In nearly all modern countries bank currency forms an important element of the circulating medium, and, as already noted, the banks are the sole source of paper money in the leading countries of Europe. Bank notes are promises of the bank to pay a specified sum to the bearer on demand. They get into circulation by being paid out by the banks to customers either in exchange for metallic money or for the customer's evidences of credit in the form of promissory notes or bills of exchange. Thus, for example, when a customer has a promissory note discounted at a bank he may receive the proceeds, that is, the face value of the note less the discount, either in the form of money or of a credit on the books of the bank, against which he may draw checks as need arises. If he prefers to accept money, the bank ordinarily will be willing to pay him in any kind of money he chooses. If he has no preference, the bank will give him whatever kind of money is most convenient to itself, possibly its own circulating notes. Unless there is some special reason for distrusting the bank, these notes pass readily from hand to hand, performing all the essential functions of money.
Because the rank and file of people have no means of judging of the solvency of banks issuing notes the conditions under which they are issued and redeemed are usually subject to strict legal regulation. The methods adopted under different currency systems to regulate note issues operate either on the notes themselves, fixing a maximum limit to their volume, or on the reserve.1 Regulation of note issues through the reserves may consist of a requirement that all banks shall keep on hand a certain minimum of specie or securities, or an amount of these equal to a certain proportion of the notes issued. The Bank of England notes, excepting £18,450,000 secured by government securities, are issued only against the deposit of gold. The Imperial Bank of Germany is required to keep a gold reserve of 33 1/3 per cent behind its notes, and when its issues exceed a specified minimum a tax of five per cent must be paid. The note issues of the Canadian banks are limited to an amount equal to their capital stock, except during the crop-moving months, when additional notes may be issued subject to a tax. Since 1913 the Canadian banks have had the right to issue extra notes upon depositing gold with designated trustees. The Bank of France is not required to keep any specified reserve of specie or securities behind its notes, but a maximum limit is fixed from time to time by the Government. Our national banks cannot issue notes in excess of their capital stock or of the government bonds by which they are secured. The new reserve banks authorized by the act of 1913 may issue reserve bank notes up to the par value of government bonds deposited to secure them. The Federal reserve notes, which provide a kind of "emergency currency," cannot be issued in excess of the commercial paper pledged against them, and they are further protected by a gold deposit equal to 40 per cent of the amount issued.
1 For a full discussion of this question see Jevons: Money, Ch. 18; also Kinley: Money, pp. 373-389.
Up to the time of the Civil War a very large proportion of the actual circulating medium of this country consisted of notes issued by state banks. The Constitution expressly forbids the issue of "bills of credit" by the states, but most of the states permitted citizens to organize banks having the privilege of issuing bills of credit, that is, bank notes. In some states the banks were carefully regulated and their note issues were always' redeemable in specie. In many instances, however, there was little or no supervision of banking or restriction of note issues. So-called "wild-cat" banks sprang up, issuing great quantities of notes, with neither intention nor hope of redeeming them. These notes, like the government notes when issued in excess and without adequate provision for redeeming them, soon depreciated and in many cases became worthless. Nearly all banks suspended specie payments in the panics of 1814, 1837 and 1857.
One of the chief reasons urged for the establishment of the national banking system in 1863 was to secure a sound and uniform bank note currency for the entire country. Under the terms of the act of 1863, banks were required to purchase government bonds, against which they were allowed to issue their circulating notes. Existing state banks, however, retained and exercised the right to issue notes, and the paper currency of the country was in greater confusion than ever. To compel state banks to come into the new national system and thus to secure uniformity of note issues, Congress in 1866 passed a law imposing a tax of 10 per cent on the note issues of all state banks. Since it was unprofitable to lend their notes subject to such a heavy tax, and since the issue of notes was one of their most important and profitable functions, most of the state banks entered the national system. Subsequent changes in banking and credit methods greatly lessened the relative importance of bank notes as an instrument for facilitating exchange, so that state banks have been able to carry on a profitable business without the note issuing privilege. But for nearly fifty years after the passage of the act of 1866 no bank notes, except those issued by national banks, were in general circulation.
National bank notes are issued and redeemed under the general direction of a government officer, the Comptroller of the Currency, according to the terms of the National Bank Act, which has assured to the country a sound and a uniform currency. It is uniform because it is issued by all national banks under the same conditions and terms, and it is sound because it is protected by the deposit of government bonds in the United States Treasury, which is in effect responsible for the final payment of all national bank notes. Soundness and uniformity have been gained, however, at the expense of elasticity, the ability to expand and contract in response to the changing needs of business. Fundamentally this is due to the fact that our bank notes are based upon deposits of government bonds in the public Treasury instead of upon the general assets of the bank, which is the practice of most modern banking systems, except those of the United States and England.