13. Need for a central long as a bank is able to extend loans it can furnish its customers with deposit accounts which serve the purposes of a medium of exchange for most ordinary transactions. But the bank may reach the limit of its loaning power. The cash may get so low that it cannot risk the as sumption of any more deposit liabilities. Borrowers with urgent and legitimate demands may come only to be turned away, unless the bank can find some way out of the difficulty. The logical thing for the bank to do at such a time is to take some of the commercial paper in its portfolio and rediscount it with another bank. But all the banks may be in the same position.
If this is the case, the only thing that can save busi ness from a credit and currency stringency is the es tablishment of a great central bank to which all the banks can go to rediscount. But even the resources of such a bank would soon be exhausted if it should pay out gold during a crisis. The central bank should be given power to issue notes in exchange for the paper which it rediscounts. The banks can then pay out these notes and hold their reserves.
Of course, there should be a limit to the amount of notes which the central bank can issue, for it must be able to redeem on demand. The volume of redis counting must then be regulated according to the gold reserve held by the central bank. In later chap ters it will be shown what steps are taken by the great central banks of the world to protect their gold re serves and even to build them up when necessity arises.
14. Relation of business credit to bank credit.— We have attempted to show how the loans of a bank are related to the liabilities that it assumes against them, whether those liabilities happen to take the form of notes or of deposits; and how the liabilities in turn are related to one another, to the gold reserve, to the rediscounting bank and to a general discount market. It remains to be shown how the credit which business men extend to one another is related to the credit extended by banks.
A typical example will serve to illustrate the point : White, a piano manufacturer in Philadelphia, sells to Tyson, a wholesaler in Massachusetts, offering a liberal discount for cash, as he needs working capital.
If Tyson is a good merchant he will borrow from his bank and pay White cash so as to take advantage of the discount. If Tyson cannot borrow, White may have to borrow the funds necessary to cover the trans action, and carry Tyson on his books. If neither can borrow, Tyson must either wait for the goods until he can pay cash, or do without them altogether.
Suppose White borrows and carries Tyson on his books. Tyson sells the pianos to various retailers and carries them; and they, in turn, sell to their cus tomers on the instalment plan. Hard times come, and the instalments are not paid promptly. Retailers cannot pay Tyson, he cannot pay White, and White fails to meet his note at the bank. This is rather an extreme example, but it illustrates conditions in the piano trade and, to a certain degree, it illustrates con ditions in all business.
Of course, it may be said that White, Tyson and the retailers should all carry a heavy cash reserve if they are engaged in that sort of business. They may do it in ordinary times, but a temporary period of prosperity may make them unduly confident. They may not foresee the impending stringency in time to prepare for it. Consequently, they and their bankers too, for that matter, may go along living in a "fools' paradise" until they are caught in the final crash.
At such a time it is highly important that the bank be able to extend White's note. If it cannot, it may spell ruin for White, and perhaps for Tyson and the retailers as well. The bank is likely to have a num ber of notes defaulted at the same time. Other banks may be in the same position. Unless they have a strong central bank to fall back upon, a general crash in business may result. In the last analysis, business credit is absolutely tied to the banking system.
So far, in discussing the need for an elastic credit system, we have laid emphasis upon the side of ex pansion. In later chapters, especially in those on the Canadian banking system and the Federal Reserve system, there will be a discussion of the importance of contractability and of the means by which it can be secured.