Basis of Security of Commercial Paper Considered in the aggregate, the security which true commer cial paper represents is the security furnished by the purchasing power of the population and the general condition of trade and industry as a whole. It is based upon the capacity of the popula tion to consume and pay for a definite quantity of goods which are the products of past operations. It rests upon consuming power. But loans, the proceeds of which are used to carry on speculative operations, give no assurance that the borrower will be in a better position to liquidate at maturity than he was at the time of negotiation.
So long as bank paper is limited to strictly commercial paper credit inflation is less possible; and the aggregate of commercial paper must be as sound as the business community itself. It is in consideration of this that the Federal Reserve Act restricts rediscounts to paper arising from commercial, industrial, and agricultural transactions. The promissory note does not always show the nature of the transaction by which it is created, much reliance, therefore, must be placed upon the honesty and character of the borrower. Single-name paper, inasmuch as it does not disclose the exact nature of the use to which the pro ceeds are put, requires that great care and discrimination be exercised on the part of the bank; and since it is so generally accepted by banks as the basis of loans it is difficult to know what paper is strictly commercial, and bankers vary in their definition.
The Open Account and the Discount Market Before the Civil War the commercial practice was to close the contract of sale at the time of sale, by the buyer giving his note to the seller, or by the seller drawing on the buyer who accepted and returned the bill. The country merchant visited personally the jobbing market at periodical times and bought heavily, giving his note or acceptance, which he paid at his next visit. Several factors combined during and shortly after the Civil War to sub stitute the open account, cash discount system. The wide fluc tuations in the value of the greenback made long periods of credit undesirable to the seller, and to induce prompt payment cash discounts were devised and the period of credit shortened.
Transportation and communication facilities also developed, so that it was no longer necessary to buy in large lots and single shipments or make personal visits to the jobbers. The average size of bills declined, and one loan from a bank was procured to cover what would otherwise occasion many acceptances or notes, as the settlement of accounts of such small size with notes or acceptances would be bothersome. The improved means of com
munication and travel gave rise to the traveling salesman and sale by sample; except in seasonal lines, visits to the jobbing center by the retailer gave place to regular visits to the retailer by sales men with samples. So long as the buyer bought by personal se lection from an accumulated stock he bought by the rule of caveat emptor; but when he buys on the basis of samples he does so under implied warranties, that is, that the goods delivered conform to the standard of the sample; and since the buyer hesitates to pay until the goods are received for inspection unless he receives due induce ment, there arose the practice of consignment on open account and of allowing discount for cash within ro days, whether the goods had arrived by that time or not. Local banking facili ties also developed by which the local dealer could borrow on his unsecured note to avail himself of cash discounts offered him.
The absence of double-name paper and a discount market and the existence of the single-name, cash discount, open account system in the United States have been characteristic of our bank ing and mercantile system for the last fifty years and stand in contrast to the European systems which are based upon the acceptance method. To a degree this distinctiveness has been unfortunate, for it isolated us in international finance and also forced our bankers to an undue dependence upon the stock market. One object in the mind of the framers of the federal reserve was to provide facilities for financing foreign business after the manner of the rest of the world, to divorce the commercial and financial loan markets, and to create strictly commercial forms of paper and a discount market.
Open-Market Borrowing Wider mercantile operations and national advertising and the development of credit investigation have given certain houses a national reputation and enabled them to borrow widely in the open market. These loans are procured by flotation of paper through note-brokers. Such paper is sometimes distinctively called " commercial " paper. The nomenclature, however, is not apt, since it confuses the fundamental nature of commercial paper —it may or may not be used in whole or part to finance strictly commercial transactions, and it usurps the name of paper that is assuredly so used. If such paper is constantly renewed it means that the borrower is procuring fixed capital by means of short term obligations instead of bonds.