If we are to cling to the bond-secured note system, this matter of the artificial value of government bonds will become an important practical problem whenever it becomes necessary for the United States to make any addition to its debt. Either the rate of interest will have to be raised to 3 per cent. or higher, or, if that alternative is rejected, means will have to be found to induce the banks to use the greater part of the new loans as security for additional note issues.[258] In practical effect, this is only a thinly disguised resort to the time-honored but now thoroughly discredited practice of compelling the people to use the government debt as a circulating medium.
The bearing of this matter on the safety of the national bank note is simple. The burden of the ultimate redemption of the bank notes has been placed on the shoulders of the Treasury, to add to its other burdens of maintaining the value of the greenbacks and of the silver dollars. If loss of confidence in the bank notes should ever lead people to demand their wholesale redemption, the Treasury would have to meet the demand in gold. But the moment it tried to sell the bonds, it would find there was no market for them except at a discount of perhaps 30 or 40 per cent. It is true that the Treasury would still be able to recoup itself for this loss in the value of the bonds by exercising its prior lien on the assets of the banks. But this leads us to the important conclusion that the final security for our bond-secured notes rests on the assets of the banks after all. A more striking argument for asset currency could hardly be discovered.
It must be remembered, however, that the foreclosure by the Government of its claim on the assets of the national banks would cut into the wealth on which deposits are based and so have a most disastrous effect on the deposit system. The pressure upon the Government to refrain from such a crushing blow to credit would be overwhelming. It is almost inconceivable that in time of panic or a national crisis the Government would resort to such a procedure. Almost any alternative would be preferred. It would not be too difficult a matter for the Government to persuade itself that the wiser and safer course would be to suspend specie payments, perhaps even declaring the bank notes a legal tender. A more plausible case could be made out in favor of such action than was found sufficient to justify the issue of the greenbacks of the Civil War. Yet such action would mean the breakdown of our financial system.
This is, of course, looking into the future and anticipating a state of disaster which may never come. But a system which bids fair to break down in time of disaster should be remodelled before disaster comes. And we should not rest too confidently in the notion that disaster can never reach us. It is only thirteen years ago [1895] that the burden of supporting its paper and silver currency brought the United States within twenty-four hours of suspension....
Speculation Involved in the Issue of Notes
[259]When a banker takes out currency he engages in two distinct transactions and enters upon two different hazards. In one transaction he assumes the risk and holds the expectation of greater profit for taking out circulation. Since buying bonds and taking out circulation most of the time shows some theoretical profit over loaning direct, presumably if there were no other consideration, most of the time our bankers would keep outstanding all the notes they could. In the other transaction, however, the banker engages in a speculation in government securities. As a matter of fact, if the price of government bonds advances, the profit from taking out circulation declines; but our banker is pretty likely to view with equanimity the declining circulation profit when he considers the profit he is making in his speculation in bonds. On the other hand, as the price of government bonds declines, circulation grows more profitable. The banker is likely to view this with sour satisfaction when he looks on his loss in his bond speculation. Profit or loss in the bond speculation is likely to outbalance loss or profit in the circulation transaction.[260]
Let us examine the situation more closely. Just what is the profit or loss from taking out circulation? In the first place the bank gets the regular current money rates on the loans it makes through issuing notes. Also it gets the interest on the government bonds it buys. This, of course, means the real interest, or income on the investment, called basis, taking into consideration coupon interest, price paid, and date of maturity. Excepting for the tax of 1/2 per cent. on the circulation taken out (1 per cent. if taken out on the 3's or 4's) and for the expenses attendant on taking out circulation, which the government actuaries compute to average $63 on the $100,000, this interest on the government bonds looks like clear "velvet." It would be, too, if the banker did not have to pay more for the bonds than the amount of circulation he can take out against them. To figure his net profit he must deduct from the gain items just stated what he would have made if he had loaned his funds direct instead of investing in bonds.
Expressed as an algebraic equation the situation becomes much clearer. Let
x = current money rate;
y = basis rate at which government bonds are bought;
z = price of government bonds;
b = circulation received ($100,000 used as basis of calculation);
c = taxes, redemption, and other circulation expenses.
(As already stated, government actuaries have calculated that circulation expenses average to cost the banks $63 on the $100,000 of circulation taken out. Taxes depend on whether the 2's, in which case the tax is 1/2 per cent., or the 3's or 4's, in which case the tax is 1 per cent., are bought. Taxes, then, amount to either b(.01) or b(.005). We can take b as a constant in our calculations and base all our computations on taking out $100,000 of circulation.)