THE THEORY OF MONEY AND OF THE FOREIGN EXCHANGES
The evil consequences of instability in the standard of value have
now been sufficiently described. In this chapter[19] we must lay
the theoretical foundations for the practical suggestions of the
concluding chapters. Most academic treatises on monetary theory have
been based, until lately, on so firm a presumption of a gold standard
régime that they need to be adapted to the existing régime of mutually
inconvertible paper standards.
[19] Parts of this chapter raise, unavoidably, matters of much
greater difficulty to the layman than the rest of the book.
The reader whose interest in the theoretical foundations is
secondary can pass on.
I. _The Quantity Theory of Money_
This Theory is fundamental. Its correspondence with fact is not open to
question.[20] Nevertheless it is often misstated and misrepresented.
Goschen’s saying of sixty years ago, that “there are many persons
who cannot hear the relation of the level of prices to the volume of
currency affirmed without a feeling akin to irritation,” still holds
good.
[20] “The Quantity Theory is often defended and opposed as
though it were a definite set of propositions that must
be either true or false. But in fact the formulæ employed
in the exposition of that theory are merely devices for
enabling us to bring together in an orderly way the
principal causes by which the value of money is determined”
(Pigou).
The Theory flows from the fact that money as such has no utility except
what is derived from its exchange-value, that is to say from the
utility of the things which it can buy. Valuable articles other than
money have a utility in themselves. Provided that they are divisible
and transferable, the total amount of this utility increases with their
quantity;--it will not increase in full proportion to the quantity,
but, up to the point of satiety, it does increase.
If an article is used for money, such as gold, which has a utility
in itself for other purposes, aside from its use as money, the
strict statement of the theory, though fundamentally unchanged, is a
little complicated. In present circumstances we can excuse ourselves
this complication. A Currency Note has no utility in itself and is
completely worthless except for the purchasing power which it has as
money.
Consequently what the public want is not so many ounces or so many
square yards or even so many £ sterling of currency notes, but a
quantity sufficient to cover a week’s wages, or to pay their bills,
or to meet their probable outgoings on a journey or a day’s shopping.
When people find themselves with more cash than they require for
such purposes, they get rid of the surplus by buying goods or
investments, or by leaving it for a bank to employ, or, possibly, by
increasing their hoarded reserves. Thus the _number_ of notes which
the public ordinarily have on hand is determined by the amount of
_purchasing power_ which it suits them to hold or to carry about,
and by nothing else. The amount of this purchasing power depends
partly on their wealth, partly on their habits. The wealth of the
public in the aggregate will only change gradually. Their habits
in the use of money--whether their income is paid them weekly or
monthly or quarterly, whether they pay cash at shops or run accounts,
whether they deposit with banks, whether they cash small cheques at
short intervals or larger cheques at longer intervals, whether they
keep a reserve or hoard of money about the house--are more easily
altered. But if their wealth and their habits in the above respects
are unchanged, then the amount of purchasing power which they hold in
the form of money is definitely fixed. We can measure this definite
amount of purchasing power in terms of a unit made up of a collection
of specified quantities of their standard articles of consumption or
other objects of expenditure; for example, the kinds and quantities of
articles which are combined for the purpose of a cost-of-living index
number. Let us call such a unit a “consumption unit” and assume that
the public require to hold an amount of money having a purchasing power
over _k_ consumption units. Let there be _n_ currency notes or other
forms of cash in circulation with the public, and let _p_ be the price
of each consumption unit (_i.e._ _p_ is the index number of the cost
of living), then it follows from the above that _n = pk_. This is the
famous Quantity Theory of Money. So long as _k_ remains unchanged, _n_
and _p_ rise and fall together; that is to say, the greater or the
fewer the number of currency notes, the higher or the lower is the
price level in the same proportion.
So far we have assumed that the whole of the public requirement for
purchasing power is satisfied by cash, and on the other hand that this
requirement is the only source of demand for cash; neglecting the fact
that the public, including the business world, employ for the same
purpose bank deposits and overdraft facilities, whilst the banks must
for the same reason maintain a reserve of cash. The theory is easily
extended, however, to cover this case. Let us assume that the public,
including the business world, find it convenient to keep the equivalent
of _k_ consumption units in cash and of a further _k´_ available
at their banks against cheques, and that the banks keep in cash a
proportion _r_ of their potential liabilities (_k´_) to the public. Our
equation then becomes
_n = p(k + rk´)_.
So long as _k_, _k´_, and _r_ remain unchanged, we have the same
result as before, namely, that _n_ and _p_ rise and fall together. The
proportion between _k_ and _k´_ depends on the banking arrangements of
the public; the absolute value of these on their habits generally; and
the value of _r_ on the reserve practices of the banks. Thus, so long
as these are unaltered, we still have a direct relation between the
_quantity_ of cash (_n_) and the level of prices (_p_).[21]
[21] My exposition follows the general lines of Prof. Pigou
(_Quarterly Journal of Economics_, Nov. 1917) and of Dr.
Marshall (_Money, Credit, and Commerce_, I. iv.), rather
than the perhaps more familiar analysis of Prof. Irving
Fisher. Instead of starting with the amount of cash held by
the public, Prof. Fisher begins with the volume of business
transacted by means of money and the frequency with which
each unit of money changes hands. It comes to the same
thing in the end and it is easy to pass from the above
formula to Prof. Fisher’s; but the above method of approach
seems less artificial than Prof. Fisher’s and nearer to the
observed facts.
We have seen that the amount of _k_ and _k´_ depends partly on the
wealth of the community, partly on its habits. Its habits are fixed by
its estimation of the extra convenience of having more cash in hand
as compared with the advantages to be got from spending the cash or
investing it. The point of equilibrium is reached where the estimated
advantages of keeping more cash in hand compared with those of spending
or investing it about balance. The matter cannot be summed up better
than in the words of Dr. Marshall:
“In every state of society there is some fraction of their income
which people find it worth while to keep in the form of currency;
it may be a fifth, or a tenth, or a twentieth. A large command of
resources in the form of currency renders their business easy and
smooth, and puts them at an advantage in bargaining; but on the
other hand it locks up in a barren form resources that might yield
an income of gratification if invested, say, in extra furniture; or
a money income, if invested in extra machinery or cattle.” A man
fixes the appropriate fraction “after balancing one against another
the advantages of a further ready command, and the disadvantages
of putting more of his resources into a form in which they yield
him no direct income or other benefit.” “Let us suppose that the
inhabitants of a country, taken one with another (and including
therefore all varieties of character and of occupation), find
it just worth their while to keep by them on the average ready
purchasing power to the extent of a tenth part of their annual
income, together with a fiftieth part of their property; then the
aggregate value of the currency of the country will tend to be
equal to the sum of these amounts.”[22]
[22] _Money, Credit, and Commerce_, I. iv. 3. Dr. Marshall
shows in a footnote as follows that the above is in fact
a development of the traditional way of considering the
matter: “Petty thought that the money ‘sufficient for’
the nation is ‘so much as will pay half a year’s rent
for all the lands of England and a quarter’s rent of the
Houseing, for a week’s expense of all the people, and about
a quarter of the value of all the exported commodities.’
Locke estimated that ‘one-fiftieth of wages and one-fourth
of the landowner’s income and one-twentieth part of the
broker’s yearly returns in ready money will be enough to
drive the trade of any country.’ Cantillon (A.D. 1755),
after a long and subtle study, concludes that the value
needed is a ninth of the total produce of the country; or,
what he takes to be the same thing, a third of the rent
of the land. Adam Smith has more of the scepticism of the
modern age and says: ‘it is impossible to determine the
proportion,’ though ‘it has been computed by different
authors at a fifth, at a tenth, at a twentieth, and at a
thirtieth part of the whole value of the annual produce.’”
In modern conditions the normal proportion of the
circulation to this national income seems to be somewhere
between a tenth and a fifteenth.
So far there should be no room for difference of opinion. The error
often made by careless adherents of the Quantity Theory, which may
partly explain why it is not universally accepted, is as follows.
Every one admits that the habits of the public in the use of money
and of banking facilities and the practices of the banks in respect
of their reserves change from time to time as the result of obvious
developments. These habits and practices are a reflection of changes
in economic and social organisation. But the Theory has often been
expounded on the further assumption that a _mere_ change in the
quantity of the currency cannot affect _k_, _r_, and _k´_,--that is to
say, in mathematical parlance, that _n_ is an _independent variable_
in relation to these quantities. It would follow from this that an
arbitrary doubling of _n_, since this in itself is assumed not to
affect _k_, _r_, and _k´_, must have the effect of raising _p_ to
double what it would have been otherwise. The Quantity Theory is often
stated in this, or a similar, form.
Now “in the long run” this is probably true. If, after the American
Civil War, the American dollar had been stabilised and defined by law
at 10 per cent below its present value, it would be safe to assume that
_n_ and _p_ would now be just 10 per cent greater than they actually
are and that the present values of _k_, _r_, and _k´_ would be entirely
unaffected. But this _long run_ is a misleading guide to current
affairs. _In the long run_ we are all dead. Economists set themselves
too easy, too useless a task if in tempestuous seasons they can only
tell us that when the storm is long past the ocean is flat again.
In actual experience, a change of n is liable to have a reaction both
on _k_ and _k´_ and on _r_. It will be enough to give a few typical
instances. Before the war (and indeed since) there was a considerable
element of what was conventional and arbitrary in the reserve policy
of the banks, but especially in the policy of the State Banks towards
their gold reserves. These reserves were kept for show rather than for
use, and their amount was not the result of close reasoning. There
was a decided tendency on the part of these banks between 1900 and
1914 to bottle up gold when it flowed towards them and to part with
it reluctantly when the tide was flowing the other way. Consequently,
when gold became relatively abundant they tended to hoard what came
their way and to raise the proportion of the reserves, with the result
that the increased output of South African gold was absorbed with less
effect on the price level than would have been the case if an increase
of _n_ had been totally without reaction on the value of _r_.
In agricultural countries where peasants readily hoard money, an
inflation, especially in its early stages, does not raise prices
proportionately, because when, as a result of a certain rise in the
price of agricultural products, more money flows into the pockets of
the peasants, it tends to stick there;--deeming themselves that much
richer, the peasants increase the proportion of their receipts that
they hoard.
Thus in these and in other ways the terms of our equation tend in
their movements to favour the stability of _p_, and there is a certain
friction which prevents a moderate change in _n_ from exercising its
full proportionate effect on _p_.
On the other hand a large change in _n_, which rubs away the initial
friction, and especially a change in _n_ due to causes which set up
a general expectation of a further change in the same direction, may
produce a _more_ than proportionate effect on _p_. After the general
analysis of Chapter I. and the narratives of catastrophic inflations
given in Chapter II., it is scarcely necessary to illustrate this
further,--it is a matter more readily understood than it was ten years
ago. A large change in _p_ greatly affects individual fortunes. Hence a
change after it has occurred, or sooner in so far as it is anticipated,
may greatly affect the monetary habits of the public in their attempt
to protect themselves from a similar loss in future, or to make gains
and avoid loss during the passage from the equilibrium corresponding to
the old value of _n_ to the equilibrium corresponding to its new value.
Thus after, during, and (so far as the change is anticipated) before a
change in the value of _n_, there will be some reaction on the values
of _k_, _k´_, and _r_, with the result that the change in the value of
_p_, at least temporarily and perhaps permanently (since habits and
practices, once changed, will not revert to exactly their old shape),
will not be precisely in proportion to the change in _n_.
The terms _inflation_ and _deflation_ are used by different writers
in varying senses. It would be convenient to speak of an increase
or decrease in _n_ as an inflation or deflation of _cash_; and of a
decrease or increase in _r_ as an inflation or deflation of _credit_.
The characteristic of the “credit-cycle” (as the alternation of boom
and depression is now described) consists in a tendency of _k_ and
_k´_ to diminish during the boom and increase during the depression,
irrespective of changes in _n_ and _r_, these movements representing
respectively a diminution and an increase of “real” balances (_i.e._
balances, in hand or at the bank, measured in terms of purchasing
power); so that we might call this phenomenon deflation and inflation
of real balances.
It will illustrate the “Quantity Theory” equation in general and the
phenomena of deflation and inflation of real balances in particular,
if we endeavour to fill in actual values for our symbolic quantities.
The following example does not claim to be exact and its object is to
illustrate the idea rather than to convey statistically precise facts.
October 1920 was about the end of the recent boom, and October 1922
was near the bottom of the depression. At these two dates the figures
of price level (taking October 1922 as 100), cash circulation (note
circulation _plus_ private deposits at the Bank of England[23]), and
bank deposits in Great Britain were roughly as follows:
[23] It would take me too far from the immediate matter in hand
to discuss why I take this definition of “cash” in the case
of Great Britain. It is discussed further in Chapter V.
below.
Price Level. Cash Circulation. Bank Deposits.
October 1920 150 £585,000,000 £2,000,000,000
October 1922 100 £504,000,000 £1,700,000,000
The value of _r_ was not very different at the two dates--say about
12 per cent. Consequently our equation for the two dates works out as
follows[24]:
October 1920 _n_ = 585 _p_ = 1·5 _k_ = 230 _k´_ = 1333
October 1922 _n_ = 504 _p_ = 1 _k_ = 300 _k´_ = 1700
[24] For 585 = 1·5(230 + 1333 × ·12), and 504 = 1(300 + 1700 ×
·12).
Thus during the depression _k_ rose from 230 to 300 and _k´_ from 1333
to 1700, which means that the cash holdings of the public at the former
date were worth 23/30, and their bank balances 1333/1700, what they
were worth at the latter date. It thus appears that the tendency of
_k_ and _k´_ to increase had more to do, than the deflation of “cash”
had, with the fall of prices between the two periods. If _k_ and _k´_
were to fall back to their 1920 values, prices would rise 30 per cent
without any change whatever in the volume of cash or the reserve policy
of the banks. Thus even in Great Britain the fluctuations of _k_ and
_k´_ can have a decisive influence on the price level; whilst we have
already seen (pp. 51, 52) how enormously they can change in the recent
conditions of Russia and Central Europe.
The moral of this discussion, to be carried forward in the reader’s
mind until we reach Chapters IV. and V., is that the price level is not
mysterious, but is governed by a few, definite, analysable influences.
Two of these, _n_ and _r_, are under the direct control (or ought to
be) of the central banking authorities. The third, namely _k_ and _k´_,
is not directly controllable, and depends on the mood of the public and
the business world. The business of stabilising the price level, not
merely over long periods but so as also to avoid cyclical fluctuations,
consists partly in exercising a stabilising influence over _k_ and
_k´_, in so far as this fails or is impracticable, in deliberately
varying _n_ and _r_ so as to _counterbalance_ the movement of _k_ and
_k´_.
The usual method of exercising a stabilising influence over _k_ and
_k´_ especially over _k´_, is that of bank-rate. A tendency of _k´_
to increase may be somewhat counteracted by lowering the bank-rate,
because easy lending diminishes the advantage of keeping a margin for
contingencies in cash. Cheap money also operates to _counterbalance_
an increase of _k´_, because, by encouraging borrowing from the banks,
it prevents _r_ from increasing or causes _r_ to diminish. But it
is doubtful whether bank-rate by itself is always a powerful enough
instrument, and, if we are to achieve stability, we must be prepared to
vary _n_ and _r_ on occasion.
Our analysis suggests that the first duty of the central banking
and currency authorities is to make sure that they have _n_ and _r_
thoroughly under control. For example, so long as inflationary taxation
is in question _n_ will be influenced by other than currency objects
and cannot, therefore, be fully under control; moreover, at the other
extreme, under a gold standard _n_ is not always under control, because
it depends on the unregulated forces which determine the demand and
supply of gold throughout the world. Again, without a central banking
system _r_ will not be under proper control because it will be
determined by the unco-ordinated decisions of numerous different banks.
At the present time in Great Britain _r_ is very completely controlled,
and _n_ also, so long as we refrain from inflationary finance on the
one hand and from a return to an unregulated gold standard on the
other.[25] The second duty of the authorities is therefore worth
discussing, namely, the _use_ of their control over _n_ and _r_ to
counterbalance changes in _k_ and _k´_. Even if _k_ and _k´_ were
entirely outside the influence of deliberate policy, which is not in
fact the case, nevertheless _p_ could be kept reasonably steady by
suitable modifications of the values of _n_ and _r_.
[25] In the case of the United States the same thing is more or
less true, so long as the Federal Reserve Board is prepared
to incur the expense of bottling up redundant gold.
Old-fashioned advocates of sound money have laid too much emphasis
on the need of keeping _n_ and _r_ steady, and have argued as if
this policy by itself would produce the right results. So far from
this being so, steadiness of _n_ and _r_, when _k_ and _k´_ are not
steady, is bound to lead to unsteadiness of the price level. Cyclical
fluctuations are characterised, not primarily by changes in _n_ or _r_,
but by changes in _k_ and _k´_. It follows that they can only be cured
if we are ready deliberately to increase and decrease _n_ and _r_, when
symptoms of movement are showing in the values of _k_ and _k´_. I am
being led, however, into a large subject beyond my immediate purpose,
and am anticipating also the topic of Chapter V. These hints will
serve, nevertheless, to indicate to the reader what a long way we may
be led by an understanding of the implications of the simple Quantity
equation with which we started.
II. _The Theory of Purchasing Power Parity._
The Quantity Theory deals with the purchasing power or commodity-value
of a given national currency. We come now to the _relative_ value of
_two_ distinct national currencies,--that is to say, to the theory of
the Foreign Exchanges.
When the currencies of the world were nearly all on a gold basis, their
relative value (_i.e._ the exchanges) depended on the actual amount of
gold metal in a unit of each, with minor adjustments for the cost of
transferring the metal from place to place.
When this common measure has ceased to be effective and we have instead
a number of independent systems of inconvertible paper, what basic
fact determines the rates at which units of the different currencies
exchange for one another?
The explanation is to be found in the doctrine, as old in itself as
Ricardo, with which Professor Cassel has lately familiarised the public
under the name of “Purchasing Power Parity.”[26]
[26] This term was first introduced into economic literature in
an article contributed by Prof. Cassel to the _Economic
Journal_, December 1918. For Prof. Cassel’s considered
opinions on the whole question, see his _Money and Foreign
Exchange after 1914_ (1922). The theory, as distinct from
the name, is essentially Ricardo’s.
This doctrine in its baldest form runs as follows: (1) The purchasing
power of an inconvertible currency within its own country, _i.e._ the
currency’s _internal_ purchasing power, depends on the currency policy
of the Government and the currency habits of the people, in accordance
with the Quantity Theory of Money just discussed. (2) The purchasing
power of an inconvertible currency in a foreign country, _i.e._ the
currency’s _external_ purchasing power, must be the rate of exchange
between the home-currency and the foreign-currency, multiplied by
the foreign-currency’s purchasing power in its own country. (3) In
conditions of equilibrium the _internal_ and _external_ purchasing
powers of a currency must be the _same_, allowance being made for
transport charges and import and export taxes; for otherwise a movement
of trade would occur in order to take advantage of the inequality.
(4) It follows, therefore, from (1), (2), and (3) that the rate of
exchange between the home-currency and the foreign-currency must
tend in equilibrium to be the ratio between the purchasing powers of
the home-currency at home and of the foreign-currency in the foreign
country. This ratio between the respective home purchasing powers of
the two currencies is designated their “purchasing power parity.”
If, therefore, we find that the internal and external purchasing
powers of the home-currency are widely different, and, which is the
same thing, that the actual exchange rates differ widely from the
purchasing power parities, then we are justified in inferring that
equilibrium is not established, and that, as time goes on, forces will
come into play to bring the actual exchange rates and the purchasing
power parities nearer together. The actual exchanges are often more
sensitive and more volatile than the purchasing power parities, being
subject to speculation, to sudden movements of funds, to seasonal
influences, and to _anticipations_ of impending changes in purchasing
power parity (due to relative inflation or deflation); though also on
other occasions they may lag behind. Nevertheless it is the purchasing
power parity, according to this doctrine, which corresponds to the old
gold par. This is the point about which the exchanges fluctuate, and at
which they must ultimately come to rest; with one material difference,
namely, that it is not itself a fixed point,--since, if internal prices
move differently in the two countries under comparison, the purchasing
power parity also moves, so that equilibrium may be restored, not only
by a movement in the market rate of exchange, but also by a movement of
the purchasing power parity itself.
At first sight this theory appears to be one of great practical
utility; and many persons have endeavoured to draw important practical
conclusions about the future course of the exchanges from charts
exhibiting the divergences between the market rate of exchange and the
purchasing power parities,--undeterred by the perplexity whether an
existing divergence from equilibrium will be remedied by a movement of
the exchanges or of the purchasing power parity or of both.
In practical applications of the doctrine there are, however, two
further difficulties, which we have allowed so far to escape our
attention,--both of them arising out of the words _allowance being
made for transport charges and import and export taxes_. The first
difficulty is how to make allowance for such charges and taxes. The
second difficulty is how to treat purchasing power over goods and
services which _do not enter into international trade at all_.
The doctrine, in the form in which it is generally applied, endeavours
to deal with the first difficulty by assuming that the percentage
difference between internal and external purchasing power at some
standard date, when approximate equilibrium may be presumed to have
existed, generally the year 1913, may be taken as an approximately
satisfactory correction for the same disturbing factors at the present
time. For example, instead of calculating directly the cost of a
standard set of goods at home and abroad respectively, the calculations
are made that $2 are required to buy in the United States a standard
set which $1 would have bought in 1913, and that £2·43 are required to
buy in England what £1 would have bought in 1913. On this basis (the
pre-war purchasing power parity being assumed to be in equilibrium
with the pre-war exchange of $4·86 = £1) the present purchasing power
parity between dollars and sterling is given by $4 = £1, since 4·86 ×
2 ÷ 2·43 = 4.
The obvious objection to this method of correction is that transport
and tariff costs, especially if this term is taken to cover all
export and import regulations, including prohibitions and official or
semi-official combines for differentiating between export and home
prices, are notoriously widely different in many cases from those which
existed in 1913. We should not get the same result if we were to take
some year other than 1913 as the basis of the calculation.
The second difficulty--the treatment of purchasing power over articles
which do not enter into international trade--is still more serious.
For, if we restrict ourselves to articles entering into international
trade and make exact allowance for transport and tariff costs, we
should find that the theory is always in accordance with the facts,
with perhaps a short time-lag, the purchasing power parity being never
very far from the market rate of exchange. Indeed, it is the whole
business of the international merchant to see that this is so; for
whenever the rates are temporarily out of parity he is in a position
to make a profit by moving goods. The prices of cotton in New York,
Liverpool, Havre, Hamburg, Genoa, and Prague, expressed in dollars,
sterling, francs, marks, lire, and krone respectively, are never for
any length of time much divergent from one another on the basis of
the exchange rates actually obtaining in the market, due allowance
being made for tariffs and the cost of moving cotton from one centre to
another; and the same is true of other articles of international trade,
though with an increasing time-lag as we pass to articles which are
not standardised or are not handled in organised markets. In fact, the
theory, stated thus, is a truism, and as nearly as possible jejune.
For this reason practical applications of the theory are not thus
restricted. The standard set of commodities selected is not confined
to goods which are exported from and imported into the countries
under comparison, but is the same set, generally speaking, as is used
for compiling index numbers of general purchasing power or of the
working-class cost of living. Yet applied in this way--namely, in a
comparison of movements of the _general_ index numbers of home prices
in two countries with movements in the rates of exchange between their
currencies--the theory requires a further assumption for its validity,
namely, that in the long run the home prices of the goods and services
which do not enter into international trade, move in more or less the
same proportions as those which do.[27]
[27] “Our calculation of the purchasing power parity rests
strictly on the proviso that the rise in prices in the
countries concerned has affected all commodities in a like
degree. If that proviso is not fulfilled, then the actual
exchange rate may deviate from the calculated purchasing
power parity.” Cassel, _Money and Foreign Exchange after
1914_, p. 154.
So far from this being a truism, it is not literally or exactly true
at all; and one can only say that it is more or less true according
to circumstances. If capital and labour can freely move on a large
scale between home and export industries without loss of relative
efficiency, if there is no movement in the “equation of exchange” (see
below) with the other country, and if the fluctuations in price are
solely due to monetary influences and not to changes in other economic
relationships between the two countries, then this further assumption
may be approximately justified. But this is not always the case; and
such a cataclysm as the war, with its various consequences to victor
and vanquished, may set up a new equilibrium position. There may, for
example, be a change more or less permanent, or at least as prolonged
as the reparation payments, in the relative exchange values of
Germany’s imports and exports respectively, or of those German products
and services which can enter into international trade and those which
cannot. Or, again, the strengthening of the financial position of the
United States as against Europe, which has resulted from the war, may
have shifted the old equilibrium in a direction favourable to the
United States. In such cases it is not correct to assume that the
coefficients of purchasing power parity, calculated, as they generally
are calculated, by means of the relative variations of index numbers of
general purchasing power from their pre-war levels, must ultimately
approximate to the actual rates of exchange, or that internal and
external purchasing power must ultimately bear to one another the same
relation as in 1913.
The Index Number calculated for the United States by the Federal
Reserve Board illustrates how disturbing may be the influence of the
change since 1913 in the relative prices of imported goods, exported
goods, and commodities generally:
Goods Goods All
Imported. Exported. Commodities.
1913 100 100 100
July 1922 128 165 165
April 1923 156 186 169
July 1923 141 170 159
Thus the theory does not provide a simple or ready-made measure of the
“true” value of the exchanges. When it is restricted to foreign-trade
goods, it is little better than a truism. When it is not so restricted,
the conception of purchasing power parity becomes much more
interesting, but is no longer an accurate forecaster of the course of
the foreign exchanges. If, therefore, we follow the ordinary practice
of fixing purchasing power parity by comparisons of the _general_
purchasing power of a country’s currency at home and abroad, then we
must not infer from this that the actual rate of exchange _ought_ to
stand at the purchasing power parity, or that it is only a matter of
time and adjustment before the two will return to equality. Purchasing
power parity, thus defined, tells us an important fact about the
relative changes in the purchasing power of money in (_e.g._) England
and the United States or Germany between 1913 and, say, 1923, but it
does not necessarily settle what the equilibrium exchange rate in 1923
between sterling and dollars or marks ought to be.
Thus defined “purchasing power parity” deserves attention, even though
it is not always an accurate forecaster of the foreign exchanges. The
practical importance of our qualifications must not be exaggerated.
If the fluctuations of purchasing power parity are markedly different
from the fluctuations in the exchanges, this indicates an actual or
impending change in the relative prices of the two classes of goods
which respectively do and do not enter into international trade. Now
there is certainly a tendency for movements in the prices of these
two classes of goods to influence one another in the long run. The
relative valuation placed on them is derived from deep economic and
psychological causes which are not easily disturbed. If, therefore, the
divergence from the pre-existing equilibrium is mainly due to monetary
causes (as, for example, different degrees of inflation or deflation in
the two countries), as it often is, then we may reasonably expect that
purchasing power parity and exchange value will come together again
before long.
When this is the case, it is not possible to say in general whether
exchange value will move towards purchasing power parity or the other
way round. Sometimes, as recently in Europe, it is the exchanges
which are the more sensitive to impending relative price-changes and
move first; whilst in other cases the exchanges may not move until
after the change in the relation between the internal and external
price-levels is an accomplished fact. But the essence of the purchasing
power parity theory, considered as an explanation of the exchanges,
is to be found, I think, in its regarding internal purchasing power
as being in the long run a more trustworthy indicator of a currency’s
value than the market rates of exchange, because internal purchasing
power quickly reflects the monetary policy of the country, which is
the final determinant. If the market rates of exchange fall further
than the country’s existing or impending currency policy justifies by
its effect on the internal purchasing power of the country’s money,
then sooner or later the exchange value is bound to recover. Thus,
provided no persisting change is taking place in the basic economic
relations between two countries, and provided the internal purchasing
power of the currency has in each country settled down to equilibrium
in relation to the currency policy of the authorities, then the rate
of exchange between the currencies of the two countries must also
settle down in the long run to correspond with their comparative
internal purchasing powers. Subject to these assumptions comparative
internal purchasing power does take the place of the old gold parity
as furnishing the point about which the short-period movements of the
exchanges fluctuate.
If, on the other hand, these assumptions are not fulfilled and changes
are taking place in the “equation of exchange,” as economists call it,
between the services and products of one country and those of another,
either on account of movements of capital, or reparation payments, or
changes in the relative efficiency of labour, or changes in the urgency
of the world’s demand for that country’s special products, or the like,
then the equilibrium point between purchasing power parity and the rate
of exchange may be modified permanently.
This point may be made clearer by an example. Let us consider two
countries, Westropa and the United States of the Hesperides, and let
us assume for the sake of simplicity, and also because it may often
correspond to the facts, that in both countries the price of exported
goods moves in the same way as the price of other home-produced
goods, but that the “equation of exchange” has moved in favour of the
Hesperides so that a smaller number than before of units of Hesperidean
products exchange for a given quantity of Westropean products. It
follows from this that imported products in Westropa will rise in
price more than commodities generally, whilst in the Hesperides
they will rise less. Let us suppose that between 1913 and 1923 the
Westropean index number of prices has risen from 100 to 155 and the
Hesperidean index number from 100 to 160; that these index numbers are
so constructed in each case that imported commodities constitute 20
per cent and home-produced commodities 80 per cent of the whole; and
that the “equation of exchange” has moved 10 per cent in favour of
the Hesperides, that is to say a given quantity of the goods exported
by the Hesperides will buy 10 per cent more than before of the goods
exported by Europe. The state of affairs is then as follows:[28]
_Westropa_: Price index of imported commodities (_x_) 167.
„ home-produced „ (_y_) 152.
„ all „ 155.
_Hesperides_: „ imported „ (_x´_) 148.
„ home-produced „ (_y´_) 163.
„ all „ 160.
[Footnote 28:
For 10_x_ = 11_y_
8_y_ + 2_x_ = 1550
11_x´_ = 10_y´_
8_y´_ + 2_x´_ = 1600.
]
Thus it appears that the purchasing power parity of the Westropean
currency in 1923 compared with 1913 is (160/155 = )103; whereas the
rate of exchange, compared with the 1913 parity, is (163/167 = 148/152
= )97. If the worsening of Westropa’s equation of exchange with the
Hesperides is permanent, then its purchasing power parity (on the 1913
basis) will also remain permanently above the equilibrium value of the
market rate of exchange.
A tendency of these two measures of the value of a country’s currency
to move differently is, therefore, a highly interesting symptom. If the
market rate of exchange shows a continuing tendency to stand below the
purchasing power parity, we have, failing any other explanation, some
reason to suspect a worsening of the “equation of exchange” as compared
with the base year.
In the charts and tables below, the actual results are worked out of
applying the theory to the exchange value of sterling, francs, and lire
in terms of dollars since 1919. The figures show that, quantitatively
speaking, the influences, which detract from the precision of the
purchasing power parity theory, have been in these cases small, on the
whole, as compared with those which function in accord with it. There
seems to have been some disturbance in the “equations of exchange”
since 1913,--which would probably show up more distinctly if it were
not that the index numbers employed in the following enquiry are
of the type which is largely built up from articles entering into
international trade. Nevertheless general price changes, affecting
all commodities more or less equally, due to currency inflation or
deflation, have been so dominant in their influence that the theory
has been actually applicable with remarkable accuracy. In the case,
however, of such countries as Germany, where the shocks to equilibrium
have been much more violent in many respects, the concordance between
the purchasing power parity based on 1913 and the actual rate of
exchange has suffered, whether temporarily or permanently, very great
disturbance.
The first of these charts, which deals with the value of sterling
in terms of dollars, shows that whilst the purchasing power parity,
calculated with 1913 as base, is often somewhat above the actual
exchange, there is a persevering tendency for the two to come together.
The two curves are within one point of each other in September-November
1919, March-April 1920, April 1921, September 1921, January-June 1922,
and February-June 1923, which is certainly a remarkable illustration
of the tendency to concordance between the purchasing power parity
and the rate of exchange. On inductive grounds it would be tempting
to conclude from this chart that the financial consequences of the
war have depressed the equilibrium of the purchasing power parity of
sterling as against the dollar from 1 to 2½ per cent since 1913, if it
were not that this figure barely exceeds the margin of error resulting
from the choice of one pair of index numbers rather than another from
amongst those available.[29] It will be interesting to see what effect
is produced by the payment, just commenced, of the interest on the
American debt.
[29] Nevertheless, if I had used the Board of Trade or the
_Statist_ index number in place of the _Economist_ index
number in the table below, the presumption of a slight
worsening of the “equation of index” against Great Britain
would be somewhat strengthened.
This chart brings out clearly, as also do those for France and
Italy, the susceptibility of the foreign exchange rates to seasonal
influences, whereas the purchasing power parity is naturally less
affected by them.
In the case of France the curves are together at the end of 1919,
diverge in 1920, come together again in the middle of 1921, and keep
together until a divergence occurred again in the latter part of 1922.
For Italy, rather unexpectedly perhaps, the relationship is
extraordinarily steady, although here, as in the case of France and
Great Britain, there are indications that the war may have resulted
in a slight lowering of the equilibrium point, by (say) 10 per
cent;[30]--the parity, calculated with 1913 as the base year, has been
almost invariably somewhat above the actual rate of exchange. The
Italian curve illustrates in a remarkable way the manner in which the
external and internal purchasing powers of the currency fall together,
when the main influence at work is a progressive depreciation due to
currency inflation.
[30] The use of any of the other Italian index numbers would
have accentuated this indication. The table of American
prices given on p. 94 above confirms the suggestion that
the “equation of exchange” between the U.S. and the rest of
the world as a whole has moved, say, 10 per cent in favour
of the former.
The broad effect of these curves and tables is to give substantial
inductive support to the general theory outlined above, even under such
abnormal conditions as have existed since the Armistice. During this
period the movements of the relative price level in France and Italy
due to monetary inflation have been so much larger than any shifting
in the “equation of exchange” (a movement of more than 10 or 20 per
cent in which would be startling) that their foreign exchanges have
been much more influenced by their internal price policy in relation
to the internal price policies of other countries than by any other
factor; with the result that the Purchasing Power Parity Theory, even
in its crude form, has worked passably well.
GREAT BRITAIN AND THE UNITED STATES
+--------------+------------------------+-------------+-----------+
| | Price Index Number. | | Actual |
| Per cent of +------------+-----------+ Purchasing | Exchange |
| 1913 Parity. | Great | United | Power | (Monthly |
| |Britain[31] |States[32] | Parity.[33] | Average). |
+--------------+------------+-----------+-------------+-----------+
| 1919 Aug. | 242 | 216 | 89.3 | 87.6 |
| Sept. | 245 | 210 | 85.7 | 85.8 |
| Oct. | 252 | 211 | 83.7 | 85.9 |
| Nov. | 259 | 217 | 83.8 | 84.3 |
| Dec. | 273 | 223 | 81.7 | 78.4 |
| 1920 Jan. | 289 | 233 | 81.0 | 75.6 |
| Feb. | 303 | 232 | 76.6 | 69.5 |
| March | 310 | 234 | 75.6 | 76.2 |
| April | 306 | 245 | 80.1 | 80.6 |
| May | 305 | 247 | 81.0 | 79.0 |
| June | 291 | 243 | 83.5 | 81.1 |
| July | 293 | 241 | 82.3 | 74.2 |
| Sept. | 284 | 226 | 79.6 | 72.2 |
| Oct. | 266 | 211 | 79.3 | 71.4 |
| Nov. | 246 | 196 | 79.7 | 70.7 |
| Dec. | 220 | 179 | 81.4 | 71.4 |
| 1921 Jan. | 209 | 170 | 81.4 | 76.7 |
| Feb. | 192 | 160 | 83.3 | 79.6 |
| March | 189 | 155 | 82.0 | 80.3 |
| April | 183 | 148 | 80.9 | 80.7 |
| May | 182 | 145 | 79.7 | 81.5 |
| June | 179 | 142 | 79.3 | 78.0 |
| July | 178 | 141 | 79.2 | 74.8 |
| Aug. | 179 | 142 | 79.3 | 75.1 |
| Sept. | 183 | 141 | 77.0 | 76.5 |
| Oct. | 170 | 142 | 83.5 | 79.5 |
| Nov. | 166 | 141 | 84.9 | 81.5 |
| Dec. | 162 | 140 | 86.4 | 85.3 |
| 1922 Jan. | 159 | 138 | 86.8 | 86.8 |
| Feb. | 158 | 141 | 89.1 | 89.6 |
| March | 160 | 142 | 88.7 | 89.9 |
| April | 159 | 143 | 89.9 | 90.7 |
| May | 162 | 148 | 91.4 | 91.4 |
| June | 163 | 150 | 92.0 | 91.5 |
| July | 163 | 155 | 95.1 | 91.4 |
| Aug. | 158 | 155 | 98.1 | 91.7 |
| Sept. | 158 | 154 | 97.4 | 91.2 |
| Nov. | 159 | 156 | 98.1 | 92.0 |
| Dec. | 158 | 156 | 98.7 | 94.6 |
| 1923 Jan. | 160 | 156 | 97.5 | 95.7 |
| Feb. | 163 | 157 | 96.3 | 96.2 |
| March | 163 | 159 | 97.5 | 96.5 |
| April | 165 | 159 | 96.4 | 95.7 |
| May | 164 | 156 | 95.1 | 95.0 |
| June | 160 | 153 | 95.6 | 94.8 |
+--------------+------------+-----------+-------------+-----------+
[31] _Economist_ Index Number.
[32] U.S. Bureau of Labour Index Number, as revised.
[33] The U.S. Bureau of Labour Index Number divided by the
_Economist_ Index Number.
[Illustration: ENGLAND]
FRANCE AND THE UNITED STATES
+--------------+-------------+-----------+
| | Purchasing | |
| Per cent of | Power | Actual |
| 1913 Parity. | Parity.[34] | Exchange. |
+--------------+-------------+-----------+
| 1919 Aug. | 62 | 66 |
| Sept. | 58 | 61 |
| Oct. | 55 | 60 |
| Nov. | 53 | 55 |
| Dec. | 52 | 48 |
| 1920 Jan. | 48 | 44 |
| Feb. | 44 | 36 |
| March | 42 | 37 |
| April | 41 | 32 |
| May | 45 | 35 |
| June | 49 | 41 |
| July | 48 | 42 |
| Aug. | 46 | 37 |
| Sept. | 43 | 35 |
| Oct. | 42 | 34 |
| Nov. | 43 | 31 |
| Dec. | 41 | 30 |
| 1921 Jan. | 42 | 33 |
| Feb. | 42 | 37 |
| March | 43 | 36 |
| April | 43 | 37 |
| May | 44 | 43 |
| June | 44 | 42 |
| July | 43 | 40 |
| Aug. | 43 | 40 |
| Sept. | 41 | 38 |
| Oct. | 43 | 38 |
| Nov. | 42 | 37 |
| Dec. | 43 | 40 |
| 1922 Jan. | 44 | 42 |
| Feb. | 46 | 45 |
| March | 46 | 47 |
| April | 46 | 48 |
| May | 44 | 47 |
| June | 46 | 45 |
| July | 48 | 43 |
| Aug. | 47 | 41 |
| Sept. | 46 | 40 |
| Oct. | 46 | 38 |
| Nov. | 44 | 35 |
| Dec. | 43 | 37 |
| 1923 Jan. | 40 | 34 |
| Feb. | 37 | 32 |
| March | 37 | 33 |
| April | 38 | 35 |
| May | 38 | 34 |
| June | 37 | 33 |
+--------------+-------------+-----------+
[34] U.S. Bureau of Labour Index divided by French official
wholesale Index.
ITALY AND THE UNITED STATES
+--------------+-------------+-----------+
| | Purchasing | |
| Per cent of | Power | Actual |
| 1913 Parity. | Parity.[35] | Exchange. |
+--------------+-------------+-----------+
| 1919 Aug. | 59 | 56 |
| Sept. | 56 | 53 |
| Oct. | 54 | 51 |
| Nov. | 50 | 44 |
| Dec. | 49 | 40 |
| 1920 Jan. | 46 | 37 |
| Feb. | 42 | 29 |
| March. | 38 | 28 |
| April | 36 | 23 |
| May | 38 | 27 |
| June | 40 | 31 |
| July | 39 | 30 |
| Aug. | 37 | 25 |
| Sept. | 34 | 23 |
| Oct. | 32 | 20 |
| Nov. | 30 | 19 |
| Dec. | 28 | 18 |
| 1921 Jan. | 26 | 18 |
| Feb. | 26 | 19 |
| March | 26 | 20 |
| April | 25 | 24 |
| May | 27 | 27 |
| June | 28 | 26 |
| July | 27 | 24 |
| Aug. | 26 | 22 |
| Sept. | 24 | 22 |
| Oct. | 24 | 20 |
| Nov. | 24 | 21 |
| Dec. | 23 | 23 |
| 1922 Jan. | 24 | 23 |
| Feb. | 25 | 25 |
| March. | 27 | 26 |
| April | 27 | 28 |
| May | 28 | 27 |
| June | 28 | 26 |
| July | 28 | 24 |
| Aug. | 27 | 23 |
| Sept. | 26 | 22 |
| Oct. | 26 | 22 |
| Nov. | 26 | 23 |
| Dec. | 27 | 26 |
| 1923 Jan. | 27 | 26 |
| Feb. | 27 | 25 |
| March. | 27 | 25 |
| April | 27 | 26 |
| May | 27 | 25 |
| June | 26 | 24 |
+--------------+-------------+-----------+
[35] U.S. Bureau of Labour Index Number divided by the “Bachi”
Index Number.
[Illustration: FRANCE]
[Illustration: ITALY]
III. _The Seasonal Fluctuation._
Thus the Theory of Purchasing Power Parity tells us that movements in
the rate of exchange between the currencies of two countries tend,
subject to adjustment in respect of movements in the “equation of
exchange,” to correspond pretty closely to movements in the internal
price levels of the two countries each expressed in their own currency.
It follows that the rate of exchange can be improved in favour of one
of the countries by a financial policy directed towards a lowering
of its internal price level relatively to the internal price level
of the other country. On the other hand a financial policy which has
the effect of raising the internal price level must result, sooner or
later, in depressing the rate of exchange.
The conclusion is generally drawn, and quite correctly, that budgetary
deficits covered by a progressive inflation of the currency render
the stabilisation of a country’s exchanges impossible; and that the
cessation of any increase in the volume of currency, due to this cause,
is a necessary pre-requisite to a successful attempt at stabilising.
The argument, however, is often carried further than this, and it is
supposed that, if a country’s budget, currency, foreign trade, and
its internal and external price levels are properly adjusted, then,
automatically, its foreign exchange will be steady.[36] So long,
therefore, as the exchanges fluctuate--thus the argument runs--this
in itself is a symptom that an attempt to stabilise would be
premature. When, on the other hand, the basic conditions necessary for
stabilisation are present, the exchange will steady itself. In short,
any deliberate or artificial scheme of stabilisation is attacking the
problem at the wrong end. It is the regulation of the currency, by
means of sound budgetary and bank-rate policies, that needs attention.
The proclamation of convertibility will be the last and crowning
stage of the proceedings, and will amount to little more than the
announcement of a _fait accompli_.
[36] Dr. R. Estcourt, criticising one of my articles in _The
Annalist_ for June 12, 1922, writes: “The arrangement
would not last for any appreciable period unless, as a
preliminary, the Governments took the necessary steps to
balance their budgets. If that were done, the so-called
stabilisation speedily would become unnecessary; exchange
would stabilise itself at pre-war rates.” This passage puts
boldly an opinion which is widely held.
There is a certain force in this mode of reasoning. But in one
important respect it is fallacious.
Even though foreign trade is properly adjusted, and the country’s
claims and liabilities on foreign account are in equilibrium over
the year as a whole, it does not follow that they are in equilibrium
every day. Indeed, it is well known that countries which import large
quantities of agricultural produce do not find it convenient, if they
are to secure just the quality and the amount which they require, to
buy at an equal rate throughout the year, but prefer to concentrate
their purchases on the autumn period.[37] Thus, quite consistently
with equilibrium over the year as a whole, industrial countries
tend to owe money to agricultural countries in the second half of
the year, and to repay in the first half. The satisfaction of these
seasonal requirements for credit with the least possible disturbance
to trade was recognised before the war as an important function of
international banking, and the seasonal transference of short-term
credits from one centre to another was carried out for a moderate
commission.
[37] Whilst the fact of seasonal pressure is well ascertained,
the exact analysis of it is a little complicated. Food
arrivals into Great Britain, for example, are nearly 10
per cent heavier in the third and fourth quarters of the
year than in the first and second, and reach their maximum
in the fourth quarter. (These and the following figures
are based on averages for the pre-war period 1901–1913
worked out by the Cambridge and London Economic Service).
Raw material imports are more than 20 per cent heavier
in the fourth and first quarters than in the second and
third, and reach their maximum in the three months November
to January. Thus the fourth quarter of the year is the
period at which there are heavy imports of both food and
raw materials. Manufactured exports, on the other hand,
are distributed through the year much more evenly, and are
about normal during the last quarter. Allowing for the fact
that imports are paid for, generally speaking, before they
arrive, these dates correspond pretty closely with the date
at which seasonal pressure is actually experienced by the
dollar-sterling exchange. In France, since the war, imports
in the last quarter of the year seem to have been quite 50
per cent heavier than, for example, in the first quarter.
In Italy the third quarter seems to be the slackest, and
the last quarter, again, a relatively heavy period. When we
turn to the statistics for the United States we find the
other side of the picture. August and September are the
months of heavy wheat export; October to January those of
heavy cotton export. The strength of the dollar exchanges
in the early autumn is further increased by the financial
pressure in the United States during the crop-moving
period, which leads to a withdrawal of funds from foreign
centres to New York.
It was possible for this service to be rendered cheaply because, with
the certainty provided by convertibility, the price paid for it did
not need to include any appreciable provision against risk. A somewhat
higher rate of discount in the temporarily debtor country, together
with a small exchange profit provided by the slight shift of the
exchanges within the gold points, was quite sufficient.
But what is the position now? As always, the balance of payments
must balance every day. As before, the balance of trade is spread
unevenly through the year. Formerly the daily balance was adjusted by
the movement of bankers’ funds, as described above. But now it is no
longer a purely bankers’ business, suitably and sufficiently rewarded
by an arbitrage profit. If a banker moves credits temporarily from
one country to another, he cannot be certain at what rate of exchange
he will be able to bring them back again later on. Even though he may
have a strong opinion as to the probable course of exchange, his profit
is no longer definitely calculable beforehand, as it used to be; he
has learnt by experience that unforeseen movements of the exchange
may involve him in heavy loss; and his prospective profit must be
commensurate with the risk he runs. Even if he thinks that the risk is
covered actuarially by the prospective profit, a banker cannot afford
to run such risks on a large scale. In fact, the seasonal adjustment of
credit requirements has ceased to be arbitrage banking business, and
demands the services of speculative finance.
Under present conditions, therefore, a large fluctuation of the
exchange may be necessary before the daily account can be balanced,
even though the annual account is level. Where in the old days a banker
would have readily remitted millions to and from New York, hundreds
of thousands are now as much as the biggest institutions will risk.
The exchange must fall (or rise, as the case may be) until either the
speculative financier feels sufficiently confident of a large profit to
step in, or the merchant, appalled by the rate of exchange quoted to
him for the transaction, decides to forgo the convenience of purchasing
at that particular season of the year, and postpones a part of his
purchases.
The services of the professional exchange speculator, being discouraged
by official and banking influences, are generally in short supply, so
that a heavy price has to be paid for them, and trade is handicapped
by a corresponding expense, in so far as it continues to purchase its
materials at the most convenient season of the year.
The extent to which the exchange fluctuations which have troubled trade
during the past three years have been seasonal, and therefore due, not
to a continuing or increasing disequilibrium, but merely to the absence
of a fixed exchange, is not, I think, fully appreciated.
During 1919 there was a heavy fall of the chief European exchanges due
to the termination of the inter-Allied arrangements which had existed
during the war. During 1922 there was a rise of the sterling exchange,
which was independent of seasonal influences. During 1923 there has
been a further non-seasonal collapse of the franc exchange due to
certain persisting features of France’s internal finances and external
policy. But the following table shows how largely _recurrent_ the
fluctuations have been during the four years since the autumn of 1919:--
PERCENTAGE OF DOLLAR PARITY
+------------+------------------+------------------+------------------+
|August-July.| Sterling. | Francs. | Lire. |
| | Lowest. Highest. | Lowest. Highest. | Lowest. Highest. |
+------------|------------------+------------------+------------------+
| 1919–1920 | 69 88 | 31 66 | 22 56 |
| 1920–1921 | 69 82 | 30 45 | 18 29 |
| 1921–1922 | 73 92 | 37 48 | 20 28 |
| 1922–1923 | 90 97 | 29 41 | 20 27 |
+------------+------------------+------------------+------------------+
On the experience of the past three years, francs and lire are at their
best in April and May and at their worst between October and December.
Sterling is not quite so punctual in its movements, the best point of
the year falling somewhere between March and June and the worst between
August and November.
The comparative stability of the highest and lowest quotations
respectively in each year, especially in the case of Italy, is very
striking, and indicates that a policy of stabilisation at some mean
figure might have been practicable; whilst, on the other hand, the wide
divergences between the highest and lowest are a measure of the expense
and interference that trade has suffered.
These results correspond so closely to the facts of seasonal trade
(see above, p. 108) that we may safely attribute most of the major
fluctuations of the exchanges from month to month to the actual
pressure of trade remittances, and not to speculation. Speculators,
indeed, by anticipating the movements tend to make them occur a little
earlier than they would occur otherwise, but by thus spreading the
pressure more evenly through the year their influence is to diminish
the absolute amount of the fluctuation. General opinion greatly
overestimates the influence of exchange-speculators acting under the
stimulus of merely political and sentimental considerations. Except
for brief periods the influence of the speculator is washed out; and
political events can only exert a lasting influence on the exchanges,
in so far as they modify the internal price level, the volume of trade,
or the ability of a country to borrow on foreign markets. A political
event, which does not materially affect any of these facts, cannot
exert a lasting effect on the exchanges merely by its influence on
sentiment. The only important exception to this statement is where
there exists on a large scale a long-period speculative investment in a
country’s currency on the part of foreigners, as in the case of German
marks. But such investments are comparable to borrowing abroad and
exercise a different kind of influence altogether from a speculative
transaction proper, which is opened with the intention of its being
closed again within a short period. And even speculative investment
in a currency, since it is bound to diminish sooner or later, cannot
permanently prevent the exchanges from reaching the equilibrium
justified by conditions of trading and relative price levels.
It follows that, whilst purely seasonal fluctuations do not interfere
with the forces which determine the ultimate equilibrium of the
exchanges, nevertheless stability of the exchange from day to day
cannot be maintained merely by the _fact_ of stability in these
underlying conditions. It is necessary also that bankers should have a
sufficiently certain _expectation_ of such stability to induce them to
look after the daily and seasonal fluctuations of the market in return
for a moderate commission.
After recent experience it is unlikely that they will actually
entertain any such expectation, even if the underlying facts were of
a kind to justify it, with sufficient conviction to act, unless it is
backed up by a guarantee on the part of the Central Authority (Bank or
Government) to employ all their resources for the maintenance of the
level of exchange at a stated figure. At present the declared official
policy is to bring the franc and the lira (for example) back to par,
so that operations favouring a fall of these currencies are not free
from danger. On the other hand no steps are taken to make this policy
effective, and the conditions of internal finance in France and Italy
indicate that their exchanges may go much worse. Thus, since no one can
have complete confidence whether they are to be a great deal better or
very much worse, there must be a wide fluctuation before financiers
will come in, purely from motives of self-interest, to balance the
day-to-day fluctuations and the month-to-month fluctuations round about
the unpredictable point of equilibrium.
If, therefore, the exchanges are not stabilised by policy, they
will never come to an equilibrium of themselves. As time goes on
and experience accumulates, the oscillations may be smaller than at
present. Speculators may come in a little sooner, and importers may
make greater efforts to spread their requirements more evenly over the
year. But even so, there must be a substantial difference of rates
between the busy season and the slack season, until the business world
knows for certain at what level the exchanges in question are going to
settle down. Thus a seasonal fluctuation of the exchanges (including
the sterling-dollar exchange) is inevitable, even in the absence of
any decided long-period tendency of an exchange to rise or to fall,
unless the Central Authority, by a guarantee of convertibility or
otherwise, takes special steps to provide against it.
IV. _The Forward Market in Exchanges._
When a merchant buys or sells goods in a foreign currency the
transaction is not always for immediate settlement by cash or
negotiable bill. During the interval before he can cover himself by
buying or selling (as the case may be) the foreign currency involved,
he runs an exchange risk, losses or gains on which may often, in these
days, swamp his trading profit. He is thus involuntarily engaged in a
heavy risk of a kind which it is hardly in his province to undertake.
The subject of what follows is a piece of financial machinery--namely,
the market in “forward” exchanges as distinguished from “spot”
exchanges--for enabling the merchant to avoid this risk, not, indeed,
during the interval when he is negotiating the contract, but as soon as
the negotiation is completed.
Transactions in “spot” exchange are for cash--that is to say, cash in
one currency is exchanged for cash in another currency. But merchants
who have bought goods in terms of foreign currency for future delivery
may not have the cash available pending delivery of the goods; whilst
merchants who have sold goods in terms of foreign currency, but are
not yet in a position to sell a draft on the buyer, cannot, even if
they have plenty of cash in their own currency, protect themselves by a
“spot” sale of the exchange involved, save in the exceptional case when
they have cash available in the foreign currency also.
A “forward” contract is for the conclusion of a “spot” transaction
in exchanges at a later date, fixed on the basis of the spot rate
prevailing at the original date. Pending the date of the maturity
of the forward contract no cash need pass (although, of course, the
contracting party may be required to give some security or other
evidence for his ability to complete the contract in due course), so
that the merchant entering into a forward contract is not required to
find cash any sooner than if he ran the risk on the exchange until the
goods were delivered; yet he is protected from the consequences of any
fluctuation in the exchanges in the meantime.
The tables given below show that in London, in the case of the
exchanges which have a big market (the dollar, the franc, and the
lira), competition between dealers has brought down the charges for
these facilities to a fairly moderate rate. During 1920 and 1921 the
cost to an English buyer of foreign currency for forward delivery
was a little more expensive than for spot delivery in the case of
francs, lire, and marks, and a little cheaper in the case of dollars.
Correspondingly, French, Italian, and German merchants were generally
in a position to buy both sterling and dollars for forward delivery
at a slightly cheaper rate than for spot delivery--that is to say, if
they dealt in London. As regards the rates charged in foreign centres
my information is not extensive, but it indicates that in Milan,
for example, very much less favourable terms for these transactions
are frequently charged to the seller of forward sterling than those
ruling in London. During 1922, however, the effect of the progressive
cheapening of money in London was, for reasons to be explained in a
moment, to cheapen the cost to English buyers of foreign currency for
forward delivery, forward francs falling to an appreciable discount
on spot francs, and forward dollars becoming at the end of the year
decidedly cheaper than spot dollars. Later on, the raising of the
bank-rate in June 1923 acted again, as could have been predicted, in
the opposite direction.
Proceeding to details, we see below (pp. 118, 119) the quotations for
forward exchange ruling in the London market since the beginning of
1920. During 1920–21 forward dollars were generally cheaper than spot
dollars to a London buyer to the extent of from 1 to 1½ per cent per
annum. Occasionally, however, when big movements of the exchange were
taking place, the discount on forward dollars was temporarily much
higher, having risen, for example, in November 1920, when sterling
was at its lowest point, to nearly 6 per cent--for reasons which I
will endeavour to elucidate later. During the first half of 1922 the
discount on forward dollars dwindled, but rose again during the latter
half of the year, reacting again in the middle of 1923 after money
rates in London had been slightly raised. Thus a London merchant, who
has had dollar commitments for the purchase of goods, has not only been
able to cover his exchange risk by means of a forward transaction, but
on the average he has got his exchange a little cheaper by providing
for it in advance.
TABLE OF EXCHANGE QUOTATIONS IN LONDON ONE MONTH FORWARD[38]
+--------------------------------------------------+
| NEW YORK. |
+----------+------------+-------------+------------+
| | | One Month | Difference |
| Date. | Spot. | Forward. | per cent |
| | | | per annum. |
+----------+------------+-------------+------------+
| 1920 | | | |
|January | 3·79 | + ⅜ cent | +1·2 |
|February | 3·48⅞ | + ¼ „ | + ·9 |
|March | 3·41⅜ | + ¼ „ | + ·9 |
|April | 3·90¾ | + ⅜ „ | +1·2 |
|May | 3·82⅞ | + ½ „ | +1·6 |
|June | 3·89-15/16 | + ⅜ „ | +1·2 |
|July | 3·96⅛ | + ⅝ „ | +1·9 |
|August | 3·67 | + ½ „ | +1·6 |
|September | 3·56⅞ | + ½ „ | +1·7 |
|October | 3·48-5/16 | + ½ „ | +1·7 |
|November | 3·44⅜ | +1⅝ „ | +5·7 |
|December | 3·49 | + ½ „ | +1·7 |
| 1921 | | | |
|January | 3·58⅜ | + ⅜ „ | +1·3 |
|February | 3·84¾ | +1 „ | +3·1 |
|March | 3·88⅜ | + ⅞ „ | +2·7 |
|April | 3·92 | + ⅜ „ | +1·1 |
|May | 3·98 | + ½ „ | +1·5 |
|June | 3·90⅝ | + ¾ „ | +2·3 |
|July | 3·71-15/16 | + ⅝ „ | +2·0 |
|August | 3·56⅜ | + ½ „ | +1·7 |
|September | 3·71⅝ | + ⅜ „ | +1·2 |
|October | 3·76⅛ | + ½ „ | +1·6 |
|November | 3·92-1/16 | + ⅞ „ | +2·7 |
|December | 4·08-5/16 | + ⅜ „ | +1·1 |
| 1922 | | | |
|January | 4·20½ | + ⅛ „ | + ·4 |
|February | 4·30½ | par | ... |
|March | 4·42 | „ | ... |
|April | 4·39 | „ | ... |
|May | 4·44½ | „ | ... |
|June | 4·46¾ | + 3/16 cent | + ·5 |
|July | 4·44¾ | + 1/16 „ | + .17 |
|August | 4·45¼ | + 3/16 „ | + .5 |
|September | 4·46 | + ⅜ „ | +1 |
|October | 4·42 | + ¼ „ | + .68 |
|November | 4·46½ | + ⅝ „ | +1·68 |
|December | 4·51¾ | +1 „ | +2·65 |
| 1923 | | | |
|January | 4·64¾ | +1¼ „ | +3·23 |
|February | 4·67 | + ⅞ „ | +2·25 |
|March | 4·70⅝ | +1 „ | +2·55 |
|April | 4·66⅞ | + ¾ „ | +1·93 |
|May | 4·62½ | + 15/16 „ | +2·43 |
|June | 4·62¾ | + ⅞ „ | +2·27 |
|July | 4·56½ | + ½ „ | +1·31 |
|August | 4·57 | + ¼ „ | +0·66 |
+----------+------------+-------------+------------+
+--------------------------------------------------+
| PARIS. |
+----------+------------+-------------+------------+
| | | One Month | Difference |
| Date. | Spot. | Forward. | per cent |
| | | | per annum. |
+----------+------------+-------------+------------+
| 1920 | | | |
|January | 40·90 | + 6 centime | +1·7 |
|February | 46·90 | + 4 „ | +1·0 |
|March | 48·55 | + 3 „ | + ·7 |
|April | 57·80 | + 3 „ | + ·6 |
|May | 64·04 | + 1 „ | + ·18 |
|June | 50·45 | - 5 „ | -1·2 |
|July | 47·05 | -10 „ | -2·8 |
|August | 49·00 | -10 „ | -2·4 |
|September | 51·22½ | - 5 „ | -1·2 |
|October | 52·10 | -10 „ | -2·3 |
|November | 54·45 | -15 „ | -3·3 |
|December | 57·45 | -15 „ | -3·2 |
| 1921 | | | |
|January | 61·07½ | -30 „ | -5·9 |
|February | 54·50 | -20 „ | -4·4 |
|March | 54·40 | -27 „ | -5·9 |
|April | 55-37½ | -15 „ | -3·3 |
|May | 50·22½ | -12 „ | -2·9 |
|June | 46·35 | -10 „ | -2·6 |
|July | 46·72½ | -10 „ | -2·6 |
|August | 46·77½ | + 2 „ | + ·5 |
|September | 48·68½ | + 3 „ | + ·7 |
|October | 52·27½ | + 1 „ | + ·2 |
|November | 53·44 | + 4 „ | + ·9 |
|December | 54·24 | + 2 „ | + ·4 |
| 1922 | | | |
|January | 52·32½ | par | ... |
|February | 51·62½ | „ | ... |
|March | 48·45 | „ | ... |
|April | 48·15 | - 1 centime | - .25 |
|May | 48·47 | + 1 „ | + .25 |
|June | 49·00 | + 2 „ | + ·49 |
|July | 56·20 | + 8 „ | +1·8 |
|August | 54·10 | +10 „ | +2·21 |
|September | 57·40 | + 3 „ | + ·63 |
|October | 58·25 | + 3 „ | + ·62 |
|November | 64·65 | +14 „ | +2·59 |
|December | 64·30 | + 8 „ | +1·49 |
| 1923 | | | |
|January | 66·40 | + 5 „ | + ·9 |
|February | 75·50 | +16 „ | +2·54 |
|March | 77·50 | +11 „ | +1·70 |
|April | 70·40 | + 5 „ | + .85 |
|May | 69·35 | + 5 „ | + ·86 |
|June | 71·60 | + 5 „ | + ·84 |
|July | 78·35 | + 4 „ | + ·61 |
|August | 79·20 | + 9 „ | + ·60 |
+----------+------------+-------------+------------+
First day of month in 1920, first Wednesday in 1921, and first Friday
thereafter.
TABLE OF EXCHANGE QUOTATIONS IN LONDON ONE MONTH FORWARD
+--------------------------------------------------+
| ITALY. |
+----------+------------+-------------+------------+
| | | One Month | Difference |
| Date. | Spot. | Forward. | per cent |
| | | | per annum. |
+----------+------------+-------------+------------+
|1920[38] | | | |
|January | 50 | - ⅛ lire | - 3·0 |
|February | 55 | - ⅛ „ | - 2·7 |
|March | 62¾ | - ¼ „ | - 4·7 |
|April | 80½ | - ¼ „ | - 3·7 |
|May | 83 | - ½ „ | - 7·1 |
|June | 66⅜ | - ½ „ | - 9·1 |
|July | 65⅜ | - ½ „ | - 9·2 |
|August | 70 | - ½ „ | - 8·5 |
|September | 76¼ | - ½ „ | - 7·9 |
|October | 83-9/16 | - ½ „ | - 7·2 |
|November | 93-11/16 | - ½ „ | - 6·4 |
|December | 94-11/16 | - ½ „ | - 6·3 |
| 1921 | | | |
|January | 104⅜ | par | ... |
|February | 105½ | - ¾ lire | - 8·5 |
|March | 106½ | - ⅝ „ | - 7·0 |
|April | 92¼ | - ½ „ | - 6·5 |
|May | 81⅜ | - ⅝ „ | - 9·1 |
|June | 73-11/16 | - ½ „ | - 8·1 |
|July | 77 | - ½ „ | - 7·8 |
|August | 85-1/16 | - ¼ „ | - 3·5 |
|September | 85-9/16 | - ⅜ „ | - 5·2 |
|October | 94⅛ | - ⅜ „ | - 4·8 |
|November | 96⅝ | - ¼ „ | - 3·1 |
|December | 93-15/16 | - ½ „ | - 6·4 |
| 1922 | | | |
|January | 97⅛ | - ¼ „ | - 3·0 |
|February | 92½ | - 7/16 „ | - 5·7 |
|March | 83-3/16 | - ¼ „ | - 3·6 |
|April | 83-5/16 | -15 pts. | - 2·16 |
|May | 83 | -10 „ | - 1·45 |
|June | 85⅞ | - 3 „ | - ·41 |
|July | 100 | par | ... |
|August | 96 | par | ... |
|September | 101 | -11 „ | - 1·31 |
|October | 103 | -10 „ | - 1·16 |
|November | 106 | - 8 „ | - ·91 |
|December | 93¾ | -20 „ | - 2·56 |
| 1923 | | | |
|January | 92 | -11 „ | - 1·43 |
|February | 97½ | -23 „ | - 2·83 |
|March | 97⅜ | -23 „ | - 2·82 |
|April | 93¾ | -18 „ | - 2·30 |
|June | 99 | -15 „ | - 1·82 |
|July | 106⅞ | -22 „ | - 2·47 |
|August | 105½ | -28 „ | - 3·18 |
+----------+------------+-------------+------------+
+-------------------------------------------------------+
| GERMANY. |
+----------+------------+------------------+------------+
| | | One Month | Difference |
| Date. | Spot. | Forward. | per cent |
| | | | per annum. |
+----------+------------+------------------+------------+
|1920[38] | | | |
|January | 187 | marks | |
|February | 305 | | |
|March | 337 | | |
|April | 275 | | |
|May | 218½ | - 1 „ | - 5·5 |
|June | 150½ | - 1 „ | - 8·0 |
|July | 150 | - ½ „ | - 4·0 |
|August | 160½ | - 1 „ | - 7·5 |
|September | 176 | - ½ „ | - 3·4 |
|October | 215 | - 1 „ | - 5·6 |
|November | 266½ | - ½ „ | - 2·2 |
|December | 241½ | - 1 „ | - 4·9 |
| 1921 | | | |
|January | 269½ | - 2 „ | - 8·9 |
|February | 243½ | - 1 „ | - 4·9 |
|March | 24½ | - 1 „ | - 4·9 |
|April | 239½ | - 2 „ | -10·0 |
|May | 262½ | - 1¾ „ | - 8·0 |
|June | 245¼ | - 1½ „ | - 7·3 |
|July | 279½ | - 1½ „ | - 6·45 |
|August | 286 | - 1 „ | - 4·2 |
|September | 347½ | - 1½ „ | - 5·1 |
|October | 471 | - 5 „ | -12·7 |
|November | 764½ | - 2¼ „ | - 3·5 |
|December | 855 | - 1½ „ | - 2·1 |
| 1922 | | | |
|January | 777½ | - 3½ „ | - 5·4 |
|February | 872 | - 2½ „ | - 3·4 |
|March | 1117 | - 1½ „ | - 1·6 |
|April | 1440 | - 8 „ | - 6·6 |
|May | 1270 | - ½ „ | - ·47 |
|June | 1222 | par | ... |
|July | 2320 | + 5 marks | + 2·59 |
|August | 3175 | +20 „ | + 7·56 |
|September | 5700 | nominal | ... |
|October | 9900 | + 450 mks | + 54·54 |
|November | 26,250 | + 6,000 „ | +274·3 |
|December | 35,000 | + 5,500 „ | +188·58 |
| 1923 | | | |
|January | 39,500 | + 1,750 „ | + 53·16 |
|February | 190,000 | + 27,000 „ | +170·53 |
|March | 105,000 | + 10,000 „ | +114·28 |
|April | 97,500 | + 20,000 „ | +141·18 |
|June | 350,000 | + 40,000 „ | +137·14 |
|July | 900,000 | + 30,000[38] „ | + 40·00 |
|August | 5,500,000 | +1,500,000[38] „ | +327·27 |
+----------+------------+------------------+------------+
[38] Nominal.
Forward purchases of francs, after being dearer than spot transactions
by 2½ per cent per annum or more from the middle of 1920 to the middle
of 1921, were nearly level in price from the middle of 1921 to the
middle of 1922, whilst since that time they have been ½ to 2½ per cent
per annum cheaper. In the case of lire there have been much wider gaps,
forward purchases being frequently 3 per cent or more dearer than
spot. In the case of German marks, the forward rate, after ranging
round about 5 per cent per annum dearer than spot, has reached, since
the autumn of 1922 and the complete collapse of the mark, a figure
fantastically cheaper, thus reflecting the sensational rate of interest
for short loans current inside Germany.
But in all these cases (except in Germany since the complete collapse
of the mark), whether forward exchange is at a discount or at a
premium on spot, the expense, if any, of dealing forward has been small
in relation to the risks that are avoided.
Nevertheless, in practice merchants do not avail themselves of these
facilities to the extent that might have been expected. The nature of
forward dealings in exchange is not generally understood. The rates
are seldom quoted in the newspapers. There are few financial topics of
equal importance which have received so little discussion or publicity.
The present situation did not exist before the war (although even at
that time forward rates for the dollar were regularly quoted), and did
not begin until after the “unpegging” of the leading exchanges in 1919,
so that the business world has only begun to adapt itself. Moreover,
for the ordinary man, dealing in forward exchange has, it seems, a
smack of speculation about it. Unlike Manchester cotton spinners, who
have learnt by long experience that it is not the hedging of open
cotton commitments on the Liverpool futures market, but the failure to
do so, which is speculative, merchants, who buy or sell goods of which
the price is expressed in a foreign currency, do not yet regard it as
part of the normal routine of prudent business to hedge these indirect
exchange commitments by a transaction in forward exchange.
It is important, on the other hand, not to exaggerate the extent to
which, at the present time, merchants can by this means protect
themselves from risk. In the first place, for reasons, some of which
will be considered below, it is only in certain of the leading
exchanges that these transactions can be carried out at a reasonable
charge. It is not clear that even the banks themselves have yet learnt
to look on the provision for their clients of such facilities at fair
and reasonable rates as one of the most useful services they can offer.
They have been too much influenced, perhaps, by the fear that these
facilities might tend at the same time to increase speculation.
But there is a further qualification, not to be overlooked, to the
value of forward transactions as a protection against risk. The price
of a particular commodity, in terms of a particular currency, does
not exactly respond to changes in the value of that currency on the
exchange markets of the world, with the result that a movement in a
country’s exchanges may, in the case of a commodity of which that
country is a large seller or a large purchaser, change the commodity’s
world-value expressed in terms of gold. In that case a merchant, even
though he is hedged in respect of the exchange itself, may lose,
in respect of his unsold trading stocks, through a movement in the
world-value of the commodity he is dealing in, directly occasioned by
the exchange fluctuation.
* * * * *
If we turn to the theoretical analysis of the forward market, what is
it that determines the amount and the sign (whether plus or minus) of
the divergence between the spot and forward rates as recorded above?
If dollars one month forward are quoted cheaper than spot dollars
to a London buyer in terms of sterling, this indicates a preference
by the market, on balance, in favour of holding funds in New York
during the month in question rather than in London,--a preference the
degree of which is measured by the discount on forward dollars. For
if spot dollars are worth $4.40 to the pound and dollars one month
forward $4.40½ to the pound, then the owner of $4.40 can, by selling
the dollars spot and buying them back one month forward, find himself
at the end of the month with $4.40½, merely by being during the
month the owner of £1 in London instead of $4.40 in New York. That
he should require and can obtain half a cent, which, earned in one
month, is equal to about 1½ per cent per annum, to induce him to do the
transaction, shows, and is, under conditions of competition, a measure
of, the market’s preference for holding funds during the month in
question in New York rather than in London.
Conversely, if francs, lire, and marks one month forward are quoted
dearer than the spot rates to a London buyer, this indicates a
preference for holding funds in London rather than in Paris, Rome, or
Berlin.
The difference between the spot and forward rates is, therefore,
precisely and exactly the measure of the preference of the money and
exchange market for holding funds in one international centre rather
than in another, _the exchange risk apart_, that is to say under
conditions in which the exchange risk is covered. What is it that
determines these preferences?
1. The most fundamental cause is to be found in the interest rates
obtainable on “short” money--that is to say, on money lent or deposited
for short periods of time in the money markets of the two centres under
comparison. If by lending dollars in New York for one month the lender
could earn interest at the rate of 5½ per cent per annum, whereas by
lending sterling in London for one month he could only earn interest
at the rate of 4 per cent, then the preference observed above for
holding funds in New York rather than in London is wholly explained.
That is to say, forward quotations for the purchase of the currency of
the dearer money market tend to be cheaper than spot quotations by a
percentage per month equal to the excess of the interest which can be
earned in a month in the dearer market over what can be earned in the
cheaper. It must be noticed that the governing factor is the rate of
interest obtainable for short periods, so that a country where, owing
to the absence or ill-development of an organised money market, it
is difficult to lend money satisfactorily at call or for very short
periods, may, for the purposes of this calculation, reckon as a low
interest-earning market, even though the prevailing rate of interest
for longer periods is not low at all. This consideration generally
tends to make London and New York more attractive markets for short
money than any Continental centres.
The effect of the cheap money rates ruling in London from the middle of
1922 to the middle of 1923 in diminishing the attractiveness of London
as a depository of funds is strikingly shown, in the above tables,
by the cheapening of the forward quotations of foreign currencies
relatively to the spot quotations. In the case of the dollar the
forward quotation had risen by the beginning of 1923 to a rate 3 per
cent per annum above the spot quotation (_i.e._ forward dollars were 3
per cent per annum _cheaper_ than spot dollars in terms of sterling),
which meant (subject to modification by the other influences to be
mentioned below) that the effective rate for short loans approached 3
per cent higher in New York than in London.
In the case of francs forward quotations which had been below spot,
so long as money was dear in London, rose above the spot quotations,
thus indicating that the relative dearness of money in London as
compared with Paris had disappeared; whilst in the case of lire forward
quotations, although still below spot quotations, rose, under the same
influence, nearer to the spot level. Nevertheless, in the case of both
these currencies, a preponderance of bearish anticipations about their
future prospects probably also played a part, for the reasons given in
detail below, in producing the observed result.
The most interesting figures, however, are those relating to marks,
which illustrate vividly what I have mentioned on page 23 above
concerning the enormous money rates of interest current in Germany
subsequent to the collapse of October 1922, as a result of the effort
of the real rate of interest to remain positive in face of a general
anticipation of a catastrophic collapse of the monetary unit. It will
be noticed that the effective short money rate of interest in terms
of marks ranged from 50 per cent per annum upwards, until finally the
quotations were merely nominal.
2. If questions of credit did not enter in, the factor of the rate of
interest on short loans would be the dominating one. Indeed, as between
London and New York, it probably is so under existing conditions.
Between London and Paris it is still important. But elsewhere the
various uncertainties of financial and political risk, which the
war has left behind, introduce a further element which sometimes
quite transcends the factor of relative interest. The possibility of
financial trouble or political disturbance, and the quite appreciable
probability of a moratorium in the event of any difficulties arising,
or of the sudden introduction of exchange regulations which would
interfere with the movement of balances out of the country, and
even sometimes the contingency of a drastic demonetisation,--all
these factors deter bankers, even when the exchange risk proper is
eliminated, from maintaining large floating balances at certain foreign
centres. Such risks prevent the business from being based, as it should
be, on a mathematical calculation of interest rates; they obliterate by
their possible magnitude the small “turns” which can be earned out of
differences between interest rates plus a normal banker’s commission;
and, being incalculable, they may even deter conservative bankers from
doing the business on a substantial scale at any reasonable rate at
all. In the case of Roumania or Poland, for example, this factor is, at
times, the dominating one.
3. There is a third factor of some significance. We have assumed so
far that the forward rate is fixed at such a level that the dealer or
banker can cover himself by a simultaneous spot transaction and be left
with a reasonable profit for his trouble. But it is not necessary to
cover every forward transaction by a corresponding spot transaction; it
may be possible to “marry” a forward sale with a forward purchase of
the same currency. For example, whilst some of the market’s clients may
wish to sell forward dollars, other clients will wish to buy forward
dollars. In this case the market can set off these, one against the
other, in its books, and there will be no need of any movement of
cash funds in either direction. The third factor depends, therefore,
on whether it is the sellers or the buyers of forward dollars who
predominate. To fix our minds, let us suppose that money-market
conditions exist in which a sale of forward dollars against the
purchase of spot dollars, at a discount of 1½ per cent per annum for
the former, yields neither profit nor loss. Now if in these conditions
the purchasers of forward dollars, other than arbitragers, exceed
sellers of forward dollars, then this excess of demand for forward
dollars can be met by arbitragers, who have cash resources in London,
at a discount which falls short of 1½ per cent per annum by such amount
(say ½ per cent) as will yield the arbitragers sufficient profit for
their trouble. If, however, sellers of forward dollars exceed the
purchasers, then a sufficient discount has to be accepted by the former
to induce arbitrage the other way round--that is to say, by arbitragers
who have cash resources in New York--namely, a discount which exceeds
1½ per cent per annum by, say, ½ per cent. Thus the discount on forward
dollars will fluctuate between 1 and 2 per cent per annum according as
buyers or sellers predominate.
4. Lastly, we have to provide for the case, quite frequent in practice,
where our assumption of a large and free market breaks down. A business
in forward exchange can only be transacted by banks or similar
institutions. If the bulk of the business in a particular exchange is
in a few hands, or if there is a tacit agreement between the principal
institutions concerned to maintain differences which will allow more
than a competitive profit, then the surcharge representing the profit
of a bank for arbitraging between spot and forward transactions may
much exceed the moderate figure indicated above. The quotations of the
rates charged in Milan for forward dealings in lire, when compared
with the rates current in London at the same date, indicate that a
bank which is free to operate in both markets can frequently make an
abnormal profit.
But there is a further contingency of considerable importance which
occurs when speculation is exceptionally active and is all one way. It
must be remembered that the floating capital normally available, and
ready to move from centre to centre for the purpose of taking advantage
of moderate arbitrage profits between spot and forward exchange,
is by no means unlimited in amount, and is not always adequate to
the market’s requirements. When, for example, the market is feeling
unusually bullish of the European exchanges as against sterling, or
of sterling as against dollars, the pressure to sell forward sterling
or dollars, as the case may be, may drive the forward price of these
currencies to a discount on their spot price which represents an
altogether abnormal profit to any one who is in a position to buy
these currencies forward and sell them spot. This abnormal discount
can only disappear when the high profit of arbitrage between spot and
forward has drawn fresh capital into the arbitrage business. So few
persons understand even the elements of the theory of the forward
exchanges that there was an occasion in 1920, even between London and
New York, when a seller of spot dollars could earn at the rate of 6
per cent per annum above the London rate for short money by converting
his dollars into sterling and providing at the same time by a forward
sale of the sterling for reconversion into dollars in a month’s time;
whilst, according to figures supplied me, it was possible, at the end
of February 1921, by selling spot sterling in Milan and buying it back
a month forward, to earn at the rate of more than 25 per cent per annum
over and above any interest obtainable on a month’s deposit of cash
lire in Milan.
It is interesting to notice that when the differences between forward
and spot rates have become temporarily abnormal, thus indicating an
exceptional pressure of speculative activity, the speculators have
often turned out to be right. For example, the abnormal discount on
forward dollars, which persisted more or less from November 1920 to
February 1921, thus indicating that the market was a bull of sterling,
coincided with the sensational rise of sterling from 3.45 to 3.90.
This discount was at its maximum when sterling touched its lowest
point and at its minimum (in the middle of May 1921) when sterling
reached its highest point on that swing, which showed a remarkably
accurate anticipation of events by the balance of professional opinion.
The comparatively high discount on forward dollars current at the
end of 1922 may, in the same way, have been partly due to an excess
of bull speculation in favour of sterling based on an expectation of
its recovery towards par, and not merely to the cheapness of money in
London as compared with New York.
The same thing seems to have been true for the franc. In January and
February 1921, the abnormal premium on the forward franc indicated
that, in the view of the market, the franc had fallen too low, which
turned out to be the case. They turned round at the precise moment
when the franc reached its highest value (end of July 1921), and were
right again. During the first five months of 1922, when the franc was
almost stable, spot and forward quotations were practically at par with
one another, whilst the progressive fall of the franc since June 1922
has been accompanied by a steady and sometimes substantial discount on
forward francs; indicating, on this test, that the professional market
was bearish of francs and therefore right once more. The lira tells
somewhat the same tale. Thus, whilst the reader can see for himself by
a study of the tables that no precise generalisation would be accurate,
nevertheless the market has been broadly right when it has taken a
very decided view, as measured by forward rates.
This result may seem surprising in view of the huge amounts which
exchange speculators in European currencies, more particularly on
the bull side, are reputed to have lost. But the mass of amateur
speculators throughout the world operate by cash purchases of the
currency of which they are bulls, forward transactions being neither
known nor available to them. Such speculation may afford temporary
support to the spot exchange, but it has no influence on the difference
between spot and forward, the subject now under discussion. The above
conclusion is limited to the fact that when the type of professional
speculation which makes use of the forward market is exceptionally
active and united in its opinion, it has proved roughly correct,
and has, therefore, been a useful factor in moderating the extreme
fluctuations which would have occurred otherwise.
* * * * *
Out of the various practical conclusions which might be drawn from this
discussion and the figures which accompany it, I will pick out three.
1. Those exchanges in which the fluctuations are wildest and the
merchant is most in need of facilities for hedging his risk are
precisely those in which facilities for forward dealing at moderate
rates are least developed. But this is to be explained, not
necessarily by the instability of the exchange in itself, but by
certain accompanying circumstances, such as distrust of the country’s
internal arrangements or its banking credit, a fear of the sudden
imposition of exchange regulations or of a moratorium, and the
other analogous influences mentioned above (pp. 126–7). There is no
theoretical reason why there should not be an excellent forward market
in a highly unstable exchange. In those countries, therefore, where
regulation is still premature, it may nevertheless be possible to
mitigate the evil consequences of fluctuation by organising facilities
for forward dealings.
This is a function which the State banks of such countries could
usefully perform. For this they must either themselves command a
certain amount of foreign currency or they must provide facilities for
accepting short-period deposits in their own currency from foreign
bankers, on conditions which inspire these bankers with complete
confidence in the freedom and liquidity of such deposits. Various
technical devices could be suggested. But the simplest method might be
for the State banks themselves to enter the forward market and offer
to buy or sell forward exchange at a reasonable discount or premium on
the spot quotation. I suggest that they should deal not direct with the
public but only with approved banks and financial houses, from whom
they should require adequate security; that they should quote every day
their rates for buying and selling exchange either one or three months
forward; but that such quotation should take the form, not of a price
for the exchange itself, but of a percentage difference between spot
and forward, and should be a quotation for the double transaction of
a spot deal one way and a simultaneous forward deal the other--_e.g._
the Bank of Italy might offer to sell spot sterling and buy forward
sterling at a premium of ⅛ per cent per month for the former over the
latter, and to buy spot sterling and sell forward sterling at par.
For the transaction of such business the State banks would require
to command a certain amount of resources abroad, either in cash or
in borrowing facilities. But this fund would be a revolving one,
automatically replenished at the maturity of the forward contracts, so
that it need not be on anything like the scale necessary for a fund
for the purpose of supporting the exchange. Nor is it a business which
involves any more risk than is inherent in all banking business as
such; from exchange risk proper is free.
With free forward markets thus established no merchant need run an
exchange risk unless he wishes to, and business might find a stable
foothold even in a fluctuating world. A recommendation in favour of
action along these lines was included amongst the Financial Resolutions
of the Genoa Conference of 1922.
I shall develop below (Chap. V.) a proposal that the Bank of England
should strengthen its control by fixing spot and forward prices for
gold every Thursday just as it now fixes its discount rate. But other
Central Banks also would increase their control over fluctuations in
exchange if they were to adopt the above plan of quoting rates for
forward exchange in terms of spot exchange. By varying these rates they
would be able, in effect, to vary the interest offered for _foreign_
balances, as a policy distinct from whatever might be their bank-rate
policy for the purpose of governing the interest obtainable on _home_
balances.
2. It is not unusual at present for banks to endeavour to distinguish
between speculative dealings in forward exchange and dealings which are
intended to hedge a commercial transaction, with a view to discouraging
the former; whilst official exchange regulations in many countries have
been aimed at such discrimination. I think that this is a mistake.
Banks should take stringent precautions to make sure that their clients
are in a position to meet any losses which may accrue without serious
embarrassment. But, having fully assured themselves on this point,
it is not useful that they should inquire further--for the following
reasons.
In the first place, it is almost impossible to prevent the evasion
of such regulations; whilst, if the business is driven to methods
of evasion, it tends to be pressed underground, to yield excessive
profits to middlemen, and to fall into undesirable hands.
But, what is more important and is less appreciated, the speculator
with resources can provide a useful, indeed almost an essential,
service. Since the volume of actual trade is spread unevenly through
the year, the seasonal fluctuation, as explained above, is bound to
occur with undue force unless some financial, non-commercial factor
steps in to balance matters. A free forward market, from which
speculative transactions are not excluded, will give by far the best
facilities for the trader, who does not wish to speculate, to avoid
doing so. The same sort of advantages will be secured for merchants
generally as are afforded, for example, to the cotton trade by the
dealings in “futures” in the New York and Liverpool markets. Where risk
is unavoidably present, it is much better that it should be carried by
those who are qualified or are desirous to bear it, than by traders,
who have neither the qualification nor the desire to do so, and whose
minds it distracts from their own business. The wide fluctuations in
the leading exchanges over the past three years, as distinct from
their persisting depreciation, have been due, not to the presence of
speculation, but to the absence of a sufficient volume of it relatively
to the volume of trade.
3. A failure to analyse the relation between spot and forward exchange
may be, sometimes, partly responsible for a mistaken bank-rate policy.
Dear money--that is to say, high interest rates for short-period
loans--has two effects. The one is indirect and gradual--namely, in
diminishing the volume of credit quoted by the banks. This effect is
much the same now as it always was. It is desirable to produce it when
prices are rising and business is trying to expand faster than the
supply of real capital and effective demand can permit in the long run.
It is undesirable when prices are falling and trade is depressed.
The other effect of dear money, or rather of dearer money in one centre
than in another, used to be to draw gold from the cheaper centre for
temporary employment in the dearer. But nowadays the only immediate
effect is to cause a new adjustment of the difference between the
spot and forward rates of exchange between the two centres. If money
becomes dearer in London, the discount on forward dollars diminishes or
gives way to a premium. The effect has been pointed out above of the
relative cheapening of money in London in the latter half of 1922 in
increasing the discount on forward dollars, and of the relative raising
of money-rates in the middle of 1923 in diminishing the discount. Such
are, in present circumstances, the principal direct consequences of a
moderate difference between interest rates in the two centres, apart,
of course, from the indirect, long-period influence. Since no one is
likely to remit money temporarily from one money market to another
on any important scale, with an uncovered exchange risk, merely to
take advantage of ½ or 1 per cent per annum difference in the interest
rate, the direct effect of dearer money on the _absolute_ level of
the exchanges, as distinguished from the difference between spot and
forward, is very small, being limited to the comparatively slight
influence which the relation between spot and forward rates exerts on
exchange speculators.[39] The pressure of arbitragers between spot
and forward exchange, seeking to take advantage of the new situation,
leads to a rapid adjustment of the difference between these rates,
until the business of temporary remittance, as distinct from exchange
speculation, is no more profitable than it was before, and consequently
does not occur on any increased scale; with the result that there is no
marked effect on the absolute level of the spot rate.
[39] If interest rates are raised in London, the discount on
forward dollars will decrease or a premium will appear.
This is likely to have some influence in encouraging
speculative sales of forward dollars (how much influence
depends on the proportion borne by the difference
between the spot and forward rates to the probable range
of fluctuation of the spot rate which the speculator
anticipates); and in so far as this is the case, the
covering sales of spot dollars by banks will move the rate
of exchange in favour of London.
The reasons given for the maintenance of a close relationship between
the Bank of England’s rate and that of the American Federal Reserve
Board sometimes show confusion. The eventual influence of an effective
high bank-rate on the general situation is undisputed; but the belief
that a moderate difference between bank-rates in London and New York
reacts directly on the sterling-dollar exchange, as it used to do under
a régime of convertibility, is a misapprehension. The direct reaction
of this difference is on the discount for forward dollars as against
spot dollars; and it cannot much affect the absolute level of the
spot rate unless the change in relative money-rates is comparable in
magnitude (as it used to be but no longer is) with the possible range
of exchange fluctuations.