One method for bringing about the desired correlation between the expansion or contraction of the volume of bank notes and the increased or lessened demand of the business world is to allocate the issue function to a central body and require the pledge of strictly defined commercial paper, bearing evidence of its commercial origin and use, as the basis of notes issued. If the quantity of such eligible paper increases in response to seasonal development of trade, more may be pledged as security for bank note issues. When business again slumps, the payment of the commercial paper will recall the bank notes.
It is evident that such seasonal responsiveness is defeated if the volume of bank notes depends upon long-term investments instead of self-liquidating paper, for there is no assurance that the funds are being used for the alleged original purpose, or, having been so used, that they are not being used in subsequent illegitimate operations. Moreover the loaning bank, feeling amply secured and perhaps therefore indifferent as to the uses to which the loan is put, may freely renew the loan until it becomes practically a continuous loan; the request for renewal would never have been made, however, if the loan had been self-liquidating. The ideal collateral for bank note issues is, therefore, strictly self-liquidating commercial and industrial paper of short usance.
It is not impossible, of course, to effect elasticity, even though the bank notes are secured by pledge of stocks and bonds or other permanent investments, provided bankers assure themselves that the funds are used in short-term commercial and industrial ways and that they are withdrawn from circulation when those uses have ceased. In fact, it may be very desirable to issue bank notes freely upon the basis of promissory notes secured by pledge of bonds and other investment securities. In the United States during the late war, the great disturbances of the money market occasioned by war financing were very much alleviated by the legal possibility of rediscounting such war paper and procuring in this way federal reserve notes or credit with the federal reserve banks. In this case the need for currency was oftentimes too suddenly and too greatly increased to place dependence upon pledging strictly commercial paper, the volume being too small or too constant, and it was expedient, therefore, to provide for direct loans by the federal reserve banks against government securities, or for rediscounting war paper given to member banks by loan subscribers.
If no limitations are laid by law on credit issues, the bankers will of their own accord normally provide elastic note issues and elastic deposit currency. The needs of the business world will be indicated by the aggregate of applications for loans and by the rates of interest that borrowers are willing to pay. As loans and discounts expand, deposits and note issues will expand in piopor-tion; and subsequently, when business men sell their stores of goods or realize upon their customers' accounts, the loans at the bank will be lifted, the deposits canceled, and the notes retired. If the state requires a minimum percentage reserve in gold against notes or deposits, or both, it is evident that a maximum for the issue is fixed by the gold in the bank's reserves. If the state goes further and allows issues only against certain assets specifically pledged, a more rigid limit is put on the issue and, as in the case of our national bank note, all elasticity may be forfeited. The federal reserve system has a plan for pledging commercial papers as collateral for notes which achieves elasticity of issue.
Elasticity cannot be attained simply by providing a means of expanding the issue; it must also provide for contracting the issue by redemption when the exigency has passed. If a banker might issue his own notes freely, self-interest would incline him to withdraw from circulation the notes of other banks and fill their place with his own; if he could not use them for reserves nor pay them out over his counter, they would be idle funds in his hands and he would send them for redemption at once. If a loan were paid with bank notes of the loaning bank, the notes in circulation would contract by that amount; if it were paid with bank notes of another bank and the loaning bank were to send those notes immediately to the issuing bank for redemption, the circulation would be likewise reduced; under such conditions, checks and bank notes would be cleared at once and together. This is the situation in Canada.
It is to be noted that the restrictions which defeat elasticity of bank notes may not defeat elasticity of the country's aggregate currency; elasticity may be secured through issue of government paper money or by deposit currency. England, for example, has a very inelastic bank note system, but its deposits expand and contract freely to conform with business needs. If the deposit-check system is thoroughly understood throughout the country, there is relatively little need of an elastic note issue. In actual practice, however, large industrial classes, such as wage-earners, and large geographical areas, such as the agricultural South and Northwest of our own country, find checks inconvenient, and the seasonal demands for means of payment are best met by an elastic note issue. As deposit banking permeates the United States the evils of the inelastic national bank note are reduced.