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 circ.u.mstances 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) ill.u.s.trates 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 a.s.sumed normal proportions.
For the Canadian statistics involved the editor is indebted to Mr. G. W. Morley, Secretary of the Canadian Bankers"
a.s.sociation.]
[Ill.u.s.tration]
NATIONAL BANK NOTES UNSOUND AND UNSAFE
[257]... Any correct system of credit currency must be based on a foundation of gold. Bank credit is issued in the two forms of deposits and notes. The former are based on a reserve of gold, the latter are not. We have here a fundamental weakness of our bank-note system. Under proper banking methods, deposits cannot expand without a proportional increase of the gold reserves of the banks. This furnishes the natural and necessary check to inflation. Our bank notes, however, have no such connecting link with the business and the monetary stock of the world.
The basis of the American bank-note currency is the government debt, a very inferior kind of foundation. Such a system carries with it the possibility of paper money inflation of a peculiarly dangerous kind, because its real meaning is apt to be concealed. For example, between January 1, 1900, and January 1, 1908, the volume of national bank notes outstanding increased from $246,000,000 to $690,000,000, an expansion of $444,000,000. In other words, the circulation nearly trebled in eight years. The cause of this great increase was not the need of more currency but the changes in the National Bank Act made in 1900, changes which made the establishment of national banks easier and the issue of notes more profitable.... The future is likely to witness further expansion, unless some change is made in our system.... It is undoubtedly the present intention to give ... to future [bond] issues [the privilege of being used as security for notes]. Indeed, unless this privilege is given, there will be no market for the 2 per cent. bonds.
We may expect, therefore, to see each issue made the basis of a further increase in the volume of bank notes.
All this means inflation, and inflation by means of a circulating medium having no connection with the gold stock of the world. To make room for the additional currency, gold must be forced to leave the country, and our whole monetary system, by no means too strong to-day, will be weakened at its foundation. This is the fundamental difference between expansion of credit by means of deposits and expansion by means of national bank notes. The one is based on gold; the other is based on the government debt. When deposits expand, the reserves of the banks must increase proportionately and, if carried far enough, the result must be to bring in gold rather than to force it out. In like manner, deposits cannot for any considerable time be in excess of business needs. But bank notes may be increased indefinitely, if the Government only borrows enough, and the result will be the expulsion of gold whenever the currency becomes redundant. That this is an actually present danger is sufficiently demonstrated by the recent action of the Secretary of the Treasury, who has seen fit to add to the national debt at a time when the Treasury had a surplus of over 250 millions, for the sole purpose of increasing the circulation of the national banks. Our currency system can never be sound until the bank circulation is entirely divorced from the government debt.
The danger of inflating our monetary system with bank notes having no gold reserve back of them is all the more serious from the fact that the notes of the national banks are used as reserves by state banks, private banks, trust companies, etc. They are part of the "cash reserves" on which these banks base their deposits. Thus we have a system of credit based on credit, and any weakness in the national bank note is carried over and multiplied in the deposits of other banks.
The complete _reductio ad absurdum_ of this multiple credit system came when at a recent convention of the American Bankers" a.s.sociation it was seriously proposed that it be made lawful for national banks to count their notes as "lawful money" in their own reserves. There is good reason to believe that this is actually practised to some extent by national banks to-day, though the practice is, of course, illegal.
The safety of the national bank notes is seldom questioned. Whenever the evils of our currency system are pointed out and plans for a.s.set currency or other reforms are proposed, the reformer is apt to be met by the reply that, at any rate, our bank notes are perfectly safe, and we had better put up with their other shortcomings rather than launch out on new schemes which may possibly sacrifice that safety which we now enjoy. The foregoing discussion should already have cast some suspicion on this complacent att.i.tude. It will be further weakened by a closer a.n.a.lysis of the basis of the national bank circulation.
National banks may issue their notes up to the amount of their paid-up capital, and up to 100 per cent. of the par value of United States bonds deposited with the Treasury, but never in excess of the market value of the bonds. The notes are engraved by the Government and issued to the banks. When signed by the proper officers of the bank, they become the bank"s promise to pay upon demand and may be issued for circulation. The United States Treasury is also required by law to redeem on demand all notes of national banks presented to it. For this purpose each bank must keep with the Treasury a reserve fund equal to 5 per cent. of its circulation. The duty of the Treasury to pay notes on demand, however, is not limited to the amount of this reserve, but applies to all notes properly presented. In case of the failure of a national bank, the Treasury is required by law to immediately redeem all its notes. The Treasury is secured against loss by the bonds deposited, by the 5 per cent. cash reserve, by its prior lien on the a.s.sets of the banks, and by the personal liability of the stockholders for an amount equal to their stock investments.
It is thus seen that the popular idea that the holder of a national bank note is secured against loss by the government bonds deposited in Washington is not strictly correct. What protects the holder of a note is the absolute responsibility of the Treasury to redeem all notes on demand. The bonds are to secure the Treasury, not the individual noteholder, against loss. The noteholder is secured so long as the Treasury is able to meet its legal obligations.
Let us examine the character of our government bonds as security to enable the Treasury to meet its obligations. To understand the situation, it should be remembered that the leading purpose in the establishment of the national banking system was not the creation of a scientific currency system. The National Bank Act was a war measure enacted largely for the purpose of improving the market for government bonds during the Civil War. It was for this purpose that the circulation of state banks was forced out of existence by a 10 per cent. tax and the right of issue restricted to national banks on condition of the deposit of government bonds as security. In the accomplishment of this purpose the act has been eminently successful. United States bonds have been given a new utility over and above their utility as an investment. From the very beginning, this has given them an added value and enabled the Government to borrow at lower rates of interest than it would otherwise have had to pay. The act of March 14, 1900, made provision for the ultimate refunding of all the United States debt into 2 per cent. bonds, and gave an added inducement to the use of these bonds as note security by lowering the annual tax on circulation from 1 per cent. to one-half of 1 per cent., provided the notes were secured by the new 2 per cent.
bonds. All bonds issued since 1900 have borne 2 per cent. interest. Yet the market value of these bonds has always stood above par....
Obviously, this value is not based on earnings. British consols paying 2-1/2 per cent. are to-day quoted in the neighborhood of 85, which makes them yield about 3 per cent. on the investment. The French and German 3 per cent. loans are both considerably below par. United States bonds have been given an artificial value through their use as security for bank circulation. The national banks to-day hold for this purpose about two-thirds of the total funded debt of the United States. Remove this privilege from the national debt, and we should see the 2 per cent.
bonds (which compose two-thirds of the interest-bearing debt of the United States) fall to perhaps seventy cents on the dollar, very likely even lower.
Here we have a remarkable situation. Our national bank notes are safe because they are secured by government bonds, and our government bonds are valuable because they are security for national bank notes. This looks very much like lifting oneself by one"s bootstraps.
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 a.s.sets of the banks. But this leads us to the important conclusion that the final security for our bond-secured notes rests on the a.s.sets of the banks after all. A more striking argument for a.s.set currency could hardly be discovered.
It must be remembered, however, that the foreclosure by the Government of its claim on the a.s.sets 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 antic.i.p.ating 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 a.s.sumes 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.)
The equation of profit or loss on taking out circulation then reads:
yz + bx - xz - c = profit or loss.
But circulation taken out (b) can never be greater than the amount of money paid for the bonds (z).
If government bonds should be at par or at a discount, the nominal profit would always be just the basis interest on the bonds, less the tax and the cost of taking out circulation, or a constant advantage in the case of the 2"s of 1.437 per cent. For the purpose of this discussion we will consider only the 2"s of 1930.
In the regular case, then, the money paid for the bonds (z) is greater than the amount of circulation received (b). With that statement in mind we can draw certain very definite conclusions about our circulation direct from the equation we have formed; z is greater than b.
Repeating the equation in order to have it directly before us:
yz + bx - xz - c = profit or loss.
Then as the current interest rate (x) increases, if all the other quant.i.ties remain constant, the negative influence in the equation grows greater, or profit from circulation decreases. We can, then, make definitely:
STATEMENT I
_If all other circ.u.mstances remain the same, circulation grows less profitable as the current money rate advances._
As business increases and the demand for both credit and money increases, as reflected in the rising interest rates, taking out circulation _caeteris 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 quant.i.ties of the equation is growing less. Then follows:
STATEMENT II