CHAPTER II
THE SIGNIFICANCE OF DEPRECIATED EXCHANGES
Misunderstood Problem
Foreign exchange, by means of which the trade of the world is conducted, is one of the least understood phenomena of commerce. This is not because the subject is inherently obscure or difficult, but only because in normal times the exchange mechanism works with such automatic precision that, save to a few special students or dealers in exchange, it appears to be of little significance. A great American merchant confessed to the authors that, although for years he had purchased large quantities of foreign goods and paid for them with bills of exchange, not until after war dislocated the exchanges had he ever taken the trouble to learn the principles determining exchange rates. Even now, after two years of disastrous experience with exchange gyrations, it is not an exaggeration to say that the mass of business men do not clearly understand the forces governing exchange fluctuations and the significance of the relative depreciation of the exchanges of different countries.
Witness the persistent purchasing and holding of German marks by thousands of speculators throughout the world—speculators who possess not the slightest knowledge of the forces that will ultimately determine the value of German exchange. Witness the astounding statement made recently by a well-known American business man that prior to the war European exchanges fluctuated as much as they do now. Witness the equally astounding statement of a French financier that the depreciation of French exchange is merely due to the speculation of American bankers.
The whole problem of international trade and world recuperation is intricately interwoven with the functioning of the foreign exchanges. If in our efforts to stem the tide of economic deterioration and restore world prosperity we are to grapple intelligently with the problems involved, we must begin with a fairly definite notion of what foreign exchanges are and what fundamental forces control them.
Exchange Explained
The conclusion to which an analysis of the foreign exchange mechanism leads is that the depreciation of the exchanges of the various European countries roughly reflects the economic deterioration of each. Now to understand why this is so it is necessary to consider not only what the exchanges are, but also what undepreciated exchanges mean and how in ordinary times before the war the exchanges were kept from depreciating. Only by so doing can one come to appreciate the enormous significance of the disruption of international trade and finance that was wrought by the war.
Exchange between the United States and Great Britain before the war, for example, was said to be at par when a one-pound British sterling bill was worth $4.866 in New York. What did par or parity of exchange mean, and how was this quotation, 4.866, derived? Parity of exchange was only a simple statement of the relative quantities of gold in the American gold dollar and in the British gold pound. The British monetary unit, the gold pound sterling, has 4.866 times as much gold as the American monetary unit, the dollar. To cite other exchanges, the par between the United States and France is 19.3, which means that the gold franc is worth 19.3 cents. Belgium, Italy, Switzerland, and Greece have coins of exactly the same value as the French franc, and thus have the same parity with United States money. The German gold mark is worth 23.8 cents. The gold coin of each of the various countries thus has its particular parity as compared with United States gold, and in turn the gold pound sterling, franc, etc., each has its parity with the coins of all the other countries.
Bills of exchange largely obviate the necessity of shipping currency in settling international obligations. The use of bills of exchange in international transactions can best be revealed by some concrete illustrations.
Assume that you are a New York exporter and that you have sold £1,000 worth of shoes to one Perlmutter in London. At the same time your friend Jones in New York has bought £1,000 worth of lace from a well-known London lace merchant, one Potash. If you could then step over to your friend Jones's office and receive payment of £1,000 from him, while at the same time Perlmutter in London was paying Potash £1,000, both obligations would be settled. How much easier this would be than for Perlmutter to ship £1,000 in specie across the ocean westward to you, and for friend Jones to ship another £1,000 in specie across the ocean eastward to Potash.
The exchange mechanism, in fact, makes it possible to settle such international obligations without shipping specie every time. If you in New York were to draw an order (bill of exchange) on Potash in London, instructing him to pay Perlmutter £1,000; if you then sold this bill of exchange to your friend Jones, you would receive payment for your shoes. Then if Jones should send this bill of exchange, which he had purchased from you, to Potash in payment for the lace, Potash would be satisfied as soon as he had collected from Perlmutter. Thus the shoes and the lace would be paid for without any necessity for shipment of specie across the ocean.
Foreign Exchange Banker
But in practice there are usually two difficulties which slightly complicate the process. In the first place, the various parties concerned may not all be acquainted with each other. Secondly, the amounts involved in the two transactions may not be identical, as was supposed above. Accordingly, dealers in foreign exchange (banks and brokers) are required as financial intermediaries. When the exporter in New York draws his bill of exchange for £1,000 on the importer in London—or more frequently on a London bank which has agreed to lend its name to the importer for the purpose—the exporter in New York sells the bill to a foreign exchange banker in New York who will pay, when exchange is at par, $4,866. This banker then sends the bill to a correspondent bank in London which presents it for payment to the London importer, or to his bank. The funds received are deposited in the London bank to the credit of the New York bank which had forwarded the bill for collection.
Now when your friend Jones in New York wants to buy a bill of exchange with which to pay for the lace bought from Potash, he goes to the foreign exchange banker in New York, and the banker sells him a bill of exchange drawn by it against this London bank account—a bill for £1,000 or for whatever amount the buyer may desire. Jones then sends this bill of exchange to Potash, in London, who presents it for payment to the bank against which it is drawn.
In this manner the New York banker plays the part of an intermediary between New York exporters and importers, serving in effect to bring them together, and serving also to make "change," that is, to break up bills of exchange into whatever denominations may be found necessary.
Rate Fluctuations
Exchange will be at par when the supply of and the demand for bills of exchange are equal. The price of a bill of exchange, like the price of wheat or any other commodity, depends upon the relative demand for and supply of bills in the market at the moment. If at any given time ii, 000,000 worth of American products have been exported to Great Britain, there will be i 1,000,000 worth of bills on London offered for sale in New York. If at the same time £1,000,000 worth of goods have been imported, there will be a demand for i 1,000,000 of bills of exchange. The supply and demand will be equal and the price of sterling exchange will be at par, that is, at 4.866. But if it happens that while f 1,000,000 worth of bills is offered in the market for sale, as much as £1,200,000 is demanded, the price will be bid up above 4.866 by those who desire the bills as a means of meeting their obligations abroad. On the contrary, if only £500,000 is demanded, the sellers will have to make concessions in order to dispose of their bills.
Exchange rates before the war normally fluctuated within narrow limits. The maximum extent to which (under normal pre-war conditions) the price of exchange could be bid up or forced down, as the case might be, was determined by the costs involved in shipping the actual gold. One would be willing to pay $4,866 for a bill of exchange with which to settle a £1,000 obligation, because that would be cheaper than shipping the gold. One would be willing to pay as high as $4,885, under normal conditions, for such a bill; but not more than that because it would be cheaper to ship the actual specie instead. On the other hand, it would be profitable to sell a £1,000 bill for $4,845; but not for less, since it would be cheaper to pay the expense of importing the actual currency. These points, 4.885 and 4.845, are known as gold-exporting and gold-importing points.
The International Scale-Pans
The supply of and demand for bills of exchange do not depend merely upon the relative volume of exports and imports of commodities. Whatever the occasion for remittances of funds to Great Britain, bills of exchange are demanded, and whatever the occasion for payments to the United States, bills of exchange are supplied. For instance, if an individual is contemplating a trip abroad he places, say, $4,886 with a bank, express company, or one of the tourist concerns, and asks for letters of credit or travelers' checks. It then becomes necessary for the bank where the funds have been deposited, to transmit means of payment to the other side. This it does by buying a bill of exchange which it sends to a correspondent bank in Europe, where it is credited to the account of the American bank, and made available for the payment of checks when properly signed by the authorized party. Similarly, if an American corporation owes dividends to a stockholder in England, it buys and remits a bill of exchange.
The operations which give rise to the total supply of and demand for bills of exchange may be shown by an exhibit of the international financial status of the United States in a single year before the war. The following figures are for the year 1909. The items listed in the left-hand column give rise to a supply of bills of exchange and those in the right-hand column to a demand for such bills.
Requiring Payments to United States Requiring Payments Abroad
Exports of merchandise Imports of merchandise
and silver 11,7x9,000,000 and silver f 1,356,000,000
Exports of gold (net) .... 48,000,000 Interest on European investments in U. S 250,000,000
Total 11,767,000,000
Tourist expenditures. . . . 170,000,000
Balance against United Remittances to friends. .. 150,000,000
states 184,000,000 r, ■ ,. ,
Freight charges 25,000,000
Grand total 11,767,000.000 f 1,951,000,000
It should be carefully noted that our exports abroad were largely paid for by imports of foreign goods. No gold was received in payment; on the contrary, we exported on balance $48,000,000 of the precious metal. The difference in the trade balance (between exports and imports of merchandise and silver) amounting to $363,000,000, plus the $48,000,000 of gold exports, was more than offset by other items in the international scale-pans. We owed interest on European investments in the United States; our tourists were entertained in Europe; immigrants and others sent funds to friends abroad; and we owed foreign ship-owners for transporting our goods. The final outcome of all these operations showed a balance of $184,000,000 still to be accounted for. This might have been settled by an exportation of gold; but it was in fact offset by new—permanent or temporary—investments in the United States by other countries.
Gold Movements
The United States will thus have, in any given year, a net inflow or net outflow of gold as a result of variations in the supply of and demand for bills of exchange arising from trade and financial operations with all the world. The simplified treatment which we have presented ignores such factors as "finance," as distinguished from "trade" bills. Nor is mention made of roundabout operations involving several countries. These three-cornered operations play an important part in minimizing the flow of specie in the settlement of international obligations. But the essence of the problem is revealed in the analysis stated above.
The mechanism of the exchanges makes it unnecessary for any country to ship specie except when the total of all foreign financial obligations that must be met is greater than the volume of remittances of every kind due it. International obligations are thus largely canceled; currency moves only as a last resort. Foreign exchange quotations, moreover, in ordinary times, fluctuate only from the gold-exporting to the gold-importing point, that is to say, in terms of British currency, from 4.885 to 4.845.
Currency movements maintain the equilibrium of the exchanges. Under normal circumstances it is impossible for an outflow of specie from any country (except, of course, from a gold-producing country) to continue for any great length of time. The reason for this is that such an outflow is soon followed by financial and trade readjustments, which shortly restore the balance of international obligations. An outflow of gold from the United States to England, for example, would reduce the volume of funds in New York, and lead to higher interest rates there. The inflow of funds to the London banks would at the same time tend to lower interest rates in England. In consequence, international bankers would find it profitable to transmit, by means of bills of exchange, funds from London to New York. This would serve to restore the equilibrium of the exchanges and to prevent a further outflow of gold from New York, if not to bring about a reverse movement.
Variations in exchange rates above or below parity thus reflect temporary fluctuations in the supply of and demand for bills of exchange arising from international financial transactions of whatever nature. And gold movements serve as the corrective for any pronounced excess or deficiency in the supply of, as compared with the demand for, bills of exchange in any particular country. In this manner the gold movements act as a balance wheel in international economic relations, keeping the world in economic adjustment.
Disruption of Exchange Mechanism
The World War quickly threw this delicately adjusted foreign exchange mechanism completely out of gear. In the autumn of 1914 there was a great rush on the part of European holders of American securities to sell them back to us as a means of securing the funds required for war purposes. At the same time the usual autumn exports of our cotton and other products were checked, both by a temporary decline in European demand and by the fear of German raiders. Insurance rates also tremendously increased, so that the gold-exporting point no longer remained at 4.885. So great was the demand for sterling bills as compared with the supply, that British exchange rose at one time as high as $7.
But in the autumn of 1915 the situation was sharply reversed. When Great Britain began to buy great quantities of war supplies from the United States, the supply of sterling bills of exchange outran the demand, and exchange quickly fell to the gold-importing point. For a time Great Britain attempted to use the normal method of correcting adverse exchanges, namely, by allowing an export of gold; but this had shortly to be abandoned because of the disastrous consequence to the British monetary system of continued large exports of specie. An embargo was therefore placed upon exports of specie, except as government operations might require it. What was true of Great Britain was of course also true of other European belligerents.
The balance of payments continued to run so heavily in favor of the United States that sterling declined to 4.48—far below the gold-importing point. With the normal means of correcting depreciated exchanges—that is, by payments in gold—perforce abandoned, exchange rates, under the pressure of a great volume of exports, could fall almost indefinitely. During the war, however, the British and other European governments undertook and successfully accomplished an artificial stabilization of exchange rates—the sterling rate being "pegged" at 4.765. This was done through purchase of exchange by the British government whenever the rate dropped below that figure. At the same time the United States government began the war-time policy of shipping American goods abroad on credit. Such a method of regulating the exchanges could not be continued as a permanent policy after the war.
Sharp Decline of Rates
In order to restore the normal functioning of the international exchanges, the various European governments in the spring of 1919 abandoned the artificial policy of "pegging" the exchanges, and shortly thereafter the United States government ceased making further loans to Europe. But for reasons to be discussed presently, Europe did not remove the embargoes on gold shipments; hence the normal corrective of depreciated exchanges could not operate. The results of the international economic maladjustments caused by the war were quickly shown in a sharp fall in exchange rates on all of the European belligerents.
What students of the international exchange mechanism had long foreseen must occur, now for the first time manifested itself to the general public. In the summer of 1919 the financial press daily discussed the sensational decline in foreign exchange; and business men, with a practical interest in foreign trade, began for the first time in our national history to interest themselves in the phenomenon of the exchanges. And thousands of innocent bystanders, acting on the familiar principle that what goes down must soon go up again, speculated heavily in francs, marks, and kronen. They are still pocketing their losses.
The explanation of the present depreciated European exchanges is in reality twofold: It is due in part to the tremendous changes that have occurred in the financial and trade relations between the United States and the several European countries—changes which have transformed the United States from a debtor to a creditor nation. And it is in part attributable to the fact that all of the European nations have been forced to abandon the gold standard for irredeemable paper money. These factors must be considered separately.
International Scale-Pans Unbalanced
The changes that have occurred in the international financial relationships of the United States, as a result of the war, may be best shown by setting off against the items entering into the international balance in 1909, the items entering into it in 1919. 1 1These figures are taken from Vanderlip and Williams, "The Future of Our Foreign Trade," an article prepared for The Review of Economic Statistics, Harvard University Committee on Economic Research. The year 1920 still further increased the disparity, although the excess of exports was not so large as in 1919. The figures for 1909 are the same as were presented on page 13 above. For convenience they are repeated here.
Figures for 1909
Requiring Payments to United States Requiring Payments Abroad
Exports of merchandise
Imports of merchandise
and silver |i, 719, 000,000 and silver
Ii
Exports of gold (net) . .. 48,000,000
Interest on European in-
250,000,000
Tourist expenditures 170,000,000
Remittances to friends . .
150,000,000
Freight charges due Europe
25,000,000
Figures for 1919
Requiring Payments to United States Requiring Payments Abroad
Exports of merchandise Imports of merchandise
sad silver.. $8,151,000,000 and silver 18. 151, 000,000 and silver $3,993,000,000
Exports of gold (net) . 368,000,000 Tourists expenditures . 50,000,000
Interest on American in- 2 2The $122,000,000 represents the estimated interest on private investments and credits abroad; the $500,000,000 is 5 per cent on the $10,000,000,000 loaned by the United States government to European governments. Payment of this is being indefinitely postponed, the annual interest charges thus being added to the principal. It has been computed that by 1923 the accumulated amount will stand at $12,350,000,000, the interest charge on which would equal at 5 per cent, $617,000,000 annually. In addition to these debts owing to the American government, foreign governments owe to private individuals in the United States approximately $2,000,000,000. (Financial report of the American Committee to International Chamber of Commerce meeting in London, June 26, 1921.)122,000,000 Remittances to friends.. 300,000,000
vestments in Europe.. \ 500,000,000
Freight charges due U. S. 73,000.000
Jo. 1 1 4.000.000 S4.343.000.000
Balance in favor of United States $4,771,000,000
$9,114,000,000 $9,114,000,000
Changes in Trade Balance Items
It will be seen that nearly every item entering into the international balance has been changed during the war in such fashion as to increase the supply of, and reduce the demand for, bills of exchange on foreign countries. The great increase in exports as compared with the increase in imports would alone have congested the exchange market and forced a decline in the price of bills of exchange. But in addition, the United States has become a creditor nation, with the result that the $250,000,000 interest formerly payable by us to Europe has been wiped out and replaced by an annual interest charge against Europe of $622,000,000.3 3As a result of further credit extensions since 1919, this figure is now considerably larger. Europe can therefore no longer use interest due as an offset to the excess of imports; she must rather find means of meeting huge interest charges due against her. 4 4Interest. This is, however, temporarily being funded. See footnote 3. Tourist expenditures in Europe have also been reduced.5 5The years 1920 and 1921 have, however, shown considerable increase in this connection. And freight charges due Europe have been replaced by freight charges due to the United States. Only a single item in the balance has changed to the advantage of Europe, namely, the increase in remittances to friends abroad. It should be noted, moreover, that the export of gold was much larger in 1919 than in 1909. All but one of the elements entering into the international scales, therefore, worked to bring about a fall in exchange rates—through increasing the supply relatively to the demand for bills of exchange.
It remains to be noted that the international scale-pans for the year 1919 were balanced through the extension of American investments abroad. This was accomplished partly by the sale in the United States of European securities; but much more largely by the sale of goods by American exporters on credit. That is to say, exporters shipped goods abroad and received not cash, but promises to pay at some not distant date in the future. Necessary renewals of these credits have, however, made them in the nature of long-term rather than short-term credit extensions. Meanwhile the exporters have borrowed funds with which to carry such export credits largely from the commercial banks.
Depreciated Paper Currency
The second factor instrumental in the depreciation of the exchanges, namely, the abandonment of the gold monetary standard in Europe, while not so generally understood, is even more easily explained. We have already seen that the normal parity of exchange is an expression of the comparative quantities of gold in the American and foreign monetary units. At the present time, however, the parity of exchange between the United States and Great Britain is not 4.866, for the reason that American money which is redeemable in gold and is therefore the equivalent of gold, is exchangeable only for British paper money, which is not redeemable in gold and is therefore not the equivalent of gold. Since all of the European countries now have irredeemable paper money, the parity of exchange between American gold and European paper currency is in no case the same as the former parity between American gold and the gold of the several European countries. In fact, strictly speaking, there is no longer any parity.
Since British paper money has depreciated about 20 per cent in comparison with British gold, American traders and financiers are now unwilling to exchange $4.866 in American gold for £1 in British paper money.
Foreign exchanges have fallen to the extent that the domestic paper currency of European countries is now worth less than gold. With reference to Great Britain this is a factor that is probably secondary in importance to the maladjustment in trade and financial transactions, since the British paper currency is not very greatly depreciated. But with reference to the continental countries, particularly those cast of the Rhine, depreciation of the paper currency is the principal cause of falling exchanges.
The truth of this last contention may be seen from the fact that while the trade and financial relations between the United States and the central European countries have been far less unbalanced than between, for example, the United States and England, the depreciation of the exchanges, as will be seen from the table below, is far greater in the central European countries.
The following table gives the pre-war normal parities between the United States and the principal European countries, the rates one year ago, and the present quotations:
Great Britain
France
Italy
Belgium
Germany
Austria
Roumania
Czechoslovakia
Poland
Yugoslavia
Denmark
Finland
Holland
Sweden
Norway
Switzerland
Spain
Par Aug. 3, 1921 Aug. 3, 1920
$ 3-S6 7.62 cents 7.35 cents
5-20
8.07 "
Germany (mark) 23.8 "1.22 " 2.20 Austria (krone) 20.3 ".12 " 1.60 2.56 "
Czechoslovakia (krone) 20.3 "1.25 " 2.00 60 1.35 Denmark (krone) 26.8 "15.18 " 15.60 3-95 33-10 "
3.95
Holland (guilder) 40.2 "30.50 " 33.10
Sweden (krone) 26.8 "20.33 " 21.15 15-70 16.9s 15-25
The extent of the depreciation of the exchanges mirrors in a rough way the degree of general impoverishment and economic retrogression in each European country. And the relative depreciation from par of the exchanges of the different countries reflects pretty accurately the varying degrees of economic deterioration in the several European countries. Classified in broad groups, it will be seen that the exchanges of the neutral nations are the least depreciated; those of the Allied belligerents next; and those of the central and eastern European nations most of all.
During the past year (1921) the exchanges on every European country, except France,6 6The reasons why French exchange has been held up relatively to the others is discussed on page 91. It is not, however, indicative of genuine improvement in French conditions. have declined. Those on the countries of central and eastern Europe have declined very heavily; those of the neutral countries considerably; and those of the Allied nations, France excepted, somewhat. One must therefore conclude that on the whole the foreign exchanges indicate a European situation somewhat worse this year than last.
Many persons have been misled during the first half of 1921 by rising exchanges that were merely attributable to seasonal influences. The rates of the winter and spring every year are substantially higher than those of the summer and autumn. This is mainly because it is during the summer and fall that our exports are largest. The significant thing to note, therefore, is that, speaking generally, the rates this year have been below those of last year at each season of the year. The upward movement did not go as high as last year, and the downswing is therefore more pronounced than in 1920.
Effects of Depreciated Exchanges—1. Risks of Trade
The depreciated exchanges, while reflecting the economic decadence of European nations as compared with the United States, at the same time also act as a deterrent to European economic recovery. There are two ways in which the instability of the exchanges impedes foreign trade and the economic rehabilitation of Europe. First, it greatly increases the risk of trading operations and thus operates as a damper to business enterprise. The exchanges fluctuate widely from month to month, due (1) to speculative buying or selling of exchange in anticipation of improving or worsening conditions in Europe; (2) to changes in the volume of trade and other international transactions; and (3) to fluctuations in the value of the irredeemable paper currency of the various European countries.
Since all modern business is organized on a profit-making basis, it is of the utmost importance that business men be able to calculate their chances of profit with a reasonable degree of certainty. But fluctuating exchange rates mean great uncertainty as to the value of the money ultimately received in payment for a shipment of goods. Contracts entered into on the basis of the exchange quotations of January I, are settled on the basis of exchange quotations some months later, with resulting uncertainty for both parties to the transaction. The greater and more unpredictable the fluctuations in exchange rates, the greater the hesitancy to undertake the fulfilment of time obligations.
2. Curtailment of American Exports
The second way in which depreciated exchanges impede the economic recovery of Europe is through increasing the cost of goods purchased in the United States and other countries whose exchange rates are relatively high. For example, when French exchange is quoted at 6.40, it is worth only about one-third of its normal value of 19.3. This means that a French importer has to pay 19.3 cents for every 6.4 cents worth of goods received, or $3 for every $1 worth of goods bought in the United States. This would not matter if prices in France were higher than those in the United States in precise proportion to the depreciation of French exchange, that is to say, if the $1 worth of goods bought in the United States could be sold in France for $3, plus profit. But such is not precisely the case. When, for example, at the worst French exchange was worth only about one-third its normal parity, French prices were only about double American prices.
It should be observed, moreover, that since French exchange is less depreciated as compared with British than with American money, it pays France to import from Great Britain rather than from the United States, whenever it is possible to obtain the required goods there; and inasmuch as German exchange is greatly depreciated even as compared with the franc, France can buy still more cheaply in Germany. Since America is the dearest market in the world, purchases have to be confined to the minimum.
While this situation thus threatens our export trade, it could not seriously impede the recovery of Europe were it not for the fact that European countries are in so large a degree dependent upon American imports. Since the Armistice they have in fact been buying huge quantities of American goods on credit, but at a very heavy cost to themselves. As we shall presently see, European nations have been going ever more deeply into debt, without having effected any substantial recovery from the effects of the war. And not the least unfortunate aspect of this increasing indebtedness is the fact that so considerable a portion of it was contracted in the purchase of non-essential commodities during the period of the post-war luxury debauch. In view of the psychological effects of the war it was perhaps inevitable that we should pass through such a period. Be this as it may, the consequence has been that Europe still stands in great need of purchasing certain kinds of materials from the United States. But Europe is on the whole less able to make these purchases now than it was at the time of the Armistice. The truth of this statement will be more fully revealed in subsequent chapters.