If, however, all forms of wealth could be made equally saleable, we should find interest rates rising for those loans and securities which now have the highest saleability. They would lose the peculiarity which now enables them to perform a service as bearer of options. Money-rates and long-time rates of interest would tend to come together. Long-time rates on formerly unsaleable loans would fall, and rates on highly saleable loans would rise. The present low rates in the "money market" grow out of differential advantages.
We turn now to the third important aspect of the technique of banking, namely, the matter of cash reserves. First I would point out that this is merely a part of the more general problem of liquid assets. The difference between cash and liquid paper is a matter of degree. There is large possibility of substitution of the one for the other, as it becomes more profitable to use one or the other. When money-rates are low, it may well be worth while to carry large reserves; when money-rates are higher, the gains to be made by substituting paper for cash in the bank's assets are much greater. I have pointed out the use which great European banks, notably the Austro-Hungarian Bank, make of foreign bills of exchange as "reserve," selling bills when money is "easy," and the yield on bills is small, buying bills when money is "tight," and the yield on bills is large.[555] The great Joint Stock Banks of England, the chief sources of bank-credit in the great banking country of the world, also make use chiefly of deposits with the Bank of England as their "reserves." Some cash they keep, but it is "till money," rather than reserve. They carry, also, "secondary reserves" in highly liquid paper, stock exchange loans and commercial bills. The differences are differences in degree. The Bank of England does keep a large reserve in cash (including notes of the Issue Department and gold bullion) but it denies that it has any definite ratio in mind,[556] and it protects its reserves, when they are low, not by ceasing to loan, but by raising its discount-rate. The whole thing is highly flexible.
This is, in general, true throughout the world,[557] where banking is highly developed. A country which has expanding business, based on rising values of goods and rising capital values of anticipated incomes, which in turn grow out of increasing business confidence, etc., and out of the development of new enterprises which make readjustment necessary, expands its bank-credit to meet the situation. Expanding bank-credits in time grow so large that bankers feel larger cash reserves to be desirable. Their reserves may be also, in some measure, drawn upon by the growing retail trade and wage-payments, which call for more money in circulation. They meet the situation by raising money-rates. This tends to prevent the exportation of gold, and tends to encourage the importation of gold, which finds its way into bank reserves. Banks may even borrow directly from banks in other countries, to get the gold they need, or to prevent the exportation of the gold they have. The higher money-rates, also, tend to check marginal borrowing—the borrowing by those who see only very small profits to be made by the use of the bank-credit they borrow. If the rising values of goods, however, and the profits to be made by effecting exchanges, speculative and other, are large, the volume of bank-credit will, none the less, grow. If the tide of rising business confidence is strong, the banks will be disposed to accept securities and rights as collateral which they would distrust at other times. A very big difference indeed may appear between bank reserves in active times and bank reserves in dull times. The banks need less reserves in proportion to deposits in active times, because the very activity itself increases the liquidity, the saleability, of their paper assets, and so makes actual cash less necessary. Even in this country, the practice of counting deposits in other banks as reserve is well developed. This is not only true of country banks, or banks outside the reserve cities. It has been, in considerable degree, the practice of the big trust companies in New York City. It is the practice of private bankers connected with the stock exchanges, and the practice of brokers, who are, for many purposes, bankers, especially those who allow their customers to check on their accounts. Such houses may carry no cash at all. One, with whose workings the writer is somewhat familiar, makes the rule—"We pay by check and receive only checks." None the less, this house allows its customers to check upon it, and checks drawn on it perform all the functions of checks drawn on banks which keep a cash reserve. Of course, our new Federal Reserve system is built, in part, on the principle of collecting reserves in central reservoirs, and our banks will doubtless increase the practice of counting deposits with other banks as reserve.[558] They will feel the need for less reserves, also, with a wider rediscount market.
Within a given country, I think that we may safely generalize the doctrine that the causal relation between reserves and deposits is exactly the reverse of that asserted by the quantity theory, within very wide limits indeed. That is to say, increasing reserves are a result, and not a cause, of increasing loans and deposits. We shall further hold that the relation between them instead of being definite, is highly flexible. This is not to assert that reserves may not increase without a prior increase in loans and deposits. That has happened in the United States during the present War. It does mean, however, that increasing loans and deposits will pull gold into a country, and that increasing reserves do not force increasing deposits and loans.[559] If a country's business is growing, if that business is soundly based, so that expectations are being met, obligations being paid out of the income which arrives, on schedule time, to meet anticipations, there need be no effective check to the amount of gold that will come into the country to serve as reserves, within limits that are rarely reached. It is miscalculation, maladjustment of costs and prices in particular enterprises, failure of "interstitial adjustments," especially failure of particular crucial links in the business chain, as the businesses engaged in producing iron and steel, to respond to the needs of other expanding businesses, that check movements of expansion in business, not inadequacies of bank reserves.[560] As long as only wise plans are made, as long as they meet no mishaps, as long as the carrying out of the new plans does not itself so change the facts on which the calculations of business men have been based as to cut under anticipated profits, so long may business, within a given country, expand without danger from inadequate reserves. Of course, if the whole world is simultaneously expanding, the competition for gold in the international money markets may be so severe that all may be hampered.
That reserves will increase, as expanding credit, due to increasing business or rising prices, requires increased reserves, can hardly be disputed, I think, if we look at a country of small size, or (what is the same thing from the angle of economic analysis, so far as the present problem is concerned) if we take a particular part of a country. Seasonal movements of cash for reserves in this country have been obviously determined by the movements of credit, rather than the reverse. Expanding business at crop moving seasons, requiring advances of credit by country banks, and an unusual drain on the cash resources of the country banks, has regularly meant that the country banks draw cash from the New York banks. When the need for such cash in the country banks passes, when they can no longer employ it to advantage at home, they send it back to New York. New York, to meet the emergency caused by the withdrawal of cash, draws to a considerable extent on Europe for gold. It is not as easy for New York to get gold quickly from Europe as it is for France to get gold in an emergency from England. More time is required. Inelasticity, too, in the forms of currency most needed for small transactions, has made very real difficulties for us. But that, within the country, the sections whose business and credit were expanding take cash reserves from those sections where credit is less urgently demanded, needs no debating. This is seasonal. But the same thing is true in the long run. As business and bank-credit have expanded, year by year, in Oklahoma, Oklahoma's cash reserves have grown. Bank-credit in a country cannot go on indefinitely mounting, if bankers are making unsound loans, if the values on which the loans rest are based on vain imaginings, if anticipated profits are not realized. But if a country have rich resources and intelligent entrepreneurs, with sagacious bankers who can discriminate between sound and unsound business, it may, within very wide limits indeed, expand its bank-credit without check from inadequate reserves, as its business expands, and as prices, particularly prices of lands and securities, rise.[561]
If the country in question be a very large country, however,—large in the sense that its business and volume of bank-credit are very large, and particularly in the sense that bankers' assets are of such character that a large volume of reserves is desirable—restraints on the process of expansion may come. Reserves will come in, but the resistance in stiffer money-rates will be felt. Bankers in other countries will compete with the bankers in the country in question for reserves. Rising money-rates will put an end to many marginal exchanges. They will lessen the saleability of many rights which might otherwise be available as banking collateral. The extension of bank-credit will feel a drag. There is large flexibility here. But, in a long run period of many years, the volume of gold in the world will impose a maximum limit upon the possibility of expansion of bank-credit in the world as a whole. This limit is doubtless never reached. Within the limit, the variations in the volume of the world's credit are primarily determined by the other concrete factors we have been discussing. Proportionality between the world's gold and the world's volume of credit does not at all obtain. Under certain conditions, much higher proportions of reserves to bank-credit will be found in a given country than at other times, and the same will be true in the world at large.
I would refer again to the discussion by J. M. Keynes, quoted in Part II.[562] Reserves have absorbed enormous quantities of gold, easily obtained as a consequence of abundant gold production, in the past fifteen years. Proportions of gold reserves to bank-credit have grown. In the preceding period, when gold production went on less rapidly than business development, percentages of reserves were lower. Most bankers feel better with large reserves. When they can get gold, they prefer gold to other substitutes. When they cannot easily get gold, they use other substitutes, of the various kinds of paper, particularly, which have been described. Gold differs from other things, in bankers' assets, in degree, rather than in kind. Instead, therefore, of the law of the proportionality of reserves to volume of bank-credit, I venture the generalization[563] that, as gold production increases rapidly, the tendency is for the proportion of gold reserves to volume of bank-credit to rise; with diminished gold production, the tendency is for the proportion of reserves to fall, assuming that the factors other than volume of gold production which make for expansion of business maintain themselves.
Increasing volume of gold tends to increase the volume of trade. But there are other causes for the increase or decrease of trade as well. These causes, working in harmony with rapidly expanding volume of gold, lead to a very rapid growth of trade.[564] Working in the face of a drag from less rapidly growing gold supply, they strain the possibilities of bank-credit expansion. Various substitutes for gold in bank reserves are employed. Substitutes in the form of other forms of credit are employed. Barter is resorted to increasingly. Methods of employing other things than gold in the retail trade of a country are resorted to. "Gold-exchange" standards are devised. Countries "wait their turns " to come on the gold standard. Coöperation, not only within countries, but among countries, seeks to economize the scanty stock of the precious metal. Very large slack is thus revealed. But the expansion of business is checked, the volume of business confidence is reduced, the values of future incomes in enterprises is lowered, production is checked, and prices are reduced, (a) because the value of money rises; and (b) because the values of goods and income-bearers is reduced. The exchange side of production is hampered. Substitutes for gold, through increased activities of bankers and other agents of exchange, are costly. Greater tolls on values are taken by those who handle the mechanism of exchange. It does make a difference whether or not the world's gold is abundant! But the difference is not made solely, or even mainly, in the price-level.[565]
The reserve function of money is essentially a dynamic function. The reserve function is merely a phase of the bearer of options function.[566] It is the practice of quantity theorists to speak of "normal" ratios between reserves and deposits (or reserves and demand liabilities), and to speak of the "static" laws governing this relation. This in true of Kemmerer, of Fisher, of A. P. Andrew, and, in general, of contemporary quantity theorists. Kemmerer very explicitly puts it as a matter of static theory, "If we divide the money of the country into two parts; one, that used directly in daily cash transactions, and the other, that kept in banks as reserves, it may be said that, under perfectly static conditions [italics mine], the proportion of the total represented by each of these parts would be constant. Each banker would find from experience what proportion of reserve to liabilities it was advisable for him to maintain, and would order his business, as far as possible, so that his reserve would neither exceed nor fall below that most desirable proportion."[567] Kemmerer quotes the following passage from A. P. Andrew: "In the long run, as apart from cyclic oscillations, the quantity of bank-credit is governed by the quantity of money."[568] Fisher's view we have considered at length in Part II. It is essentially the same. He is working with the statics of the problem of money and credit. These different writers differ greatly in the extent to which they would insist on the validity of their static tendency in real life. Professor Fisher, as we have seen, is exceedingly uncompromising, holding tenaciously to his principle as subject only to slight modification during transition periods. Professor Kemmerer, in the chapter from which the quotation just given is taken, gives an important realistic analysis of dynamic conditions and makes liberal concessions to the view that the ratio is no constant in real life.[569] Professor Taussig, whose view was summarized at length in chapter IX, finds, in real life, so many exceptions to the doctrine of proportionality of reserves and deposits that he virtually abandons that doctrine. What I wish to insist on here, however, is that there are no static laws possible in this connection. The reserve function is a dynamic function. The theory of reserves must rest in an analysis of friction, of transitions, of dynamic uncertainty and dynamic change. It is a part of the general theory of liquidity of bank assets, of saleability of rights, and the like. If one can find a "normal" amount of dynamic change, a "normal" amount of uncertainty, a norm for the coming of technical inventions, a normal prospect of war, a normal rate of gold production, a normal rate of growth for population, a normal amount of Jew-baiting in Russia, with a norm for migration, and if one can hold these norms, and a multitude of similar norms, in fixed relation to one another, one might have justification for speaking of a "normal ratio" of bank reserves to bank demand liabilities!
Apart from dynamic changes, from frictional elements which create uncertainties, in general, apart from uncertainty and irregularity and lack of "normality," there would be no occasion for bank reserves at all! To the extent that static conditions are realized, bank cash reserves may be, and are, dispensed with. It is well known that England gets along with surprisingly little gold. The total stock in the country has been smaller than the gold reserve of the Banque de France, and much of the gold in England was in use among the people, since small paper money (before the War) was not in use in England. The gold reserve of the Bank of England has been usually only a fraction of that of the Banque de France. Some years since, the distribution of gold as between England and the United States, was, roughly, England six hundred million dollars, the United States, one billion, six hundred million. A larger proportion of gold was in reserves in the United States than in England. Yet England was doing the banking business of the world, while we had trouble in doing our own! The Bank of England carries virtually the only reserve in the country. The Joint Stock Banks, with demand liabilities vastly in excess of the demand liabilities of the Bank of England, carry only "till money" in cash or Bank of England notes, and for the rest, carry as their "reserve" their deposit credits with the Bank. A great deal of criticism, from Bagehot down (to go no further back) has been directed at the "inadequacy" of English banking reserves, and many dire predictions have been made as to the dangers that impended unless the reserves were increased. We shall probably hear less of this after the War! The Bank of England still stands! It has never failed to pay out gold over its counters, even though it has, with the aid of the government, doubtless restricted and controlled foreign shipments of gold. But it has met the unprecedented emergency better than any other bank in Europe, and to-day (Sept. 1916) is in exceedingly good shape. Sterling exchange at New York seems "pegged" at the "lower gold point," and apprehensions regarding the stability of the English financial system seem definitely allayed. It is aside from our present purpose to discuss war time conditions. I am rather interested in analyzing the features of the English money market which have made it possible, in the period preceding the War, for English bankers to get on with so little gold. As will appear, it is because English business and financial affairs have been more nearly "static," have come nearer to realizing the assumptions of static economic theory, than is true of any other country on earth.