began buying into western companies and properties. Still, the OPEC countries had a lot of these surplus ‘petrodollars’, which they placed as deposits in the western banks they knew best. The big American and British banks began to compete for more and more OPEC money. The natural consequence was an unprecedented rush of bank lending to some very shaky countries in the third world on the premise that countries never go bankrupt. The list is big but you are familiar with the names: Argentina, Brazil, Mexico, Iran, Indonesia, Poland, Nigeria, Zaire, et al. The more populated OPEC countries had grandiose plans for industrial and commercial development and they found they could, so to speak, pledge their future oil earnings to raise huge loans which they might have otherwise not got at all. The Finance Ministers of third world countries with large natural resources and significant development potential, had become an enviable lot with the marketing officers of big banks chasing them to sell loans!

The Iranian crisis of 1979 – the taking of American diplomats in Teheran as hostages on November 4 followed quickly by the freezing of all Iranian deposits in American banks whether held in the United States or abroad – was the eye-opener for the aggressive money lenders. This was followed by the Latin American crisis of 1982 when several Latin American countries were almost on the verge of default as a consequence of the Fed’s tight monetary policy and the second oil shock in 1979. At the end of 1983, the military coup in Nigeria - an OPEC country – made even more questionable the soundness of these bankers’ sovereign risk assessment procedures. In the late eighties, under the aegis of the Bank for International Settlements, Basle several central banks introduced the country risk matrix for more objective assessment thereof. However, in the end, banking was and is still a ‘ people business’. No matter how complex and mathematical the business has become, it still depends on the assessment of trust by individuals with very human failings.

Age of Plastic Money

The style of a bank had changed since medieval moneylenders counted coins on a bench. It had become much harder to trace the money from the beginning to the end – from the small saver leaving a few Dollars in his local bank to the billion-Dollar Eurodollar loans raised by a syndicate of say 10-20 international banks to finance a country in any corner of the world. Big banks were making new profits from re-lending the OPEC billions but were still dependent on their retail home base of savers and borrowers. Many bankers began to pay more attention to this market segment as global competition intensified.

Citibank was again setting the pace in this area. In 1974, it had already decided on a ‘consumer strategy’ to compete for small savings and by 1977, it was beginning to install automated banking centers across New York, which could take deposits and give out cash all round the clock without any tellers.

The extraordinary development of the credit card had begun modestly in 1950 with the establishment of the ‘Diners’ Club’ which provided select members with credit at 22 restaurants in New York and collected a commission for paying the bills promptly. Then in 1958, American Express began selling their green-and-white card as a prestigious open-sesame to hotels, restaurants, shops or airlines in America and across the world.

In the meantime, many banks were moving into credit cards. They were not so much concerned with collecting commissions from shops. Instead, they saw and exploited a new opportunity of granting unsecured loans at high interest rates to credit-card holders who did not pay their bills promptly. The controllers of this empire of credit cards had given great benefit to those citizens who were inside the system of credit while automatically rejecting those who were not. The whole of concept of trust, which underlay credit, seemed to have been taken over by computers.

Bankers Will Always be the same

In the words of John Maynard Keynes, "a sound banker is not one who foresees danger and avoids it, but one who, when he is ruined, is ruined in a conventional and orthodox way along with his fellows, so that no one can really blame him."

Most ambitious customers know how to exploit the human weaknesses of ambitious bankers – greed, jealousy (or one-upmanship), arrogance and lust. The Japanese banking crisis following the bursting of Japan’s asset market bubble in the early nineties, the recent East Asian crisis and the collapse of Bank of Credit and Commerce International are in the ultimate analysis an example of bankers succumbing to one or more of the human weaknesses.

Indian bankers might of course like to think that they are an exception. The top brass of the PSU banks may not hesitate to say in anonymity that a large portion of their NPAs are due to government interference in some form or other. This may be true to some extent. But who was responsible for the NPAs abroad in reckless financing of ambitious NRI businessmen?

The Dollar Crisis

The severance of the Dollar’s gold link in 1971 and the shift to flexible exchange rates in 1973 removed the constraint on monetary expansion. The price level of what had become the mainstream of the world economy, was now in the hands of the US Federal Reserve System. The quadrupling of oil prices had created deficits in Europe, Japan and elsewhere which were funded by Eurodollar credits, in turn fed by US monetary expansion. The Fed argued that its policy was not inflationary because domestic money supply did not rise unduly. However, the world’s Dollar base had increased at a rapid pace via the Eurodollars and as the recent Nobel Laureate, Robert Mundell had shown way back in 1971, US inflation was governed by the global Dollar supply. US inflation had risen to double digits. From March 11, 1973 till November 1, 1978 when President Carter moved to support the Dollar, it had fallen from 3.20 marks to 1.72 marks and from 301 yen to 177 yen.

Formation of the European Monetary System

The devastation of World War II created the desire for greater economic and political union in Europe, in order that World War III would never be fought. The Treaty of Rome was signed in 1957 but it wasn’t until 1962 that the European Commission proposed a single currency for Europe.

The Werner Report, approved in 1971, proposed a single currency by 1980. The first step was to tie Europe’s currencies to each other through the "snake" which ended up becoming more of a Deutsche Mark bloc than a single currency. Membership of this union was however fluid. France left in 1974, rejoined in 1975 and pulled out again in 1976. Sweden left in 1977 and Norway left in 1978.

However, the persistent weakness of the Dollar in the seventies gave further impetus to European monetary integration. Following the Bremen summit in 1978, French President, Giscard d’Estaing and German Chancellor, Helmut Schmidt made an agreement to create the European Monetary System (EMS), which came into existence in March 1979.

The EMS created the European Monetary Cooperation Fund and introduced a kind of pre-money, the ecu, defined as a basket of the currencies of the EC countries, weighted by a formula that took account of both trade and GDP.

The exchange rate mechanism (ERM) within the EMS in theory was symmetrical with respect to its member countries but in practice the Deutsche Mark became the "inflation anchor" of the system. The ERM gravitated to a mark standard in the 1980s. The Bundesbank had only one objective, that is, of controlling inflation in Germany and maintaining the internal purchasing power of the mark. Other member nations had to pursue policies to stabilize their exchange rates and preserve balance of payments equilibrium.

The Reagan/Bush Era

President Ronald Reagan came to power in November 1980 when the Dollar was at 1.95 marks and 212 yen. He embarked on a very expansionary fiscal policy cutting taxes and hiking spending, particularly on defense. To check inflation, the Fed under the chairmanship of Paul Volcker followed a tight monetary policy. The Dollar rallied sharply thereafter under the combination of loose fiscal policy and tight monetary policy. The Latin American crisis of 1982 saw the Fed lower interest rates at the behest of the big American banks. The US bond market soared and the Dollar continued to rise. By March 1985, the Dollar had soared to 3.47 marks and over 260 yen. As for the Fed funds rate, it rose from around 9% in July 1980 to 19% in June 1981 but then fell back to around 8% by the end of 1982.

In September 1985, the G-7 countries reached the Plaza Accord, deciding to take concerted action including currency market intervention to help correct the Dollar’s overvaluation and reduce the rising US current account deficit. By then the Dollar had retreated to 2.85 marks and 240 yen but its slide accelerated thereafter. The US trade deficit continued to rise and the Dollar continued to fall. Finally, following the first Black Monday on October 19, 1987 at Wall Street, the Dollar crashed to new record lows of 1.56 marks and 120 yen by the end of 1987.

The stock market had stabilized thanks to prompt monetary easing by the Fed under its new Chairman, Alan Greenspan. However, after March 1988, the Fed began to tighten monetary policy to ward off inflationary pressures and in a year’s time the Fed funds rate was up sharply from about 6.5% to about 10%. The Dollar recovered sharply and despite a cyclical hiccup ahead of the presidential election in November 1988, reached around 2.05 Marks and 152 Yen by mid-June 1989.

The US economy then slowed down sharply and went into a recession. The Fed began aggressive monetary easing and the Fed funds rate was down to 3% by the time of the 1992 presidential elections - which were won by Bill Clinton.

German Reunification and the 1992 ERM Crisis.

At the time of the German reunification in 1990, the Bundesbank had advised the German government that the East German currency be replaced at a ratio of 1 DEM to 4 East Marks. In retrospect, it would seem that Chancellor Kohl did not want to spoil the celebration of his "dream come true" with monetary stinginess. He decided on a magnanimous exchange of 1 DEM for every East Mark. The consequent explosion of money supply in united Germany put pressure on the German price level and Bundesbank reacted in the only way that it could i.e tighten monetary policy and jack up interest rates regardless of the conditions in other ERM member countries.

Britain had joined the ERM in 1990 just around the time of the reunification. As interest rates kept going up in Germany, Britain had to follow suit at a time when its economic position did not permit it to do so.

The Maastricht Treaty was signed in 1992 setting the timetable for the launch of a single currency by January 1, 1999.

The rejection of the Maastricht treaty by a Danish referendum in 1992 however led to a speculative attack on the ERM in September 1992. This led to devaluations by Britain and Italy and caused Britain to leave the ERM. And George Soros, as you know, became world famous.

Dollar’s Secular Decline and Turnaround

The Dollar’s secular decline, which began in March 1985, seems to have ended only in March/April 1995 after the US administration switched to a strong Dollar policy under the leadership of the market savvy Robert Rubin. By then the Dollar had already fallen as low as 1.34 marks and 80 yen. This 10-year decline was, however, interspersed with 3 significant recovery periods against the mark - January 1988 to June 1989, February 1991 to August 1991 and October 1992 to February 1994. Against the Yen, the Dollar enjoyed only one significant recovery period lasting from January 1988 till April 1990.

The adoption of a strong Dollar policy by the US administration together with the robust, non-inflationary growth enjoyed by the US economy helped the Dollar to rise sharply as foreign capital flowed into Dollar-denominated assets. The Dollar rose to 1.89 marks by August 1997 but then fell to 1.59 marks by October 1998 due mainly to the White House crisis, Russian default/devaluation and euphoria in the run-up to the launch of the Euro.

The Dollar rose against the Yen too (from 80 Yen in April 1995 to about 147 yen in August 1998) but then fell to about 112 Yen by October 1998 before recovering to about 125 Yen in May 1999. The Dollar again fell sharply and has come close to the magical 100 Yen level after nearly 4 years. While the reason cited is the nascent Japanese economic recovery and the rally in Japanese equities, the real reasons appear to be an extra-loose fiscal policy and an extra-tight monetary policy as in the US during the early eighties and in Germany during the early nineties.

EMU and the Euro

The European Economic and Monetary Union began on January 1, 1999 with the launch of the single currency called the Euro. Out of the 15 European Union countries, Greece was disqualified under the Maastricht criteria while Britain, Denmark and Sweden did not join in the first round. The remaining 11 countries - Austria, Belgium, Finland, France, Germany, Ireland, Italy, Luxembourg, the Netherlands, Portugal and Spain joined the single currency. The main operating characteristics of the EMU are a common monetary policy and a single interest rate decided by the European Central Bank and irrevocable, locked-in conversion rates between the Euro and the 11 national currencies.

The early Europhoria subsided very quickly and for a host of economic and political reasons, the Euro has been in a downtrend ever since its launch. It has so far fallen 15% against the Dollar, 23% against the yen and 12% against sterling. In all fairness, however, the external strength or weakness of the Euro is not a measure of EMU’s success or failure - which will instead be decided by the extent to which the single interest rate, etc help maintain convergence between the 11 members. Initial signs are not quite encouraging inasmuch as inflation in several countries has exceeded 2% and is rising, essentially because quite a few countries like Ireland and Spain had to cut interest rates sharply to the level of German repo rate, contrary to their own domestic needs. Yet, in the absence of clairvoyance, it may be too early to say whether these are just teething troubles or a signal of the beginning of an early breakdown of the EMU.

Archives Forex and money market This report is prepared by emecklai.com .(http://www.mecklai.com/.)