Principles of Political Economy · John Stuart Mill
Chapter XVI. Of The Foreign Exchanges.
A merchant in the United States, A, has exported American commodities, consigning them to his correspondent, B, in England. Another merchant in England, C, has exported English commodities, suppose of equivalent value, to a merchant, D, in the United States. It is evidently unnecessary that B in England should send money to A in the United States, and that D in the United States should send an equal sum of money to C in England. The one debt may be applied to the payment of the other, and the double cost and risk of carriage be thus saved. A draws a bill on B for the amount which B owes to him: D, having an equal amount to pay in England, buys this bill from A, and sends it to C, who, at the expiration of the number of days which the bill has to run, presents it to B for payment. Thus the debt due from England to the United States, and the debt due from the United States to England, are both paid without sending an ounce of gold or silver from one country to the other.(274)
This implies (if we exclude for the present any other international payments than those occurring in the course of commerce) that the exports and imports exactly pay for one another, or, in other words, that the equation of international demand is established. When such is the fact, the international transactions are liquidated without the passage of any money from one country to the other. But, if there is a greater sum due from the United States to England than is due from England to the United States, or _vice versa_, the debts can not be simply written off against one another. After the one has been applied, as far as it will go, toward covering the other, the balance must be transmitted in the precious metals. In point of fact, the merchant who has the amount to pay will even then pay for it by a bill. When a person has a remittance to make to a foreign country, he does not himself search for some one who has money to receive from that country, and ask him for a bill of exchange.
In this, as in other branches of business, there is a class of middle-men or brokers, who bring buyers and sellers together, or stand between them, buying bills from those who have money to receive, and selling bills to those who have money to pay. When a customer comes to a broker for a bill on Paris or Amsterdam, the broker sells to him perhaps the bill he may himself have bought that morning from a merchant, perhaps a bill on his own correspondent in the foreign city; and, to enable his correspondent to pay, when due, all the bills he has granted, he remits to him all those which he has bought and has not resold. In this manner these brokers take upon themselves the whole settlement of the pecuniary transactions between distant places, being remunerated by a small commission or percentage on the amount of each bill which they either sell or buy.
Now, if the brokers find that they are asked for bills, on the one part, to a greater amount than bills are offered to them on the other, they do not on this account refuse to give them; but since, in that case, they have no means of enabling the correspondents on whom their bills are drawn to pay them when due, except by transmitting part of the amount in gold or silver, they require from those to whom they sell bills an additional price, sufficient to cover the freight and insurance of the gold and silver, with a profit sufficient to compensate them for their trouble and for the temporary occupation of a portion of their capital. This premium (as it is called) the buyers are willing to pay, because they must otherwise go to the expense of remitting the precious metals themselves, and it is done cheaper by those who make doing it a part of their especial business. But, though only some of those who have a debt to pay would have actually to remit money, all will be obliged, by each other’s competition, to pay the premium; and the brokers are for the same reason obliged to pay it to those whose bills they buy. The reverse of all this happens, if, on the comparison of exports and imports, the country, instead of having a balance to pay, has a balance to receive. The brokers find more bills offered to them than are sufficient to cover those which they are required to grant. Bills on foreign countries consequently fall to a discount; and the competition among the brokers, which is exceedingly active, prevents them from retaining this discount as a profit for themselves, and obliges them to give the benefit of it to those who buy the bills for purposes of remittance.
When the United States had the same number of dollars to pay to England which England had to pay to her, one set of merchants in the United States would want bills, and another set would have bills to dispose of, for the very same number of dollars; and consequently a bill on England for $1,000 would sell for exactly $1,000, or, in the phraseology of merchants, the exchange would be at par. As England also, on this supposition, would have an equal number of dollars to pay and to receive, bills on the United States would be at par in England, whenever bills on England were at par in the United States. If, however, the United States had a larger sum to pay to England than to receive from her, there would be persons requiring bills on England for a greater number of dollars than there were bills drawn by persons to whom money was due. A bill on England for $1,000 would then sell for more than $1,000, and bills would be said to be at a premium. The premium, however, could not exceed the cost and risk of making the remittance in gold, together with a trifling profit; because, if it did, the debtor would send the gold itself, in preference to buying the bill. If, on the contrary, the United States had more money to receive from England than to pay, there would be bills offered for a greater number of dollars than were wanted for remittance, and the price of bills would fall below par: a bill for $1,000 might be bought for somewhat less than $1,000, and bills would be said to be at a discount.
When the United States has more to pay than to receive, England has more to receive than to pay, and _vice versa_. When, therefore, in the United States, bills on England bear a premium, then, in England, bills on the United States are at a discount; and, when bills on England are at a discount in the United States, bills on the United States are at a premium in England. If they are at par in either country, they are so, as we have already seen, in both.(275) Thus do matters stand between countries, or places which have the same currency. So much of barbarism, however, still remains in the transactions of the most civilized nations, that almost all independent countries choose to assert their nationality by having, to their own inconvenience and that of their neighbors, a peculiar currency of their own. To our present purpose this makes no other difference than that, instead of speaking of _equal_ sums of money, we have to speak of _equivalent_ sums. By equivalent sums, when both currencies are composed of the same metal, are meant sums which contain exactly the same quantity of the metal, in weight and fineness.
The quantity of gold in the English pound is equivalent to $4.8666+ of our gold coins. If the bills offered are about equal to those wanted, a claim to a pound in England will sell for $4.86. If many are wanted, and but few to be had, their price will go up, of course; but it can not go more than a small fraction beyond $4.90, since about 3-¼ cents is sufficient to cover the brokerage, insurance, and freight per pound sterling in a shipment of gold to London. Therefore, in order to get money to a creditor in London, no one will pay more for a pound in the form of a bill than he will be obliged to pay for sending it across in the form of bullion. Bills of exchange, then, can not rise in price beyond the point ($4.90 +) since, rather than pay a higher sum for a bill, gold will be sent. This point is called the “shipping-point” of gold. When the exchanges are at $4.90, it will be found that gold is going abroad. On the other hand, when the supply of bills is greater than the demand, their price will fall. A man having a bill on London to sell—i.e., a claim to a pound in London—will not sell it at a price here lower than $4.86, by more than the expense of bringing the gold itself across. Since this expense is about 3-¼ cents, bills can not fall below about $4.83. When exchange is at that price, it will be found that gold is coming to the United States from England. This price is the “shipping-point” for imports of gold. This, of course, applies to sight-bills only.
Formerly, we computed exchange on a scale of percentages, the real par being about 109. This was given up after the war. When bills on foreign countries are at a premium, it is customary to say that the exchanges are against the country, or unfavorable to it. In order to understand these phrases, we must take notice of what “the exchange,” in the language of merchants, really means. It means the power which the money of the country has of purchasing the money of other countries. Supposing $4.86 to be the exact par of exchange, then when it requires more than $1,000 to buy a bill of £205, $1,000 of American money are worth less than their real equivalent of English money: and this is called an exchange unfavorable to the United States. The only persons in the United States, however, to whom it is really unfavorable are those who have money to pay in England, for they come into the bill market as buyers, and have to pay a premium; but to those who have money to receive in England the same state of things is favorable; for they come as sellers and receive the premium. The premium, however, indicates that a balance is due by the United States, which must be eventually liquidated in the precious metals; and since, according to the old theory, the benefit of a trade consisted in bringing money into the country, this prejudice introduced the practice of calling the exchange favorable when it indicated a balance to receive, and unfavorable when it indicated one to pay; and the phrases in turn tended to maintain the prejudice.
So that what is called an unfavorable exchange is an encouragement to export, and a discouragement to import. And if the balance due is of small amount, and is the consequence of some merely casual disturbance in the ordinary course of trade, it is soon liquidated in commodities, and the account adjusted by means of bills, without the transmission of any bullion. Not so, however, when the excess of imports above exports, which has made the exchange unfavorable, arises from a permanent cause. In that case, what disturbed the equilibrium must have been the state of prices, and it can only be restored by acting on prices. It is impossible that prices should be such as to invite to an excess of imports, and yet that the exports should be kept permanently up to the imports by the extra profit on exportation derived from the premium on bills; for, if the exports were kept up to the imports, bills would not be at a premium, and the extra profit would not exist. It is through the prices of commodities that the correction must be administered. Disturbances, therefore, of the equilibrium of imports and exports, and consequent disturbances of the exchange, may be considered as of two classes: the one casual or accidental, which, if not on too large a scale, correct themselves through the premium on bills, without any transmission of the precious metals; the other arising from the general state of prices, which can not be corrected without the subtraction of actual money from the circulation of one of the countries, or an annihilation of credit equivalent to it.
It remains to observe that the exchanges do not depend on the balance of debts and credits with each country separately, but with all countries taken together. The United States may owe a balance of payments to England; but it does not follow that the exchange with England will be against the United States, and that bills on England will be at a premium; because a balance may be due to the United States from Holland or Hamburg, and she may pay her debts to England with bills on those places; which is technically called arbitration of exchange. There is some little additional expense, partly commission and partly loss of interest in settling debts in this circuitous manner, and to the extent of that small difference the exchange with one country may vary apart from that with others. A common use of bills of exchange is that by which, when three countries are concerned, two of them may strike a balance through the third, if both countries have dealings with that third country. New York merchants may buy of China, but China may not be buying of New York, although both may have dealings with London.
A, we will suppose, is a buyer of £1,000 worth of tea from F, in Hong-Kong; B is an exporter of wheat (£1,000) to C in London; D has sent £1,000 worth of cotton goods to E in Hong-Kong. A can now pay F through London without the transmission of coin. A buys B’s claim on C for £1,000, and sends it to F. E wishes to pay D in London for the cotton goods he bought of him; therefore, he buys from F for £1,000 the claim he now holds (i.e., a bill of exchange on London) against C for £1,000. E sends it to D, and, when D collects it from C, the whole circle of exchanges is completed without the transmission of the precious metals. Chapter XVII. Of The Distribution Of The Precious Metals Through The Commercial World. § 1. The substitution of money for barter makes no difference in exports and imports, nor in the Law of international Values. Having now examined the mechanism by which the commercial transactions between nations are actually conducted, we have next to inquire whether this mode of conducting them makes any difference in the conclusions respecting international values, which we previously arrived at on the hypothesis of barter.
The nearest analogy would lead us to presume the negative. We did not find that the intervention of money and its substitutes made any difference in the law of value as applied to adjacent places. Things which would have been equal in value if the mode of exchange had been by barter are worth equal sums of money. The introduction of money is a mere addition of one more commodity, of which the value is regulated by the same laws as that of all other commodities. We shall not be surprised, therefore, if we find that international values also are determined by the same causes under a money and bill system as they would be under a system of barter, and that money has little to do in the matter, except to furnish a convenient mode of comparing values. All interchange is, in substance and effect, barter; whoever sells commodities for money, and with that money buys other goods, really buys those goods with his own commodities. And so of nations: their trade is a mere exchange of exports for imports; and, whether money is employed or not, things are only in their permanent state when the exports and imports exactly pay for each other. When this is the case, equal sums of money are due from each country to the other, the debts are settled by bills, and there is no balance to be paid in the precious metals. The trade is in a state like that which is called in mechanics a condition of stable equilibrium.
But the process by which things are brought back to this state when they happen to deviate from it is, at least outwardly, not the same in a barter system and in a money system. Under the first, the country which wants more imports than its exports will pay for must offer its exports at a cheaper rate, as the sole means of creating a demand for them sufficient to re-establish the equilibrium. When money is used, the country seems to do a thing totally different. She takes the additional imports at the same price as before, and, as she exports no equivalent, the balance of payments turns against her; the exchange becomes unfavorable, and the difference has to be paid in money. This is, in appearance, a very distinct operation from the former. Let us see if it differs in its essence, or only in its mechanism.
Let the country which has the balance to pay be the United States,(276) and the country which receives it, England. By this transmission of the precious metals, the quantity of the currency is diminished in the United States, and increased in England. This I am at liberty to assume. We are now supposing that there is an excess of imports over exports, arising from the fact that the equation of international demand is not yet established: that there is at the ordinary prices a permanent demand in the United States for more English goods than the American goods required in England at the ordinary prices will pay for. When this is the case, if a change were not made in the prices, there would be a perpetually renewed balance to be paid in money. The imports require to be permanently diminished, or the exports to be increased, which can only be accomplished through prices; and hence, even if the balances are at first paid from hoards, or by the exportation of bullion, they will reach the circulation at last, for, until they do, nothing can stop the drain.
When, therefore, the state of prices is such that the equation of international demand can not establish itself, the country requiring more imports than can be paid for by the exports, it is a sign that the country has more of the precious metals, or their substitutes, in circulation, than can permanently circulate, and must necessarily part with some of them before the balance can be restored. The currency is accordingly contracted: prices fall, and, among the rest, the prices of exportable articles; for which, accordingly, there arises, in foreign countries, a greater demand: while imported commodities have possibly risen in price, from the influx of money into foreign countries, and at all events have not participated in the general fall. But, until the increased cheapness of American goods induces foreign countries to take a greater pecuniary value, or until the increased dearness (positive or comparative) of foreign goods makes the United States take a less pecuniary value, the exports of the United States will be no nearer to paying for the imports than before, and the stream of the precious metals which had begun to flow out of the United States will still flow on. This efflux will continue until the fall of prices in the United States brings within reach of the foreign market some commodity which the United States did not previously send thither; or, until the reduced price of the things which she did send has forced a demand abroad for a sufficient quantity to pay for the imports, aided perhaps by a reduction of the American demand for foreign goods, through their enhanced price, either positive or comparative.
Now, this is the very process which took place on our original supposition of barter. Not only, therefore, does the trade between nations tend to the same equilibrium between exports and imports, whether money is employed or not, but the means by which this equilibrium is established are essentially the same. The country whose exports are not sufficient to pay for her imports offers them on cheaper terms, until she succeeds in forcing the necessary demand: in other words, the equation of international demand, under a money system as well as under a barter system, is the law of international trade. Every country exports and imports the very same things, and in the very same quantity, under the one system as under the other. In a barter system, the trade gravitates to the point at which the sum of the imports exactly exchanges for the sum of the exports: in a money system, it gravitates to the point at which the sum of the imports and the sum of the exports exchange for the same quantity of money. And, since things which are equal to the same thing are equal to one another, the exports and imports which are equal in money price would, if money were not used, precisely exchange for one another.(277) § 2. The preceding Theorem further illustrated.
Let us proceed to [examine] to what extent the benefit of an improvement in the production of an exportable article is participated in by the countries importing it. The improvement may either consist in the cheapening of some article which was already a staple production of the country, or in the establishment of some new branch of industry, or of some process rendering an article exportable which had not till then been exported at all. It will be convenient to begin with the case of a new export, as being somewhat the simpler of the two. The first effect is that the article falls in price, and a demand arises for it abroad. This new exportation disturbs the balance, turns the exchanges, money flows into the country (which we shall suppose to be the United States), and continues to flow until prices rise. This higher range of prices will somewhat check the demand in foreign countries for the new article of export; and will diminish the demand which existed abroad for the other things which the United States was in the habit of exporting. The exports will thus be diminished; while at the same time the American public, having more money, will have a greater power of purchasing foreign commodities. If they make use of this increased power of purchase, there will be an increase of imports; and by this, and the check to exportation, the equilibrium of imports and exports will be restored. The result to foreign countries will be, that they have to pay dearer than before for their other imports, and obtain the new commodity cheaper than before, but not so much cheaper as the United States herself does. I say this, being well aware that the article would be actually at the very same price (cost of carriage excepted) in the United States and in other countries.
The cheapness, however, of the article is not measured solely by the money-price, but by that price compared with the money-incomes of the consumers. The price is the same to the American and to the foreign consumers; but the former pay that price from money-incomes which have been increased by the new distribution of the precious metals; while the latter have had their money-incomes probably diminished by the same cause. The trade, therefore, has not imparted to the foreign consumer the whole, but only a portion, of the benefit which the American consumer has derived from the improvement; while the United States has also benefited in the prices of foreign commodities. Thus, then, any industrial improvement which leads to the opening of a new branch of export trade benefits a country not only by the cheapness of the article in which the improvement has taken place, but by a general cheapening of all imported products.
Text from Project Gutenberg, public domain in the United States.