Back in prehistory, there was no concept of currency. A cow was a cow and a sheep was a sheep. People bartered goods for other goods. The problem was that when you traded ten sheep for five cows, you had to find somewhere to keep the cows. Cows are large; they don't fit in your pocket. Something had to change.
Urban societies started to emerge in Mesopotamia about 5300 BC. Wealth was based on agricultural products - primarily grain. Grain was stored in temple granaries, and when people made deposits, they needed receipts - the receipt came in the form of a piece of metal.
By 3000 BC, this evolved into the shekel, a measure of barley. Shekels could be converted into metals such as copper, silver and gold.
Money was born.
Coins solved this problem. They had a standard weight, and were stamped with symbols by the state to prove their authenticity. The first standardised metal coins appeared in Greece in the seventh century BC.
The gold standard
However, as trade grew, coins became more and more impractical. Banks started to issue money in large denominations, using cheap materials such as paper. Physical money no longer had an intrinsic value; instead it could be redeemed at banks for gold or other precious metals.
After the Napoleonic wars of 1803-1825, a number of nations fixed the value for their currencies against gold, and promise to redeem the notes directly. Currencies could now be exchanged based on their fixed values.
This was the gold standard.
The world at war
The chaos of World War I put an end to the gold standard, and nothing replaced it until 1944.
Although the gold standard was dead, international financial institutions did start to emerge between the wars. The most important was the Bank or International Settlements (BIS), founded in Basel in 1930. Its charter was to support countries without mature financial systems, or those with balance of payments deficits.
In 1944, delegates from 44 Allied nations met in the United States at Bretton Woods. Economic luminaries including John Maynard Keynes and Harry Dexter White worked to create a new global financial system, so that shattered countries could be rebuilt after the war.
The Bretton Woods Agreements were signed in July, 1944 with the following results:
The International Monetary Fund (IMF) was established
Countries who cooperated with the IMF could receive stabilisation loans
The US dollar and British pound were announced as international reserve currencies
Currency values were fixed against the US dollar - with only 1% deviation allowed
The value of the dollar was fixed against gold
Countries could only alter their exchange rates with IMF permission
Currencies became convertible
Governments were required to hold reserves and intervene in currency markets
Nations had to pay a fee in gold and national currency to join the IMF
After World War II, the US became increasingly concerned with the ability of a war-ravaged Europe to resist Soviet communism. In 1947, it established the European Recovery Plan, popularly known as the Marshall Plan after the US Secretary of State, George Marshall.
US dollar inflation became a major issue, and the US administration took steps to control US dollar transactions through taxation of exchange differentials. Costs increased for foreign borrowers, leading to the creation of a new eurodollar market.
The British balance of payments deteriorated through the 1960s, and their gold reserves declined from $18 billion to $11 billion. In 1967, the UK had to devalue the pound, striking Bretton Woods a crippling blow. At the same time, US debt continued to grow.
Events accelerated in 1971:
In May, Germany and The Netherlands allowed open trading of their currencies
In August, the US balance of payments deficit reached crisis point and President Nixon responded by stopping conversion of US dollars into gold
In December, matters came to a head:
A last attempt was made to save Bretton Woods in a meeting at the Smithsonian Institute in Washington
Exchange rates were allowed to deviate up to 4.5% from their fixed values
Central banks made major interventions in the currency markets - including $5 billion from the Bundesbank
Exchange rates could not be controlled despite these interventions
Currency exchanges in Europe and Japan were closed temporarily
The US devalued the dollar by 10%
Developed countries floated their currencies - ending fixed exchange rates
1973 to 1974
Over this period, events continued to unfold:
The US dismantled the tax measures and other restrictions it had introduced in 1964
Central banks stopped intervening in the currency market
Speculators made enormous profits once interventions stopped
Two major banks - Bankhaus Herstatt and Franklin National Bank - went bankrupt
Speculation damaged many other banks
The Bretton Woods system ceased to exist
Representatives of major nations met in Kingston, Jamaica, to create a new global currency system. This had the following results:
Gold was no longer used as the basis of currency valuation
International organisations were set up to control currency conversion
Currencies were used to buy other currencies
Commercial banks became the main mechanism for currency conversion
Exchange rates were floated - and were driven by market forces
The modern forex market had begun.