t-^ C^^t:^^^'^-^ /^ •TJ^^^ THE MACMILLAN COMPANY NEW YORK • BOSTON • CHICAGO • DALLAS ATLANTA • SAN FRANCISCO MACMILLAN & CO., Limited LONDON • BOMBAY • CALCUTTA MELBOURNE THE MACMILLAN CO. OF CANADA, Ltd. TORONTO FOREIGN EXCHANGE A STUDY OF THE EXCHANGE MECHANISM OF COMMERCE BY HARRY GUNNISON BROWN ASSISTANT PROFESSOR OF ECONOMICS IN THE UNIVERSITY OF MISSOURI THE MACMILLAN COMPANY 1920 All rights reserved V '5>b'13 54 Copyright, 1914, By the MACMILLAN COMPANY. J. 8. Gushing Co. — Berwick A Smith Co. Norwood, Mass., U.S.A. PREFACE This small volume, also published as Part I of my International Trade and Exchange^ deals chiefly with the subject of Foreign Exchange, though it also contains two introductory chapters on Laws of Money and The Nature of Banking, which, in my judgment, make pos- sible a clearer understanding of the economic theory of foreign exchange operations. In these and the follow- ing chapters, I have endeavored to analyze, more fully than is usually done, the interrelations of different per- sons, buyers and sellers, et al., in the credit mechanism of exchange, — to show who are the ultimate creditors when bank checks and bank notes are used in trade and when bills of exchange (especially " long bills ") are used. Thus, after the explanation of the nature of banking, the reader is led, in Chapter III, The Nature and Method of Foreign Exchaiige, to an appreciation of the international nature of the credit relations growing out of trade. The flow of money from country to coun- try having been explained briefly in Chapter I, the relation of this flow to the rate of exchange and to fluctuations in the rate of exchange is set forth at length in Chapter V. In the last chapter emphasis is placed on the fact, ordinarily passed without mention, that whatever may be the relation or non-relation of the cur- rency of a country to the currencies of other countries, its trade with them cannot all be either an export or an import trade for any great while, without introducing a vi PREFACE tendency to a reverse flow or to equilibrium. Since this last chapter was written, the outbreak of the European war, and the consequent risk and cost of shipping gold, have given practical significance to a discussion which would perhaps have appeared to be theoretical and academic. Acknowledgment should be made here of various courtesies extended, and of the aid rendered by a num- ber of friends who have done much toward removing errors of statement and expression and in suggesting critical and illustrative additions. To the Quarterly Journal of Economics I am under obligation for per- mission to include,. in Chapter II, substantially without change, an article on Commercial Banking and the Rate of Interest^ originally published in August, 19 lo. To Brown Brothers of New York I am indebted for in- formation on a number of special points regarding for- eign exchange. ' To one of my students, Mr. Lawrence M. Marks, Yale 19 14, I am indebted for the calculation of seasonal sterling exchange rates, presented in a foot- note of Chapter IV, Section 2. Mr. Franklin Escher, of New York City, formerly editor of Investment, has given me the benefit of a careful criticism of the manu- script, particularly regarding the matter of conformity of statement to business practice. To Professor F. R. Fairchild of Yale College I am indebted for a search- ing criticism from the standpoint both of theory and of form. Finally, I would acknowledge here the obliga- tion I am under to my wife, who has given me valuable assistance in reading and criticizing the manuscript in its various stages of completion, and in correcting the proof. HARRY GUNNISON BROWN. MiLFORD, Connecticut. CONTENTS VAGBS Chapter I — Laws of Money 1-25 § I . Quantitative Statement of the Relation between Money and Prices § 2. Causal Explanation of the Price of a Given Kind of Goods § 3. Causal Explanation of the General Level of Prices § 4. Causal Explanation of the Value or Purchasing Power of Money, the Reciprocal of the Level of Prices of Goods § 5. The Theory of Bimetallism § 6. The Value of Subsidiary Money § 7. The Value of Money as Related to the Value of a Stand- ard Money Metal § 8. The Level of Prices and the Value of Money in One Country or Locality as Related to the Level of Prices and the Value of Money in Another § 9. Summary Chapter II — The Nature of Bank Credit . . 26-50 § I. How and When Credit Takes the Place of Money § 2. How Commercial Banking is Carried On § 3. Analysis of Relations Involved in Commercial Bank- ing § 4. Why Commercial Banking Commends Itself to Busi- ness Men, both as Lenders and Borrowers, so that Commercial Bank Credit becomes a Substitute for Money § 5. Application of Principles Arrived at, to Bank Notes § 6. Quantitative Statement of the Relation of Money, together with Bank Credit, to Prices viii CONTENTS § 7. Fluctuations of Bank Credit § 8. Summary Chapter III — The Nature and Method of Foreign Exchange 51-76 § I . The Function of Bills of Exchange § 2. The Nature of Bills of Exchange § 3. How Bills of Exchange Might be Used to Settle Obli- gations, Assuming no Banks § 4. Settlement of Obligations by Drafts (Bills of Ex- change), through Intermediation of Banks, Assum- ing Creditors to Draw Drafts on Debtors § 5. Settlement of Obligations by Bank Drafts, when Debtors Remit to Creditors § 6. How Exchange Banks Make Profits § 7. Various Types of Drafts § 8. The Sale of Demand Drafts against Remittances of Long Bills § 9. Summary Chapter IV — The Rate of Exchange . . . 77-102 § I . The Meaning of Par of Exchange § 2. The Supply of and the Demand for Bills of Exchange § 3. The Effect on the Exchange Market of any Country of Disturbed Political or Industrial Conditions in That Country, and in Other Countries § 4. Analysis of the Relations Involved in, and Explanation of the Results of. Short Time Loans Made Ostensibly by Foreign Banks, through the Intermediation of the Exchange Market § 5. Finance Bills, What they Are, Whose Accumulations Make them Possible, and What are their Results § 6. How a Bank in One Country and a Bank in Another May, through the Aid of the Exchange Market, Invest in One of the Countries for Joint Account, without Either Bank Using its Own Funds § 7. Analysis of the Relations Involved in a Letter of Credit § 8. Place Speculation or Arbitraging in Exchange CONTENTS IX FAGBt § 9. Time Speculation in Exchange § 10. Summary Chapter V — The Rate of Exchange and the Flow OF Specie 103-125 § I. The Upper Limit to Fluctuation of the Rate of Ex- change, Determined by the Cost of Exporting Specie § 2. Some Details Connected with the Exportation of Specie § 3. The Lower Limit to Fluctuation of the Rate of Ex- change, Determined by the Cost of Importing Specie § 4. Circumstances which May Cause the Rate of Exchange to Fall Below What is Usually its Lower Limit § 5. The Cost of Money Shipment in Domestic Exchange § 6. The Long Run Effect of a Balance of Payments from One Country to Another, for Commodities or Services § 7. The Long Run Effect of International Investments upon the Rate of Exchange and the Flow of Money § 8. The Long Run Effect of Various Other Payments from One Country to Another § 9. Summary Chapter VI — Further Considerations Regarding the Rate of Exchange 126-154 § I . The Price of Long Drafts Determined in Part by the Rate of Interest or Discount § 2. How Long Drafts on Foreign Countries are Held as Investments by American Banks § 3. Influence on the Price of Long Drafts, of Interest Rate in Drawing Country and of Interest Rate in Country Drawn Upon § 4. How and Why the Bank Discount Rate Affects the Price of Demand Drafts and the Flow of Specie § 5. Effect of a Panic in One Country on Conditions in Other Countries § 6. Exchange between Two Countries when One has a Gold and the Other a Silver Standard CONTENTS § 7. Exchange between Two Countries when One has a Gold and the Other an Inconvertible Paper Stand- ard § 8. Exchange between Two Countries when Both have Inconvertible Paper Standards § 9. Exchange between Two Countries, Assuming Effec- tive Prohibition of Specie Shipment §10. The Effect on the Rate of Exchange of High Im- port and Export Duties §11. Summary INTERNATIONAL TRADE AND EXCHANGE CHAPTER I Laws of Money Quantitative Statement of the Relation between Money and Prices Primitive trade is often a direct trading of one kind of goods for another, the process called barter. The exchange of knives, hatchets, guns, mirrors, etc., with the Indians, in return for land and furs, with which we have been made familiar in our school histories and in stories of adventure, was trade of this sort. But even the Indians had wampum, which they used as a medium of exchange, and the highly civilized countries have long since made use of money, whether of gold or silver or other material, in their commerce. A study of the laws of commerce involves, then, and may well involve as a preliminary step, a study of the laws of money. We are not likely to find that the basic principles of trade are so very different with money used than they would be if the world traded, supposing it conveniently could, goods of one kind directly for goods of another. The 2 THE EXCHANGE MECHANISM OF COMMERCE moniey-using' method of trade is more efficient. The motives: ipjr'tlrafJe ^d.tlie'nature of the advantages from it are the same'wlietKef money is used or not. But it is worth while analyzing the commercial processes, as they are actually carried on, even in many of their mod- ern complications. To do so, may perhaps the more clearly elxpose fallacies regarding trade, not uncommonly held. We shall begin, then, with a study of money, considered as an important part of the mechanism of trade. Money, as a medium of exchange, is a kind of wealth or property for which other goods are sold and with which, in turn, desired goods are bought. It may be distinguished from other wealth or property by its characteristic of general exchangeabihty. A person desiring, as all do desire who are engaged in any business or regular occupation or who have capital to invest, to dispose of some kinds of goods or services in exchange for others, does not need to seek out those who both want what he has to sell and will sell what he wants to buy and with whom he can make a satisfactory trade ''in kind." Instead, he sells for money, for a universally desired medium, what he has to dispose of, to whoever desires it, and, with this money as purchasing power, seeks out those who have for sale what he himself wishes to buy. The use of money is an intermediate step in what is still the exchange of goods for goods. In order that money may perform its function of faciHtating trade, both goods to be sold and goods to be bought must be valued in terms of money. Money becomes a measure of value as well as a medium of exchange. One kind of goods will have a higher value, measured in money, than an- other kind, if its cost of production is greater, or if, for LAWS OF MONEY $ any other reason, only the higher value will equalize supply of and demand for this kind of goods. The same relation of values, between two sorts of goods, would exist if money were not used, but the use of money makes it measurable in a generally familiar standard. An analysis of the prices or values of one sort of goods as compared with those of other sorts, leads us to a con- sideration of the special forces of demand and supply, such as utihty and cost of production, acting upon such goods. In studying the laws of money we need to attend not so much to the conditions determining the value of one kind of goods in relation to some other kind or kinds, as to the conditions determining the average value of goods in relation to money, and vice versa. We have to consider, that is, the general level of prices, and conversely the purchasing power of money. This relation between money and other goods has sev- eral times been given a mathematical form of statement.^ Let S represent the total amount of money (number of dollars) spent in a given community during a given period of time, say a year. Let M represent the (average) number of dollars in that community during the same period. Then the average number of times a dollar is spent during the year will be S/M. This is the velocity of circulation of money and may be called V. S = MS/M, and therefore, by the method of substi- tution, S = MV. In words, the total dollars spent for goods is equal to the number of dollars in the community times the average velocity of circulation of those dollars. But the total number of dollars spent for goods is also * For instance, Newcomb, Principles of Political Economy, New York (Har- p)er), 1885, p. 346; Edgeworth, "Report on Monetary Standard," Report of the British Association for the Advancement of Science, 1887, p. 293; Hadley, Economics, New York (Putnam), 1906, p. 197. 4 THE EXCHANGE MECHANISM OF COMMERCE equal to the sum of the quantities of all the kinds of goods bought, times their respective prices. Let the price per pound and the number of pounds of sugar bought be represented respectively by p and q, the price per bushel of wheat and the number of bushels bought by p^ and q' , and so on. Then the total number of dollars spent for goods, i.e. S, is equal to pq + p'q^ + etc. Since two things equal to the same thing are equal to each other, and since S = MV and also S = pq + p'q' + etc., therefore MV = pq + p'q' + etc. This is the mathematical statement of the so-called quantity theory of money, omitting, however, any reference to credit currency.^ It asserts simply that the quantity of money times its velocity of circulation, equals the prices of goods bought with money, times the quan- tities bought. The conclusion follows, therefore, that if the quantity of money, M, increases, while the velocity of circulation and the volume of trade remain the same, prices will rise in the same proportion. A decrease in the amount of M would, on the same assumption, be accompanied or followed by a fall in the money prices of goods. An increase in the g's ^ or volume of trade would, other things equal, occasion a fall of prices ; and a decrease in the g's, a rise of prices. 1 For consideration of credit, see Chs. II and III (of Part I), 'The g's or quantities of goods should be held to include not only finished goods exchanged in trade and goods purchased for raw material, but also the additions made by labor to the utility of goods and paid for in wages and the additions made by the service of "waiting" and paid for by means of interest, dividends, etc. LAWS OF MONEY S Causal Explanation of the Price oj a Given Kind of Goods A quantitative or mathematical statement of a prin- ciple is not, however, an adequate explanation of that principle. In this case, the explanation must be found in the working of the market, in competition with each other of buyers and of sellers. This means that there must be an analysis of the forces of supply and demand in relation to general or average prices, in addition to the usual study of those forces in relation to particular prices. The price of any particular kind of goods, say the price of wheat per bushel, is commonly said to be fixed by the equation of supply and demand. But these terms are frequently misunderstood. For example, supply is sometimes thought of as the total stock. Demand is thought of as the amount wanted by pur- chasers, but without much reference to the exact condi- tions determining this amount. As a matter of fact, supply is not the total stock of a good, whatever relation it may have to this stock. Supply is different according as price is different. Hence any reference to supply should specify a price^ The supply of any good at a given price is the amount which sellers are ready to dispose of at that price.^ Thus, the supply of wheat at a price of $i.io per bushel may be, in a given market, 1 ,000,000 bushels. That is, at a price of $1 . 10 per bushel, there are so many persons ready to sell wheat and ready to sell such quantities, that 1,000,000 bushels may be had. 1 See J. S. Mill, Principles of Political Economy, Book III, Ch. II, § 4. One of the best recent presentations of the theory of supply and demand is to be found in Fisher, Elementary Principles of Economics, New York (Macmillan), 1912, Ch. XV. 6 THE EXCHANGE MECHANISM OF COMMERCE In general, the higher the price, the larger, other things equal, will be the supply ; and, similarly, the lower the price, the smaller will be the supply. If the price of any good is lower relatively to other desired goods, producers and sellers will be less incKned to bring the good to market for disposal, and may even turn their attention to other lines. If the price is higher, they will be more inclined to sell large quantities, and some may be tempted to forsake other lines to produce the good in question. In the same way, reference to demand should specify a price. Analogously, the demand for any good at a given price is the amount that purchasers stand ready to take at that price. If at $i.io per bushel the demand for wheat is for 1,000,000 bushels, then the number of per- sons wishing to buy wheat is such, and the amounts they individually stand ready to buy are such, as to make an aggregate of 1,000,000 bushels. Other things equal, demand rises as price falls, and falls as price rises. The lower the price of any good in relation to prices of other goods, the more ready are purchasers to buy it ; and the higher the price, the less ready. The price of any good, whether of cotton, labor services, bills of exchange or anything else marketable, is fixed where supply and demand are equal. It is not, however, an explanation of price merely to state that it is fixed where supply and demand are equal. It is necessary further to inquire why price is fixed at that point. If supply of and demand for wheat in a given market are equalized at $1.10 per bushel, why may not the price nevertheless be $1 ? If we assume $1 to be the price, we see that such a price represents a position of unstable equilibrium. At this price, the demand would be in excess of the supply. The persons anxious to buy LAWS OF MONEY 7 wheat are ready to buy, at this price, more than can be had, and since even at $1.10 the amounts they will buy are equal to the amounts they can get, it appears that there are many who would gladly pay more than $1 per bushel rather than go without wheat entirely. Here, then, are persons, many of whom would pay more rather than not get the wheat, the aggregate of whose desired purchases at $1 per bushel must exceed the total supply offered. If $1 is the price, some who would gladly pay that and more cannot get the wheat they desire.^ Each intending purchaser will fear that he will be one of those who fail to get what they wish. Since all cannot be satisfied and since he himself may not be, he is likely to offer more than $1 in the hope that sellers will be per- suaded to sell to him, at least. But he is not likely to offer more than $1.10. According to our hypothesis, a price of $1.10 will bring forth a supply fully equal to the demand. Even if other buyers are foolish enough to offer a higher price and are sold to in preference, yet since the demand of these others would not absorb the entire supply, a purchaser who offered $1.10 would secure the wheat desired. As the price is kept from going below that height which equahzes supply and demand, by the competition of buyers, so, by the competition of sellers, it is kept from going above that height. If $1.10 a bushel is the equal- izing price, the competition of sellers will prevent the price from being higher, say $1.15. For at $1.15 there would presumably be a smaller demand and a greater supply. That is, at $1.15 there would be sellers anxious to dispose of, in the aggregate, more wheat than buyers ^ This explanation of the nature of competition is well set forth in Hadley, Economics, pp. 75-77. 8 THE EXCHANGE MECHANISM OF COMMERCE would take. Some of these prospective sellers must be doomed to disappointment, and those most anxious to sell would therefore bid against each other in lowering the price to the point where supply and demand were equal. This they would do because in no other way could they be sure of selling their wheat. But they need not go below the equalizing price, because when that price is reached there are enough more buyers or enough fewer sellers, or both, to insure sales by those still in the market and desiring to sell. Even if some should offer, unwisely, to sell at a lower price, yet since these could not, by our hypothesis, satisfy the demand, all who charged the equahzing price would still find purchasers. The market price of any kind of goods, therefore, tends to be that price which equalizes supply and demand, and is pre- vented by the forces of competition from going above or below it. §3 Causal Explanation o] the General Level of Prices Let us now apply the principles of supply and demand to the general level of prices. We shall see that much the same kinds of competitive forces which fix any one price (as above explained) in relation to other prices, fix the general level of prices of goods in terms of money. We shall consider, first, the supply of goods, including the services of labor and of "waiting" {i.e. investing, or putting capital into use, the service for which interest is paid) offered for money, and the demand for goods by those having money to spend. Afterwards we can reverse our method and consider the supply of and the demand for money in exchange for other goods. Where there is only fiat (inconvertible paper) money, LAWS OF MONEY g the supply of goods in general, offered for money, at any level of average prices of those goods, would be just the same as at any other level of prices. This is very nearly true no matter what the money system.^ If wheat prices are higher than corn prices, or vice versa, productive effort may be diverted from one line into another. But we are now not discussing changes in individual or rela- tive prices. We are discussing only changes in the general level of prices, the average of prices. If the gen- eral level of prices should double, there is no reason to believe that the amount of goods produced for sale would on that account greatly increase. Supposing a com- munity to be in reasonable prosperity and business activity at the lower prices, an increase of these prices would not make possible a very greatly increased pro- duction. It would not enable men to work longer hours nor would it make machinery more efficient. Neither would it stimulate the sales of goods by making such sales more profitable, since a general rise of prices simply means that money has a less value. If everything should sell for twice as much money as before, the sellers would gain nothing, for the things they desired to buy would also cost twice as much. Looking at the matter from any reasonable point of view, it must be admitted that the supply of goods in general, at a higher level of prices, would be no greater (or but slightly greater) ^ than at a lower level. Likewise, at a lower level of prices, the supply of goods would be no less than at a higher one. A lower level of prices would not mean less activity or a smaller sale of goods. It would pay as well to sell goods at a low level of prices as at a high level, since at the lower 1 See remainder of this section for explanation of why it is not always entirely true. 2 See next paragraph. lo THE EXCHANGE MECHANISM OF COMMERCE level the money received would have correspondingly greater purchasing power. The lower level of prices would only decrease the supply of other goods and the higher level increase it, in one contingency, and then only to a very limited degree. When the currency system is based on a precious metal, e.g. gold, a lower level of prices means a higher value of gold as money. It might therefore divert some labor from the production of other goods to the production of gold for coinage. A higher level of prices might tend, in the same degree, to divert labor from gold production towards the production of other goods. To this extent only, a higher level of prices would tend to increase the supply of goods in general other than money, and a lower ievel of prices to decrease it. On the other hand, a higher level of prices of goods would tend to decrease the demand for goods by persons having money to spend. For with higher prices, and no greater amount of money to spend, buyers of goods would be unable to purchase as much as at lower prices. Lower prices of goods would mean that the money of purchasers would go farther. Let us now suppose a doubling of the amount of money. Prices would tend to increase in nearly the same pro- portion. Suppose prices did not rise. Then purchasers of goods would buy all they were in the habit of buying and still have as much money left to spend as they formerly spent all together. This they would endeavor to spend at once. For in modern countries money is not hoarded away, but only enough is kept on hand for emergency requirements, and the rest is spent. Those who save are spending just as effectually as any others. The difference is in what they buy. Those who savq LAWS OF MONEY ii buy factories, warehouses, railroads, farms, etc. Even though their savings are put into a savings bank, they are none the less spent for investment goods. It follows that a sudden doubling of the amount of money, if prices did not increase, would mean a demand for goods far exceeding the supply. The amount of land is practically constant. Doubling the amount of money would not enable people to work longer hours and so increase the products of labor. In a busy community the supply of goods to be sold simply could not be doubled except with an increase of population or invention. The in- creased money would therefore mean that at the old prices the demand for goods in general would exceed the supply. Purchasers would bid against each other. Prices would rise. Equilibrium would only be reached, supply and demand be equal, at a general level of prices nearly (or, if fiat money, quite) twice that which had preceded. If prices rose equally, this would mean a doubling in the money wages of labor for the same results produced and, similarly, a doubling in the money interest, dividends or profits received for ''waiting." Aside from disturb- ing effects during the period of transition, the rate of interest would be the same with the high prices as with the low. The money value of the sum waited for would be doubled and the money value of the interest would be doubled. The ratio between them would be the same as before. In other words, since prices have doubled, borrowers, for example, would require twice as many dollars as before and would also, of course, pay twice as many dollars in interest. In the light of the principles above set forth, regarding supply and demand, we can explain why the excessive 12 THE EXCHANGE MECHANISM OF COMMERCE amounts of inconvertible paper money sometimes issued by governments, issued particularly in time of war, have resulted in very exceptional rises in the price level. This increased amount of money means, at any level of prices, a greater demand for goods. Therefore, that the demand for goods may not exceed the supply, the level of prices must rise. There is another factor of impor- tance at such times, viz. public confidence in the money issued. If there is a general belief that the money will become absolutely valueless or greatly decrease in value, then many who have goods to sell will refuse to sell them for this money, but will demand gold or silver or other goods in exchange. This decrease in the supply of goods, offered for money, will mean that only a higher level of prices than otherwise would result can equalize supply and demand. Thus is to be explained the high prices (and, reciprocally, the great depreciation of money) in such periods as the American Revolution, the Civil War, etc. §4 Causal Explanation of the Value or Purchasing Power of Money, the Reciprocal of the Level of Prices of Goods Let us look at the same problem, the general level of prices, from the other side, that of the purchasing power of money or the value of money in terms of goods. We shall consider now the supply of money offered by purchasers of goods (corresponding to demand for goods) and the demand for money coming from sellers of goods (corresponding to the supply of these goods). Before defining supply of and demand for money, we must select a phrase to express the price of money. The value or price of money is usually expressed, not in terms LAWS OF MONEY 13 of any one thing, but in terms of all, or most other, purchasable goods. Its value or its price is measured in the amount of other goods it can buy. The value or price of money we shall therefore call the purchasing power of money. We may now define money supply and demand con- sistently with wheat or coal supply and demand. First, as to supply, we may say that the supply of money at any given purchasing power is the amount of money which would he supplied — i.e. would be offered in purchase of goods — at that purchasing power. Just as, at a higher price of wheat, the supply in the long run would tend to be greater than at a lower price, so, at a higher purchas- ing power of money, the supply of money would tend to be greater than at a lower purchasing power. The supply would be greater at a higher purchasing power, because, at a higher purchasing power, it would be worth while to turn bullion into coins or even to mine more gold for that purpose. The supply of fiat money (irredeemable paper) would not be greater, but would be just the same at a higher purchasing power as at a lower. The normal supply of money at any purchasing power and during any period of time, the amount that would be offered by sellers of money {i.e. buyers of goods) involves, as Walker has pointed out,^ the quantity of money and its rapidity or velocity of circulation. This velocity of circulation may be less than unity ; that is, most of the money may circulate less than once if we are deahng with an instant or a short period of time. But if we are dealing with a long period of time, say a year, and with the conditions determining normal purchasing power, the velocity will 1 Political Economy, Advanced Course, third edition, New York (Holt) 1887, p. 129. 14 THE EXCHANGE MECHANISM OF COMMERCE perhaps be 20 or more.^ In any case, the supply, the amount that would be offered at any given purchasing power, is the total amount which, at that purchasing power, would be on hand, multiplied by its velocity; and it may be represented, therefore, as MV. Turning to the subject of demand, we may properly define the demand for money, at any purchasing power, as the amount of money that would be taken by sellers of goods, at that purchasing power. The demand for money comes from the sellers of other goods who wish to take money in exchange for those goods. They may be said to buy money with the goods they sell. When the money is altogether fiat (inconvertible paper) money, the amount of goods offered for money will not be affected by the purchasing power of money. With an exception shortly to be noted, this is also true in the case of such a commodity money as gold or silver. That the purchas- ing power is at any time greater or less, provided only it is not fluctuating, affects neither for good nor ill the sellers of goods. If the purchasing power of money is greater, they will still sell their goods as readily for money since the smaller amount of money so received will go as far as would a larger amount having a smaller purchasing power per unit {e.g. per dollar). But their demand for money, in the proper use of the term ''demand," will not be the same. If the purchasing power of money is doubled, demand for money will be exactly halved. If the purchasing power of money is halved, demand for money will be doubled. Sellers of goods will take all the money which the goods they desire to sell will bring. If, therefore, the purchasing power of money is halved, 1 See Fisher, The Purchasing Power of Money, New York (Macmillan), 191 1, p. 290. LAWS OF MONEY 15 i.e. if it takes twice the former amount of money to buy the same goods, then the demand for money, the amount sellers of goods (buyers of money) will take, at this pur- chasing power, will be exactly doubled.^ The exception to be noted has already been referred to in the discussion of the general level of prices.^ It oc- curs when money is based on some standard commodity, as gold, having an appreciable cost of production. To double the purchasing power of money would, in fact, probably reduce the demand for it to something very slightly less than half what it had been, for a small (rela- tively a very small) amount of labor would probably be diverted from the production of other goods to the mining of gold. Therefore, unless the value of money more than doubled {i.e. unless money prices of goods became less than half), the money which would be taken by sellers of the somewhat smaller stock of goods would be less than half as great. Similarly, a fall of half in the value of money would very probably divert some labor from gold mining into other lines, and so might slightly more than double the demand for money. For every one would be ready to sell his goods at twice the former price, and there would be more goods to sell. Normal demand, therefore, for money, i.e. long-run demand, cannot be distinguished by any exact proportion from demand for other goods. But when the money does not involve an appreciable cost of production, but is inconvertible paper, or, for any money, where an extremely short period is involved, the demand for money varies inversely with its purchasing power. 1 Were it not for the exception next to be mentioned, the demand curve for money would be always a rectangular hyperbola. * § 3 of this chapter (I of Part I). i6 THE EXCHANGE MECHANISM OF COMMERCE The demand for money by sellers of goods may be said to be the money value at which they would sell those goods ; therefore, the prices times the quantities ; there- fore, pq + p'q + etc. The purchasing power of money is fixed where supply is equal to demand, where MV = pq -\- p'q' + etc. The equation of exchange may be regarded as simply a mathematical mode of stating that the p^s, the purchasing power of money, must be such that supply of money equals demand, i.e. that MV = pq + p'q' + etc. § 5 The Theory oj Bimetallism The laws of supply and demand serve to explain the effects of the various monetary systems which have been tried in different countries. Important among those monetary systems is bimetalHsm. BimetalHsm involves the concurrent circulation of two metals at a fixed legal ratio. Both metals are coined by government, for those bringing the metals to the mints, in any desired quantity, and coined without charge or for the mere cost to gov- ernment of coining. Both metals, when so coined, are legal tender for the payment of debts and taxes, at the value ratio fixed. Thus, bimetallism at i6 to i meant, for the United States, that the amount of silver in the silver dollar should be approximately i6 times the amount of gold in a gold dollar, that gold and silver should both be coined freely and without Kmit, and that a debtor should be able to Liquidate the same debt with loo silver dollars as with loo gold dollars. Bimetallism may succeed if the legal ratio is not too far from the market ratio of values existing when the system LAWS OF MONEY 17 is started. If the amount of silver in the legal silver dollar is worth 98 per cent as much as the gold in the gold dollar, or 98 cents, then the system may succeed.^ It will succeed because the possibihty of using 98 cents' worth of silver, if coined, to pay a $1 debt (or tax) previously payable in gold,^ will stimulate the coinage of silver. This extra demand for silver will increase its value. Otherwise expressing the matter, we may say that the withdrawal of silver from the arts, tending to cause a de- creased supply of silver for arts uses, will increase its valu6. The greater quantity of money will tend to make some- what higher prices and a somewhat lower value of a dollar (whether gold or silver) . This may discourage the coin- age of gold or even cause the melting of some gold coin into bullion. We may say that the less demand for gold has made its value fall, or that the melting of gold coin and the consequent greater supply of gold in the arts has made its value fall. The sequence is, then, flow of silver from bullion into coin, slightly depressed value of coin, flow of gold from coin into bullion. Silver has risen in value. Gold has fallen. Probably the silver dollar is, therefore, now worth the same as the gold dollar instead of 98 per cent as much. If the bullion content of the gold dollar came to be of the less value, debtors would prefer to coin gold and the flow would be in the opposite direc- tion, but likewise towards the estabHshment of equiHb- rium. Suppose, however, that the amount of silver in a silver dollar is worth only 40 per cent of the gold dollar (which was more nearly the case with the silver dollar when its 1 Cf. Fisher, Elementary Principles of Economics, pp. 230, 231. 2 Or money, on a parity with the gold, other than silver money coined for account of the debtor. C i8 THE EXCHANGE MECHANISM OF COMMERCE free coinage was advocated in 1896). Then the danger would be that, long before the increased demand for silver as money and its decreased supply in the arts, coupled with the decreased demand for gold as money and its increased supply in the arts, had brought about the desired equilibrium of value, the gold would be entirely driven out and the money used would simply be silver instead of gold. The whole question would be whether the scarcity of silver in the arts and the plentifulness of gold in the arts would be sufficiently marked to make the relative values the same as in the legal ratio, before silver enough had been taken from the arts uses to fill all the money circulation; and then, whether sufficient additional suppHes of silver could be got from the mines to drive out the gold without forcing the margin of pro- duction unprofitably low, i.e. without mining, at a loss, from poor mines. For one country alone, the prospects of success in es- tabHshing bimetalHsm would be much less bright than for a group of important commercial countries. For if one country tried it alone, endeavoring by free coinage to make 40 cents' worth of silver equal to $1 worth of gold, it would have to absorb into its currency, not only silver from within its own borders, but silver flowing to it from all the world, and its own demand in relation to such a great supply might increase the value of silver relatively Httle. And, as the silver drove out the gold, the latter would not fall rapidly in value through con- gesting the arts, but would be distributed to the money supplies, as well as the arts, of all other countries. LAWS OF MONEY 19 §6 The Value of Subsidiary Money At the present time, in the United States, France, and elsewhere, there exists the so-called limping standard, i.e. there are silver coins the bullion value of which is not equal to their face value, but the amount of which is strictly limited. In the United States, there are a cer- tain number of silver dollars and silver certificates. The silver in the silver dollars is worth perhaps about half of their face value. But they cannot drive out gold because not enough are coined to produce such a result. Any money, even paper, if put forth in very limited quantities and made legal tender for the payment of debts and taxes, may circulate at par with gold. The possibility of using it for debts and taxes creates a demand for it, and others will take it because they in turn can pass it to those hav- ing such uses for it. A general public confidence in and willingness to take it at the legal value, is developed. On the other hand, the limitation of its quantity means a limited supply. The demand for it equals this supply, at a value equal to par. Where a limited amount of money is issued by coining metal of less value than the money, or by printing paper, this is done by government exclusively on its own account. Otherwise there would be special favor shown, at the general expense, to those persons for yrhom the coining was done. Making paper or other money redeemable in gold is merely a way of making the forces of demand and supply automatic in keeping up the value of such credit money .^ If for any reason, e.g. overissue or lack of confidence, the value of such money sinks below tjie value of the gold 1 Cf. Fisher, The Purchasing Power of Money, pp. 262-263. 20 THE EXCHANGE MECHANISM OF COMMERCE in which it is redeemable, the holders of the paper money at once present it in large quantities for redemption. This immediately decreases the supply of it, and thus automatically prevents its entire driving out of gold. Prompt redemption at the same time gives confidence and so maintains a demand for it. But the limitation of supply, automatic or otherwise, is important, for no amount of confidence can prevent a fall in the value of money which increases indefinitely in quantity. An increase in gold itself tends to raise prices and lower the value of gold. An increase of paper money tends to increase prices in paper. Redeemability prevents prices in paper from ever rising higher than prices in terms of gold. In the case of paper money, the receiver is really a creditor. He gets a credit claim, not real wealth. The paper money evidences a right based on its general acceptability, or on its redeemabihty by government, to an amount of wealth or income services equal to the value of the money. The issue of paper money is a species of borrowing by government ; but no interest is paid, because the holder, unlike the holder of government bonds, has, if the money is generally acceptable, a demand claim. He does not need, therefore, to wait for his desired goods any longer than he wishes to, but can spend the money and get goods at any time from another, who can do hkewise with a third, etc. He does not need, there- fore, to be in the position of a creditor longer than his own convenience dictates. The general acceptabihty of such money, if it is generally acceptable, makes the holder willing to forego any other interest.^ The money of the United States includes gold and silver 1 See Cb. II (of Part I), §§ 3, 4- LAWS OF MONEY 21 coins, gold certificates, silver certificates, United States notes (greenbacks), treasury notes, and subsidiary coins (quarters, dimes, etc.). There are also bank notes, but these may be better considered, along with other bank credit, in the next chapter. All the paper money except silver certificates is redeemable by law in gold. Silver certificates are redeemable in silver. No law expressly makes the silver dollars redeemable in gold ; but it is the duty of the Secretary of the Treasury to maintain the parity of the silver coinage with gold, and in practice any kind of our money is exchangeable at the United States Treasury for any other kind. Even without this prac- tice, the Kmitation on the number of silver dollars and their full legal tender quality would doubtless maintain them at par value, although the value of the contained bullion is much less. §7 The Value 0} Money as Related to the Value of a Standard Money Metal Most countries have now the gold standard. All money is redeemable in or in some way related to gold, and the value of money tends to equal the value of the mint equivalent in gold. So long as gold is coined freely, and in any quantity desired, into money, the value of gold as money and as bullion must be the same. For if gold coin came to have more value than gold bulKon to be used in the arts, then persons having gold bullion would hasten to get it coined. The consequent increase of money would raise the prices of goods and lower the value of money. The decrease of gold for use in the arts would increase its value in that use. Equal value in the two uses must soon be reached. If, on the other hand, 22 THE EXCHANGE MECHANISM OF COMMERCE gold as money should have, at any time, a less value than the same amount of gold as bulHon, then all newly mmed gold would be used in the arts and Httle or none coined, until gold in the arts was so plentiful and money so scarce as to make the values even again. Gold money, if full weight, might even be melted into bullion, if it were worth enough more in the latter use to pay for the trouble. Eventually, then, since, when the gold standard is in force, the value of money and the value of gold bulHon tend to be the same, both depend upon the amount of gold mined relative to the use for it. The cost of pro- duction of gold, and, therefore, the number and richness of gold mines, is not without an influence, in the last analysis, on the level of prices, and on its reciprocal, the purchasing power of money.^ §8 The Level of Prices and the Value of Money in One Country or Locality as Related to the Level of Prices and the Value of Money in Another Before concluding this chapter, something should be said regarding the relation of the quantity of money and prices in one locality or country to the quantity of money and prices in others.^ The subsidiary and credit money of one country is commonly not received in other countries. Gold or silver (at present, with the gold standard general, chiefly gold) is passed from one country to another in payment for goods or services or to redeem obligations. » These facts are mechanically expressed in Fisher, The Purchasing Power oj Money, pp. 96-11 1. ' For a fuller statement see Fisher, The Purchasing Power of Money, pp. 90- 96. LAWS OF MONEY 23 Between different countries, the gold passes only by- weight, but since gold coin and bulHon are related in all gold standard countries, the effect of the flow of gold from one country to another is to decrease, relatively, the quantity of money in the one and to increase it, rela- tively, in the other. Between parts of the same nation, all legal tender money, whether gold, silver, or paper, passes freely. What are the laws of this flow? Obviously, money, like all things else, flows to those places where it has the greatest value, where it can buy the most of other things. That is, money flows from those places or countries where prices of goods are high, to those places or countries where prices are low. Goods are bought where they can be bought the cheapest. Money goes to pay for the goods. Hence, money flows to those places where there are low prices. But low prices means high purchasing power or value of money. Therefore money flows to those places where its value is high. When, however, one country has an inconvertible paper money unrelated to the money of another, no such flow can take place. When paper money is first issued in one country it tends, by raising prices, to cause purchases abroad, where prices have not thus been raised. As the paper money is not legal tender elsewhere, gold must be sent to pay for the goods thus bought. The continuing issue of paper money may drive all the gold out of the currency of the country issuing the paper. Until it does so, the effect on prices appHes to other countries as well; the effect is distributed over all. Though the paper circu- lates only in the issuing country, it displaces gold and pushes the gold into other countries. But, when enough paper money has been issued completely to drive out 24 THE EXCHANGE MECHANISM OF COMMERCE gold, no such further effect on other countries can be produced. Trade will still take place. ^ Commodities of one sort are bought and commodities of another sort are sold. Gold itself may be traded back and forth. But the currency of the one country is absolutely unrelated to the currencies of others. §9 Summary In this chapter we have been concerned chiefly with the laws of money, an important part of the mechanism of civilized commerce. We saw, first, that the general level of prices of goods varies, other things equal, with the quantity of money. This fact was mathematically expressed in the so-called *' equation of exchange," MV = pq + p'q' + etc. Analysis of the causal relations between quantity of money and prices led us to demand and supply and the ordinary forces of competition as an explanation. It was seen that increased money involves higher prices of goods to equalize supply of and demand for those goods, and, conversely, a lower purchasing power or value of money, to equalize supply of and demand for that money. Supply of money might be determined by government in the case of inconvertible paper but is generally a matter of the production of the precious metals, especially gold. The possibiUty of successful bimetallism was shown to depend upon the ratio chosen and the relative amounts of money of each metal available under that ratio. Supply and demand acting through the money and bulHon markets tend to bring market ratio to equivalence with » See Ch. VI (of Part I), §§ 7, 8. LAWS OF MONEY 25 legal ratio, but may not have the effect of doing this before one metal is driven out of circulation. The limping standard and paper money were shown to depend upon limited quantity of the paper money or the over- valued (in comparison to weight) silver (or other metallic) money, and upon their legal tender qualities. The supply is limited ; the demand kept up. Redeemability automatically tends to prevent oversupply of credit money or that loss of confidence which decreases demand for the money. With free coinage of gold, the value of gold as coin and as bulKon tends to be the same. Finally, we saw that the flow of money from place to place or country to country is a flow from where it is cheap to where it is dear, from where it buys little to where it buys much, from where prices of goods are high to where they are low. CHAPTER II The Nature of Bank Credit §1 How and When Credit Takes the Place of Money Credit is given whenever goods are sold for a promise to pay, for a tacit obligation to pay later, or for some form of claim upon a third party such as a bank. The characteristic of all credit is the fact that the person disposing of goods to another does not immediately receive payment in the form in which he is entitled, ultimately, to receive it ; but receives, instead, a right to future payment, a right commonly evidenced by some kind of commercial paper. Most frequently this evidence is the check on a bank, showing the title of the receiver or payee to money from the bank on demand ; or the bill of exchange, showing a title of the payee to money from the drawee, sometimes on demand and sometimes on a definitely agreed date. The term "currency" we shall use generically to in- clude money, which is generally acceptable in exchange for other goods, and those credit rights, less generally acceptable, which are, nevertheless, largely used as media of exchange and therefore serve as money substitutes. Such credit instruments as checks, bills of exchange, and promissory notes, act as substitutes for money only if the rights to the sums which they have reference to are trans- ferred to third, fourth and other parties. Only in such 26 THE NATURE OF BANK CREDIT 27 cases, therefore, can these credit instruments or the rights which they certify be considered as currency. If a prom- issory note is given by one person to another and kept by the second until maturity, the use of the note merely means that money is paid from the one person to the other at a later date instead of an earlier. There is no saving of the use of money in the sense that credit takes its place. But if A owes B $100 and B owes C the same sum, and if A's promissory note to B is used by the latter to pay C, then the use of money is to some extent avoided. A eventually redeems his note by paying C the money. Money is passed once instead of twice. The ordinary check, sometimes called the ** customer's check," is similarly used. A may give to B a check for $100. B, though he does not perhaps use the same check to pay C, uses the same demand right or claim on the bank. He sends in the first check and has it credited to his account. Then he gives his own check to C. C may collect from the bank or may in turn pay a fourth party by check, and so on. In practice, the sums owed by the different parties will probably not exactly balance. B may pay C by giving the latter a check evidencing the right to draw the sum received by B from A plus other sums received by B from D, E, F, etc. But however this may be, the principle is the same. Thus, the bank deposit, or right to draw from a bank, takes the place of money in effecting exchanges of goods or services. The use of bills of exchange also facilitates the balancing off of obligations against each other, without the payment of coin.^ 1 See Ch. Ill (of Part I), § i. 28 THE EXCHANGE MECHANISM OF COMMERCE §2 How Commercial Banking is Carried On Credit instruments, or credit rights — for the paper is in each case but evidence of the underlying obligation — act as substitutes for money primarily through the inter- mediation of commercial banking/ and foreign exchange banking. Commercial banks constitute an important part of the mechanism of trade. Their work facilitates internal trade and, in connection with the work of foreign exchange banks and brokers, facihtates external trade as well. It is estimated that nine tenths of the total business in the United States is carried on through the use of bank credit.^ Bank deposits (rights to draw from a bank or banks), which circulate by means of checks, may come into being in any one of several ways. One may become a de- positor by directly depositing money (or the right to draw money, received by check from some one else, but this merely registers a transfer of a deposit and does not create one) . One may become a depositor by borrowing from the bank in which the deposit is to be. If A goes to his bank and leaves there $50,000 cash, he thereupon is said to have deposited such an amount in the bank and can draw on this sum at will by issuing checks against it in favor of any persons to whom he wishes to make payments. But A may also go to the same bank, give his endorsed note or other satisfactory security, and bor- row $50,000. This money he leaves on deposit. The bank is then said to lend its credit. What A has bor- 1 Savings banks and investment banks perform, of course, important functions, but do not have a part in providing a substitute for money. 2 See Fisher, The Purchasing Power of Money, New York (Macmillan), igii, pp. 317, 318. THE NATURE OF BANK CREDIT 29 rowed is not money but the right to draw money by check, at will. The bank is under as much obligation to redeem his checks on demand as if he had directly put money into the bank. On the other hand, A is under obligation to pay the bank, when his note matures, the amount borrowed plus interest. It should be readily apparent that a bank can, in ordi- nary times, redeem all checks presented for redemption, without keeping for that purpose a cash reserve which at all nearly equals its liabilities. The total value of deposits which a bank is under obligation to pay out on demand, may be $500,000. Yet it is certain that all the depositors will not call for their money at the same time. Instead of drawing it out, most of them send checks back and forth to and from others who do likewise. A cash reserve of $100,000 may be ample. Putting the matter in the opposite way, we may assert that if there is $100,000 in cash in such a bank, the bank can lend its credit, i.e. more deposits or rights to draw, to the extent of (say) $400,000. We have said that different depositors in a bank liqui- date their obhgations to each other by giving checks. There is, then, simply a change on the bank's books. Any amount of obhgations can be thus balanced. Dif- ferent persons are made successively creditors of the bank for larger or smaller sums. The situation is compKcated, but the principle is not changed, when depositors of dif- ferent banks have business deahngs with each other. In this case, which is a decidedly usual one, the banks become successively each other's debtors and creditors and have to settle through a clearing house. Bank A may have accepted and paid cash for, or credited to depositors, many checks on Bank B. Bank B therefore 30 THE EXCHANGE MECHANISM OF COMMERCE owes Bank A. Similarly, Bank C may owe Bank B, etc. All of these complicated obligations are balanced by a clearing house, so that each bank pays what it owes net or receives what is owed to it net, and a great deal of flow of money is avoided. In other words, the principle of cancellation is appHed whenever possible between banks, just as it is in any one bank to the depositors in it. §3 ., Analysis of Relations Involved in Commercial Banking But our analy^ of the nature of commercial banking is not complete until we go back of the banks and examine the relations to each other, through the banks, of those who deal with the banks and with each other.^ When a man borrows from a bank (giving proper se- curity and receiving credit on the bank's books), he is getting command over present wealth in return for a promise to repay wealth in the future. Those who pro- vide him with this present wealth must wait before being repaid. Lending always involves giving up something now and getting something in the future, i.e. lending always involves waiting.^ In order, then, that any one may borrow from a bank, some person or persons must be the lenders, must be ready to give up goods in the present for goods in the future, must provide waiting. The bank itself is, for the most part, only an intermediary. It brings together a supply of waiting, but it does not, to any considerable extent, furnish that supply. It places * The argument of this and the following section is substantially the same as that presented by the writer in the Quarterly Journal of Economics, August, 1910, in an article entitled "Commercial Banking and the Rate of Interest." ' Though there may also be waiting where there is no lending but only in- vesting. THE NATURE OF BANK CREDIT 31 loanable funds at the disposal of borrowers, but it is not itself the ultimate lender. The persons who provide the waiting, i.e. who are the real lenders, may be divided into two classes: (a) those who, in return for goods, receive checks from borrowers of the banks (or personal notes or "ac- ceptances," which the banks discount 0. (b) Those who have deposited money in the banks. Both of these classes have claims on the lending banks, claims which, taken all together, cannot be redeemed by the banks except as those who have borrowed, those who are indebted to the banks, make good the claims of the banks on them. When a man has accepted a check from one who has borrowed of a bank, and has given goods in exchange for this check, he has actually given present wealth in exchange for a mere right to draw on the bank. He may, therefore, so long as he does not exercise this right, be regarded as a lender. If he passes a check for a like amount to another, in return for goods, the other becomes the lender, since this other now has the right to draw, and has given up for it present wealth. If, instead of passing a check to another, the original payee avails himself of this right to draw, taking money from the bank, then some one who has deposited cash in the bank vaults may be looked upon as the lender, since his money has been taken from the bank and the borrower is expected to make good the subtraction. Thus, either the original receiver of a deposit right from a borrower, or some one to whom he passes this right, or some depositor whose cash is withdrawn to redeem the check, may be regarded as a lender. One person after another holds, for a time, the right to draw money from 1 See § 4 of this chapter (II of Part I). 32 THE EXCHANGE MECHANISM OF COMMERCE a bank, and delays using that right. In the aggregate, there is a very great deal of such delaying or waiting on the part of persons who are entitled to money whenever they desire it, but who do not find it convenient to claim it at once. Each of them knows that he can collect from a bank, at will, or can pass his claim to another, at will, for any desired goods. Yet commonly there is an interval during which such a person remains a creditor or lender, preferring the convenience of an available bank account to the immediate possession of other goods. Commercial banking has as a function to combine and coordinate such sporadic potential lending or sporadic waiting, so as to put at the disposal of borrowers a sum total of actual lending which is fairly constant in amount. If A leaves his claim on a bank untouched for one week, B for two weeks, and C for a week and a half, because convenience so dictates, why may not D, in the meanwhile, be using the capital which they do not yet wish to use? By bringing all these parties together, commercial banking enables D to get the use of capital without at all incon- veniencing A, B, or C. Each of these can get his capital to use whenever it is convenient, but, in practice, all of them will not want it at the same time. It may be objected that the foregoing treatment is too concrete to be true. In any individual case of borrowing, it is perhaps not legitimate to pair off each borrower with one or more ultimate lenders, assuming that a particular holder of a deposit (or two or three such) is the real lender to some special borrower. Banks bring together bor- rowers and lenders in large numbers, and there is no log- ical way to assign two or more into pairs or small groups. But it cannot be denied that if the total of loans is taken, the ultimate lenders are the total number of acceptors of THE NATURE OF BANK CREDIT s^ checks and depositors of money, both of which classes are depositors in the broad sense, because both are possessors of the right to draw. Since the receivers of checks are as much holders of rights to draw, that is, of deposits, as are the cash depositors, we may say that all the borrowers are in debt to all the holders of deposits and that the latter are lenders to the former. When a borrower of a deposit has not transferred it, he may be regarded as indebted to himself, since his right to draw may be regarded as in the main backed up by his own promise to pay. The interrelations of banks through a clearing house merely extend these relations to persons depositing in, borrowing from, and receiving checks on, other banks. The prin- ciples are the same as in the case of a single bank. The upshot of the matter is that modern commercial banking makes it possible for men to do business with each other by becoming, successively and alternately, through the banks as intermediaries, each other's debtors and creditors ; while yet no one of them needs to remain a creditor or lender longer than suits his convenience. §4 Why Commercial Banking Commends Itself to Business Men, both as Lenders and Borrowers, so that Com- mercial Bank Credit becomes a Substitute for Money Thus bank credit acts as a substitute for money. Its use is simply a process by which persons become, so to speak, successively each other's creditors, m such way as ultimately to cancel obligations with only a h'ttle use of cash. But we have yet to see, fully, just why bank credit is able to displace money, to a large extent, as a medium of exchange. It does this by conferring an 34 THE EXCHANGE MECHANISM OF COMMERCE advantage upon both borrowers and ultimate lenders. Ultimate lenders, as such, are benefited by the conven- ience of a banking service for which they do not have to pay. Borrowers are benefited in that they can borrow on better terms from banks than would otherwise be possible. We have already seen that commercial banking com- bines and coordinates waiting which would in any case be done. Such waiting includes, for example, the wait- ing done by a man who has money in his pocket which he intends to spend. It may be a long time before he does spend it, but he knows that at any time he may spend it, and when it is convenient he will do so. Practically everybody finds it desirable to keep part of his assets in ready cash, to use as occasion may require. The convenience of having the ready cash compensates for the loss of the interest that might be received from various investments, and so may perhaps be regarded as, itself, a kind of interest. The same holds true of bank deposits subject to check demand. Business firms must keep part of their assets in such form as to be able to meet current expenses and occasional emergencies. They usually keep considerable amounts to their credit in some bank. Even in the absence of banks, money would have to be kept on hand, and there would be a great deal of sporadic waiting remunerated only by the convenience of having cash on hand when wanted. The lender, therefore, that is, for example, the receiver of a check on a bank, who becomes a depositor and supplies waiting, is not injured but rather is benefited by commercial banking. He can draw upon his account at will, and this account is both safer and more convenient (especially for making large payments and payments of it THE NATURE OF BANK CREDIT 35 odd sums) than the equivalent of ready cash would be. There are, consequently, many persons who would be and are lenders, without any further payment of interest than the deposit service of banks. The lending involves, in each case, only such waiting as is convenient and as would be done an)rway. And it is more satisfactory to have the bank deposit, thus making this waiting available as lending, than to keep all quick assets in cash. From the side of the ultimate lenders, there is no difficulty in seeing how bank credit may be substituted for money, to a large extent, with advantageous results. It should be noted that the ultimate lenders are, by making their waiting available to borrowers, really adding to the wealth-producing efficiency of the community. Were it not for this bank credit, i.e. this combination of sporadic waiting, borrowers could only be similarly provided for by the use of money. But a quantity of money corresponding to such possible bank credit, sup- posing the money to be of standard money metal, e.g. gold, would be a tremendous capital investment and would involve, therefore, great expense. An equivalent additional investment in other capital, if made possible by a partial substitution of safe bank credit for specie money, is more profitable to the community. The same total amount of capital is thus made to produce larger results. "^^^ Let us now consider the interests of the borrowers. ^^^ They also will be ready to encourage the system, because ^l^it enables them to secure loans at relatively favorable rates. The banking system combines and coordinates, as we have seen, a great deal of waiting which would be done in any case. This it puts at the disposal of short- term borrowers, so adding to the supply of loans. If borrowers will avail themselves of these loans, which will, 36 THE EXCHANGE MECHANISM OF COMMERCE obviously, on the principles already set forth, take chiefly the form of bank credit rather than of cash, a lower rate of interest becomes possible. But it becomes possible only because borrowers are making use of waiting which would in any case be done, only because such use enables society to get along with less of other currency, pre- sumably with less of gold, and so enables a larger amount of society's total capital to be held in other forms.^ These conclusions apply no less when the formal ar- rangement is somewhat different. Not infrequently A buys goods for which he gives his promissory note to B. B endorses this note and deposits it with his bank, and thereby secures a deposit account. The bank is under obligation to honor B's checks upon it for the amount for which A's note was discounted. But A is under obligation to pay the bank. Taking a large number of such transactions, we may say that all the makers of notes so deposited, along with other debtors to banks, are in debt to all the holders of bank deposits, and that the latter are creditors of the former. Business takes place by means of different persons assuming, suc- cessively, the position of creditors, through the banks as intermediaries, to such persons as A. The fact that spo- radic waiting is brought together, undoubtedly tends to give A's personal note more value, i.e. makes the interest 1 The same principle applies to government paper money, as was shown in Chapter I (of Part I), § 6. In that case, the government is the borrower and pays no interest. So far as bank credit makes impossible the issue of so much paper money by government, the lower interest to borrowers from banks does not involve economy in the use of gold and lower average interest. For then the government itself, having to borrow by issuing more bonds than would, perhaps, be necessary if it issued credit money, must pay interest which, other- wise, it would not have to pay. This conclusion does not mean, of course, that inelastic government paper money is to be preferred to elastic bank credit; nor does it mean that government paper money is to be preferred to bank credit, on other accounts. THE NATURE OF BANK CREDIT 37 he has to pay somewhat lower. The bank can give more for the note than it otherwise could, just because its own creditors will not all want cash at once, just because its lending power (for the bank is making itself a creditor of or lender to A) is made greater by the existence of the sporadic waiting which it has combined ; and since the bank can give more for the note to B, B can give more for it (in goods) to A. The principle is the same if B deposits, not A's promis- sory note, but a bill (or draft) on A, payable in some 30 or 60 days, for goods shipped to A. This draft will be presented to A for his signature as soon as possible. That is, A will be expected to acknowledge his in- debtedness by "accepting" the draft.^ The bill (or draft) thus becomes, in effect, A's promissory note indorsed by B. In Europe, particularly in England, still another method of securing bank credit is common. This is the method of bank acceptances.^ The would-be borrower, A, instead of directly borrowing of his bank a checking account, or instead of giving his creditor, B, a promissory note, for deposit, if desired, in B's bank, or instead of having B make out a draft directly upon him, gets some bank to agree to '^ accept" (i.e. become responsible for the payment of) drafts which B may draw upon this bank up to an agreed amount. A can then pay to B whatever is owing to the latter, by arranging to have B draw a draft upon the bank with which the agreement has 1 For fuller discussion of such "bills of exchange" and their security, see Ch. Ill (of Part I), § 7. ' For a description of acceptances and a study of their effects, see Lawrence Merton Jacobs, "Bank Acceptances," National Monetary Commission, igio. See further, also in National Monetary Commission, Paul M. Warburg, "The Discount System in Europe," pp. 7-13. 38 THE EXCHANGE MECHANISM OF COMMERCE been made. The bank in question will undertake to pay the draft when it becomes due, say in 60 days. But the agreement is that before it does become due, A shall provide the bank with the necessary funds. The bank with which the agreement is made, guarantees payment to B, but does not expect to draw upon its own resources in making such payment. B can deposit the draft with his own bank for credit. B then has a right to draw from his own bank on demand ; his bank has a claim upon the bank with which A made the above described arrange- ment; and this bank has a claim upon A. B, or those receiving from him checks upon his bank, may be regarded as the ultimate creditor or creditors; A is obviously the ultimate debtor. The banks are inter- mediaries. Also, the banks have brought together the waiting of those who successively, for periods dictated by their own convenience, become creditors of the bank- ing system by receiving checks or deposit rights based on the draft for which A is ultimately responsible. Further, the fact that this sporadic waiting is made available as actual lending, means that B's draft on the bank will be discounted at a somewhat lower rate than it otherwise probably could be, and will therefore bring a better price. Since the draft for a given sum has thus a somewhat higher value to B than it would else have, the latter will be ready to charge A in payment for any definite amount of goods sold, a somewhat lower price than otherwise. In effect, because of the waiting made available by the banking system, A borrows at a lower rate of interest. The same principle is involved if, as frequently happens, A himself draws a draft upon a bank which agrees to "accept" it, and sells it to another bank for credit. Those who receive A's checks on this THE NATURE OF BANK CREDIT 39 credit,^ in payment for goods, are then the ultimate lenders'in the sense above explained. Whatever the formal . arrangement by which bank credit is utiHzed, the charges to the borrowers or debtors (for, in the last analysis, it is always the borrowers or debtors who pay) must be enough to cover the cost of banking service. These charges must remunerate the banks for concentrating waiting where it has the greatest usefulness. They must cover salaries of bank officials, depreciation of bank property, interest on the capital invested by the banks themselves, and compensation for the risk to the banks, of insolvency, for the banks, though chiefly go-betweens or intermediaries, do nevertheless insure the credit of borrowers. If all the borrowers failed to make good, the banks must fail; but within limits the banks can and do guarantee depositors. This they do, largely, by maintaining cash reserves of per- haps Yo to i of their deposits, according to conditions and the requirements of law, from which they can liqui- date as many of their demand obligations as are likely to be suddenly presented for payment at any one time. On these reserves, as on their other capital, the banks expect to realize a reasonable interest. In other words, the payments made by borrowers must cover the cost of banking plus a fair return on banking capital. These payments would not do this if the demand for loans from banks were very small, and if such demand could be sufficiently met by the funds of depositors who would be willing to pay the cost of banking, for the sake of the convenience of banking service. The demand for bank loans, however, is far in excess of what could be supplied by means so trivial, and is, indeed, sufficient to throw upon borrowers or 40 THE EXCHANGE MECHANISM OF COMMERCE debtors as such, the whole cost of banking service. When those who, through the intermediation of banks, are the ultimate lenders or creditors, have become such by having the promissory notes of or drafts on their debtors discounted, the creditors may seem to be paying the cost of banking. But, in such cases, they have, pre- sumably, made allowances for the bank rate of discount, in the prices they have charged for goods sold, and the debtors, therefore, really pay for the services of the banks. The payments by borrowers or debtors may be re- garded, then, as real interest payments in the sense that the ultimate lenders profit by the existence of a place of deposit other than their own vaults, for which they do not have to pay, and profit further by the facility of check payments thus made practicable. If no money interest is received by the ultimate lenders, the amounts paid by borrowers are, in the long run, because of the competition of different banks, determined by the labor cost of rendering the service, plus the interest (including compensation for risk) on the cost value of the machinery, such as buildings, necessary reserves, etc., used in bring- ing borrowers and real lenders together. If, however, there is not a sufficiency of this '^ convenience waiting" to be had to supply the demand for loans at the mere cost of concentration, then the banks will bid against each other, not so much to cut down the charge for the service performed for borrowers, as to get deposits. Hence we are beginning to see direct interest, though at low rates, very generally offered on deposits subject to check, either on monthly balances or otherwise. THE NATURE OF BANK CREDIT 41 §5 Application of Principles Arrived at, to Bank Notes The same principles apply to bank notes as to bank deposits. The bank note, when issued on the sole responsibility of a bank, is, like the deposit, a credit obligation of the bank to the holder. The holder is entitled to specie or other legal tender money on demand. As with deposits, these rights to draw circulate from hand to hand in payment for goods. And as with deposits, the real lender or creditor is the person wl o receives the bank notes, which represent only a claim in payment for goods sold; while the ultimate debtor is the person — or the persons — who has borrowed the bank's credit in this form, either directly or by any of the methods just described in relation to deposits, and is under obligation to repay. The bank is a legally re- sponsible intermediary, but is chiefly dependent, in the long run, for means to redeem, on repayment of loans by its debtors. The bank, in the main, is merely an inter- mediary, although, as with deposits, part of its own cap- ital serves as an insurance fund to cover all contingencies which are reasonably likely to occur. But the holders of bank notes are frequently given, by government, greater protection against loss than the holders of deposits. In Canada, for example, the note- issuing banks have to contribute to a special reserve fund . to redeem the notes of failed banks, besides which note holders have a prior lien. In the United States, note holders are insured against loss by the Federal govern- ment, which makes itself ultimately responsible for all notes issued in conformity with the national banking law, and, therefore, for all bank notes issued, since a 42 THE EXCHANGE MECHANISM OF COMMERCE lo per cent tax on other bank notes effectually keeps them out of circulation. The notes issued by national banks are based chiefly ^ on government bonds. Each national bank must have purchased bonds of the United States, the par value and also the market value of which shall be at least equal to all its notes in circulation. These bonds must have been deposited with the Comptroller of the Currency. The banks must also have deposited in cash a redemption fund of 5 per cent of the face value of their notes. In consideration of these safeguards, the United States assumes ultimate responsibility for the redemption of the bank notes in case of the failure of any bank, and, in fact, undertakes to redeem the notes currently for those persons presenting them, out of the 5 per cent redemption fund. These bond-secured bank notes will, however, be gradually withdrawn over a period of years. The recent Federal Reserve Act permits their gradual retirement and, in addition, the 2 per cent gov- ernment bonds, on which alone they can be based, will, as they mature, be permanently withdrawn. The recent Federal Reserve Act, however, creates from eight to twelve ^ Federal reserve banks through which Federal reserve notes shall be issued. Back of these the Federal reserve banks must keep a 40 per cent gold reserve, of which not less than J, or 5 per cent, shall be in the Treasury of the United States. These notes are to be, in each case, a first lien upon the assets of the bank through which they are issued. But the government makes itself ultimately responsible for their redemption. The notes 1 The provisions of the Aldrich-Vreeland emergency currency measure will shortly be superseded by those of the Federal Reserve Act of 1913. The Aldrich- Vreeland Act cannot be availed of after July i, 1915. The new law is already (August 1914) being put into operation. 2 Made twelve by the Organization Board. THE NATURE OF BANK CREDIT 43 are issued to the Federal reserve banks for them to lend out, at the discretion of the Federal Reserve Board, a government regulating body. They partake in part of the character of government paper money and in part of the character of bank notes. It is customary in European countries also, to safeguard especially bank notes as contrasted with deposits. The holder of a deposit is supposed to become a depositor only delib- erately and after consideration of the financial soundness of his chosen bank. But bank notes circulate from hand to hand as ''money," are received often in the form of wages by the comparatively poor, and are not usually scrutinized to see from what bank they come; nor is the soundness of the bank usually considered. §6 Quantitative Statement of the Relation of Money y together with Bank Credit, to Prices The foregoing explanation of the nature of commercial banking operations makes clear, it is hoped, that these operations economize the use of money and why they do economize such use. The rights to draw from banks, thus circulating in place of government or "lawful" money (whether these rights are evidenced by checks or by bank notes) we may call M\ and the average velocity ^ with which they circulate, V\ Then our equation becomes ^ MV + M'V = pq + p'q' + etc.^ 1 Estimated by Fisher, Purchasing Power of Money, p. 285, as averaging, in recent years, towards 50. 2 Stated in Ch. I (of Part I), § i, without the inclusion of bank credit. 3 The equation of exchange has been so stated as to include credit, by Kem- merer. Money and Credit Instruments in their Relation to General Prices, New York (Holt), 1907, p. 75 ; and by Fisher, The Purchasing Power of Money p. 48. 44 THE EXCHANGE MECHANISM OF COMMERCE The general level of prices is somewhat higher and the value of money is somewhat lower, because of the addi- tional use of credit. The conditions of supply and demand require a somewhat higher level of prices, just as we have seen that they do when there is more money. Gold is cheaper. The demand for it is less. It does not need to be produced, and cannot profitably be produced, at such a low margin, i.e. from such unfavorable sources of supply, as would otherwise be worth while. But this bank credit is not altogether an addition to currency ; it decreases the amount of gold money, and so is largely a substitution of a cheaper for a dearer currency. But if bank credit can thus take the place of money, is there any Hmit to such substitution? Why might not credit expand and prices rise, or money be pushed out, indefinitely? The answer is that the amount of bank credit is pretty definitely related to the amount of money. In the first place, a certain amount of cash is needed in the banks, to maintain confidence. The amount so needed bears a relation to the amount of bank credit, and must be some reasonable per cent of such credit. Otherwise, the public is likely to become frightened and demand cash, and this cash cannot be paid. A margin against such contingencies is always essential and, for national banks of the United States and Federal reserve banks, as well as frequently for State banks, is required by law. Ref- erence has just been made^ to this requirement in the case of the Federal reserve notes. So the total bank credit is related to the total bank reserves or cash in the banks. ^ Banks maintain the proper relation between deposits and reserves, by adjusting their rates of interest (or dis- 1 § 5 of this chapter (II of Part I). 2 White, Money and Banking, third edition, Boston (Ginn), 1908, p. 197 THE NATURE OF BANK CREDIT 45 count) charged to borrowers. If the deposits are in danger of becoming too great, relative to the reserves, a higher charge to borrowers will' discourage borrowing, and so will limit the increase of those deposits which originate in the borrowing of deposit rights (or in the discounting of notes and acceptances) . The total bank credit is related, also, to the total cash in circulation.^ Bank deposits passed by means of checks are absolutely unavailable for very many transactions. They are unavailable when the maker of a check is unknown, and they are unavailable, practically, for small payments, such as street car fares. Even bank notes cannot fill up the entire circulation when, as is usually the case, the government allows them to be issued only in relatively large denominations. The smaller denomi- nations are needed and government money is used. Business convenience, then, also compels a relationship between the quantity of bank credit and the quantity of government money. Since the quantity of bank credit is related in these two ways to the quantity of government coined and government issued money, changes in the latter tend to bring proportionate changes in the former. It is still true that prices depend upon the quantity of money, though the dependence is in part indirect. The demand for goods comes from those who have bank credit to offer as well as from those who have only money. And we may now speak, not merely of the supply of money and the demand for it, but of the supply of currency (includ- ing both money and circulating credit), and the demand for it. * Fisher, The Purchasing Power of Money, p. 50. 46 THE EXCHANGE MECHANISM OF COMMERCE Fluctuations of Bank Credit But though the amount of bank credit is thus related to the amount of money, the ratio between them is slightly rhythmic rather than definitely constant. During periods of hope and confidence, bank credit tends to expand, and prices to rise. During periods of distrust and depression, the volume of circulating credit tends to be smaller, and prices to be lower. When prosperity is generally expected, business men are anxious to extend their credit by borrowing of the banks for the purchase of merchandise and for other business purposes. The banks can then increase their deposits by making loans, as much as their available reserves will permit. When, for any reason, doubt and fear prevail, even low discount rates may not induce an equal amount of borrowing. The sharpest changes in the relation of the quantity of circulating bank credit to the quantity of money come as the consequence of panic. So far as a panic is foreseen, the banks endeavor to prepare themselves for it by decreasing their demand liabilities in relation to their cash on hand or reserves. That is, they cut down their loans by raising their rates of discount. As the panic spreads, the necessity of such a policy becomes evident to nearly all the banks. Any bank may suddenly find itself sub- jected to the danger of a run upon it, and dares not increase the danger by making extensive loans. Those banks upon which there actually are runs, find themselves with depleted reserves, and are peculiarly unable to extend credit. The bank rate of discount, then, rises THE NATURE OF BANK CREDIT 47 rapidly, while the volume of bank credit, if', decreases, and prices fall. At such a time of stress, a great national bank (or a few great banks) which keeps large reserves beyond the requirements of ordinary years, is a tower of strength, and can usually prevent any general collapse of credit. Such an institution is the Bank of England, which holds itself responsible for the credit structure of the nation, and maintains always an emergency reserve. In the United States, the recent Federal Reserve Act (of 1913) directs the estabHshment of not less than eight or more than twelve ^ Federal reserve banks. All national banks, and all other banks which become members of the system,^ are required to keep a portion of their reserves in one of the Federal reserve banks. The aim is to have a large part of the nation's banking reserve concentrated in these few large banks so that ample means may be available in time of panic for the aid of any sound bank which finds itself threatened by the unreasoning fear of depositors. The Federal reserve banks are themselves required to keep each a 35 per cent reserve in lawful money against deposits and a 40 per cent reserve in gold against the Federal reserve notes which they have out- standing. This requirement insures the maintenance in ordinary times of a reserve which may be needed in case of a financial crisis. But when there is financial crisis or the fear of it and many banks are curtailing their loans, one of the things most needed is the assurance that credit can be secured by those whose assets are good and whose business is dependent upon credit. At such a time new reservoirs of credit may need to be opened 1 Made twelve by the Organization Board. ' With a temporary exception stated in the act. 48 THE EXCHANGE MECHANISM OF COMMERCE until the old ones, temporarily closed, are again un- locked. The new law therefore provides that the Federal Reserve Board, the government regulating body, may temporarily suspend any of the reserve re- quirements, but only by levying a proportional tax on the banks so favored. But while it is desirable that the violent credit fluc- tuations associated with crises should be avoided, some seasonal rise and fall of bank credit is desirable. In agricultural countries, particularly, the amount of trade immediately after the crop season is greater than at other times, and an alternate expansion and contraction of bank credit, corresponding to the expansion and contrac- tion of business, tends to keep prices more stable rather than to make them less so. In the United States, the circulation of the Federal reserve notes provided for in the new currency bill, and the gradual retiring of the old bond-secured bank notes, will tend to an elasticity of bank credit in the form of notes, comparable to, though perhaps less than, the elasticity of deposits. The new law requires that no Federal reserve notes originally issued by one Federal reserve bank shall be paid out by another such bank but shall be sent promptly for credit or redemption to the issuing bank. The effect of this provision must be to give at least some slight elasticity to the volume of these notes. For the notes will be lent out as business conditions favor, and will pass into circulation. They will then be used by borrowers, along with other means of payment, to liquidate debts to the various banks, will flow in considerable volume to the Federal reserve banks, and must then be cancelled against other debts or re- deemed. Bank deposits in the United States are nor- mally elastic, and will doubtless continue to be so. The THE NATURE OF BANK CREDIT 49 banks lend perhaps nearly all their reserves will support, at certain times, and at other times accumulate reserves in preparation for the season or seasons of largest lending. §8 Summary Let us now bring together, in brief compass, the main conclusions of this chapter. We saw, to begin with, that credit does not really act as a substitute for money unless there is the possibility of cancellation, unless the same credit (though not necessarily the same paper evidence of it) circulates more than once. It usually does this in the case of the bank deposit or right to draw from a bank. This right to draw, circulating by check or draft, is a substitute in trade for legal tender money, tends somewhat to increase the total supply of currency, and tends to drive out other currency. Analysis of the relations of the various parties con- cerned, to each other, showed that, apart from their function of insuring the credit of borrowers by risking some capital of their own, banks are really but inter- mediaries between those who borrow of them, and the real lenders. These lenders are the depositors, since it is the depositors who have given up present goods by de- positing, in the banks, money which they might have spent, by accepting checks in return for goods sold, or by receiving the promissory notes of or drawing drafts on the purchasers of the goods, and having such notes or drafts discounted by banks. If the borrowers as a whole were unable to repay, then the banks would be unable to pay the depositors what the latter were entitled to. What the banks do is to bring together borrowers so THE EXCHANGE MECHANISM OF COMMERCE and lenders, making available to borrowers, in the form of loans, sporadic waiting which would in any case exist. Through the institution of commercial banking, trade is carried on by means of people becoming successively and alternately each other's creditors. The demand for loans from borrowers is sufficient to throw upon them the cost of maintaining the banking system. Nevertheless, the existence of that system, by making possible the bringing together of sporadic waiting, tends to make the interest charge to borrowers lower than it would probably otherwise be. Bank notes involve the same principles as bank deposits, though the holders of bank notes are commonly protected or insured to a greater degree by government than depositors. Bank credit is related to the quantity of money by the habits and business requirements of the community and by the necessity of a sufficient reserve. But the relation between bank credit and money is rhythmic rather than exactly constant. The fluctuations seem to be, in large part, closely connected with the alternation of business confidence and business distrust, and with the occurrence of panics. The banking system should be so well organized and conservatively managed as to minimize such fluctuations of credit. On the other hand, a certain degree of elasticity in bank currency, making it expand and contract according to the seasonal variations of trade, appears to be desirable. CHAPTER III The Nature and Method of Foreign Exchange §1 The Function of Bills of Exchange In the last chapter we saw that in the most highly civilized countries, particularly the Enghsh-speaking countries, the largest part of trade is carried on by means of bank credit. This form of credit, circulating by means of checks, is, in the United States, of almost universal use as to all large scale dealings within a city or other circumscribed area. We saw, also, that the use of this bank credit, through checks or bank notes, is merely a means by which bor- rowers and lenders are brought together, the bank being but an intermediary ; that it is a means by which one person or firm can become, in the sense explained in the preceding chapter, a debtor successively to a second, third, fourth, fifth, etc., so that money has only to pass from the first through the bank or through two or more banks and a clearing house, to the last. All the inter- mediate transactions may then cancel, or cancellation may at times be complete, so that no balance remains. Cancellation of these serial and opposing debts thus be- comes our principal means of carrying on modern busi- ness. And trade is still, in the last analysis, as in primi- tive barter or as where money is the medium, an exchange of goods for other goods. We buy goods and become, in SI 52 THE EXCHANGE MECHANISM OF COMMERCE effect, debtors. We sell goods and become creditors. The debts cancel and we have traded goods for goods. Bills of exchange enable us to extend this system of credit beyond the town or city, beyond the state, beyond the nation. Business firms separated hundreds of miles from each other can become debtors and creditors of one another through the intermediation of the banking and exchange system. The credit structure becomes inter- national. Through the commercial and the exchange banks, a New York firm can become, in effect, suc- cessively the debtor of a London firm, another London firm, a Glasgow firm, a Berlin firm, a Boston firm, and another New York firm. That is, these different business houses successively become claimants of the banking system, through their receipts of checks or drafts from one another, or through their drawing bills of exchange on one another, or both, of the sum, or part of it, originally borrowed from a New York bank, as a deposit, by the first mentioned New York firm. In trade between nations, or between widely separated parts of the same nation, credit is used, debts in large part cancel, and money is used to a relatively small degree. Bills of exchange or drafts serve in large part, then, the same purposes as ordinary checks. Over long distances, however, whether business crosses national boun- daries or not, the ^'customer's check" is not likely to be satisfactory. The receiver may have hard work to cash it or to get for it an immediate addition to his bank balance. In the distant locality to which the check is sent, nobody, probably, knows the maker well, or knows whether the maker's check is good. In this regard, the bank draft is superior. Or the creditor may not wish to wait for what is owed to him, until a check arrives METHOD OF FOREIGN EXCHANGE 53 from his debtor. In this regard, a commercial draft is superior. Foreign and domestic exchange are in principle the same. The former involves payments between persons in different countries, countries which have, generally, different currencies and which are often separated from each other by natural barriers. Domestic exchange in- volves dealing between different parts of the same coun- try, but parts too far from each other for the ordinary, convenient use of checks. §2 The Nature of Bills of Exchange Let us now inquire what is the nature of the bill of exchange. Suppose, to take the simplest possible case, that B owes to A the sum of $1000, and that A owes a like sum to C. The form of settlement will be that of the bill of exchange if A orders B to pay C. When B compKes with the order, his debt to A and A's debt to C are both liquidated. Usually the bill of exchange involves an exchange banker or broker as one of the parties. But in any case it is always of the form : A orders B to pay C. The reader may at once note that in so far the bill of exchange resembles the ordinary check, which is, in fact, but one species of bill of exchange. But a distinction can be made, based partly upon the relation of a bank or banks to others concerned. In the case of the " custom- er's check," A, the drawer, is a mercantile or industrial establishment or a person, while B, the drawee, is always a bank. In the case of the commercial draft, A and B are usually persons, or commercial or industrial establish- ments (except that, as with the "bank acceptances" de- 54 THE EXCHANGE MECHANISM OF COMMERCE scribed in the previous chapter/ B's bank may be desig- nated by him as the drawee in his place), while C, the payee, is usually, though not necessarily, a bank. In the case of the hank draft, both A, the drawer, and B, the drawee, are banks. The payee may be a person or an ordinary business firm. Furthermore, a check is always a demand claim (a demand draft of one bank on another is frequently called a ''check"), while a draft may or may not be. We shall have occasion to notice, later on, the significance of some of these different re- lations. What we have here to emphasize is that the bill of exchange or draft and the ordinary check are exactly alike in involving three parties, of whom one orders a second to pay a third ; and that the distinction rests, in part, upon the position which the bank or banks concerned, if any, occupy in relation to the other persons or person. §3 How Bills oj Exchange Might he Used to Settle Ohligations, Assuming no Banks If credit is to serve appreciably as a medium of ex- change or substitute for money, then when credit is given there must generally be three parties. When there are but two persons concerned, the giving of credit is usually only a postponement of payment. There is not an' avoidance of the use of money, except in those com- paratively rare cases where B's debts to A now are balanced, or partly balanced, by later obligations incurred by A to B. Then, of course, credit may lead to cancella- tion. If three or more persons are concerned, in addition to banks or other intermediaries (and even if banks are 1 § 4 of Ch. II (Part I). METHOD OF FOREIGN EXCHANGE 55 included in the three, this would be true in form), can- cellation always takes place. But we have yet to see just how bills of exchange or drafts are used to balance obligations in foreign trade. To begin with, we shall take, as being the simplest, a case seldom realized in practice, namely, where four parties can settle up their various debts without resort to any bank, exchange broker, or other go-between. Suppose that an American merchant, whom we shall designate as Ai, owes to an English manufacturer, Ei, the sum of £100 ($486.65), while the latter owes as much to an English merchant, Eo, who in turn owes an equal sum to an American manufacturer, A2. We may represent the situation, graphically, as follows : Ai > owes f owes owes Obviously, if the parties all know each other and know of the situation, they can very easily settle all three debts with but one use of money. Ei may make out a bill on Ai ordering him to pay E2. Thus Ei cancels his debt to E2. E2 may then indorse the bill, making it payable to A2, thus Hquidating his (E2's) debt to A2. Finally, A2 presents the bill to Ai, who cancels his debt 56 THE EXCHANGE MECHANISM OF COMMERCE to El by paying it. Thus, three debts have been paid with but one use of money. Suppose that, in addition to the other debts, A2 owes $486.65 to Ai. Then our diagram would be : Ai ^ — — o^«5 5 E, I 1 CM^ owes [ f At < -"^ ^ Ea A2 might then pay by indorsing the bill to Ai, who would, therefore, have only to pay himself. In that case, four debts would be settled with no use of money at all. §4 Settlement of Obligations by Drafts (Bills of Exchange), through Intermediation of Banks, Assuming Creditors to Draw Drafts on Debtors Our illustration, however, must be modified if it is to picture the usual commercial practice. The different parties having occasion to use or to pay drafts or bills of exchange cannot be expected, ordinarily, to know each other. They must therefore deal with middlemen, with the so-called exchange bankers or exchange brokers. When foreign exchange is carried on through the inter- mediation of bankers or exchange brokers, each bill of exchange is still of the form, A orders B to pay C. But METHOD OF FOREIGN EXCHANGE 57 an exchange banker is now in the position of both A and B, or of C. There are several ways by which debts can be settled through the use of the exchange banking machinery. One way is for the creditor to draw upon the debtor, ordering him to pay a bank. Another is for the debtor to remit to the creditor by sending the latter a bank draft. Let us take up, first, cases where the creditor draws on the debtor. We will suppose the same four persons, Ai, A2, Ei and E2, but will now assume what is the usual, if not indeed the universal, fact, that they deal with each other through middlemen. These middle- men may be two banking houses dealing in foreign exchange, one, Ba, an American bank, and the other. Be, an English bank. We shall suppose, as before, that Ai owes El, El owes E2, E2 owes A2, and A2 owes Ai. All that is needed for cancellation is that the parties be brought together. Diagrammatically this situation is: El makes out a draft on Ai ordering Ai to pay Bg. Ei may be said to sell this draft to Be. Ei's bank, Bg, may then give Ei the money, but will more probably (since El is likely to prefer it) put the amount to his credit as 58 THE EXCHANGE MECHANISM OF COMMERCE a depositor. Bg sends this draft, directly or indirectly, to Ba for collection. Ba will subtract it from the credit account of its customer, Ai. So far, no money has been used. El has an addition to his deposit account. Ai has suffered a subtraction from his. Ei has the claim on the banks which Ai has lost. Ei may now settle his obligation to E2 by a check on Bg. E2 then reahzes an addition to his deposit account with Bg, while Ei suffers a diminution of his bank account. Next, A2 may make out a draft on his debtor, E2 (or, as where E2 has arranged for "acceptances," directly on E2's bank), ordering E2 (or his bank for him) to pay Ba. Ba may send this draft to Bg for collection. A2 now has an addition to his deposit account in Ba. E2's bank account is decreased. Lastly, A2 settles with Ai by check on Ba. Ai has now an addition to his bank account which may cancel the original subtraction, while A2 suffers a sub- traction which may be equal to the previous addition. Four debts may have been cancelled, with no use of money. In any case, there has been less use of money because of the use of drafts, for the banks concerned com- pare accounts, and only net balances have to be paid in money or in gold. The use of bills of exchange extends to trade between nations, and equally to trade between widely separated parts of the same nation, the operation of the bank credit system. Even if we suppose that Ba (for example) , the exchange bank which collects the draft on Ai, is not the bank in which Ai regularly keeps a deposit account, nevertheless the rule that trade is carried on by a cancellation of credits, still holds. Though Ba, upon receiving from Bg the draft drawn by Ei upon Ai, cannot then directly subtract the amount from Ai's account, it can call on Ai METHOD OF FOREIGN EXCHANGE 59 for payment. Either the draft will be made payable to Ai's bank and by that bank subtracted from his deposit there, or it will be presented directly to Ai himself, in which case he will probably pay it by giving Ba a check on his own bank. In any case, then, Ei's bank account will probably be increased and Ai's bank account de- creased by virtue of the draft. On the other hand, A2's bank account will be increased when he sells his draft on E2, though he sells this draft to an exchange dealer not engaged in a regular banking business. For such an exchange dealer will presumably pay him for his draft by means of a check upon some bank, which he can then deposit for credit in his own bank. His deposit account is increased and E2's is decreased by the transaction. In any case, Ba, or some other exchange bank, has to pay A2, directly or indirectly, and receives payment, directly or indirectly, from Ai ; in any case, Ba collects one draft for Be and sends one draft to Be for collection. In any case, there is cancella- tion, and the shipment of gold is wholly or partially avoided. A2 may pay Ai by check as above suggested, or, if they are widely separated, Ai may draw a domestic draft on A2 and deposit the draft in his bank for credit. The draft will go to A2's bank or to A2 for collection and A2's bank account will be decreased. Attending only to the international relations involved, we may say that A2's draft on E2 constitutes part of the supply, in the United States, of bills on England. The desire of an American bank, e.g. Ba, to purchase this bill, signifies a demand, in the United States, for bills on Eng- land. This demand may be said, in the last analysis, to result, partly, from the necessity which some American bank (or banks) is under, of remitting to an English 6o THE EXCHANGE MECHANISM OF COMMERCE bank or banks, after collecting for the latter; and so may be said to result, to some extent, from the supply, in England, of commercial drafts on Americans. We may assert, therefore, that the supply of such commercial bills on America, in the English market, corresponds, in part, to demand for bills on England, in the American market, and, in part, gives rise to this demand. The basic principle is of course similar in the relations between different parts of the same country. In general, supply in one place, of commercial bills on another, gives rise to demand in the other, for bills on the first. To avoid misunderstanding, it should be pointed out that foreign exchange, in the compHcations of practical business, is often three cornered, four cornered, etc., involving merchants and banks of several countries. Thus, Americans may have purchased goods of English merchants ; the latter may have bought goods in Ger- many ; and Germans may have imported goods from the United States. Supposing the creditors in each case to draw upon their debtors,^ there would be sold in Eng- land, drafts on merchants in the United States; in Germany, drafts on English purchasers; and in the United States, drafts on Germans. The drafts in England, on Americans, would be sent to American banks* for collection. The American banks must then- settle with their English correspondents. This would create a demand for drafts on foreign countries, but might not directly create a demand for drafts on England. For the American banks might purchase drafts on Germany and send these in settlement to their correspondents in England. These drafts would be collectible through German banks, which might settle 1 See, however, § 5 of this chapter (III of Part I). METHOD OF FOREIGN EXCHANGE 6i by purchasing, and sending to their EngKsh correspond- ents, the drafts on England drawn by German exporters. In practice, then, the supply in England of drafts on the United States may not directly give rise to a demand in the United States for drafts on England. Instead, it may lead to a demand in the United States for drafts on Germany, and to a demand in Germany for drafts on England. These complications should not be over- looked, but, since they introduce no new principle, they may, for simpKcity, be ignored in most of our study. ^ §5 Settlement of Obligations by Bank Drafts, when Debtors Remit to Creditors Obligations between persons in widely separated places may also be cancelled through the use of bank drafts. Instead of creditors drawing on their debtors, the debtors then remit to their creditors. What method shall be adopted in each case will depend upon the understanding between the parties concerned as creditor and debtor. If Ai owes El and is to pay by means of a bank draft, he may go to the bank, Ba, and request such a draft payable to Ei. This he will pay for out of his deposit with Ba, or by a check on whatever bank he has an account with, or (conceivably but rarely) with money. The draft Ai gets is really a kind of check made out by one bank on another. Ba makes out an order upon Bg (or some other English bank) requiring payment to Ei. This order is handed by the American bank to Ai, who sends it to Ei, and the last named person is then in a position to present the draft for cash or, more probably, credit, to Be or to his regular deposit bank. E2 may simi- 62 THE EXCHANGE MECHANISM OF COMMERCE larly settle with A2 by getting a draft from Be ordering Ba to pay A2. We may suppose Ei to settle with E2 and A2 with Ai by check, as before. Or we may suppose that they are separated from each other by considerable dis- tances and Hkewise settle witli each other by using bank drafts. The matter of form is unessential. In any case, most obhgations, both international and intranational, can be settled by cancellation, through the banks. /^ Where settlement is made by the use of bank drafts, < there must, of course, be some arrangement between the banks concerned, such as deposit accounts kept by each y with the other, so that all of these drafts will be honored ^without question. There is no need of any special arrangement in the case of checks, since these can be sent at once, and with no appreciable loss of time in transit, through a clearing house, to the bank on which they are drawn. But with bank drafts, used where the distances are greater, the situation is otherwise. Where bank drafts are used, these constitute part of the supply of drafts, and the demand for them is a demand by persons and by business houses, who have remittances to make, as well as by banks. Thus, a part of the supply, in the United States, of bills on England is made up of the drafts of American upon EngHsh banks ; and a part of the demand, in the United States, for bills on England is the demand for bank drafts, by business houses having obligations to meet in England and desiring to meet them in that way. Third, cancellation may take place by the use of both of these methods, i.e. by both drawing and remitting. For instance, A2 makes out a bill on E2 ordering the latter to pay Ba. Ba sends it to Be for collection (or discount). Ba thus gets a claim upon or a credit with Be. Ai desires METHOD OF FOREIGN EXCHANGE 63 to remit a bank draft to Ei. He seeks of Ba, such a draft. Ba, having purchased A2's draft on E2 and secured a credit balance in England, is able to sell Ai a draft on Bg payable to Ei. This is the way in which, as a matter of practice, most of our transactions with England are settled. When Englishmen owe us, we usually draw drafts upon them or their banks, i.e. we draw upon London. We do not, as a rule, arrange for them to remit drafts on New York. On the other hand, if we owe them, the understanding commonly is that we shall purchase drafts on London and remit. American banks, then, buy drafts on London from those Americans having English debtors, send these drafts to their London correspondents, and, on the balances in London so secured, sell drafts on their London correspondents to Americans having English creditors. The opposite operations are indeed carried on, but they are much less common. In general, it may be said that other countries draw drafts on England in much larger volume than England draws upon them.^ Three-cornered exchange, also, may involve chiefly bills on London. Thus, if Americans have exported cot- ton to England and imported mechanical instruments from Germany, while Germany has purchased cloth of England, drafts on London may be used in part for all three settlements. American exporters of cotton will draw drafts on the English purchasers. These drafts may be used, in part, by American banks, for remittances to Germany, as a basis for the sale of bank drafts to American importers who must remit to Germany. German banks will, in turn, send these drafts on the ^ Clare, The A. B.C. of the Foreign Exchanges, London (Macmillan), 1893, p. 12. 64 THE EXCHANGE MECHANISM OF COMMERCE English importers of cotton to England, in order to maintain balances there for the sale of drafts to remit- ting German importers of cloth. London is, in fact, the world's greatest financial centre. Partly, perhaps, because banking is most fully developed in England, partly because of the magnitude of England's foreign trade and the fact that payments have to be made to EngUsh exporters by merchants of all other countries, drafts on London are nearly everywhere in demand. Sellers of goods, in most parts of the world, usually prefer to take advantage of this fact and realize on their sales at once. On the other hand, English exporters more usually, though not always, wait for remittances from foreign purchasers of their goods. The loss of time necessarily incident to exchange transactions falls, then, except as it is allowed for in higher prices of goods sold, more largely on English manufacturers and merchants and less largely on other countries. Coming back to the consideration of trade between England and the United States, we may conclude that drafts drawn by American business houses on EngHsh business houses (or upon banks properly designate^ by the latter), and drafts drawn by American banks upon English banks, are both part of the supply, in the United States, of bills on England. The demand for such bills has also a twofold source. It comes, first, from those persons and firms other than banks, who have obli- gations to meet in England which they wish to meet by remitting bank drafts. Second, the demand comes from banks which may desire bills of exchange on England for either or both of two purposes : in order to maintain accounts in England, against which they may sell bank drafts; and, though less frequently, in order to remit METHOD OF FOREIGN EXCHANGE 65 funds to English banks which are sending to them, for collection and settlement, drafts on American business men. As there is, in the United States, both supply of and demand for exchange on England, so there is, in England, both supply of and demand for exchange on the United States. The case is similar in our commercial relations with other countries, and in the relations of different parts of the United States itself, to each other. §6 How Exchange Banks Make Profits A market may be defined as the coming together of buyers and sellers. It therefore involves all the mecha- nism necessary to faciHtate their intercourse. One may speak of a general market or of a local market, of a market in one or in another place. Thus, there is the New York market for the buying and selHng of exchange on London. A bank in New Haven, Conn., may be a part of that mar- ket if it buys from and sells to it. That market includes, besides the commercial and industrial organizations whicK buy or sell drafts, all middlemen of whatever class who engage in the trade. The middlemen may be divided roughly into three classes.^ First may be mentioned banks which do a reg- ular foreign exchange business, buying bills from those who have them to sell and selling their own drafts on foreign correspondents to persons desiring to remit. Much of this business is done by foreign exchange banks which carry on little or no other business. Some of it is done by ordinary commercial banks, such as United 1 Cf . Escher, Elements of Foreign Exchange, New York (The Bankers Publish- ing Company), igii, p. 60. 7 66 THE EXCHANGE MECHANISM OF COMMERCE States National banks, in addition to their other banking business. Second, we may call attention to those ex- change dealers whose principal business is to buy com- mercial and bankers' bills, and to resell them, chiefly to banks. Third are the independent brokers who make small commissions by bringing buyers and sellers to- gether. These do not invest their own capital, do not, that is, buy bills of exchange in the market, but assist those desiring to sell bills to find buyers, and vice versa. The bankers and brokers engaged in the business of foreign exchange make their money from commissions and by the difference between what they pay for exchange and what they get for it. Thus, when a bank sells its own drafts drawn upon a correspondent bank, it will probably expect to receive a better price than it is wilHng to pay for the commercial drafts it buys and remits. Its credit is probably better than the credit of most mer- cantile and industrial establishments, and its drafts, therefore, more to be desired. And it will hardly care to engage in the business without receiving some profit as a reward or payment for its services. It might be supposed that business men, e.g. in the United States, desiring to remit to foreign creditors, would sometimes buy, through the intermediation of exchange brokers, the identical bills drawn by other American merchants on their foreign debtors, instead of remitting by means of bank drafts. This, however, while perfectly possible, is seldom done in practice. Perhaps one reason is that the business man desiring to remit has much more confidence in the credit of a bank than in the credit of any other company, and hence prefers to buy a claim on a bank to use in remitting. Another and a very practical reason is that an exchange See Escher, Elements of Foreign Exchange, p. 35. » See Ch. Ill (of Part I), § 7. •Escher, Elements oj Foreign Exchange, p. loi. icx) THE EXCHANGE MECHANISM OF COMMERCE to sell for May delivery, counting on his ability to pur- chase the wheat in May, in order to make good the agree- ment. Similarly an exchange dealer sells short if he agrees to sell a draft, e.^. in June for August delivery, but has, when the contract is made, no bank balance abroad or salable drafts held in his name in some foreign bank, on which he may draw. He relies upon August purchases of bills to provide this foreign balance. The same in principle as short selling is the finance bill al- ready described, and other similar bills. In the case of the finance bill, one bank does not merely promise to sell at a future time ; it actually does sell, in the present, a draft on another bank where it has at the time no credit balance and no deposit of discountable bills. This draft, though sold in the present, is of course for future payment. It is a draft for 60 or 90 days or for some other period. It requires to be ^'covered" before maturity. Hence it may properly be classed with or alongside of other short selling. § 10 Summary The starting point of our discussion of the rate of exchange has been supply and demand. At any given time the price, say in New York, of drafts on London; i.e. the rate of exchange on London, is fixed where supply of and demand for such exchange are equal. Thus, exchange may go above or below par, the mint equiva- lent in coinage. Going back of supply and demand, we found that these depend upon purchases and sales, investments, interest and dividends, etc. Whatever tends to increase THE RATE OF EXCtjA^G^: / ; ip? the total payments to be made by Americans to English- men tends to increase the demand here for drafts on England. Vice versa, whatever increases the total payments to be made from them to us increases the supply here of drafts on England (or decreases the de- mand). Analysis of the short time loan by a foreign bank, of the so-called finance bill, and of investment here by an American and a foreign bank for joint account, led to the conclusion that in all cases the borrower was the business firm here which profited by the loan, while the ultimate lender was the person in the London or other discount market who bought the bill and held it till maturity, or the depositors of the bank from which such a buyer obtained the means of purchase. In the case of some of these bills, most of all, perhaps, the finance bill, there is probably a tendency for more to be sold, other things equal, at those times of year when gold must otherwise be more largely exported; and to be redeemed, later, when gold must otherwise be more largely imported. The letter of credit is a scheme to get immediate payment for an exporter, a period of credit for an importer, and a chance for the exporter to make out a draft on an important financial centre and therefore a more salable draft than he might else have. As with the finance bill, short time loan, etc., the credit is really furnished by investors or by bank depositors in the discount market of the big banking centre, most likely London, where the draft is sold. Exchange is speculated in, much as are wheat, corn, stocks, etc. There may be arbitraging in exchange, i.e. sending exchange on some point, from where it is rela- tively cheap to where it is relatively dear. Exchange :i(f2: TBE^KXCHANGE MECHANISM OF COMMERCE may be, in a sense, held for a rise, thus tending to steady the exchange market and decrease the flow of specie; it is subject to "future" deahngs; it is sold "short." The finance bill is really, in principle, a kind of short sell- ing of exchange. An agreement to sell at some future date, relying upon purchases of exchange in the mean- while, to cover, is clearly selling short. CHAPTER V The Rate of Exchange and the Flow of Specie §1 The Upper Limit to Fluctuation of the Rate of Exchange, Determined by the Cost of Exporting Specie We have seen that, by the use of finance bills and other similar arrangements, the excessive obligations of a country to other countries during any short period may be in part balanced by the reverse obligations of a later period. We have also seen that, by speculative holding (accumulation) of exchange, the surplus obHgations to a country during an earHer period may be used to offset, in part, the obligations incurred by it in a later. But sometimes there will be a net balance of obKgations in one direction for several months or a year or a series of years. If so, the obligations probably will not be Hquidated for the most part by postponement or by exchange accumu- lation. The demand for bills with which to meet a long continued balance of indebtedness will hardly be satisfied by the sale of finance bills or other bills of similar nature, for the bankers of a country cannot be indefinitely add- ing to their obligations of this sort and not repaying. Neither will the supply of bills caused by a long continued excess of obKgations to a country be taken care of by speculative purchase and holding for a rise, since there is a limit to the amount which bankers can afford to invest in such speculative holding. If, therefore, our obliga- 103 I04 THE EXCHANGE MECHANISM OF COMMERCE tions are larger for any great length of time than the obHgations to us, there will be a great demand for bills of exchange with which to remit and there will be a relative scarcity of such bills. Consequently, the price of bills or the rate of exchange on other countries, which will / equalize supply and demand, must maintain a fairly high y^ average. On the other hand, if obligations to us are for y^/^ a long period in excess, the rate of exchange here, on foreign countries, must be fairly low, else the supply of drafts on these countries will exceed the demand. Are there any Hmits, upper and lower, to the rate exchange may reach ? Are there any limits, for instance, upper and lower, to the price that drafts on London may command in New York? If there are, what forces determine these Limits ? Let us consider, first, the question of an upper limit of exchange. The price in the United States, of drafts on England, will not go above par by much more than the cost of shipping specie. For if it does so, either the demand for such drafts will decrease, or the supply will increase, or both, to such an extent that supply will exceed demand. A rise of exchange above par by more than the cost of specie shipment must decrease the demand for drafts, because many of those in this country who are debtors will, if their debts are large, find it cheaper to ship specie than to buy drafts. It is true that in some cases the debts of merchants, etc., are settled by their English creditors drawing on them. But if so, the bills drawn on these Americans have to be sent to American banks for collection and these American banks must then settle with the English banks sending the drafts. And if the rate of exchange goes above par by more than the cost of shipping gold, American banks RATE OF EXCHANGE AND FLOW OF SPECIE 105 having large remittances to make will prefer to ship gold rather than to buy for shipment the more expensive bills of exchange. As a matter of fact, merchants, manu- facturers, etc., will rarely have the facilities and knowl- edge or the large indebtedness to warrant their shipping gold, and will continue to send drafts. But debtor banks frequently do ship gold. We may say, then, that at a rate of exchange much farther above par than the cost of shipping specie, the demand here for drafts on Eng- land (and other foreign countries) would fall short of the supply. Therefore, such a rate could not continue. We arrive at the same conclusion from a study of the supply side of the market. If the rate of exchange, i.e, the price of drafts, rises above par by more than the cost of specie shipment, then it will pay some banks, even though they owe nothing, to export gold. The gold will be exported to a consignee, say a foreign correspondent bank in London. Then the American bank can count on having a balance or drawing account in the London bank, in the same manner as if drafts had been sent. On this balance, the American bank can draw its own drafts for sale in the United States, at the high ruling rate, to persons having remittances to make. By so doing, the bank adds to the supply, here, of drafts on England, and the ordinary business man has no occasion, himself, to ship gold. So a rise in the price of drafts on England, beyond a certain point, will tend to increase the supply of such drafts. And at a price which exceeds par by much more than the cost of shipping specie, supply would al- most necessarily exceed demand, because the shipment of specie on which to sell drafts would be so profitable. It follows that the rate of exchange cannot, ordinarily, be expected to exceed par by much more than the gold io6 THE EXCHANGE MECHANISM OF COMMERCE shipment cost. It is kept down by forces on the supply ^ side of the market, as well as by forces on the demand side. We may fairly assume the cost of gold shipment between New York and London to be, for large quanti- ties, about $2 per £ioo, including charge for transporta- tion, insurance, and all other expenses. Then, since par between New York and London is $486.65 = £100, the price in New York of sight drafts on London could not much exceed $488.65 = £100. So soon as it gets as high as that or higher, it becomes as cheap or cheaper for New York banks to settle their indebtedness to English banks by purchasing and shipping gold as by purchasing and shipping drafts. A draft on London for £100 would cost, if exchange were at its highest point, $488.65 or more. But if $486.65 in gold could be shipped to London / for $2, making a total expense of $488.65, no New York bank, having a remittance to make, would pay a higher price for a draft. Hence the demand for drafts on Eng- land must fall. Likewise, so soon as exchange gets higher than $488.65 = £100, it becomes profitable for New York banks to purchase gold, ship it abroad, and sell drafts drawn on the credit so secured. $486.65 in gold plus $2 for shipment, loss of interest, insurance, etc., makes $488.65, total expense. The $486.65 is worth in England, mint equivalent, £100. If a draft on the English consignee for £100 will sell for more than $488.65, it is obviously profitable to ship gold and sell drafts. To ship drafts instead of gold might be less profitable, because of their high price. Because of gold shipments, the supply of drafts on England must be greater. The cost of gold shipment, however, may, under the RATE OF EXCHANGE AND FLOW OF SPECIE 107 pressure of special circumstances, go far above $2 per £100; and this cost is, therefore, a somewhat elastic rather than a definitely rigid limit to the possible rise of exchange. For example, the prospect of a great Eu- ropean war caused insurance rates on gold shipments to Europe to rise as high as i per cent on July 30 and 31 of this year (1914).^ Such charges, nearly $5 per £100 for insurance alone, at a time when there was a strong movement in foreign countries to sell securities and real- ize gold, and when, consequently, the United States was exporting gold, made possible a rise in exchange rates much above the usual upper limit. In fact, the foreign exchange market seems to have been, in this case, com- pletely demoralized by the suddenness of the crisis.^ The immediately ensuing outbreak of war on an extended scale brought a sudden check to trade in general, in- cluding the export of gold. One vessel, the Kronprin- zessin Cecilie of the North German Lloyd Company, which had left New York July 28 carrying over $10,000,000 in gold and silver consigned to Enghsh and French banking houses, returned with her cargo to the United States (Bar Harbor, Me., Aug. 4) rather than risk capture.^ §2 Some Details Connected with the Exportation of Specie A number of details of the gold export operation may now claim our attention. Let us consider first the loss of interest during transportation of the gold. If it takes seven days to transport the gold and if the draft drawn upon it is sold when the gold is shipped and goes abroad 1 See New York World, July 31 and Aug. i, 1914, *Ibid., July 31, 1914. ' New Haven Evening Register, Aug. 4, 1914. io8 THE EXCHANGE MECHANISM OF COMMERCE at about the same time, this draft can hardly be honored in less than seven days. The purchaser of the draft, there- fore, must pay for it seven days before his foreign creditor can receive the money, and so must lose seven days inter- est. The alternative to such a purchase would be to wait seven days and buy a cable. If he buys the banker's draft on the gold he will, presumably, pay very slightly less for it in consequence of this period of waiting. Accordingly, the price received by the drawing bank is very sHghtly less. Any demand draft, however, other than a cable, must suffer such a deduction for interest. / And demand drafts drawn when goods are shipped, on the consignees, cannot usually be cables, since the con- signees cannot be expected to pay for goods before receiving them. Any exporter, then, may be said to lose interest in the same way. He ships goods which may not reach their destination for several days or weeks. If they arrive on the same steamer as his draft (which is at once shipped by the purchasing American bank), the draft may be made payable at sight. But even then there is time lost. Had the goods been sold at home, this loss need not have occurred. It is one of the deductions from the benefits of trade between widely separated areas, that wealth in transit is temporarily kept out of use. The American exporter may get more for his goods, if sold in England, than he could get at home, and the English buyer may get these goods more cheaply than if he purchased them in his own country. This gain to both parties will presumably exceed all losses, including the loss of time, incident to handling and transporting the goods. Otherwise the trade would not take place. But the cost of transportation makes the net gains con- siderably less than they would else be, and the loss of RATE OF EXCHANGE AND FLOW OF SPECIE 109 time involved makes them somewhat less. The exporter of any goods, then, may be said to lose something in interest when he sells a sight draft on the consignee, though the price he receives for the goods may make the transaction well worth while. The gold exporting bank is no exception. This slight loss, however, is not ordi- narily reckoned as one of the expenses of exporting gold. The banker thinks of the price his draft brings, as his receipts, and does not regard the sKght reduction below what it would yield if collectible at once, as an expense. Insurance of the gold, transportation charges, etc., are deductions, along with the cost of the gold, from his gross returns, and these he regards as his expenses. When gold is exported, it must be assayed, weighed, etc., on arrival, and, since this requires some three days, there must be subtracted interest for that time from the shipper's gross profit. If the draft drawn upon the gold is a sight draft, it may be presented and paid three days before the gold shipped can rightly be credited to the drawer. If so, there is technically an "overdraft" on which interest has to be allowed by the American gold exporting bank^ to the EngHsh consignee bank. That is, this interest must be deducted from the balance in England on which the American bank can draw. When the American bank exports gold as the cheapest means of settling a debt, there is the same loss of time, and so, in a sense, loss of interest, during assaying, weighing, etc., as well as during transit. Still another detail should be mentioned. In New York, or at any United States sub treasury, gold is always purchasable with dollars {e.g. United States notes, gold 1 See Escher, Elements of Foreign Exchange, New York (The Bankers Publish- ing Co.), 1911, PP- 114, 115- no THE EXCHANGE MECHANISM OF COMMERCE certificates or silver) at the same rate or price. An ounce of pure gold is always worth $20,671, and an ounce of gold 9/10 fine is worth $18,604. The sub treasuries aim to have bar gold available, but if the supply is exhausted, then gold coin can be secured for export. There is no question, therefore, here, as to the cost of the gold to be shipped. But there is some variation in the amount of coin of the realm w^hich the specie may be worth on arrival in Great Britain. This is because, while the bank of England is by law compelled to pay £3 175. gd. per ounce for gold, the mint equivalent of an ounce is £3 175. io\d. Any one can get the larger amount for his gold by waiting to have it coined. But on account of the delay and consequent loss of interest while the gold is being coined, together with the labor of weighing and assaying, the bank is not compelled to give the mint par for gold; though, to relieve others of the necessity of waiting, it is under obligation to give for it the somewhat less price stated above. The bank, how- ever, may have sufficient use for gold, for reserve, export, or other purpose, so that it will bid the full mint price or even more. If all gold coins were full weight, the bank would never bid more than the mint price, since coined gold could be used and it would be cheaper to use coined gold for any purpose for which the gold bars (or bullion) might be desired, than to pay a higher price for the latter. The price of gold would, in that case, fluctuate between £3 175. ()d. and £3 17^. io\d. In fact, it may and some- times does go slightly above the latter price, because the bank may be purchasing gold with worn coins, which, while within the legal Kmit of tolerance in England, would have to pass by weight if exported. The American bank which exports gold to England cannot tell, there- RATE OF EXCHANGE AND FLOW OF SPECIE iii fore, just what it will be worth on arrival (though doubt- less some one could be found to guarantee a price). The money value on arrival will depend, slightly, on what is being offered for gold at the time. Sometimes the export of gold involves a triangular operation.^ For instance, Ba wishes to get a balance with Be in England, on which to sell drafts. Drafts on England, here, are high, and Ba does not wish to buy any in such a market. But it may happen that in Paris, drafts on London are below par. The high rate in New York of drafts on Paris, however, tends to discourage arbitraging. Instead, Ba can ship gold to its Paris correspondent, Bf, and order the Paris bank to buy a draft on London. This draft is sent to London for dis- count, and Ba then has a balance in London, with Be, on which it can draw at a profit above cost. §3 The Lower Limit to Fluctuation oj the Rate of Exchange^ Determined by the Cost of Importing Specie As the rate of exchange has an upper limit, though of course a sUghtly elastic one, so also it has a lower limit. If exchange falls below par by much more than the cost of importing specie, either the supply of drafts on foreign countries must decrease, or the demand for such drafts must increase, or both, to such an extent that sup- ply exceeds demand. The supply of drafts on foreign countries would tend to decrease, because those having collectible debts abroad in any considerable quantities, on which they desired to realize, would find it cheaper to pay for the importation of specie than to sell at so great * See Escher, Elements of Foreign Exchange, p. 120. 112 THE EXCHANGE MECH.\NISM OF COMMERCE a discount, drafts on their foreign debtors. Suppose, for example, that exchange in New York on London were below $484.65 = £100. Then any New York bank, or other person, desiring to call back funds h^ld in London or to collect a debt from there, would prefer to pay $2 per £100 for importation, and have $486.65 minus $2, or $484.65 for each £100, than to get less than that amount by selHng a draft at a very low rate of exchange. This applies, of course, only when the circumstances (or agreement) are such that the creditor is obliged to bear the risk of exchange fluctuations. Otherwise, the debtor would be expected to remit draft or specie. But wher- ever settlement is to be made at, in this regard, the creditor's risk (and this might be the case, for example, where a creditor bank has decided to withdraw funds which it has itself put on deposit abroad) , the effect of a very low rate of exchange on any point would be to decrease the supply of drafts on that point and substitute importation of specie. With exchange so low, it would pay better for banks to withdraw their balances from abroad than to sell drafts upon those balances. A low rate of exchange, below $484.65 = £100, would also tend to increase the demand for drafts. For such a rate of exchange would make it worth while to import gold for profit. £100 of full weight English money would be worth, in this country, $486.65. Subtracting $2 as cost of transportation, insurance, etc., there is left $484.65. If the gold can be purchased with a draft on an English bank, a draft which, because of the low rate of exchange, costs less than the above sum, the operation is profitable. (It is not intended to assert that the im- portation of so small a sum would be profitable. Rather is it here assumed that the £100 is only a part of a much RATE OF EXCHANGE AND FLOW OF SPECIE 113 larger sum.) The low price of drafts, then, stimulates the demand for drafts as a means of paying for English gold. Thus, on the supply side as on the demand side, there is a Kmitation on the extent to which exchange can fall. The lower limit of exchange fluctuations, like the upper limit, is not, however, absolutely and permanently fixed, since the cost of shipping gold may vary, — for example, by higher insurance rates in war time. In practice, the ordinary business man does not himself import gold but takes advantage of the demand for his drafts by banks which use the drafts to pay for gold. With importation of gold from England, as with ex- portation to England, allowance must be made for the possible slight fluctuation in the price of gold in terms of pounds sterling. §4 Circumstances which May Cause the Rate of Exchange to Fall Below what is Usually its Lower Limit But the rate of exchange may sink considerably below what is ordinarily the gold shipping point or so-called specie point, in times of panic or of great financial disturb- ance accompanied by a relatively large supply of ex- change.^ The principles involved are the same at such times as always, and the factors to be considered are the same, but one of these factors, loss of time or loss of in- terest, comes to have exceptional importance. If, when panic conditions prevail, sellers of goods have bills on for- eign purchasers, they will be anxious to realize on these bills at once. In a crisis, both cash and credit are rel- atively hard to get.^ At the peak of the crisis, there is a so-called stringency. Interest rates are high. The sellers of ^ See Goschen, The Theory of the Foreign Exchanges, London (Effingham Wilson), 1896, pp. 49-52 ; also Bastable, The Theory of International Trade, Lon- don (Macmillan), 1903, pp. 85, 86. » See Ch. II (of Part I), § 7. 114 THE EXCHANGE MECHANISM OF COMMERCE drafts do not want to lose interest and will, therefore, seU at a low price so as to get cash immediately. Especially if their creditors are pressing them hard or bank loans are difficult to get, they must make the most of every avail- able resource, at once. Rather than wait for importa- tion of gold, they would sell drafts at a considerable reduction below the usual price. It is the same when the creditor is a bank. If, at such a time, it has occasion to draw on a foreign balance, it will desire, like others, to get control of such resources at once, and may accept an unusually low rate of exchange rather than resort to importation. Neither will a bank, at such a time, be likely to import gold for profit unless the profit is excep- tionally great. To buy gold abroad is to subject itself to a considerable wait pending the arrival of the gold, during which time part of its funds are unavailable for other business. But during a crisis a bank is least Hable to desire, even temporarily, to part with funds. It will be induced to do this only by hope of an exceptional profit, only, that is, if the price of the exchange which it must use to buy foreign gold is below the usual gold importing point. Some few creditors may be in a posi- tion to secure immediate payment by cable. But those whose claims are based on the export of goods cannot expect thus to be paid in advance of the goods' arrival. Furthermore, at a time when the balance of indebtedness is from foreign countries to us (and it is such a time that we are considering), a part of that indebtedness must be settled by shipments of gold and so necessarily requires an interval of waiting while the gold is in transit. It is this necessary wait, most unwelcome at a time of stringency, which forces the rate of exchange below the usual specie point. RATE OF EXCHANGE AND FLOW OF SPECIE 115 §5 The Cost of Money Shipment in Domestic Exchange It should be noted that the principles of domestic exchange are not different from those of foreign exchange. Money has to be shipped from one part of the United States to another, as it has to be shipped between coun- tries, and it costs something to ship it. But in domestic exchange the distances average less and the expense is smaller. The express companies will carry $1000 from New York to Chicago for 40 cents.^ To carry $486.65 across the ocean, pay for insurance, weighing, assay- ing, etc., costs about $2 (in large quantities), or over $4 per $1000, making an expense more than ten times as great. Of course even the trifling charge of carrying money about our own country might well affect the price of drafts to that extent, and in fact it does so when banks buy and sell domestic exchange of and to each other. But in dealing with customers, it is usual for the banks to pay no attention to this expense. On the contrary, they pay to their customers when buying the latters' drafts, and charge them when selling drafts to them, a more nearly flat rate, which includes only a proper fee for bank services, reasonable interest for time elapsing before maturity, and reasonable insurance for the possibility of non-payment. The up and down fluctuations of ex- change between the shipping Hmits are borne by the banks, and, since they gain about as much by one set of fluctuations as they lose by the reverse changes, they just about make, on the average, a fair return for their service to the community. ^ See Taussig, Principles of Economics, New York (Macmillan), igii, Vol. I, p. 466. ii6 THE EXCHANGE MECHANISM OF COMMERCE As a matter of fact, such a small proportion of the total business done requires shipment of actual money that the expense, considering the low cost of domestic shipments, may well be regarded as negligible. To illustrate, a New York bank might have sold $1,000,000 of drafts on Chicago and bought $998,000 of drafts on Chicago. It might then be necessary to ship $2000 to Chicago at a cost of 80 cents. But this would be an expense for the entire business transacted, extremely small, and the bank might well ignore it. At any rate, such, in domestic exchange within the United States, is the custom. §6 The Long Run Effect of a Balance of Payments from One Country to Another, for Commodities or Services So far we have discussed chiefly the more immediate efifects, upon the exchange market, of given conditions. Let us now consider some of the long run or ultimate effects. These depend mainly on the relative prices or levels of prices of goods in different countries. We have seen that the determination of the level of prices in any country is expressed in the equation MV + M'V = pq + p'q' + etc., where M is money, M' is bank deposits, V and V are velocities of circulation, the p's are the prices respectively of different kinds of goods, and the q's are the quanti- ties of these goods. We have seen, also, that M' tends to increase or decrease in sympathy with M. We have, therefore, drawn the conclusion that if, in any country, M increases faster than the q's, prices will rise, while if M decreases, they will fall. RATE OF EXCHANGE AND FLOW OF SPECIE 117 Bearing in mind these facts, lef" us now consider the long run influences of the following sources of exchange, on the rate of exchange and on the flow of money : a — Payments for commodities. a' — Payments for services, e.g. freight, banking, etc. h — Payments of funds for investments, e.g. interna- tional lending and investing. c — Payments of interest, dividends, etc. on such invest- ments. c' — Payments from home funds to persons of one sec- tion or country, travelling in others. c" — Payments to families of immigrants. Regarding payments for commodities, it is to be noted that these are generally purchased where they can be got most cheaply. If we can buy most commodities more cheaply in England than here, then there will be a demand for exchange on England with which to pay for them, and exchange on England will rise. If such a condition (large purchases from England) lasts for any great while, the rate of exchange will probably go high enough to encourage the exportation of gold. As a consequence, since in each country there is a relation between gold bullion and money ,^ M, and therefore M' also, will increase in England and decrease here. Prices will rise there by comparison, and fall here. We shall cease to buy so much in England, and England will buy more of us. Great purchases by us of foreigners tend, therefore, to cause great purchases by foreigners of us. Money flows one way or the other because commodities are pur- chased, all things considered, where they are cheapest. Briefly, commodities are bought where prices are low; the rate of exchange elsewhere on these low price places 1 See Ch. I (of Part I), § 7. ii8 THE EXCHANGE MECHANISM OF COMMERCE is therefore high ; gold is therefore shipped to the low price places, and, since it is in large part coined, because of the law of flow between bullion and coin, prices in those places tend to rise. Though equihbrium is ever being departed from, it is ever tending to be restored. But this does not mean that if, for instance, wheat is cheaper in the United States than in England, and Eng- land buys wheat of us, we then, when Enghsh prices have fallen and ours have risen, begin in turn to buy wheat of England. Wheat never becomes cheaper there than here. What is more likely to happen is that, when our prices rise and theirs fall, they will buy less of our wheat than before, and either raise more themselves, buy more elsewhere, use a substitute, or simply get along with less. We, on the contrary, when prices have fallen in England and risen here, will perhaps buy more cotton cloth in England, and either make less here, buy less else- where than in England, substitute it for another kind of cloth, or use more cloth. A purely superficial consideration might lead to the conclusion that we can always buy goods in England more cheaply when exchange on England is low. A lot of Enghsh goods worth £ioo or, in our money, at the mint equivalent, $486.65, might cost $489 if exchange were high and only $484 or some $5 less, if exchange on Eng- land were low. But the conclusion that low exchange on England means an opportunity to buy goods there more cheaply appUes with certainty only on the supposition that other things are equal. And the very fact that exchange on England is low is evidence that other things are not equal. Low exchange on England indicates, as we have seen, a large supply of drafts on England. Therefore it probably indicates that we have been selling RATE OF EXCHANGE AND FLOW OF SPECIE 119 to England a relatively large amount and buying from England a relatively small amount of goods. The pre- sumable cause of this situation is relatively high prices there and relatively low prices here, as compared with other times or seasons. To be specific, at the time when low exchange would enable us to buy in England £100 worth of goods for $484, it is probable that prices in England are comparatively high and that £100 will buy less there than at other times, compared with what money will buy here. Expressing the fact in general terms, we may say that, when money has flowed from here to England in such quantities as to make their prices higher and ours lower, it pays to sell to them rather than to buy from them, even though, at such a time, exchange on England is below par. Low exchange on foreign coun- tries does tend to stimulate importation, and high exchange to stimulate exportation, but exchange fluc- tuations are too narrow to be of determining influence. If, for example, Americans purchase largely in England, the necessity of remitting will make exchange on Eng- land high, and will in so far discourage further purchases from England, while encouraging sales to England and encouraging English merchants to purchase goods here. But exchange cannot rise high enough to influence, very strongly, the importation and exportation of other goods, because so slight a rise causes shipment of gold (which, because of its great value in small bulk, is inexpensive in proportion to value, to ship) } It is quite likely, then, that excess buying of Americans from abroad, will not be checked or give rise to corresponding purchases by foreigners from this country, until a flow of gold has changed relative price levels. » Cf. Ch. VI (of Part I), § g. I20 THE EXCHANGE MECHANISM OF COMMERCE Payments for freight, banking, and other services affect exchange in the same way as do payments for commodities. For example, payments for ship trans- portation services are supposedly made where these services can be secured most cheaply. Thus, a maritime nation like Great Britain could sell to us the services of her ships; and the resulting flow of money towards Great Britain and higher prices there of various goods, would give rise to their purchase of such goods, e.g. wheat, from us. Great Britain might be said to export transportation, banking, and other services, and to import food. Summarizing the conclusions of this section and com- bining them with previous conclusions, we may assert (i) that the rate of exchange in one country on another depends upon the supply of and the demand for drafts ; (2) that the supply of and demand for drafts depends on tlie direction of obligations and other occasions for mak- ing payments between the countries ; (3) that the direc- tion of obHgations, etc., depends largely upon the surplus of commodities and services purchased by one country of another ; and (4) th at the sur plus of commodities and services purchased by one country of another depends upon the relative prices of those commodities andser-. vices in (or as sold by) the countries concerned. §7 The Long Run Effect of International Investments upon the Rate of Exchange and the Flow of Money We have next to examine the long run effect of inter- national (or interterritorial) investments upon the rate of exchange and upon the flow of money. If, for example, RATE OF EXCHANGE AND FLOW OF SPECIE 121 Englishmen invest in the United States, if we borrow of them or sell securities and other property to them, what is the immediate effect? It is to increase the supply, here, of drafts on England, or decrease the demand for such drafts,^ and so to lower the rate of exchange on England; and to increase the demand in England for drafts on the United States, raising there the rate of exchange on us (though this fact is obscured by the cus- tom of quoting the rate in England, as here, in American money). Then it becomes worth while for American banks to import and for English banks to export, gold. As a second consequence, therefore, gold flows from England to the United States. Since much of this gold, because of the laws of interflow between gold bullion and gold coin 2 is a subtraction from English money and an addition to American money, prices will tend to fall in England and will tend to rise in the United States. Then it will become profitable for us to buy more goods in England, while England will buy less goods of us. As a next consequence, the obligations from us to them will be in excess, and the rate of exchange on London will rise. Therefore, gold will be shipped back again in return for other goods.^ This return flow must continue until English and American prices (supposing no new influences to intervene) are in about the same relation as before the lending or investing began. That means that in each country the quantity of money must be in about the same relation as before to the quantity of goods. Speaking roughly, we may say that the invested money flows back for goods, or that what is really invested is 1 See Ch. IV (of Part I), § 2. 2 See Ch. I (of Part I), § 7. » See Taussig, Principles of Economics, pp. 468-471. 122 THE EXCHANGE MECHA>ftSM OF COMMERCE usable capital. If Englishmen invest in the securities of a new American railroad, what we really get from England may be steel rails, engines, etc., or cloth, coal, and other goods to be consumed by us while we are mak- ing tlie rails and engines. International lending and investing is most decidedly a lending and investing of capital wealth in such forms as are here suggested, and not merely a flow of money. Foreign investments here may, in fact, take largely the form of usable capital, without the intermediation of these stages of inflow and outflow of money. The fall in the rate of exchange on foreign countries, consequent on such investments, itself tends to make foreign goods slightly cheaper in terms of American money and so to encourage, somewhat, importation of usable capital, even before the tendency to importation is accentuated by the change in relative price levels.^ And if gold does flow in to some extent, the tendency for it to flow out for other goods may show itself so quickly that, aside from the first slight inflow, the purchase of capital goods abroad keeps pace with the investments made by foreigners here. In effect, the foreign investors send us, perhaps almost at once, capital other than money. §8 The Long Run Effect of Various Other Payments from One Country to Another The third group of purposes for which bills of exchange and money are sent from country to country, is to pay interest, dividends, and profits on investments, to send remittances to persons travelling abroad, and to send » Cf. § 6 of this chapter (V of Part I). RATE OF EXCHANGE AND flOW OF SPPCIE 123 remittances to the families of immigrants. We have just seen that, when foreigners invest here, such invest- ment, in the long run, is an investment of consumable goods, or of the machinery of production, or both. In the long run, what flows here is goods rather than money. After a time, interest is earned on the bonds foreign investors have purchased, dividends are declared on the stock, etc. Having secured the use of for^i^n capital, we must pay interest on it. There arises then a demand for exchange on foreign countries in order to pay these investors their profits. This demand makes exchange on foreign countries high (while on us it is low), and it becomes worth while for gold to be shipped from us to them. The same kind of result occurs if and when the invested capital is itself repaid (i.e. if American investors buy back from foreigners American land, securities, etc.). Consequently foreign prices tend to rise and ours to fall. Therefore, foreigners buy more goods of us than previously, and the money flows, chiefly,^ back here. In the last analysis the interest and dividends received are practically all in the form of food, raw material, manufactured goods, etc., and are not merely money. So, in the last analysis, remittances to Americans travelling abroad and to the families of immigrants, have the same result. Our countrymen travelHng abroad receive from home, in the long run, not money, but goods. Of course they may purchase chiefly European ^ Not, perhaps, entirely, because the somewhat larger amount of goods in foreign countries, consequent on the flow back to us, for goods, of the interest and dividends money, may require a little more money to be circulated. But the rapidity of circulation of money and the fact that it is the basis for bank credit circulating even more rapidly, would seem to signify that a very large increase in the quantity of goods abroad would call for but a slight increase in money. 124 THE EXCHANGE MECHANISM OF COMMERCE goods, but, if so, they thereby put some Europeans in a position to get American goods. In the long run, it is chiefly goods other than money which flow in trade. §9 Summary Though the use of bills of exchange obviates, to a large degree, the necessity of shipping money or gold, never- theless, as we have seen,. balances must be thus settled. A continuous balance of obligations in one direction will cause gold to be shipped, by affecting the rate of exchange. It will become cheaper to settle indebtedness by shipping gold, and the exportation or importation of gold may be undertaken for profit. A high rate of exchange, here, on any country, will cause shipments of gold to that country ; a low rate will cause importations of gold from that country. Exportation of gold to any country will tend to keep down the price of drafts on that country by decreasing the demand for them (debts being settled by gold) and by increasing the supply of them (drafts being drawn on consignees when gold is shipped for profit). Importation of gold from any country will, analogously, tend to keep up the price of drafts on that country by decreasing the supply of drafts (gold being imported instead of drafts being drawn), and by increasing the demand for them (to purchase foreign gold imported for profit). The rate of exchange can, therefore, go above or below par by only about the cost (with perhaps a reasonable profit) of shipping specie. But at a time o^ stringency, when most business men in a country desire to secure funds as quickly as possible, the rate may go somewhat lower than what would usually be the gold importing point. RATE OF EXCHANGE AND FLOW OF SPECIE 125 In the long run, specie tends to flow to those places where other desired goods are cheapest (and specie, therefore, of most value or purchasing power in com- parison with those goods), and from places where goods other than money are high. So lending and investing between countries is really, in the main, a lending and investing of capital goods rather than money ; for the flow of money changes the relative levels of prices of the countries concerned, and brings about a reverse flow. The same principle appHes to the payments of interest and dividends, remittances to persons abroad, etc. The use of bills of exchange and money complicates these business relations of countries and territories; but it does not change the essential fact that trading, lending, investing, and profiting involve, in the last analysis, capital and consumable goods rather than money. Money (as well as bills of exchange, etc.) is a part of our machiner}^ of production, but only a part, and it is as a part of this machinery that it is of use in international and interterritorial business relations. FxjRTHER Considerations Regarding the Rate of Exchange §1 The Price of Long Drafts Determined in p^ri by the Rt^ of Interest or Discount The price, here, of bills of exchange on any given country, at a given time, may be^regarded as being made up chiefly of two factors. These are, the rate of Interest Cj / or discount, and the pure rate of exchange. The pure (^'^ rate of exchange is the rate on demand or sight drafts. As to these there is no element of time except, of course, the time required for the carriage of the drafts from the one country to the other. Ignoring the sHght interest thus involved, some -^V of the yearly rate, we may say that the rate of exchange on sight drafts is pure exchange. It is the rate of exchange on sight drafts, which we have in mind when we say that exchange can ordinarily fluc- tua^_only.between the specie points or shipping Kniits. But with other drafts, the rate of interest or discount is an important fact to consider. Many of these drafts are drawn to run for periods of 60, 90, and even 120 days after sight. Since payment on such a draft can- not be required before maturity, the investing pur- chaser of the draft is in the position of a lender or in- vestor until then, unless, of course, he sells to another. As a lender or investor, he will wish to get interest on his investment, and since the amount he is to receive at 126 flM^THER CONSIDERATIONS ON EXCHANGE 127 maturity is definitely fixed, he can secure interest only by paying somewhat less than this amount when he buys the draft. In short, the investing purchaser must dis- count the draft for the time it has to run, and the amount of this discount will depend upon the rate of discount or the rate of interest. Since the investing purchaser is sure to discount the draft, the exchange bank which buys it in the first instance, intending to have it sold in the exchange market, must also discount it. Thus, even if exchange here, on England, were above par, say $488.65 = £100, a draft for £100 having some time to run might, because of the element of time, be selling for $482. It may be noted in passing that an importer can, in effect, secure a cash discount on his purchases by remit- ting a 60-day or 90-day draft. Suppose he has pur- chased £100 worth of goods in London, payment to be made in 90 days. If it is agreed that he shall remit, he can, just before maturity of the debt, buy a draft and send it. But he can also, if he prefers, buy immediately a draft payable in 90 days. If he does this, he will get the draft at a discount. His goods will cost him less because he is prepared to pay at once. As a matter of fact, banks frequently sell such time drafts to importers. §2 How Long Drafts on Foreign Countries are Held as Invest- ments by American Banks The fact that many drafts run for periods of several months and, being purchased at a discount, yield interest to the holders of them, makes these drafts desirable as short term investments. Sometimes the bank which 128 THE EXCHANGE MECHANISM OF COMMERCE originally purchases long drafts, in the *' drawing" country, prefers to realize this interest, rather than to have such drafts sold at once in the discount market of the *' accepting" country. Let us suppose that for a time the discount rate on safe drafts, in the German market, is 7 per cent, while conditions of business in the United States are such that American banks cannot earn more than about 5 per cent on their capital used at home. Under these conditions, an American bank purchasing drafts on Qcrn^f iiy, having some time to run, would probably not send them to Germany for imme- diate discount at the comparatively high rates there prevailing ; but would be more apt to hold them in its own vaults, or have them held for its account by its German correspondent, until maturity or near maturity, in order to reahze a larger sum. Before describing the method of procedure commonly followed when drafts on foreign countries are held in its own vaults for investment by an American bank, it is essential to note that bills of exchange or drafts used in international trade, are generally made out in duplicate, the different copies being known as firsts and seconds. This has long been the custom in such trade, as a safe- guard against possible loss or miscarriage of one of the drafts. Whichever draft first reaches its destination is presented for acceptance, and when it is paid the debt is cancelled. Extra copies of bills of lading and other documents may also be made. Consider now the procedure which may be followed by the investing American bank in holding the drafts on Germany.^ On the day of purchase by an American 1 Described in Margraff, International Exchange, Chicago (Fergus Printing Co.), 1903, p. 61. FURTHER CONSIDERATIONS ON EXCHANGE 129 bank of drafts on German banks or merchants, the '^firsts" of these drafts or bills of exchange are not indorsed by the American bank to the order of its German correspondent, as would be done if the drafts were to be sent over for immediate discount and credit or for holding abroad subject to cable order. On the contrary, there are written on the faces of these firsts the words ''for acceptance only." Then the German correspondent bank to which the drafts are forwarded, is requested to have them "accepted," and to hold them subject to the call of the seconds properly indorsed by the American bank. Any dupHcate documents, such as dupUcate bills of lading, attached to the seconds, are detached and sent to the German correspondent bank, which is instructed to turn these documents over to the drawees provided the latter accept the drafts. The seconds, clean of all other papers, are kept by the invest- ing American bank. On the face of each of these seconds is written: "Accepted firsts held by — — ," giving the name of the bank to which the firsts were sent. The American bank gets as profit the difference between the discounted value paid for the drafts and the amount realizable from them at maturity, minus the corre- spondent's commission. When the date of maturity approaches, the American bank will indorse the seconds, presumably to the above described correspondent bank, and forward them to it for credit. As a matter of fact, the American bank need not, if it prefers otherwise, send the indorsed seconds to the foreign bank which holds the firsts. The seconds can, if occasion requires, be indorsed to any bank, for the firsts are held subject to the call of the indorsed seconds, and must be handed over (or credited, as the case may be) K I30 THE EXCHANGE MECHANISM OF COMMERCE on presentation of these indorsed seconds.^ The two together constitute a completed bill. The drafts may be so indorsed and forwarded to the correspondent bank for discount and credit at any time when rates of discount make it seem profitable to send them.2 They are not necessarily held until maturity. But, in any case, the amount realized (minus commis- sion) is placed to the American bank's credit, and it can then sell drafts on this credit. Of course, the investing bank takes some risk of fluctuations in the rate of ex- change. If the rate falls, the bank will get somewhat less when it sells its drafts on this credit. If, on the other hand, the rate of exchange on Germany was low when the American bank bought the drafts for invest- ment, so that they could be purchased more cheaply, and is high when the bank is ready to sell its own drafts on the credit secured (at maturity or before), then the bank will realize an additional profit. But the American bank, even if desiring to avail itself of higher interest rates existing temporarily in Germany, will often prefer to indorse the drafts it has purchased to its German correspondent, and have them held by the latter, after acceptance, subject to instructions by cable. An advantage of this method lies in the possibility of immediate sale at any time before maturity if low dis- count rates make it desirable to have the drafts sold. If to have them sold does not appear to be profitable, they can be retained till maturity for account of the remitting bank. 1 Margraff, International Exchange, p. 65. ' Ibid., p. 63. FURTHER CONSIDERATIONS ON EXCHANGE 131 §3 Influence on the Price of Long Drafts, of Interest Rate in Drawing Country and of Interest Rate in Country Drawn Upon We have seen that the prices of bills of exchange, other than sight bills, depend upon the rate of interest. We have also seen that bills of exchange involve two trading countries ; and in the previous section attention has been called to the fact that the rate of interest in one such country may be different from the rate of interest in the other. Which of the two rates of interest or discount will, in such a case, determine the price of a bill of exchange drawn in one country on the other ? ^ In the first place, let us suppose interest to be com- paratively high in the country where the bill in question is drawn, say the United States, and comparatively low in the country on which it is drawn, say England. On this assumption, the amount of the discount, and, therefore, the price of the draft, will depend on the rate of interest or discount in the country on which the draft is drawn, viz., England. For if the rate of discount in England is very low, then the draft will sell, in England, for a high price, that is, for a price comparatively near the maturity value. And since it will thus sell in the EngHsh discount market for a high price, therefore the American bank which first allows cash for it to a mer- cantile or other estabHshment, can afford to pay a high price for the draft. The American bank which buys the draft does not need to wait until maturity to realize on it, but can have it discounted immediately on its arrival ^ The reasoning here followed is that of Goschen, The Theory of the Foreign Exchanges, third edition, London (Efl&ngham Wilson), 1896, p. 137. ^^ 132 THE EXCHANGE MECHANISM OF COMMERCE at London. The American bank does not need to lose, for a long period, the use of its capital. As a conse- quence, competition among American banks will force up the price of such drafts to somewhere near what they will bring in the English discount market. Our conclu- \ sion must be that if the interest rate in the country- drawn upon is the lower, this interest rate determines the price of long drafts in the drawing country also. But suppose, on the other hand, that the rate of inter- est is higher in the country drawn upon, say England, than in the drawing country, the United States. On this hypothesis, a draft on England would be discounted in England at a comparatively high rate, that is, would bring a relatively low price. Would its price be equally low in the drawing country? Certainly if the pur- chasing bank in the United States intended to send the draft at once abroad for discount, such a bank could not afford to pay more. To do so would mean a definite loss. But, on our present hypothesis, a draft purchased at the low price based on the discount rate in England, will yield a greater return on the investment than the prevailing rate of interest in the United States, the draw- ing country. Competition among banks in the drawing country, desiring to invest in such bills of exchange, may, therefore, raise the price of the draft slightly above its value in the country drawn upon ; for even then it will bring a larger return by way of interest than is being realized generally in the drawing country. The seller of the draft may hope to get for it a Httle more than the price it would bring in England, while the purchasing bank realizes more than the rate of interest in the United States, enough more to induce this bank to buy and hold the draft as an investment, or have it held for its account FURTHER CONSIDERATIONS ON EXCHANGE 133 abroad. When, therefore, the rate of interest is lower in the drawing country, the price of the draft will be determined, at least in small part, by that rate of interest. It should be added that if conditions change during the life of a draft, so that interest is lower in England, such a draft held here as an investment is likely to be sent there for immediate discount at the high price realizable. As a matter of fact, the discount rate in London, as also in other great European centres, is almost always lower than in New York. The usual rule, therefore, is for American banks to have their drafts on England discounted there at once. Their capital can be more profitably invested at home than in holding long drafts on English debtors. On the other hand, Enghsh banks do not have long drafts which they buy on Americans, discounted in the United States. The absence, here, of a rediscount market, makes it practically impossible for them to do this, though the usually higher rates of dis- count prevailing in the United States might, in any case, disincline them to have such drafts sold on this side. There are, in practice, very few long bills drawn upon the United States, and such long bills as are drawn upon this country are usually held till maturity, for account of the foreign remitting banks, by their American correspondents.^ §4 ^^ How and Why the Bank Discount Rate Affects the Price oj Demand Drafts and the Flow of Specie Changes in the relative rates of interest in different countries affect, temporarily, rates of exchange and the flow of specie; though such changes in relative rates 1 See Ch. Ill (of Part I), § 8. 134 THE EXCHANGE MECHANISM OF COMMERCE of interest do not permanently affect the international distribution of specie, independently of comparative price levels. For example, much is said of the influence on the rate of exchange and on the flow of gold, of the Bank of England discount rate. If the Bank of England, because of too rapidly expanding loans or because of depletion of reserves, raises its rate of discount, being followed in this move by the other English banks, its doing so has a tendency to lower the rate of exchange in England on the United States and other countries, and to raise the rate in the United States and elsewhere on England. It has this effect because the increased interest in England tempts to investment there rather than in the United States. English banks are more likely to invest current funds at home, and may even draw on debtor banks in the United States and other countries. American and other banks may be tempted to make short term loans in England or to hold or have held until maturity, long bills which they would otherwise have immediately discounted. This holding of drafts until maturity will compel them to buy more drafts on Eng- land than otherwise would be necessary, in order to maintain their usual balances. The general result of a high discount rate in England is, therefore, a high rate of exchange on and a flow of gold to England.^ Similarly, a sharp rise in the discount rate in New York would tend to produce elsewhere a high rate of exchange on New York, and would tend to cause a flow of gold to New York. But we have seen that the flow of gold from country to country is determined by comparative prices of goods. If, because of a high discount rate in England, gold flows 1 Goschen, The Theory of the Foreign Exchanges, third edition, pp. 129-140. FURTHER CONSIDERATIONS ON EXCHANGE 135 to England in large quantities, so that prices rise there and fall here ; then England becomes a good place to sell to, and the United States (and other countries) by comparison a good place to buy from. The gold will therefore flow back for goods until prices are, relatively, what they were before. Americans, or American banks, who have invested in England because of the high rates- of interest there, will have invested, in fact, not money but other capital. But at this point a qualification must be made, based fs on the fact that the bank rate of discount influences, in- directly, the prices of goods. The bank discount rate in- "^ fluences prices by affecting credit. It was pointed out, in 1 Chapter II (of Part I) ,^ that the general level of prices in a modern industrial and commercial community or coun- try is determined not alone by the quantity of money and its velocity of circulation and by the volume of trade, but also by the amount and velocity of bank credit. The relationship set forth was expressed in the equation, MV + M'V' ^ pq-{- p'q' + etc. Ordinarily, it was shown, M' maintains a fairly constant rather than a violently fluctuating ratio to M. The total amount of this M' or bank credit in a community will depend partly on the business needs and customs of that community, but partly, also, on the quantity of such credit which the banks can safely keep in circula- tion with a given support of cash reserves. If lack of confidence depletes these reserves, or if banks have expanded their credit too far for their reserves safely to support, contraction of this credit is necessary. The banks discourage borrowing, and so decrease the amount »§6. 136 THE EXCHANGE MECHANISM OF COMMERCE of circulating bank credit by charging higher interest to borrowers, i.e. by raising their rates of discount. Suppose, then, that because of a condition of business distrust and comparatively small reserves, the Bank of England and other English banks raise their rates of discount. As a consequence, there is a fall in the rate of exchange on New York, and, in New York, a rise in the rate on London. There follows a flow of gold to London and the bank reserves there are replenished. But this gold does not, at least for the time being, raise English prices and result in a corresponding flow of gold back to the United States (and other countries) ; for the increase of the bank charges on loans discourages borrowing from banks, and so tends to decrease M'. In the equation, MV + M'V = pq + p'q' + etc., for England, the p^s may not be at all increased or may even be decreased.^ Only when bank credit, in England, is again allowed to expand, will the full effect of the inflow of gold be felt in higher prices. So long as high discount rates keep the total of circulating bank credit in England less than before in relation to money, the inflow of gold does not so much raise prices as substitute itself for bank credit. Hence, gold will not flow out again, for goods.^ 1 Cf. Goschen, The Theory of the Foreign Exchanges, p. 129, where this idea, though not developed, seems to be implied. ' Just before the outbreak of the European war now (August, 1914) in progress, the efforts of European investors to dispose of securities for gold and the closing of the principal bourses of the world, caused a flood of sales on the New York stock exchange, large piirchases of these securities by Americans, and an unusually strong tendency for gold to flow abroad. In view of the sudden- ness and violence of the movement, it was perhaps not unwise that the New York stock exchange should be temporarily closed (see New York World, August I, 1914) and that the sale of securities here by foreigners should thus be made diflScult. It is true that the flow of gold abroad (and we are not here concerned with any other reason for the closing of the exchange) is not ordinarily a proper cause for alarm, can be checked by a rise in bank discount rates if such a check is necessary, and will in any case, if long continued, give rise to a re- FURTHER CONSIDERATIONS ON EXCHANGE 137 f'is Effect of a Panic in One Country on Conditions in Other Countries Since prices and interest rates in different countries are related, a panic in one country cannot usually be altogether without effect on other countries having close commercial relations with it/ though these other coun- tries may not be affected acutely. When, for any reason, in a country of large commercial importance, business confidence gives place to acute distrust, and the banks, with reserves depleted or fearing that the reserves will be depleted, raise their discount rates, their action will affect discount rates in commercially related countries. The strain on the bank reserves of the first country, and the rise of the discount or interest rate, tends to draw gold from other countries. This will tend to deplete the bank reserves of those countries in relation to circulating bank credit. Either the gold will come directly from these bank reserves as when it is drawn from the great central banks of Europe for export, or it will come indirectly but just as surely from bank reserves, as when gold is bought for export from a United States sub treasury and is paid for by lawful money which might otherwise be used as reserves.^ turn flow. Yet so unprecedented a movement as the recent one here under discussion, might conceivably, if met only by a rise in the discount rate (which would also have to be great and sudden), dangerously and, considering the probable temporary nature of the crisis, unnecessarily disturb credit conditions. ^ Cf. Fisher, The Purchasing Power of Money, New York (Macmillan), igii, p. 267. ' Even if the gold is purchased with bank credit, the reserves become smaller in proportion as compared with the total amount of such credit ; and they tend (since, as we have seen — Ch. II, § s — business men keep some relation between their bank accounts and cash assets, and will draw out cash if the latter become relatively too small) to become absolutely smaller. 138 THE EXCHANGE MECHANISM OF COMMERCE The conclusion is that in any case the banks in those countries from which the gold is drawn, will also have occasion to raise, somewhat, their discount rates, in order to keep their reserves and their deposits (and notes) in proper relation to each other. And if contraction of credit causes a fall of prices in one country, the mitigated effect of this, at least, must spread to other countries. It does not follow that a severe panic in one country must be accompanied by or succeeded by a correspond- ingly severe panic in others ; but only that in each of a group of commercially related countries there will be practically simultaneous rises in price levels, nearly simultaneous high prices and high discount (interest) rates, and substantially simultaneous decline. The goodness of its banking system (and other facts), may make the changes more gradual and less severe in one country than in others, but is not likely to prevent the changes altogether. §6 Exchange between Two Countries when One has a Gold and the Other a Silver Standard An excess production of gold in any country raises prices there compared to prices in other countries, encourages buying goods in other countries, and there- fore raises the rate of exchange on other countries. Export of gold follows. The introduction of a cheaper standard of value has the same effect. A large coinage of cheaper money, e.g. silver at a ratio of i6 to i (which would greatly overvalue silver and lead to a large coin- age), would increase M. Prices would rise and the value of money would fall. Goods would therefore be pur- chased abroad. The rate of exchange on foreign coun- FURTHER CONSIDERATIONS ON EXCHANGE 139 tries would rise and gold would be exported. As long as the silver and gold both circulated and were generally acceptable for goods at the legal ratio, the rate of ex- change would not rise much above the gold export point. But if this ratio encouraged the continued coin- age of silver, the gold would eventually be entirely driven out of the currency of the silver coining country. Then the rate of exchange would rise even higher, for prices in the silver country would continue to rise until silver coin had no greater value than silver bullion. But ouce the gold had been entirely driven out, there could be no further effect on the amount of money and there- fore on prices, in other countries,^ produced by the coin- age of silver. Consequently, the prices of the silver country would be permanently higher than formerly, compared to prices abroad, and its money standard of less value. Instead of the rate of exchange on England, supposing the United States to be the silver standard country, averaging $486.65 = £100, it might average $973.30 = £100, or some other new and higher rate. The rate of exchange would have risen tremendously. In fact, such a rise in the rate of exchange is good evi- dence of a cheaper or depreciated currency. But the rate of exchange, though in figures much higher than before, would not necessarily be above par. Instead, there would be a new par. $973.30 = £100 might have become this par. Exchange would thereafter fluctuate about this new instead of about the old and lower par. Par of exchange would no longer be steady. For with one country on a silver standard and the other on a gold standard, the monetary unit of one, e.g. the dollar, would have no fixed relation to the monetary unit of the other, ^See, however, remainder of this section (6). I40 THE EXCHANGE MECHANISM OF COMMERCE e.g. the pound. The value ratio of these units would vary with the value ratio in the bulHon markets, of sil- ver and gold. But exchange in neither country, on the other, could go above par by much more than the cost of shipping specie. Exchange in the silver standard country on the gold standard country, would be Hmited by the cost of gold in terms of silver, plus the cost of shipment.^ Vice versa, exchange in the gold country on the silver country, could not go higher than the cost of silver in terms of gold, plus the cost of shipment. How would trade balance when there was no longer, between two such trading countries, the influence of price relations in the same precious metal, to make the flow of goods one way balance a return flow ? The balance might then be brought about by the flow of gold one way, and of silver the other. If we should for a time buy more in England than the Enghsh of us, and had a net indebted- ness to meet, we might purchase gold in the bullion market here, with which to settle. This (assuming the United States to be on a silver standard) would not directly affect our prices, but would increase the quantity of money and tend to raise prices in England. In this country it would tend to make gold bulHon scarce and dear as compared with our silver money and with other goods. A given amount of English money would buy more American dollars than before, and would buy more American goods than before, as compared with the goods it would buy in England. That is, par of exchange in England on the United States would be lower. There would also, of course, be some tendency for prices in one country to fall and in the other to rise because of the flow * Goschen, The Theory of the Foreign Exchanges, pp. 76-81 ; cf . Clare, The A. B.C. of the Foreign Exchanges, London (Macmillan), 1893, pp. 139-142. » FURTHER CONSIDERATIONS ON EXCHANGE 141 of goods as well as because of the flow of money. The greater supply of goods in the importing country, the United States, in relation to money, would tend to lower the price level; while the outflow of goods from the exporting country, England, would tend, there, to raise the price level. The fact that a given amount of English money would buy more American goods than before, would encourage EngHsh buying here ; while the less purchasing power over English goods, of American money, would dis- courage American buying in England.^ Hence trade would reach equihbrium or would flow, for a time, in the opposite direction.^ Exchange in England on the United States would rise above par, and specie would be shipped. If exchange on England should be below par and the flow of specie should be from them to us, the same prin- ciple would apply. The silver sent to us in settlement of balances would tend to raise our prices and lower the value of silver in the United States. Its exportation from England would tend to make silver in England relatively scarce and dear. As a consequence, a given number of American dollars would buy more pounds than before and would buy more goods in England than * Cf. Bastable, The Theory of International Trade, fourth edition, London (Macmillan), 1903, pp. 59, 60. See also Professor Marshall's "memorandum" on the effect in international trade of different currencies, Appendix to Final Report of the Gold and Silver Commission, 1888, pp. 47-53. 2 If we suppose American silver exported to buy English gold for settling the balance against us, because of a more favorable price of gold in England com- pared to silver, we shall nevertheless reach the same final conclusion. On this supposition, the outflow of silver would tend to lower American prices, raising here the value of silver. In England, silver would become of less value in com- parison with gold. A given sum of EngUsh money would buy more American money, and would buy more American goods than before as compared with the goods it would buy in England. Therefore, the flow of trade must reach equilib- rium or even be temporarily reversed. 142 TJfB tXCHAl^OE' MECHANISM OF COMMERCE before as compared to what they would buy here. The surplus flow of goods from the United States to England would, other things equal, be brought to an end. If, therefore, two trading countries have, respectively, a silver and a gold standard, the laws of trade between them are not greatly different than if both have the same standard. It is still true that each will buy goods of the other ; and it is still true that an excess flow of trade in /one direction tends so to change monetary and price ' conditions as to bring its own termination. §7 Exchange between Two Countries when One has a Gold and the Other an Inconvertible Paper Standard Let us now suppose the case of a paper standard, i.e. paper money not redeemable in specie, in one of two trading countries, and a gold standard in the other, as with the United States and England during our Civil War period. The rate of exchange in the paper money country on the other, would depend chiefly on the cost of gold in terms of paper, and therefore would rise as the paper money depreciated in relation to gold.^ Thus, during the Civil War, exchange in the United States on other countries, e.g. England, rose to a very high figure, because of the depreciation of the greenbacks. Con- versely, the rate of exchange in the gold standard country on the country with a paper standard would depend mainly on the cost of this paper money in terms of gold, and therefore would fall as the paper money depreciated.^ In the paper money country, the upper limit of exchange on the other cannot much exceed the cost of purchasing 1 Goschen, The Theory of the Foreign Exchanges, pp. 69, 70. * /j j^^ FURTHER CONSIDERATIONS ON EXCHANGE 143 gold with paper, plus the cost of shipping the gold.^ If we regard exchange between two such countries as at par (though the paper money might be depreciated far below par) when the money of the paper standard coun- try will buy just as much exchange on the gold standard country as it will buy gold at home,^ then we may say that exchange could rise above par by the cost of shipping specie.^ In general, we may say that exchange might either rise above or fall below this par, by the cost of specie shipment, just as it might rise above or fall below par by the cost of specie shipment if both countries had the same specie as standard. When one of two countries has inconvertible paper and UbU. 'This is the logical though not the ordinary use of the word "par" in re- lation to exchange, when one country has a depreciated currency. It is custom- ary to regard as par what would be par if there were no depreciation. Strictly speaking, however, the departure from this rate, due to depredation, means a departure of the money from par, rather than of exchange. ' This is not inconsistent with Bastable's statement {Theory of International Trade, pp. 87, 88) regarding the possible rise of the exchanges on other countries, in a country having an inconvertible but not depreciated paper money. In such a case, it is said, if a sudden demand for exchange and, consequently, for gold to export, is coincident, in the paper money country, with a temporarily inadequate supply of gold, exchange may rise above the usual specie shipping point. But though the rate may go up beyond the usual shipping point, it can hardly be said to do so if the paper money is in no sense depreciated. Though the paper money may not have depreciated in relation to goods in general, and may not have depreciated, permanently, in relation to gold, yet, for the time being, it has depreciated compared to gold in the paper standard country. Under such circumstances, however, it may fairly be emphasized that the rise of ex- change is due rather to a local rise in the value of gold than to a fall in that of the paper. A special case discussed by Goschen (The Theory of the Foreign Exchanges, pp. 70-72), is that of a country which, having an inconvertible paper money, has also forbidden the export of the precious metals. In such a country, exchange on others cannot be prevented, by shipment of specie, from rising above the gold shipping point, since the law forbids such shipment. Except as the law may be evaded, a rising exchange rate can then only be limited by a retardation of imports and a stimulation of exports (see § 9 of this chapter) or, for a time, by borrowing from abroad (see Goschen, Foreign Exchanges, loc. cit.). 144 THE EXCHANGE MECHANISM OF COMMERCE the other a gold standard, the effect on prices, produced by the flow of specie consequent on trade between them, could occur only in the gold standard country. When the paper standard country has a balance to pay, gotd may be purchased with this paper money and exported (or, which for purposes of our discussion amounts to the same thing, imported by the gold standard country). This will raise prices in the gold standard country to which the gold flows. If the trade, however, is between a paper standard country and several gold standard countries, the effect on the latter will be more diffused and their prices raised but sUghtly. But the outflow of gold bullion from the paper standard country will tend, if long continued, to make gold in that country scarce and dear in relation to other desired goods. A given amount of gold will buy not only more paper money, but also more of other goods than before. Drafts drawn on the gold standard country, or remitted by its people, in payment for goods purchased in the paper standard country, will represent less gold than previously for the same goods bought. Therefore, more goods will be purchased in the paper standard country by the people of the other, and gold will flow back again to the former country. This tendency is accentuated by the flow of goods. If, at first, goods are imported by the paper standard country, the larger supply of goods in that country, relative to the paper money and to gold, tends to make the prices of these goods lower in either standard. In the exporting country, relative scarcity of goods tends to make prices somewhat higher measured in gold. Hence, for this reason also, more goods are bought with gold in the paper standard country, and gold tends to flow to that country. FURTHER CONSIDERATIONS ON EXCHANGE t^ §8 Exchange between Two Countries when Both have In- convertible Paper Standards Suppose, next, that there is in each of two trading countries an inconvertible paper standard. Then the rate of exchange in either upon the other, so long as gold is the medium for settHng international balances, will depend on the value of both currencies in relation to gold. Suppose the two countries to be the United States and France. Then, in the United States, exchange on France would rise if American money depreciated compared to gold (French money remaining the same) , or if French money appreciated in relation to gold (American money remaining the same), or if, simultaneously, American money depreciated and French money appreciated. The same causes would make exchange in France on the United States fall. The rise in exchange on France and the fall in exchange on the United States would be limited by the depreciation of the American money plus the appreciation of the French money, plus the cost of specie shipment. For if American money depreciated one-half compared to gold, exchange on France (excluding the cost of gold shipment) would double, since it would take twice as many American dollars to buy the same amount of gold for shipment to France, and, therefore, to buy the gold equivalent of a certain number of francs. Likewise, if French money doubled in value in relation to gold, exchange on France would double, since it would take twice as many dollars as before to buy the double amount of gold which was now the equivalent of a given number of the doubled value francs. Above this amount, exchange could rise by the cost of shipping gold. 146 THE EXCHANGE MECHANISM OF COMMERCE Under the assumed circumstances, the currencies of the two countries would be unrelated to each other. No amount of buying by the merchants of the United States, in France could, through a flow of money, lower Ameri- can or raise French prices, for American money would not be legal tender in France or (being paper) of any intrinsic value there. Neither could French buying in the United States produce, by the flow of money, the reverse consequence. How, then, would excess buying by one country in the other eventually cause more buying by the second in the first ? It would have this effect through the flow of gold and the consequent influ- ence on the value of gold in the two countries ; and also through the flow of goods and the effect of that flow on prices in the two countries and so on the relative values A of gold, in both countries, in relation to goods. 'I If the United States should buy more of France in any / period than it sold to France, gold would flow to France. / Gold would therefore come to have more value in the / United States, where it was scarce, and less value in / France, than before. A given number of francs would buy / more gold, and a given amount of gold would buy more dollars. Par of exchange, in the sense here used, would be lower in France on the United States, and higher in the United States on France. This means that in terms of French money, goods could be purchased in the United States more cheaply than before; while in terms of American money, French goods would be more expensive than before. As a consequence, the French would buy more American goods, and Americans would buy less French goods; the rate of exchange in France on the United States would rise above this low par, and in the United States on France it would fall ; and gold would flow back from France to the United States. FURTHER CONSIDERATIONS ON EXCHANGE 147 In addition, if the United States should buy a net balance of goods from France, in any period, this would tend to make goods more plentiful in the United States and less so in France, in relation to gold, so that, for this reason also, it would become more profitable than before to send gold from France to the United States for goods. §9 Exchange between Two Countries, Assuming Effective Prohibition of Specie Shipment So far we have assumed, even when discussing trade between countries having unrelated currencies, that gold or silver would be used to settle international balances. But suppose that the mediaeval theory of prohibiting the export of specie were still in vogue and were com- monly appHed. Would there be, then, any limits to the fluctuations of exchange (assuming obligations still to be settled by using drafts), and would there still be a tendency for the trade in opposite directions, to balance ? Under usual existing conditions, the fluctuations of ex- change with any country are limited, as we have seen, by the cost of shipping specie. Any further rise or fall is checked by specie shipment and by the consequent efltect on supply of drafts, or demand for them, or both. But if specie shipment were prohibited, and prohibited at all effectively, the Hmits to exchange fluctuations could not be so narrow. The rate of exchange, for example, in the United States on England, if the balance of obKga- tions were markedly in England's favor, could then go considerably above $488.65 without at once increasing the supply of or decreasing the demand for drafts on England, to such an extent as to stop the rise. Since 148 THE EXCHANGE MECHANISM OF COMMERCE gold could not be exported, Americans owing money in England would have to settle by remitting drafts or by redeeming drafts drawn against them.^ In the latter case, American banks must purchase drafts on England in order to settle with correspondents, since the alterna- tive of shipping specie is excluded. Drafts on England might, therefore, sell at a rate which American debtors and debtor banks would refuse to pay if they had the forbidden alternative. Yet there would still be limits, though wider and perhaps less definite ones, to the fluctuations in the price of drafts. The high price of drafts on England would encourage and stimulate the sale of American goods in England and would discourage buying goods from Eng- land. Goods which would bring, in England, say £ioo, but which would not ordinarily be sent there for sale, because that sum yielded no profit, might be exported if a draft on England for £ioo would sell, here, for $495. And the sale of goods in England, thus stimulated, would tend, by increasing the supply of drafts on England, to prevent further rise in the prices of such drafts. Also, goods which could be purchased in England for £100 and which, if $486.65 would buy a draft for £100 and so would pay for the goods, would be bought in England, very probably would not be bought if the draft necessary to pay for them cost $495. • Conversely, even though exchange on England fell below the gold shipping point, because of a net balance owing from England to us, combined with an English prohibition on the outflow of gold from England, such a fall in exchange would not be without limit. For it * Renewal of credit, use of finance bills, etc., would of course serve as tempo- rary expedients to postpone settlement. FURTHER CONSIDERATIONS ON EXCHANGE 149 would encourage buying in and discourage selling to England. Goods which could be sold in England for £100 and which it would ordinarily pay to ship there, it might not be profitable to ship if a draft on London for £100 would only reaHze, in New York, $460 or less. The consequent refusal to ship goods to England would tend to decrease the supply of drafts on England and to prevent further fall in their prices. At the same time, it might become more profitable for us to buy goods in England, paying for these goods by purchasing and maiHng the low-priced London drafts and so adding to the demand for such drafts. During the summer and fall of this year (191 5) drafts on the principal European belligerent countries have been selling at rates far below the ordinary, gold-ship- ping points. Sight drafts on London, for instance, have sold at 4.70, at 4.60, even at 4.50, and correspond- ing discounts have ruled with respect to other European centers. It would seem that these discounts cannot be sufficiently explained by citing the war risk of gold shipment, since war risk insurance is but i per cent in British bottoms and in American vessels is even less. This risk, in addition to the ordinary cost and risk of shipment, might account for a rate on London as low as 4.80 or 4.79, but hardly for a rate much lower. There seems no escape from the conclusion that interference with gold exports from the countries at war is an im- portant factor in the problem. Such interference there has been and is.^ For example, France has forbidden *The more important commercial countries engaged in the present war, e.g. Great Britain, France, and Germany, would appear thus far (October, 191 5) to have been successful in preventing depreciation of their paper money, in the commonly understood sense of depreciation in relation to gold. The success which they have had in this direction is probably due, in considerable measure. I50 THE EXCHANGE MECHANISM OF COMMERCE any person other than the Bank of France to export gold, and the Bank of France is controlled by the govern- ment, which appoints its manager. Great Britain has not formally prohibited the export of gold ; but probably no English bank would venture, under existing circum- stances, to export gold without the approval of the Bank of England, and the Bank of England will arrange for the export of so much gold only as its officials and the government think may wisely be parted with. Hence the ordinary free flow of gold has ceased, price levels in America and in Europe are not closely related through such a flow, and exchange rates can fall, and have fallen, far below par. To such an extent has this occurred that we should perhaps soon cease to find it profitable to sell food supplies, munitions, etc., to the Entente Allies, had they not arranged to correct mat- ters, in part, by borrowing of us heavily through the sale of their bonds in the United States. When balances are habitually settled by the shipment of gold (or other precious metals), as in modern trade, the limits of fluctuation in exchange are narrow because gold, having large value in small bulk, can be shipped for a small per cent of its value. An excess of trade in one direction, therefore, acts largely through a flow of gold as an intermediate cause, in bringing about a balancing flow of trade in the contrary direction. This flow of gold affects prices in both countries, if both have the gold standard. In any case, it affects the relative to the fact that they will not allow gold to be exported. They have thus nar- rowed the market for gold and have, in effect, cheapened it along with the paper. Hence, the paper money may not appear to be depreciated even though, in the sense of its piu-chasing power over goods, it is so. It is not denied, of course, that, under all the circumstances, a belligerent government may find it desirable to husband its stock of gold and avoid, if possible, any depredation of the sort usually meant by the term. FURTHER CONSIDERATIONS ON EXCHANGE 151 purchasing power of gold in these countries, and the amount of goods that the currency of the one, by being first exchanged for gold, will buy in the other, compared to what it will buy at home. There follows, as a result of this change in relative prices or in relative values of the two money standards, a change in the flow of trade. This change in the flow of trade is, therefore, in large part, but an indirect consequence, through the flow of gold, of a rising or falling rate of exchange. But if jfehe" flow of specie is effectively prohibited, and the fluctuations in exchange are, in consequence, greater (assuming drafts to be still used as the chief means of settling obligations between countries), the high and low prices of drafts will act with greater force directly on the flow of trade. It should be emphasized that high and low exchange have always, to some extent, this direct influence. If a draft on England for £100 will sell for $488 in New York, it may be profitable to export goods to England which it would not pay to export if exchange were low. Simi- larly, if drafts on England for £100 can be secured for $484.70, it may be worth while to buy goods there which, if exchange were higher, would not be purchased. A flow of trade in one direction has always, then, some slight tendency to bring about its own termination through affecting the rate of exchange, and thereby the direction of trade.^ But this more direct influence is greater, because the possible fluctuations in exchange are greater, if and when specie cannot be exported from either of two trading countries. Our conclusion is that whatever the relation of the currencies of two trading countries, and whatever the mechanism of settUng balances, or whatever the restrictions on settlement by the use of any 1 Cf. Ch. V. (of Part I), § 6, 152 THE EXCHANGE MECHANISM OF COMMERCE special commodity, e.g. gold, an excess flow of trade in one direction introduces always a tendency towards an opposite and balancing flow. § lo The Effect on the Rate of Exchange of High Import and Export Duties Let us now give very brief consideration to the effects on exchange of high import duties, e.g. the so-called protective tariff. The protective tariff is a high tax on imports, intentionally made so high as to prevent or decrease imports, and encourage buying at home. For the time being, the country adopting such a policy will export an excess, the rate of exchange on other coun- tries will be low, and specie will flow in. Then prices rise in the protectionist country in relation to prices elsewhere, exports are checked, and an equilibrium is reached ; and, in the absence of other disturbing causes, exchange will again average par. On the other hand, the first effect of a high tariff on exports would be to decrease exports. For a while imports would be in excess. Therefore, the rate of exchange would rise. Eventually specie would flow out, prices would fall, impoiits and exports would again balance (other disturbing factors absent), and there would no longer be the tendency caused by excess imports for the fall of prices to continue. • § II Summary In this chapter the attempt has been made to bring together various considerations regarding exchange. FURTHER CONSIDERATIONS ON EXCHANGE 153 which seemed to have no proper place in the chapters preceding. To begin with, a distinction was made between sight drafts and those payable some time after sight. A study of the pure rate of exchange has to do only with the former. The prices of the latter depend also upon the rate of interest. Two possible methods of procedure when an American bank invests, for the interest, in drafts on foreigners, were described. It was shown that the prices of long drafts may be influenced- by the rate of interest in the drawing and in the accept- ing country. If the rate of interest in the accepting country is the lower, this rate determines the prices of V long drafts; but if the rate of interest in the drawing country is the lower, purchase of the drafts by investors or investing banks in that country may make these drafts sell for somewhat more than the higher rate of interest in the accepting country would otherwise allow. Consideration was given to the influence, on the pure rate of exchange and on the flow of specie, of changes in interest or discount rates in different countries. It was seen that a rise of the bank discount rate in any country tends to create, elsewhere, high rates of exchange on that country and a flow of specie to it. But it was also seen that the chief effect of such a rise in bank discount is to check undue credit expansion or reduce excessive credit. Only as it has this effect, will the inflow of specie be pre- vented from so raising prices as to result in a subsequent corresponding outflow. Since interest rates and prices in different countries are related, it follows that a finan- cial panic in one country must produce some, though per- haps comparatively mild, effects upon other countries. The rates of exchange between countries having dif- ferent monetary standards were next considered. If 154 THE EXCHANGE MECHANISM OF COMMERCE one country has gold and another silver, exchange can fluctuate as the ratio of value of silver to gold fluctuates, and, in addition, by the cost of specie shipment. If one country has gold and the other has inconvertible paper, exchange in the latter on the former can rise (and in the former on the latter, fall) by the amount of depreciation of the paper in terms of gold, plus the cost of gold ship- ment. If both countries have inconvertible paper, ex- change in either on the other can rise by the amount of depreciation in the currency of the first plus the amount of appreciation in that of the second, plus the cost of specie shipment. Whatever the monetary standard or standards of trading countries, exchange can fluctuate beyond the above assigned Hmits, if the movement of specie is effectively prohibited. But whatever the standard or standards, it appeared that trade cannot flow continuously in one direction without introducing a tendency to a reverse flow. By acting on relative price levels, or on relative values of currency in relation to gold, or only on rates of exchange, the surplus flow in one direction will eventually bring itself to an end. Lastly, brief attention was given to the effects on exchange, of import and export duties. The former make exchange on other countries temporarily lower. The latter make it temporarily higher. In the former case, equilibrium is reached, after an inflow of specie, with a higher level of prices m the country levying the duties. In the latter case, when, after an outflow of specie, equi- librium is again reached, the level of prices in the duty- levying country is lower. INDEX Acceptance bills, form of documentary commercial drafts called, 69. Arbitraging in exchange, 96-97. B Bank acceptances, system of, used in Europe, 37-39, 69. Bank credit, nature of, 26 ff . ; relation of money, together with, to prices, 43-45 ; fluctuations of, due to periods of hope and confidence and doubt and fear, 46; changes in, resulting from panics, 46-47 ; means provided for avoiding violent fluctuations of, 47-49- Bank deposits, 28. Bank drafts, use of, 52; both drawers and drawees of, are banks, 54; settlement of obligations by, when debtors remit to creditors, 61 ff. ; different types of, 67-70. See Long drafts and Sight drafts. Banking, commercial, 28-30; analysis of the relations to each other of persons concerned in, 30-33 ; ad- vantages possessed by, for business men, both as lenders and borrowers, 33-40- Bank notes, are credit obligations of banks to holders of, 41 ; protection of holders against loss, 41-43 ; pro- visions of Federal Reserve Act relative to, 42-43. Bank of England, emergency reserve of, 47. Bank reserves, 42, 44; method of maintaining proper relation be tween deposits and, 44—45. Banks, function of, to act as inter mediaries between borrowers and lenders, 30-33 ; Federal reserve, 42-43. Barter, primitive trade called, i. Bastable, The fheory of International Trade, cited, 92, 113, 141, 143. Bills of exchange, 26, 27, 51-53; ad- vantage of, over checks for long- distance transactions, 52-53; nature of, 53—54 ; relations of bank to other parties concerned in, 53-54; il- lustration of use of, to settle obliga- tions, assuming no banks, 54-56; settlement of obligations by, through intermediation of banks, assuming creditors to draw drafts on debtors, 56-61 ; settlement by bank drafts, when debtors remit to creditors, 61- 65 ; variety of types of, 67-70 ; sight drafts and long bills, 67; "clean" bills and documentary, 67-69 ; dis- count of, 69-70; sale of demand drafts against remittances of long bills, 71-73; method of drawing of, by letters of credit, 94-96 ; specula- tion in, 96-100; relation between price of long drafts and rate of in- terest or discount, 126-127; holding of long drafts on foreign countries by American banks, as investments, 127-130; influence on price of long drafts of interest rate in drawing country and interest rate in country drawn upon, 131-133 ; effect of bank discount rate on price of demand drafts and the flow of specie, 133- 136 ; fluctuations in price of, in case of prohibition of specie shipment, 147-152. Bimetallism, operation of theory of, 16-18. Borrowers, relation between lenders and, in commercial banking, 30-33; 155 156 INDEX benefits to, from banking system, 35-37- Canada, protection of holders of bank notes, under banking system of, 41. Checks on banks, common form of credit, 26, 27 ; similarity of bills of exchange to, 52; advantages of bills of exchange over, in long-dis- tance transactions, 52-53. Clare, The A. B.C. of the Foreign Ex- changes, cited 63, 83, 93, 97, 140. "Clean" bills, defined, 67. Clearing houses, 29, 30. Commercial drafts, use of, 52 flf. ; character of drawers and drawees of, 53-54; method of using, for settlement of ' obligations, 54 ff. Competition, effect of, on prices, 6-8. Credit, substitution of, for money, 26-27. Crops, relation between rate of ex- change and, 82-83. Currencies, effect of difference in, on exchange between two countries, 138-142. Currency, use of term, 26. Currency loans, 85, 86. Customer's check, use of, for money, 27. D Demand drafts, sale of, against re- mittances of long bills, 71-73. See Sight drafts. Discount, effect of, on price of long drafts, 126-127; effect of bank dis- count rate on price of demand drafts and the flow of specie, 133- 136; effect of panics on rate of, 137-138. Discounting of documentary payment bills, 69-70. Discount market, absence of a, in United States, 72-73. Documentary commercial drafts, 67, 68-69. Domestic exchange, cost of money shipment in, 115-116. E Edgeworth, "Report on Monetary Standard," cited, 3. England, exchange transactions be- tween America and, 62-65 J dis- counting in, of bills drawn by Ameri- cans on their English debtors, 71- 72. Equation of exchange of money, 3-4, 24; statement of, including bank credit, 43. Escher, Elements of Foreign Exchange, cited, 6s, 67, 69, 70, 71, 85, 90, 93, 94, 96, 97, 99, 109, III. European war, and the exchange market, 107 ; effect of, on flow of specie abroad, 136 n. Exchange, foreign and domestic, 52- 53; par of, 77-78, 139; place speculation or arbitraging in, 96- 97; time speculation in, 97-100; between two countries when one has a gold and the other a silver standard, 138-142. See Bills of exchange and Rate of exchange. Exchangeability of money, 2. Exchange banks and brokers 53, 56; how profits are made by, 65-67. Exchange market, the, 65 ; effect on, of disturbed political or industrial conditions, 83-84 ; demoralization of, by the European war, 107. Exportation of specie and the rate of exchange, 107-111. Export duties, effect of high, on rate of exchange, 151. Export trade, influence of rate of ex- change on, 118-H9. Federal Reserve Act, provisions of, relative to national bank notes, 42-43 ; function of Federal reserve banks established by, 47 ; pro- visions of, for suspending reserve requirements, 48 ; rediscounting per- mitted and encouraged by, 73. Federal reserve banks, reserves kept by, 47- Fiat money, 8, 13. Finance bills, 90-93. INDEX 157 Financial disturbances, influence of, on rate of exchange, 113-114. Firsts and seconds, explanation of terms, applied to drafts, 128. Fisher, Irving, Elementary Principles of Economics, cited, 5, 17; The Purchasing Power of Money, cited, 14, 19, 22, 28, 43, 45, 137. Foreign exchange, nature and method of, 51 ff. Futures, speculation in, in foreign exchange, 98-99. Gold, value of money as related to value of, 21-22. See Specie. Goschen, The Theory of the Foreign Exchanges, cited, 89, 92, 113, 131, 134, 136, 140, 142, 143. Hadley, Economics, cited, 3, 7. Importation of specie and the rate of exchange, 111-113. Importations, influence of rate of ex- change on amount of, 118-119. Import duties, effect of high, on rate of exchange, 152. See Protective tariff. Individualism, philosophy of, applied to use of finance bills, 92-93. Insurance rates on gold shipments, 107. Interest, loss of, during transportation of gold, 107-109 ; relation between rate of, and price of long drafts, 126-127, 131-133. Investments, long run effect of inter- national, upon rate of exchange and flow of money, 120-122; long drafts on foreign countries held by American banks as, 127-130. Jacobs, L. M., "Bank Acceptances" by, cited, 37 n., 73. Joint account, investment by two banks for, 93-94- Kemmerer, Money and Credit Instru- ments in their Relation to General Prices, cited, 43. Laws of money, i ff. Lenders, viewed as persons who pro- vide waiting, 30-33 ; advantages to, of system of commercial banking, 34-35- Letters of credit, analysis of relations involved in, 94-96. Limping standard, conditions for suc- cessful operation of the, 19-21. Loans, short time, made through in- termediation of exchange market, 85 ff. ; sterling and currency, 85- 86. London, the world's financial centre, 63-64; effect on disposal of long drafts at lower discount rate in, than in New York, 133. Long drafts or bills, 67; sale of de- mand drafts by banks, against re- mittances of, 71-73; effect on price of, of rate of interest or discount, 126-127 ; me'thod of procedure when held as investments by American banks, 127-130 ; influence on price of, of interest rate in drawing country and of interest rate in coimtry drawn upon, 131-133. M Margraff, International Exchange, cited, 70, 96 n., 128, 130. Marks, Lawrence M., statistics of rate of exchange compiled by, 83 n. Marshall, memorandum on effect in international trade of different currencies, 141 n. Mill, J. S., Principles of Political Economy, cited, 5. Monetary standards, effect of different, on exchange between two countries 138-142. Money, laws of, i ff. ; position of as a medium of exchange. 2-3 ; re- lation between prices and, 3; 158 INDEX causal explanation of value or "purchasing power" of, 12-16; theory of bimetallism, 16-18; value of subsidiary, 19-21; relation of value of, to value of a standard money metal, 21-22; relation be- tween level of prices and value of, in one country or locality and level of prices and value of, in another, 22-24; substitution of credit for, 26-27; reasons why bank credit is able to displace, as a medium of exchange, 33 S. ; relation of, to- gether with bank credit, to prices, 43~4S; substitutes for, in inter- national and long-distance trade, 52 ; cost of shipment of, in domestic exchange, 115-116. N National banks, guaranteeing of notes issued by, by Federal government, 41-42 ; foreign exchange business of, 65-66. Newcomb, Principles of Political Economy, cited, 3. Panics, effect of, on bank credit, 46- 47 ; lowering of rate of exchange due to, 113-114; effect of, in one country on discount rate and flow of specie in other countries, 137- 138. Paper money, exchange between coun- tries under existence of, as an in- convertible standard, 142-147. Par of exchange, 77-78; establishment of a new, between countries with different monetary standards, 139. Place speculation in exchange, 96- 97. Prices, quantitative statement of re- lation between money and, 3-4; causal explanation of, of given kinds of goods, 5-8; causal explanation of general level of, 8-1 2 ; relation between level of, and value of money in one country or locality and level of, and value of money in another, 22-24; relation of money, together with bank credit, to, 43-45; in- fluence of, in the long run, on the exchange market, 11 6-1 20; affected by bank discount rate, 135-136; effect of a panic in one country on level of, in other countries, 137-138; effect on, of different currencies in two different countries, 138-142. Promissory notes, use of, for money, 26-27. Protection. See Protective tariff. Protective tariff, effect of, on rate of exchange, 152. Purchasing power of money, a phrase used to express the price of money, 12-13; explanation of, 13-16. Quantity theory of money, 3-4. R Rate of exchange, 77 ff. ; causes o! fluctuation in, 78; effect on, of disturbed political or industrial con- ditions, 83-84 ; short time loans and, /" 85-90 ; upper limit to fluctuation of, f^ determined by cost of exporting specie, 103-107 ; lower limit to fluctuation, determined by cost of importing specie, II i-i 13; influence of panics or financial disturbances on, 113-114; long run effects on, of a balance of payments from one country to another, 116 ff. ; long run effect of international invest- ments on, 120-122; long run effect of payments for various purposes on, 122-124; when one of two countries has a gold and the other a silver standard, 138-142 ; when one of two countries has a gold and the other an inconvertible paper stand- ard, 142-144 ; conditions as to, in case of prohibition of specie ship- ment, 147-152; effect on, of high import and export duties, 152. Rediscounting bills of exchange, 71- 72; not practised in United States, 72-73- Reserves in banks, 42, 44. INDEX 159 Seasonal variations of trade, desir- ability of elasticity in bank currency to meet, 48, 50. Selling short in foreign exchange, 99- 100. Short time loans made through the exchange market, relations involved in and results of, 85-90. Sight drafts, 67; rate on, constitutes the pure rate of exchange, 126; relation between bank discount rate and price of, 133-136. Specie, rate of exchange and the flow of, 103 flf. ; upper limit to fluctuation of rate of exchange determined by cost of exporting, 103-107; details connected with exportation of, 107- III ; lower limit to fluctuation of rate of exchange determined by cost of importing, 111-113; long run effects on flow of, of a balance of payments from one country to another, 116 ff. ; long run effects on flow of, of international invest- ments, 120-122; effect of bank dis- count rate on price of demand drafts and the flow of, 133-136 ; flow of, abroad prior to outbreak of European war, 136 n. ; effect of panics on flow of, 137-138; effect on flow of, of dif- ferent currencies in two countries, 138 ff. ; exchange between two countries, assuming prohibition of shipment of, 147-152. Speculation in foreign exchange, 96-100. Sterling loans, 85-86. Stock exchange. New York, closing of, to impede flow abroad of specie, 136 n. Subsidiary money, conditions deter- mining successful employment of, 19-21. Supply and demand, relation between price of a given kind of goods and, 5-8; application of principles of, to the general level of prices, 8-12; applied to money and prices, 13-16; effects of laws of, on various mone- tary systems, 16; price of bills of exchange or drafts determined by, 77; forces affecting, of bills of ex- change, 78-83. Tariffs. See Protective tariff. Taussig, Principles of Economics, cited, 115. 121. Time drafts, 127. Time speculation in exchange, 97-100. Trade, primitive, i ; money as a part of the mechanism of, 1-2. Transportation, cost of, of money, in domestic exchange, 115-116. Velocity of circulation, relation be- tween supply of money and, 13-14. W Waiting, element of, provided by de- positors or lenders, in commercial banking, 30-33- Walker, Political Economy, cited, 13. Wampum, medium of exchange among Indians, i. War, the European, and the exchange market, 107; effect on flow of specie to Europe, 136 n. Warburg, Paul M., "The Discount System in Europe," cited, 37 n. ; quoted, 72 n. White, Money and Banking, cited, 44. Printed in the United States of America. \»' •w >\^v If"!- '» 1p~ f ' If UNIVERSITY OF CALIFORNIA LIBRARY BERKELEY Return to desk from which borrowed. This book is DUE on the last date stamped below. DEC 22 1948 "