Convertible Paper. The second class of paper money has a fraction of its face value held in reserve in standard money, to meet demands for redemption. It is spoken of as "convertible," that is, the Treasury stands ready to redeem it at any time. As long as this convertible money is faithfully and freely re deemed, the promises are worth their face value; any distrust, however, results in a run on the Treasury, which, if great and long continued, may exhaust the reserve fund. The government may also suffer reverses in revenue receipts, or expenditures may be extraordinary, and its ability to carry on conversion may be impaired. While a reserve of ioo per cent is at no time necessary, since there is no probability of a simultaneous demand on the part of all holders, it is nevertheless expedient to keep a considerable reserve; one of the best evidences of the intention and ability of the government to fulfil its promises to redeem is the creation and maintenance of a special fund for this purpose. The fund should be separate from the general funds of the Treasury and be used exclusively for redemption purposes; the size of the fund must vary with the probability of the demand for conversion, which must be determined from experience and from the contingencies of the government credit.
It is also important to note that ultimate redeemability is not equivalent to immediate convertibility. If the paper is immedi ately convertible it stays at par, but if redeemable only after a period of indefinite length it will be regarded as an investment or as a deferred payment, and its present value will differ from its face value by discount for interest and risk. In this case it does not matter whether the issuing government is rich in natural resources; it is the present means of payment that maintains the parity.
The reserve held may be determined in several ways, such as the following: It may be a minimum percentage required, the issue and the reserve bearing a predetermined minimum ratio; or it may be a certain fixed minimum quantity of specie whose ratio to the issue would vary inversely with the amount of issue; or the reserve may consist of securities and gold, the law fixing the maximum amount of the " uncovered " issue (the notes backed by the pledged securities) and requiring the excess above that amount to be " covered " by roo per cent of gold.
Inconvertible Paper. The third class of government paper money is variously called "fiat" money, "political" money, and "in convertible" paper money. This kind usually results from exces sive issues of convertible paper money so large that the citizens doubt the government's ability or intention to redeem on de mand, a doubt which is later justified by an actual suspension of specie payments. These inconvertible bills are promises of the government to pay on demand, though at the time of issue the government may have no intention of keeping its promise.
Sometimes they are issued as orders on the Treasury to pay upon demand, the government well knowing the Treasury's inability to meet such demands; and sometimes they are simply printed statements proclaiming the bills to be the equivalent of such and such amounts of metallic money.
Value of Inconvertible Money To give acceptability to inconvertible paper, the government usually makes special provisions. One is to declare it legal tender in payment of private and public dues. Unless the people unite to boycott the use of inconvertible money, the government's legal sanction can force its receipt at par for debts, with the result that its acceptability for other purposes will follow. Of course, the existence of inconvertible money does not prevent a creditor from contracting in terms of gold, nor does it prevent his asking a higher sum in payment, if the contract be drawn in terms of general money. Its depreciation may, therefore, persist despite legal-tender laws.
The extent to which the paper declared is legal tender may, however, be limited to the payment of taxes and debts to the government. If issued in anticipation of taxes soon to be levied and in amounts equal to those taxes, it will likely keep at par, for the people accepting it will really be paying their taxes in advance, and when the taxes come due they will not care whether they pay in standard or in inconvertible money. Such issues will not be excessive; the tax levy will act as governor of the issue, and loss of faith in the issue is, therefore, unlikely. If, however, issues ex ceed taxes, laid or to be laid, the volume of circulation will be inflated by the excess.
The above methods of promoting acceptability and maintain ing parity are unavailing if the issues become excessive. The volume issued may be so large as to discredit the government's ability or intention to redeem, and far exceed its capacity to absorb by way of taxes. Depreciation then becomes inevitable. After the public has become used to convertible paper a certain volume that is inconvertible will by force of habit circulate with out question. If the issue thereafter is limited to the growing needs of business at the existing price level, there will be no depre ciation; greater issues, however, will result in depreciated values in terms of gold inversely proportional to the volume. The most effectual method of maintaining the value of inconvertible money is, therefore, to limit its issue. There is no way of determining in advance the amount which a country may issue and keep at par; the risk is psychological, varying with the people, time, and con ditions. In times of peace, normal order, and ready collection of taxes, a much larger sum of credit can be supported than in times of panic, war, or falling tax receipts.