The process is exactly the same, and is even more simple and easy to understand when we take away the complication of the exchange of the moneys of two different nations, and look at it at work between two distant towns of the same country. If in the course of trade New York has large payments to make in Chicago, money in Chicago will be wanted in New York, and competition there will send up the price of it, so that a dollar in Chicago will be worth more for the time being to New Yorkers than a dollar in New York, and any New York bank or firm that has a balance or a credit in Chicago will be able to dispose of it at a premium. The extent of this premium, however, will obviously be limited by the expense involved in sending lawful money, as the Americans call it, from New York to Chicago. If we suppose, for the sake of simplicity, that the cost of sending a dollar and insuring it is covered by a cent, no one in New York will pay much more than one dollar and a cent for a dollar in Chicago. Rather than do so he will send his dollar. He will probably pay a small fraction more to save himself the trouble and time involved by sending and insuring money, and this minute fraction that he will sacrifice is the opportunity of the exchange dealer, who will send money to Chicago, and put himself in funds there, and so be able to supply money in Chicago to any one in New York who will pay for it at the rate of one dollar and one cent plus any profit that the exchange dealer can squeeze out of him.
Viewed in this simple example the problem of exchange has few terrors. It is merely a question of the price of money in one place, as expressed in the same money in another, with fluctuations governed by supply and demand and limited by the cost of sending money from place to place. This limitation does not mean that supply and demand cease to govern the market, but merely that at a point supply can be increased to meet any demand by the despatch of currency.
"Favourable" and "Unfavourable" Exchanges
[104]The general feeling with regard to the function of the exchanges, as giving evidence of the mercantile (or rather monetary) situation of any country, is indicated by the usual phrase of a "favourable or unfavourable state of the exchanges." A phrase which occurs so frequently in all banking discussions that it cannot be passed over without remark. It may originally have implied the erroneous theory that the object of commerce is to attract gold, and that that country towards which the tide of bullion sets with the greatest force is ipso facto the most prosperous. Political economists, from their point of view, are correct in their statement that, as regards the country at large and the interchange of commodities, exports and imports are always balanced, and that both the words "unfavourable balance of trade" and "unfavourable exchanges" involve fallacy. But merchants and bankers are influenced by the feeling, that at any given moment they may be under greater liabilities for imports than they can temporarily meet, owing to the system of credit which disturbs the coincidence of payments for exports and imports, though their value may actually be equal; and further, by the anxiety as to the possibility of meeting these liabilities in that specific mode of payment to which they are pledged, namely, in gold or convertible notes. When, therefore, in banking treatises, it is said that the exchanges are favourable to any particular country, it should be understood that the intention is simply to state the fact that bills of that country upon foreign cities are difficult of sale, whilst bills drawn upon it from abroad are at a premium, indicating an eventual influx of specie. So, when it is said that the exchanges are unfavorable, a situation is described in which foreign bills are in great demand, and when, consequently, their value seems likely to be so enhanced as to render the export of bullion an unavoidable alternative.
The Origin and Supply of Foreign Exchange
[105]Underlying the whole business of foreign exchange is the way in which obligations between creditors in one country and debtors in another have come to be settled—by having the creditor draw a draft directly upon the debtor or upon some bank designated by him. John Smith in London owes me money. I draw on him for 100 pounds, take the draft around to my bank and sell it at, say, 4.86, getting for it a check for $486.00. I have my money, and I am out of the transaction.
The fact that the gold in a new British sovereign (or pound sterling) is worth $4.8665 in our money by no means proves, however, that drafts payable in pounds in London can always be bought or sold for $4.8665 per pound. To reduce the case to a unit basis, suppose that you owed one pound in London, and that, finding it difficult to buy a draft to send in payment, you elected to send actual gold. The amount of gold necessary to settle your debt would cost $4.8665, in addition to which you would have to pay all the expenses of remitting. It would be cheaper, therefore, to pay considerably more than $4.8665 for a one-pound draft, and you would probably bid up until somebody consented to sell you the draft you wanted.
Which goes to show that the mint par is not what governs the price at which drafts in pounds sterling can be bought, but that demand and supply are the controlling factors. There are exporters who have been shipping merchandise and selling foreign exchange against the shipments all their lives who have never even heard of a mint par of exchange. All they know is, that when exports are running large and bills in great quantity are being offered, bankers are willing to pay them only low rates—$4.83 or $4.84, perhaps, for the commercial bills they want to sell for dollars. Conversely, when exports are running light and bills drawn against shipments are scarce, bankers may be willing to pay 4.87 or 4.88 for them.
For a clear understanding of the mechanics of the exchange market there is necessary a clear understanding of what the various forms of obligations are which bring foreign exchange into existence. Practically all bills originate from one of the following causes:
1. Merchandise has been shipped and the shipper draws his draft on the buyer or on a bank abroad designated by him.