Global Trade Center

Credit cards proved so
profitable that banks sought frantically to sign up more customers. Cards were mailed, unsolicited, to millions of Americans. Not surprisingly, default losses skyrocketed. In response, the credit card industry developed an online computer system, called a switch. In response, the credit card use. Retailers now generally connect to the switch by phone to receive authorization for each purchase. The issuing bank receives instant notification of the purchase, facilitating billing.

Some transactions-renting a car, checking into a hotel, or making a mail order purchase-are today quite difficult without a credit card. Yet many people are unable to obtain a credit card because they are bad risks. However, people who do not qualify for a normalcredit card can often obtain a secured credit card. With this type of card, the cardholder provides collateral for the line of credit, usually in the form of a time deposit equal in amount to the credit limit on the card.

In 1999, U.S. consumers were holding some 511 million bank credit cards and, in addition, some 595 retailer credit cards

Gains to trade in borrowing and lending

We have savers and wealth holders with an excess of purchasing power now that they wish to trade for purchasing power in the future. On the other, we have businesses and house holds needing purchasing power now to finance investments. Both groups stand to gain from trade.  

The gain to borrowers is obvious. Borrowing allows you to open your bike shop and to setup factory to produce the EZ shift. If these investments are sufficiently productive, you will be happy to pay interest on the loan – to pay back in the future more purchasing power than you received at the time you took out of loan. 

Lenders too gain from trade. The interest you pay gives the lender a better return than he could achieve otherwise. What are his alternatives? He could hold cash . But this earns no interest t all. He could make a productive investment himself. But finding productive investments is difficult. Some people are much better at it than others. The typical saver does better by lending his money to someone with a highly productive use for it than by making an investment himself.

As in this example, most foreign exchange transactions today are international  and involve bank deposits  denominated in different currencies. This was not always the case. Historically, distance and poor communications were  more important barriers than differences in currency. In the nineteenth century, a merchant in New Orleans would have found it just as difficult to pay a supplier in New York as to pay of the United States. Banks in New Orleans offered  “domestic exchange” -claims on New York deposits-as well as foreign exchange-claims on London deposits.

The introduction of the Euro, a common currency for 11 of the 15 member states of the European Union in 1999 has created a situation in “Euroland” not unlike that in the early United States. The member countries all use of the same currency, but they have retained their individual clearing systems and these are only partially connected. The European Central Bank operates a system called TARGET that links the large-value online payment systems of EU member countries. This enables large-value, cross-border payments to be made relatively easily. However, there is no link yet for smaller payments. As a result, the cost of making payments in Euros between, say Rome and Pairs has remained quite high (much like the cost of making a dollar payment between New Orleans and NewYork 200 years ago). A survey in 2000 found that the average cost of a 100 Euro cross-border transaction was over 17 Euros, with enormous variations from country to country.

The Foreign Exchange Market

The interbank market in foreign exchange is an international market, active around the clock. Its major centers are London, NewYork, and Tokyo.The prices in the foreign exchange market are the exchange rates we studied  in Chapter 4. For example, the exchange rate between the U.S. dollar  and the pound sterling might be $1.40 to the pound. This means, in our example, that Henriette would have to give up $1.40 of her bank money(deposits  at her bank) in order to obtain a claim on 1 of British bank money (deposits at a British  bank). Trade in the foreign exchange market includes forward transactions as well as spot transactions like Henriette’s. 22

The banks came up with a solution to the problem of acceptability-the four-party card. This type of card involves two banks in each transaction-the cardholder’s bank (the issuer of the ard) and the retailer’s bank. The retailer hands over the credit card slips to its own bank for payment (at a discount of 2-5%). The retailer’s bank then passes the slips on to a clearing system. The clearing system presents each slip for payment to the bank that issued the card on which it was written.  

The issuing bank collects from the cardholder. The credit card clearing system, called an interchange, is very much like the clearing system for checks. In particular, it nets the claims of one bank on another to minimize the need for actual settlement. A large number of regional interchanges were set up along these lines. Most of these have since been consolidated into one of the two international systems of interchanges-Visa and MasterCard.

Most payments are made with bank dollars. To use bank dollars in payment there must be a way to convert the payer’s bank dollars (dollars in the payer’s bank deposit) into bank dollars the recipients is willing to accept (dollars in the recipient’s bank deposit). This is easy if both payer and recipient share the same bank. It is almost as easy, if a little more expensive, if they have different banks  but the two banks are part of the same clearing system.

However, if the two banks are not part of the same clearing system, payment is much more difficult.The payer must find a way to trade his bank dollars for bank dollars at the recipient’s bank or bank dollars that are convertible into the same through a common clearing system. Trade in bank dollars of bank in different clearing system is called foreign  exchange.

A Foreign Exchange Transaction

To see how foreign exchange works, let us look at an example. Henriette Gourmet Foods in the United STates imports tea from Chelsea Tea in England. In payment for a recent shipment, Henriette needs to pay Chelsea in pounds sterling the sum of  100,000 (about $140,000). To do this, Henriette cannot simply write Chelsea a check. She does not have a deposit  in pounds sterling, and her bank and Chelsea’s do not belong to the same clearing system.

Henriette must go to the foreign exchange department of her bank, First National. There she buys  100,000 in British bank money-that is,  100,000 in a bank deposit in the United Kingdom. A check drawn on that deposit is sent to Chelsea. It clears in the normal fashion through the British clearing system, and Chelsea ultimately receives payment  in bank money  at its own bank.

Where does First National get the British bank money to sell to Henriette? If it is  large  enough  and does enough business  in foreign exchange, it may maintain a deposit of its own at a British bank for just such a purpose. If not, it can by the pounds in the interbank market in foreign exchange where deposits in different countries are traded.

Trade and the gains from trade

As you line up to be issued uniforms, you are surprised that no one asks you your size. Uniforms are handled out seemingly at random. However, trade soon sets things right. A frantic half-hour of comparing and swapping leaves everyone dressed in clothes that more or less fit. The gains from trade are obvious to see. As this example shows, people trade because they differ in what they want. The basis of trade is diversity.

An important advantage of trade is that it allows specialization. The grassy meadows of New Zealand are a perfect place to raise sheep and cattle. So, new Zealand trades wool and cheese for automobiles and computers. Were it unable to trade, New Zealand would have to produce everything. It would have to switch resources from raising sheep and cattle to producing automobiles and computers. But this would be highly inefficient. Because new Zealand is a small country, producing the limited number of cars and computers it needs would be very expensive. Without specialization and trade, new Zealanders would have less of everything.

Although self sufficiency sounds appealing, it makes no economic sense. Many of your needs can be provided for more cheaply by others; what you have in abundance or can produce easily is often scarce and valuable for someone else. Trade benefits everyone.

The financial system offered small retailers a solution-the third –party credit card. The first such cards were travel and entertainment (T&E) cards. They worked as follows. The issuer, for example, Dinner Club or American express, would check the credit of potential customers and issues them charge cards. Cardholders could use the card at any retailer that had agreed to
accet the cards of the issuer, with the issuer guaranteeing payment.  

When a purchase was made, the retailer would receive immediate payment from the issuer. Such  payment would be at a discount of the amount of the purchase (initially 7%). For example, if the amount was $100, the retailer would receive $93. The cardholder would be sent a bill at the end of the month by the issuer of the card for all his or her purchases. Third-party cards did not initially offer customers the option of paying over time. Banks, such as Bank America and Citi, were quick to enter this business, offering third-party cards of their own. However, the acceptability of these early bank credit cards was limited geographically because of the restrictions on interstate banking.  

Consequently, because these bank credit cards were not widely acceptable, there was little demand for them.