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• Preface
• Studies In the Theory of International Trade
• Chapter I: English Theories of Foreign Trade, Before Adam Smith: I
• I. Introduction
• II. “ Mercantilism” and “bullionism”
• III. the Balance-of-trade Doctrine
• IV. Reasons For Wanting More Bullion
• V. Employment and the Balance of Trade
• Chapter II: English Theories of Foreign Trade, Before Adam Smith: Ii
• I. Legislative Proposals of Mercantilists
• II. the Collapse of Mercantilist Doctrine
• III. Some Modern Interpretations of English Mercantilism
• Chapter III: The Bullionist Controversies: I. The Inflation Phase
• I. the Participants In the Controversy
• II. the Factual Background
• III. Premium On Bullion As Evidence of Excess Issue: the Bullionist Position
• IV. Qualifications Conceded By the Bullionists
• V. Possible Objections to the Bullionist Position
• VI. the Anti-bullionist Position
• VII. the Balance of Payments Argument
• VIII. the Possibility of Excess Issue By Banks
• IX. Responsibility For the Excess Issue: Bank of England Vs. Country Banks
• X. Responsibility For Excess Issue: the Credit Policy of the Bank of England
• Chapter IV: The Bullionist Controversies: II. The Deflation Phase
• I. the Resumption of Cash Payments
• II. Responsibility of Resumption For the Fall In Prices
• III. the Economic Effect of Changing Price Levels
• IV. Ricardo's Position On the Gold Standard
• V. Reform Without Departure From the Metallic Standard
• VI. Paper Standard Currencies
• Chapter V: English Currency Controversies, 1825–1865
• I. Introduction
• II. the “currency School” -“banking School” Controversy
• III. the “palmer Rule ”
• IV. the Bank Act of 1844
• V. the Possibility of Overissue of Convertible Bank Notes
• VI. the Role of Deposits, Bills of Exchange, and “credit” In the Currency System
• VII. the Technique of Credit Control
• VIII. the Relation Between Bank of England Operations and Specie Movements
• IX. Currency Reform Proposals
• Chapter VI: The International Mechanism Under a Simple Specie Currency
• I. Introductory
• II. the Mechanism According to Hume
• III. an Omitted Factor? Relative Changes In Demand As an Equilibrating Force
• IV. Prices In the Mechanism: the Concept of “price Levels ”
• V. the “terms-of-trade” Concept
• VI. the Prices of “domestic” Commodities
• VII. the Mechanism of Transfer of Unilateral Payments In Some Recent Literature
• VIII. a Graphical Examination of Pigou's Analysis 1
• IX. Some Elaborations On the Basis of Pigou's Analysis
• X. an Alternative Solution
• XI. Types of Disturbance In International Equilibrium
• XII. Specie Movements and Velocity of Money
• XIII. Commodity Flows and Relative Price Levels
• XIV. Exchange Rates
• XV. A Criticism of the Purchasing-power Parity Theory 1
• Chapter VII: The International Mechanism In Relation to Modern Banking Processes
• I. Automatic Vs. Managed Currencies
• II. Primary and Secondary Expansion of Means of Payments
• III. Short-term Loans In the International Mechanism
• IV. Primary and Secondary Expansion In Canada , 1900–13
• V. the International Mechanism and Business Cycles
• Chapter VIII: Gains From Trade: the Doctrine of Comparative Costs
• I. the Nature and Origin of the Doctrine
• II. the Division of the Gain From Trade
• III. Trade In More Than Two Commodities
• IV. Trade Between More Than Two Countries
• V. Transportation Costs
• VI. Increasing and Decreasing Costs
• VII. Prices, Money Costs, and Real Costs
• VIII. Dependence of Comparative Cost Doctrine On a Real-cost Theory of Value
• IX. Differences In Wage Rates In Different Occupations
• X. Variable Proportions of the Factors and International Specialization
• XI. Variable Proportions of the Factor and Comparative Real Costs
• XII. “ Opportunity Cost” Analysis As a Substitute For Real Cost Analysis
• Chapter IX: Gains From Trade: the Maximization of Real Income
• I. “ Mass of Commodities” and “sum of Enjoyments”: Ricardo and Malthus
• II. Reciprocal Demand and the Terms of Trade
• III. Terms of Trade and the Amount of Gain From Trade
• IV. “ Net Benefit” In International Trade: Marshall
• V. Total Net Utility Derived From International Trade: Edgeworth
• VI. the Gain From Trade Measured In Money
• Appendix: a Note On the Scope and Method of the Theory of International Trade

III. Short-Term Loans in the International Mechanism

International short-term lending takes many forms; interbank credits, transfers of deposits, purchase of foreign bills of exchange, purchase of foreign treasury bills, commercial credits, purchase of long-term securities in a foreign market with the expectation of their early resale abroad, etc. Whatever form it takes, the international movement of short-term funds derives its importance for the mechanism of adjustment of international balances from the fact that these funds are highly mobile and in the absence of financial or political disturbance respond quickly, especially as between well-developed money markets, to even moderate relative fluctuations in interest rates. Since outward drains of gold ordinarily tend to result in rising rates of interest or at least to occur under circumstances which cause a rising rate of interest to be associated with them, and since inflows of gold are ordinarily similarly associated with falling rates of interest, the short-term funds and the specie are likely to move in opposite directions. Such movements of short-term funds in a reverse direction from the actual or incipient movement of specie are helpful to the international mechanism of adjustment in two main ways.

To take first the less important type of case, the balance of immediate obligations of any country is likely to be undergoing constant fluctuation and to be repeatedly shifting from a debit to a credit status. The most marked instances of such fluctuations in the balance of immediate obligations are to be found in countries whose export and import trade have marked and divergent seasonal patterns. If such countries did not resort to international short-term credit operations, specie would repeatedly have to be exported in substantial quantities to liquidate a debit balance, only to return soon thereafter upon the development of a credit balance. If such countries have well-developed money markets, such credit operations will take place through the initiative of individual banks or traders, in response to the seasonal relative shifts in interest rates at home and abroad. These operations will be further stimulated, moreover, by seasonal fluctuations in exchange rates resulting from the seasonal fluctuations in the trade balance. This goes counter to the doctrine sometimes expounded that the cost of shipping gold, or the deviation of the exchanges from the mint par, acts as a deterrent to the movement of short-term funds in response to small differentials in interest rates.1 This doctrine overlooks the fact that the movements of short-term funds and of gold are frequently, and perhaps in the majority of cases, in opposite directions rather than in the same direction, and that when the former is the case the turn of the exchanges which is to be anticipated is a stimulus rather than a deterrent to short-term movements of funds. An individual in a country whose currency is above par in the exchange market who lends in terms of the foreign currency to a country whose currency is below par stands to profit not only from whatever interest differential he can obtain but also from the gain on the turn of the exchanges which may be expected to occur, and for which he can wait before recalling his funds.2 When the movement of short-term funds is in the opposite direction from the actual or incipient movement of gold, it operates to reduce the extent of the gold movement to a corresponding degree.

Secondly, a major disturbance of international equilibrium requiring for its complete adjustment a more or less enduring contraction of means of payment and deflation of prices in some country may come so suddenly, or may have been so long neglected by the banking authorities of that country, that if short-term loans could not be made abroad a large amount of gold would have to be exported at once and bank credit contracted suddenly and sharply, with the danger that a major crisis would result. By resort to borrowing on short-term abroad, the necessary drain of gold can be spread over a longer period and even reduced in its total amount, and bank credit can be more gently and gradually contracted, thus avoiding or moderating the internal crisis.

This cushioning effect of short-term loans is especially important for long-term capital-exporting countries, where the flotation of foreign issues is likely to be irregularly spaced. Suppose, for instance, that country A floats the first of a series of great long-term loans in country B, whose balance of payments had previously been in approximate equilibrium. Even if the flotation of the loan were followed immediately by a substantial transfer of specie from B to A, and by supporting secondary expansion of means of payment in A and secondary contraction of means of payment in B, it would still ordinarily take some time before the demands for and the prices of commodities in the two countries would shift sufficiently to effect a transfer of the remainder of the loan in the form of commodities. In the meantime there would have been a heavy and unnecessarily large specie movement, an excessive credit expansion in the borrowing country, and an even more disturbing credit deflation in the lending country. But if the short-term money markets of the two countries are flexible and responsive to differentials in money rates, there will be a rise in short-term interest rates in B and a fall in A which will induce A to lend B on short term some of the funds it has borrowed from B on long term. The adverse balance of immediate obligations of B to A will thus be lessened; the flow of specie from B to A will be reduced; and the long-term loan will obtain transfer in the form of commodities more smoothly and with less disturbance to the economies of the two countries, even if more slowly.

The role of short-term capital movements as an equilibrating factor is limited, however, by the imperfect international mobility of such funds. While, in the absence of “fear movements,” the international movement of short-term funds tends to bring about equality of short-term interest rates in different money markets, the amount of short-term funds which will move across national frontiers in response to moderate differentials in interest rates is for many frontiers always, and for all frontiers frequently, insufficient in quantity to bring about actual equality of interest rates or to reduce to-and-fro movements of gold to a minimum.3

When a central bank, in order to check an expansion of bank credit, raises its discount rate or engages in selling operations in the open market, the resultant rise in the market rate of interest tends to attract foreign funds. It has become the custom to say that an inflow of short-term funds under these circumstances may offset or even more than offset the efforts of the central bank to bring about contraction in the amount of means of payment,4 but this overlooks the fact that the foreign funds will flow in only as the market rate becomes higher than it was previously. The inflow of short-term funds under these circumstances will provide the member banks with increased reserve assets and thus lessen their dependence on the central bank, and will operate to reduce the degree of response of the market rate to the central bank rate. But the market rate must rise somewhat if foreign funds are to be attracted, and at this higher rate the amounts borrowers are willing to borrow will presumably fall, while the higher cost of their borrowed reserves will check the willingness of the banks to lend.

It is true, however, that variations in the market rate of interest in response to variations in the specie reserve position of the banking system, whether these variations in the market rate of interest occur automatically or as the result of central bank manipulations of its discount rate, do tend to convert the fluctuations in the exchange rates from such as would exercise a direct equilibrating influence on the trade balance to such as would exercise a direct disequilibrating influence on the trade balance. Suppose that a relative shift in demand for commodities results in an adverse trade balance and an adverse balance of payments for England. Let us first assume that no change occurs in the English market rate of interest. Sterling will fall in the foreign exchange markets, with a consequent stimulus to English exports and check to English imports. Let us next assume that the external drain of specie results in a relative rise in the English market rate of interest, and that this attracts a flow of short-term funds to England, which stops the external drain of specie and causes sterling to rise in the exchange markets, possibly to higher than the mint parities. The direct equilibrating influence of the exchange rate fluctuations on the English trade balance is lost, and may even give place to a direct disequilibrating influence. So limited, however, is the possible range of exchange rate fluctuations under an international metallic standard that their direct influence on trade balances must be of negligible proportions, and it cannot be regarded as an important drawback to the use of variations in the discount rate to maintain or restore equilibrium in international balances that it prevents exchange rate fluctuations from exercising a direct equilibrating influence.

While short-term lending has a useful role to play in the international mechanism, it is capable, nevertheless, and more so than any other element in the mechanism, of operating perversely. International short-term lending still awaits its historian, but there have been notorious cases, and especially in recent years, where the erratic and unpredictable movement of short-term funds has influenced the international mechanism during a period of stress very much in the manner in which loose cargo operates on a ship during a storm. The high degree of international mobility of short-term funds becomes a liability instead of an asset when there is alarm in the air, for short-term funds are quick to fly to foreign countries in search of safety when there is alarm at home, and are even quicker to be called back home when there are signs of trouble abroad.

Disturbances to international equilibrium resulting from the excessive mobility—or timidity—of short-term funds appear to be an ancient phenomenon. During the Napoleonic Wars, for instance, there were substantial fluctuations in the foreign holdings of British securities which were at the time believed by some to have been due more largely to the rise and fall of confidence in the military fortunes of England or in the future of the paper pound than to relative fluctuations in the interest rate,5 and which may therefore have operated rather to accentuate than to moderate the fluctuations in the gold value of the inconvertible paper pound.6 Later in the century, the growth in the international movement of funds attracted considerable attention, but most observers regarded this development as a wholly desirable one.7 Some writers held that the development of international movement of short-term funds had rendered specie movements, changes in price levels, and even adjustments of trade balances unnecessary except in major disturbances.8 An occasional note of warning was struck, however. Milner, for instance, although he regarded the development as on the whole a desirable one, saw that international capital movements could act as a disturbing as well as an equilibrating factor, and therefore recommended state control of the export of capital either directly or through regulation of the English discount rate with reference to prevailing rates abroad, both with a view to conserving ample capital resources for English industry and to guard against undue pressure on the English balance of payments.9 It was pointed out also that if there was distrust of the financial situation funds might flow from the high-rate to the low-rate money market, and that attempts by the former to check the drain by raising the discount rate still further might serve only to increase the distrust and to accentuate the drain.10 But scarcely a voice was raised during the nineteenth century in England to warn the banking authorities that short-term indebtedness to foreigners should be treated as special claims against specie reserves, and that extra precautions should be taken to provide the means to meet such claims.11 The fact that in English pre-war banking practice neither the Bank of England nor the clearinghouse banks sold their own bills to banks abroad and that the English holdings of short-term claims on the rest of the world were certainly in ordinary times and probably at all times substantially in excess of the foreign holdings of short-term claims on England was at least a partial justification of this complacency. But there were always, nevertheless, substantial holdings of sterling bills abroad, and substantial deposits of foreign funds with London “foreign” banks, and when for any reason foreigners asked for their funds the clearinghouse banks and the Bank of England were indirectly called upon to meet these demands. The development in the post-war period of the practice by central and other banks of deliberately holding part of their reserves on deposit or otherwise invested in foreign money markets added to the danger, first, because it increased the amount of short-term foreign funds held in the money markets most used for this purpose, namely, London and New York, and, second, because bank funds, and especially funds regarded by the creditor banks as constituting part of their reserves, were more likely than the funds of private investors to be withdrawn simultaneously and suddenly upon the appearance of some signs of lack of safety in the investment or of impending need of extra financial resources at home. There was little outward sign of recognition by banking authorities in the countries having particularly large external short-term indebtedness that such liabilities required special treatment.12 Bank authorities of these countries do not appear even to have made much effort to keep informed as to the amount and trend of such indebtedness, until, as the depression beginning in 1929 continued and became more intense, there occurred extraordinarily great flights of short-term funds from country to country, in which the central banks13 participated at least as actively as did other banks and private individuals.14

Where the agencies concerned are private individuals or business firms, there is no easy solution for the problem of excess mobility of short-term funds, since direct regulation of such movement would be troublesome, costly, and, unless reinforced by censorship of communications, easily evaded. But the chief offenders have been banks, including central banks operating under the so-called gold-exchange standard, and here certain fairly practicable remedies seem to be indicated. The only legitimate functions of the gold-exchange standard are to facilitate international payments and to eliminate the expense of to-and-fro gold movements occurring within short intervals of time. But the claim often made for it, that it enables poor countries to adhere to the gold standard without bearing the burden of maintaining non-income-earning gold reserves, makes a virtue out of the gold-exchange standard's defect. Either the expense of carrying such reserves is transferred to the country in which the reserve funds are invested, or else that country assumes dangerous liabilities against its own reserves without adopting protective measures. Properly administered, the gold-exchange standard would approximate in its mode of operation to reciprocal earmarking of gold. Central banks would still count their holdings of claims on foreign banks as part of their reserves. But they would treat their own liabilities and the liabilities of member banks to foreign banks as demand claims against their own reserves, and would enforce very high specie reserve ratios against such liabilities. No central bank would invest funds at interest in another country except in or through the mediation of the central bank of that country, at the request of such central bank, and to aid it during a crisis rather than to earn interest on reserve assets. Such a reform would not be costless, and would not completely remedy the situation, but it would reduce to much smaller proportions one of the major defects of the international gold standard as it has operated in modern times.

The Gold Delegation of the League of Nations has defended the use of the gold-exchange standard as a means of economizing for poor countries the cost of maintaining gold reserves, and has proposed, as a remedy for the problem of the excess mobility of short-term funds, that “it is necessary for lending countries to assure that foreign lending does not exceed or fall short of their net active balance on income account.” 15 Taken literally, this would mean that any country having a favorable balance of immediate obligations on commodity and service account should feel obligated to lend sufficiently abroad to prevent any inflow of gold, and presumably also that any country having an unfavorable balance on commodity and service account should feel warranted in borrowing sufficiently abroad to prevent any outflow of gold. Gold flows, under such a regime, would either not occur at all, or would occur only in connection with the liquidation of old debts. This is surprising doctrine to be found in a document intended to be a plea for the maintenance and rehabilitation of the international gold standard. Under such a regime, balances, favorable or unfavorable, on income account would never be liquidated.16

[1]Cf., e.g., G. J. Goschen, The theory of the foreign exchanges, 1861, pp. 129–30, and R. G. Hawtrey, The art of central banking, 1932, p. 142.

[2]If the gain which can be anticipated on the turn of the exchanges exceeds the loss on the interest differential, it will pay even to transfer funds from the high to the low interest rate market. The amount of differential in interest rates necessary to move short-term funds in the same direction as the gold movements will be greater than the amount of differential in interest rates necessary to move them in the opposite direction from the gold movements.

[3]Axel Nielsen warns against exaggerating the international mobility of short-term capital: it is only a fraction of the short-term funds that is truly “cosmopolitan,” —Bankpolitik, II (1930), 279 ff., as cited by Carl Iverson, Aspects of the theory of international capital movements, 1935, p. 239.

[4]Cf., e.g.: A. F. W. Plumptre, “Central banking machinery and monetary policy,” The Canadian economy and its problems, 1934, p. 197; A. D. Gayer, Monetary policy and economic stabilization, 1935, pp. 10–11; W. Edwards Beach, British international gold movements and banking policy, 1881–1913, 1935, pp. 17–18.

[5]Cf., however, Henry Thornton, with reference to what would happen under a metallic standard and with no legal restrictions in interest rates if England's exports were curtailed by embargoes or other wartime disturbances: Doubtless much of our gold coin would be taken from us; and, perhaps, a larger quantity of this than of other articles. The whole, however, would not leave us; a high rate of interest would arise, and this extra profit on the use of gold, which would increase as its quantity diminished, would contribute to detain it here—some foreigners, probably, transferring property which would take the shape of the precious metals, or continuing to afford to us the use of it for the sake of this high interest. (Substance of two speeches ... on the bullion report, 1811, p. 10.)

[6]Cf. (Commons) Report ... on the expediency of the Bank resuming cash payments, 1819, appendix no. 43, p. 354; Sir John Sinclair, The history of the public revenue of the British Empire, 3d ed.III [1804], appendix no. 5, pp. 160–63; John Hill, An inquiry into the causes of the present high price of gold bullion in England, 1810, p. 36; G. R. Porter, The progress of the nation, new ed., 1851, pp. 628–29.

[7]Cf. David Salomons, A defence of the joint-stock banks, 2d ed., 1837, p. 12: ... I ... assert that their transmission [i.e., of British funds for investment abroad] has on the whole been favorable to commerce, that they have tended to regulate the exchanges, instead of having had an injurious effect on them; and many most important payments could not have been made, without the powerful assistance derived from the export of foreign stock, as the most ready means of payment. It will be, indeed, difficult to show how such descriptions of foreign funds, for which a ready market exists on the Continent as well as in London, could at all injuriously affect the exchanges. Such funds are, in truth, a universal currency, and payments either at home or abroad can be made by their transmission, and the balance of trade as readily adjusted, as by an import or export of the previous metals.

[8]Cf. Fullarton, On the regulation of currencies, 2d ed., 1845, p. 149:

Since the practice, however, of investing capital in foreign securities has become general in this country, a new element has been introduced into the economy of our exchanges. The capital required for the liquidation of a foreign debt may be transmitted as well in the form of a marketable security for money, as in gold or merchandise. And, as the price of such securities rises and falls with the fall and rise of the market rate of interest, and the securities themselves accordingly are in a continual course of transition from places where the rate of interest is high to places where it is low, the fluctuations of interest have become an engine of some importance in the regulation of the exchanges, and to the extent of their action, are found certainly a more manageable and safe instrument for facilitating foreign payments and correcting irrgularities in the distribution of the precious metals, than the fluctuations of price. Cf. also, Supra, pp. 278 ff.

[9]T. H. Milner, Some remarks on the Bank of England, 1849, pp. 17 ff., 42. He claims that “the regulation of foreign investment is ... the effectual key to the regulation of the monetary affairs of the country.” (Ibid., p. 18.)

[10]Cf. “History and exposition of the currency question,” Westminster and foreign quarterly review,XLVIII (1848), 468, note: “the depression of English securities may as often induce the foreign capitalist to withdraw his gold from England, by alarming him for its safety, as to send it here for profitable investment.”

[11]Cf. supra, p. 271, for one such warning in 1857.

[12]Cf., however, Thirteenth annual report of the Federal Reserve Board, 1927, p. 16: Dollar balances in New York have been built up not only by foreign industrial corporations and commercial banks but also by European and South American central banks, which in many instances are authorized by law to keep a portion of their reserves in the form of foreign exchange in countries with stable currencies. These dollar balances of foreign central banks, whether they are invested or kept on deposit, are in liquid form and subject to immediate withdrawal at any time. If they were to be withdrawn in gold in whole or in part the demand for the gold, though it would first be felt by the commercial banks, both member and nonmember, would promptly reach the federal reserve banks as the only holders of gold in any considerable amount. These balances are, therefore, potential sources of demand upon the federal reserve banks for gold out of their reserves, the central banking reserves of the United States, which have thus become indirectly a part of the reserves against bank credit and currencies in other countries. The existence in America of these foreign balances consequently presents a condition in the banking situation to be taken into account in determining the federal reserve system's credit policy with a view to maintaining the country's banking system in a position to meet demands for gold from abroad without disturbing business and credit conditions in this country.

[13]In their hasty abandonment of the gold-exchange standard, the European banks of issue, according to a computation of the Banque de France, reduced their holdings of foreign short-term funds from 48,464,405,000 francs French on January 1, 1931, to 3,921,500,000 francs French on November 30, 1933, or by more than 95 per cent. The ratio of such funds to the total reserves of these banks fell during the same period from about 35 per cent to about 2½ per cent. (Cf. Federal Reserve bulletin, March, 1934, p. 164.)

[14]From March 31, 1931, to the middle of July, 1931, withdrawals of foreign short-term funds from Germany amounted to over 1,000,000,000 marks, or over 20 per cent of the total short-term foreign indebtedness of Germany at the earlier date—“The Wiggin report,” Annex V, Economist, CXIII (Aug. 22, 1931), supplement, p. 6. From June 30, 1931, to November 30, 1931, the American dollar acceptances in Europe—mostly in Germany—were reduced from about $500,000,000 to about $300,000,000 (New York Times, Jan. 4, 1932, p. 32). These withdrawals would of course have been even greater and more rapid if the debtors had met all the demands made upon them by their creditors. During this period, money rates were substantially higher in Germany than in the creditor countries, i.e., funds were moving from a high-rate money market to low-rate money markets.

[15]League of Nations, Report of the Gold Delegation of the Financial Committee, 1932, p. 52.

[16]The validity of this interpretation depends on how the Gold Delegation would deal with a situation such as the following: country A has a favorable balance of trade with country B, and in accordance with the rule laid down lends to B the funds with which to meet that balance. Next week, B repays this debt. Is the payment on capital account, and therefore such as to justify gold shipments, or is it on income account, and therefore to be countered by country A by a new loan to country B or to some third country? If the former answer is correct, then the proposal of the Gold Delegation amounts merely to the recommendation that specie movements should never occur immediately whenever there is not an even balance of payments on income account, but should always be delayed until they can take the form of liquidation of capital liabilities. If the latter answer is correct, as seems to me to be the case, then no gold movements would ever occur except in connection with the amortization of borrowings not made to liquidate preexisting indebtedness on incomeaccount, while borrowings could be made only for the purpose of such liquidation.