The Natural Economic Order/Part IV/Chapter 6 A

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A. The Mechanism of the Exchanges

It is often asserted that foreign trade cannot be carried on with paper-money, that gold is needed for this purpose. But in reality foreign payments can be made with paper-money, and the mechanism of such payments is simple enough, though it is still not generally understood.

Do you see the lemons in the greengrocer's over there? They come from Malaga. And the packing cases yonder being trundled from the Hamburg Parasol Company to the station are going to Seville. The question is, can these two transactions be carried on with German and Spanish paper-money, without the intervention of gold?

If the same dealer imported the lemons from Spain and exported the parasols to Spain, everybody would see that paper-money offers no obstacles to the execution of the two transactions. The dealer would sell the parasols in Seville for Spanish paper-money, and with this paper-money buy lemons in Malaga. He would then send the lemons to Hamburg, sell them for German paper-money, and with it pay for the parasols. He would repeat this transaction indefinitely without being troubled by the circumstance that Spanish paper-money is not legal tender in Germany. The Spanish paper-money received for the parasols is spent in Spain for lemons, and the German paper-money paid him for the lemons is used for the purchase of parasols. His capital changes continually: to-day it consists of lemons, tomorrow of German marks, next of parasols and then again of Spanish pesetas. The dealer is concerned only about the profit, about the surplus yielded by the continual transmutation of his capital. And his guarantee that there will be a surplus depends, not on the currency, but on the laws of competition.

Import and export are seldom, however, united in one hand, as a rule we have here also division of labour which requires a special action to effect the payment. But here again paper-money is no obstacle. The transaction is as follows: The importers and the exporters living in the same town meet on the Exchange where the exporter of parasols sells to the importer of lemons, for German money, his claim on Seville in the form of a bill of exchange. At what price (rate of exchange) that is done we shall see presently. This bill of exchange, which is made out in Spanish pesetas, is sent by the importing firm to Malaga in payment for the lemons received. The wording of the bill is as follows:

Thirty days after sight pay to the order of Hamburg Lemon Importers Ltd. the sum of One Thousand Pesetas, value received (our invoice of August 1st. for parasols).

To Mr. Manuel Sanchez, Seville.
The Hamburg Parasol Company.

The sale of the bill by the parasol exporting firm to Lemon Importers Ltd. is already certified by its being made out to the order of Lemon importers Ltd. The further sale of the bill to the lemon exporting firm at Malaga will be inscribed on the back of the bill, as follows: For us to the order of Messrs. Cervantes y Saavedra, Malaga, Hamburg Lemon Importers Ltd.

From Malaga the bill is sent through a banking-house to Seville and is there met by the dealer in parasols, Mr. Manuel Sanchez.

The transaction in parasols and lemons is then effected in all four directions, the parasol exporting firm in Hamburg and the lemon exporting firm in Seville having received their money, the lemon importing firm in Hamburg and the parasol importing firm in Seville having paid their bills. Yet the only money that entered into the transaction was German and Spanish paper-money. Although there were four parties concerned in the export and import, goods were paid for with goods, German goods with Spanish goods.

The transaction is similar if instead of being negotiated between the importing and the exporting firms direct, the bills are handed in at banks, which is the general rule if the importer and the exporter live in different towns- it would lead us too far to describe the whole course of such a transaction, but there is no essential difference.

One important question has yet however to be answered: What determines the rate of exchange of the peseta bill of exchange in Hamburg, what is the price, in German money, paid by the lemon importing firm in Hamburg for the bill of exchange made out in a foreign currency ?

This question, also, we shall answer. The price of bills of exchange, like the price of lemons and potatoes, is determined exclusively by demand and supply. Many potatoes, many bills, mean low prices for potatoes and bills. Now many Spanish peseta bills are offered for sale in Germany when many goods are exported to Spain, and there is little demand for peseta bills in Hamburg when few goods are imported from Spain. Hence the price (rate of exchange) of peseta bills falls, to rise again when the tide turns.

As long as imports and exports remain unchanged, the supply of and the demand for bills will balance. But a change immediately occurs if, for any reason, prices in Spain or Germany (to come back to our example) depart from their general level. If commodity prices rise in Spain, say because comparatively more paper-money has been issued there than in Germany, these higher prices will attract more foreign commodities and at the same time make the export of Spanish goods less profitable or altogether unprofitable. Imports into Spain therefore increase, while exports decrease. The supply of peseta bills in Hamburg is then large, whereas the demand for them becomes small. But demand and supply determine the market price of the peseta, so the peseta, instead of standing at 80 pfennigs will cost 75 or 70 pfennigs or even less. The parasol exporters do not realise in German currency as much as formerly for their bill of exchange on Seville, so that what they gained by the high prices obtained for their parasols in Seville, the expected additional profit, they lose again by the falling rate of exchange when selling their bill of exchange in Hamburg. The lemon importers on the contrary, will recover in the lower price of the peseta bill of exchange in Hamburg the excess paid for the lemons in Malaga.

This play of forces continues until the high prices of Spanish goods caused by the inflation of the Spanish currency, have been compensated by the fall in the rate of exchange of the peseta, when the stimulus to increased imports and decreased exports disappears. The equilibrium between import and export is thus automatically restored, which means that a special fund for the payment of balances between two countries with paper currencies is superfluous, because such balances cannot occur.

Figure 6A. German-Spanish Balance of Trade, Surplus of German Export

Figure 6A. German-Spanish Balance of Trade Surplus of German Export

The supply of peseta bills increases, and the demand for peseta bills decreases, so the German rate of exchange falls (in the figure to 72 marks for 100 pesetas).

The German exporter then loses, and the Spanish exporter gains, on the rate of exchange.

We need hardly add that if prices rise in Germany and remain stable in Spain, things will be reversed: the export of parasols becomes unprofitable, while import into Germany from the countries with which Germany normally competes in the world market becomes increasingly profitable. Fewer foreign bills of exchange are then offered for sale in Germany, whereas there is a brisk demand for them; this means higher prices (in German paper-money) for foreign bills, and the rising price (rate of exchange) of these bills automatically restores the equilibrium between imports and exports.

Figure 6B. German-Spanish Balance of Trade, Deficit of German Export

Figure 6B. German-Spanish Balance of Trade Deficit of German Export

The supply of peseta bills decreases, and the demand for peseta bills increases, so the German rate of exchange rises, (in the figure to 89 marks for 100 pesetas).

The German exporter then gains, and the Spanish exporter loses, on the rate of exchange.

Both figures (6A and 6B) show how a surplus balance of trade depresses the rate for foreign bills of exchange and restricts export Fluctuations in the rate of exchange tend, therefore, to counteract their causes.

Fluctuations in the rate of exchange at one moment favour and at the next injure exporters or importers and so add greatly to the risk of commerce. Between two countries with different paper currencies there is evidently no limit to such fluctuations in the rate of exchange, for they depend simply on the internal currency policies of the two countries. But does not the fact that it is possible through currency policy to cause arbitrary and unlimited fluctuations of the rates of exchange prove that it is also possible through suitable currency policy to stabilise, to fix arbitrarily, the rates of exchange ? If the equilibrium of exports and imports can be disturbed by currency policy, it must be possible, by currency policy to forestall the fluctuations of imports and exports, even those due to natural causes, such as failure or unusual abundance of the harvest. All that is necessary is the adoption of a uniform currency policy by the countries concerned. If we in Germany and the Spaniards in Spain by suitable regulation of the currency maintain a stable level of prices, the ratio of exports and imports will also remain stable. The ratio of demand and supply of bills of exchange and, finally, the rate of exchange will then also be stabilised. For a solution of this problem we only need an agreement between the two countries and action based thereon.

What we here demand of the currency administration was realised, to a certain extent automatically, by the international gold standard. When the currency (gold and banknotes) in any country became over-abundant and prices consequently rose above their natural level in the world market, what happened was exactly what now happens in a country with a paper standard when the circulation is increased. The bills drawn on the country with rising prices had a falling rate of exchange. If, for example, the country was Spain, the rate of exchange of the peseta in Hamburg fell from 80 to 79 or 78 pfennigs and continued to fall until the seller of such gold peseta bills (in our example the exporter of parasols) wrote to his correspondent in Seville: "I find it difficult to sell the bills drawn on you for the parasols supplied. I am offered only 78 pfennigs instead of 80 for a peseta. I therefore cancel the bill and request you to remit the amount of my invoice in gold coins of your country". Our parasol exporter has now of course to pay the expense of this shipment of gold, so he will not have recourse to this expedient unless the loss on the rate of exchange exceeds the expense of shipping the gold. The Spanish gold coins are delivered to the Reichsbank, which converts them for the parasol exporter free of charge, into German currency, or else exchanges them for banknotes at the fixed rate of 2790 marks for a kilogram of fine gold.

Now what happens here and in Spain in consequence of this business custom ? In Spain the currency is diminished by the amount of the gold shipment from Seville. If the gold is withdrawn from the Spanish central Bank of Issue, this bank is obliged to withdraw from circulation three times the amount in banknotes, in accordance with the law that the notes issued must be covered up to one-third of their value by gold. In Germany, on the contrary, the circulation of money is increased by three times the amount of the shipment of gold from Spain. The effect is that prices in Spain fall, and prices in Germany increase, and this increase continues until equilibrium is restored.

Had the general rise of prices which caused the fluctuation in the rate of exchange occurred in Germany instead of in Spain, the lemon importer in Hamburg would have acted like the parasol exporter. He would have written to his Malaga correspondent that on account of the high rate of the peseta in Hamburg he was sending German gold coins, instead of making the customary remittance by bill of exchange in payment for the lemons he had received.

As gold shipments of this kind were frequent, it was generally believed that reserves of gold were necessary for this purpose, but that was a misconception. For equilibrium would have been restored automatically without these gold shipments, through the obstacles or facilities to import or export resulting from fluctuations in the rate of exchange. The effect of the shipments of gold, and of the gold reserves which rendered them possible, was not due to the shipping of the gold itself, but to the influence of the gold shipments on commodity prices. It was the change of prices and not the gold shipments that restored equilibrium. If the currency administration in countries with rising rates of foreign exchange (for example in Germany when peseta bills fetched a high price in marks) had reduced the circulation of currency by withdrawing banknotes from circulation, the consequent fall of prices would immediately have restored equilibrium of exports and imports, and the rate of exchange would have returned to par. A very simple action, namely an increase of the rate of discount for bills of exchange by the Bank of Issue, would have rendered gold shipments and the gold-reserves destined for them superfluous.

A conscious action must be substituted for a dead mass of gold, since the monetary standard cannot be conceived as a substance, but only as an action, as an administrative measure.[1]

With the gold standard fluctuations in the rate of exchange could never exceed the cost of shipping gold. At a low level of civilisation, in which no intelligent State control is possible, such automatic compensation of currencies has certain advantages. But at the present day, the retention of the gold standard for this reason is an insult to the national administrations.

For a machine automatic regulation may be preferable to the human hand, but the currency cannot be compared with a machine. The regulation of the currency under the gold standard is moreover, automatic only in a restricted sense. The shipments of gold are not automatic, for the gold has to be counted, packed, shipped, insured, recoined. The withdrawal of an equal sum of money from circulation as an administrative measure of the Bank of Issue would have the same effect, with less effort and no expense whatever.

We must further keep in mind that with the gold standard fluctuations in the rate of exchange between distant countries, allowing for interest, may amount to 4 % or more.[2]

The automatic mechanism of the gold standard does not prevent fluctuations; it begins to act only when the fluctuations have reached the maximum, at the so-called gold point (the cost of gold shipments mentioned above), or in other words, with the setting in of the import and export of gold. When the fluctuations in the rate of exchange have done all the damage they can, and not till then, does the remedy begin to operate. With a paper standard, on the other hand. if the statistical service of the currency administration is reasonably efficient, the remedial measures make themselves felt simultaneously with the first signs of a disturbance of the equilibrium, and the fluctuations of the exchanges are confined to these signs. With the gold standard it might indeed also be possible to prevent and forestall fluctuations, and the central Banks do assert that they are not mere automata. But if the gold standard has to be assisted by a conscious act, what remains of the automatic functioning claimed by its advocates?

What has here been said applies to ordinary paper-money. With Free-Money, owing to its compulsory circulation, the measures of the monetary administration are immediately effective, and the claim that no reserves of any kind are necessary to maintain stable rates of exchange becomes doubly true.


  1. See also: Frankurth und Gesell: Aktive Währungspolitik.
  2. The expense of a shipment of gold from Europe to Australia is fully 2 %. It is composed of the interest lost during the voyage, freight, insurance, packing and brokerage. The rate of exchange between Europe and Australia may therefore fluctuate above or below par by 2 %, so in this case the margin may exceed 4 %. That is what was called a standard!