Analyze the growing importance of currency markets and currency trading

Describe how nations have used different manipulations of other nation's currencies to create economic warfare

The largest investment market in the world

As was mentioned earlier in the course, world currency trading is the largest financial market on the planet today, with over a trillion dollars in national currencies changing hands every 24 hours. People have likened the world currency market to a thousand-pound gorilla: governments may try to keep it under control, but at best they can only hope to persuade it to keep its violence to a minimum. There are over 200 national currencies traded and being speculated on daily. Currency transactions are instantaneous, with the rates of exchange largely fluctuating, as always, based on the market forces of supply and demand.

Before 1971, when a typical national currency was tied either to gold reserves or the comparatively stable US dollar (which was still a gold standard currency), currency values often remained fairly stable, in many cases for years or even decades. In those days, there wasn't much of a market for currency speculation. But today thousands of traders are buying and selling currencies and these trades can have dramatic effects on the internal economy of a country.

The reason a nation's currency can be bought and sold is that it is needed by foreigners in order to buy export goods from the country in question. Consequently, if a nation's exports are in demand, its currency tends to be in demand too. As the demand for a currency goes up, its value against other currencies increases. Money traders will also buy a nation's currency if that nation's banks offer high interest rates, as the money can then be invested in the country and earn more interest. Factors such as these influence the rise and fall of a currency's value. Speculators buy currency when they think it is likely to go up in value in the future.

Like other financial markets, the currency markets are at the mercy of people's moods and emotions, and the typical currency trader is young, male, and aggressive. Currency speculators now have the power to impact whole nations and governments, and both emotion and personal politics sometimes play a part. If a certain government falls out of favour, such as we've seen in the European Union, both the currency and the bond markets may "punish" those governments by demanding higher interest rates or pushing the value of their currency down by selling it as they abandon ship on the national market.

Using Canada as an example, what factors might cause a decrease in the demand for Canadian dollars? The demand for dollars on the foreign exchange market will decrease if...

• there is a decrease in the demand for Canadian goods abroad;
• there is a decrease in the real GDP/income of foreign speculators in CDN dollars;
• there is a decrease in foreign wealth generally;
• there is an increase in the riskiness of Canadian investment for whatever reason; or
• the dollar is expected to depreciate in the future for any reason.

Weapons of mass destruction

In the 21st century, economic activity can contribute dramatically to the destabilization, weakening, or even political devastation of a country, and an attack on a country's currency is one means of creating such turmoil. Governments often try to defend themselves by such measures as increasing domestic interest rates or buying up large amounts of their own currency on international exchange markets, so that the demand and price of their currency will rise. But these defensive techniques tend to be no match for the brute forces of the overall marketplace and the economic principle of supply and demand. A currency can be crippled by the kind of herd investor panic we discussed in an earlier week. This happened to the Mexican peso in 1995. The country was brought to its knees by investors dumping Mexican currency and it had to rely heavily on the US to bail it out.

A gold coin worth 20 Mexican pesos, minted in 1866.

Like a great white shark, the currency market will attack if it smells blood. Signs that tip investors to a currency devaluation include such things as unsound government fiscal policy, excess spending and excess debt. If a trend in selling off the currency continues, it lowers the value and others rush to dump their holdings, thus lowering the value further.

Old school currency warfare

In the past, enemy powers sometimes tried to attack a country directly through its currency. One method that was used in the early 20th century was counterfeiting. During the 1930s, when Japan was in conflict with China, the Japanese flooded China with counterfeit money in order to discredit Chinese currency and create economic destabilization.

In the 1940s during the Second World War, Nazi Germany created counterfeit British currency worth as much as 150,000,000 pounds sterling in an effort to destabilize the English economy and war effort. Millions of forged British pounds were to become a weapon of war and were to be dropped over Europe from German bombers. The Germans ran a production line of Jewish concentration camp prisoners turning out millions of British pounds. The Oscar-winning 2007 film The Counterfeiters tells the story of a famous Jewish counterfeit artist who was brought in by the Nazis from a German jail to create one of the world's most successful counterfeits of a British pound. From 1942 to 1945 the Germans forged more pound notes than there were in the vaults of the Bank of England, the equivalent of about 15% of the genuine notes in circulation, and enough to cast suspicion on all of England's paper money. A number of Nazis, however, behaved like greedy gangsters and hoarded the counterfeit money for their own use, thereby undermining this war effort. By 1943, the German air force was too decimated to be used for dropping bogus currency and the Nazis instead used the fake money to help finance their espionage service.

Another famous moment in the history of currency warfare occurred in 1956, when the US government used currency trade as a threat to the United Kingdom. The US sold large quantities of its holdings in British pounds, forcing down the value of the British currency and creating a financial crisis for the Brits. The US used this measure as a way of persuading the British to come on side with the US political and military policy surrounding the Suez Canal. This can be seen as a watershed event, where the US dollar finally took clear dominance over the pound, which had still been the world standard in many people's eyes up until then.

Prior to the 2003 US invasion of Iraq, the CIA reportedly considered plans to destabilize the Iraqi dinar, and they have also been plotting attacks on the currency of Iran. Big inflows of foreign currency into poorer nations can also create problems, notably driving up exchange rates and thus making it more expensive for the citizens to buy foreign exports, which in turn can drive up inflation. Currency has thus become one of the weapons one nation can use to disrupt another. Or perhaps it should be seen more as one of the most vulnerable aspects of a nation's power.