One other bad feature of this dependence on government debt is that there is no physical limit to the inflation of notes. If the notes were made dependent on a reserve of gold they could be increased only by some multiple of that reserve, and the reserve could not be increased largely or suddenly since the gold must first be dug from the earth. On the other hand, if the notes were made dependent upon commercial paper they would vary with business need. But the inflation of notes based on debt may come at the very times when the currency is being inflated by gold, and may therefore accelerate the rise of the price level unduly. Such was the case after 1900.
Another disadvantage of national bank notes is that the volume of circulation is at the caprice of the legislature. By permitting banks to organize at smaller capitalization and requir ing them to buy fewer bonds, and by lowering the tax on cir culation, Congress caused a sudden and tremendous expansion in the bank note circulation between 1900 and 1914. National banks of small size were organized in great numbers, particularly in the South and West, and generally in rural districts. It is true that these were the proper regions for the circulation of bank notes, and the increase occurred during a period of rapid in dustrial expansion; but the increase was a factor in unduly accelerating the rise of prices at the time. (See the table, page 234, for the periods of rapid increase and decrease of our bank note currency.) The fact that national bank notes have a 5 per cent redemp tion fund but no strictly reserve fund held against them, is an additional disadvantage. Since they remain in circulation in definitely, the issuing bank usually minimizes or disregards the liability of their presentation for redemption and keeps on hand little, if any, gold for this purpose. But the state banks, trust companies, savings and private banks regard the notes as reserve, in accordance with the law, and base extensions of deposit credit upon them. As a result there is a pyramiding of credit, which extends the weaknesses of the bank notes to the deposits. It was still more dangerous when national banks sometimes, contrary to law, counted the bank notes in their tills as part of their reserve. At present the legal reserve of all member banks of the federal reserve system consists wholly of credits with the federal reserve bank.
Inelasticity The chief criticism of national bank notes, however, is their inelasticity—the quantity of notes does not bear a direct ratio to the volume of business done. Bank notes should expand and con tract in amount automatically with the flow and ebb of business, otherwise there will be a plethora of money in dull times and a dearth of it in good times, fostering high prices and speculation in dull seasons and depressing the periods of business activity. The full profit from the note issue privilege can be earned only if the notes are constantly in circulation; a bank therefore takes out only such circulation as it finds by experience it can keep circulating nearly all the time. The profit on the circulation is so small that it has been difficult to get banks to take out enough to provide for periods of great business activity. On the other hand, the expense incident to the retirement of bank notes has discouraged banks from retiring them whenever business slackens.
The law allows the bank to pay out over its counter the notes of other banks, and in most states to consider national bank notes as legal reserve money. The law also compels every national bank to accept at par the notes of every other bank. The results of these facts are: i. The volume of national bank notes changes relatively little from season to season and from year to year.
2. In dull times the notes drift into the cash of the national and state banks and are paid out over the counter of non-issuing banks, and also drift into the reserves of state banks, and remain out of circulation permanently.
3. The motive for presenting the notes for redemption is minimized, so that most of them are presented only when they become unfit for redemption.
4. When business becomes more active, the volume of cash transactions increases as well as the volume of credit transactions, but, since the bank notes are not increased, the extra money required is drawn from the bank reserves or till money by the public withdrawing from the banks more money than is deposited; this results in "tight money," high interest rates, and contracted accommodation at a time when just the opposites are needed; the inelasticity of the bank notes therefore not only throws upon deposit currency the burden of providing elasticity of credit, but also tends to defeat the natural elasticity of that deposit cur rency.