Chapter Two: The Nature of Exchange Rates

Chapter Two

On Bills of Exchanges and their Nature

Abstract: There is an expense associated with transporting money based on the distance, risks, and other transaction costs. Bills of Exchange are a type of contract that can reduce this cost by avoiding shipments that are offsetting between two locations. When money must be sent, bankers charge a fee for arranging the shipment and providing their customers with a bill of exchange, or check, that can be drawn or cashed at a correspondent bank where the money is sent. When the exchange rate is above par, it indicates a balance of payments deficit, and when the exchange rate is below par, it indicates a balance of payments surplus.

IN THE CITY OF PARIS, transporting money from one place to another usually costs five sols per bag of 1,000 livres.¹²⁹ If it were necessary to carry it from the Faubourg St. Antoine to the Invalides,¹³⁰ it would cost more than twice as much, and if there were no generally trustworthy money couriers, it would cost even more. If there were likely to be robbers on the road, the money would be sent in large amounts, with an escort, at greater cost, and when someone bears the cost and risks of transport, he will require payment in proportion to these costs and risks. Therefore, the cost of transport from Rouen¹³¹ to Paris and from Paris to Rouen generally amounts to 50 sols per bag of 1,000 livres,¹³² which, in the language of the bankers, is ¼ percent. Bankers generally send money in strongboxes¹³³ which robbers have difficulty taking because of the iron and the weight, and as there are always mail coaches on this route, the costs are negligible on large sums sent between these two places.

Assume that, every year, the city of Châlons-sur-Marne¹³⁴ pays 10,000 ounces of silver to the king’s tax collector, and wine merchants from Châlons and the surrounding areas sell to Paris, through their distributors, Champagne wine for a total of 10,000 ounces of silver. If the ounce of silver is worth five livres in France, the 10,000 ounces in question will be worth 50,000 livres in both Paris and Châlons.

The tax collector, in this example, has 50,000 livres to send to Paris, and the distributors have 50,000 livres to send to Châlons’ wine merchants. This double transaction, or transport, may be avoided by an exchange contract known as bills of exchange, if the parties get together and arrange for it.

In this example, let each wine distributor take his portion of the 50,000 livres to the cashier of the tax collector’s office in Paris and in return he will be given a check or bill of exchange payable to the Châlons’ tax collector. When these checks are endorsed and transferred to the Châlons’ tax office, the tax obligations of the Châlons’ wine merchants of 50,000 livres will be paid. In this manner, the 50,000 livres in Paris will be paid to the cashier of the tax department in Paris and the wine merchants of Châlons will, in effect, be paid, and by this exchange or offset, the trouble of sending this money from one city to the other is avoided. Or else, let Châlons’ wine merchants, who have 50,000 livres in Paris, offer bills of exchange from their distributors to their tax collector and endorse them to the cashier of the tax office in Paris, who will in turn collect from the distributors the amount of 50,000 livres, which they owed to the merchants of Châlons for the bills of exchange. Whichever way this offsetting is achieved, whether the bills of exchange are drawn from Paris on Châlons or, as in this example, from Châlons on Paris, ounce for ounce, or 50,000 livres for 50,000 livres, is paid, and the exchange is said to be at par.

The same method might be adopted between Châlons’ wine merchants and the rent collector for the nobility in Paris who own land in the Châlons district, and the wine merchants, or other merchants in Châlons who have sent goods or merchandise to Paris and have money there, and other merchants who have purchased goods from Paris and sold them in Châlons. If there is a large trade between these two cities, bankers will set up in Paris and Châlons, they will enter into relationships with the interested parties on both sides, and will become the agents or intermediaries for the payments that would otherwise have to be sent from one city to the other. Now if all the wine and other goods and merchandise, which have been sent from Châlons to Paris and have actually been sold there for cash, exceed in value the total receipts of the taxes in Châlons, plus the rents from Paris’ nobility owning property in the Châlons district, as well as the value of the goods and merchandise sent from Paris to Châlons and sold there for cash, by 5,000 ounces of silver or 25,000 livres, it will be necessary for the banker in Paris to send this amount to Châlons in cash. This sum will be the excess or balance of trade between these two cities. This sum must be sent to Châlons in cash and this operation will be carried out in the following way or in some similar fashion.

The agents or distributors of the Châlons’ wine merchants, and others, who have sent goods or merchandise to Paris, have money from these sales in Paris and that must be sent to Châlons. They are not in the habit of transporting the money—at risk—and will go the tax office’s cashier to obtain a check or bill of exchange (generally at par) for the tax office in Châlons, up to the amount which it has available in Châlons. If they need to send additional sums to Châlons, they will go to the banker who has, at his disposal, the rents of the Paris nobility who own estates in that district. This banker will furnish them, like the tax office’s cashier, with bills of exchange to be cashed with his correspondent banker in Châlons, up to the amount which he has at his disposal and that must otherwise be sent from Châlons to Paris. This offsetting will also be made at par between the agents who request that their money be sent to Châlons, as well as from the nobility who ask to have their money brought to Paris from Châlons, unless the banker tries to make a small profit from the transaction for his trouble. If the banker also has at his disposal money in Châlons from the sale of the merchandise imported from Paris, he will also furnish bills of exchange for this amount.

However, in our example, the agents for the Châlons’ merchants still have 25,000 livres in Paris, which they must send to Châlons, in addition to all the sums mentioned above. If they offer this money to the tax office’s cashier, he will reply that he has no more funds in Châlons, and that he cannot supply them with bills of exchange or checks to that city. If they offer the money to the banker, he will tell them that he has no more funds in Châlons from which he can draw, but if they will pay him three percent of the exchange, he will provide a bill of exchange. They will offer one or two percent, and will settle at two and half, unable to do better. At this price, the Banker will give them bills of exchange, that is if they pay him two livres ten sols in Paris, he will supply a bill of exchange for 100 livres to be cashed by his correspondent bank in Châlons, payable in 10 or 15 days, so as to put his correspondent in a position to make the 25,000 livres payment he is obtaining from him. At this rate of exchange, he will send him the money by messenger or stagecoach in gold or, in absence of gold, in silver. This delivery of gold will cost ten livres for each bag of 1,000 livres, or in banker’s jargon, one percent. He will pay his correspondent in Châlons a commission of five livres per bag of 1,000 livres, or one half percent, and he will keep one percent for his own profit. On this basis, the exchange between Paris and Châlons is at two and half percent above par, because one pays two livres ten sols for every 100 livres exchanged.

In a similar manner, the balance of trade is transported from one city to the other through bankers, and generally on a large scale. Not all those who bear the name of bankers are accustomed to these transactions, and many of them deal only in commissions and bank speculations. I will only count among bankers those who transmit money. They are the people who regulate such exchanges, where the price is based on the costs and risks of transporting currencies in different cases.

The exchange premium between Paris and Châlons is rarely more than two and half or three percent over or under par. But from Paris to Amsterdam, the exchange premium will be up to five or six percent when currencies have to be sent. The journey is longer, the risk is greater, and more correspondents and commission agents are involved. From India to England, the price for transport will be ten to twelve percent. From London to Amsterdam, the exchange premium will hardly exceed two percent in times of peace.

In our present example, it could be said that the exchange in Paris for Châlons is two and half percent above par, and in Châlons, it could be said that the exchange for Paris is two and half percent below par, because in these circumstances, those who provide money in Châlons for a bill of exchange for Paris will give only 97 livres 10 sols to receive 100 livres in Paris. And it is evident that the city or place where the exchange is above par is in debt to that where it is below par, as long as the exchange premiums continue on this basis. Exchanging money from Paris to Châlons is two and half percent above par because Paris is in debt to Châlons and the money for this debt must be transported from Paris to Châlons. This is why when the exchange premium is commonly below par in one city as compared with another, it may be concluded that this first city has a balance of trade with the other.¹³⁵ When the exchange premium in Madrid or Lisbon is above par for all other countries, it shows that these two capitals must send specie to these other countries.

In all places and cities that use the same money and the same gold and silver specie like Paris and Châlons-sur-Marne, or London and Bristol, the exchange premium is known and expressed by giving and taking a certain percent above or below par. When 98 livres are paid in one place to receive 100 livres in another, it is said that exchange premium is about two percent below par. When 102 livres are paid in one place to receive only 100 livres in another, it is said that the exchange premium is exactly two percent above par. When 100 livres are given in one place for 100 livres in another, it is said that the exchange is at par. There is no difficulty or mystery in all this.

When the regulation¹³⁶ of exchange occurs between two cities or places where the money is different, where the coins have different sizes, fineness, forms, and names, the nature of exchange seems at first more difficult to explain, though in reality, this exchange differs from that between Paris and Châlons only in the jargon used by bankers. In Paris, one speaks of the Dutch exchange premium by reckoning the écu (equal to three livres) against so many Dutch deniers, but the parity of exchange between Paris and Amsterdam is always 100 ounces of gold or silver against 100 ounces of gold or silver of the same weight and fineness. One hundred and two ounces paid in Paris to receive 100 ounces in Amsterdam always comes to two percent above par. The banker who transports the balance of trade must always know how to calculate parity. But in the language of foreign exchange, the price of exchange in London with Amsterdam is made by giving a pound sterling in London to receive 35 escalins at a Dutch bank: with Paris, by giving 30 deniers or pence sterling in London to receive one écu or three livres tournois in Paris. This way of speaking does not reveal whether exchange is above or below par, but the banker who transmits the balance of trade understands it and knows how much foreign money he will receive for specie of his own country, which he is transporting.

Whether we fix the exchange premium in London for English silver in Rubles from Moscow, in Marks from Hamburg, in Rixdollars¹³⁷ from Germany, in Livres from Flanders, in Ducats from Venice, in Piastres from Genoa or Leghorn,¹³⁸ in Millreis or Crusadoes from Portugal, in Pieces of Eight from Spain, or Pistoles, etc., the parity of exchange for all these countries will be always 100 ounces of gold or silver against 100 ounces; and if, in the language of exchange, one gives more or less than this parity, it is the same as saying that the exchange is so much above or below par, and we will always know whether or not England owes a balance to the place with which the exchange is settled, just as we know in our example between Paris and Châlons.

Châlons Balance of Trade with Paris

Paris		Châlons
30,000 oz. silver.	→	Wine from Châlons
− 5,000 oz. silver Parisian goods	←
− 10,000 oz. silver paid in taxes
− 10,000 oz. silver paid in rents
5,000 oz. silver balance of trade owed to Châlons

Châlons wineries sell 30,000 oz. of silver worth of wine to the people of Paris who, in turn, sell the people of Châlons 5,000 oz. of goods. Of the 30,000 oz. on account in Paris, 5,000 oz. are transferred to the merchants who sold goods to the people of Châlons, 10,000 is transferred to the government to pay the taxes for the people of Châlons, and 10,000 oz. are transferred to the property owners living in Paris to pay the rents they are owed.

All this is done by the use of bills of exchange. The remaining 5,000 oz. must be paid in silver, which must be physically moved from Paris to Châlons. Châlons has a balance of trade and Paris owes a balance of trade. The banker gives bills of exchange to the wine merchants for a 2.5% fee who in turn sends them to the winery owners who can then cash them at local banks after the silver arrives from Paris.

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¹²⁹ The livre tournois was equal to 20 sols so that the transport charge would be one quarter livre or two and a half one hundreths of one percent.

¹³⁰ Faubough Saint Antoine was a suburb of Paris to the east and north of the River Seine. Hôtel des Invalides was a complex of buildings founded in 1671 by Louis XIV who was providing housing for disabled war veterans. At the time, it was located in western Paris south of the River Seine, but is now east of the Eiffel Tower.

¹³¹ Rouen is located in the province of Normandy near Paris.

¹³² The 50 sols was the equivalent of two and a half livres or one quarter of one percent.

¹³³ Cantillon uses a phrase that translates literally as “double barrels,” which Higgs translated as “strong kegs”.

¹³⁴ Châlons-sur-Marnes was renamed Châlons-en-Champagne in 1998 and is the capital of the Champagne-Ardenne.

¹³⁵ Higgs wrote that “when exchange is commonly seen to be below par in one city as compared with another it may be concluded that this first city owes a balance of trade to the other.” This would be a mistake as the first city has a positive balance of trade in that it provided the other city more goods than it received and is owed this balance. The mistake is also in the original French edition. Hayek attributes the mistake to a printers error, which is possible, but not as likely as an error by a manuscript copyist. We have strong reasons to believe the French edition is not based on Cantillon’s own manuscript, but on a copy. This is a common error, but it is highly unlikely that Cantillon himself would make such an error because of his familiarity with and experience in these markets.

¹³⁶ Remember that when he uses the word regulation he is not speaking of government regulation, but of market regulation.

¹³⁷ Rixdollar was the English term for silver coins used throughout northern Europe which were originally based on the Reichsthaler. This was a standard thaler of the Holy Roman Empire and the mispronouciation of thaler in the American colonies is the basis for the word “dollar.”

¹³⁸ The city of Livorno Italy, just southeast of Genoa on the Mediterranean Sea.