Readings in Money and Banking / Selected and Adapted

by Chester Arthur Phillips

Dangers of the System.—So conclusive are the lessons to be learned from the experience of the last half century with the system of redeposited reserves, that there is a practical unanimity among bankers and financial experts that the reserves of our banks, with the exception of the money actually held in the vaults, are, in the words of William Ingle, vice-president of the Merchants and Mechanics National Bank of Baltimore, "A great deal of a delusion and a snare." In every panic, the country banks and the reserve city banks have found that it has been impossible for them to secure the return of the portion of these reserves which has been redeposited in New York, Chicago, and St. Louis. At a time of great stress, when the banks have been subjected to a drain, they have been suddenly bereft of the support which, in theory, should have been forthcoming from their reserve agents, and have been forced to depend upon the 6 per cent. or 12-1/2 per cent. reserve, which was contained in their own vaults. What is even worse, the outbreak of a panic in New York City, where every panic of the last half century has started, was the signal for the suspension of cash payments by every bank in the country, within a few hours.... Thus a local panic, in many cases occurring when business conditions were exceedingly prosperous and healthy, has completely disorganized the exchanges of the country and brought business to a standstill.

The Perverse Elasticity of National Bank Notes

[255]... It is not quite correct to call our national bank notes inelastic. They are decidedly elastic. The trouble is that their elasticity is of a wrong sort; they expand when there is need of contraction, and contract when the need is for more currency. By calling the notes inelastic we mean that their volume does not correspond automatically to the need for currency. This is true, and is one of the most serious defects of the bond-secured notes....

The demand for currency depends upon the volume of business to be transacted, and is continually in a state of fluctuation. Various causes have only to be mentioned to explain the unequal demand at different times. We have thus the payments of salaries, bills, etc., coming usually, on the first of each month. Then there are the quarterly payments of dividends, interest, etc., falling generally on the first of January and at intervals of three months thereafter during the year. Above all, we have in this country a regularly recurring seasonal change in the volume of business, due to the harvesting and moving of the crops every fall and early winter. Besides these normal fluctuations in the demand for currency there are of course such abnormal circumstances as business emergencies, panics, depressions, etc., which at irregular intervals call for expansion or contraction of the currency. To meet all these varied demands an elastic currency is a necessity.

The most serious evils of inelasticity in this country are seen in connection with the annual handling of the crops. It may be safely said that for this purpose the United States needs every fall at least one hundred and fifty million dollars of extra currency. Since our monetary system contains no really elastic element, this extra business of the fall has to be done with little or no increase of the country's currency. The crops must be handled by means of a shifting of currency from one part of the country to another. In the spring and early summer the agricultural districts are apt to have more money than they need. Accordingly, the country banks are in the habit of depositing part of their reserves in banks situated in the reserve cities. A large part of these sums eventually finds its way into the money markets of New York and other Eastern cities, where a low rate of interest is paid to outside banks for such deposits. Now comes the harvest season, and a demand goes up from the country banks for the return of their deposits. Every fall the clearing-house banks of New York City alone give up about fifty millions of "lawful money" to meet this demand.[256] Of course this means a tight money market. In the spring and summer the funds obtained from the country banks were loaned out or used as reserves for deposits. Money was in excess, interest rates were low, and speculation was encouraged. Now loans must be called in and deposits reduced. This sudden contraction is a hard blow to all business interests. It is especially hard on the speculators, and their desperate demands cause the enormous rates on call loans which are witnessed every fall on the New York money market....

It has ... been suggested that the inelasticity of the national bank notes does not mean that their volume never changes. As a matter of fact, the circulation has been marked by enormous fluctuations, and these fluctuations, having no relation to the demands of business, have simply aggravated the evils of inelasticity which have been described. Thus, between June 1, 1880, and June 1, 1891, the total volume of bank notes outstanding declined from $345,000,000 to $169,000,000, a decrease of $176,000,000, or 51 per cent. This retirement of half the circulation came during a decade marked by large growth in population and wealth, and by remarkable industrial expansion and business activity. The reason for this decline lies in the fact that the Government was using part of its large surplus revenue to pay off the debt. In eleven years the Treasury paid $1,105,000,000, reducing the debt by more than half, something without parallel in the history of public finance. The retirement of half the debt caused a scarcity of United States bonds, and their prices went soaring. Four per cents of 1907 rose from 103-113 in 1880 to 125-130 in 1888. The inevitable result was the decline of circulation. The opposite course of events has been seen in recent years....

[The subjoined diagram (suggested by a similar one for 1902-1906, accompanying the article a part of which is here reproduced) illustrates the comparative seasonal elasticity of the notes of our national banks and the circulation of the chartered banks of Canada for the period 1910-1914. The marked expansion of national bank notes in 1914 was due to the crisis brought on by the outbreak of the European war. The Aldrich-Vreeland notes which were issued in that emergency were retired in a few months and the volume of national bank notes assumed normal proportions.

For the Canadian statistics involved the editor is indebted to Mr. G. W. Morley, Secretary of the Canadian Bankers' Association.]