A Tract on Monetary Reform

by John Maynard Keynes

1. Those exchanges in which the fluctuations are wildest and the merchant is most in need of facilities for hedging his risk are precisely those in which facilities for forward dealing at moderate rates are least developed. But this is to be explained, not necessarily by the instability of the exchange in itself, but by certain accompanying circumstances, such as distrust of the country’s internal arrangements or its banking credit, a fear of the sudden imposition of exchange regulations or of a moratorium, and the other analogous influences mentioned above (pp. 126–7). There is no theoretical reason why there should not be an excellent forward market in a highly unstable exchange. In those countries, therefore, where regulation is still premature, it may nevertheless be possible to mitigate the evil consequences of fluctuation by organising facilities for forward dealings.

This is a function which the State banks of such countries could usefully perform. For this they must either themselves command a certain amount of foreign currency or they must provide facilities for accepting short-period deposits in their own currency from foreign bankers, on conditions which inspire these bankers with complete confidence in the freedom and liquidity of such deposits. Various technical devices could be suggested. But the simplest method might be for the State banks themselves to enter the forward market and offer to buy or sell forward exchange at a reasonable discount or premium on the spot quotation. I suggest that they should deal not direct with the public but only with approved banks and financial houses, from whom they should require adequate security; that they should quote every day their rates for buying and selling exchange either one or three months forward; but that such quotation should take the form, not of a price for the exchange itself, but of a percentage difference between spot and forward, and should be a quotation for the double transaction of a spot deal one way and a simultaneous forward deal the other—e.g. the Bank of Italy might offer to sell spot sterling and buy forward sterling at a premium of ⅛ per cent per month for the former over the latter, and to buy spot sterling and sell forward sterling at par. For the transaction of such business the State banks would require to command a certain amount of resources abroad, either in cash or in borrowing facilities. But this fund would be a revolving one, automatically replenished at the maturity of the forward contracts, so that it need not be on anything like the scale necessary for a fund for the purpose of supporting the exchange. Nor is it a business which involves any more risk than is inherent in all banking business as such; from exchange risk proper is free.

With free forward markets thus established no merchant need run an exchange risk unless he wishes to, and business might find a stable foothold even in a fluctuating world. A recommendation in favour of action along these lines was included amongst the Financial Resolutions of the Genoa Conference of 1922.

I shall develop below (Chap. V.) a proposal that the Bank of England should strengthen its control by fixing spot and forward prices for gold every Thursday just as it now fixes its discount rate. But other Central Banks also would increase their control over fluctuations in exchange if they were to adopt the above plan of quoting rates for forward exchange in terms of spot exchange. By varying these rates they would be able, in effect, to vary the interest offered for foreign balances, as a policy distinct from whatever might be their bank-rate policy for the purpose of governing the interest obtainable on home balances.

2. It is not unusual at present for banks to endeavour to distinguish between speculative dealings in forward exchange and dealings which are intended to hedge a commercial transaction, with a view to discouraging the former; whilst official exchange regulations in many countries have been aimed at such discrimination. I think that this is a mistake. Banks should take stringent precautions to make sure that their clients are in a position to meet any losses which may accrue without serious embarrassment. But, having fully assured themselves on this point, it is not useful that they should inquire further—for the following reasons.

In the first place, it is almost impossible to prevent the evasion of such regulations; whilst, if the business is driven to methods of evasion, it tends to be pressed underground, to yield excessive profits to middlemen, and to fall into undesirable hands.

But, what is more important and is less appreciated, the speculator with resources can provide a useful, indeed almost an essential, service. Since the volume of actual trade is spread unevenly through the year, the seasonal fluctuation, as explained above, is bound to occur with undue force unless some financial, non-commercial factor steps in to balance matters. A free forward market, from which speculative transactions are not excluded, will give by far the best facilities for the trader, who does not wish to speculate, to avoid doing so. The same sort of advantages will be secured for merchants generally as are afforded, for example, to the cotton trade by the dealings in “futures” in the New York and Liverpool markets. Where risk is unavoidably present, it is much better that it should be carried by those who are qualified or are desirous to bear it, than by traders, who have neither the qualification nor the desire to do so, and whose minds it distracts from their own business. The wide fluctuations in the leading exchanges over the past three years, as distinct from their persisting depreciation, have been due, not to the presence of speculation, but to the absence of a sufficient volume of it relatively to the volume of trade.

3. A failure to analyse the relation between spot and forward exchange may be, sometimes, partly responsible for a mistaken bank-rate policy. Dear money—that is to say, high interest rates for short-period loans—has two effects. The one is indirect and gradual—namely, in diminishing the volume of credit quoted by the banks. This effect is much the same now as it always was. It is desirable to produce it when prices are rising and business is trying to expand faster than the supply of real capital and effective demand can permit in the long run. It is undesirable when prices are falling and trade is depressed.

The other effect of dear money, or rather of dearer money in one centre than in another, used to be to draw gold from the cheaper centre for temporary employment in the dearer. But nowadays the only immediate effect is to cause a new adjustment of the difference between the spot and forward rates of exchange between the two centres. If money becomes dearer in London, the discount on forward dollars diminishes or gives way to a premium. The effect has been pointed out above of the relative cheapening of money in London in the latter half of 1922 in increasing the discount on forward dollars, and of the relative raising of money-rates in the middle of 1923 in diminishing the discount. Such are, in present circumstances, the principal direct consequences of a moderate difference between interest rates in the two centres, apart, of course, from the indirect, long-period influence. Since no one is likely to remit money temporarily from one money market to another on any important scale, with an uncovered exchange risk, merely to take advantage of ½ or 1 per cent per annum difference in the interest rate, the direct effect of dearer money on the absolute level of the exchanges, as distinguished from the difference between spot and forward, is very small, being limited to the comparatively slight influence which the relation between spot and forward rates exerts on exchange speculators.[39] The pressure of arbitragers between spot and forward exchange, seeking to take advantage of the new situation, leads to a rapid adjustment of the difference between these rates, until the business of temporary remittance, as distinct from exchange speculation, is no more profitable than it was before, and consequently does not occur on any increased scale; with the result that there is no marked effect on the absolute level of the spot rate.

[39] If interest rates are raised in London, the discount on forward dollars will decrease or a premium will appear. This is likely to have some influence in encouraging speculative sales of forward dollars (how much influence depends on the proportion borne by the difference between the spot and forward rates to the probable range of fluctuation of the spot rate which the speculator anticipates); and in so far as this is the case, the covering sales of spot dollars by banks will move the rate of exchange in favour of London.