Chapter Three: Further explanations of the Nature of Exchange Rates

Chapter Three

Further Explanations on the Nature of Exchanges

Abstract: Exchange rates are explained as a function of the balance of trade and other factors. A trade deficit can cause your money to exchange below par, while a trade surplus will cause it to exchange above par. In fact, the exchange rate, above and below par, is an indicator of the general balance of trade in a country. An attempt to prohibit the export of gold necessary to pay for deficits only hurts the economy.

WE HAVE SEEN THAT EXCHANGES are regulated by the intrinsic value of specie, i.e., at par, and that their variation arises from the costs and risks of transporting money from one place to another when a balance of trade has to be sent in specie. There is no need for reasoning with something we can observe in fact and practice. Bankers sometimes introduce refinements into this practice.

If England owes France 100,000 ounces of silver for the balance of trade, if France owes 100,000 ounces to Holland, and Holland 100,000 ounces to England, these three amounts may be offset by bills of exchange between the respective bankers of these three states, without the need to send silver on any side.

If Holland sends goods worth 100,000 ounces of silver to England in January and England only sends goods worth 50,000 ounces to Holland during the same month (I’m assuming that the sale and payment are made in January on both sides), a balance of trade of 50,000 ounces will be due to Holland, and the exchange rate with Amsterdam, in January, will be two or three percent above par in London, or in the language of exchange, the exchange rate with Holland, which was at par or at 35 escalins to the pound sterling in London in December, will rise to about 36 escalins in January. However, after the bankers send this balance of 50,000 ounces to Holland, the exchange rate with Amsterdam will naturally fall back to par in London, or to 35 escalins.

However, an English banker may foresee in January, if an extraordinary quantity of goods is being sent to Holland, that Holland will owe a considerable amount to England at the time of payment in March. Instead of sending the 50,000 écus or ounces due to Holland in January, he may provide bills of exchange on his Amsterdam correspondent bank that will be payable two months later. By this method, he will profit on the exchange, which was above par in January and will be below par in March, and gain doubly without sending a sol to Holland.

This is what bankers call speculations, which often cause variations in the exchange rates for short periods of time, independently of the balance of trade. In the long run, however, we must return to this balance which makes the rules of exchange constant and uniform. And though the speculations and credits of bankers may sometimes delay the transport of the sums that one city or state owes to another, in the end, it is always necessary to pay the debt and send the balance of trade in specie to the place where it is due.

If England regularly gains a balance of trade with Portugal and always loses a balance with Holland, the exchange rate premium between Holland and Portugal will make this evident. In London, the exchange rate with Lisbon will be below par as Portugal is in debt to England. It will also be evident that the exchange rate with Amsterdam is above par because England is in debt to Holland. However, the amount of the debt cannot be seen from the exchange rates. It cannot be seen whether the balance of silver withdrawn from Portugal will be greater or less than what has to be sent to Holland.

However, there is one thing which will always be apparent in London, whether England gains or loses the general balance of her trade (the general balance should be understood as the net balance between England and all the foreign states which trade with her), as seen in the price of gold and silver, but especially of gold (now that the proportion between gold and silver in coined money differs from the market rate, as will be explained in the next chapter). If the price of gold in the London market, which is the center of English trade, is lower than the price at the tower¹³⁹ where guineas¹⁴⁰ or gold coins are minted, or at the same price as these coins intrinsically, and if gold is taken to the Tower in exchange for their value in guineas or minted coins, it is a certain proof that England is a gainer in the general balance of her trade. It proves that the gold taken from Portugal suffices not only to pay the balance which England sends into Holland, Sweden, Muscovy,¹⁴¹ and the other states where she is indebted, but that there remains some gold to be sent to the Mint, and the amount or sum of this general balance of trade is known from the amount of specie coined at the Tower of London.

But if gold is sold in the London market above the Tower price, which is usually £3.18.0 an ounce, the metal will no longer be taken to the Mint, and this is a certain sign that not enough gold is being received from abroad (from Portugal, for instance) compared to the amount necessary to send to other countries that England is in debt to. This is proof that the general balance of trade is against England. However, this would not be known except for the prohibition in England against sending gold coins out of the country. This prohibition is the reason why the timid London bankers prefer to buy gold metal (which they are allowed to send abroad) at £3.18.0 up to £4 an ounce for export rather than sending out guineas or gold coins at £3.18.0 illegally at the risk of confiscation. Some of them take this risk, others melt the gold coins to send out as bullion, so that it is impossible to judge how much gold England loses when the general balance of trade is against her.

In France, they deduct the cost of minting, which is usually 1.5 percent. In other words, the price for coins is always higher than that of uncoined metal. To know whether France loses in the general balance of her trade, one only needs to know whether bankers send French coins abroad. If they do so, it is a proof that they cannot purchase enough bullion to export, since the bullion, though at a lower price than coined money in France, is of greater value than these coins in foreign countries by at least 1.5 percent.

Exchange rates rarely diverge from the balance of trade between one country and all others, and this balance is merely the difference in value between the commodities and merchandise which a state sends to other countries and receives from them. Yet, there are often circumstances and incidental causes for which considerable sums are conveyed from one state to another aside from the question of merchandise or trade, and these causes affect the exchange rates just as the balance of trade would do.

The sums of money which one state sends into another for its secret services and political purposes, subsidies to allies, the upkeep of troops, ambassadors, noblemen who travel, etc., the capital which the inhabitants of one state send to another to invest in public or private projects, the interest which these inhabitants receive annually from such investments, etc., are all of this nature. The exchange rates fluctuate with all these incidental causes and follow the same rule as the transportation of money. In considering the balance of trade, matters of this kind are not separated, and indeed it would be very difficult to separate them. They have most certainly an influence on the increase and decrease of money circulating in a state and on its comparative strength and power.

My subject does not allow me to further develop the effects of these incidental causes. I confine myself always to the simple views of commerce so as to not complicate my subject, which is already complex by the multiplicity of related facts.

Exchange rates rise more or less above par in proportion to the greater or smaller costs and risks of transporting money. That being said, they naturally rise much more above par in cities or states where it is forbidden to export money than in those where its export is free.

Assume that Portugal annually consumes considerable quantities of woolen and other manufactured goods from England, for its own people as well as for those of Brazil. It pays for them partly in wine, oils, etc., but for the surplus payment, there is a regular balance of trade sent from Lisbon to London. If the king of Portugal strictly prohibits under penalty, not only of confiscation but also of life, the transport of any gold or silver out of his states, the terror of this prohibition will, in the first place, stop the bankers from sending the balance. The money for English manufactures will be kept in Lisbon. English merchants, unable to receive payments from Lisbon, will stop sending cloth there. The result will be that cloth will become extraordinarily expensive. Though their price has not gone up in England, they cease to be sent to Lisbon because their value cannot be recovered. In order to have these cloths, the Portuguese nobility, and others who cannot do without them, will offer twice the usual price, but as they cannot get enough of them without sending money out of Portugal, the increased price of cloth will become the profit of any one who, in spite of the prohibition, will export gold or silver. This will encourage various Jews¹⁴² and others to take gold and silver to English vessels in the port of Lisbon, even at the risk of their lives. At first, they will gain 50 to 100 percent in this traffic and this profit is paid by the Portuguese in the high price they give for the cloth. They will gradually familiarize themselves with this maneuver, after having often practiced it successfully, and eventually, money will be put on board English ships for a payment of one to two percent.

The king of Portugal lays down the law or prohibition. His subjects, even his courtiers, pay the cost of the risk run to circumvent and elude it. Therefore, no advantage is gained by such a law. On the contrary, it causes a real loss to Portugal since more of the state’s money is sent abroad than if there were no such law.

Those who gain by this maneuver, whether Jews or others, often send their profits abroad, and when they have enough of them or when they get scared, they often follow their money abroad.

If some of these lawbreakers were caught in the act, their goods confiscated and their lives taken, these events, instead of stopping the export of money, would only increase it, because those who formerly were satisfied with one or two percent for exporting money, will ask 20 or 50 percent, and so the export must always go on to pay the balance.

I do not know whether I have succeeded in making these reasons clear to those who have no knowledge of trade. I know that for those who understand exchange rates, nothing is easier to comprehend, and they are rightly astonished that those who govern states and administer the finances of great kingdoms have so little knowledge of the nature of exchange rates as to forbid the export of bullion and coins of gold and silver.

The only way to keep them in a state is to conduct foreign trade so that the balance is not adverse to the state.

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¹³⁹ The Tower refers to the Tower of London where the mint was housed.

¹⁴⁰ A gold coin nicknamed after the place in Africa where much of the gold came from.

¹⁴¹ This refers to Moscow or the Grand Dutchy of Moscow, but by Cantillon’s time it was used to describe the Russian Empire of Peter the Great.

¹⁴² Jews were traditionally active in the money and banking trade due to the prohibition of usury imposed by the Catholic Church in Spain and Portugal.