CHAPTER X

SUMMARY OF THE VIEWS ON THE NATURE AND

UTILITY OF BANKS

The dual rôle of commercial banking. — The utility of banks as source of a form of currency. The utility of banks as distributors of loanable funds.

WHETHER Consciously or otherwise, banks were regarded in their dual rôle: first, as the institutions that provide the community with a large part of its media of payment; secondly, as establishments for the lending of purchasing power. When it was asserted that banks provide an inexpensive currency, that they increase capital in the guise of circulating media, or that they lend elasticity, be it pernicious or desirable, to the media of payment, it was their rôle as a source of currency that was being primarily referred to. But when they were being considered as intermediaries between borrowers and lenders, or as lenders, in addition, of a peculiarly significant credit of their own, it was their function in directing the resources of the country that was being contemplated. Not, of course, that these two aspects of banking permit of separation, except in the abstract and with due consciousness of the limitations of such treatment. It is in placing purchasing power in the hands of this or that entrepreneur that banking brings media of payment into existence. Unfortunately, many (I think we may say the great majority) of the writers of the early nineteenth century, did, to a large degree, regard these two functions of banking separately; and in this mode of treatment lay the source of a number of their errors.

The first notable experience of Western civilization with paper money began in 1690, with the emission of bills of credit by the colony of Massachusetts Bay. The problem at once arose of determining the economic significance of an increase in the quantity of media of payment, whether through the issue of government paper, or of bank notes. Not a few believed that a net addition

to existing capital was the result. To this was opposed the quantity theory, and among our own colonial writers appeared a number of sound thinkers, like Douglass, who urged that an increase in the quantity of units of currency but depreciates each unit, so that the enlarged circulation does no more work, and does it no more effectively than the smaller supply that previously obtained. The appearance of the modern type of bank note, issued in excess of reserves and yet convertible into specie on demand, gave the earlier view renewed popularity; but after 1825 the naïve doctrine, to which even Hamilton had fallen victim, that bank-note inflation signifies added capital, was quite thoroughly discountenanced.

Adam Smith, reasoning on the assumption that a given quantity of media of payment is necessary to effect the exchanges of each country, had held that bank notes do augment the nation's capital, in the sense that they displace a like amount of the precious metals from circulation, all of which, save what must be kept as reserves against the notes, is exported in exchange for other forms of wealth, chiefly productive capital. That banks secure this advantage, became, with some qualifications, quite generally accepted at about the time that the cruder doctrine confusing inflation and the creation of capital began to be abandoned. Even this more moderate view was rejected, however, by a relatively small group who insisted that the community exporting specie receives no compensation, thus recurring to something like the earlier simple opinion that the use of bank notes is harmful in that it causes the expulsion of gold and silver. Smith's thesis was opposed also by those who asserted that bank notes are even more costly than metallic money, since many large establishments are needed to issue them. In its least tenable form this objection emphasized the cost in the form of interest paid for the loans through which the notes are put into circulation. It was frequently complained, furthermore, that this cost is increased by the fact that banks make loans in excess of the amount of money they actually possess, thus imposing a larger interest charge upon the community, while depreciation of the

monetary standard prevents the enlarged circulation from doing any additional work.1

That banks furnish an inexpensive substitute for metallic currency, as explained by Smith, was, however, one of the major advantages most frequently ascribed to them after 1825. But Smith's doctrine was based on the belief that any tendency of bank notes to become excessive in quantity would immediately bring about a readjusting specie outflow. Not all were ready to concede this. Many thought that serious price disturbances took place before the redundant currency was drained off. Banks thus provided an inexpensive currency, but one that fluctuated in value.

Smith had dealt with this contention himself, and had maintained that convertibility precludes the possibility of a bank-note currency becoming excessive. This view, adopted by the Bullionists of England, received rather little support in America. Convertibility, it was commonly thought, does indeed prevent a permanent excess of bank notes, but not a temporary one. And this excess, even though short-lived, may be very considerable. A number of writers observed that, when the corrective export of specie occurs, the banks, in order to sustain their reserve ratio, must contract their note issue by several times the amount of the loss of specie, thus multiplying the depressing effect of a gold outflow.

Another theory, likewise transplanted from England, was that bank notes cannot be overissued because they are emitted only in response to the demands of trade. So sweeping a thesis had little support; but the more modest claim that bank notes do not admit of overissue if emitted only against real commercial paper (as distinguished from accommodation bills) was rather widely accepted. A few writers recognized, however, that the needs of trade, as indicated by the volume of bills of exchange offered for discount, may themselves become unhealthily inflated as the result of a rising price level.

The votaries of the theory that the quantity of bank notes is

1 This reasoning involved the fallacy of overlooking the fact that the interest itself is paid in the depreciated currency.

UNIV.

automatically regulated by the requirements of business generally meant thereby that the currency is thus made to vary in amount exactly as it would were it entirely metallic.1 There were a few, however, who saw that the ebb and flow of modern commerce call for a more elastic currency. In this respect, they held, a mixed currency of bank notes and specie is better than one composed of specie alone. Yet the verdict of an overwhelming majority was that the ideal norm is that of a metallic currency, and that neither their convertibility, nor the manner in which they are issued, prevents a currency of which bank notes compose a part from deviating from this standard. In part the prevalence of this view may be attributed to the fact that accommodation loans figured largely in American banking practice, and in part to the obstacles in the way of the prompt redemption of bank notes. Even Gallatin, a sane and friendly critic of banking, was inclined to think that the use of bank notes, because of their fluctuating character, is attended by a net disadvantage.

On the currency side, then, banking was credited by most of the writers with offering an economical substitute for coins of the precious metals, and to this advantage a half-dozen writers added that of introducing a desirable elasticity into the media of payment. Against this was placed the disadvantage of a fluctuating monetary standard.

With respect to those aspects of banking that have to do with the provision of general media of payment, the most important and most wholesome influence was exerted by the doctrine that bank-note inflation merely raises prices. With respect to banking as the source of loans to business men, the influence of the quantity theory was to hamper the development of sound principles. Even to the end of the period but few freed themselves from the notion, illogically derived from the quantity theory, that banks can lend to their customers only so much effective purchasing

1 The doctrine that a currency composed of both paper and specie should at all times correspond in quantity to one wholly metallic is often denominated the currency principle. (E. g., see Palgrave's Dictionary, i, 472.) But not all the disciples of the banking principle would have dissented; the two schools differed mainly in their opinion as to the need of regulation to achieve the desired end.

TO VIMU

power as they receive from stockholders and depositors. If they lend any more monetary units than they have thus taken in, they are returning into circulation more than they withdrew from it, and the sole result (if we neglect the confusion attending the transition) is a depreciation of each unit, which restores the purchasing power of the aggregate of media of payment to its former level. Time after time it was reiterated that the only important advantages which banking confers are those of providing a substitute for costly gold and silver currency, and of gathering idle surpluses of cash and placing them at the disposal of those who can give them active employment. That the reasoning underlying each of these two views is inconsistent with that of the other has already been suggested.1

In reasoning, on the basis of the quantity theory, that banks cannot lend more than they have received from depositors,2 the early writers passed incautiously from the way in which banks make loans to individuals to the way in which they provide a general circulating medium. They failed to give adequate attention to the mechanism through which media of payment are furnished. They assumed that the added media of payment brought into existence when the bank expands its loans are diffused throughout the channels of circulation, but virtually neg

1 See Chapter VIII. The alleged advantages and disadvantages of banking might conveniently be divided into two groups according to whether they deal with the influence of banks upon prices, or with their relation to the effective supply of capital in the country. The three major views on the effect of banks upon prices have already been given; namely, that bank currency causes price fluctuations; that either convertibility or the manner in which they are issued prevents bank notes from deviating from the norm of a metallic currency; and, thirdly, that bank notes improve upon a purely metallic medium of payment by introducing a desirable type of elasticity. The ways in which banks were said to increase the effective supply of capital in a country were also three in number. First came the naïve notion that confuses an increase in the amount of media of payment with that of wealth itself. This was superseded by the doctrine that banks provide an inexpensive substitute for costly currency of gold and silver, thereby, to all intents and purposes, increasing the nation's wealth to a like extent. And, finally, banks were said to gather surpluses of capital, temporarily idle in the hands of their owners, and place them at the disposition of those who can employ them productively.

2 For simplicity in exposition we may here regard stockholders as permanent depositors.