A Tract on Monetary Reform

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.

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

France and the United States

Italy and the United States

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.

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.

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

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 Forward38

First day of month in 1920, first Wednesday
in 1921, and first Friday thereafter.

Table of Exchange Quotations in
London One Month Forward