A Tract on Monetary Reform

by John Maynard Keynes

It is important, on the other hand, not to exaggerate the extent to which, at the present time, merchants can by this means protect themselves from risk. In the first place, for reasons, some of which will be considered below, it is only in certain of the leading exchanges that these transactions can be carried out at a reasonable charge. It is not clear that even the banks themselves have yet learnt to look on the provision for their clients of such facilities at fair and reasonable rates as one of the most useful services they can offer. They have been too much influenced, perhaps, by the fear that these facilities might tend at the same time to increase speculation.

But there is a further qualification, not to be overlooked, to the value of forward transactions as a protection against risk. The price of a particular commodity, in terms of a particular currency, does not exactly respond to changes in the value of that currency on the exchange markets of the world, with the result that a movement in a country’s exchanges may, in the case of a commodity of which that country is a large seller or a large purchaser, change the commodity’s world-value expressed in terms of gold. In that case a merchant, even though he is hedged in respect of the exchange itself, may lose, in respect of his unsold trading stocks, through a movement in the world-value of the commodity he is dealing in, directly occasioned by the exchange fluctuation.

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If we turn to the theoretical analysis of the forward market, what is it that determines the amount and the sign (whether plus or minus) of the divergence between the spot and forward rates as recorded above?

If dollars one month forward are quoted cheaper than spot dollars to a London buyer in terms of sterling, this indicates a preference by the market, on balance, in favour of holding funds in New York during the month in question rather than in London,—a preference the degree of which is measured by the discount on forward dollars. For if spot dollars are worth $4.40 to the pound and dollars one month forward $4.40½ to the pound, then the owner of $4.40 can, by selling the dollars spot and buying them back one month forward, find himself at the end of the month with $4.40½, merely by being during the month the owner of £1 in London instead of $4.40 in New York. That he should require and can obtain half a cent, which, earned in one month, is equal to about 1½ per cent per annum, to induce him to do the transaction, shows, and is, under conditions of competition, a measure of, the market’s preference for holding funds during the month in question in New York rather than in London.

Conversely, if francs, lire, and marks one month forward are quoted dearer than the spot rates to a London buyer, this indicates a preference for holding funds in London rather than in Paris, Rome, or Berlin.

The difference between the spot and forward rates is, therefore, precisely and exactly the measure of the preference of the money and exchange market for holding funds in one international centre rather than in another, the exchange risk apart, that is to say under conditions in which the exchange risk is covered. What is it that determines these preferences?

1. The most fundamental cause is to be found in the interest rates obtainable on “short” money—that is to say, on money lent or deposited for short periods of time in the money markets of the two centres under comparison. If by lending dollars in New York for one month the lender could earn interest at the rate of 5½ per cent per annum, whereas by lending sterling in London for one month he could only earn interest at the rate of 4 per cent, then the preference observed above for holding funds in New York rather than in London is wholly explained. That is to say, forward quotations for the purchase of the currency of the dearer money market tend to be cheaper than spot quotations by a percentage per month equal to the excess of the interest which can be earned in a month in the dearer market over what can be earned in the cheaper. It must be noticed that the governing factor is the rate of interest obtainable for short periods, so that a country where, owing to the absence or ill-development of an organised money market, it is difficult to lend money satisfactorily at call or for very short periods, may, for the purposes of this calculation, reckon as a low interest-earning market, even though the prevailing rate of interest for longer periods is not low at all. This consideration generally tends to make London and New York more attractive markets for short money than any Continental centres.

The effect of the cheap money rates ruling in London from the middle of 1922 to the middle of 1923 in diminishing the attractiveness of London as a depository of funds is strikingly shown, in the above tables, by the cheapening of the forward quotations of foreign currencies relatively to the spot quotations. In the case of the dollar the forward quotation had risen by the beginning of 1923 to a rate 3 per cent per annum above the spot quotation (i.e. forward dollars were 3 per cent per annum cheaper than spot dollars in terms of sterling), which meant (subject to modification by the other influences to be mentioned below) that the effective rate for short loans approached 3 per cent higher in New York than in London.

In the case of francs forward quotations which had been below spot, so long as money was dear in London, rose above the spot quotations, thus indicating that the relative dearness of money in London as compared with Paris had disappeared; whilst in the case of lire forward quotations, although still below spot quotations, rose, under the same influence, nearer to the spot level. Nevertheless, in the case of both these currencies, a preponderance of bearish anticipations about their future prospects probably also played a part, for the reasons given in detail below, in producing the observed result.