Inability to meet changing demands is a serioi thing

Stringenc unsettles business

Impediments in the way of the inter-transformability of the two forms of bank credit may have a similar effect. As a practical matter the transformation of note credit into deposit credit involves no difficulty. The notes representing the more generally acceptable medium can easily be converted into the less generally acceptable form through the simple process of depositing. There has been no occasion for the public authorities to step in and interfere with this process. The transformation of deposits into notes, however, is a different matter. For reasons sufficiently discussed in an earlier chapter the state has almost everywhere thrown its protecting arm around the noteholder, and the particular measures of protection employed have usually involved considerable restriction of the right freely to issue notes. But inability to issue notes when the demand for them increases tends to bring about a condition of stringency.

An increase in the demand for hand to hand money is first indicated by a withdrawal of such money from the banks in the neighborhood where the increase in demand originates. It may thence be transmitted to banks in other neighborhoods. If the banks concerned may meet the increased demand through an enlarged issue of their notes the general credit situation, as far as they are concerned, remains the same as before. Other things being equal, as was shown in a previous chapter, it is, at a given moment, virtually a matter of indifference to a bank, which of the two possible forms its credit may take. But if it be impossible for the banks to increase note issue, and thus to transform deposits into notes, then the only alternative that presents itself is the payment of "lawful money" drawn from the reserves.

The money issued by the government and available by law for reserve purposes is at any given moment being used in one of three ways. It may be used in transacting exchanges; it may be used in the pockets of the people and in the tills of storekeepers as a store of value, or it may be found in the vaults of banks or similar institutions as a reserve for credit. The last named use, notwithstanding its great economy, is, however, subservient to the other two. It is a residual use, for only such money not wanted as a medium of exchange or as a store of value flows into the banks for reserve purposes. In the same way, in any necessary readjustment between these uses, the credit use must give way to the other two. The success of the whole credit system depends upon maintaining this subserviency, - namely, upon meeting with lawful money all obligations to pay this money when such obligations are presented for payment. When, therefore, there arises an increased demand for hand to hand money, as normally evidenced by a withdrawal of bank deposits, and when it is impossible for banks to meet this demand with an increased issue of their own notes, there is no alternative for them but to draw on the cash reserves in their vaults.

Impediments in the way of note-issue have similar effects

The depletion of reserves, however, carries with it a necessary curtailment of credit. It was shown in a previous chapter that a dollar added to the reserves adds from two up to ten dollars to the bank's loanable resources. Similarly, every dollar withdrawn from reserves necessitates a corresponding contraction of such resources. In the face of withdrawals of cash the banker is forced to call in loans subject to call; maturing loans are not renewed and applications for new advances are severely discouraged. In other words a stringency in the money market is brought about, and, as described above, discount rates advance, liquidation is forced, prices drop, and even panic may ensue.

Panics are, of course, both directly and indirectly costly. The very word is the antithesis of the confidence underlying the credit upon which modern business is so largely dependent. The prostration of confidence and credit today means as well a prostration of business. Hence there usually follows in the wake of a panic a more or less prolonged period of business depression. Wealth production is curtailed, hardship and misery are endured, and only after a considerable lapse of time is confidence renewed and courage restored. The big cost to society is made up not so much of wealth destroyed, because there is no necessary destruction of wealth in the severest panic, but rather of the wealth that might have been, but was not, produced. But when closely regarded every stringency bears all the earmarks of a full-fledged panic. The difference between the two, while large, is as far as effects are concerned, simply a difference in degree. Every stringency carries with it the necessity of some liquidation and some read justment, and during such a stringency optimism is in some degree restrained and production in some measure curtailed. Were it possible to provide against them, it would be eminently desirable to avoid both stringencies and panics.

Inability to issue notes when needed throws the demand on reserve money

Depletion of reserves necessitates curtailment of credit

Panics and periods of stringency are costly

It may be concluded, therefore, that bank credit will function most efficiently when provision has been made for a reasonable expansion of both forms and for a ready transformation of one form into another.

Selected References

C. F. Dunbar, Chapter on the Theory and History of Banking (1906), Chapters IV and V.

" Deposits as Currency " in Quarterly Journal of Economics, I, July, 1887. Robert Giffen, Essays in Finance (1886),

"Trade Depression and Low Prices." E. W. Kemmerer, Seasonal Variations in Demand for Currency and Capital (Volume 22, Publications of the National Monetary Commission). David Kinley,

The Use of Credit Instruments in Payments in the United States (Volume 6, Report of the National Monetary Commission).

Report of Monetary Commission of Indianapolis Convention (1898), Part II, Sections 137-140 inclusive, and Sections 207-210 inclusive.