In June 1984, at a conference on currency markets arranged by the Financial Times, the chief speakers’ topic was “Where did we all go wrong?” .In a similar conference the next year, the question was “Where did we go wrong again?” From 1982 to 1985, poll after poll showed 90% of the currency ‘experts’ bearish of the dollar, while the US currency climbed and climbed. How could so many experts be so wrong?

The glass that is half-empty is also half-full. The pessimist sees it one way and the optimist the other. So it is with financial markets. Most movements in financial markets are accounted for by swings in sentiment between optimism and pessimism. In the currency markets, almost all movements are accounted for by swings in sentiment, for reasons that will become clear. However observers want more dignified rationalisations for price movements, so a whole body of conventional wisdom comes into being, which may have no basis in reality.

This dead weight of conventional wisdoms encourages the idea that the currencies are complex and sophisticated. But once you strip away all the rationalisations and conventions that have no basis in reality, you discover the truth: which is that the currency markets are simple. And, so far from being highly sophisticated, they are, as I have suggested, remarkably naive. And there are good reasons for this, as explained. First, they have only been operating in their present free-floating mode since 1973 –for less than 20 years. Second, surprising as it may seem for such momentous markets, there are precious few full-time forex specialists aside from dealers.

The floating* of the dollar

It’s understandable that most of the ‘pros’ went wrong in 1982-5. They were conditioned by history. Aren’t we all? Before 1971, the major currencies were fixed in relation to the dollar, which was in turn fixed in relation to gold (one ounce of gold to $35). This is fine until some country’s

inflation rate gets out of line. Then its domestic price levels would run up above its neighbours; its exports would get too pricey and imports would become excessively cheap. The currency , in a word, would become uncompetitive; and the result was usually a balance of payments crisis, as the trade account ran deep into deficit and foreigners lost confidence in the currency and sold it to repatriate funds.Britain suffered such a fate in 1967, and the only solution was to devalue, as sterling did in that year (not for the first time). In fact this was a regular occurrence among the so-called “weak” currencies like the Italian lira (Lit) and the French franc (FF). By contrast certain “ strong” currencies like the D-Mark (DM) and Swiss franc (SF) occasionally ran up such big trade surpluses and encountered such big speculative inflows that they had to be revalued upwards.

Britain, Italy, France and other European countries like Spain were all inflation-prone countries. But of course their inflation rates were tame stuff compared with those of many Latin American countries –the “banana republics” with monthly inflation rates in double figures. If domestic price levels double every 6 months or so, the external value of the currency has to halve to preserve the competitive equilibrium, or purchasing power parity (PPP) as it came to be called. If there are 10 pesos to the US dollar, you can’t have a pair of shoes costing 100 pesos at one moment and 200 pesos six months later with the dollar still standing at 10 pesos: if you do, shoe

exporters will go bankrupt and the republic of Banania will be flooded with imported shoes. The ppp* theory, that currencies will tend towards their competitive equilibrium values, is based on common sense, though its literal application was to lead pundits into treacherous seas in the 1985. Before 1971 currency speculation was child’s play-like taking candy from a baby central bank. All you had to do was keep tabs on relative inflation rates and watch for the moment when a country would run into payments

difficulties. Then you would sell it forward against the central bank, which would see it as its duty to defend the currency until it became indefensible, and had to be devalued. Then you would buy back and clean up.

In this way, bank traders would make fortunes at the expense of the central banks. And to this day, taking on the central banks is something bank traders cannot resist.

During the 19605, America flooded the world with dollars, which were lent and re-lent in the so called Eurodollar* market –the market in dollars outside America. The result was an oversupply of dollars around the world, at a time when the “economic miracles” were happening in continental Europe and Japan. While the American economy ambled forward, weighed down by the burden of the Vietnam war, between bouts of balance of payments trouble, the countries of the German-zone* and Japan surged ahead on a wave of export-led growth. This put remorseless pressure on the dollar, which was forced off the gold standard in 1971.

The key event of the 1970s was that US inflation got out of hand. At the start of the decade, the greenback had been on a pedestal. For a start, America’s record over inflation had been second to none for decades –not least during the 1960s, when it returned to the 1-2% area, after backsliding briefly at the time of the Korean War, in the early 1950s. So when US inflation soared into double figures after the first oil crisis in 1973, it was a cause of sharp disillusionment; and the dollar suffered accordingly. Bu t during the second oil crisis at the end of the decade, US inflation deteriorated even further (reaching 15% in 1980), whereas in every other major country the inflationary peak was lower than in 1974-5.

So at the end of the 1970s, the dollar was a pariah among currencies. It had been falling for 10 years, but despite this, the current account was in deficit and the currency not evidently competitive. It was death. It gave you cancer. The place to be was in D-Marks and Swissies – if not in gold, diamonds, paintings, wine, baked beans or other inflation hedges. That was the background when Paul Volcker was appointed chairman of the Fed in 1979, by President Carter.

Volcker’s medicine was tight money, along with whatever level of interest rates might result. His aim was to turn the tide of US inflation. He succeeded, and in the process most of the conventional wisdom of the currency markets was turned upside down, as the experts were to discover.

The first Volcker shock came in 1980 when US interest rates blipped up to 20% –only to slide back down again to 8% in time for November’s presidential elections, which saw Ronald Reagan take over from Jimmy Carter. The dollar rode up and down again on the back of US interest rates, like the Grand Old Duke of York.

Of course there was nothing new about the idea that hefty shifts in interest rates could move currency rates. Interest rates and currency rates have always been intimately related –often in a threesome including inflation rates. In Latin America, there has been a long tradition whereby interest rates were officially administered in line with inflation rates or alternatively bank deposits were indexed to inflation while the exchange rate was similarly indexed inversely to inflation and interest rates.