need be entertained lest in the long run this liberty will not be used to advance the general good. REFERENCES FOR COLLATERAL READING * In addition to the references given in the preceding chapter the following are suggested: * Dunbar, The Theory and History of Banking; Seligman, and others, The Currency Problem; Muhleman, Monetary and Banking Systems; Bolles, Practical Banking; Conant, History of Modern Banks of Issue; Knox, History of Banking; Hadley, Economics, Chap. VIII. CHAPTER XVI FOREIGN EXCHANGE AND SOME UNSETTLED MONETARY PROBLEMS 140. The Nature of Foreign Exchange. In foreign as well as domestic trade credit now serves as the principal medium of exchange. Those who purchase goods from abroad pay for them by buying drafts, or postoffice, express or cable money orders and sending the latter to the foreign seller, or by permitting the foreign seller to draw on them by means of drafts, or bills of exchange, for the sums due. Orders for the payment of money in a foreign country are called "foreign exchange," and the buying and selling of such exchange is, as already suggested, a usual part of the business of a modern city bank. A description of the factors that enter into this business as it is conducted between the United States and the United Kingdom will serve to introduce a discussion of some of its more general aspects. Anglo-American trade now includes as varied transactions as the trade between different sections of either country. In addition to commodities, stocks, bonds and other securities are constantly dealt in between the two countries; profits, rents, interest and even wages are transmitted; freight charges are paid; travelers abroad receive remittances from home, and finally bankers' loans are exchanged. If these different transactions be looked at from the point of view of one of the countries, say, of the United States, they arrange themselves under two heads: those involving payments to the country and those involving payments by the country. The first may be NATURE OF FOREIGN EXCHANGE 269 thought of as credits acquired by the United States. These arise from sales of commodities or securities, from payments in the way of profits, rents, interest or wages due to Americans from the United Kingdom, from the expenditures of Englishmen in the United States and finally from loans by English to American bankers. The second may be described as debits, and arise from the opposite transactions, e. g., purchases of commodities or securities, loans to English bankers, etc. For reasons which it would take too long to explain the custom has arisen of making London the clearing house for the credit instruments used in connection with foreign trade. Americans having payments to make in England usually buy drafts payable in London and transmit them to their creditors. Americans who are creditors of Englishmen, on the other hand, usually draw drafts or bills of exchange, payable in London, upon their debtors, in preference to waiting for the latter to remit. They sell these to bankers, who send them to their correspondents in London for collection. Orders for money payable in London are known as "sterling exchange" because they call for pounds sterling. If the orders for payments to English creditors are exactly offset by the orders for payments by English debtors, the credit instruments which arise in connection with the various transactions described will just balance one another when they come together in London and no other medium of exchange than credit will be required. This outcome, where transactions are so vast, is, of course, very unusual. It more frequently happens that there is a balance either on the credit or on the debit side to be liquidated by means of further transactions. 141. Sterling Exchange and the Gold Points. The rate at which sterling exchange is quoted in the United States never departs very far from the sum in American dollars into which the 113 grains of gold in the standard English coin, the sovereign (equivalent to one pound ster ling), will be coined by our mints. This is called the " par of exchange" and is $4.866. The rate of sterling exchange fluctuates within narrow limits about this par because the alternative that is always open to American bankers and brokers who have debts to pay or to collect in the United Kingdom is to export or import standard gold coin. The limits within which sterling exchange normally fluctuates are called the "gold points" and are now approximately for demand exchange $4.841⁄4 and $4.88. That is to say, when the rate for sterling exchange falls as low as $4.8414 the margin between this and par rather more than suffices to cover freight, insurance, loss of interest, etc., on the sovereigns that may be imported and exchanged, if of full weight, @ $4.866 for American coins at our mints. Under these circumstances there is always an active competition among bullion brokers to buy sterling exchange as it approaches $4.8414. The more they can buy at this low rate the larger the profit they can make by importing the gold for which it calls. This competition prevents the rate from falling lower. On the other hand, as the rate of sterling exchange rises toward $4.88 it begins to be profitable to export American gold to be converted into English money in order to sell exchange against it at the premium. The margin between the high rate and par now covers the freight, insurance, loss of interest, etc., on American gold sent to London and as before the competition of bullion brokers prevents the rate from rising above the upper gold point. In determining the gold points stated interest is figured at six per cent. A higher rate widens the gap between the gold points; a lower narrows it. 142. The Rate of Sterling Exchange. The rate of sterling exchange is determined from day to day by the relation between the demand for it and its supply. All of the transactions which have been enumerated as belonging STERLING EXCHANGE 271 on the debit side, from the point of view of the United States, give rise to a demand for sterling. The supply comes from the transactions enumerated on the credit side. International bankers and others who buy and sell foreign exchange tend by their competition to adjust the rate so that the demand and supply will just balance. Excess on the side of supply causes the rate to fall, the limit being the lower gold point, at which credit is abandoned as a medium of exchange and gold is used instead. Excess on the side of demand causes the rate to rise, the limit here being the upper gold point, at which credit again is discarded and gold used. Gold thus serves as the medium in which international balances are settled when debits and credits fail to offset each other. Among the transactions which give rise to debits and credits the most sensitive are those we have characterized as bankers' loans. Anglo-American banking houses, of which there are many, divide their banking capital between London and New York. Self-interest leads them to keep the major part of this capital and of their entire loanable funds at that center in which the higher rate of interest prevails. Suppose that for a time this center happens to be New York-as it usually is. To take advantage of the high rate, bankers will wish to transfer their funds from London to the more profitable loan market. They will do this most cheaply by selling drafts on London so long as they can get a price for these drafts above the lower gold point. A rising rate of interest in New York thus serves to attract loanable funds from abroad, and these add to the supply of sterling bills. This cause may serve to add so largely to the supply that the rate of exchange is forced down to the lower gold point and a part of the transfer is effected by means of an importation of gold. In fact, the Bank of England and the state banks of other countries, which are in a position o control the bank rates of interest, commonly secure gold |