Sunday, September 25, 2016

The Case for Equilibrium: coinage, usury and bills of exchange

In my previous post, I discussed Joan Robinson's objection to the concept of equilibrium as precisely the habitual mode of thought from which Keynes had struggled to escape:
The concept of equilibrium is incompatible with history. It is a metaphor based on movements in space applied to processes taking place in time. 
I agree substantially with Robinson but I also would admit there is some compatibility between equilibrium and history. The case I am thinking of involves a direct correspondence between "movements in space" and "processes taking place in time."

Raymond de Roover's Gresham on Foreign Exchange sought to contextualize the memorandum de Roover attributed to Thomas Gresham (probably incorrectly) in relation to early modern English monetary standards and foreign exchange mechanisms. That memorandum, written to inform the 1564 Royal Commission on the Exchange, subsequently became a much cited and plagiarized source for 17th century English debates about trade policy, which are now characterized as "mercantilist."

Metallic money minted into coins has two complicating characteristics that lead to further complications. Coins wear out and the mint charges seigniorage on the bullion that it buys from merchants. This means that older coins in circulation will eventually contain less silver or gold than new coins. At some point, people are tempted to hoard new coins or "clip" them. The mint may initially debase new coins as a countermeasure and subsequently as a source of revenue.

The price of silver or gold cannot fall below the seignorage price because the mint will buy it at that price. It also can't rise too high above the nominal value of the coins or people will melt down coins to sell as bullion. Thus there is a small but significant range within which the price of bullion can fluctuate.

These tiny perturbations are magnified in international trade. Meanwhile, piracy and bad weather create disincentives for shipping sacks of specie or stacks of bullion back and forth across the seas. Bills of exchange enable accounts to be settled on paper.

Bills of exchange also have another useful feature. They enable interest to be charged on loans without it being considered usury. That is because the banker's profit on a bill is uncertain due to fluctuations in the exchange rate between currencies. The exchange rate for a bill is determined by the par values of the two currencies, the terms of trade between the two countries and the supply of and demand for credit. The otherwise certain profit of usury is made uncertain by the other components of the exchange.

Needless to say, bankers almost always profited on these financial instruments. This led to suspicions of manipulation in the foreign exchange market and proposals for remedies for such suspected frauds. Although some sharp dealing inevitably took place, bankers didn't have to be manipulating the money market. They knew the money market. They monitored seasonal fluctuations in trade of different commodities. They observed the debasements and re-coinages of governments and estimated their effects.

Because of their unique characteristics, foreign exchange money markets did indeed usually tend toward equilibrium. But here is where I would like to suggest that what would appear to be a tendency toward equilibrium taking place in time was actually a movement in space. Bills of exchange had both a duration and a geographical element. A merchant would draw English money in London to be repaid, say, in Flemish money a month later in Antwerp. The fluctuations, over time, in the values of the respective currencies reflected the movements of commodities between locations as well as policies enacted by authorities in the two places.

Foreign exchange markets tended toward equilibrium only because of their unique characteristics. These characteristics are not shared by commodity markets in general. There is no "mint" that buys capital equipment at a mandated price to stamp it into other capital equipment. If there was, then Joan Robinson's satirical (and neoclassicism's implicit) leets would be a workable approximation of reality. Leets, that is to say, are just like money -- only better!