International Monetary Economics

CHAPTER VI

THEORIES OF FOREIGN EXCHANGES

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OUR discussion of foreign exchanges will be conducted in two stages: the first represents the general case of currencies not linked to gold; the second stage is the special case of the gold standard. This way of treatment is the application of conclusions reached in the foregoing analysis of the monetary economics of gold. It resulted from that inquiry (1) that gold currency is a special case of currency in general and (2) that linking currency to gold (as in the system of the gold standard) is a particular form of management adopted for a paper currency.1 Historically the evolution has gone from metallic to paper currencies and finally to “abstract” bank-money: but each new development has widened the scope of “money” and has reduced its less-developed forms to being merely particular cases. Economic theory must explain general phenomena on the basis of the widest conception of money, and then make appropriate allowances for particular cases, such as gold currency or gold-standard currency.

The theory of foreign exchanges is closely linked to the study of the balance of payments: “in studying the subject as a whole, it is above all things necessary to form a clear view of what is meant by international indebtedness, of the elements of which it is constituted, and the various phenomena which it represents”.2

Operations in foreign exchanges consist in the conversion of one national currency into another, which is necessary in order to make payments from country to country. This problem does not present itself in connection with interregional payments in one and the same country, even though there exists the cost of banking transfer or of sending currency from place to place. On the international scale the problem would not be so important if certain conditions of homogeneity were realized; they include: (a) similarity or even identity of monetary policies in the different countries; (b) what we might call a “homogeneous distribution of confidence throughout the world”, so that no capital movements, for example, would take place because of differences in comparative anticipations concerning the economic and political stability of the different countries; (c) freedom of international movements of commodities, of monetary funds and of men. The non-fulfilment of these three groups of conditions is at the basis of the existence in international relations of problems which do not exist interregionally.3 Were it not for these considerations, we could discuss payments from country to country in the same way as we discuss payments from one place to another in the same country, and assimilate dealings in foreign exchanges to making payments between different places in the same country. Some economists favour this approach to the problem of foreign exchanges even under existing conditions.4 In my opinion it is preferable to draw a distinction between the foreign exchanges, on the one hand, and the technical costs of transferring money from place to place, on the other, and to explain the foreign exchanges in relation to the supply and demand of national currencies in terms of one another. The literature of the subject is enormous and cannot be analysed, nor even quoted, in the present study. I shall merely endeavour to give a summary picture of the processes involved.

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The various transactions listed and classified in the preceding chapter result in payments to be effected from country to country. Such payments can be made either by sending cash or by remitting bank money (in the form of bills of exchange payable on sight, or of bank transfers).5 Foreign exchange markets are places where demand and supply of the currencies of various countries and of bank balances in these countries meet. Resulting prices are foreign-exchange quotations.6

All payments to be made abroad create a demand for foreign currency or for bank balances abroad and a corresponding supply of national currency or of bank balances at home. The corresponding supply of foreign money and demand for national money results from payments received from abroad. Payments received and payments made are due to exports and imports, to capital movements, to short-term credit operations. While it is, therefore, incorrect to relate the state of supply and demand in the foreign-exchange markets to trade only, it is quite correct to relate it to the total of international transactions.

Let us assume, for the sake of simplification, the existence of only two countries, and let us further assume that prior to the moment when our reasoning starts there is in existence a certain rate of exchange between the two national currencies. This rate is, e.g., five A francs for one B dollar (or, reciprocally, one-fifth of a B dollar for one A franc). If during the following day the payments from A to B total 1,000 francs and payments from B to A total 200 dollars, then at the prevailing price, it will be easy for B debtors to acquire A money and for A debtors to acquire B money. The transaction is accomplished by the mechanism of the market, where A debtors acquire balances in B (or B currency) and use them to pay their B creditors, while these B balances are offered for sale by B debtors who want to acquire balances in A to pay their debt there. In other words, the money of A debtors is finally used for making the payments due to A creditors, and similarly in country B. As already mentioned the operation presents no problem if the amounts due in one direction are equal at the existing rate of exchange to the amounts due in the other. In that situation we have a balance of payments equal to zero, or to use the more familiar phrase, a balance of payments in equilibrium, and we have equilibrium as well in the foreign exchange market.

Such a situation however is unlikely actually to occur: on a given day either payments exceed receipts or receipts exceed payments. Let us now further assume that there is neither arbitrage nor forward trading. Then the price of A money in terms of B money will not remain stable; there will be a movement of exchanges until equilibrium between the reciprocal supply and demand of the two currencies is reached. This will happen either when the rate of exchange has moved sufficiently to equalize the two monetary sums which were unequal at the old price, or when new transactions are carried out which fill the gap. Let us examine these two solutions.

(a) Supposing that payments from A to B are again 1,000 francs but payments from B to A are only 100 dollars. There will be a relative scarcity of dollars, since at the old rate the B debtors would need 200 dollars to make their payments; and there will be a relative superabundance of francs since the demand for franc-balances would at the old rate be only 500 (in order to make a payment equivalent to 100 dollars). This situation of supply and demand will cause the rate of exchange to move “against” the franc; it will become necessary to pay more francs for one dollar. The rate at which 1,000 francs will be exchanged for 100 dollars is, of course, 10 francs to the dollar, though the actual development would show a tendency of the franc to fall from 5 to somewhat over 10 francs for a dollar. In reality we never get such situations, since compensating transactions take place and tend to smooth out the day-to-day fluctuations, but this oversimplified “model” provides some elements of explanation.

(b) New transactions are likely to be carried out in response to changes taking place in the exchange rates or as a result of policies adopted in consequence of these changes.7 Exports of the country whose currency depreciates in terms of the other country’s currency are likely to be stimulated and imports discouraged, while changes in interest rates may induce a compensating flow of short-term funds. Thus the situation described under (a) may get reversed not only by accident, but as consequence of the very effects of the changes in quotations.

If one takes into consideration a longer period, daily fluctuations of exchanges would be due principally to the unequal distribution over time of the various transactions and financial maturities, while new transactions, induced directly or indirectly by movements of exchange rates, would tend to reduce them to mere oscillations around some equilibrium rate.

Let us now drop one of our assumptions and introduce forward transactions. “Forward Exchanges are Foreign Exchanges bought or sold for future delivery (hence the American name ‘futures’) against payment on delivery.”8 Such transactions consist in concluding contracts of purchase and sale of foreign exchanges to be carried out in the future; their object is to get a safeguard against future exchange-rate fluctuations, or to speculate in anticipation of them. According to what the anticipations of the market are, forward exchanges will be quoted at a rate higher or lower than the “spot” rate about which we have spoken so far; the difference between the two rates is called a “premium” if the forward rate is higher, or a “discount” if it is lower. If somebody who has a payment to make abroad in, let us say, two months’ time, buys forward exchange for the corresponding amount in order to safeguard himself against the appreciation of that foreign currency, he will have to pay a premium, which will be the higher the more widespread the anticipation of a rise of that exchange rate is, and the greater the anticipated rise. The difference between the “spot” and “forward rates” is a sort of insurance premium.

Without entering into more technical details, let us point out that forward transactions have, in general, a tendency to smooth out fluctuations of exchange rates over time. It is only in periods of monetary instability that they are liable to aggravate the situation by being used for purely speculative purposes.

Let us finally drop another of our simplifying assumptions, and consider the case of many countries, many currencies and many foreign-exchange markets. If each market were to develop independent quotations of rates of exchange between the national currency and foreign currencies there would be in the world a perfect maze of divergent quotations of rates of exchange between any two currencies. The operations of arbitrage intervene to establish a connection between the different markets and quotations and to correlate the various rates between any two currencies. Arbitrage operations consist in buying assets on the market where they are cheaper and in selling them where they are more expensive. This amounts, in the case of foreign-exchange arbitrage, to a movement of short-term funds between the various markets the effect of which is to equalize exchange rates. Owing to arbitrage transactions one can speak of world rates of exchange, and one can be certain that momentary divergencies between rates quoted in different markets will set into motion equalizing operations. Arbitrage can be carried out not only in spot transactions but also between forward and spot exchanges.9

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The summary picture of the mechanism of foreign-exchange operations given in section 2 was intended primarily for the general reader10 and has been included here in order to define certain fundamental notions which will be further used in later parts of our inquiry. Let us now revert to the theoretical aspects of the problem.

It follows from our discussion that foreign-exchange quotations result from the momentary position of the balance of payments. This conclusion is quite obvious since exchange rates are brought about by international payments in the way defined above. To say, however, that fluctuations in foreign exchanges depend upon changes in the balances of payments is not a complete and not a very satisfactory explanation of the phenomenon. For why are there changes in the balance of payments? What items changed, how much did they change, are the changes lasting or momentary, are they likely to be offset by future changes in the same items or are they cumulative, can they be compensated by changes taking place in other items, can compensations come about automatically or if not, what policies are necessary to bring them about? All these questions are most important and only by answering them do we come to grips with the real problems.

There is a well-established opposition, in the theory of foreign exchanges, between the so-called “balance of payments theory”, the “purchasing power of money theory” and the “psychological theory”. The first type of theory relates foreign-exchange rates to the state of the balance of payments; the second to commodity prices prevailing in the different countries, the third to individual estimations and anticipations.

The “balance of payments theory” is true within its limitations but has been much abused. It has been all too often adopted by the neo-mercantilists who postulate an “active balance of payments” as condition of monetary stability.11 As we have seen it is the equilibrium of the balance of payments which is the condition of stability; an excess of receipts over payments in one country must be accompanied by an excess of payments, over receipts in some other country (or countries); thus if the neo-mercantilists were right, worldwide monetary stability could never be realized. It is a nationalist, not an internationalist, point of view which lies behind that distortion of the balance of payments argument. Furthermore it is often overlooked by the advocates of this theory that the state of the balance of payments is not only the cause, but also the result of the rate of exchange. While the rates established at any moment on the market are the result of the position of the balance of payments, that position results in turn, in part at least, from past fluctuations of exchange rates. As has been shown above on a simplified model, fluctuations of the exchange rate12 induce directly or indirectly new transactions and therefore changes in the structure of the balance of payments. Thus the “balance of payments theory” explains only how foreign-exchange quotations get established: at every moment the rate of exchange is the result of the momentary position of the balance of payments, i.e. of the supply and demand of the various national currencies in terms of one another.13 But the balance of payments is in itself the result of changes which are continuously taking place in the various types of transactions between countries, and which are determined in part by the very rates of exchange.

The “psychological theory”14 seems to be principally the result of a misunderstanding. Nobody will deny the psychological character of individual appreciations, choices, anticipations and decisions. In general economic theory this is embodied in the “subjective” value theory. A thorough study of the “psychology of men engaged in the pursuit of economic activities” is still missing and it is to be hoped that a collaboration between economists and psychologists will succeed in the future in elucidating these problems. But whatever are the motives of human behaviour, it is their material, quantitative effects that interest us in economic theory. There are, as it were, two stages of the phenomenon: first stage: individual appreciations, evaluations, preferences, choices, fears, anticipations; second stage: the individual as buyer or seller of goods, services, funds of money. The second stage results from the first; but only in the second stage do we reach problems relating to market transactions, processes which form the subject matter of economic theory. By saying this I do not intend to diminish the importance of the “first stage”; on the contrary, for the purpose of obtaining a full understanding of the phenomena under investigation it would be fatal not to take it into account—and no economic policy could ignore it! It is important however, in order to avoid confusion, not to mix up the two stages, while realizing that they are connected one with the other. For economic theory human desires, feelings, appreciations become of interest only when they find expression in the shape of supply and demand—of monetary supply and demand in all but quite primitive forms of economic intercourse. In formulating economic policy it is however very important to know how the psychological elements may, in their endless flow and change, affect the developments of supply and demand in all the various markets for goods, services and monetary funds.

The foregoing observations apply to the whole field of economic theory and policy; a particular application of them will be found in the theory of foreign exchanges. Psychological factors enter into the determination of the size of commercial transactions, of the flows of capital and of money; they enter into the anticipations as to the future course of events which are reflected in forward transactions. A full explanation cannot ignore these elements. But they all have to be expressed by a demand for, or supply of, the various national currencies in order to lead up to the establishment of rates of exchange. These latter result from quantitative expressions which the psychological and other elements combined obtain on the market: quantities supplied and quantities demanded at different prices; supply and demand curves; a market price.

If I said before that the “psychological theory” of foreign exchanges is the result of a misunderstanding I meant just that it consists in opposing one aspect of the problem to another when both aspects are important, and that its advocates fight the “quantitative” theory on two incorrect assumptions: (1) that it ignores the psychological elements and (2) that these elements can replace the quantitative elements in explaining the establishment of rates of exchange.15

The “purchasing power of money theory” of foreign exchanges relates fluctuations in exchange rates to changes in prices quoted in the countries concerned. We shall deal with it further when discussing below the problem of monetary parities. The theory can be traced far back in the history of economic thought, but has received particularly wide currency, as a theory of monetary parities, since reformulated by Professor Cassel. The purchasing power of money theory of foreign exchanges ascribes the fluctuations of rates of exchange between various currencies to changes in prices expressed in terms of these currencies; to quote Professor von Mises, “the rate of exchange is determined by the purchasing power possessed by a unit of each kind of money; it must be determined at such a level that it makes no difference whether commodities are purchased directly with one kind of money or indirectly, through money of the other kind”.16 This is further amplified in the following polemic observations:17 “The balance of payments theory forgets that the volume of foreign trade is completely dependent upon prices; that neither export nor import can take place if there are no differences in prices to make trade profitable. The theory clings to the superficial aspect of the phenomena it deals with. It cannot be doubted that if we simply look at the daily or hourly fluctuation on the Exchanges we shall only be able to discover that the state of the balance of payments at any moment does determine the supply and the demand in the foreign-exchange market. But this is a mere beginning of a proper investigation into the determinants of the rate of exchange. The next question is, what determines the state of the balance of payments at any moment? And there is no other possible answer to this than that it is the price level18 and the purchases and sales induced by the price-margins that determine the balance of payments.” In relating exchanges to prices, one must, of course, consider chiefly the prices of goods entering international trade and of goods which may enter international trade if their price differentials between the countries concerned are sufficiently large. The following observations formulated by Alfred Marshall in his evidence before the Committee on Indian Currency19 are very judicious and worth quoting in this connection:

“What do you take to be the general relation between the Indian exchange and prices in India and England?—India is so large that prices at her ports differ widely from up-country prices; and, partly for this reason, much of the produce of India is very little connected either as a cause or effect with the course of trade. But, broadly speaking, the Indian exchange, both before and after the closing of the mints, has indicated the proportion between rupee prices at Indian ports and sterling prices at English ports; and, subject to allowance for freights, etc. between India and England, the rule holds that the exchange, or the gold price of the rupee,20 is the ratio of sterling prices to rupee prices. . . .”

“. . . If the exchange is not by telegraph, something must, of course, be allowed for interest. It is worth the while of an English importer of say, jute, to pay this price a rupee if the jute that he can get with a rupee will sell net in London for this price. By net is meant, after paying all the expenses; i.e. including insurance, interest for the time the capital is locked up in transit, and remuneration for himself.”21

The theory which relates exchange rates to prices quoted in the respective national currencies is the more satisfactory the more important are commercial transactions as sources of international payments in comparison with the other sources of such payments. The larger are the payments due to capital movements and movements of short-term funds (other than commercial credit) the less acceptable is this theory of foreign exchanges. One may argue that in the long run all financial payments must either cancel out, or be compensated by commercial transactions;22 this view seems to be entirely justified23 since if payments are not deferred by the means of new loans, they must be met by a surplus of exports of the debtor country over that country’s imports. It is true now, as it was in the beginning of the nineteenth century, that “our foreign expenditure . . . must eventually be discharged with the produce of the labour and industry of our people”.24 This, however, is a long-run development, and to a much larger extent now than a century ago. On the other hand the rate of exchange is a very short-run phenomenon, and even a monetary parity is only a medium-run one. Under such circumstances the purchasing power of money theory of foreign exchanges offers merely one of the elements of a full explanation; an exceedingly important element, but one that acts together with several others which, from the short-run point of view, may be much more determining.

In no case should one consider the relations between prices in the various countries and the corresponding rates of exchange of one currency for the other to be a one-way causal relationship, changes in prices causing changes in rates of exchange and the latter being merely a consequence of the former. Fluctuations of exchange rates may affect, and often do affect, internal prices, by changing the prices of imported goods.25 If one envisages the balance of payments in its entirety, one observes that other components of it besides trade are affected by fluctuations of exchange rates.

When we take into account all the types of transactions to which international payments are due, we cannot but find that the rate of exchange is the result of supply and demand in the foreign-exchange market. That supply and that demand are due in turn to various causes, of which, particularly under stable conditions, commercial transactions form one of the most important. But there are also to be considered capital movements and short-term credit transactions, the fluctuations of which may bring about very important changes in the respective volumes of supply and demand in the foreign-exchange market. Both these groups of operations depend little if at all on comparative prices of commodities in the respective countries. It is therefore impossible to agree with the advocates of the purchasing power of money theory of foreign exchanges when they say, in Professor von Mises’s phrase, that “it is . . . the purchases and sales induced by the price-margins that determine the balance of payments”.26

Rates of exchange between currencies depend upon the situation of supply and demand in the foreign-exchange markets; and the supply and demand depend in turn upon a variety of causes, some of which determine the volume of import and export trade, others capital movements, others short-term credit operations. Among these causes one finds previous movements of exchange rates, and anticipations of future rates.

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Up till now we have ignored gold movements; the conclusions reached till now are valid for any monetary system, whether tied to gold or some other monetary metal or not. Now we shall assume the gold standard and inquire into the meaning of international movements of gold in the theory of foreign exchanges.

The features of the gold standard which we must particularly emphasize in the present context are: (1) the freedom of importing and exporting gold and (2) the fixing by law of the price of gold and the obligation of the central bank to buy and sell any quantity of gold that is demanded or offered at that price. The buying and the selling price of gold may not be quite identical.

We shall assume, for the purpose of the present argument, that all the countries concerned are on the gold standard. Then the price of gold as expressed in terms of each of the national currencies is fixed by law and gold can always be sold for determined amounts of national currencies at the mints or at the central banks. The comparison between the price of gold expressed in one currency and its price expressed in another yields a ratio which is called the gold-parity between the two currencies (vide infra). In effect, however, if one has a certain quantity of gold in one place and wants to use it for making a payment elsewhere, this costs freight, insurance and lost interest, and thus a payment in gold yields less units of the foreign currency than would be obtained through a parity calculation. If the parity between currency B and currency A is 1 to 5, i.e., if a certain quantity of gold costs 100 units of B currency and 500 units of A currency, and if the cost of sending gold from a place b in B to a place a in A is 1 per cent, then if the payment is made by sending gold, 100 units of B currency will be worth only 495 units of A currency instead of 500. Similarly, if a payment is made from a to b in the form of gold, 500 units of A currency will be worth only 99 units of B currency instead of 100, which means that 100 units of B currency are then worth 505 units of A currency.

Let us now bring together the mechanism of the foreign-exchange markets described in section 2 and the new elements just introduced. So long as the exchange rate between the A and B currencies moves away from “parity” by less than 1 per cent people will buy and sell foreign exchange and the mechanism described will work. But if the rates should move beyond that limit it would become cheaper to buy and ship gold instead of buying foreign balances or notes. If, e.g., the exchange rate for B currency in terms of A currency is (in our hypothetical numerical example) 5.03 it is cheaper to buy balances in B than to send gold; but the situation is reversed if the rate moves to 5.06; then one ships gold. Similarly one will ship gold from B to A when the rate falls below 4.95. This means that exchanges can fluctuate only between 4.95 and 5.05; if within these limits a market price cannot be obtained, no foreign-exchange transactions take place, but gold is being bought and shipped instead. Movements of gold from country to country get substituted for foreign-exchange fluctuations. Now these two limits, within which exchanges move and beyond which gold moves, are called gold points (the lower or upper gold point, or, which amounts to the same, the gold-import or gold-export point). If the rate reaches 4.95 (in our example), gold flows into country A; if the rate reaches 5.05 gold flows out of the country, and this goes on as long as the rate stays at one or the other of the gold points.

The gap between the gold points depends upon (1) transport costs; (2) the insurance premium on gold in process of transport; (3) the duration of transport resulting in loss of interest. It further depends on the margin between the central bank’s selling price and its buying price of gold, if the two are not identical. Gold points are the nearer the more rapid and secure and the less costly transport is and the greater the political and social security in the area of transport; and reciprocally, gold points are the further apart when transport is slower, more expensive and less secure and when there is political and social unrest in the territories concerned.

Under the gold standard, exchanges can move only within narrow limits; they are stable but not fixed, since within these limits they can and do move. That stability is due to the fact that payments can be carried out by the means of a commonly accepted commodity (i.e. gold); the cost of shipping that commodity determines the maximum cost of making international payments. This limits the rôle of the foreign-exchange market to providing cheaper means of making international payments; if the market is unable to provide them, it is temporarily replaced by shipments of the internationally accepted commodity: gold. The mechanism described in section 2 can always equalize the supply and the demand of means of payments for foreign settlements, if exchange-rates move sufficiently. The applicability of the gold-standard method is limited by the supply of gold available for shipment abroad. There is an analogy between a continuous loss of gold by a country and a continuous depreciation of its currency in terms of other currencies. The loss of gold, if cumulative, must lead to an abandonment of the gold standard and to a depreciation of the national currency. If this is to be prevented, i.e. if the gold standard is to be maintained or if an inconvertible paper currency is not to depreciate continuously, forces must be set into motion which will reverse the direction in which net payments between countries are to be made. We shall analyse and discuss in another chapter27 the methods of maintaining stability in international payments and, in consequence, stability of exchange rates.

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Before discussing the stabilizing mechanism let us briefly consider the various causes of instability. According to the “purchasing power of money theory” of exchanges, only price-changes can affect the exchange stability. An inflation causes an outflow of gold, perhaps its total loss, and then the abandonment of the gold standard and a depreciation of the exchanges. One usually says less about deflation as a cause of exchange instability than about inflation. This is justified inasmuch as under the rule of the gold standard a deflation is likely to be checked in time by the inflow of gold which it would cause. There is no doubt about the disturbing effect upon exchange stability of large and cumulative price movements in some countries. But the problem of exchange instability is more complicated than that, and in order to answer it we must turn once more to the transactions in which international payments originate.

The values involved in international, as in national, economic transactions are subject to continuous variations. Hence day-to-day quotations of exchange rates vary also. At some moments the balance of a country’s payments may show a deficit, at other moments it may show a surplus; exchanges fluctuate accordingly. Only if there are certain lasting causes of deficits or of surpluses will the currency depreciate or appreciate on the foreign-exchange market. Since under the gold standard the movements of exchanges are replaced to large extent by gold movements, gold normally moves out of a country or into it in response to a deficit or surplus of her balance of payments and the direction of the gold flow keeps on as long as the particular position of the balance lasts. The “mechanism” of adjusting balances of payments and of restoring their equilibrium whenever it is disturbed, consists in inducing compensatory operations which would tend to convert a deficit into a surplus and a surplus into a deficit, so as to make all payments exactly balance over a period of time. This may be done by the types of transactions shown in the table on the opposite page.

The “mechanism of adjustment” which will be discussed presently, has this in common with direct government policies such as exchange restrictions, trade restrictions, export subsidies and the like: that it affects the various transactions in the ways listed opposite. What varies principally is the method—and the difference is fundamental for the development of international economic relations.

Besides the day-to-day fluctuations due to the irregularities in the “normal” currents of business, there may be certain systematic causes of disequilibrium in the balances of payments and certain causes which produce very large positive or negative balances which are hard to compensate.

In case of a Deficit	In case of a Surplus
Stimulation of exports (goods and services)	Stimulation of imports (goods and services)
Restriction of imports (goods and services)	Discouragement of exports (goods and services)
Stimulation of foreign investments at home	Stimulation of national investments abroad
Discouragement of national investments abroad	Discouragement of foreign investments at home
Encouragement of entries of foreign short-term deposits	Stimulation of movements abroad of short-term balances
Discouragement of purchase of short-term deposits abroad by nationals	Discouragement of entries of foreign short-term deposits

In a free economy28 the principal cause of a cumulative deficit in a country’s international payments is to be found in inflation.29 Reference to it has been already made. A sustained policy of inflation leads a gold-standard country to a cumulative loss of gold and finally to the abandonment of that system; then the national currency can freely depreciate. In a country whose currency is not convertible into gold, inflation leads to its continuous devaluation in terms of foreign currencies.

A process of inflation affects a country’s balance of payments not only because rising prices affect the volume of imports and exports. Capital movements and, even more so, movements of short-term funds, tend to aggravate the deficit and to depreciate the inflated currency even more than would be required by the “purchasing power of money theory”. Cases of acute inflation provide also a good demonstration of the fact (mentioned above) that it is not only prices which affect rates of exchange, but rates of exchange may, through their fluctuations, affect prices. Statistical records of modern monetary history provide many illustrations of that latter type of causation.

It does not follow (contrary to an opinion which is often expressed in economic literature) that inflation is the only cause of serious maladjustments in the balances of payments, and that equilibrium in international payments can be taken for granted provided that no inflation is taking place. The condition of stable equilibrium consists in the possibility of compensating rapidly changes that occur in certain items of international transactions by appropriate changes in other items. In actual economic practice this is possible only if the other items are sufficiently flexible and if the changes that take place in some items are not too large in comparison with the items that are to be adjusted.

Maladjustments or disturbances of this type can be brought about inter alia by the following circumstances:

(1) large movements of short-term balances;

(2) large and sudden capital movements such as sales of securities or real estate;

(3) cessation of new lending operations;

(4) important changes in the structure of foreign trade.

Now if the disturbance is due to large payments resulting from movements of short-term funds, the adjustment must occur either through changes in long-term capital movements or in trade transactions. Similarly if the disturbance originates with capital movements, a temporary adjustment can be sought by the means of short-term credit transactions, while a lasting adjustment must result from changes in trade items. Finally if the disturbance originates in the structure of trade, the gap in international payments can be bridged over by the means of short- or long-term financial operations until the structure of trade is in turn adapted to new circumstances. The burden of long-term adjustment falls on trade items, though momentary adjustment can best be realized by short-term credit operations.

• 1There is much difference between the views that are widely held in this matter in Great Britain and the United States, and views that are commonly accepted on the Continent. This explains the emphasis laid on that issue. Vide infra, pp. 68 and 69.
• 2The reader may find it useful in this context to contrast the United States’ unified monetary system, now embodying a Federal Reserve System, with what would have existed had each of the 48 States of the Union sovereign powers over its particular monetary system.
• 3The word “international” is used, of course, with utter disregard of its etymological significance; but this usage is universally recognized.
• 4F. A. von Hayek, Monetary Nationalism and International Stability, London, 1937.
• 5loc. cit., p. 4.
• 6Except when a World State exists.
• 7i.e., “real” factors of production (goods), monetary factors (capital) and, thirdly, labour.
• 8“In the last analysis . . . it is the political factor which gives rise to the economic problem of international monetary transfer. If historical accident had not created independent sovereign states . . . no such ‘problem’ would have arisen”. Lionel Robbins, Economic Planning and International Order, London, 1937, pp. 279–80.
• 9To change the weight of a coin (“debasement”) is analogous to the modern forms of devaluation. While, as we shall see presently, the expression “changes in the gold contents of a currency unit” is open to criticism, it shows at least clearly the analogy in question. But what Sovereign Prince of the days gone by would have accepted an international undertaking never to debase the currency? And even if he did accept it, this would be an analogous matter to the type of international monetary convention mentioned in an earlier part of this chapter. The Latin Union was to some extent an example of a limited convention of this kind. But it all goes to show that not even a general limitation of monetary circulation to precious metals would automatically insure a system which would work internationally in the same manner as a monetary system works within a country in regulating the supply of money in the different regions.
• 10loc. cit., pp. 270–80.
• 11Cf. my “Monetary Internationalism and its Crisis”, a chapter in The World Crisis, London, 1938, pp. 348 et seq.
• 12I expect to discuss it at considerable length in my book on the Theory of Banking which is in the course of preparation.
• 13For example England, the United States, etc. Vide infra, chap. ix.
• 14Statements to the contrary which can be found in economic literature rest obviously on a misunderstanding. Thus, for example, Professor Cassel writes (The Theory of Social Economy, New Edition, 1932, vol. ii, p. 458): “On a gold standard there is no sharp division between the quantity of money and the stock of gold.” If Professor Cassel means “an all-gold currency” then this statement is correct; but it is much more likely that the gold standard is really meant: and then this statement is essentially wrong. What is worse is that most of Cassel’s theory on the relations between gold and prices and on the role of gold in the monetary system rests on that assumption expressed in the sentence quoted. One cannot emphasize too often the fact that a gold-standard currency is a paper currency attached to gold (and sometimes convertible into gold); it is not a gold currency. Vide infra, chaps. iii and iv.
• 15It is important to note that the so-called “going-off the gold standard” is not tantamount to the suppression of gold as monetary metal. In the latter case we should have to speak of “demonetization of gold”. Vide infra, p. 177.
• 16Relations between gold and prices are particularly undetermined when the system existing is a de facto system consisting in Central Banks (or Treasuries) buying gold at prices fixed by them, while the regular gold standard is suspended. The price of gold is then subject to variations, but at the price prevailing at every particular moment, monetary authorities are buyers of gold, which as we shall see is one of the features of the gold standard. On the other hand, when the gold standard is suspended there are no longer any provisions about the gold cover of notes, and the value of gold stocks may become indeterminate. All this makes relations between gold stocks and prices very vague indeed, without making them non-existent.
• 17Cf. with the Macmillan Report (Committee on Finance and Industry Report), London, 1931, H.M.S.O., Cmd. 3897, para. 45.
• 18Thus, for example, The Economist wrote the following in its Editorial of 15 May 1937 (p. 404): “The world, in fact, has learned a new lesson. The value of a country’s gold stock does not merely depend upon the physical quantity of gold lying in the vaults of the Central Bank or the Treasury. It depends also upon the price of each ounce of gold expressed in the national currency.” (The italics are mine. I fear that for many it has really been a “new lesson”!)
• 19vide Appendix.
• 20I find myself in substantial agreement with conclusions reached by A. D. Gayer in his book on Monetary Policy and Economic Stabilization, p. 63, though his criticisms are considerably less severe than the ones I have developed in this chapter. Charles O. Hardy says, similarly, in the book Is There Enough Gold?: “Other factors, such as the use of bank deposits as money, and changes in the absorption of gold by India, are brought into Cassel’s analysis to account for the major deviations of the price trend from the ‘relative supply of gold’, (p. 22.) If, as Cassel believes, the increase in the amount of gold stock required to maintain prices during the 60 years before the war corresponded accurately or even approximately to the growth of production, it was because for the period as a whole these other important factors cancelled each other out.” (p. 24.) As a matter of fact these factors did not cancel each other out as there were considerable price movements in the course of these 60 years. Cancellation can only have existed in so far as prices were more stable than they would otherwise have been.
• 21In his study On Quantitative Thinking in Economics, Oxford, 1935, p. 107, Cassel says in this connection the following: “During the period within these limits Great Britain was on the gold standard and, in addition, was essentially a free-trade country. British prices, therefore, may be taken fairly well to represent gold standard prices in the world market, and British index-numbers to reflect the variations of the general price level in terms of gold.” Still it does not follow that prices in Great Britain depend upon the size of world stocks of gold! In the same context Cassel says, rightly, that “the analysis must be confined to a period in which the general system of money has been essentially unaltered”. But in the period 1850–1910 this has not been true even for Great Britain, where the great development of banking took place precisely in the second half of the nineteenth century; the fact of staying on the gold standard does not exclude the possibility of great changes taking place in the internal organization of the monetary system. If the statement that in that period of sixty years “the general system of money has been essentially unaltered” is not true for Great Britain it is much less true for the world at large; thus the condition which Professor Cassel recognizes himself as a necessary prerequisite of his analysis has not been fulfilled in the period to which he applies that analysis.
• 22This, not the “price level”, is the subject that deserves our interest, though it is clear that, thus formulated, the changes cannot be expressed by a single numerical time-series. How to represent them adequately is a problem for statisticians to solve!
• 23A change of the price of gold may, of course, affect quantities produced, besides affecting their value and the value of existing stocks.
• 24Gustav Cassel, The Downfall of the Gold Standard, Oxford, 1936, p. 7.
• 25Neither has Cassel done anything to demonstrate this sweeping statement.
• 26Ibid., pp. 3–4.
• 27Which is merely a statistical construction to be accepted for what it is worth. Vide Appendix.
• 28This is, for example, the position taken by Professor Rist. Vide infra.
• 29And, of course, the policy of commercial banks, which is more or less closely connected with that of the central bank.