As business increases and the demand for both credit and money increases, as reflected in the rising interest rates, taking out circulation cæteris paribus, with the inexorability of a mathematical law, becomes less profitable.
Further, there is an intimate relationship between y and z. If the price of bonds (z) declines, the basis rate (y) must advance. As a matter of fact as z declines yz grows greater. If, then, x remains constant and z declines the influence of the negative quantities of the equation is growing less. Then follows:
STATEMENT II
As the price of bonds declines, if the current interest rate remains constant, the profit from taking out circulation increases.
That gives the absolute mathematical basis for such general statements as that "the price of bonds is too high to make circulation profitable."
These two facts set out in Statement I and Statement II place the banker who has taken out circulation between the devil and the deep, blue sea. If the price of bonds remains the same and the current interest rate rises, his circulation grows steadily less profitable. A decline in the price of bonds affords the only offset to an increasing interest rate. But if the price of bonds declines enough to offset the advance in the current interest rate, the banks must mark off enough profits to cover the loss on the capital value of the bonds.
Speculating in securities properly forms no part of a bank's business. It is an anomalous situation that in order to fulfil a proper function of note issue a bank should have to undertake such an improper speculation.
The Lack of Adjustment Between Bank Notes and Deposits
[261]Under our present currency system the volume of money in circulation is perfectly flexible. It constantly expands and contracts in automatic adjustment to the requirements of trade and the convenience of the people. An increase in the volume of cash transactions brings promptly an increase in the volume of currency in circulation through the current withdrawals of money exceeding the current deposits of money. A lessening in the volume of cash transactions promptly drives unneeded currency out of circulation through the deposits of money exceeding the withdrawals. No other system could provide a currency which would adjust its volume in circulation more exactly to the needs of trade and the preferences of the people. There is a ceaseless flow of the money in circulation into bank reserves, and of money in bank reserves into circulation—ceaseless except in an occasional crisis when the natural flow of money from bank reserves into circulation is arbitrarily stopped by banks refusing, for self-protection, to continue paying out to the point of exhausting reserves.
While the volume of money in circulation is thus perfectly and automatically adjusted to trade requirements, it is to be noted that this flexibility arises from the flow back and forth, between the mass of money in circulation and the mass in bank reserves. In this lies the main economic defect of our present currency system. An expansion in the volume of money in circulation entails a corresponding contraction in the volume of bank reserves, and necessarily a corresponding contraction in loans. A period of expanding business would naturally be attended by both an increased volume of loans and an increased volume of cash transactions, such as increased pay-rolls, increased retail sales. Increased cash transactions cause a larger volume of money to flow into circulation. But this flow is out of bank reserves, thus contracting them and necessitating a contraction of loans depending upon them, at the very time when loans would naturally expand. Obviously, if business becomes very active, the effect upon bank reserves is so adverse, and the contraction of loans depending upon reserves so important, that embarrassment is widespread and panic ensues.