Chapter XXIV: Credit--Bank Assets and Bank Reserves (2)

This is, in general, true throughout the world,[557] where banking is highly developed. A country which has expanding business, based on rising values of goods and rising capital values of anticipated incomes, which in turn grow out of increasing business confidence, etc., and out of the development of new enterprises which make readjustment necessary, expands its bank-credit to meet the situation. Expanding bank-credits in time grow so large that bankers feel larger cash reserves to be desirable. Their reserves may be also, in some measure, drawn upon by the growing retail trade and wage-payments, which call for more money in circulation. They meet the situation by raising money-rates. This tends to prevent the exportation of gold, and tends to encourage the importation of gold, which finds its way into bank reserves. Banks may even borrow directly from banks in other countries, to get the gold they need, or to prevent the exportation of the gold they have. The higher money-rates, also, tend to check marginal borrowing--the borrowing by those who see only very small profits to be made by the use of the bank-credit they borrow. If the rising values of goods, however, and the profits to be made by effecting exchanges, speculative and other, are large, the volume of bank-credit will, none the less, grow. If the tide of rising business confidence is strong, the banks will be disposed to accept securities and rights as collateral which they would distrust at other times. A very big difference indeed may appear between bank reserves in active times and bank reserves in dull times. The banks need less reserves in proportion to deposits in active times, because the very activity itself increases the liquidity, the saleability, of their paper assets, and so makes actual cash less necessary. Even in this country, the practice of counting deposits in other banks as reserve is well developed. This is not only true of country banks, or banks outside the reserve cities. It has been, in considerable degree, the practice of the big trust companies in New York City. It is the practice of private bankers connected with the stock exchanges, and the practice of brokers, who are, for many purposes, bankers, especially those who allow their customers to check on their accounts. Such houses may carry no cash at all. One, with whose workings the writer is somewhat familiar, makes the rule--"We pay by check and receive only checks." None the less, this house allows its customers to check upon it, and checks drawn on it perform all the functions of checks drawn on banks which keep a cash reserve. Of course, our new Federal Reserve system is built, in part, on the principle of collecting reserves in central reservoirs, and our banks will doubtless increase the practice of counting deposits with other banks as reserve.[558] They will feel the need for less reserves, also, with a wider rediscount market.

_Within a given country_, I think that we may safely generalize the doctrine that the causal relation between reserves and deposits is exactly the reverse of that asserted by the quantity theory, within very wide limits indeed. That is to say, increasing reserves are a _result_, and not a _cause_, of increasing loans and deposits. We shall further hold that the relation between them instead of being definite, is highly flexible. This is not to assert that reserves may not increase without a prior increase in loans and deposits. That has happened in the United States during the present War. It does mean, however, that increasing loans and deposits will pull gold into a country, and that increasing reserves do not force increasing deposits and loans.[559] If a country's business is growing, if that business is soundly based, so that expectations are being met, obligations being paid out of the income which arrives, on schedule time, to meet anticipations, there need be no effective check to the amount of gold that will come into the country to serve as reserves, within limits that are rarely reached. It is miscalculation, maladjustment of costs and prices in particular enterprises, failure of "interstitial adjustments," especially failure of particular crucial links in the business chain, as the businesses engaged in producing iron and steel, to respond to the needs of other expanding businesses, that check movements of expansion in business, not inadequacies of bank reserves.[560] As long as only wise plans are made, as long as they meet no mishaps, as long as the carrying out of the new plans does not itself so change the facts on which the calculations of business men have been based as to cut under anticipated profits, so long may business, within a given country, expand without danger from inadequate reserves. Of course, if the whole world is simultaneously expanding, the competition for gold in the international money markets may be so severe that all may be hampered.

That reserves will increase, as expanding credit, due to increasing business or rising prices, requires increased reserves, can hardly be disputed, I think, if we look at a country of small size, or (what is the same thing from the angle of economic analysis, so far as the present problem is concerned) if we take a particular part of a country. Seasonal movements of cash for reserves in this country have been obviously determined by the movements of credit, rather than the reverse. Expanding business at crop moving seasons, requiring advances of credit by country banks, and an unusual drain on the cash resources of the country banks, has regularly meant that the country banks draw cash from the New York banks. When the need for such cash in the country banks passes, when they can no longer employ it to advantage at home, they send it back to New York. New York, to meet the emergency caused by the withdrawal of cash, draws to a considerable extent on Europe for gold. It is not as easy for New York to get gold quickly from Europe as it is for France to get gold in an emergency from England. More time is required. Inelasticity, too, in the forms of currency most needed for small transactions, has made very real difficulties for us. But that, within the country, the sections whose business and credit were expanding take cash reserves from those sections where credit is less urgently demanded, needs no debating. This is seasonal. But the same thing is true in the long run. As business and bank-credit have expanded, year by year, in Oklahoma, Oklahoma's cash reserves have grown. Bank-credit in a country cannot go on indefinitely mounting, if bankers are making unsound loans, if the values on which the loans rest are based on vain imaginings, if anticipated profits are not realized. But if a country have rich resources and intelligent entrepreneurs, with sagacious bankers who can discriminate between sound and unsound business, it may, within very wide limits indeed, expand its bank-credit without check from inadequate reserves, as its business expands, and as prices, particularly prices of lands and securities, rise.[561]

If the country in question be a very large country, however,--large in the sense that its business and volume of bank-credit are very large, and particularly in the sense that bankers' assets are of such character that a large volume of reserves is desirable--restraints on the process of expansion may come. Reserves will come in, but the resistance in stiffer money-rates will be felt. Bankers in other countries will compete with the bankers in the country in question for reserves. Rising money-rates will put an end to many marginal exchanges. They will lessen the saleability of many rights which might otherwise be available as banking collateral. The extension of bank-credit will feel a drag. There is large flexibility here. But, in a long run period of many years, the volume of gold in the world will impose a maximum limit upon the possibility of expansion of bank-credit in the world as a whole. This limit is doubtless never reached. Within the limit, the variations in the volume of the world's credit are primarily determined by the other concrete factors we have been discussing. Proportionality between the world's gold and the world's volume of credit does not at all obtain. Under certain conditions, much higher proportions of reserves to bank-credit will be found in a given country than at other times, and the same will be true in the world at large.

I would refer again to the discussion by J. M. Keynes, quoted in Part II.[562] Reserves have absorbed enormous quantities of gold, easily obtained as a consequence of abundant gold production, in the past fifteen years. Proportions of gold reserves to bank-credit have grown. In the preceding period, when gold production went on less rapidly than business development, percentages of reserves were lower. Most bankers feel better with large reserves. When they can get gold, they prefer gold to other substitutes. When they cannot easily get gold, they use other substitutes, of the various kinds of paper, particularly, which have been described. Gold differs from other things, in bankers' assets, in degree, rather than in kind. Instead, therefore, of the law of the proportionality of reserves to volume of bank-credit, I venture the generalization[563] that, as gold production increases rapidly, the tendency is for the proportion of gold reserves to volume of bank-credit to rise; with diminished gold production, the tendency is for the proportion of reserves to fall, assuming that the factors other than volume of gold production which make for expansion of business maintain themselves.

Increasing volume of gold tends to increase the volume of trade. But there are other causes for the increase or decrease of trade as well. These causes, working in harmony with rapidly expanding volume of gold, lead to a very rapid growth of trade.[564] Working in the face of a drag from less rapidly growing gold supply, they strain the possibilities of bank-credit expansion. Various substitutes for gold in bank reserves are employed. Substitutes in the form of other forms of credit are employed. Barter is resorted to increasingly. Methods of employing other things than gold in the retail trade of a country are resorted to. "Gold-exchange" standards are devised. Countries "wait their turns " to come on the gold standard. Cooeperation, not only within countries, but among countries, seeks to economize the scanty stock of the precious metal. Very large slack is thus revealed. But the expansion of business is checked, the volume of business confidence is reduced, the values of future incomes in enterprises is lowered, production is checked, and prices are reduced, (a) because the value of money rises; and (b) because the values of goods and income-bearers is reduced. The exchange side of production is hampered. Substitutes for gold, through increased activities of bankers and other agents of exchange, are costly. Greater tolls on values are taken by those who handle the mechanism of exchange. It does make a difference whether or not the world's gold is abundant! But the difference is not made solely, or even mainly, in the price-level.[565]

The reserve function of money is essentially a _dynamic_ function. The reserve function is merely a phase of the bearer of options function.[566] It is the practice of quantity theorists to speak of "normal" ratios between reserves and deposits (or reserves and demand liabilities), and to speak of the "static" laws governing this relation. This in true of Kemmerer, of Fisher, of A. P. Andrew, and, in general, of contemporary quantity theorists. Kemmerer very explicitly puts it as a matter of static theory, "If we divide the money of the country into two parts; one, that used directly in daily cash transactions, and the other, that kept in banks as reserves, it may be said that, _under perfectly static conditions_ [italics mine], the proportion of the total represented by each of these parts would be constant. Each banker would find from experience what proportion of reserve to liabilities it was advisable for him to maintain, and would order his business, as far as possible, so that his reserve would neither exceed nor fall below that most desirable proportion."[567] Kemmerer quotes the following passage from A. P. Andrew: "In the long run, _as apart from cyclic oscillations_, the quantity of bank-credit is governed by the quantity of money."[568] Fisher's view we have considered at length in Part II. It is essentially the same. He is working with the statics of the problem of money and credit. These different writers differ greatly in the extent to which they would insist on the validity of their static tendency in real life. Professor Fisher, as we have seen, is exceedingly uncompromising, holding tenaciously to his principle as subject only to slight modification during transition periods. Professor Kemmerer, in the chapter from which the quotation just given is taken, gives an important realistic analysis of dynamic conditions and makes liberal concessions to the view that the ratio is no constant in real life.[569] Professor Taussig, whose view was summarized at length in chapter IX, finds, in real life, so many exceptions to the doctrine of proportionality of reserves and deposits that he virtually abandons that doctrine. What I wish to insist on here, however, is that there are no static laws _possible_ in this connection. The reserve function is a dynamic function. The theory of reserves must rest in an analysis of friction, of transitions, of dynamic uncertainty and dynamic change. It is a part of the general theory of liquidity of bank assets, of saleability of rights, and the like. If one can find a "normal" amount of dynamic change, a "normal" amount of uncertainty, a norm for the coming of technical inventions, a normal prospect of war, a normal rate of gold production, a normal rate of growth for population, a normal amount of Jew-baiting in Russia, with a norm for migration, and if one can hold these norms, and a multitude of similar norms, in fixed relation to one another, one might have justification for speaking of a "normal ratio" of bank reserves to bank demand liabilities!

Apart from dynamic changes, from frictional elements which create uncertainties, in general, apart from uncertainty and irregularity and lack of "normality," there would be no occasion for bank reserves at all! To the extent that static conditions are realized, bank cash reserves may be, and _are_, dispensed with. It is well known that England gets along with surprisingly little gold. The total stock in the country has been smaller than the gold reserve of the Banque de France, and much of the gold in England was in use among the people, since small paper money (before the War) was not in use in England. The gold reserve of the Bank of England has been usually only a fraction of that of the Banque de France. Some years since, the distribution of gold as between England and the United States, was, roughly, England six hundred million dollars, the United States, one billion, six hundred million. A larger proportion of gold was in reserves in the United States than in England. Yet England was doing the banking business of the world, while we had trouble in doing our own! The Bank of England carries virtually the only reserve in the country. The Joint Stock Banks, with demand liabilities vastly in excess of the demand liabilities of the Bank of England, carry only "till money" in cash or Bank of England notes, and for the rest, carry as their "reserve" their deposit credits with the Bank. A great deal of criticism, from Bagehot down (to go no further back) has been directed at the "inadequacy" of English banking reserves, and many dire predictions have been made as to the dangers that impended unless the reserves were increased. We shall probably hear less of this after the War! The Bank of England still stands! It has never failed to pay out gold over its counters, even though it has, with the aid of the government, doubtless restricted and controlled foreign shipments of gold. But it has met the unprecedented emergency better than any other bank in Europe, and to-day (Sept. 1916) is in exceedingly good shape. Sterling exchange at New York seems "pegged" at the "lower gold point," and apprehensions regarding the stability of the English financial system seem definitely allayed. It is aside from our present purpose to discuss war time conditions. I am rather interested in analyzing the features of the English money market which have made it possible, in the period preceding the War, for English bankers to get on with so little gold. As will appear, it is because English business and financial affairs have been more nearly "static," have come nearer to realizing the assumptions of static economic theory, than is true of any other country on earth.

The very fact, for one thing, that England is the great _international_ banker has meant a scattering of risks. Acute panics do not come in all countries on the same date. Bad business in one country may be offset by good business in another; drains of gold to one country may be met with gold flowing in from others. The same considerations which tend to stabilize the railroad business, as compared with, say, cotton-growing, apply to the international banker as compared with the banks of a single country or section. But further, the London market has developed cooeperating agencies for smoothing out friction and eliminating uncertainties to a degree unknown anywhere else. An anonymous writer in _The Americas_ for April, 1916,[570] has given an exceedingly interesting account of this organization of the London market,--the product of the development of generations. Let us enumerate some of the points: There is nowhere in the world so much expert judgment in the grading and evaluating of hundreds of commodities from all parts of the world. There is, coupled with this, a worldwide reputation for the experts of absolute integrity, so that producers in remote countries regularly ship ("consign") to London cargoes without definite arrangements, knowing that there are in London organized facilities by which the commodities are warehoused, expertly and fairly judged, and either sold at once or else made the basis of a collateral loan against which they can draw immediately. The institutions which make this possible are (a) the system of warehousing, with its certificates or warrants which give absolute title to the goods, and which are easily negotiable; (b) the organized arrangements in connection with the warehouses by which commodities are received and either graded as they are, or separated and mixed with others to form standard blends readily marketable--this with rigid integrity and expertness which the whole world trusts; (c) a speculative community which has unlimited banking credit, ready to buy at a concession in price virtually any commodity--honey in the comb, sealing wax, pianos, farm machinery, what not; (d) the organized markets or periodical auctions which speculation and final purchase together support; (e) the banks, which, relying on the standardization of the commodities and the readiness of the speculative community, can without hesitation lend the money on which the distant shipper is relying to conduct his business.

What comes to London is fluid. Everything comes to London! The multiplicity of items dealt in gives stability to that business which deals with all--the banking business. The London Stock Exchange is no provincial affair, easily demoralized by an adverse rate decision! Securities of every country on earth are listed there, and speculated in. It must be a world catastrophe which really demoralizes the London stock market!

It will doubtless seem strange to many to say that New York cannot displace London as the centre of world finance, that the dollar cannot displace the pound sterling in financing international trade, because New Yorkers do not speculate enough! They do speculate enormously, but not in many things. A restricted list of stock exchange securities--almost wholly American; cotton--in which New York is the world centre; coffee, in which New York has the largest volume of speculative futures, though yielding precedence, ordinarily, to Havre, Hamburg and Santos[571] in spot transactions. There is extensive sugar speculation at the New York Coffee Exchange, which has, indeed, recently changed its name to indicate the fact. There is a produce exchange in New York, but it is a very small affair as compared with the Chicago Board of Trade, and its operations and scope are infinitesimal when compared with the produce speculation in London. Of course, there is a vast deal of _unorganized_ speculation in many things in New York, as in business everywhere, particularly in America. But, while the pecuniary magnitudes of organized speculation in New York are very great, the range of items dealt in is restricted. New York banks cannot possibly get such a variety of collateral, based on standardized and readily marketable goods and securities, as can London. New York, consequently, cannot finance international trade, save as an auxiliary to London--and New York banks must have vastly more gold in their vaults than London bankers need! As goods and securities become _more_ marketable, gold--whose services are needed because of its _superior_ marketability--becomes _less_ necessary.

The whole story of London's organization would be a long one. London financial institutions have a degree of expertness, growing out of specialization, in large part, which makes all manner of paper fluid in the London money market which would lack fluidity in New York. The Acceptance Houses are a sort of international Bradstreet and Dun. They know intimately the standing and business of houses all over the world. They do not give out their information, but they do put their stamp on the paper of business houses, thus standardizing it, lending, not money, but "pure credit," while the other banks, relieved of the necessity of investigating the paper, can buy it as a miller might buy No. 1 wheat. There is the extraordinary extension of insurance, so that virtually any kind of risk may be shifted to those well able to bear it. All this makes for liquidity, for "static" conditions in the money market, and dispenses with the need for gold.

As we approach static conditions, we need less and less gold reserve behind bank demand liabilities. _The static law of bank reserves is that none are needed!_ I think we have here the real reason why writers who have sought to give us the law for a "normal" ratio have given us such vague phrases as "shown by experience to be necessary," and the like. When irregularity of income and outgo in a bank's business, non-liquid assets, business cycles, uncertainties, legislative changes affecting business, crop failures, changes in demand, new inventions, wars, are abstracted from, no reason can be given why a banker should keep any reserve at all! But these things are dynamic things. And it is characteristic of irregularities that they are irregular. To get a "normal" ratio out of them is not easy.

On the static assumptions, an "ideal credit economy" is perfectly possible. If everything that needs to be marketed is perfectly marketable, if the stream of business flows regularly and without friction in the same channels, if all contingencies are foreseen and dated in advance, a bank needs no cash reserve. All payments can be made by bank-credit. Banks bookkeeping becomes merely a refinement of barter, with _money_ remaining as a measure of values, a unit for reckoning, but not being used as a medium of exchange, or as a bearer of options, or in reserves. The measure of values function is the great static function of money.

To the extent that static assumptions are not realized, we need money in bank reserves. This extent is a thing that varies from time to time, and from place to place. It is not the same for a given place from time to time, nor is it the same at all places at a given time. It is not the same for the whole world from time to time.

Since friction, preventing the free marketing of goods and securities and services, exists, since there are dynamic changes which require readjustments through exchanges, we need the work of the banker and he needs cash. But there are other things than money which make for the "statification" of the market. The speculator does it. And the other agencies of the sort represented in the London market do it. They are substitutes for gold. Gold has no monopoly. The services performed by gold can be performed in many other ways, and by many other agencies. There is enormous flexibility in the matter.