The Principles of Political Economy
by John Stuart Mill

Book 3: Distribution

Chapter 20

Of the Foreign Exchanges

    1. We have thus far considered the precious metals as a
commodity, imported like other commodities in the common course
of trade, and have examined what are the circumstances which
would in that case determine their value. But those metals are
also imported in another character, that which belongs to them as
a medium of exchange; not as an article of commerce, to he sold
for money, but as themselves money, to pay a debt, or effect a
transfer of property. It remains to consider whether the
liability of gold and silver to be transported from country to
country for such purposes, in any way modifies the conclusions we
have already arrived at, or places those metals under a different
law of value from that to which, in common with all other
imported commodities, they would be subject if international
trade were an affair of direct barter. 
    Money is sent from one country to another for various
purposes: such as the payment of tributes or subsidies;
remittances of revenue to or from dependencies, or of rents or
other incomes to their absent owners; emigration of capital, or
transmission of it for foreign investment. The most usual
purpose, however, is that of payment for goods. To show in what
circumstances money actually passes from country to country for
this or any of the other purposes mentioned, it is necessary
briefly to state the nature of the mechanism by which
international trade is carried on, when it takes place not by
barter but through the medium of money. 

    2. In practice, the exports and imports of a country not only
are not exchanged directly against each other, but often do not
even pass through the same hands. Each is separately bought and
paid for with money. We have seen, however, that, even in the
same country, money does not actually pass from hand to hand each
time that purchases are made with it, and still less does this
happen between different countries. The habitual mode of paying
and receiving payment for commodities, between country and
country, is by bills of exchange. 
    A merchant in England, A, has exported English commodities,
consigning them to his correspondent B in France. Another
merchant in France, C, has exported French commodities, suppose
of equivalent value, to a merchant D in England. It is evidently
unnecessary that B in France should send money to A in England,
and that D in England should send an equal sum of money to C in
France. The one debt may be applied to the payment of the other,
and the double cost and risk of carriage be thus saved. A draws a
bill on B for the amount which B owes to him: D, having an equal
amount to pay in France, buys this bill from A, and sends it to
C, who, at the expiration of the number of days which the bill
has to run, presents it to B for payment. Thus the debt due from
France to England, and the debt due from England to France, are
both paid without sending an ounce of gold or silver from one
country to the other. 
    In this statement, however, it is supposed, that the sum of
the debts due from France to England, and the sum of those due
from England to France, are equal; that each country has exactly
the same number of ounces of gold or silver to pay and to
receive. This implies (if we exclude for the present any other
international payments than those occurring in the course of
commerce), that the exports and imports exactly pay for one
another, or in other words, that the equation of international
demand is established. When such is the fact, the international
transactions are liquidated without the passage of any money from
one country to the other. But if there is a greater sum due from
England to France, than is due from France to England, or vice
versa, the debts cannot be simply written off against one
another. After the one has been applied, as far as it will go,
towards covering the other, the balance must be transmitted in
the precious metals. In point of fact, the merchant who has the
amount to pay, will even then pay for it by a bill. When a person
has a remittance to make to a foreign country, he does not
himself search for some one who has money to receive from that
country, and ask him for a bill of exchange. In this as in other
branches of business, there is a class of middlemen or brokers,
who bring buyers and sellers together, or stand between them,
buying bills from those who have money to receive, and selling
bills to those who have money to pay. When a customer comes to a
broker for a bill on Paris or Amsterdam, the broker sells to him,
perhaps the bill he may himself have bought that morning from a
merchant, perhaps a bill on his own correspondent in the foreign
city: and to enable his correspondent to pay, when due, all the
bills he has granted, he remits to him all those which he haS
bought and has not resold. In this manner these brokers take upon
themselves the whole settlement of the pecuniary transactions
between distant places, being remunerated by a small commission
or percentage on the amount of each bill which they either sell
or buy. Now, if the brokers find that they are asked for bills on
the one part, to a greater amount than bills are offered to them
on the other, they do not on this account refuse to give them;
but since, in that case, they have no means of enabling the
correspondents on whom their bills are drawn, to pay them when
due, except by transmitting part of the amount in gold or silver,
they require from those to whom they sell bills an additional
price, sufficient to cover the freight and insurance of the gold
and silver, with a profit sufficient to compensate them for their
trouble and for the temporary occupation of a portion of their
capital. This premium (as it is called) the buyers are willing to
pay, because they must otherwise go to the expense of remitting
the precious metals themselves, and it is done cheaper by those
who make doing it a part of their especial business. But though
only some of those who have a debt to pay would have actually to
remit money, all will be obliged, by each other's competition, to
pay the premium; and the brokers are for the same reason obliged
to pay it to those whose bills they buy. The reverse of all this
happens, if on the comparison of exports and imports, the
country, instead of having a balance to pay, has a balance to
receive. The brokers find more bills offered to them, than are
sufficient to cover those which they are required to grant. Bills
on foreign countries consequently fall to a discount; and the
competition among the brokers, which is exceedingly active,
prevents them from retaining this discount as a profit for
themselves, and obliges them to give the benefit of it to those
who buy the bills for purposes of remittance. 
    Let us suppose that all countries had the same currency, as
in the progress of political improvement they one day will have:
and, as the most familiar to the reader, though not the best, let
us suppose this currency to be the English. When England had the
same number of pounds sterling to pay to France, which France had
to pay to her, one set of merchants in England would want bills,
and another set would have bills to dispose of, for the very same
number of pounds sterling; and consequently a bill on France for
100l. would sell for exactly 100l., or, in the phraseology of
merchants, the exchange would be at par. As France also, on this
supposition, would have an equal number of pounds sterling to pay
and to receive, bills on England would be at par in France,
whenever bills on France were at par in England. 
    If, however, England had a larger sum to pay to France than
to receive from her, there would be persons requiring bills on
France for a greater number of pounds sterling than there were
bills drawn by persons to whom money was due. A bill on France
for 100l. would then sell for more than 100l., and biLls would be
said to be at a premium. The premium, however, could not exceed
the cost and risk of making the remittance in gold, together with
a trifling profit; because if it did, the debtor wouLd send the
gold itself, in preference to buying the bill. 
    If, on the contrary, England had more money to receive from
France than to pay, there would be bills offered for a greater
number of pounds than were wanted for remittance, and the price
of bills would fall below par: a bill for 100l. might be bought
for somewhat less than 100l., and bills would be said to be at a
discount. 
    When England has more to pay than to receive, France has more
to receive than to pay, and vice versa. When, therefore, in
England, bills on France bear a premium, then, in France, bills
on England are at a discount: and when bills on France are at a
discount in England, bills on England are at a premium in France.
If they are at par in either country, they are so, as we have
already seen, in both. 
    Thus do matters stand between countries, or places, which
have the same currency. So much of barbarism, however, still
remains in the transactions of the most civilized nations, that
almost all independent countries choose to assert their
nationality by having, to their own inconvenience and that of
their neighbours, a peculiar currency of their own. To our
present purpose this makes no other difference, than that instead
of speaking of equal sums of money, we have to speak of
equivalent sums. By equivalent sums, when both currencies are
composed of the same metal, are meant sums which contain exactly
the same quantity of the metal, in weight and fineness; but when,
as in the case of France and England, the metals are different,
what is meant is that the quantity of gold in the one sum, and
the quantity of silver in the other, are of the same value in the
general market of the world: there being no material difference
between one place and another in the relative value of these
metals. Suppose 25 francs to be (as within a trifling fraction it
is) the equivalent of a pound sterling. The debts and credits of
the two countries would be equal, when the one owed as many times
25 francs, as the other owed pounds. When this was the case, a
bill on France for 2500 francs would be worth in England 100l.,
and a bill on England for 100l. would be worth in France 2500
francs. The exchange is then said to be at par: and 25 francs (in
reality 25 francs and a trifle more) (1*) is called the par of
exchange with France. When England owed to France more than the
equivalent of what France owed to her, a bill for 2500 francs
would be at a premium, that is, would be worth more than 100l.
When France owed to England more than the equivalent of what
England owed to France, a bill for 2500 francs would be worth
less than 100l., or would be at a discount. 
    When bills on foreign countries are at a premium, it is
customary to say that the exchanges are against the country, or
unfavourable to it. In order to understand these phrases, we must
take notice of what "the exchange," in the language of merchants,
really means. It means the power which the money of the country
has of purchasing the money of other countries. Supposing 25
francs to be the exact par of exchange, then when it requires
more than 100l. to buy a bill for 2500 francs, 100l. of English
money are worth less than their real equivalent of French money:
and this is called an exchange unfavourable to England. The only
persons in England, however, to whom it is really unfavourable,
are those who have money to pay in France; for they come into the
bill market as buyers, and have to pay a premium : but to those
who have money to receive in France, the same state of things is
favourable; for they come as sellers, and receive the premium.
The premium, however, indicates that a balance is due by England,
which might have to be eventually liquidated in the precious
metals: and since, according to the old theory, the benefit of a
trade consisted in bringing money into the country, this
prejudice introduced the practice of calling the exchange
favourable when it indicated a balance to receive, and
unfavourable when it indicated one to pay: and the phrases in
turn tended to maintain the prejudice. 

    3. It might be supposed at first sight that when the exchange
is unfavourable, or in other words, when bills are at a premium,
the premium must alWays amount to a full equivalent for the cost
of transmitting money: since, as there is really a balance to
pay, and as the full cost must therefore be incurred by some of
those who have remittances to make, their competition will compel
all to submit to an equivalent sacrifice. And such would
certainly be the case, if it were always necessary that whatever
is destined to be paid should be paid immediately. The
expectation of great and immediate foreign payments sometimes
produces a most startling effect on the exchanges.(2*) But a
small excess of imports above exports, or any other small amount
of debt to be paid to foreign countries, does not usually affect
the exchanges to the full extent of the cost and risk of
transporting bullion. The length of credit allowed, generally
permits, on the part of some of the debtors, a postponement of
payment, and in the mean time the balance may turn the other way,
and restore the equality of debts and credits without any actual
transmission of the metals. And this is the more likely to
happen, as there is a self-adjusting power in the variations of
the exchange itself. Bills are at a premium because a greater
money value has been imported than exported. But the premium is
itself an extra profit to those who export. Besides the price
they obtain for their goods, they draw for the amount and gain
the premium. It is, on the other hand, a diminution of profit to
those who import. Besides the price of the goods, they have to
pay a premium for remittance. So that what is called an
unfavourable exchange is an encouragement to export, and a
discouragement to import. And if the balance due is of small
amount, and is the consequence of some merely casual disturbance
in the ordinary course of trade, it is soon liquidated in
commodities, and the account adjusted by means of bills, without
the transmission of any bullion. Not so, however, when the excess
of imports above exports, which has made the exchange
unfavourable, arises from a permanent cause. In that case, what
disturbed the equilibrium must have been the state of prices, and
it can only be restored by acting on prices. It is impossible
that prices should be such as to invite to an excess of imports,
and yet that the exports should be kept permanently up to the
imports by the extra profit on exportation derived from the
premium on bills; for if the exports were kept up to the imports,
bills would not be at a premium, and the extra profit would not
exist. It is through the prices of commodities that the
correction must be administered. 
    Disturbances, therefore, of the equilibrium of imports and
exports, and consequent disturbances of the exchange, may be
considered as of two classes; the one casual or accidental,
which, if not on too large a scale, correct themselves through
the premium on bills, without any transmission of the precious
metals; the other arising from the general state of prices, which
cannot be corrected without the subtraction of actual money from
the circulation of one of the counties, or an annihilation of
credit equivalent to it; since the mere transmission of bullion
(as distinguished from money), not having any effect on prices,
is of no avail to abate the cause from which the disturbance
proceeded. 
    It remains to observe, that the exchanges do not depend on
the balance of debts and credits with each country separately,
but with all counties taken together. England may owe a balance
of payments to France; but it does not follow that the exchange
with France will be against England, and that bills on France
will be at a premium; because a balance may be due to England
from Holland or Hamburg, and she may pay her debts to France with
bills on those places; which is technically called arbitration of
exchange. There is some little additional expense, partly
commission and partly loss of interest, in settling debts in this
circuitous manner, and to the extent of that small difference the
exchange with one country may vary apart from that with others;
but in the main, the exchanges with all foreign countries vary
together, according as the country has a balance to receive or to
pay on the general result of its foreign transactions. 


NOTES:

1. Written before the change in the relative value of the two
metals produced by the gold discoveries. The par of exchange
between gold and silver currencies is now variable, and no one
can foresee at what point it will ultimately rest. 

2. On the news of Bonaparte's landing from Elba, the price of
bills advanced in one day as much as ten per cent. Of course this
premium was not a mere equivalent for cost of carriage, since the
freight of such an article as gold, even with the addition of war
insurance, could never have amounted to so much. This great price
was an equivalent not for the difficulty of sending gold, but for
the anticipated difficulty of procuring it to send; the
expectation being that there would be such immense remittances to
the Continent in subsidies and for the support of armies, as
would press hard on the stock of bullion in the country (which
was then entirely denuded of specie), and this, too, in a shorter
time than would allow of its being replenished. Accordingly the
price of bullion rose likewise, with the same suddenness. It is
hardly necessary to say that this took place during the Bank
restriction. In a convertible state of the currency, no such
thing could have occurred until the Bank stopped payment.