Forex – The Beginning

Today it goes by the name of “Forex”, but people’s need for exchanging currencies manifested soon after money appeared. During the medieval times, the Medici family opened banks at foreign locations for exchanging currencies in order to facilitate textile trading for foreign merchants. This was happening in the 15th century and later, during the 17th and 18th century, Amsterdam operated an active Forex market. In 1880 emerged one of the first banks to conduct a Foreign Exchange business,  Banco Espirito e Comercial de Lisboa. Soon, foreign banks started to appear in major cities of the world, the most active being Paris, New York and Berlin, while London remained relatively uninvolved until after 1914.

The Gold Standard and the Bretton Woods Agreement

Since the 19th century, the Gold Standard was in effect. This is a monetary system that compares any currency to a fixed weight of gold. The currency was backed by gold and that’s why countries needed large reserves of gold. However, external factors (like the discovery of new deposits of gold) largely influenced the Gold Standard. With the first World War approaching, instability and turmoil generated a lack of gold to back up the currency. The main European countries were spending more on military projects and as a result, more money was printed, but the lack of gold to back it up eventually led to the abolishment of the Gold Standard and the signing of the Bretton Woods Accord in July 1944.

The main characteristic of the Bretton Woods system was the obligation for the participating countries to express their exchange rate by tying their currencies to the American Dollar. Now, the US Dollar was the most powerful currency, and the only one backed by gold. The Bretton Woods Agreement established the International Monetary Fund and the International Bank for Reconstruction and Development (today, a part of World Bank Group).  The Bretton Woods monetary system came to an end on the 15th of August, 1971 and the main reason for its failure was the fact that US Dollar was the only currency backed by gold.

Tulip Mania

I would like to return now to the 1630’s to talk about one of the greatest speculative bubbles of our economic history: the Tulip Bubble. This is the perfect example for explaining supply and demand. Around 1554, tulip bulbs reached Vienna, arriving from the Ottoman Empire and soon after, reached Amsterdam. Their popularity started growing as no other flower exhibited such vibrant colors and could withstand the harsh conditions of the Netherlands. The tulip soon became a symbol of luxury and social status and demand slowly increased.  The most sought after tulips were the ones affected by a flower virus that colored their petals with different colors. But those tulips were rare and that made supply scarce. At the peak of the tulip mania, a single bulb affected by that virus could cost ten times the annual salary of a skilled craftsman.

Tulip Mania ended abruptly in February 1637 when at an auction, no buyers showed up. That day, supply was sky high and demand was zero. The lack of data from 1630’s makes it difficult to know exactly what happened, but apparently, risk aversion played a big role and buyers refused to pay huge and constantly increasing prices for the tulip bulbs and inevitably, the speculative bubble burst. This cycle can be seen in the Forex market, with prices rising and then, demand for that currency decreases and as a direct consequence, prices start to drop. I would really recommend keeping in mind the Tulip Mania and always expect something that is overvalued to return to its real value.