It has been pointed out that government paper money lacks that prime essential quality of a good medium of exchange - elasticity - because it is issued primarily to meet the needs of the Government, which needs may not, and usually do not, correspond to the needs of business. An elastic currency can be provided only by some agency which is in constant touch with business, making loans to and receiving deposits from those actively engaged in business, "since such loans accurately represent the needs of the public for money and accumulations of cash in depositories represent surplus funds not needed in business."1 Such an agency is the bank.
Prior to the passage of the act of 1913, however, our national bank system failed to provide an elastic note currency, owing to the fact previously noted that the issue of bank notes was related to government needs and obliga tions rather than to the needs of business. No currency system can be elastic where bonds are used as a basis for the notes. To be elastic, a bank note system must be so regulated that banks will find it profitable to issue additional notes when more currency is needed, as evidenced by the withdrawal of deposits, and to retire them when they become redundant, as indicated by a heavy increase in deposits. But under a system of bond-secured note issues the tendency of bank notes is to contract when expansion is desirable and to expand when the currency is already redundant. National banks were formerly required to deposit with the Treasury government bonds in a certain proportion to their capital. Against these bonds they could issue their own circulating notes up to the par value of the bonds so deposited. To insure the redemption of its notes each bank was required to keep a deposit of lawful money in the Treasury equal to five per cent of its outstanding circulation. When, therefore, large amounts of currency were being withdrawn from the banks, for instance, in the crop-moving season, and they wished to increase their available funds, they found that they could not do it profitably by issuing notes, for they would have to pay more for government bonds, which are usually at a premium, than they would receive in circulating notes. Indeed, in times of active demand for currency, when banks are able to lend all their credit at high rates of interest, it has sometimes been more profitable for them to retire part of their circulation, since for $95 in lawful money sent to the Treasury for note redemption they would receive a bond that might promptly be sold for more than $100. On the other hand, when the currency was already redundant, banks might find it profitable to increase their note issues. When money accumulates in their vaults, banks, rather than have it idle, are tempted to buy government bonds, which return them two or three per cent interest and against which they receive an approximately equal amount of bank notes, which may be paid out to depositors. This is exactly what happened in 1894-1895, although the redundancy of the currency at that time was causing such heavy exports of gold as almost to bankrupt the Treasury. Again, during the business depressions of 1903-1904 and 1907-1908, when the country's need for cash was manifestly declining, the total volume of bank note circulation was very considerably increased.
1 Scott: Money, p. 53.
In considering the question of elasticity it must not be forgotten that in this country banks provide through their deposits a medium of exchange much greater in volume and importance than bank notes and one which is absolutely elastic. Deposit currency, so called, consists of deposits credited on the books of the bank which circulate in the form of checks and drafts. Theoretically there is no essential difference between the bank note and the credit deposit. When a borrower at a bank secures a loan or discounts a note he may take the proceeds in the form of money, say bank notes, or be credited with a book account against which he can draw as he needs funds or wishes to make payment. A check is drawn only when the depositor has some debt to pay and is always immediately available as a medium of payment in any amount not exceeding his deposit credit at the bank. Then when the check has served its purpose it is returned promptly through the banks and the clearing house and is cancelled. In this country the great bulk of wholesale and other large transactions, and a considerable proportion of smaller business exchanges, are performed by this deposit currency, which rises and falls exactly in proportion to the exchanges of goods which call forth loans and bank deposits. Deposit currency makes it possible, therefore, for "any business man to get the money he needs, at the times and in the exact form that he needs it, provided his banker will discount his notes." 1
1 Scott: Money and Banking, p. 113.