The Theory of the Foreign Exchanges

Front matter

The few weeks which have elapsed since the publication of the second edition have again proved the rapidity with which the situation of the "Foreign Exchanges" may be reversed, and the difficulty of selecting durable illustrations. In the preface to the second edition, allusion was made to the fact that the Russian Exchange, so long an example of unlimited fluctuations, had been brought almost to par. Since then a severe fall has again taken place. So, in the former edition, the rapid fall in the price of gold in America furnished the opportunity for comment and examination. But there also a turn has taken place, and to-day it would be necessary rather to seek an explanation of the rise than of the fall. It is scarcely the province of a theoretical treatise to keep pace with each new combination of facts. An author may be considered bound to watch the progress of events, as a constant test of the accuracy of his principles, but it is hardly possible, nor is it necessary, perpetually to adopt new illustrations. It has, therefore, been deemed unnecessary to make any further alterations in the present edition.

The history of the Foreign Exchanges for the last two years is a history of revolutions. The movements which have occurred in many quarters have been almost unexampled in rapidity and extent. Countries which formerly supplied illustrations of particular phenomena in the Foreign Exchanges, may now be cited as instances of perfectly opposite combinations. The various causes which have been stated in the following work as determining the course of the Foreign Exchanges have been at work with more than usual intensity, and the new combinations which events have presented have afforded many opportunities of testing the correctness and sufficiency of the principles advanced. The exchanges of those countries which, two years ago, were selected as exemplifying the results of a depreciated currency or excessive indebtedness, might now, on the contrary, be cited as instances of rapid recovery. The Austrian Exchange has recovered fully 30 per cent. The Russian rouble has approached the par value of gold. In America, on the other hand, the very opposite has occurred. The American Exchanges, which in the former edition were shown to move within certain limits—determined by the cost of bullion shipments and by the intermediate value of money—have since afforded the most notorious examples in recent days of unlimited and indeterminable fluctuation. An inquiry into the theory of the Foreign Exchanges can scarcely keep pace with the tide of events. However interesting a review of the events themselves might have been, it could not conveniently be introduced into a treatise which aimed chiefly at the statement of a theory, and dealt with contemporary fact only as illustrating general causes. The new matter which, in this respect, has been introduced into the second edition, is confined to the consideration of the American Exchanges. It would not have been compatible with the general course of the argument to treat so complicated a question exhaustively or historically. The monetary situation of America has been so extraordinary, the difficulty of acquiring accurate knowledge on it is so great, the changes to which it is subjected are so rapid, that an exhaustive inquiry into the actual facts would have assumed the proportions of a a separate work. Thus any controversy which may arise on that portion of the present treatise which deals with the American Exchanges, should turn rather on the correctness of the mode of interpretation on a common ground of fact, than on the absolute correctness of the facts themselves. The latter have been stated as carefully as possible, and every precaution against error has been taken. If, nevertheless, any uncertainty should be felt with regard to the description of particular circumstances, it must not be allowed to place in doubt the scientific certainty of the theory itself.

The other important alterations which have been made in the second edition are to be found in those chapters which discuss the question of so-called "Unfavourable Exchanges," and the "Adverse Balance of Trade," and which examine the possibility of "correcting" such a situation by means of a high rate of interest. With regard to the exact force of the term "Unfavourable Exchanges" and "Adverse Balance of Trade," as they are still used in monetary treatises, not as characterising any situation which from the general point of view of the prosperity of any country is really unfavourable, but simple as denoting a certain set of circumstances which bankers and merchants persist in calling by that name, the original text scarcely left room for much misconception. Nevertheless the endeavor has now been made to limit and define the sense of these terms still more rigorously, as it is highly important that a real discrepancy should not be supposed to exist between political economists and the banking world, whereas the discrepancy, it it exists at all, lies only in the nomenclature and not in the theory. With regard to the power of a high rate of interest to affect the exchanges, the objection has been raised against certain passages in the first edition, that they seemed to countenance the idea that money might artificially be made cheaper or dearer, and that the action of banks or individuals might accomplish that which must really be determined by supply and demand. Possibly the expression employed may have lent a colour to this objection, and, at all event, it seemed desirable to develop their meaning more fully. It is hoped that the alterations introduced will clear up any misconceptions in this respect, and that it will appear from the observations made as to the limits within which the influence of the Bank of England in dealing with the rate discount is confined, that no exaggerated ideas of its powers were intended to be conveyed.

Chapter I

FOREIGN EXCHANGES

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CHAPTER I

definition and preliminary examination of the transactions with which the foreign exchanges are concerned

In order to clear the ground for the consideration of the more interesting theories connected with the Foreign Exchanges, it is desirable in the first instance to define as clearly as possible the general meaning of the term. The phrase "Foreign Exchanges" is in itself vague and ambiguous, being more frequently used to express the rates at which the exchanges in question are effected than the exchanges themselves-the prices rather than the transactions. When it is said in technical phraseology that the exchanges are effected than the exchanges themselves - the prices rather than the transactions. When it is said in technical phraseology that the exchanges are rising or falling, or that the exchanges are at specie point, allusion is made to the fluctuations in the terms on which bargains are made between the buyers and sellers of Foreign Bills. However, before we treat the subject in this sense of the phrase, -that is to say, as denoting the rates at which exchanges take place, -it is necessary to examine the subject-matter of the exchange itself and to realize distinctly what it is that is bought or sold, transferred or given in exchange. When the transaction takes a practical form, Foreign Bills, -that is to say, bills on foreign countries, -constitute this subject-matter; but a less technical explanation can be given. That which forms the subject of exchange is a debt owing by a foreigner and payable in his own country, which is transferred by the creditor or claimant for a certain sum of money to a third person, who desires to receive money in that foreign country, probably in order to assign it over to a fourth person in the same place, to whom he in his turn may be indebted. The operation which takes place is put very clearly by Mr. Mill in the following passage:-

"A merchant in England, A, has exported English commodities, consigning them to his correspondent B in France. Another merchant in France, C, has exported French commodities, suppose of equivalent value, to a merchant D in England. It is evidently unnecessary that B in France should send money to A in England, and that D in England should send an equal sum of money to C in France. The one debt may be applied to the payment of the other, and the double cost and risk of carriage be thus saved. A draws a bill on B for the amount which B owes to him; D having an equal amount to pay in France buys this bill from A and send it to C, who, at the expiration of the number of days which the bill has to run, presents it to B for payment. Thus the debt due from France to England, and debt due from England to France, are both paid without sending an ounce of gold or silver from one country to the other."*

This explanation, however, involves the idea of the transaction being carried out by the intrumentality of an actual bill of exchange, which, at the present stage of the inquiry, it is better to ignore altogether. It will be found more convenient to treat the transaction, in the first instance, as a simple exchange of debts and claims without considering the instruments by which it is accomplished. IN its most general form, the case may be stated as follows:-

As the result of international commerce, a certain portion of the community has become indebted to

-"Principles of Political Economy," ch. xx., par.2

merchants in foreign countries; and in order to save the trouble, risk , and expense of sending coin, they seek out another portion of the community to whom a similar amount is owing by the identical foreign countries in question, and buys up these debts, assign them over in payment to their own foreign creditors. And if the aggregate sums owing by any two countries to each other were absolutely equal, -that is to say, equal in amount, equal in security, equal in the time when the debts become due, and equal in the proportion which the coin in which these debts are payable bears to the circulation of the respective country, -there would be no difficulty of any kind in determining the equivalent which the purchasers of such claims would pay to the sellers. It would simple be a sum equal to that which is payable abroad under the transferred claims. The amount required by the purchasers would be exactly equal to the amount held by the sellers; thus there would be no cause in operation to vary the price, and there would be no fluctuations in the rates of Foreign Exchanges. In technical language, they would always remain at par. But, conversely, we arrive at the point which forms the essence of the present discussion: the fluctuations which actually take place in the Foreign Exchanges are in the first instance the result, and in the second, the manifestation, of the inequalities which exist in the debts of different countries to each other, in the amount of such debts, in the time within which these debts must be paid, and in the relation of the currency of one country to that of another.

It might have seemed easier to have explained the exchanges in question as the exchanges between different currencies, as of sovereigns against francs, or of florins against dollars; the more so, as practically this is the shape which actual transactions almost invariably assume. But by confining the definition to these cases, a most important, and indeed essential, feature would have been overlooked; that is to say, that though one system of coinage were adopted for all countries, claims on foreign countries would nevertheless vary in price, and would still be either at a premium or at a discount, according as there happened to be at any moment more persons desiring to transmit funds abroad than such as had outstandings abroad which they were entitled to draw in. For this is the first cause of what is generally spoken of as the rise and fall of Foreign Exchanges. On the particular day, or through a given season, a large amount is required to be sent abroad in payment of debts; England, let us say, is heavily indebted to France, and the time has arrived for payment. At this time, however, it happens that in the opposite branch of trade, that which results in France being indebted to England, fewer transactions have taken place, and thus there are comparatively few who have accounts standing to their credit in Paris which they might transfer to those who have to remit; in other words, adopting the language of merchants, there are few who have bills upon France. The consequence is, that there is great competition for these few bills; those who do not bid high enough for them will either have to go through all the trouble of packing, insuring, and despatching gold, or else will not punctually meet their engagements. Thus those who have the bills to sell are able to obtain more than the actual par value for them; for, in consideration of their having a given sum already at a spot where another wishes to have it, and whither he will have to convey it himself at some expense if they do not cede it to him, they are able to secure for themselves the whole of the benefit, which, if the exchanges were at par (that is to say, if the indebtedness of the two countries were equal), would be divided between the buyer and the seller. Instead of the arrangement being a mutual convenience, the seller is able, by the competition of the buyers, to secure the whole convenience to himself.

Supply and demand, in their usual form, determine this part of the transaction. Bills on France would in this case be at a premium. It is needless to draw out the opposite case, in which, there being more person who had money to claim from France than those who required to send funds thither, bills on France would be at a discount. This is the first and most elementary phase in which the Foreign Exchanges can appear; and for the purpose of appreciating the most important lessons which can be derived from their study, it is better to discard the idea of the exchange taken place between different sorts of money, and to hold fast to the general principle that what is really given in exchange in the natural and simple transactions from which all others are derived, is a sum of money at one place for an equivalent sum of money at another. By way of anticipation it might, however, be stated here, that in contradistinction to this simples transaction, the most complicated would be one in which the sum of money given would be payable immediately, the equivalent recoverable three months later; the sum given be in gold, the equivalent in silver; the sum given be perfectly undoubted, being paid down at once, the equivalent be of doubtful character, because involving a lengthened credit. To establish the equality between the two sums, it would accordingly be necessary to take into consideration the relative value at the time of gold to silver, the amount of interest which would be lost by waiting three months, and the amount of risk which would be run by receiving a piece of paper representing a promise to pay three months hence in exchange for cash paid down. These are all considerations which affect the exchanges, and which indeed render the subject so complicated that the groundwork may easily be lost sight of. Discussions are sometimes held on the state of the Foreign Exchanges in which attention is paid mainly to the value of money in different countries, to the amount of bullion held by each, and to the relative position of their paper currency, -points, no doubt, of the highest moment in determining the fluctuations in the exchanges, but not entitled to exclude the first and leading feature, their relative indebtedness. In studying the subject as a whole it is above all things necessary to form a clear view of what is meant by international indebtedness, of the elements of which it is constituted, and the various phenomena which it presents. As soon as this elementary question which underlies the whole theory of the Foreign Exchanges is properly understood, and an idea has been gained of the various modes in which countries become indebted to one another, we shall proceed to consider the form which this indebtedness assumes when the time of settlement arrives and when the floating debt is fixed in bills of exchange. The course of the discussion will then naturally lead to the nature and form of these bills of exchange, to their purchase and sale, to the various influences which determine their price, to their frequent fluctuations, to the meaning and force of the term that the Foreign Exchanges are favourable or adverse, and to the value of the state of the exchanges as an index of international transactions. We shall first consider the debts themselves, and shall find them finally represented by, and embodied in, a constant mass of bill of exchange; it will then be necessary to inquire whether these bills are payable at once, or at fixed future terms, whether they represent a final transaction or whether a portion only of a commercial operation, and how the rate of interest, the credit of the debtors, the indulgence of the creditors, the depreciation of the currency in which the bills are payable, affect their exchange-ability. We shall examine what circumstances lead to a demand for bills on foreign countries, and how it is possible to check or intensify that demand. Thus, at the close of our investigation, we shall light on many of the most important questions which have lately been ventilated in monetary circles, -as to the possibility of checking the efflux of gold by a high rate of interest as to the power which foreign capitalists, holders of bills of exchange on England, may exert over our money-market, as to the effect of these bills being all forced upon the money-market for discount at once instead of being gradually encashed as they mature, and other matters of this nature; questions which are by no means theoretical or abstract, but of vital and practical importance to every one engaged in mercantile pursuits.

Chapter II

CHAPTER II

analysis of international indebtedness considered as the basis of the foreign exchanges

The first element which we have to consider in discussing the Foreign Exchanges is to be found, as has been already stated, in international indebtedness; the exchanges in question are exchanges of claims or debts, and an inquiry into the origin and nature of these debts will throw considerable light upon the subject.

It is an error often committed to imagine these debts to be incurred simply by the importation of foreign commodities, and to look on the balance of trade as a mere question of import and export, and being the excess of the one over the other. It is necessary to look closer into the transactions between two countries before an idea can be formed of the position of their mutual indebtedness.

It will be discovered to result not so much from the exchange of their respective produce as from the relative totals of all the amounts expended by each upon the other, whether in payment of produce and manufactures, or for the purchase of shares and public securities, or for the settlement of profits, commissions, or tribute of any kind, or for the discharge of the expenses incurred in foreign residence or travel; in fact, from the entire payments (or promises to pay) which pass between the respective countries. The idea of actual borrowing must be lost sight of; it is the liability incurred with which we are now concerned; and this liability is identical in its effect, whatever its origin may be.

Payments which have to be made by one country to another for any purpose whatsoever, have the same effect as payments for direct importations. Thus it is possible that the general indebtedness of two countries to each other may be almost balanced, though the one imports far more commodities from the other than those which is supplies in return. For instance, the excess may amount to three millions sterling; but the nation which, through this class of transactions, has thus become a creditor for the excess of three millions, may spend one million thereof in remittances to such of its body as have taken up their residence in the other country, or have been traveling and spending money abroad: and another million may be sent to the country which has imported the excess, in order to buy up public securities; and supposing this latter country to be a great shipping nation, another million may be due to it for freights. Thus the equilibrium between the two countries would be restored, and there would be no adverse balance on either side; the indebtedness would be equal.

It may not be superfluous to examine some of these international transactions more in detail. As an instance, we may examine the force of foreign loans. Treating the subject, as is at present the case, with a view to the Foreign Exchanges, a foreign loan will tell against the balance, not of the country which receives the loan, but of that which supplies it.

The loan will certainly have ultimately to be repaid; but, at the time when it is contracted, it acts with the same force as an export upon the country which receives it, and with that of an import to the country which gives it. In fact, the borrowing country exports its securities, which are imported by the capitalists who lend. The force of the axiom that, with regard to the balance of trade, to contract a foreign loan is equivalent to an increase of exportation, will subsequently be more fully felt when the correctives of an unfavorable exchange come to be discussed. It will be seen that when the indebtedness of a country becomes excessive and the liability cannot be liquidated either by shipments of bullion or by an increase of exportation, recourse is sometimes had to a loan in order to readjust the balance; the country exports public securities made for the purpose, when it has no other available resources left with which to satisfy its foreign creditors. Russia will furnish an illustration of this position.

Or, again, there may be a nation, rich in capital and very self-dependent, importing little, because it contains within its own limits most of its requirements, but exporting very largely. The tendency of such a country would be to become the creditor of all her neigghbours. How is the balance to be restored? This case is the converse of the one just now considered; the indebtedness under the present hypothesis is not excessive, but under the mark; such a country often restores the equilibrium by becoming the speculative purchaser and importer of loans and stocks and securities of all kinds; her manufactures are repaid by railway debentures, and the sums which other countries expend on the commodities with which she supplies them, she in her turn expends on the Stock Exchanges of foreign capitals. There is no doubt but what the balance of trade is immensely affected at such times, when any great speculative mania for foreign securities springs up. In the same way as the monetary position of a country may be endangered when it imports more foreign produce than the amount of its exportation, so may it be endangered by the undue purchase of foreign stocks, with the sole exception that the latter are often far more adapted for re-exportation than manufactured goods or produce, on which the charges of shipment or re-shipment are infinitely heavier.

It will appear from the foregoing observations that, when the relative indebtedness or the balance of trade between two countries is spoken of, the permanent debts of country to another do not enter into consideration, -at least, not until the term of payment has arrived; the balance of trade depends upon the transactions which have to be settled, not upon those which by common consent are held in abeyance for a long term of years. For instance, there is no doubt that the United States owe an enormous amount to England in the shape of American securities in the hands of English holders; but with the exception of the interest on these securities, this indebtedness, being one which does not require settlement, exercises hardly any influence on that other indebtedness which has been regulating (or rather disarranging) the exchanges between the two countries since the commencement of the year.

These securities are articles of commerce, previously imported by England, and when they were imported, they no doubt acted upon the exchanges equally with the cotton which came from the same quarter; and if they are re-exported to America (which is possible enough), they would again affect the exchanges in the contrary direction, with the same force as is exercised by cotton when it is re-exported to America is the shape of Manchester goods.

Otherwise, involving no immediate claim, they cannot be regarded as a set-off to the debts which we incur to the Americans for cotton and corn. The balance of trade may be entirely against England, though the amount of American securities in English hands should immensely exceed that balance.

The case of the coupons attached to such stock is very different. The interest which they bear is a constant and important feature in national indebtedness. It constitutes an immediate liability incurred by the borrowing country; it is expenditure in favour of a foreign creditor. A country which has large sums of interest pay annually abroad, must import so much less or export so much more. Conversely, a rich country with a tendency to import too much, both of foreign produce and of foreign securities, receives some compensation in the annual collection of interest. It sets off these receipts against its excessive expenditure. It may look upon them as capital coming in against capital going out.

The large sums which England every year in payment of interest from foreign countries, reduces considerably the balance which, notwithstanding our enormous exportation, is almost always against us; the foreign loans negotiated in England increase her indebtedness at the time when they are contracted; but, by the annual revenue subsequently derived from them, her indebtedness is afterwards reduced.

The effect of profits and commissions on the mutual liabilities of nations is much the same as that which we have just described as exercised by interest. Among such profits, we may class the freights earned by the ships of different countries; the country which becomes the carrier for others thereby establishes claims against them with which it can pays its importations from them. The charge for freight acts with the same force as a charge for a commodity actually produced and exported. An exclusively maritime country could discharge its obligations to other countries which supply it with necessaries, simply by becoming their carrier without exporting any produce or manufactures to them in return.

Or, again, a peculiarly favorable position may enable one nation to make others its debtors for various tributes and commissions, and thus to obtain a revenue equivalent to one consisting of interest, of freights, or of the proceeds of exported commodities. A country which, like England, mediates the transactions of many others, and, being the banking and mercantile centre of the world, is able to secure some slight commission or profit upon all the operations which it assists in conducting, derives no inconsiderable revenue from this source. Formerly, when London was the great emporium of goods for foreign markets, and accordingly supplied the greater part of the Continent (which was itself in no direct trade with India or America) with cotton, coffee, sugar, tea, -in fact, with all the produce of the East and West Indies, -the commissions and profits on this mediation must have been very considerable, and have been an important element in the income secured to the nation from foreign sources. However, the tendency of the age, which is constantly bringing the producer and consumer into closer and more direction connexion by eliminating middle men and intermediate profits, is likewise exhibited in the fact that the Transatlantic or Indian producer is brought more and more into immediate connexion with the continental consumer. At present the continental shipowners and merchants make their importations from the producing countries direct, thus emancipating themselves from the London market, though not entirely from the London banking facilities. The interest and commissions which are still paid by almost every country to English capitalist, certainly form a noticeable element in the revenue by which England is enable to discharge her enormous foreign liabilities.

An allusion was cursorily made to the expenditure in traveling or residence abroad. Russia supplies the best illustration of the force of this expenditure. Several millions sterling are annually spent by the rich Russian nobility in traveling or in foreign residence, and the capital which is thus taken from Russia is lost precisely in the same manner as if it had been spent in Russia in importing commodities from abroad. The bills drawn by the traveling princes on their St. Petersburg bankers affect the exchanges precisely with the same force as bills drawn on St. Petersburg for the champagne sent thither from France. The liabilities incurred by foreign travel are peculiarly felt by Russia, in the first instance, because they are of themselves excessive; in the second, because independently of this expenditure, Russia consumes more than she produces.

There are many other international transactions which, in a complete summary of the items from which the so-called balance of trade is formed, might well deserve enumeration: for instance, import duties, or transit dues, and the whole range of Government imposts. But the consideration of the force of these charges belongs to a different field of inquiry to that on which we are now employed. The expense of armaments to distant regions, especially the regular expenditure of ships of war at foreign stations, also form an item in international indebtedness which should not be overlooked.