Forex, Trade and Politics

By McMahon, Chris | Modern Trader, September 2007 | Go to article overview

Forex, Trade and Politics


McMahon, Chris, Modern Trader


To understand politics, most of the time you just have to follow the money. While central banks manage economies through interest rates, politicians use a variety of methods to influence trade and move markets.

You don't need to be an Einstein to understand that everything is relative. Whether we are talking about being early vs. being late, or being cheap vs. being expensive, you need a point of reference to make meaningful qualitative or quantitative distinctions. The same is true for money.

FIXED AND FLOATING CURRENCIES

Without turning this into a history lesson, here's a little background. After the end of World War 11 and with their economies in ruin, the 44 Allied countries met in Bretton Woods, N. H. in July 1944 and fixed the value of the U.S. dollar relative to gold at the rate of $35 per ounce. The value of the non-U.S. currencies were then individually fixed to the value of the dollar, et voila, the gold standard was bom. Each of the countries knew where they stood relative to the U.S. dollar, and where the dollar stood relative to an ounce of gold. Individual currencies were allowed to vary within a narrow band and if they floated out of that range, central banks adjusted monetary policy to bring them back in line.

That worked great for a while, but the United States had limited gold reserves and certainly not enough to cover all of the currency in circulation, a situation akin to check kiting, and the lack of gold and dollars put a damper on global economic activity.

To relieve the strain on the U.S. economy and to allow for global economic expansion, something had to give. Then President Richard M. Nixon unilaterally killed the gold standard in August 1971. In response to global economic instability that resulted, the G-10, a group of Western economic powers, entered the Smithsonian Agreement in December of that year. The agreement devalued the U.S. dollar to $38 per ounce of gold, eliminated the direct convertibility of dollars to gold and allowed the value of the U.S. dollar to float within a narrow range, and the fiat currency system was born. The United States was in the midst of the Vietnam War and continued deficit spending. The value of the dollar plummeted relative to other currencies based on supply and demand, the agreement fell apart, and within a few years all of the major industrialized countries eliminated their pegs to the U.S. dollar and floated freely, their value decided in the market place by supply and demand. One current and notable exception is China, which values its currency, called the yuan or the renminbi, against a basket of Western currencies, much like an index, and allows the value to float within couple of percentage points.

MOVING THE FOREX MARKET

What can you buy for a dollar today? Less and less is the obvious answer, but the real question is "why?" Now that currency values float freely, they reflect more accurately the economic condition of their home country and, generally speaking, there are three factors that determine the health of an economy: productivity, a measure of how much stuff is produced; investment, reflecting a confidence in that productivity; and interest rates, which attach a time value to resources invested in that productivity.

Forex traders are very interested in productivity, and they track productivity at the macro level with the gross domestic product and employment statistics. When it comes to productivity, more is better, and countries with high levels of productivity and high employment levels tend to have strong economies. However, too much productivity and employment can result in inflation, which is a devaluation of the currency.

Forex traders also are interested in whether money is being invested in, or divested from, an economy. Money flowing into a country is good, reflecting confidence in future productivity. Capital flowing out means that the grass is greener elsewhere. The United States Treasury tracks international capital flow and publishes its findings on a quarterly basis in the Treasury International Capital System, commonly called TICS data (see "Checking for TICS," right). …

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