The exchange rate refers to the ratio at which one country's currency is exchanged for another country's currency. Although gold and silver are universally regarded as symbols of value, their storage and circulation issues make them unsuitable as tools for modern world transactions. In this context, paper money, guaranteed by national credit, emerged.
Paper money, in itself, does not have the intrinsic value of gold and silver. It is a monetary symbol that the state authority enforces through compulsory means, backed by national credit. Initially, paper money could still be exchanged for gold and silver, but as more paper money was issued, the exchange between paper money and gold and silver eventually decoupled.
As countries began to issue their own currencies, the authority to issue currency had to be held by the government, as this act is essentially the creation of wealth, known in economics as "seigniorage." The central bank is responsible for issuing currency. Although this money is recorded as a liability on the balance sheet, in practice, the increase in the money supply causes inflation, which indirectly transfers some wealth to the government through rising prices.
While issuing currency has its benefits, it cannot be done recklessly, as excessive inflation can collapse a country overnight.
With the advent of currency, contradictions in international trade emerged. After all, one country's currency cannot circulate in another country, or the "seigniorage" would fall into the hands of another government, which is absolutely unacceptable. In this situation, the exchange rate system was born.
Before the Bretton Woods system, there was no fixed currency for international trade settlements. Later, through negotiations and strategic games among the victorious World War II countries, the U.S. dollar, pegged to gold, became the designated settlement currency in international trade, solidifying the dollar's dominance.
In the 1970s, the Bretton Woods system collapsed, and the European Economic Community began discussing the establishment of a European monetary system to create a new currency system outside the U.S. dollar, which was the precursor to the euro.
In October 1990, the United Kingdom announced its entry into the European Monetary System, bringing the number of member states to ten. These ten countries were France, Germany, Italy, Belgium, Denmark, Ireland, Luxembourg, the Netherlands, Spain, and the United Kingdom. The combined GDP of these countries largely represented the European economy.
The emergence of the European Monetary System formed a loose monetary union among the major European countries. The system's core was a basket of currencies (known as the European Currency Unit, or ECU) composed of the currencies of the European Community member states. Member states' currencies were pegged to the ECU, and bilateral fixed exchange rates were determined through the ECU.
These exchange rates were not entirely fixed; there was a fluctuation range of ±2.25% between member states' currencies, with the British pound having a wider range of 6% due to the UK's larger GDP.
To maintain this exchange rate system, member states had to deposit a portion of their gold and dollar reserves with the European Monetary Cooperation Fund in exchange for a corresponding amount of ECUs. If a member state's central bank needed to intervene in the exchange rate of its currency, it could use its ECUs or other forms of international reserves to buy its currency from other countries, thereby intervening in the foreign exchange market.
Given that the Deutsche Mark was the strongest currency in the European money market and one of the main trading currencies in the international foreign exchange market after the U.S. dollar, the market generally believed that significant fluctuations between a European Monetary System member state's currency and the Deutsche Mark indicated intervention by that country's central bank.
According to regulations, if the exchange rate between two member states' currencies exceeded the specified range, both central banks were obligated to intervene. However, due to the Mark's dominant position, when the exchange rate of many currencies reached the specified range, only the affected country would intervene in the foreign exchange market, while Germany was not required to fulfill this obligation.
This imbalance planted the seeds of crisis in the exchange rate system among European countries.
In the 1990s, the world underwent a dramatic transformation. The Berlin Wall fell, and the East German parliament decided to join the Federal Republic of Germany (West Germany), ceasing the East German government's operations in October, thus ending the post-World War II division of Germany.
The Soviet bloc, already weakened internally and externally, was unable to prevent its member states from declaring independence and leaving the Soviet Union and the Warsaw Pact. The largest military alliance in history thus dissolved.
After German reunification, the lagging East German economy severely burdened the Federal Republic of Germany. The influx of a large population and the need to provide equal welfare to all citizens, along with the extremely unreasonable one-to-one exchange rate between the East and West German marks, led to a massive fiscal deficit for the German government.
Within the European Community, economic development was uneven, and policy orientations varied. For example, countries like the United Kingdom and Italy had sluggish economies, high unemployment, and slow growth. Without control over monetary policy, they urgently needed to implement low-interest-rate policies to stimulate the economy.
In this context, the German Mark and the policies of the German government, which held a significant position in the European Currency Unit, became important indicators.
International capital, familiar with the workings of the European Monetary System, focused on this point, with Germany's direction determining their market operations.
The act of attacking a country's currency first appeared in the world financial market, becoming a powerful tool in the hands of hedge funds and later sweeping many countries.
This also marked the definitive entry of macro-strategy hedge funds onto the historical stage, where they would shine brightly. (To thank the recommendation votes exceeding 7,000, I am adding an extra chapter today, and also thank the readers TomUN and Kunsha for their support!)