Readings in Money and Banking / Selected and Adapted

by Chester Arthur Phillips

From the beginnings of agitation for currency reform the advocates of elasticity have recognized more or less clearly two kinds: (1) what we may call seasonal or ordinary elasticity, and (2) what we may call emergency elasticity. By the former was meant the power of a note issue to adjust its volume to those moderate changes in the need for money which show themselves in the course of an ordinary year. By emergency elasticity was meant the power of a note issue to adjust its volume to those extraordinary changes in need which connect themselves with the typical banking panic. The evils which it was believed that seasonal or ordinary elasticity would remedy were principally (1) the summer shortage of currency for moving crops, together with the temporary but more or less serious stringency in the New York money market which accompanies that shortage, and (2) the plethora or excess of currency which usually appears three or four months after the crop-moving period has terminated. The evils which emergency elasticity was expected to relieve were principally (1) the stringency which precipitates the panic, (2) the money famine consequent on general bank suspension after the panic has fully developed, and (3) the glut of currency which attends the depression following a panic, often leading to excessive exports of gold and thus endangering the whole credit system of the country.

Let us, now, take up seasonal or ordinary elasticity, and ask ourselves whether the new notes are likely to possess this characteristic. First, how about the expansibility needed to supply adequate funds for crop-moving? At this point, it must at once be admitted that the new currency does not meet the demands of the case in quite the thoroughgoing way which the earlier schemes thought to be necessary. The ideal of the earlier plans was to provide an adequate and easily utilized power of issue, located at the very place where the need for expansion is felt, i. e., in the local bank. The new law gives up this idea entirely. The local bank will not have power to issue the new currency at all. In so far as its customers are to get any benefit from that currency the benefit must come through two channels which the country bank could use in getting the needed funds, even if the currency had no expansibility, namely, (1) calling in its balances kept with banks more centrally situated, and (2) borrowing from such central banks. In other words, the new power of issue will help out in the crop-moving period merely because it will put the reserve banks in a better position to respond to the call of the country banks for the return of their own balances and for advances on discounted paper. Judged from this point of view only, the elasticity provided by the new law is doubtless adequate. If the reserve banks have not kept themselves in a position to meet the calls of their country members from money already in possession, they will surely be able to put themselves into such a position by expanding their issue of notes. In one sense, then, the new issue has adequate expansibility for ordinary needs. There still perhaps remains a doubt whether effective elasticity is after all assured, for it is not clear that the country bank which needs money for crop-moving purposes will have the wherewithal to get advances from the reserve bank—that is, that it will have paper of the proper kind and in sufficient amount for rediscount. However, it seems probable that the act as finally passed has met this need by providing that agricultural paper shall be admitted on rather more liberal terms than paper arising out of ordinary commercial or manufacturing business. If this be so, it would seem that the provisions of the new law for securing one phase of seasonal elasticity—expansibility—are fairly adequate.

Passing, now, to the other side of elasticity—i.e., contractility—can we say as much? Will the new issues promptly retire when their special task is over? Prima facie, the verdict here is less favorable than in the previous case. In general, there are two principal processes by which a note circulation may be contracted: (1) driving the notes out of circulation, and (2) drawing them out. In so far as the former process is depended upon, means are devised to make sure that the notes shall persistently return to the issuer even against his will—they shall have good homing power. By the second process, it is made to the advantage of the issuer of the notes to hasten their withdrawal himself.

As respects insuring contractility by the former of these processes, the act certainly cannot claim to promise high efficiency. The driving-out process requires roughly the fulfilment of two conditions: (1) keeping the channels for the return of notes to the issuer fairly open, and (2) supplying outsiders with a motive for sending the notes home. As regards the former of these conditions, the new system probably is all right. The return of the notes to the issuer seems not to be impeded by the inconvenience or expensiveness of the process. All member banks and all reserve banks must receive these notes; and the reserve banks will probably have branches within easy reach of any part of the district. Hence, any holder desiring to get notes back to the issuing bank will find the process easy and the way open. But good homing power requires more than this. It requires, namely, that adequate motives be supplied to people generally, or, at least, to banks generally, for seeing that the notes get back. It is not enough that the track be smooth; people must desire to use it. Now, earlier plans for securing elasticity relied on two principal motives for inducing holders to send notes back to the issuer: (1) the desire of such holders to make room for their own notes, and (2) their desire to exchange money which has various limitations imposed upon it for money which is free from those limitations. It is plain that the new system makes only a limited use of the former of these methods of procedure. Within the district for which any particular reserve bank is the central bank, this particular force will be practically inoperative; for the power to issue notes on the basis of common assets is not given to any but the reserve banks, and the profitableness of the power to issue the old type of note has always proved too low to induce banks generally to take much trouble to get their own notes into circulation. As between the reserve banks of the different districts, however, this particular motive will, of course, be more or less in evidence, since these reserve banks will all be competitors for this opportunity. But even here the motive in question will not play a large part, since more effective means for insuring the return of the notes from outside reserve banks are provided in other parts of the law.

As regards the second motive for returning idle notes—that is, the desire to exchange a money subject to various limitations or disabilities for one not subject to those limitations—the new act does somewhat better than it does in respect to the first motive. It is, indeed, true that, within their own district, no special disability, like being forbidden to be paid out by other banks, is put on the new notes. But they are always subject to the disability of not being legal reserve money in the case of federal banks; and hence such banks will be more or less disposed to return the notes issued by their own reserve banks, in order to exchange them for reserve money. It may be doubted, however, whether in ordinary times this will prove a very potent force, since country banks will usually keep reserves considerably in excess of legal requirements, and so will not need to discriminate nicely between the two sorts of money. As between different districts, the case for the homing power of the new notes is rather stronger, since reserve banks are prohibited from paying out the notes of other reserve banks under penalty of a 10 per cent. tax. Even here, however, the provisions are none too adequate. While the notes of a particular reserve bank must not be paid out by the reserve banks of other districts, there is no prohibition against their being paid out by the member banks of other districts; and it is doubtful whether there is sufficient motive to induce said member banks of other districts to send in these notes to their own reserve banks and so start them on their homeward journey. The desire to exchange money which cannot be used as reserve for that which can be would have some force; but, under many circumstances, it would probably prove rather inadequate.

Another disability which contributes to the homing power of a bank note, and which is actually used in the case of our old note, is not used with this new note—I mean, the fact that they are not receivable for customs dues. The decision to omit this provision was perhaps wise; but it throws out a potent motive for sending notes home, and thus throws away an opportunity to make better provision for their contractility.

On the whole, then, it must be acknowledged that, in so far as homing power is dependent on giving to outsiders strong and persistent motives for sending notes home, the new law is not altogether satisfactory.

We have seen that there is very little in the new system to secure that the notes shall have good homing power—shall get home by what we have called the driving-in process. Is the system better off as respects the drawing-in process? Are matters so arranged that the issuing bank will have the power and the desire to withdraw its notes—or at least contract the currency proportionately—when the need for the notes has fallen off? As respects the first part—making sure that the issuing bank shall have the power to retire its notes, or at any rate to effect a corresponding contraction of the currency—the new system is practically perfect, as indeed was the old one. That is, any reserve bank desiring to contract its note obligations may at its discretion deposit with the federal reserve agent reserve notes, gold, or lawful money. Obviously, this, if not strictly a contraction of its note circulation, at least brings about the desired contraction of the general circulation.

When, however, we consider the provisions of the new law for insuring that reserve banks shall desire to contract their circulation when the special need has passed, we find that the law does not promise quite so well. The favorite device for accomplishing this result has been, of course, a tax on issues, similar to the 5 per cent. tax of the German system. Apparently, the new law provides for something equivalent to this in the shape of an interest charge by the Federal Reserve Board, the rate to be fixed by said board. How far this device will prove effective in practice it is not safe to predict. In order that it should induce the banks to contract their circulation, circumstances must have arisen under which the issuing bank would be earning on its outstanding notes a profit smaller than the tax itself. Now, it does not seem certain that an excessive issue of notes would necessarily bring about this condition. In the first place, in the absence of good homing power, a volume of notes in excess of business needs would not necessarily cause an accumulation of those notes in the vaults of the bank issuing them. Secondly, so long as member banks are free to keep their balances in banking institutions other than their reserve banks, an excess of notes would not necessarily cause the general cash holdings of reserve banks to be abnormally large. For, so long as the ordinary New York banks are permitted to pay interest on bankers' balances, country banks will to a considerable extent keep their balances with these outside New York banks; and it seems not unlikely that the excessive monetary stock thus accumulating in New York City would, instead of getting into the hands of the New York reserve bank, largely remain in the hands of the outside banking institutions and be employed more or less as it has been in the past, that is, in financing doubtful enterprises and supporting excessive speculation. But if the reserve banks do not feel the pressure of excessive issues in the shape of accumulations of notes or some form of money in their own vaults, they may conceivably be able to invest advantageously all the funds in their possession, and, in that case, the rate of interest charged by the Federal Reserve Board will not furnish an adequate motive for the retirement of their issues. Doubtless, however, this may in some degree be answered by saying that even an excess which was felt only outside the reserve bank would, after all, compel the reserve bank to contract its issues, since it would lower the rate of discount so greatly that reserve banks could not profitably invest their ordinary holdings, and consequently would wish to get rid of the interest charge. Perhaps this is true; but it would by no means insure the prompt and full contraction which most reformers have considered desirable.

From the foregoing it would seem that one of the devices for inducing the reserve banks to contract their issues after the need for them had passed—that is, charging interest upon such issues—is not certain, at any rate, to prove adequate; it will not surely eliminate the winter plethora in New York City which is supposed to stimulate and support excessive stock speculation. But the new law contains another provision which may be viewed as a device for supplying the issuing banks with a motive for contracting their issues, namely, the requirement that such banks shall keep a gold reserve equal to 40 per cent. of their issues. Is this likely to prove effective? Probably not. Whatever might be true in panicky times, it seems certain that in an ordinary year the gold holdings of a reserve bank will be much above 40 per cent. of its note issue. If this be true, the maintenance of this 40 per cent. could become difficult only when the excess of money was so great as to cause a dangerous exportation of gold from the country, and this surely would show a very inadequate degree of contractility. In short, the new law does not insure that issuing banks shall be sufficiently disposed to draw in their notes any more than it insures that outsiders will drive them in. It would seem, then, that the new law does not promise to give to the note issue the degree of contractility which has hitherto been considered desirable. In other words, there is some point in the fear expressed by many bankers that the new law will result in note inflation—at least in so far as the avoiding of this danger is dependent on the contractility of the note issue. Very likely, however, the possibility of such inflation is sufficiently guarded against by other provisions of the law.