15. Inelasticity of government credit money.— Since changes in the gold supply are felt effectively only thru the resulting changes in the supply of credit, it is important that the credit system of a country be properly organized if elasticity is to be se cured. One of the forms of credit most widely used is government credit money, such as the greenbacks of the United States and the Dominion notes of Canada. Government credit money cannot be made elastic, for the simple reason that no credit money can be elastic unless it is issued in exchange for com mercial paper; and that, for obvious reasons, no gov ernment can go into the business of discounting and purchasing commercial paper. This practice would throw open the gates to such a flood of corruption, and would lead to such a state of governmental pater nalism, that it is not to be thought of under our present political organization.
Since a government cannot make its credit money elastic, it should leave the issue of credit money to the banks under such conditions as will secure sound ness. The issue of subsidiary coins does not meet with the usual objection that is made in regard to the issue of government credit money. Indeed other money issued in limited amounts does no harm so long as the amount so issued does not exceed the demand of business when at its minimum. Up to this mini mum amount there is no need for elasticity, and there are many reasons why coins should be issued only by the government, or, at least, under strict governmen tal supervision. Credit above this minimum should be issued only by banks and by business men. As much of this credit as is intended for general circula tion, as a substitute for money, should be issued by the banks.
16. How bank notes can be made notes can be made elastic only by permitting the banks to issue them in exchange for commercial paper. When a business man wishes to buy something and has not the necessary cash, he can always borrow at the bank if there is a good reason for making the purchase—that is, if his wish is backed up by real ability to pay the market price. The bank may give him a deposit in exchange for his promissory note. Bank notes can be had if checks cannot be used, and the business demand for a medium of exchange is satisfied, provided the bank is permitted to issue notes against the commercial paper. Many occasions arise when there is need for some medium having a wider acceptability than a check. The issue of notes on the basis of commercial paper is in accord with the "banking" principle of issue mentioned in Sec tion 12.
We have already pointed out the danger of over expansion and the safeguards that should be provided, viz., the maintenance of adequate gold reserves, the provision for swift and sure redemption, the intelli gent scrutiny of all commercial paper that is offered, and a close observation of general business conditions. The use of any kind of credit contains an element of danger, but this fact is no argument that it should be abandoned entirely. We take the risk of using steam and electricity for the conveniences which they bring, altho the danger of death from an explosion or by electrocution is ever present.
In the next chapter there will be a discussion of the elasticity of bank deposits and of the credit issued by business men.
17. Profits from issue.—Some people are unable to see why banks should be allowed to issue and charge interest upon notes for which they pay no interest.
When a merchant exchanges his promissory note for the note of a bank, why should his note be discounted when he accepts the bank's note at par? There are two reasons. In the first place, the bank's note is worth more to the merchant than his own note. The bank's credit is better known. Then it must not be forgotten that the merchant's note is a time promise, whereas that of the bank is payable on demand. This is the real basis for discounting paper.
The profit to a bank from the issue of notes results from the fact that under a simple reserve system, the loanable funds of the bank are increased, while under a system of bond-secured notes, the return on a given investment of capital is greater than if the same amount were employed in making, loans only.
Suppose a bank is permitted to issue notes on carry ing a 60 per cent reserve against circulation, and pays a tax at the rate of one-half per cent per annum. Profits, as shown in the following table, will result.
The $1,800 interest foregone would have been earned on the $30,000 if loaned outright. The profit of $887.50 is made over and above this, so that the bank's percentage of profit on the amount of capital tied-up, i.e., $30,000, is about 2.96 above what could have been made by simply loaning the money out right.
In the foregoing illustration, it is assumed that only the $30,000 could be loaned. This would be true if the bank's customers were demanding cash and could not use checks. In ordinary times, how ever, borrowers leave the proceeds of loans on de posit ; and the bank finds it possible to loan, not merely $30,000, but even $150,000—assuming the proceeds of all loans to be left on deposit and a 20 per cent reserve to be held against deposits. Evidently, it is more profitable to loan $150,000 outright than to issue $50,000 in notes and loan them.
In ordinary times, then, which is the more profitable.
note issue or direct loans? The answer depends upon which ties up the larger ratio of cash, whether a larger reserve is required against notes or against de posits.
In our national banking system, the reserve against notes is only 5 ger cent while that against demand deposits runs from 12 to 18 per cent. Note issue would be much more profitable than direct loaning if our banks were not required to use so much cash in the purchase of bonds. The following table illustrates the point : In spite of the small profit and the risk involved, national banks find it worth while to issue notes, Even under the conditions assumed in the first illus tration, it would be profitable to issue notes at certain times. Business men may demand a medium of ex change which has a wider acceptability than that pos sessed by the check. If so, they will begin to draw cash out of the bank and to deplete its reserve. Under these circumstances, the ordinary reserve against deposits is not nearly sufficient. If a run is actually made, the bank may need cash up to 75 or 80 per cent of its deposits. The bank can protect its cash reserve by issuing notes, for notes do as well as gold unless foreign payments are to be made. When business men demand some kind of cash and will not leave their funds on deposit, the bank gains by issuing notes to protect its reserve so long as the amount of cash tied up in the operation does not equal the amount of notes issued.