The Clearing-House and Foreign Exchange
( Originally Published Early 1900's )
IN the great financial centres the banks have a system of balancing their accounts, the study of which is instructive to the student of economics, because it shows an ideal system by which we might imagine the accounts of every individual with the community to be balanced in the actual commerce of the world. To understand it let us commence by considering what the banks are to do with the cheques which they hold upon other banks. Let us suppose that there are ten banks of deposit in a town. Then, under the system explained in Chapter XIII., each bank will have deposited with it each day a greater or less number of cheques drawn upon each of the other nine banks. It therefore has the right to send these cheques around to the banks on which they are drawn and receive the money for them. Were this process actually gone through with, the amount of coin to be transported back and forth would be very great, almost equal in fact to the sum total of all the mercantile transactions of the town during the day. But it is evident that since bank A holds cheques drawn on bank B, and bank B holds cheques on bank A, only the difference of the sums total of these two classes of cheques will have to be paid in money. Thus a certain amount of transportation of coin may be saved by each bank, through a representative, meeting each of the others in advance of payment, exchanging cheques, and having each debtor bank pay the balance due to the creditor bank.
But a little consideration will show that a still greater saving is ideally possible. Let each bank at the end of the day add up the sum total of the cheques which it holds against all the other banks. Let the sum total of these credits be called C.
Then take the sum total of all the cheques against it held by other banks, which it must pay. If we call this sum total of its debts D, it is clear that, after all payments are made, the amount of money in its vault will be algebraically increased by C minus D. In other words, it will have received C dollars and will have paid out D dollars. When D is greater than C, its stock of coin will be diminished by the difference of the two quantities; when less, it will have been increased by this difference. Hence all the money which it is really necessary for the bank to handle is this difference. Moreover, since every cheque appears as a credit in favor of one bank, and an equal debit against the other bank, it is evident that the sum total of the C's for all the banks will be exactly equal to the sums total of the D's. If, therefore, we call each bank whose C is greater than its D a creditor bank, and each bank whose D is greater than its C a debtor bank, the sum total of the credits held by the creditor banks will be exactly equal to the sum total of the debts due by the debtor banks. Hence : If any agency collects all the amounts due from the debtor banks, the agency can with the money thus collected pay all that is due to the creditor banks.
Such an agency is called a clearing-house. All the cheques drawn on any day are brought to the clearing-house on the following morning. The sum total of the cheques held by each bank is added up, thus showing the amount C of each bank's gross credits. The grand total of all these credits is the sum of all the cheques.
The cheques are then re-classified with reference to the banks on which they are drawn. The sum total drawn against each bank is its D. The grand total is again formed, which is of course equal to the grand total of the C's. The table on the opposite page shows how the operation may be performed.
Under each bank whose name is found at the top of a column is written the amount of the cheques which it holds against the several other banks whose names appear on the side. Thus the Exchange Bank is supposed to hold cheques to the amount of 284 units (which we may consider to be dollars, hnudreds or thousands of dollars as we please) against the Planter's Bank; 276 against the Merchant's Bank; 420 against the Grocer's Bank, etc.
Now consider the horizontal lines. The Planter's Bank has against it $532 held by the Merchant's Bank, $216 by the Grocer's Bank, etc. The sum total is found in the right-hand column to be $2778.
Now take the banks individually with reference to their total debts and credits. The Planter's Bank has a total credit of $2903, and the total debt is found in the right-hand column to be $2778. Balancing this account, it is a net creditor to the amount of $125. Taking the other banks in the same way.
The debts are now balanced in the following way : The Merchant's Bank pays into the clearing-house $230, the Grocer's $347, the Exchange $168, and the City $13, making a total of $758. The clearing-house pays $125 of this sum to the Planter's Bank, $294 to the State Bank, and $339 to the North Bank, which at the same time exhausts the fund and settles all the accounts. By these small payments transactions amounting in all to $19,283 are settled with exactly the same result to each bank as if each account had been settled separately. A mass of indebtedness which amounts to a vast sum total is thus balanced by comparatively. small payments.
In practice this clearing-house system can only be applied to banking institutions. But if all mankind were perfectly reliable and honest, it could be carried into all the ac-counts of society, and the use of money would then be confined to the payment of balances at stated periods. Every man who produces and sells anything, or who renders to his neighbor or the public at large any services for which he receives money in payment, is, by the act of supplying such commodity or service, a creditor; and this credit or service is balanced by the money he receives. For whatever he purchases or gains from others he is a debtor; and he pays his debt in money (cf. § 55). We might then imagine an account kept between each person and society at large, the latter being the clearing-house. The value of every commodity or service which he rendered to others would be recorded, this value being exactly what would have been paid for it had it ben done for money. On the other side of the account everything he gained or received from others would be charged against him. Then at stated intervals, once a year for instance, we might suppose his accounts balanced by his paying to some central person the excess of his debits, and receiving the excess of his credits. The final result of this system would be the same to which the actual system of exchange by means of money leads. But owing to the imperfections of human nature, and the impossibility of keeping such an account in a way which every one would agree upon as perfect and free from error, the balance has to be preserved in each individual case by the actual transfer of money back and forth.
Of Foreign Exchange. If we consider once more the subject of credit, we shall see that to give a credit entire precision two agencies and two provisions come into play.
The first agency is a debtor, who may be any legal person whatever, but in the case that we are now considering is generally a banking or mercantile firm.
The second agency is a creditor, or person to whom the payment is due, who also may be any legal person whatever. One provision is a designated place of payment.
Another is a designated time of payment.
The necessity of having a designated place of payment will appear on reflecting that without it the debtor might not know where to find the creditor. Hence in mercantile credits the bank or other point where the parties or their agents must meet in order to make and receive payment lias to be specified. Again, if no time of payment were understood, but if the act could be postponed indefinitely at the option of the creditor, the debt would be worthless. Hence in mercantile credits the time when payment is to be made is always specified, and when not specified the debt is payable on demand. For our present purpose we need not take account of any postponement of the time of payment, but may consider the debt as payable upon demand.
Now the creditor and debtor need not live in the same place nor in the same country. The place of payment may be yet a third country, though it is more commonly the country in which the debtor resides. Hence a person may be the owner of the right to receive money in a foreign country.
Credit payable in a country foreign to the creditor is called foreign exchange, or simply exchange. Exchange is said to be on the country or city where the payment is to be made. Thus, exchange on London means the right, which may be possessed by a person in any part of the world, of requiring a money payment in London.
In order that foreign exchange may have any value it is evident that there must be intercommunication between the residence of the creditor and the country where the debt is payable. A debt payable in the moon would have no value, even if by looking through our telescopes we could see the gold piled up and only waiting for the creditor to get it. But an American may buy goods in London, and he must then make payment in London. A credit payable in London will be of greater utility to him for this purpose than one payable at home, because it will save him the expense of transporting money to London.
The ownership of foreign exchange is transferred by an instrument in writing called a bill of exchange, of the same general character as a bank cheque, but usually more elaborate. Like a choque. It consists of a formal order from the creditor, or drawer, to the debtor, or drawee, directing him to pay a specified sum of money to the order of a third person, called the payee. When this bill is transferred from the drawer to the payee, the latter becomes the owner of the foreign ex-change, with all the rights which pertain to that ownership.
The payee may reside in any part of the world without in any way impairing his ownership. But in order that the bill may become payable it has of course to be transferred to some person in the place of payment, which we may suppose to be London. This, person presents it to the payer, who acknowledges the obligation of paying it by writing upon it an acceptance.
Foreign exchange may be transferred like any other credit. Exchange on London is bought and sold as if it were a commodity in all parts of the world. To see its origin, suppose that an American merchant ships a cargo of goods to a London correspondent for sale. When the goods are sold, the correspondent becomes indebted to the shipper in the amount agreed upon.. Thus the shipper in New York becomes the creditor of the firm in London. He can then draw a bill of exchange on his London correspondent, take it to a banker, and sell it for whatever sum it commands from the banker. The latter transfers it to his London banker by the usual indorsement, and the London banker collects the money from the payer. Thus the New York banker becomes the owner of the credit in a London bank.
Now suppose that another American merchant desires to purchase goods in London. In order to pay for them he goes to the banker and asks him for a bill of exchange on London. A bill for the required amount is sold to him at any price that may be agreed upon, and is by him transferred to his London correspondent. The correspondent takes it to the London banker and receives payment.
The advantage of this system is that much of the trouble and expense of transporting money backward and for-ward is saved. If every merchant in New York who bought goods in London had to send money over to pay for them, and every one who sold goods there had to bring his money home, the expense of transporting the money back and forth would be considerable. With bills of exchange it is only necessary to transport the excess of the sum total of debits over the sum total of credits. So long as the payments to men in Lon-don balance the payment due from them, there will be a continual supply of bills of exchange in the hands of New York bankers, and an equal sale of them to merchants. But it sometimes happens that the goods purchased abroad exceed those sold there. New York bankers then find that the quantity of bills of exchange which they sell exceed those which they buy. Consequently their credits in the hands of London bankers diminish and will soon be exhausted. To make them good they have to ship gold from New York to London to an amount sufficient to balance the account. But if the value of the American goods sold in London exceeds the value of those bought, the opposite effect will take place. New York bankers will find the amount of foreign exchange sold them to exceed that purchased from them, and their idle credits in the London banks will increase. Gold must therefore be transported from London to New York to pay the balance due the latter city.
Of course the converse of what we have said holds true of New York in its relations to London. The merchants of the latter city buy and sell goods in New York, and may then have to make payment in New York. Thus exchange on New York is bought and sold in London.