The expansion of note issue is more carefully controlled. Two kinds of notes are provided. The first kind grows out of the necessity of taking care of the bond-secured national bank notes. It was considered unfair suddenly to withdraw the circulation privilege from bonds that had gone to a premium because of that privilege, and, at the same time, it was believed to be essential to guard against the possibility of a sudden contraction of the currency. Hence, a special type of bond-secured "Federal Reserve Bank Note" was devised to supplement and finally to supplant the national bank notes. The second form of note provided for, namely, the "Federal Reserve Note," is intended to be the permanent and elastic type. These can be considered in turn.

The law provides that for a period of twenty years (beginning two years after the law's enactment) a member bank wishing to reduce, or to retire, circulation may apply to the Treasurer of the United States to sell for its account the necessary amount of its bonds deposited with the government. These applications are to be turned over to the Federal Reserve Board at the end of each quarter. The Board may then require the federal reserve banks to purchase such bonds up to %25,000,000 per year, allotting the purchases to the several banks on the basis of proportionate capital and surplus. The reserve banks may then deposit such bonds with the government, and may take out notes which are their own obligations, and which are of the "same tenor and effect" as national bank notes. These are the "Federal Reserve Bank Notes," and are issued and redeemed under the same terms as national bank notes except that the total amount issued by a reserve bank is not limited to the capital stock of such bank.

Expansion

Federal reserve bank notes

Should the federal reserve bank prefer, however, not to issue notes under this provision, it may, with the permission of the Federal Reserve Board, turn over to the Secretary of the Treasury the 2% bonds bearing the circulation privilege, but against which no circulation is outstanding, and get in exchange one-half of the amount in one-year 3% United States gold notes, and one-half in 3% gold bonds. But, at the time of making the exchange, the federal reserve bank must bind itself to purchase, at the maturity of the notes, an equal amount for gold, if so requested by the Secretary of the Treasury, and to renew the obligation annually for a period of thirty years. The significance of this strange provision lies, of course, in the availability of the one-year notes as quick assets. At a given moment they could be quickly sold by a bank, even though, some months later, the bank had to purchase with gold a new lot. Should it so desire, the federal reserve bank may, with the approval of the Reserve Board, exchange the notes for more 3% bonds. These bonds have not, of course, the circulation privilege.

The elastic notes in the new system are known as "federal reserve notes." These are the obligations of the United States government itself. They are issued at the discretion of the Federal Reserve Board, to the federal reserve banks, and through the federal reserve agents.

Exchange of bonds with circulation privilege

Federal reserve notes

The notes are to be held in readiness at the Treasury, at sub-treasuries, or at the mints nearest to the federal reserve banks for which they are prepared. They are issued in denominations of %5, %10, %20, %50, and %100, and they have on their faces the numbers of the banks through which they are issued, each federal reserve bank having for this purpose a distinctive letter, serial number, etc.

Federal reserve notes are receivable by the federal reserve and by member banks, and by the government for all public dues. They are not legal tender in payments to individuals; but this will not seriously influence their acceptability. They are redeemable in gold on demand at the treasury in Washington, and in gold or lawful money at any federal reserve bank. Furthermore, they constitute a first lien against the assets of the reserve bank through which they are issued.

When it wishes to issue notes, a federal reserve bank makes application through its federal reserve agent. As special guaranty for the notes, it must supply an equal amount of collateral made up of notes, drafts, bills of exchange or acceptances which it has rediscounted, or bills of exchange indorsed by a member bank and bankers' acceptances purchased in the open market. The Reserve Board may call for more collateral should that be deemed necessary, but the point is that the major portion of the reserve banks' normal investments become thoroughly acceptable cover for note issue. The transformation of credit from deposit form into note form ought not, therefore, to be a matter of difficulty. By amendment, in June, 1917, gold and gold certificates were also made legal cover for reserve notes.

A limitation of note expansion is implied in the reserve prescriptions. The reserve banks are required to hold a reserve in gold (not simply gold or lawful money as with deposits) of 40% against federal reserve notes in actual circulation, and not offset by gold or lawful money deposited with the federal reserve agent for the purpose of retiring notes. Since June, 1917, gold and gold certificates deposited as collateral may be counted as a part of the required reserve against notes. The effect of this appears to be the changing of the legal basis of note issue from a minimum of 100% paper and 40% gold to 60% paper and 40% gold.1 A part of the gold reserve must be deposited with the United States treasurer. How large this part should be is left to the discretion of the Secretary of the Treasury, but it must in any case be not less than 5%. But here, too, a more adjustable check is provided in the authority vested in the Reserve Board to grant in whole or in part, or to reject altogether, the application of a federal reserve bank for notes, and to fix a rate of interest on notes, the collateral for which is something other than gold or gold certificates. In an article in the North American Review, for October, 1913, Mr. Paul M. Warburg criticises the arbitrary power granted to the Federal Reserve Board over note issues. The probability is, however, that the provision for a possible interest charge on note issues was regarded as an emergency expedient to prevent inflation. Ac in the case of deposits, so in the case of notes, in order to prevent the reserve requirements from acting under all circumstances as a "dead line" authority is granted to the Reserve Board to suspend the reserve requirements for thirty days, and to renew the suspension for periods of fifteen days. But in order that needed expansion may not degenerate into out-and-out inflation, the Reserve Board is required to establish a graduated tax of not more than 1% per annum on the deficiency in the reserve below 40%, and above 32 1/2%, and of not less than 1%% per annum on each 2 1/2% that the reserves diminish below 32 1/2%. Furthermore, to insure that this tax also will have the proper discouraging effect on the ultimate borrower, it is required that while in first instance the tax is paid by the federal reserve bank concerned, the bank itself must add an amount equal to the tax to the rates of interest fixed by the Federal Reserve Board. Thus while expansion of note issue to meet real demand is provided for, the necessity of guarding against over-expansion has not been neglected.

How issued

Denominations

Tender and redemption

Cover

Control of note expansion

Prescribed reserves no "dead line"

1 This is, however, not a weakening of the notes. In any case a bank has assets equal to liabilities and reserve notes enjoy a prior lien against all assets.

The law contains a series of provisions designed to insure contraction of notes when demand falls off. The notes may not be counted as lawful money for reserve purposes, either by member banks or by reserve banks. It is therefore to the interest of a member bank to deposit in its reserve bank as speedily as possible all federal reserve notes that it receives as deposits, excepting in so far as it may need a portion of them for till-money purposes. There is a certain inconsistency here, since deposits in the reserve banks are regarded as reserves by member banks. This inconsistency, however, as in the case of the provision for a possible interest charge on note advances, finds its explanation in the desire to exert upon the notes such pressure as may be necessary to enforce their redemption. Nevertheless, the Reserve Board is on record in favor of making federal reserve notes lawful money for reserve purposes for member banks.

Another provision, the purpose of which is to stimulate redemption, is that which not only specifically requires reserve banks to return each other's notes, either to the original bank of issue or to the treasury for retirement, but which also imposes a penalty of 10% of the amount involved for the paying out by one reserve bank of the notes of another. The reserve banks must also reimburse the treasury for notes redeemed there; and if in redeeming such notes, the treasury paid out gold or gold certificates, the Secretary of the Treasury may demand reimbursement in like funds. The notes received by the treasury otherwise than for redemption may be exchanged for gold out of the redemption fund or may be simply returned to the issuing bank for the credit of the United States. The results of these alternatives may or may not be the same. Redemption in gold, on the basis of 40% reserves, means a contraction of $250 in credit for each $100 worth of notes redeemed. Returning the notes for government credit means simply a transformation of credit from note form into deposit form. As the reserve required against deposits is smaller than that required against notes, the net result of this alternative may be further expansion rather than contraction. Still the result is the same if the gold taken from the redemption fund is immediately put back into the banks. In both cases, however, there is the initial redemption which is the important consideration. In the case of redemption in gold, the redemption can be made more than doubly trenchant simply by holding the gold in the treasury. Should reserve banks desire of their own accord to reduce their note liabilities, they may do so by depositing with their several reserve agents, notes, gold, gold certificates, or lawful money. As amended in June, 1917, the law permits gold turned over to the treasury for redemption purposes, and taken from the fund held by the federal reserve agent as collateral security, to be still regarded as collateral security just as if it were deposited with the reserve agent.

Contraction

Contraction of notes in response to falling demand would seem therefore to be reasonably assured under the new system.