Foreign Exchange Market, 1909

Turn-of-the-Century Foreign Exchange

What is Foreign Exchange?

Foreign Exchange means the buying and selling of the money of other countries, and is handled in the same was as the buying and selling of most other things. If there is a strong demand for foreign money its price goes up, and that of the local money goes down, and if there is a great supply of foreign money coming to be sold, the movement is the other way. . . . [Foreign Exchange] is merely a question of the price of money in one place, as expressed in the same money in another, with fluctuations governed by supply and demand and limited by the cost of sending money from place to place. This limitation does not mean that supply and demand cease to govern the market, but merely that at a point supply can be increased to meet any demand by the [physical] dispatch of currency [or gold].¹

"Exchange" on any place may be defined as an order drawn on any individual or institution situated in such place and made payable in funds there current. . . . In foreign exchange, . . . the necessity arises to transform one kind of money for another. . . . Business results as a practical matter are, however, all measured in terms of money. Receipts and expenditures, profit and losses are all calculated in money terms. Most of the peculiarities of foreign exchange grow out of the fact that in foreign business transactions, buyer and seller, or borrower and lender, each regard a given transaction from the viewpoint of their own respective money systems. Thus the Englishman carries on his business operations in terms of pounds sterling. The American figures in dollars and cents. Hence, when they have dealings with each other it is not only necessary to transfer sums from one country to another but also to transform such sums from one kind of money to another. 
. . . 
huge sums are [often] transferred from one country to another in connection with lending and investment operations. 
. . . 
The whole business of foreign exchange constitutes a gigantic clearing machine. Clearing involves the attempt to offset reciprocal obligations with a settlement of differences in cash or an equivalent. . . . 
In foreign exchange international bankers and their agents or correspondents supply the necessary intermediaries. Suppose, for example, that A in New York owes B in London for a shipment of Sheffield cutlery. Suppose also that C in London owes D in New York for a shipment of tobacco. Assume that the amounts involved are the same and that the custom is to arrange the payments in pounds sterling. A, owing B, buys from Banker 1 in New York a sterling bill payable to B; D, on the other hand, sells to Banker 1 [in New York] a bill drawn on C in London. Thus Banker 1 has sold a sterling bill and has bought one - or in other words has offset one transaction with another. In like manner Banker 2 in London, assumed to be the correspondent of Banker 1 in New York, pays over to B the amount called for in the draft sold to A. On the other hand Banker 2 [in London] presents for acceptance or payment the bill drawn by D on C in London. When paid, D's bill on C offsets A's remittance to B. In other words, the London transactions correspond to those in New York and the net result is an offset of a debit with a credit. When the amounts involved are equal, exact balance results, but, of course, when unequal amounts are involved there is a necessary readjustment of balances as between bankers. When Banker 1 buys a larger sum-total of bills than he sells, he obviously strengthens his balance in London with his correspondent, Banker 2. An excess of sales works in the opposite direction. 
. . . 
While foreign exchange operations thus really represent attempts to bring into play the principal of clearing or offset so complex are modern economic relationships all over the world that exact equality in debits and credits is practically never to be expected. The question then arises as to how differences are adjusted. 
The complete answer to this question cannot be given until the subject of gold movements is discussed, because as a last resort the shipment of bullion may become necessary. . . . [T]here is rather the tendency to fuse all of a country's relationships into solid masses of credits on the one hand and debits on the other, and it is this ultimate relationship between all debits and all credits that mainly determines the bullion movements to settle final differences.²

Simply defined the rate of foreign exchange in any given country is the price that must be paid in that country's currency for bills of exchange payable abroad and expressed in terms of the money current in the markets where the bills are made payable.³

Reality of international transfers - Under the conditions which existed in the international money market between 1863 and 1913, the only transfer of funds between London and New York which affected banking reserves was the shipment of gold. Most of the so-called "transfers" consisted merely of a shifting of book credits by the banks from the accounts of the nationals of one country to the accounts of the nationals of another. When funds were being "sent" from London to New York, for example, sterling bills were being sold in New York by English agents, and purchased with American bank deposits. No gold would be shipped until this demand for dollars had driven the price up to a point where it was less expensive to ship the metal than to use sterling bills. Gold shipments entered only into the settlement of balances.⁴

And, gold shipments may not, necessarily, be a result of market-driven foreign exchange . . .

[T]here is an important distinction to be noted between the shipments made to order for a specific object [Emphasis supplied.], and those which result from the unfavourable course of the exchange. The former nearly always come as a surprise on the market, as it is usually impossible to know of them until they are announced by the Bank [of England]; but the latter, being an outcome of conditions which are apparent to everyone, can be seen approaching, so to say, and the market prepares itself for them in advance.⁵