# The Theory of the Foreign Exchanges/Chapter V

CHAPTER V
remarks on the interpretation of the foreign exchanges.
In the preceding chapter we have been occupied in tracing the origin and development of the transactions which result in the Foreign Exchanges, from their simplest to their more complicated forms, with the special object of discovering the various causes which combine to produce constant and important fluctuations in the prices of foreign bills. Having gained a theoretical insight into the principles of the system, we are now in a position to approach the more practical and interesting portion of the subject, and to examine it in its direct bearing upon commerce in general. Being acquainted with the influences which are proved to determine the fluctuations in question, we are enabled, by a reverse process, to argue back from them to the existence of their determining causes, and to consider the Foreign Exchanges in their peculiarly valuable character as an unerring mercantile and monetary barometer. But they are more than this. Not only do they offer to the trading community the means of ascertaining the state of the commercial atmosphere - indicating when the air is charged with a storm, or when fair weather is likely to set in, - they so clearly point to the disturbing currents, that their study and due comprehension suggest the course by which danger can be avoided, and moderate the precipitate action of panic.
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. Of its inaccuracy, in so far as it enters into the domain of political economy and applies to the general prosperity of the country, it is not necessary to speak. 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; that, accordingly, a position of the exchanges which points to an influx of specie is favourable, whereas, when bills become so scarce that the precious metals must be exported, the situation is eminently unfavourable. But the phrase is accurate enough from the monetary or banking point of view. Under the present state of legislation all engagements involve payments in gold or in paper convertible into gold, the merchants engaging to pay in gold or bank-notes, at their option, and the Bank of England being bound by law, without option, to pay those banknotes in gold. Consequently it is of the highest importance to the whole banking and mercantile community, with a view to the certain fulfilment of such engagements, that the aggregate stock of bullion in the country should suffice to meet all wants. Whether the law is wise in itself is beside the argument, so long as the currency laws continue as they are. Under present circumstances a merchant or banker will consider that to be an unfavourable state of things which points to a dangerous diminution of the stock of gold, and he will consider that a favourable turn of the exchanges which tends in the opposite direction. When the stock of gold is evidently adequate, it is even in a banking point of view erroneous to consider a further accumulation advantageous or desirable. And just fault may be found with the use of the term "favourable exchange" beyond the limits of the sufficiency of the bullion for the purposes of the currency; for the temporary excess of gold at one point is of no advantage whatever, but rather the reverse. The limit of the phrase should be strictly kept in view as legitimately applied to express the anxiety or confidence of the banking world as to the means of meeting their legal obligations. And accordingly there is no real discrepancy as to the class of facts which, in practice, the words "favourable and unfavourable" exchanges denote. 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 a 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. A proper understanding on these points is absolutely necessary, as otherwise differences of opinion might be supposed to exist, while the difference does not lie in the opinion or the theory, but simply in the application of a technical phrase. 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 unfavourable, 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.
It is necessary to call attention to another point before we proceed to consider the interpretation of fluctuating rates of exchanges. It must be borne in mind that it is the price of short bills, not of those which have some time to run, which determines the course of bullion shipments. Most of the primary elements of value affect long and short bills equally; but the rate of interest and the question of credit exercise an additional influence upon the former, and so modify the fluctuations in their price as to render them unreliable as indications of the currents of gold. If there is a demand for bills upon any particular town, the price of all such bills, whether short or long, will rise. That is the general tendency. If, however, in the city in question, the rate of interest were at a very high point, it is evident that the price of long bills would not rise in the same proportion as that of short; for the purchaser must bear the discount, which has to be deducted from the long bill before it can become equally available with the short bill; and for any increase in this discount he requires to be compensated by a so much cheaper price. He must be compensated in the same manner for the risk which he will run till the bill be ultimately paid.
As an index of the general position of trade, the value of short bills is the more important; whereas the rates given for long paper, as compared with those for bills on demand, point mainly to the rate of interest, and partially to the state of credit.
Bearing in mind the existence of this distinction in those cases where (as, for instance, between London and Paris) the short exchange is the most prominent, and not straining it too much where, owing to various circumstances, long bills only are to be obtained to any amount, as is the case in St. Petersburg, we may now proceed to illustrate the method to be followed when it becomes desirable to interpret the indications afforded at any given moment by the Foreign Exchanges. It results, from the whole tenor of the previous arguments, that it is, above all, essential to remember that fluctuations can arise not only from one cause but many, and that till proof is given that actually no other influence is at work than the one which may be selected as possible and plausible, no trustworthy opinion can be formed. It is an error often committed, when scientific subjects are superficially or popularly treated, to consider it enough to point out one cause as sufficiently accounting for any phenomena, regardless of the fact that it is far more important to prove that there are no other causes which could have led to the same results. But on no occasion does this fallacy more frequently blind the judgment that in questions of mercantile finance, possibly because the facts with which they have to deal are so complex and entangled that any clear and intelligible solution of the difficulty is held to be sufficiently satisfactory, without regard to the necessity of applying further tests. Half of the benefit which might be derived by a study of the exchanges is lost in consequence of the tendency to be satisfied with the first plausible explanation. Egregious errors might be committed if an argument were founded on the state of the exchanges between Hamburg and London which relied on the balance of trade alone, without considering the difference of value which would result from a premium on silver, the currencies of the two countries being dissimilar. So it is not sufficient to consider the Russian exchanges simply as indicating the enormous indebtedness to foreign creditors, to the exclusion of the influence of the depreciated currency.
A notable instance of the necessity of never losing sight of any of the various elements of value which enter into the prices paid for bills of exchange, and also a valuable illustration of the question of interpretation generally, was afforded by the extraordinary course of the American exchanges at the beginning of 1861. A large efflux from Europe to the United States took place, and various theories were started as to its cause. But strangely enough, months elapsed before it was clearly acknowledged and understood by the majority of the public that this efflux of bullion was mainly the consequence of indebtedness. Another explanation, grounded on the growing troubles in the States (which were leading to a kind of panic), and on the presumed speculations of English capitalists, had been put forward as sufficiently explaining the prevailing drain; whereas the test of indebtedness should have been applied first of all. The specie shipments were hurried and intensified by peculiar modifications of that indebtedness; for instance, by the Americans drawing sooner than usual against their claims on England, by their suspending their orders for English manufacturers, and by the forced and unnatural increase of exportation even of articles not wanted in Europe. But the primary cause of the fall of the exchanges which led to the flow of bullion to America lay in the immense excess of their exports of wheat and flour, following too, on a cotton crop of unprecedented extent. Independently of the political crisis, Europe would have had to pay a balance to America in gold; and this was surely the cardinal point to keep in view, in considering whether the export of bullion would continue or cease. Such authorities as, at the commencement of the efflux of bullion, insisted on considering it as a simple speculation, and pointed to the folly of the merchants who sent it out, prophesying that probably it would return to them in the same ships, committed the error of looking principally to the stock of gold in New York, to the speculations in American securities, and to the operations of capitalists, rather than to the one broad fact, which was clearly discernible on closer inspection, that England and Europe were simply paying for their importations from America.
Stress was continually laid upon the fact that the stock of gold was accumulating in New York and was decreasing here, and it was argued that consequently the gold must return. It is plain, however, that for this result to take place, one of the following events would have to occur; either the bullion would be returned because the Americans owed money to us, and sent it to pay debts; or it would be remitted against fresh orders for English manufactures or for American stocks held in English hands; or it would be sent here as a loan to English capitalists, in the expectation that money would, as was certainly probable, become dearer here than in America. Those who maintained that bullion would return, were bound to prove that one of these operations would take place. The first was a question of fact: Did the Americans owe much to Europe? The second was a question of probability: Was it likely that the Americans would regain sufficient confidence to enter upon new mercantile transactions? The third was also a question on which opinions might be divided: Was it more probable, or the reverse, that in a time of great national emergency the New York bankers would remit their capital for employment to Europe, because gold accumulated rapidly in their vaults? (94)